CTP Exam Quiz 04

Ratio analysis
Ratio analysis uses a firm’s financial information to calculate ratios and then compare them to other past or present ratios. This helps to form an accurate assessment of a firm. One method of deriving a ratio is to use a ‘Common-size’ ratio where each factor is represented using a common unit of measure; all line items are expressed as a percentage. For example, if the total revenue is $1 million, and gross profit is $100,000, then the gross profit margin would be 10%.

Ratio analysis
There are several ratios that can be used singly or in combination. A liquidity ratio shows a firm’s short term financial situation. Profitability ratios show the return on capital employed. Operational ratios show how efficient assets are used. Liquidity ratio is also known as working capital ratio and is frequently used to assess a firm’s cash conversion rate. The cash conversion cycle is the conversion of cash outflows to cash inflows.

Liquidity ratios
Liquidity ratios are standardized formulas for assessing a firm’s ability to pay off their short term debts. Higher ratio numbers generally indicate greater ability to fulfill obligations. Lenders rely heavily on liquidity ratios to determine the creditworthiness of a firm. Three kinds of liquidity ratios are current ratio, quick ratio, and the operational cash flow ratio (or cash flow to total debt ratio).

Three kinds of liquidity ratios are current ratio, quick ratio, and the operational cash flow ratio (or cash flow to total debt ratio). The current ratio divides total current assets by total current liabilities. The quick ratio is also known as the ‘acid test ratio’. It divides cash, accounts receivable, and short term investments by total current liabilities. Prepaid expenses and inventory are not liquid enough to be included in the quick ratio. The operational cash flow ratio divides net income and depreciation by total long and short term debt, including commercial paper.

Cash Conversion Cycle
The cash conversion cycle (CCC) calculates the time it takes for an input dollar to work through the production and sales process and then to be received from a customer. It shows the amount of time for each stage of production; the time it takes to sell inventory, collect receivables, and then pay debt obligations. There is often a time lag between the time a firm pays production costs and the time it receives payment for goods sold. This gap is called the working capital gap. The CCC uses three factors; Day’s inventory (or DIO, Days Inventory Outstanding), Day’s receivables (or DSO, Days Sales Outstanding), Day’s payables (or DPO, Days Payable Outstanding).

Profitability and efficiency ratios
Profitability ratios calculate the earnings capability of a firm. These include profit margin, return on assets, and return on equity. Efficiency ratios measure how efficiently assets are used. The higher the ratio, the more likely that the firm is financially healthy. However, since the numbers can vary considerably depending on the industry, these ratios must be carefully analyzed.

Profitability and efficiency ratios
The profit margin ratio divides net income by revenues, or it can divide net profit by sales. The return on common equity ratio divides the amount of earnings available to shareholders by the common equity. The return on assets ration divides the net income by the total assets. The efficiency ratios include total asset turnover, fixed asset turnover, and working capital turnover. The total asset turnover divides revenues by total assets.

Advantages and disadvantages
Profitability and efficiency ratios help determine a firm’s earnings capability. They can be computed quickly because the information used to calculate these ratios are readily available from a firm’s financial statements. These ratios can also be easily compared to the ratios of other firm’s ratios within the industry. A disadvantage to using the profitability and efficiency ratio is that the final analysis might be incorrect.

Advantages and disadvantages
An example, if different accounting methods have been used for different firms, or for different periods, then the information used to derive the ratios would be inaccurate. The ratios only account for specific numbers, not economic value, talent, or strategy. Also, whatever analysis results, it is still true that past performance cannot guarantee future results. Some industries are in rapid decline (i.e. the photo film industry compared to digital cameras). And so the firm’s will not be able to maintain their position, despite what the profitability ratios would indicate.

WACC
Generally, financial assets (capital) are financed by either equity or debt. A firm’s capital is its retained earnings (equity), stockholder payments (equity), preferred stock, and long term debt. This capital has certain costs associated with it. The interest paid is a cost of debt and the returns paid to shareholders is the cost of equity.

Weighted average cost of capital (WACC)
The opportunity cost is the amount avoided if capital did not have to be allocated or raised at all. The cost of capital is the amount of return needed to justify the expenditure. These costs of capital have varying degrees of risk. To better assess the costs, a weighted average cost of capital (WACC) formula is used to derive a more accurate cost of capital.

Production costs
To accurately assess a firm’s financial needs, the firm’s production costs need to be analyzed. A firm’s production costs can be fixed, variable, or semi-variable and these can affect a firm’s actions. Fixed costs remain constant regardless of a firm’s activity. Lease payments are a fixed cost. Variable costs change in proportion to a firm’s activity.

Production costs
Raw material costs are variable since they can fluctuate (i.e. the price of copper fluctuates). Semi-variable (mixed or semi-fixed) costs are fixed to a point and then increase as the level of production increases. Utility costs are fixed up to a certain consumption level and then a higher rate is charged beyond that.

Operating leverage and economies of scale
The operating leverage of a firm is the extent to which a firm incurs mixed or variable costs. Firms that rely on few but large revenue sales are considered to have higher operating leverage compared to firms that rely on many low revenue sales. Also, firms with higher percentage of fixed costs have higher operating leverage. Firms with high operating leverage require a greater number of sales to break even.

Operating leverage and economies of scale
A firm could benefit from economies of scale if they can increase production in a way that lowers the per-unit cost. They can sell to larger geographic area. However, some firms reach a point where increasing production does not lower cost per unit, but increases them. These firms are limited by their output capacity. A firm’s production capacity will generate a specific amount of revenues and then further sales of their product will be more costly.

