PART 2. Financial Decision Making

Transcription

1 Financial Decision Making &HUWLǰHG 0DQDJHPHQW $FFRXQWDQW SMART STARTER Section A of CMA Part 2

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3 PART 2 Financial Decision Making

4 Introduction Acknowledgements: PRC extends its appreciation to the Institute of Management Accountants and its team for their support in developing this material. The CMA is a registered trademark owned by the IMA. Intro Powers Resources Corporation. All rights reserved

5 Introduction IMPORTANT NOTE Dear Valued Candidate, Please check our website regularly for downloads of any new supplemental updates of this material, or for other information provided to assist you in the preparation for your CMA examination. While every effort was made to ensure accuracy and minimize any errors in this 2 nd edition of the PRC CMA Review, errors are an integral part of the publishing process. We continuously seek and value your feedback on how we can improve this material. It is also critical to emphasize that this review material was prepared in accordance with the IMA s disclosed Content Specification Outline, but due to the nature of the exam and the topics covered, a candidate is expected to apply reasoning and logic to a wide array of potential scenarios that may not be fully covered in review materials. Moreover, when considering the body of knowledge for the CMA exam, it is sometimes impractical to divide with clear lines between the various topics. All information pertaining to the CMA examination was valid as of the time of printing this material. For more up to date information, log on to our Website at: Sincerely, PRC Development Team 2017 Powers Resources Corporation. All rights reserved Intro-3

6 Introduction NOTES Intro Powers Resources Corporation. All rights reserved

7 Introduction INTRODUCTION TO THE CMA EXAM 1. Introduction Admission to the CMA Program Content of the CMA Exam CMA Application and Exam Registration (IMA CMA Handbook) Identification Requirements Calculator Policy Examinee Conduct Exam Rules and regulations PRC s Passing Tips for Taking The CMA Exam All Section Read this introduction about the CMA exam. Make sure to read the exam section a couple of days before your exam Powers Resources Corporation. All rights reserved Intro-5

8 Introduction NOTES Intro Powers Resources Corporation. All rights reserved

9 Introduction 1. Introduction To become Certified Management Accountant (CMA ), you are required to sit and pass the two parts of the exam. The exam is administered by The Institute of Management Accountants IMA. CMA exams are offered through computer-based testing (CBT). This means that you will be able to take your exam in any one of Prometric s available testing centers around the world ( The exam consists of two parts multiple choice and writing questions as follows: 1- Part 1: Financial Reporting, Planning, Performance, and Control (4 hours 100 multiple-choice questions and two essay questions) 2- Part 2: Financial Decision Making (4 hours 100 multiple-choice questions and two essay questions) 2. Admission to the CMA Program To become certified, you need to fulfill ALL the following requirements. 1. Active membership in the Institute of Management Accountants 2. Pay the CMA Entrance Fee 3. Satisfy the Education Qualification (A Bachelor s or advanced degree, from an accredited college or university, or a professional certificate, such as CIA or CFA. A list of approved certifications is available in the CMA handbook) 4. Satisfy the Experience Qualification (two continuous years of professional experience in management accounting and/or financial management) 5. Complete all required examination parts 6. Comply with the IMA Statement of Ethical Professional Practice You may sit for the CMA exam before fulfilling the education and experience requirements, but you must complete the CMA program within three years from the date of entry into the program (date of payment of CMA entrance fee) Powers Resources Corporation. All rights reserved Intro-7

10 Introduction 3. Content of the CMA Exam 1. Part 1 Financial Reporting, Planning, Performance, and Control A. External Financial Reporting Decisions (15%) B. Planning, Budgeting and Forecasting (30%) C. Performance Management (20%) D. Cost Management (20%) E. Internal Controls (15%) 2. Part 2 Financial Decision Making A. Financial Statement Analysis (25%) B. Corporate Finance (20%) C. Decision Analysis (20%) D. Risk Management (10%) E. Investment Decisions (15%) F. Professional Ethics (10%) The Board of Regents of the Institute of Certified Management Accountants (ICMA ) has overall responsibility for developing the CMA examinations. The ICMA was created for the purpose of developing and administering the CMA program. PRC is committed to continuously adjust the content of its materials and the level of concentration of each topic to keep abreast with the changes in the exam coverage. 4. CMA Application and Exam Registration (IMA CMA Handbook) The CMA examination is given in a computer-based format, and is offered at Prometric Testing Centers located throughout the world. An up-to-date listing of all Prometric Testing Centers can be found at Prometric s website ( Parts 1 and 2 are offered during the following three testing windows. January/February May/June September/October Exam registration steps: 1- IMA Membership application 2- CMA Entrance Fee 3- Exam scheduling Intro Powers Resources Corporation. All rights reserved

