Fin 404 exam 2 review

Identify the four major parts to profitability analysis

Analysis of revenue, analysis of income statement, analysis of balance sheet, analysis of statement of cash flows

Define cash and net cash flows and describe its relevance

Cash is the residual balance from cash inflows less cash outflows for all prior periods of a company. Net cash flows, or simply cash flows, refer to the current period's cash inflows less cash outflows. Cash flow measures recognize inflows when cash is received but not necessarily earned, and they recognize outflows when cash is paid but the expenses not necessarily incurred. Relevance: Cash is the most liquid of assets and offers a company both liquidity and flexibility. It is both the beginning and the end of a company's operating cycle.

Define financial analysis

Financial analysis is the use of financial statements to analyze a company's financial position and performance, and to assess future financial performance.

Define free cash flows

Free cash flow is the cash remaining after providing for commitments necessary to maintain operations at current levels. These commitments include a company's continuing operations, interest payments, income taxes, net capital expenditures, and dividends. FCF = NOPAT - Change in NOA. This definition defines free cash flows to the firm as net operating profits after tax (NOPAT) less the increase in net operating assets (NOA). (Positive free cash flow reflects the amount available for business activities after allowances for financing and investing requirements to maintain productive capacity at current levels.) (A negative free cash flow implies a company must either sell assets or acquire financing (debt or equity) to maintain current operations.)

What are the goals of profitability analysis?

Profitability analysis is a component of enterprise resource planning (ERP) that allows administrators to forecast the profitability of a proposal or optimize the profitability of an existing project.

Calculate RNOA and ROCE

RNOA = NOPAT / NOA ROCE = NI - Preferred Dividends/Avg. Common Equity

Compare and contrast the effects of ROIC, given the two measures of invested capital

RNOA = NOPAT / NOA - analyzing a company along this operating/nonoperating dimension, with RNOA as the summary measure of performance - ROCE = NI - Preferred Dividends/Avg. Common Equity CE = Shareholders Equity - Preferred Stock OR Total Assets - (Debt + Preferred Stock)

Define income for each of the two measures of invested capital.

RNOA: The appropriate income measure to compare with net operating assets is net operating income after tax (NOPAT), which equals revenues less operating expenses such as cost of goods sold, SG&A expenses, and taxes (NOPAT excludes investment income and interest expense). ROCE: the numerator (net income) is impacted by the amount of interest expense that the company must pay on its debt.

Define return on invested capital. (ROIC)

Return on invested capital refers to a company's earnings relative to both the level and source of financing. It is a measure of a company's success in using financing to generate profits. Income / Invested Capital

What is the purpose of the Statement of Cash Flows?

This statement is important to analysis and provides information to help users address questions such as these: a) How much cash is generated from or used in operations? b) What expenditures are made with cash from operations? c) How are dividends paid when confronting an operating loss? d) What is the source of cash for debt payments? e) How is the increase in investments financed? f) What is the source of cash for new plant assets? g) Why is cash lower when income increased? h) What is the use of cash received from new financing? The statement of cash flows reports cash receipts and cash payments by operating, financing, and investing activities—the primary business activities of a company. Cash flow measures are increasingly used for credit analysis, bankruptcy prediction, assigning loan terms, earnings quality assessments, solvency forecasts, and setting dividend and expansion policies.

Compare and contrast the indirect and direct methods of reporting operating cash flows.

With the indirect method, net income is adjusted for noncash income (expense) items and accruals to yield cash flows from operations. An advantage of this method is the disclosure of a reconciliation of differences between net income and operating cash flows. This can aid some users that predict cash flows by first predicting income and then adjusting income for leads and lags between income and cash flows— that is, using the noncash accruals. The indirect method is most commonly employed in practice and we use it initially to illustrate preparation of the statement of cash flows. The direct method is provided subsequently for comparison. This method adjusts each income item for its related accruals and, arguably, provides a better format to assess the amount of operating cash inflows (outflows). The format for computing net cash provided by investing and financing activities is the same for both methods. Only the preparation of net cash flows from operations differs.

Describe the process of analyzing expenses.

• Analyze the financial statements and the standing of the company

Define and interpret the importance of capital structure.

• Capital structure refers to a company's sources of financing and its economic attributes. Financing can range from relatively permanent equity capital to more risky or temporary short-term financing sources.

What does the term earnings power refer to?

• Earning power refers to the earnings level for a company that is expected to persist into the foreseeable future. With few exceptions, earning power is recognized as a primary factor in company valuation. Accounting-based valuation models include the capitalization of earning power, where capitalization involves using a factor or multiplier reflecting the cost of capital and its future expected risks and returns. Many analyses of earnings and financial statements are aimed at determining earning power.

