Finance

Short-term solvency or liquidity ratios

Ability to meet short-term obligations as they come due

Current ratio = current assets / current liabilities

1.0-2.0 often used as benchmark

Too low could indicate financial difficulties and too high could indicate long-run negative impact on profitability (could be invested elsewhere at higher rates of return or too much inventory/AR)

Quick ratio = (current assets - inventory - prepaid expenses) / current liabilities

Only concerned with current assets that can be readily converted into cash

Acid-test ratio

Better measure of liquidity but not as common as current ratio

Activity or asset management ratios

Measure ability to efficiently use investment in assets to generate profitability

Asset turnover = sales / avg total assets

Higher in retail than manufacturing (low investment in non-current assets)

Receivables turnover = credit sales / avg AR

Average collection period = days in the period / AR turnover OR average AR / (credit sales/365)

Likely to be longer if credit sales make up a large % of sales

Inventory turnover = COGS / avg inventory

Days in inventory = days in the period / inventory turnover OR average inventory / (COGS/365)

Financial leverage or debt service ratios

Measure the extend to which the firm is relying on debt financing and the ability to service the debt

Use book value of debt and equity unless current market values are significantly different or more relevant

Debt ratio = total liabilities / total assets

How much total assets are financed using debt

Lower preferred risk wise but debt cheaper than equity

Debt to equity ratio = total liabilities / total equity

Firms in industries with stable revenue streams and stable earnings can support greater levels of debt

Equity multiplier ratio (leverage ratio) = total assets / total equity

Measures the total asset investment per $1 of total shareholders’ equity

Equal to 1 + debt ratio

Higher = more reliance on debt

Should use average values if available for both values

Times interest earned (interest coverage) = EBIT / interest expense

Number of times that a company can afford to pay its interest charges

Generally a value of at least 3.0 is considered acceptable and as the value increases that company is adding a margin of safety to its financial position

Profitability ratios

Profit margin = net income / sales

Return on assets = net income / avg total assets

Can also use EBIT for numerator to get gross return or use profit margin x total assets turnover for the DuPont model

Higher risk calls for higher return

Return on equity = (net income - preferred dividends declared) / avg total common equity

Can also use profit margin x total asset turnover x equity multiplier for DuPont model

Never use EBIT instead of net income (need to use what is available to common shareholders)

Ability to earn satisfactory rate of return for shareholders

Dividend payout ratio = dividends declared / net income

Both profitability and market value ratio

Sustainable growth rate = ROE (DuPont model) x retention ratio

Maximum rate of growth that can be sustained and maintain the debt to equity ratio

Retention ratio = 1 - dividend payout ratio

Market value ratios

Measure the value of the firm relative to earnings and cash dividends

Always use basic EPS never diluted unless otherwise instructed

Price earnings ratio = market price of shares / EPS

Indicates how investors view the prospects of the firm, higher = more highly valued

Typically use a forward P/E ratio based on current share price and estimated earnings for next year

Reflects risk and expected growth in earnings (firms with higher business risk normally have lower P/E ratios)

Dividend yield = dividend declared per share / market price of shares

Reflects market’s or investor’s perception of the company’s future growth

High growth prospects = lower dividend yield because likely pays lower dividends so can reinvest earnings to support growth and market is likely to recognize growth potential of higher price per share

Dividend payout ratio = dividend declared per share / EPS OR dividends / net income

Also profitability ratio

Indicates how much of the company’s net income is being distributed in the form of cash dividends rather than reinvested in the company

Net working capital

Current assets - current liabilities

Common issues:

Amount of cash to keep on hand and how to invest excess cash

Amount of credit to extend to customers and related credit terms

Level of inventories to carry

Timing of paying suppliers

Amount of short-term borrowing to undertake

Cash conversion cycle

Inventory period + average collection period - days payable outstanding

If positive this is the number of days that financing is required for the shortfall

Why to keep cash on hand:

Take advantage of discounts on purchases and attractive interest rates, liquidity risk, timing of collections not synchronized with disbursements, minimum cash balance as loan requirement

Fixed income investments

Maturity date set at time of purchase with higher return for longer term

Principal returned at maturity

Risk of default - issuer not paying principal and interest as they come due

Interest rate affected by ability to access cash as needed - lowest interest if investment is cashable at any time, medium if a penalty is payable if investment redeemed prior to maturity, and highest if cash is locked in until maturity

Earn interest income and capital gains/losses if sold

Low risk investment if held to maturity

Common fixed income instruments:

Guaranteed investment certificate (GIC) and term deposits - low risk and guaranteed, 30 days to one year, $500-$100,000, cashability (not a word but whatev) and interest terms can change