11 Introduction DETAILED APPLICATION, REGISTRATION, AND SCHEDULING INSTRUCTIONS are available in the CMA handbook. You are kindly requested to go over them as they are an important guide for the online registration. The handbook is available on the IMA s website through the following link: 5. Identification Requirements For admission to a Prometric Test Site, you must present proof of your identify. The name on your ID must match exactly with the name on your authorization letter. Following are the only acceptable forms of valid identification. 1. Valid, signed, non-expired Government-issued passport. Or 2. Two original forms of non-expired identification, one with a photograph, both with your signature. Acceptable forms of ID include a drivers license, military ID, credit card or bank debit card with photo and signature, bank debit card with signature, or company ID. Or 3. A Government-issued National country ID Card with a photograph (with or without a signature), and another acceptable valid form of ID with a signature as defined in #2 above. 6. Calculator Policy Small battery or solar powered electronic calculators restricted to a maximum of six functions addition, subtraction, multiplication, division, square root, and percentage are allowed. The calculator must not be programmable and must not use any type of tape. Candidates can also use the Texas Instrument s BA II Plus, Hewlett- Packard 10BII, HP 12c, or HP 12c Platinum calculators when taking the exams. Candidates will not be allowed to use calculators that do not comply with these restrictions. 7. Examinee Conduct All candidates are required to sign a statement agreeing not to disclose the contents of the examinations nor remove examination materials from the testing room. All candidates are also required to attest to the authenticity of their credentials and the accuracy of all statements made in their application. Cheating will not be tolerated, and all instances of suspected cheating will be fully investigated. Examinees who are caught cheating will have their grades invalidated and will be disqualified from future examinations. Cheating includes, but is not limited to, the following; copying answers from another candidate during the exam, using unauthorized materials during the exam, helping another candidate during the exam, removing exam materials from the testing room, divulging exam questions, and/or falsifying credentials. For those already certified by the ICMA, failure to comply with the non- disclosure policy or the subsequent discovery of cheating will be considered a violation of the IMA Statement of Ethical Professional Practice and will result in revocation of the certificate Powers Resources Corporation. All rights reserved Intro-9

12 Introduction 8. Exam Rules and regulations ( 1. You will be continuously monitored by video, physical walk-throughs and the observation window during your test. All testing sessions are video and audio recorded. 2. You must present valid (unexpired) and acceptable ID(s) in order to take your test. Validity and number of IDs required is predetermined by your test sponsor. 3. You are required to sign out on the test center roster each time you leave the test room. You must also sign back in and show your ID to the Test Center Administrator (TCA) in order to be readmitted to the test room. 4. You are prohibited from communicating, publishing, reproducing, or transmitting any part of your test, in any form or by any means, verbal or written, for any purpose. 5. You must not talk to other candidates or refer to their screens, testing materials, or written notes in the test room. 6. You must not use written notes, published materials, or other testing aids, except those allowed by your test sponsor. (The TCA will refer to the applicable client practice for allowances.) 7. You are allowed to bring soft ear plugs (with no wires/cords attached) or center-supplied tissues in the test room. 8. Any clothing or jewelry items allowed to be worn in the test room must remain on your person at all times. Removed clothing or jewelry items must be stored in your locker. 9. You will be scanned with a metal detector wand prior to every entry into the test room. If you refuse, you cannot test. 10. You will be asked to raise your slacks/pants legs above your ankles and pull your sleeves up (if long sleeves are worn) prior to every entry into the test room. 11. You will be asked to empty and turn your pockets inside out prior to every entry into the test room to confirm that you have no prohibited items. 12. You must not bring any personal/unauthorized items into the testing room. Such items include but are not limited to: outerwear, hats, food, drinks, purses, briefcases, notebooks, pagers, watches, cellular telephones, recording devices, and photographic equipment. Weapons are not allowed at any Prometric Testing Center. 13. You must return all materials issued to you by the TCA at the end of your test. 14. You must comply with the policy of your test sponsor regarding the use of phones during scheduled breaks in your test. 15. Your test may have either scheduled or unscheduled breaks which are determined by your test sponsor. The TCA can inform you what is specifically permitted during these breaks. 16. If a break is taken during the exam you must return to your original, assigned seat. 17. Repeated or lengthy departures from the test room for unscheduled breaks will be reported by the TCA. 18. If you need access to an item stored in the test center during a break such as food or medicine, you must inform the TCA before you retrieve the item. You are not allowed to access any prohibited item (as defined by the client practice applicable for the test you are taking). Intro Powers Resources Corporation. All rights reserved

13 Introduction 19. You must conduct yourself in a civil manner at all times when on the premises of the testing center. Exhibiting abusive behavior towards the TCA, or any other staff member of the test center, may result in criminal prosecution. 20. To protect the privacy of all testers, the TCA can neither confirm nor deny if any particular individual is present or scheduled at the test center. 21. Persons not scheduled to take a test are not permitted to wait in the test center. Note: Client practice policies applicable to individual exams may supersede any of these regulations. 9. PRC s Passing Tips for Taking The CMA Exam A. Preparing for the Exam - Plan your study program. - Periodically review, reassess, and revise your study program as to keep yourself within the time budget. - Make sure to read through all the lectures and solve ALL multiple-choice questions (MCQs). - Second attempts on solving the MCQs should be concentrated on questions answered incorrectly in previous attempts. - Spend more time on topics that you are answering incorrectly. - It is highly recommended to enroll in one of PRC s live courses, or intensive seminars in your area. - Utilize PRC s essay writing support techniques. When practicing your essays, you can send us a sample essay that you answered and one of our lead instructors will provide you with customized support on what you need to do to improve you essay writing techniques. B. Before you Go - Have a good night s sleep before the exam. - Arrange for a light breakfast. - Plan to arrive at the exam site at least half an hour before the exam. - Remember to have the following items with you: Authorization letter. Valid photo identification. C. During the Exam - You have 180 minutes /3 hours to answer 100 questions, and 60 minutes to answer to essay questions. - Read the exam instructions carefully. - If you do not use all the 180 minutes allocated for the MCQ questions, the remaining time will be added to the time allocated for essay questions Powers Resources Corporation. All rights reserved Intro-11