Explain earnings coverage and earnings coverage ratios.

• Earnings coverage measures focus on the relation between debt-related fixed charges and a company's earnings available to meet these charges. These measures are important factors in debt ratings • If one objective of an earnings coverage ratio is to measure a creditor's maximum exposure to risk, an appropriate earnings figure is one that occurs at the low point of the company's business cycle. • If there are two or more preferred issues outstanding, the coverage ratio is usually computed for each issue by omitting dividend requirements of junior issues and including all prior fixed charges and senior issues of preferred dividends.

What is earnings management and income smoothing

• Earnings management is the use of accounting techniques to produce financial reports that may paint an overly positive picture of a company's business activities and financial position. • Earnings management, variability, trends, and incentives are all potential determinants of earnings persistence. We also should assess earnings persistence over both the business cycle and the long run. • Probably one major motivation of earnings management is to affect earnings trends. Earnings management practices assume earnings trends are important for valuation. • Income smoothing is a common form of earnings management under this strategy, managers' decrease or increase reported income so as to reduce its volatility. Can imply more stability and predictability than present in the underlying characteristics.

Identify and discuss the three primary assessments of cash. (Liquidity, Solvency, and Financial flexibility)

Liquidity is the nearness to cash of assets and liabilities. Cash flow from operations focuses on the liquidity aspect of operations. (Operating cash flow is useful for evaluating and projecting both short-term liquidity and longer-term solvency.) Solvency is the ability to pay liabilities when they mature. Financial flexibility is the ability to react and adjust to opportunities and adversities

Identify the two measures of invested capital.

1) Return on Net Operating Assets (RNOA) 2) Return on Common Equity (ROCE)

Describe the Two-Phase analysis of income.

1. Analysis of accounting & its measurements 2. Applying analysis tools to income (2 its components) & interpreting the analytical resume

Define the terms earnings persistence, equity valuation, and earnings forecasting.

1. Earning persistence is broadly defined to include the stability, predictability, variability and trend in earning. We consider earning management as a determinant of persistence. 2. Equity valuation analysis emphasizes earning and other accounting measures for computing company value. 3. Earning forecasting considers earning power, estimation techniques, and monitoring mechanisms.

Identify the ten steps in the projection of the balance sheet.

1. Project current assets other than cash, using projected sales or cost of goods sold and appropriate turnover ratios as described below. 2. Project PP&E increases with capital expenditures estimate derived from historical trends or information obtained in the MD&A section of the annual report. 3. Project current liabilities other than debt, using projected sales or cost of goods sold and appropriate turnover ratios as described below. 4. Obtain current maturities of long-term debt from the long-term debt footnote. 5. Assume other short-term indebtedness is unchanged from prior year balance unless they have exhibited noticeable trends. 6. Assume initial long-term debt balance is equal to the prior period long-term debt less current maturities from (4) above. 7. Assume other long-term obligations are equal to the prior year's balance unless they have exhibited noticeable trends. 8. Assume initial estimate of common stock is equal to the prior year's balance. 9. Assume retained earnings are equal to the prior year's balance plus (minus) net profit (loss) and less expected dividends. 10. Assume other equity accounts are equal to the prior year's balance unless they have exhibited noticeable trends.

Identify and explain financial leverage ratios.

Debt ratio = TL /TA : the percentage of a company's assets that are provided via debt. Equity ratio = 1 - Debt ratio : measures the proportion of the total assets that are financed by stockholders, as opposed to creditors. Debt-Equity ratio = TD / TE : how much debt a company is using to finance its assets relative to the amount of value represented in shareholders' equity. Equity Multiplier = TA / TE : what % of assets is financed with equity. Times Interest Earned = EBIT / Interest : can they meet interest payments?

Discuss the importance of return on invested capital.

The relation between income and invested capital, referred to as return on invested capital (ROIC) or return on investment (ROI), is probably the most widely recognized measure of company performance. It allows us to compare companies on their success with invested capital. It also allows us to assess a company's return relative to its capital investment risk, and we can compare the ROIC to returns of alternative investments. a) Measure of Managerial Effectiveness: Management is responsible for a company's business activities. It makes financing, investing, and operating decisions. It selects actions, plans strategies, and executes plans. b) Measure of Profitability: ROIC is an important indicator of a company's long-term financial strength. It uses key summary measures from both the income statement (profits) and the balance sheet (financing) to assess profitability. It can effectively convey the return on invested capital from varying perspectives of different financing contributors (creditors and shareholders). c) Measure for Planning & Control: ROIC serves an important role in planning, budgeting, coordinating, evaluating, and controlling business activities. A well-managed company exercises control over returns achieved by each of its profit centers and rewards its managers on these results. In evaluating investing alternatives, management assesses performance relative to expected returns. Out of this assessment come strategic decisions and action plans for the company.