Treasury bills (T-bills) - purchased from financial institutions and issued by the government of canada, low risk and guaranteed, 30-364 days, easily converted to cash, $1,000-$100,000, sold at a discount and receive face value at maturity

Banker’s acceptances - issued by corporation, higher risk than T-bills, bank guarantees value, one month to one year, $50,000-$500,000, can be sold prior to maturity, issued at a discount and receive face value at maturity

Commercial paper - issued by corporations with good credit, guaranteed by issuer so level of guarantee varies, 1 month-1 year, minimum $100,000, can be sold quickly and easily in secondary market, issued at a discount and mature at face value

Money market funds - pools of short-term securities managed by a fund manager, interest rate fluctuates with market rates of underlying securities in the fund, no guarantee, $10 per unit in the fund, easily sold and converted to cash, yield fluctuates with market

Cost of not taking supplier discount

Effective annual interest rate = (1 + (cash discount / (price - cash discount)))^(365/extra days) - 1

If terms 3/10 net 30, 3 is cash discount 100 is price, and extra days are 30 - 10 = 20

Represents rate of return earned by taking the discount

Compare the effective annual rate from this formula to current short-term borrowing rate or interest being earned on excess cash - would be worth it to pay like 7% interest on a line of credit to pay early and realize a 75% return for example

Free cash flow

The cash that a company can generate at the end of an accounting period after it has paid its expenses and amounts required to maintain or expand its working capital and long-term asset base

Cash available to pursue opportunities that enhance shareholder value

Unlevered FCF = EBIT - income taxes + all non-cash expenses including depreciation and amortization ± investment in working capital (incremental changes in working capital) - capital expenditures required to maintain the business

Unlevered is the industry norm and excludes cash flows related to debt

Levered FCF = net income + all non-cash expenses including depreciation and amortization ± investment in working capital (incremental changes in working capital) - capital expenditures required to maintain the business - scheduled debt repayments

Determining assets available for collateral

Can’t use anything already listed as collateral

May be able to use land and building even when first charge is already on them if a second mortgage is taken out

Assess assets using fair value not book

Do not secure against any kind of joint venture investment unless the case specifies when the company will receive dividends

Capital market vs money market

Capital market = Stock market and bond market

Used for medium to long term financing

Money market = used for short term financing

Term deposits - held at bank or credit union, fixed interest rate

Treasury bills - issued by government, fixed interest rate

Commercial paper - issued by corporation or bank, unsecured, 2-270 days, allows for borrowing for flexible period of time at interest rates often slightly below company’s bank borrowing rate

Steps to issuing securities

1. Board of directors approves the issuance and determine public offering or private placement - there are normally minimum revenue/asset requirements to qualify for listing on stock exchange and private has lower flotation costs, is more flexible, and is faster, but investors are likely to demand higher returns (lack of liquidity), investors may want board representation and involvement in the company, and are likely to demand tighter covenants → majority of bonds and preferred shares sold through private placement

2. Investment bank hired to act as underwriter - intermediary to get it DONE and advise

3. Offering memorandum prepared by investment bank if private placement - securities issue is sold to group of institutional investors (insurance company, pension plan, mutual fund)

4. Cash offer method or rights offer method must be chosen if public offering - securities offered to existing shareholders first (rights offering) or straight to the public

5. Underwriting arrangement decided upon if cash offer - firm commitment (investment bank syndicate buys entire issue at guaranteed price and resells to public market at purchase price plus underwriting spread), dutch auction (purchasers submit bids for blocks of shares to set the price of the issue), or best efforts (investment bank dealers do their best to sell issue at highest possible price or they buy the issue with an option to return if the market price drops significantly, normally used for smaller and lesser-known companies as less risk for underwriter) → if overallotment option or green shoe provision, underwriter can purchase specified % of additional shares from issuer within a limited time period but the issuer still only receives agreed upon price so results in a loss for them but big gains for underwriter

6. Necessary documents prepared, finalized, and filed

7. Underwriter advises on final offer price and shares start to trade

Market efficiency

Weak form = trading prices already reflect all past information

Semi-strong form = prices reflect all publicly available information past and present

Strong form = prices reflect all information available, whether or not it is available to all investors

Strong form is also semi-strong and weak

General consensus that Canadian and US markets are semi-strong but not strong as insiders can earn abnormal profits if they trade on the basis on their privileged information

Credit ratings

Highest AAA = very low probability of default

AA, A, BBB, BB, B = strong/adequate/less vulnerable

CCCC, CCC, CC = in danger of defaulting

D = in default

Higher rating from credit agency = lower required yield on bonds and higher share price

