finance exam 1

unlimited liability

The owners can be personally responsible for the business's debts and obligations.

agency costs

Costs associated with conflicts between managers and owners and the efforts used to control those conflicts.

principle-agent conflict

management (agents) acting in personal interest rather than shareholder (principle) interest

EX: executive misuse of corporate funds for personal perks/luxuries

solution mechanisms to principle agnet conflict

executive stock options with multi-year vesting periods, board oversight, and threat of proxy fights

how can agency costs be reduced?

• Provide management with rewards aligned with shareholder interests

  • Tie financial incentives to metrics that matter to shareholders- earning, cash flow etc. 

• Give management an equity stake in the business

  • Make them shareholders themselves!

goal of financial management

maximize the current market value of existing equity/stock

why market value?- reflects long-term risk and future cash flows, unlike book value or revenue

corporate advantages: limited liability for owners and ease of raising equity capital versus partnerships

stakeholders

Anyone who has an interest in or is affected by the company, including employees, customers, suppliers, creditors, and shareholders.

stockholders

owns part of the company

accounting equity value

represents the net worth of a business, calculated as total assets minus total liabilities

market equity value

Share price times shares outstanding

reflects the public market's forward-looking price for those shares

what somene is willing to pay for the item

accounting income

cash flow

determines the cash available to creditors and shareholders and drives market value

what is equity on the balance sheet?

the net worth of a company, representing the amount of money that would be left over for the owners or shareholders if all assets were sold and all debts were paid off

average tax rates

the total amount of tax you pay divided by your total taxable income

how do you calculate average tax rates?

total taxes paid / total taxable income

marginal tax rates

amount of tax payable on next dollar earned

important for financial decision making, since we’re thinking about projects that will (hopefully) increase existing income

how do you calculate marginal tax rates?

the change in total tax divided by the change in total taxable income

determine cash flow from assets

CFFA = OCF - NCS - NWC

CFFA = CFC + CFS

why do we add back non cash items?

to convert accounting profit into real cash flow because these expenses reduce reported net income without any actual money leaving the bank account

purpose of common-sized finanical statements

A financial statement that expresses every line item as a % of Total Sales

how do you read common-sized finaical statements?

express every line item as a percentage of a core base figure rather than absolute dollar amounts

lets you easily compare companies of different sizes or evaluate a single company's performance over multiple periods

measure of short-term solvency

what does it imply?

company’s ability to meet its short-term obligations

the higher the solvency ratio, the company is more liquid and better able to meet short-term obligations

the exception is the total debt ratio where you want to see less debt as a % of assets

current ratio

A broad measure of short-term solvency because it considers all current assets

quick ratio

A stricter measure of short-term solvency because it excludes inventory- due to lower liquidity

cash ratio

The strictest short-term solvency measure because it focuses only on cash.

measure of long-term solvency

what does it imply?

indicates the company is more liquid and better to meet its long-term financial goals

finanical leverage

the use of debt to finance a company’s assets

total debt ratio

measures the proportion of assets financed with debt

debt-equity ratio

Measures the amount of debt used relative to shareholders' equity.

equity multiplier

Measures how much assets are supported by each dollar of equity and reflects financial leverage.

times interest earned ratio

Shows how many times operating profit can cover interest expense.

cash coverage ratio

Similar to times interest earned but adds back depreciation to get closer to cash-based measure.

asset managemnt ratios

Ratios that measure how efficiently a company uses its assets to generate sales and profits.

inventory turnover

Measures how quickly a company turns inventory into sales.

high inventory turnover meaning

Inventory is converted into sales more quickly, freeing up cash.

liquidity vs. solvency

Short-term solvency measures liquidity, while long-term solvency assesses debt and obligation safety over time.

days sales in inventory

measures the average number of days inventory takes to be sold

recievables turnover

measures how quickly a company collects money from credit sales

days sales in inventory

Measures the average number of days inventory takes to be sold.

recievables turnover

Measures how quickly a company collects money from credit sales.

higher receivables turnover meaning

The company is collecting its receivables more quickly.

days sales in recivables

measures the average number of days to collect money from customers

payables turnover

measures how quickly a company pays its bills

longer days in payables meaning

the company keeps its cash longer before paying suppliers

turnover ratio general trend

Faster turnover is better for assets, while longer payment periods can benefit payables.

profitability ratios

ratios that measure how effectively a company generates profits

profit margin

Measures how much profit a company generates from each dollar of sales

return on assets (ROA)

Measures the profit generated from the company's assets.

return on equity (ROE)

Measures the profit generated from shareholders' equity.

why is ROE often higher than ROA

Debt financing allows a company to control more assets with less equity.

higher profitability ratios indication

The company generates more profit from its sales, assets, or equity.