What are the three ways of reporting by activities?

The statement of cash flows reports cash receipts and cash payments by operating, financing, and investing activities—the primary business activities of a company. Operating activities are the earning-related activities of a company. Investing activities are means of acquiring and disposing of noncash assets. Financing activities are means of contributing, withdrawing, and servicing funds to support business activities.

Identify and discuss three possible external sources of change.

• Expected level of macroeconomic activity. Since Target customers' purchases are influenced by the level of personal disposable income, our analysis might incorporate estimates relating to the overall growth in the economy and the expected growth of retail sales in particular. For example, if the economy is in a cyclical upturn, we might be comfortable in projecting an increase in sales greater than that of the recent past. • The competitive landscape. Has the number of competitors increased? Or have weaker rivals' ceased operations? Changes in the competitive landscape will influence our projections of unit sales as well as Target's ability to raise prices. Both of these will impact top line growth. • New versus old store mix. New stores typically enjoy significantly greater sales increases than older stores since they may tap poorly served markets or provide a more up-to-date product mix than existing competitors. Older stores, by comparison, typically grow at the overall rate of growth in the local economy. Our analysis must consider, therefore, expansion plans announced by management.

Define the term financial leverage.

• Financial leverage is the use of debt to increase earnings. Leverage magnifies both managerial success (income) and failure (losses). Excessive debt limits management's initiative and flexibility for pursuing profitable opportunities. For creditors, increased equity capital os preferred as protection against losses from adversities

What statements are involved in prospective analysis?

• Includes forecasting of the balance sheet, income statement, and statement of cash flows

Describe the sources of earnings-based equity valuation.

• Income statement, continuing operations more in the

Identify and define the measures of liquidity.

• Liquidity refers to the availability of company resources to meet short-term cash requirements. A company's short-term liquidity risk is affected by the timing of cash inflows and outflows along with its prospects for future performance. Analysis of liquidity is aimed at companies' operating activities, their ability to generate profits from sale of products and services, and working capital requirements and measures. • Liquidity is the ability to convert assets into cash or to obtain cash to meet short-term obligations

Explain equity analysis and valuation.

• One task in equity analysis is to recast earnings and earnings components so that stable, normal, and continuing elements that constitute earnings are separated and distinguished from random, erratic, unusual, and nonrecurring elements. The latter elements require separate analytical treatment or investigation. Recasting also aims to identify elements included in current earnings that should more properly be included in the operating results of one or more prior periods.

Identify and discuss the four factors in measuring income.

• Profitability • Revenues ( when earned ) and expenses (when incurred) •

How is income defined in analyzing profitability?

• Profitability is measured with income and expenses. • An Income Statement is traditionally used to measure profitability of the business for the past accounting period. However, a "pro forma income statement" measures projected profitability of the business for the upcoming accounting period.

What is prospective analysis?

• Prospective analysis is the final step in the financial statement analysis process. It can be undertaken only after the historical financial statements have been properly adjusted to accurately reflect the economic performance of the company. • Prospective analysis is central to security valuation. Both the free cash flow and residual income valuation models require estimates of future financial statements.

Identify the four items of concern in analyzing revenues

• Revenue is the money a company receives during a particular financial period • Revenue is listed as revenue, sales, net sales or net revenue on the first line of a company's income statement.

Define the process of analyzing solvency

• Solvency refers to a company's long-run financial viability and its ability to cover long-term obligations. All business activities of a company-financing, investing, and operating-affect a company's solvency. One of the most important components of solvency analysis is the composition of a company's capital structure.

Identify and define the key concepts used to assess the creditworthiness.

• The bond credit rating is a composite expression of judgment about the creditworthiness of the bond issuer and the quality of the specific security being rated. • This judgment of creditworthiness is expressed in a series of symbols reflecting degrees of credit risk. Specifically, the top four rating grades from Standard & Poor's

Define sensitivity analysis.

• The projected financial statements are primarily based in expected relations between income statement and balance sheet accounts. • Sensitivity analysis is a way to predict the outcome of a decision if a situation turns out to be different compared to the key prediction(s). • A sensitivity analysis is a technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that will depend on one or more input variables, such as the effect that changes in interest rates will have on a bond's price.

Describe the process of analyzing cost of sales (and gross profit).

• To determine if the products and services it sells are generating adequate profit after paying expenses. • A company should take a look at the financial figures from previous years. If the gross margin was higher in past years, it may be necessary to make some business adjustments. For a business to maximize its profit, it needs to pay particular attention to its cost of sales.