14 Introduction - Use PRC s Exam Answering Technique : Go through the questions answering only short and/or questions that you are familiar with. Do not attempt to answer long and/or questions pertaining to topics you are not familiar with or do not like. This step should give you more time on the more difficult questions in addition to building your confidence. Make a second pass attempting to answer medium length and/or medium difficulty questions. Repeat the process until you have completed the entire exam Session. When you have exhausted all the questions you are able to answer, and there are still unanswered questions, attempt to guess the answers. Be sure to choose only the appropriate checkbox. Budget your time and use PRC s Exam Answering Technique to maximize your chances of passing. Read the answer choices carefully. If you do not know the correct answer, select the best possible choice. Double check that you have answered all questions before submitting your exam. Make sure to read and sign the nondisclosure agreement. Maintain your positive attitude before and during the exam; do not panic if you encounter difficulties while studying or while doing the exam. D. After Each Exam - Do not discuss the exam with anyone as it may potentially violate the IMA s exam nondisclosure clause. - Contact PRC at contact@powersresources.com and let us know how we did and what we need to improve to help future candidates. GOOD LUCK! Intro Powers Resources Corporation. All rights reserved

15 Section A Financial Statement Analysis All Section Financial statement analysis is a separate section of the Part 2 exam comprising 25% tested at all three Levels (A, B, and C). Remember to read the answers of all questions whether solved correctly or incorrectly. When reviewing the lecture before the exam, emphasize and concentrate on questions solved incorrectly in prior solving attempts.

16 FINANCIAL STATEMENT ANALYSIS (25% LEVELS A, B, AND C) A.1 Basic Financial Statement Analysis... 3 Common Size Financial Statements...3 A.2 Financial Ratios Ratio Analysis Liquidity Ratios Leverage Ratios Activity Ratios Profitability Ratios Market Ratios Other Performance Ratios Limitations of Ratio Analysis A.3 Profitability Analysis Income Measurement Analysis Revenue Analysis Cost of Sales Analysis Expense Analysis Variation Analysis Sustainable Equity Growth A.4 Special Issues Impact of Foreign Operations Effects of Changing Prices and Inflation Off-Balance Sheet Financing Impact of Changes in Accounting Treatment Accounting and Economic Concepts of Value and Income Earnings Quality A.5 Comprehensive Example A Powers Resources Corporation. All rights reserved

17 STUDY SESSION 1 A.1 Basic Financial Statement Analysis 1. Basic financial statement analysis a. Common size financial statements b. Common base year financial statements Common Size Financial Statements Financial statement analysis is the process of analyzing reported financial data in order to evaluate the risk and financial performance of a company, as well as identifying its financial strengths and weaknesses. Among the basic accounting tools used in this process are accounting ratios analysis and trend analysis. A. Accounting Ratios Analysis an accounting ratio measures the relationship between two or more items or accounts of the company s financial statements based on the logical relationship among those accounts or items. Once calculated, accounting ratios provide deeper understanding of the financial aspects of the company and allow for comparing the financial performance of the company with other companies, with its industry average, and with the past performance of the same company. Accounting ratios can be grouped into categories based on the financial aspects of the business which the ratios are intended to measure. B. Trend Analysis trend and time series analysis can be used in analyzing financial statements. Elements of the financial statements or ratios are prepared for successive periods and then analyzed to identify the pattern (or trend) of the changes in those elements or ratios over time. Trend analysis shows the amount and direction of the changes and allows for investigating the reasons of those changes. C. Common-Size Analysis common-size format is an important tool that can help in financial statement analysis. Common-size statements are financial statements in which each element is presented as a percentage of a base amount. This presentation helps mainly in comparing the financial statements elements among companies with different sizes because each element is presented as a percentage regardless of its size. Common-size analysis can be vertical or horizontal. 1. Vertical Common-Size Analysis in vertical common-size statements, the elements of the statement for one year are presented as a percentage of a base amount. The base amounts are generally total assets for the balance sheet and sales for the income statement. Vertical commonsize statements are used in comparing the data of a company over two or more periods, comparing the data of two or more different companies, and comparing the data of a company with the industry s average. 2. Horizontal Common-Size Analysis in horizontal common-size statements, the elements of the financial statement for one year are presented as a percentage of base-year elements. This presentation allows for comparing data of a single company over several periods, showing the trends of the changes, and evaluating the overall performance. This is also called variation analysis or trend series analysis. This format allows for calculating the growth rate of individual line items on the financial statements. For example if the sales increased from 100% in the base-year to 125% in the next year, then the growth rate of sales would be 25% Powers Resources Corporation. All rights reserved A-3

18 Comprehensive Example - Comparative Balance Sheets Future Tech Company Balance Sheet As of December 31, ASSETS CURRENT ASSETS Cash 9,819,206 7,329,405 6,052,754 Inventories 8,341,092 17,304,624 35,572,405 Accounts receivable 1,867,869 3,758,779 11,008,546 Other receivables 276, ,214 10,313,047 Advances and prepayments 143, ,823 17,921,150 Other debit balances 3,968,589 6,816,175 3,194,441 Total Current Assets 24,417,329 36,148,020 84,062,343 FIXED ASSETS 15,174,832 14,912,847 24,219,521 TOTAL ASSETS 39,592,161 51,060, ,281,864 LIABILITIES AND PARTNERS' EQUITY CURRENT LIABILITIES Accounts payable 626, ,984 26,592,825 Bank overdrafts 145, ,932 13,377,466 Current portion of long-term debt 3,599,980 3,937,690 4,307,080 Total Current Liabilities 4,372,016 4,346,606 44,277,371 LONG-TERM LIABILITIES 18,108,770 14,171,080 9,864,000 TOTAL LIABILITIES 22,480,786 18,517,686 54,141,371 SHAREHOLDERS EQUITY Paid-in Capital 12,213,134 12,213,134 30,790,634 Retained Earnings 4,898,241 20,330,047 23,349,859 Total Shareholder's Equity 17,111,375 32,543,181 54,140,493 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 39,592,161 51,060, ,281,864 A Powers Resources Corporation. All rights reserved