Operating leverage
The operating leverage of a firm is the extent to which a firm incurs mixed or variable costs. Firms that rely on few but large revenue sales are considered to have higher operating leverage compared to firms that rely on many low revenue sales. Also, firms with higher percentage of fixed costs have higher operating leverage. Firms with high operating leverage require a greater number of sales to break even.

Economies of scale
A firm could benefit from economies of scale if they can increase production in a way that lowers the per-unit cost. They can sell to larger geographic area. However, some firms reach a point where increasing production does not lower cost per unit, but increases them. These firms are limited by their output capacity. A firm’s production capacity will generate a specific amount of revenues and then further sales of their product will be more costly.

Relevant costs
Before a firm can make a significant financial decision, a cost/benefit analysis is made. The relevant economic benefits are compared to the relevant economic costs. Relevant benefits and costs are those that pertain only to the project being considered. For example, if a project requires a piece of equipment that the firm does not already own, then its cost is a relevant cost. If the firm does own the equipment and does not need to spend additional funds on it, then the cost of the equipment is not relevant (it is considered a sunk cost).

Relevant costs
The opportunity costs of the project are also considered relevant. That is, investment alternatives should also be analyzed to determine if a greater benefit could be achieved elsewhere. If the firm is already receiving some benefits but would receive additional benefits from the project, then only the additional benefits are considered relevant. A cost/benefit analysis helps determine the best place to allocate funds.

Breakeven analysis
In business, the breakeven point is when losses equal gains, or when costs equal benefits. After the break even point is reached, additional revenues are profits. The goal of a breakeven analysis is to calculate the breakeven point, which practically applied means the number of sales needed to equal costs.

Breakeven analysis
In particular, the firm’s Treasury uses breakeven analysis extensively. The transfer of funds, whether manually, via wire transfer, or via electronic depository transfers (EDTs) is a common responsibility of the Treasury. These fund transfers should be done in the most efficient and cost effective way possible. A breakeven analysis helps the treasury manager determine which method will be most cost effective under the circumstances (i.e. urgency of the funds needed, time of day, day of week, etc.).

Capital budgeting
Before a firm can invest in new equipment or a long term project they need to determine if it is worthwhile to expend the capital. This is capital budgeting and there are several methods that can be used to budget capital including Net Present Value (NPV), Internal Rate of Return (IRR), Discounted Cash Flow (DCF), and Payback Period. NPV is the comparison of a dollar today with the inflation adjusted dollar in the future.

Capital budgeting
Depending on what kind of project is being considered, NPV can also mean the difference between the present cash inflow values and present cash outflow values. The IRR calculates the expected growth rate a particular project will generate. The Payback Period method of capital budgeting looks at the number of years it will take until the cash flows equal the initial investment. The DCF method is a time value adjusted estimate of the money that an investment would generate. It uses a WACC (Weighted Average Cost of Capital) to discount future cash flow projections and to determine the present value of the investment.

Master budget
All firm’s have to plan their financial activities, both short and long term. The financial statements provide the information that forms the basis for a financial plan. This financial plan is implemented through the use of a budget. The budget specifies where funds will be spent in a given period. There are different kinds of budgets and some budgets are based on other budgets. A master budget is the annual financial plan that includes the entire firm.

Master budget
A master budget is the annual financial plan that includes the entire firm. It addresses the day to day operational financial activities with an operating budget. The master budget must also consider the firm’s larger investment activities and so includes the financial budget, which is based in part on the operating budget. The financial budget incorporates the sales, production, purchase, and operating budgets. The treasury is actively involved in the budget creation process either by providing financial statements that support the budget, or by assessing the effectiveness or impact of a given budget. The treasury can also use a budget to help manage the firm’s short term assets and liabilities and to alert management of any variances.

Risk analysis
Risk analysis attempts to minimize the impact of unknown variables by accounting for all possible variables. A risk analysis provides a range of possible outcomes based on given information. Three types of risk analysis are sensitivity analysis, scenario analysis, and a simulation of two combined. Sensitivity analysis uses all the factors in a given project (i.e. costs, revenues, interest rate), but changes only one factor at a time, to see how the change could affect the outcome.

Risk analysis
Investments are particularly sensitive to interest rate changes and a sensitivity analysis can demonstrate that. Scenario analysis is a kind of sensitivity analysis that changes the factors to reflect a worse case and then a best case scenario. The goal is to identify the lower and upper limits of possible outcomes. A simulation analysis uses sophisticated computer programs that can change all variables simultaneously to find possible outcomes. A Monte Carlo simulation shows the distribution and the probability of the outcomes.

Performance measurements
A performance measurement is basically the calculation of return on investment (ROI) over a set period of time. Performance measurement can be calculated for the entire firm or for just a specific project. The ROI can be calculated by dividing the profit by the invested capital. However, ROI has a limited assessment value because of factors it doe not include. If cash flows are not uniform over a given period (i.e. annually) and the ROI uses values from just a part of the period (i.e. quarterly) the ROI will be inaccurate. ROI generally does not include cost of capital. The Residual Income measure does account for the cost of capital.

Working capital
Working capital is the difference between current assets and current liabilities. Sometime working capital is considered just the current assets and net working capital is the current assets minus the current liabilities. Current assets include cash, securities, accounts receivable, and inventory. Current liabilities include accounts payable and short term debt.

Working capital
Working capital management strives to balance current assets and liabilities in a way that maintains sufficient cash flow but also maximizes rates of return. This can involve choosing strategies that increase earnings. For example, if the current ratio is high, it indicates low risk, and there will likely be enough cash to pay operating expenses. However, it also means that the cash is likely earning relatively little (low risk generally means low interest rates) and the current liabilities are likely paying high interest rates.