Foundations of Finance and Accounting

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Foundations of Finance and Accounting

0.2 Finance quick Reference Guide

Basic Equations
The Accounting Equation Assets = Liabilities + Equity This equation tells us two things, 1) Assets (the things a business has to help it generate profit are either owned by the business (equity) or owed by the business (liabilities). 2) Financial Accounting is not concerned with revenues and profit. Its purpose is to keep accurate records of all financial transactions that have transpired.
The Financial Equation(s) Revenue = Price x Volume; Cost = Fixed + Variable; Income = Revenue – Cost The foundation of the Financial Equation is: Income = Revenue – Cost. However, in order to perform this equation, we must first calculate Revenue (Price x Volume) and Cost (Fixed + Variable). It is therefore the job of financial managers (and all management) to concern themselves with revenues, costs and profits. Though emphasis from department to department may vary, management must concern themselves with all three. Generally speaking, both revenues and profits must increase over the medium and long terms while costs most often must be maintained or decreased over the same period.
The Financial Statements
Balance Sheet Assets = Liabilities + Equity (a “snapshot” moment in time) A financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders.
Income Statement Income = Revenues – Cost (over a period of time) A financial statement that measures a company’s financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period, typically over a fiscal quarter or year.
Cash Flow Statement Cash in and out (over a period of time) and added to (or subtracted from) the opening cash value. Because public companies tend to use accrual accounting, the income statements they release each quarter may not necessarily reflect changes in their cash positions. This document provides aggregate data regarding all cash inflows a company receives from both its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given quarter.
Statement of Shareholders’ Equity Changes in equity due to such things as net income (or loss), sale (or repurchase) of stock and changes in asset values since the last reporting period. Also known as “equity” and “net worth”, the shareholders’ equity refers to the shareholders’ ownership interest in a company. It is comprises of Preferred stock, Additional contributed (paid-in) capital, Common stock, Retained earnings, Other items (such as valuation allowances)
Liquidity Ratios
Working Capital Ratio Current Assets / Current Liabilities The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient.Also known as “net working capital”.
Quick Ratio (Acid Test) (Current Assets – Inv) / Current Lliabilities An indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. For this reason, the ratio excludes inventories from current assets.The quick ratio measures the dollar amount of liquid assets available for each dollar of current liabilities. Thus, a quick ratio of 1.5 means that a company has $1.50 of liquid assets available to cover each $1 of current liabilities. The higher the quick ratio, the better the company’s liquidity position. Also known as the “acid-test ratio” or “quick assets ratio.”
Debt Ratios Total Debt / Total Assets The debt ratio is the ratio of total debt to total assets, expressed in percentage, and can be interpreted as the proportion of a company’s assets that are financed by debt.The higher this ratio, the more leveraged the company and the greater its financial risk. Debt ratios vary widely across industries.
Debt to Equity Ratio Total Liabilities / Shareholder’s Equity See Asset Management Ratios
Asset Turnover Ratios
Inventory Turnover Sales / Inventory or COGS / Ave Inventory or (12 months Cost of Revenue / (Inventories from current year + Inventories from prior year) / 2)) Although the first calculation is more frequently used, COGS (cost of goods sold) may be substituted because sales are recorded at market value, while inventories are usually recorded at cost. Also, average inventory may be used instead of the ending inventory level to minimize seasonal factors. This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall.
Accounts Receivable Collection Period Average Accounts Receivable /Average Daily Sales (also called days sales outstanding) measures the average number of days that accounts receivable are outstanding. Accounts receivable collection period measures the average number of days between sending invoices to customers and collecting payments from them. To calculate this ratio, the average accounts receivable are divided by the average daily sales in the period. The average accounts receivable can be determined by adding beginning accounts receivable to ending accounts receivable and dividing the result by two. The average daily sales can be determined by dividing the sales for the period (e.g., a year) by the number of days in the period (e.g., 365 days).
A/R Turnover (12 Months Net Sales / (Total Accounts Receivable from current year + Total Accounts Receivable from prior year) / 2)) Number of times per year that the A/R account turns over.
A/P Turnover (12 Months Cost of Revenue / (Total Accounts Payable from current year + Total Accounts Payable from prior year) / 2)) Number of times per year that the A/P account turns over.
Inventory to Cash Days Average accounts receivable days + average inventory days where accounts receivable days is 365 days divided by accounts receivable turnover, and inventory days is 365 divided by inventory turnover. Inventory to cash days calculates the total average days from receiving inventory to receiving cash for its sale. Thus, this metric adds average days in inventory to average days of accounts receivable to arrive at a final number (of days) that combines the two.
Profitability Ratios
Return on Equity (ROE) Net Profit / Total Equity The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.
Return on Assets (ROA) Net Profit / Total Assets The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment. For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit. When you really think about it, management’s most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.
ROCE (Return on Capital Employed) ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed (Assets – Current Liabilities) A financial ratio that measures a company’s profitability and the efficiency with which its capital is employed.Instead of using capital employed at an arbitrary point in time, analysts and investors often calculate ROCE based on “Average Capital Employed,” which takes the average of opening and closing capital employed for the time period
Return on Investment (ROI) Gain from Investment – Cost of Investment / Cost of Investment Keep in mind that the calculation for return on investment and, therefore the definition, can be modified to suit the situation -it all depends on what you include as returns and costs. The definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one “right” calculation. For example, a marketer may compare two different products by dividing the gross profit that each product has generated by its respective marketing expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by the total value of all resources that have been employed to make and sell the product.
Net Profit Margin Net Income / Revenues or Net Profits / Sales Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.