19 Comprehensive Example - Comparative Income Statements Future Tech Company Income Statement For the Year Ended December 31, Sales 95,217, ,867, ,621,574 Less: Cost of sales (71,737,302) (193,200,932) (218,060,917) Gross Margin 23,479,757 53,666,382 49,560,657 Selling Expenses (2,909,848) (12,386,993) (13,234,362) General and administrative expenses (3,187,398) (6,528,463) (18,636,785) Depreciation (1,845,800) (2,557,028) (3,200,034) EBIT 15,536,711 32,193,898 14,489,476 Interest (2,116,430) (1,807,700) (2,941,511) EBT 13,420,281 30,386,198 11,547,965 Tax (4,026,084) (9,115,859) (3,464,390) Net Income for the period 9,394,197 21,270,339 8,083,576 Comprehensive Example - Comparative Statements of Changes in Equity Future Tech Company Statement of Changes in Equity For the Year Ended December 31, Beginning balance as of January 1, - 17,111,375 32,543,181 Prior period adjustment - - (400,000) Adjusted Beginning Balance - 17,111,375 32,143,181 Issuance of Shares 12,213,134-18,577,500 Net income for the period 9,394,197 21,270,339 8,083,576 Dividends (4,495,956) (5,838,532) (4,663,764) Ending balance as of December 31, 17,111,375 32,543,181 54,140, Powers Resources Corporation. All rights reserved A-5

20 Comprehensive Example - Comparative Statement of Cashflows Future Tech Company Statement of Cash Flows For the Year Ended December 31, CASH FLOWS FROM OPERATING ACTIVITIES Net income 9,394,197 21,270,339 8,083,576 Adjustments to reconcile net income to net cash flows from operating activities Depreciation 1,845,800 2,557,028 3,200,034 Losses (Gains) Operating gain (loss) before changes in assets and liabilities used in operating activities 11,239,997 23,827,367 11,283,610 Net (increase) decrease in assets Inventories (8,341,092) (8,963,532) (18,267,781) Accounts receivable (1,867,869) (1,890,910) (6,310,730) Other Receivables (276,986) (321,228) (10,313,047) Advances and prepayments (143,587) (197,236) Other debit balances (3,968,589) (2,847,586) 3,621,734 Net increase (decrease) in liabilities Current liabilities 626,402 (436,418) 26,183,909 Bank overdrafts 145,634 73,298 13,377,466 Net cash provided by operating activities (2,586,090) 9,243,755 1,654,011 CASH FLOWS FROM INVESTING ACTIVITIES Fixed assets (17,020,632) (2,295,043) (12,906,708) Net cash used in investing activities (17,020,632) (2,295,043) (12,906,708) CASH FLOWS FROM FINANCING ACTIVITIES Issuance of Shares 12,213,134-18,577,500 Long-term Loan 25,000, Repayment of long-term debt (3,291,250) (3,599,980) (3,937,690) Dividends (4,495,956) (5,838,532) (4,663,764) Net cash provided by financing activities 29,425,928 (9,438,512) 9,976,046 NET INCREASE IN CASH AND CASH EQUIVALENTS 9,819,206 (2,489,800) (1,276,652) Cash and cash equivalents, January 1-9,819,206 7,329,406 CASH AND CASH EQUIVALENTS, DECEMBER 31 9,819,206 7,329,406 6,052,754 A Powers Resources Corporation. All rights reserved

21 Illustration of Vertical Common-Size Analysis Balance Sheet Future Tech Company Vertical Common-Size Balance Sheet As of December 31, ASSETS CURRENT ASSETS Cash Inventories Accounts receivable Other receivables Advances and prepayments Other debit balances Total Current Assets FIXED ASSETS TOTAL ASSETS LIABILITIES AND PARTNERS' EQUITY CURRENT LIABILITIES Accounts payable Bank overdrafts Current portion of long-term debt Total Current Liabilities LONG-TERM LIABILITIES TOTAL LIABILITIES SHAREHOLDERS EQUITY Paid-in Capital Retained Earnings Total Shareholder's Equity TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY Powers Resources Corporation. All rights reserved A-7

22 Illustration of Horizontal Common-Size Analysis Balance Sheet Future Tech Company Horizontal Common-Size Balance Sheet As of December 31, ASSETS CURRENT ASSETS Cash Inventories Accounts receivable Other receivables Advances and prepayments Other debit balances Total Current Assets FIXED ASSETS TOTAL ASSETS , LIABILITIES AND PARTNERS' EQUITY CURRENT LIABILITIES Accounts payable Bank overdrafts Current portion of long-term debt Total Current Liabilities LONG-TERM LIABILITIES TOTAL LIABILITIES SHAREHOLDERS EQUITY Paid-in Capital Retained Earnings Total Shareholder's Equity TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY , Note that the growth rate of inventory from 2011 to 2012 is 76.23% ( ), and in 2013 is % ( ). This increase may draw management attention to analyze its implications. A Powers Resources Corporation. All rights reserved

