Financial Management and Leverage Lecture Notes

Practice flashcards covering financial risk, various leverage ratios, hybrid financing, dividend policies, and working capital management concepts.

Financial Risk

The potential monetary gain or loss associated with an investment, which can result in the loss of capital to interested parties.

Financial Leverage

An investment strategy that uses borrowed money - specifically, the use of various financial instruments or borrowed capital - to increase the potential return of an investment

Forms of Financial Risk

1. credit risk

2. operational risk

3. market risk

4. liquidity risk

5. legal and regulatory risk

Credit Risk

Also known as default risk, it is the danger associated with borrowing money where the borrower will likely default should they become unable to repay the loan.

Five Cs of Credit

Character, Capacity, Capital, Collateral and Conditions.

Operational Risk

The risk of failing to succeed in undertakings based on internal factors such as poor management or flawed financial reasoning.

Market Risk

The potential for an investor to experience losses due to factors that affect the overall performance of financial markets.

Liquidity Risk

The risk of not being able to buy or sell an asset quickly enough to prevent a loss or to meet financial obligations.

Legal and Regulatory Risk

The potential financial loss arising from non-compliance with laws, regulations, or contractual obligations, including exposure to lawsuits, fines, and reputational damage.

Operating Leverage

A cost-accounting formula (a financial ratio) that measures the degree to which a firm or project can increase operating income by increasing revenue.

Operating Leverage Formula

$$=\frac{\text{Quantity} \times\text{CM}}{(\text{Q} \times\text{CM}) - \text{FC}}$$

Contribution Margin

The incremental money generated for each product/unit sold after deducting the variable portion of the firm's costs; it shows the portion of sales that helps cover fixed costs.

Contribution Margin Formula

$$=\text{Price}-\text{Variable Cost Per Unit}$$

Cost Volume Profit (CVP) Analysis

A method of evaluating the impact that varying levels of costs and volume have on a company's operating profit.

Break Even Sales Volume Formula

$$\frac{\text{FC}}{\text{CM}}$$

Degree of Operating Leverage (DOL)

A multiple that measures how much the operating income of a company will change in response to a change in sales

Degree of Financial Leverage (DFL)

A leverage ratio that measures the sensitivity of a company's earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure.

DFL Formula

$\frac{\%\, \text{Change in EPS}}{\%\, \text{Change in EBIT}}$ or $\frac{\text{EBIT}}{\text{EBIT} - \text{Interest}}$

Degree of Combined Leverage (DCL)

A leverage ratio summarizing the combined effect of the degree of operating leverage (DOL) and the degree of financial leverage (FL) on earnings per share (EPS).

DCL Formula

$\frac{\%\, \text{Change In EPS}}{\%\, \text{Change in Sales}}$ or $\text{DOL} \times \text{DFL}$

Hybrid Financing

A source of finance that combines features of both typical equities and typical bonds.

Types of Hybrid Financing

1. preference stocks

2. convertible debentures

3. warrants

4. in toggle notes

5. hybrid securities

components of working capital

1. Cash

2. Account Receivables

3. Payables

4. Inventory

types of working capital

1. permanent

2. regular

3. reserve

4. fluctuating/ temporary

5. gross

6. net

Preference Stocks

A type of hybrid financing considered a mixture of fixed and variable income streams where holders receive dividends before common stock holders.

Convertible Debentures

Financial instruments that include the option to convert debentures into equity, contingent on certain terms and conditions.

Warrants

Contracts that give the right to buy and sell shares at a particular price on or before a particular date, functioning similarly to call options.

In-Toggle Notes

A resource for cash-strapped companies that enables them to meet short-term cash flow issues.

hybrid securities

these are mostly tied with common economic variables which include commodity price, interest rate, as well as foreign exchange rate

Dividends

A distribution of a portion of a company's earnings to its shareholders, usually declared by a board of directors.

Dividend Policies

It outlines how a company will distribute its dividends to its shareholders. This policy details specifics about payouts including how often, when, and how much is distributed

Types of Dividend Policies

1. stable

2. constant

3. residual

4. no dividend

5. hybrid

Stable Dividend Policy

A policy providing shareholders with a steady and predictable dividend payout each year, regardless of whether earnings are up or down.

Constant Dividend Policy

A policy where the company pays a specific percentage of its earnings as dividends every year.

Residual Dividend Policy

A policy where dividends are paid from what remains after the company has paid for capital expenditures (CAPEX) and working capital.

No Dividend Policy

A policy prioritizing reinvestment of earnings into research, development, acquisitions, or debt reduction.

Dividend Payout Ratio (DPR)

A financial metric/percentage showing the proportion of total earnings a company pays its shareholders

Stock Dividend

Issued in place of or in addition to cash dividends, occurring when a company issues additional shares of its own stock to existing shareholders.

Stock Dividend

No. of Shares of Stocks x Company's declared Stock Dividend (%)

Stock Split

The subdivision of outstanding stock units resulting in a decrease in par value while the number of shares increases, with no change in the paid-up share capital.

New Numbers of Shares

Current Shares x Split Ratio

New Share Price

Current Share Price ÷ Split Ratio

After Stock Split

New Share x New Price per Share

Before Stock Split

Old Share x Old Price per Share

inventory methods

1. lifo

2. fifo

3. weighted average

LIFO (Last In, First Out)

An inventory method where the newest items purchased are sold or used first.

FIFO (First In, First Out)

An inventory method where the oldest/first items purchased are sold or used first.

Weighted Average Inventory Method

A method where inventory cost is calculated using the average cost of all units purchased.

categories of inventory

1. Raw Materials

2. Work & Process (Work in Process)

3. Finished Goods

4. Merchandise

Working Capital Management

The process of managing a company's short-term assets and liabilities to operate smoothly and pay short-term obligations

Permanent Working Capital

The minimum amount of funds always needed for operations, such as rent and utilities.

Regular Working Capital

The amount of current assets maintained to run daily business smoothly, such as petty cash.

Reserve Working Capital

A safety buffer or extra funds kept for emergencies.

Fluctuating / Temporary Working Capital

Extra funds required for seasonal or temporary business needs, such as peak season supplies.

Gross Working Capital

The total value of all current assets, including inventory and cash.

managing current assets

1. cash

2. receivables management

3. inventory management

two main types of assets

1. permanent curret assets

2. temporary current assets

DFL Formula

$\frac{\%\, \text{Change in EPS}}{\%\, \text{Change in EBIT}}$ or $\frac{\text{EBIT}}{\text{EBIT} - \text{Interest}}$.

Dividend Payout Ratio (DPR)

$$\frac{\text{Total Dividends}}{\text{Total Net Income}}$$

Net Working Capital Formula

$$=\text{Current Assets}-\text{Current Liabilities}$$