Sales Growth % ((Total Revenue for the current period / Total Revenue for the last period) – 1) x 100 Yields period to period sales growth
Gross Profit Growth % ((Gross Profit for the current period / Gross Profit for the last period) – 1) x 100 Yields period to period gross profit growth
Operating Income Growth ((Operating Income for the current period / Operating Income for the last period) – 1) x 100 Yields period to period operating income growth
Break Even Analysis
Break Even Analysis in Units Break Even Analysis in Sales $ Fixed Cost / Contribution per Unit (i.e. Price -Variable Cost) Fixed Cost/ (Contribution/Price) Break-even analysis is used to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point. Break-even analysis is a supply-side analysis; it only analyzes the costs of the sales. It does not analyze how demand may be affected at different price levels.
Asset Management Ratios
Debt Ratio Total Debt / Total Assets A financial ratio that measures the extent of a company’s or consumer’s leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed in percentage, and can be interpreted as the proportion of a company’s assets that are financed by debt.The higher this ratio, the more leveraged the company and the greater its financial risk. Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and pipelines having much higher debt ratios than other industries like technology. In the consumer lending and mortgage businesses, debt ratio is defined as the ratio of total debt service obligations to gross annual income.
Debt to Equity Ratio Total Liabilities / Shareholder’s Equity The debt-equity ratio is another leverage ratio that compares a company’s total liabilities to its total shareholders’ equity. This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed. To a large degree, the debt-equity ratio provides another vantage point on a company’s leverage position, in this case, comparing total liabilities to shareholders’ equity, as opposed to total assets in the debt ratio. Similar to the debt ratio, a lower the percentage means that a company is using less leverage and has a stronger equity position.
Gross Margin to Net Sales % (Gross Profit / Net Sales) x 100 Expresses Gross Margin as a percentage of Net Sales
Expenses to Revenues (Expenses / Revenues) x 100 This ratio can be performed for total expenses or for a specific expense account
Expenses to Net Sales % (Expenses / Net Sales) x 100 This ratio can be performed for total expenses or for a specific expense account
The DuPont Pyramid
DuPont Pyramid Profit Margin = Profit/Sales Total Asset Turnover = Sales/Assets Equity Multiplier = Assets/Equity DuPont analysis tells us that ROE is affected by three things: 1) Operating efficiency, which is measured by profit margin 2) Asset use efficiency, which is measured by total asset turnover 3) Financial leverage, which is measured by the equity multiplier
Profit Margin = Profit / Sales Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.
Total Asset Turnover = Sales /Assets The amount of sales or revenues generated per dollar of assets. The Asset Turnover ratio is an indicator of the efficiency with which a company is deploying its assets.Generally speaking, the higher the ratio, the better it is, since it implies the company is generating more revenues per dollar of assets. But since this ratio varies widely from one industry to the next, comparisons are only meaningful when they are made for different companies in the same sector.
Equity Multiplier = Assets / Equity The ratio of a company’s total assets to its stockholder’s equity. The equity multiplier is a measurement of a company’s financial leverage. Companies finance the purchase of assets either through equity or debt, so a high equity multiplier indicates that a larger portion of asset financing is being done through debt. The multiplier is a variation of the debt ratio. The ratio is calculated fairly simply. For example, a company has assets valued at $3 billion and stockholder equity of $1 billion. The equity multiplier value would be 3.0 ($3 billion / $1 billion), meaning that one third of a company’s assets are financed by equity.
Company/Investment Valuation
Earnings Per Share (EPS) Net Income – Dividends on Preferred Stock / Average Outstanding Shares The portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio. For example, assume that a company has a net income of $25 million. If the company pays out $1 million in preferred dividends and has 10 million shares for half of the year and 15 million shares for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from the net income to get $24 million, then a weighted average is taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).
Dividend Per Share (DPS) Dividend (- Special Dividends) / Number of Shares Outstanding The the sum of declared dividends for every ordinary share issued. Dividend per share (DPS) is the total dividends paid out over an entire year (including interim dividends but not including special dividends) divided by the number of outstanding ordinary shares issued. Dividends per share are usually easily found on quote pages as the dividend paid in the most recent quarter which is then used to calculate the dividend yield. Dividends over the entire year (not including any special dividends) must be added together for a proper calculation of DPS, including interim dividends. Special dividends are dividends which are only expected to be issued once so are not included. The total number of ordinary shares outstanding is sometimes calculated using the weighted average over the reporting period. For example: ABC company paid a total of $237,000 in dividends over the last year of which there was a special one time dividend totalling $59,250. ABC has 2 million shares outstanding so its DPS would be ($237,000-$59,250)/2,000,000 = $0.0889 per share.
Price Earning Ratio (P/E Ratio) Market Value Per Share / Earnings Per Share A valuation ratio of a company’s current share price compared to its per-share earnings. For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.The P/E is sometimes referred to as the “multiple”, because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.The average market P/E ratio is 20-25 times earnings.
Net Present Value (NPV) (Excel Function) The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. Determining the value of a project is challenging because there are different ways to measure the value of future cash flows. Because of the time value of money, a dollar earned in the future won’t be worth as much as one earned today. The discount rate in the NPV formula is a way to account for this. Companies have different ways of identifying the discount rate, although a common method is using the expected return of other investment choices with a similar level of risk.
Internal Rate of Return (IRR) (Excel Function) The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project’s internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can’t find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.
Weighted Average Cost of Capital (WACC)
Weighted Average Cost of Capital (WACC) A calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources – common stock, preferred stock, bonds and any other long-term debt – are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.
Where:
Re = cost of equity Rd = cost of debt E = market value of firm’s equity
D = market value of firm’s debt V = E + D E/V = percentage of financing that is equity
D/V = percentage of financing that is debt Tc = corporate tax rate