23 Illustration of Vertical Common-Size Analysis Income Statement Future Tech Company Income Statement For the Year Ended December 31, Sales Less: Cost of sales (75) (78) (81) Gross Margin Selling Expenses (3) (5) (5) General and administrative expenses (3) (3) (7) Depreciation (2) (1) (1) EBIT Interest (2) (1) (1) EBT Tax (4) (4) (1) Net Income for the period Illustration of Horizontal Common-Size Analysis Income Statement Future Tech Company Horizontal Common-Size Income Statement For the Year Ended December 31, Sales Less: Cost of sales Gross Margin Selling Expenses General and administrative expenses Depreciation EBIT Interest EBT Tax Net Income for the period Powers Resources Corporation. All rights reserved A-9

24 Practice Questions Session 1 1. Gordon has had the following financial results for the last four years. Year 1 Year 2 Year 3 Year 4 Sales $1,250,000 $1,300,000 $1,359,000 $1,400,000 Cost of goods sold 750, , , ,000 Gross profit 500, , , ,000 Inflation factor Gordon has analyzed these results using vertical common-size analysis to determine trends. The performance of Gordon can best be characterized by which one of the following statements? a. The common-size gross profit percentage has decreased as a result of an increasing common-size trend in cost of goods sold. b. The common-size trend in sales is increasing and is resulting in an increasing trend in the commonsize gross profit margin. c. The common-size trend in cost of goods sold is decreasing which is resulting in an increasing trend in the common-size gross profit margin. d. The increased trend in the common-size gross profit percentage is the result of both the increasing trend in sales and the decreasing trend in cost of goods sold. 2. In assessing the financial prospects for a firm, financial analysts use various techniques. An example of vertical, common-size analysis is: a. An assessment of the relative stability of a firm s level of vertical integration. b. A comparison of financial ratio between two or more firms in the same industry. c. Advertising expense is 2% greater compared with the previous year. d. Advertising expense for the current year is 2% of sales. 3. The major advantage of vertical analysis is a. The ability to see trends within specific line items. b. The ability to determine if a company is a going-concern. c. The ability to compare companies of various sizes. d. The ability to determine if the company s strategic goals are being achieved. 4. When preparing a common-size balance sheet, the base amount is usually a. Current assets b. Long-term assets c. Total assets d. Sales A Powers Resources Corporation. All rights reserved

25 Feedback: 1. Answer (a) is correct. Gordon s common-size gross profit percentage has decreased as a result of an increasing common-size trend in cost of goods sold as shown below. Year 1 Year 2 Year 3 Year 4 Sales 100% 100% 100% 100% Cost of goods sold ( Sales) 60.0% 60.3% 60.7% 60.7% Gross profit ( Sales) 40.0% 39.6% 39.2% 39.2% 2. Answer (d) is correct. Vertical, common-size analysis compares the components within a set of financial statements. A base amount is assigned a value of 100%. For example, total assets on a common-size balance sheet and net sales on a common-size income statement are valued at 100%. Common-size statements permit evaluation of the efficiency of various aspects of operations. An analyst who states that advertising expense is 2% of sales is using vertical, common-size analysis. 3. Answer (c) is correct. Vertical analysis allows companies that vary in size to be compared since the absolute dollar amounts are ignored and a percentage is calculated from the total account. Answer (a) is not correct because horizontal analysis allows trends to be identified from the base year to future years. Vertical analysis allows companies that vary in size to be compared since the absolute dollar amounts are ignored and a percentage is calculated from the total account. Answer (b) is not correct because determining whether a company is a going-concern (which assumes that the company will have an indefinite life) is not determined from vertical analysis. Liquidity and solvency analysis is more likely to help determine if a company is not a going-concern. Vertical analysis allows companies that vary in size to be compared since the absolute dollar amounts are ignored and a percentage is calculated from the total account. Answer (d) is not correct because determination of achieving strategic goals is done through comparison of goals and multiple financial analyses. Vertical analysis allows companies that vary in size to be compared since the absolute dollar amounts are ignored and a percentage is calculated from the total account. 4. Answer (c) is correct. The total assets amount is typically the base on the balance sheet. Answer (a) is not correct because the current assets amount is not the base used when preparing a common-size balance sheet. The total assets amount is typically the base on the balance sheet. Answer (b) is not correct because the long-term assets category is not the base used when preparing a common-size balance sheet. The total assets amount is typically the base on the balance sheet. Answer (d) is not correct because sales revenue is the base used when preparing a common-size income statement. The total assets amount is typically the base on the balance sheet Powers Resources Corporation. All rights reserved A-11

26 STUDY SESSION 2 A.2 Financial Ratios 2. Financial ratios a. Liquidity b. Leverage c. Activity d. Profitability e. Market Ratio Analysis A. Ratio calculations include the comparison of various numbers, amounts, percentages... etc. to calculate predetermined relationships. These relationships may then be tested for reasonableness, compared with each other, and/or compared with industry averages. B. Financial ratio calculations are typically the most common and widespread use of ratio analysis, but the potential ratios that can be used by management accountants in the various areas include financial and non-financial ratios. For example: 3. Ratios of labor hour usage during production as a test for efficiency of production. 4. Financial ratios (discussed in more detail in Part III Section B. 5. Ratio of defects in various periods/processes. C. Ratio analysis has its inherent problems and limitations that necessitate care and judgment. These limitations are discussed at the end of Section A-2. For the purpose of the CMA exam, the following groups of ratios will be discussed: Liquidity ratios Leverage Activity ratios Profitability ratios Market ratios Liquidity Leverage Activity Profitability Market A Powers Resources Corporation. All rights reserved