Earnings per share (EPS)

Net income allocated to each share of stock.

why is EPS important

Stock price performance is strongly related to earnings.

turnover ratios

the faster a company is turning over the assets, the better

the shorter the days inventory and recievables, the better (collecting money faster)

the longer the days payables, the better (the longer we keep our cash)

determinants of Return on Equity

profit margin x asset turnover x equity multiplier

how does profit margin contribute to ROE

acting as the core profitability driver in the DuPont Analysis framework

how does asset turnover contribute to ROE

directly increases a company's return on equity (ROE) by generating more revenue per dollar of assets owned

how does equity multiplier contribute to ROE

The equity multiplier directly multiplies a company's return on assets (ROA) to determine its Return on Equity (ROE)

if one of the components moves higher/lower, what is the imoact of ROE?

profit margin: Moves Higher: Net income increases relative to revenue, driving ROE up

asset turnover: Moves Higher: More revenue is squeezed from each dollar of assets, pushing ROE up.

equity multiplier: Moves Higher: Financial leverage increases via more debt funding, mechanically amplifying ROE up

P/E

Measures how much investors are willing to pay for each dollar of earnings.

factors influencing P/E ratio

Growth, profitability, risk, and prevailing interest rates.

effects of higher growth and profitability

Lead to a higher P/E multiple, all else equal.

P/S

Compares a company's market value with its sales.

Useful for companies with negative earnings where P/E is not meaningful.

PEG ratio

Relates a company's P/E ratio to its expected growth rate.

Evaluates whether a stock's P/E is high or low compared to expected growth.

P/BV

compares a company's market value to its book value, showing how much investors pay for each dollar of the company's net worth

EV

Value of operating assets, considering equity and debt while subtracting cash

Considers both equity and debt while subtracting cash.

EBITDA

Earnings before interest, taxes, depreciation, and amortization.

drivers of “r” for PV

• Discount rate

• Cost of capital or equity

• Required rate of return

• opportunity cost

discount rate

The rate used to determine the present value of a future cash flow.

rate of return/compounding of FV

Future value increases with time and higher rate of return

common size balance sheet

expresses every line as a % of total assets

liquidity ranking

cash > recievables > inventory

cash coverage ratio practice

formula: (EBIT + Depreciation) / Interest Expense

EX: COGS = 6200 SG&A = 3400 Depreciation = 600 Interest = 250

(6200-3400-600) = 2200
2200 + 600/200

2800/200 = 11.2

3 Step DuPont Formula

ROE = profit margin x asset turnover x equity multiplier

EX: 2021: Profit margin = 6.0% asset turnover = 2.5x Equity multiplier = 1.20x

2026: Profit margin = 6.0% asset turnover = 1.5 x Equity multiplier = 2.0x

While ROE is the same, …..

SGR

ROE x b

b= retention ratio - 1- divident payout ratio

key conceptual rule for SGR

increasing the divident payout ratio decreases the retention ratio (b)

lower retention means less profit reinvested, which directly REDUCES sustainable growth rate

SGR price calculation

Problem data

Net income= $10,000,000

retained earnings addition = $7,000,000

ROE = 16%

Calculation:

b = 70% (retained earnings is 70% of NI)

1-b = 30%

but what does it mean?

solving for rate of return ex problem

An initial investment of $2,000 in an equity fund 30 years ago is worth $40,000 today. Find CAGR ( r)

N =30

I/Y = ? = 10.5

PV = -2000

PMT = 0

FV = 40000

inflation

furture cash flows lose purchasing power over time

default/credit risk

uncertainty that future promised cash may not be paid

opportunity cost

Cash received today can be invested immediately to earn interest/returns