Interest rate determinants

Short-term, risk-free, real return - government treasury bills with no uncertainty about whether all promised future payments will be made, excludes effect of inflation

Expected inflation - protect against loss in purchasing power

Nominal rate = (1 + real rate) x (1 + expected inflation rate) - 1

Higher rates on longer term securities

Risk premium added for default risk (borrower may not be able to make required payments) and liquidity risk (may not be readily sold if no active market or cash committed for period of time)

That one graph in notes where you first find the 1 year risk free real rate, then move along to the right where it slowly curves up based on number of years, and then jump up to the second curve for nominal rate, then jump up again for risk premium

Bond prices

Bond price = PV of interest payments (annuity) + PV of principal repayment at face value (lump sum)

Yield to maturity used as discount rate - if below coupon rate then premium bond and if above then discount bond

PV formula - rate = YTM, PMT = amount of each interest payment, FV = face value of bond

Preferred share prices

Current share price (at today, time 0) = annual stated dividend rate per share divided by required rate of return on preferred shares

Common share price

If not growing at constant rate then have to do dividend in year 1 divided by (1 + required rate of return on common equity)^1 and then repeat for each year but increase the exponent (is that the word?) for whatever year it is and add them all together

If dividends will grow at a constant rate then can do dividend in period 1 (dividend right now x (1+ growth rate)) divided by (required rate of return on common equity minus constant growth rate)

Annual return on a bond

Interest (rate given x face value) + market value less face value and then divide total by face value

Portfolio theory

Holding a sufficiently large number of investments with returns that are not perfectly positively correlated ensures that realized average of returns will be close to expected return

Efficient portfolio = smallest level of portfolio risk for given level of expected portfolio return OR highest expected return for given level of risk

Portfolio risk eliminated if securities are perfectly negatively correlated

Allocation to many different assets = less effect if one loses a lot of value

Types of risk

Unsystematic = unique to the security

Diversifiable, can be eliminated by comining with other securities

Systematic = non-diversifiable, market risk

Estimated through beta for individual security which is a measure of volatility of returns in relation to market returns

Cannot be totally eliminated through diversification

Capital asset pricing model

CAPM

Describes relationship between security’s expected return and systematic risk

Expected return = risk free return + beta x (expected rate of return on the market - risk free return)

Brackets = market risk premium and beta x market risk premium = risk premium related to risk of investment

Investments ranked by risk level (least risky to riskiest

1. Short-term term deposits

2. Government bonds

3. Corporate bonds

4. Preferred shares

5. Common shares - publicly traded

6. Common shares - private companies

7. Derivatives

Strategic investments and alliances:

Outsourcing and alliances vs joint arrangements vs strategic investment - associate vs strategic investment - subsidiary

Compared on:

Number of partners

Upfront costs

Legal form

Governance and control

Duration

Ease of structure

Timing

Difficulties

Contribution of resources

Financial returns

GET TABLE FROM TEXTBOOK CH 11

Approaches to managing risk

Opportunistic - actively forecast financial and/or commodity prices and make decisions based on forecast to benefit from changes in prices → very high costs, appropriate when management has superior forecasting ability

Passive - ignore risk and rely on ability to ride out fluctuations assuming that any gains/losses will balance over the long run → no costs and appropriate when risks are moderate

Defensive - react when potential adverse changes in interest rate, FX rate, or commodity prices threaten substantial losses that could lead to financial distress and take action in the financial market to insure against major risks → moderate costs and appropriate when risks are high

Compromise - develop a complete hedging strategy to minimize risk exposure and follow with some exceptions when strongly believe that can benefit by taking opportunistic position, takes more time but can create positive returns from hedging → high costs and appropriate when risks are not so high

Derivatives

Forwards and futures contracts:

Agreement for delivery of specified asset at agreed-upon price at pre-specified future date under contractual obligation

Futures - exchange traded and require margin account with broker that must be settled daily and cash deposited when margin account balance falls below minimum level, commonly used for managing commodity prices risks

Forwards - non-exchange traded, counterparty risk

Can eliminate downside losses and upside gains - fixed selling price regardless of market

Call (put) options:

Right not obligation to sell at agreed-upon price at any time before option’s maturity

Premium must be paid regardless of whether exercised

Eliminate downside risk but allow for upside gains

Exercised when strike price is in the money

Traded on an exchange

Swaps:

Contracts between two parties to exchange cash flows on specified future dates based on underlying value of FX rates or interest or whatever

Interest rate swaps most common

Commonly used with lending agreements where companies swap a floating rate for a fixed rate and effectively lock in an interest rate

Pay the fixed rate and receive from the dealer the floating

Natural hedge:

No derivative used but natural offset of risk