27 Liquidity Ratios Liquidity Ratios are ratios that measure the relationship of a firm s cash and other current assets to its current liabilities. The liquidity of current assets is generally dictated by their type (cash, receivables, inventory... etc.). The liquidity of current liabilities is general a function of the firm s creditworthiness, reputation, size, and capital levels. Larger, creditworthy organizations with high capital levels are generally able to obtain short term credit for longer periods and at relatively lower or no interest. A. Current Ratio 1. Is calculated by dividing current assets by current liabilities. 2. It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. 3. It is the most commonly used measure of short-term solvency. 4. If the company s current ratio is low, it may face a potential solvency problem. On the other hand, a significantly high current ratio may be due to excess current assets implying improper current asset management (excess cash, accounts receivable, and/or inventory). Current Ratio = Current Ratio Current Assets Current Liabilities Liquidity Leverage Activity Profitability Market B. Quick (Acid test) Ratio 1. Is calculated by deducting inventories and prepayments from current assets and dividing the remainder by current liabilities. 2. It measures the ability to pay off short-term obligations without relying on the sale of inventories. 3. An increase in the quick ratio generally implies that a company is better able to meet its short-term financing needs and vice versa. 4. The quick ratio is a better indicator about the company s ability to meet its short-term obligations than the current ratio as it excludes inventory. Inventory may require significant time for liquidation and therefore, may not be readily available to meet short-term obligations. 5. For example, a library or a retail department store maintain high inventory amounts that may indicate a healthy current ratio, however, because such inventories may not be readily convertible into cash to meet short-term obligations without a compromise on the sales value, the current ratio becomes misleading. Quick Ratio = Quick Ratio = Quick Ratio Current Assets Inventories Prepayments Current Liabilities Or Cash + Marketable Securities + Receivables Current Liabilities 2017 Powers Resources Corporation. All rights reserved A-13

28 C. Cash Ratio 1. Is calculated by dividing cash and marketable securities by current liabilities. 2. The cash ratio is used to measure the company s ability to pay off current liabilities if both inventory and accounts receivable are not liquid. Cash Ratio = Cash Ratio Cash + Marketable Securities Current Liabilities D. Cash Flow Ratio 1. Is calculated by dividing operating cash flow by average current liability. 2. Measures the company s ability to meets its current debt obligations with cash generated from the normal operations of the company. Cash Flow Ratio = Cash Flow Ratio Cash flow from operations Average Current Liabilities E. Working Capital (Net Working Capital) 1. The terms Working Capital and Net Working Capital mean the same thing on the CMA exam 2. Is calculated by deducting current liabilities from current assets. 3. Working capital measures the company s liquidity in absolute terms i.e. remaining working capital after paying all outstanding current liabilities. Working Capital Working Capital = Current Assets Current Liabilities F. The Liquidity of Current Liabilities In addition to examining the above ratios, the analyst must examine the liquidity of current liabilities which is determined by the degree of how urgent current liabilities must be paid. In addition, any unrecorded current liabilities must be examined and considered because these unrecorded liabilities will be paid in the near future using the current assets and that affects the liquidity of the company. Examples of unrecorded current liabilities include expected insurance obligations, purchase commitments, and operating lease obligations. A Powers Resources Corporation. All rights reserved

29 Leverage Ratios A. Capital Structure and Solvency - Leverage 1. Capital Structure - refers to a company s combination of the two major sources of funds, debt capital and equity capital. Debt capital is funds obtained through borrowing. Equity capital is funds obtained mainly from stock issues to the general public. This combination affects the company s risk and return. Increasing the debt percentage in the capital structure allows the company to generate more returns to owners and to take advantage of opportunities. On the other hand, increasing the debt level increases the risk of default and insolvency of the company due to the fixed charges (interests and principal payments) associated with debts. These charges and payments must be made regardless of the earnings or losses. Liquidity Leverage Activity Profitability Market 2. Solvency - refers to the firm s ability to meet its long term liabilities as they mature. 3. Leverage - in general, leverage is the ability to increase return to owners by using debts (financial leverage) or by using operating fixed cost (operating leverage). A. Total Debt to Total Assets 1. Total debt includes both current liabilities and long-term debt. Creditors prefer lower debt ratios because the lower the debt ratio, the greater the cushion against creditors losses in the event of liquidation. 2. Debt ratio indicates the percentage of assets financed by creditors and measures the long-term debt paying ability 3. The owners on the other hand, may want more leverage because it magnifies earnings. 4. Generally, firms operating in cyclical industries tend to have lower debt ratios than those in noncyclical industries. Total Debt to Total Assets Total Debt Total Debt to Total Assets = Total Assets B. Debt/Equity Ratio 1. Total debt includes both current liabilities and long-term debt. The optimal debt/equity ratio is that which minimizes the firm s weighted average cost of capital (WACC). Debt/Equity Ratio Total Debt Debt/Equity Ratio = Common Stockholders Equity C. Long-Term Debt to Equity Ratio 1. Current liabilities are excluded in this case in order to compare long-term debt only with stockholder s equity. Long-Term Debt to Equity Ratio Total Debt Current Liabilities Long-Term Debt to Equity Ratio = Common Stockholders Equity 2017 Powers Resources Corporation. All rights reserved A-15

30 D. Times Interest Earned (Interest Coverage) 1. Measures the ability of the firm to meet its annual interest payments. 2. Creditors rely on TIE to measure a firm s ability to meet its interest payment obligations. A high TIE ratio, even when coupled with a high debt ratio is considered more acceptable by lenders than a low TIE ratio with a relatively low debt ratio. Times Interest Earned (TIE) = Times Interest Earned Earnings Before Interest and Taxes (EBIT) Interest Expense E. Earnings to Fixed Charges Ratio (Fixed Charge Coverage Ratio) 1. It is the ratio of (earnings before interest and taxes + operating leases expenses) divided by (interest expenses on loans and capital leases + annual principal payments on loans and capital leases + operating leases expenses). 2. Measures the ability of the firm to meet its fixed-charge contractual obligations. Earnings to Fixed Charges Ratio = Earnings to Fixed Charges Ratio Earnings Before Fixed Charges and Taxes Fixed Charges Or Earnings to Fixed Charges Ratio = EBIT + Operating Lease Payments Interest + Principal Payments + Operating Lease Payments F. Cash Flow to Fixed Charges Ratio 1. It is the ratio of (operating cash flow OCF + cash interest on loans and capital leases + operating leases expenses + taxes paid with cash) divided by (interest expenses on loans and capital leases + annual principal payments on loans and capital leases + operating leases expenses). 2. This ratio uses adjusted operating cash flow instead of adjusted earnings used in Fixed Charge Coverage Ratio. It measures the ability of the firm to meet its fixed-charge contractual obligations with its operating cash flow. Cash Flow to Fixed Charges = Cash Flow to Fixed Charges Ratio Earnings Before Fixed Charge and Taxes Fixed Charges Or Cash Flow to Fixed Charges = OCF + Cash Interests + Cash Taxes + Operating Lease Payments Interest + Principal Payments + Operating Lease Payments A Powers Resources Corporation. All rights reserved

31 G. Financial Leverage Ratio 1. Calculated by dividing the total assets by the common equity (preferred stocks are excluded from equity). 2. Indicates the amount of assets that are financed by debts. Financial Leverage Ratio = Financial Leverage Ratio Total Assets Common Stockholders Equity H. Degree of Financial Leverage (DFL) is a measure of the ratio of debt to equity in a company. 1. Companies with a relatively higher debt to equity ratio will have a relatively high degree of financial leverage. 2. DFL measures the percentage increase in net income as a result of a 1% increase in EBIT (Earnings Before Interest and Taxes). Degree of Financial Leverage = Degree of Financial Leverage Degree of financial Leverage = Q(P VC) FC Q(P VC) FC Interest Or = % Change in Net income % Change in EBIT EBIT EBIT I 3. Higher DFL reduces a company s cost of capital because interest on debt is tax deductible while dividends are not. 4. Higher DFL is associated with a higher financial risk due to the fixed interest payments that are payable whether the company has earned the interest or not. Degree of Financial Leverage Example The following is a comparison of two scenarios, one with relatively high interest costs and one with relatively low interest costs. Each scenario demonstrates the change in net income as a result of a 10% increase and 10% decrease in EBIT DFL High Interest Costs Low Interest Costs 10% in (10%) 10% in (10%) Base EBIT in EBIT Base EBIT in EBIT EBIT 20,000 22,000 18,000 20,000 22,000 18,000 Less: Interest (15, 00) (15,000) (15,000) (2,000) (2,000) (2,000) EBT 5,000 7,000 3,000 18,000 20,000 16,000 Less: Taxes (20) (1,000) (1 400) (600) (3,600) (4,000) (3,200) Net income (NI) 4,000 5,600 2,400 14,400 16,000 12,800 % change in NI 40% -40% 11% -11% 2017 Powers Resources Corporation. All rights reserved A-17

32 I. Degree of Operating Leverage (DOL) is a measure of the fixed costs in operations as compared to the variable costs. 1. Companies with high fixed costs (typically associated with high investments in plant and equipment) will have a relatively high degree of operating leverage. 2. DOL measures the % increase in EBIT as a result of a 1% increase in sales. Degree of Operating Leverage Q(P VC) Contribution Margin Degree of Operating Leverage = Q(P VC) FC = Contribution Margin Fixed Costs Or Degree of Operating Leverage = % Change in EBIT % Change in Sales Degree of Operating Leverage Example The following is a comparison of two scenarios, one with relatively high fixed costs and one with relatively low fixed costs. Each scenario demonstrates the change in EBIT (Earnings Before Interest and Taxes) as a result of a 10% increase and 10% decrease in sales DOL High Fixed Costs Low Fixed Costs 10% in (10%) 10% in (10%) Base Sales in Sales Base Sales in Sale Sales 100, ,000 90, , ,000 90,000 Less: Variable Costs (10,000) (11,000) (9,000) (10,000 (11,000) (9,000) Contribution 90,000 99,000 81,000 90,000 99,000 81, 00 Less: Fixed Costs (70,000) (70,000) (70,000) (20,000) (20,0 0) (20,000) EBIT 20,000 29,000 11,000 70,000 79,000 61,000 % change in EBIT 45% -45% 13% -13% Passing Tip: Companies with high fixed costs have higher operating leverage, and companies with higher debt to equity ratios have higher financial leverage. J. Degree of Total (Combined) Leverage is a measure of the combined impact of operating and financial leverage. 1. DTL measures the % increase in net income as a result of a 1% increase in sales. Degree of Total Leverage = Degree of Total Leverage Q(P VC) Q(P VC) FC I = Contribution Margin EBIT I 2. Since a high DTL is associated with high risk, companies tend to mitigate the risk by attempting to stabilize the DTL. Since DTL is the combination of both the DOL and DFL, a company with a high DOL would tend to reduce its DFL and vice versa. A Powers Resources Corporation. All rights reserved

33 Degree of Total Leverage Example The following is a comparison of four scenarios, with various combinations of relative fixed costs and interest costs. Each scenario demonstrates the change in net income as a result of a 10% increase and 10% decrease in sales DTL High Fixed High Interest High Fixed Low Interest 10% in (10%) 10% in (10%) Base Sales in Sales Base Sales Sales Sales 100, ,000 90, , ,000 90,000 Less: Variable Costs (10,000) (11,000) (9,000) (10,000) (11,000) (9,000) Contribution 90,000 99,000 81,000 90,000 99,000 81,000 Co ts (70,000) (70,000) (70,000) (70, 00) (70,000) (70,000) EBIT 20,000 29,000 11,000 20,000 29,000 11,000 Less: Interest (15,000) (15,000) (15,000) (2,000) (2,000) (2,000) EBT 5,000 14,000 (4,000) 18,000 27,000 9,000 Less: Taxes (20%) (1,000) (2,800) 800* (3,600) (5,400) (1,800) Net income (NI) 4,000 11,200 (3,200) 14,400 21,600 7,200 % change in NI 180% -180% 50% -50% * Tax refund DTL Low Fixed High Interest Low Fixed Low Interest 10% in (10%) 10% in (10%) Base Sales in Sales Base Sales in Sales Sales 100, ,000 90, , ,000 90,000 Less: Variable Costs (10,000) (1,000) (9,000) (10,000) (11,000) (9,000) Contribution 90,000 99,000 81,000 90,000 99,000 81,000 Less: Fixed Costs (20,000) (20,000) (20,000) (20,000) (20,000) (20,000) EBIT 70,000 79,000 61,000 70,000 79,000 61,000 Less: Interest (15,000) (15,000) (15,000) (2,000) (2,000) (2,000) EBT 55,000 64,000 46,000 68,000 77,000 59,000 Less: Taxes (20%) (11,000) (12,800) (9,200) (13,600) (15,400) (11,800) Net income (NI) 44,000 51,200 36,800 54,400 61,600 47,200 % change in NI 16% -16% 13% -13% From the above four scenarios, it s evident that when a company has relatively high fixed costs, it should aim to reduce its interest expense (by reducing its reliance on debt) if it intends to reduce its overall risk. If a company has relatively low fixed costs, it can tolerate relatively higher interest costs while still achieving a relatively lower risk. If companies have no control over their fixed costs, they should aim to control their interest charges when attempting to achieve an acceptable risk level. On the other hand, if companies have control over their fixed costs, then they could borrow and incur interest, and control their overall risk by controlling their fixed costs Powers Resources Corporation. All rights reserved A-19

34 Activity Ratios Activity Ratios are a set of ratios that measure how effectively a firm is managing its assets and resources. A. Inventory Turnover Ratio 1. Is calculated by dividing cost of goods sold by inventories. 2. Measures the inventory turnover rate. 3. A higher turnover rate for inventory indicates that the firm is better utilizing its capital that is invested in inventory. Successful companies can keep their inventory low with higher turnovers while still meeting customer orders on a timely basis. Liquidity Leverage Activity Profitability Market Inventory Turnover Ratio Inventory Turnover Ratio = Cost of Goods Sold Average Inventories B. Days Sales in Inventory (Inventory Turnover days) 1. Is calculated by dividing 360 by the inventory turnover ratio. 2. Indicates the average length of time the firm must wait from the date of purchasing inventory to the date of selling it. 3. A shorter period indicates that management is better managing its inventory purchase functions, however, care should be taken to also measure any associated stock-out costs. Days Sales in Inventory Days Sales in Inventory = Average Inventory Average Daily Cost of Goods Sold Or Days Sales in Inventory = 360 Inventory Turnover Ratio C. Accounts Receivable Turnover Ratio 1. Is calculated by dividing the net credit sales by the average trade receivables. 2. Indicates the number of times average accounts receivable are collected during the period. 3. Measures the company's effectiveness in extending credit and collecting accounts receivable. Accounts Receivable Turnover Ratio Accounts Receivable Turnover = Net Credit Sales Average Trade Receivables A Powers Resources Corporation. All rights reserved

35 D. Days Sales Outstanding in Receivables (DSO) 1. Is calculated by dividing accounts receivable by average sales per day. 2. Indicates the average length of time the firm must wait after making a sale before receiving cash. 3. A high ratio indicates deteriorating liquidity. 4. While a low ratio indicates better liquidity, a too low ratio indicates tight credit policy that could result in lost sales. Days Sales Outstanding in Receivables = Days Sales Outstanding in Receivables Average Trade Receivables Average Daily Sales Or Days Sales Outstanding in Receivables = 360 Accounts Receivables Turnover Ratio E. Accounts Payable Turnover Ratio 1. Is calculated by dividing the net annual credit purchases by the average accounts payable. 2. Indicates the number of times average accounts payable are paid during the period. 3. Measures the company's effectiveness in obtaining credit and paying off its accounts payable. 4. Generally, the increase in this ratio is more favorable as accounts payable are being paid more quickly. A decrease in this ratio implies that the company is paying off its suppliers more slowly. Accounts Payable Turnover = Accounts Payable Turnover Ratio Net Credit Purchases Average Accounts Payable F. Days Purchases in Accounts Payable 1. Indicates the average length of time between making the purchase and paying for it. Days Purchases in Accounts Payable = Days Purchases in Accounts Payable Average Accounts Payable Average Daily Purchases Or Days Purchases in Accounts Payable = 360 Accounts Payable Turnover Ratio 2017 Powers Resources Corporation. All rights reserved A-21