Financial Management Fall

Common size balance sheet

% of assets

Common size income statement

% of revenue

Common size percentage of the equity

Equity / Total Assets

For common size percentage of equity problems…

…Find total assets first. Use this total assets number and subtract the liabilities from it.

Liquidity ratios measure:

The level of liquidity a firm has. It indicates whether a firm can pay its bills in the short term.

There are three liquidity ratios

1. Current ratio

2. Quick ratio

3. Cash ratio

Current ratio is:

Current assets / current liabilities

Quick ratio is:

(Current assets - inventory) / current liabilities

Cash ratio is:

Cash / current liabilities

For problems like “Motor Works has total assets of $919,200, long-term debt of

$264,500, total equity of $466,900, net fixed assets of $682,800,

and sales of $1,021,500. The profit margin is 6.2 percent. What is

the current ratio?”
REMEMBER THIS:

Current assets = total assets - net fixed assets 

Current liabilities = total assets - total equity - LTD

Which one of these transactions will increase the

liquidity of a firm?

OOF

FINANCIAL LEVERAGE

Total debt ratio:

Total debt / total assets

FINANCIAL LEVERAGE
Debt-to-equity ratio:

Total debt / total equity

FINANCIAL LEVERAGE

Equity multiplier:

1 + total debt / total equity 

Times interest earned:

EBIT / Interest

You would like to borrow money three years from now to build a new building. In

preparation for applying for that loan, you are in the process of developing target

ratios for your firm. Which set of ratios represents the best target mix considering

that you want to obtain outside financing in the relatively near future:

C. Cash coverage ratio = 2.6; debt-equity ratio = .3

Profit margin:

Net income / sales

Return on assets:

Net income / assets

Return on equity:

Net income / total equity

Bed Bug Inn has annual sales of $137,000. Earnings before interest

and taxes is equal to 5.8 percent of sales. For the period, the firm

paid $4,700 in interest. What is the profit margin if the tax rate is

34 percent?

1.56 percent

Inventory turnover

cost of goods sold / inventory

Days sales in inventory

365 / inventory turnover

Inventory turnover and receivables ratios are inherently linked

Inventory ratios BECOME receivables ratios!

Receivables turnover

Sales / accounts receivable

Days sales in receivables

365 / receivables turnover

Asset turnover

Sales / total assets

PE ratio

Price per share / earnings per share 

EPS:

net income / # of shares outstandinv

DuPont identity:

ROE = net income / total equity
is the same as
ROE = profit margin x asset turnover x equity multiplier

Assets = 

Liabilities + owners equity 

Revenue - expenses =

Net income

Depreciation

Lowers taxes

Cash flow from assets = 

operating cash flow - net capital spending - change in net working capital

Operating cash flow

TWO FORMULAS

1. EBIT + Depreciation - Taxes

2. Net Income + Depreciation + Interest

Net capital spending =

Ending Net Fixed Assets - Beginning Net Fixed Assets + Depreciation

Changes in NWC = 

Ending NWC - Beginning NWC

Alternative Cash Flow From Assets =

Cash Flow To Creditors + Cash Flow To Shareholders

1. Cash flow to creditors = Interest Paid - Net Borrowings + Loans Paid Back

2. Cash flow to shareholders = Dividends Paid - Net New Equity Raised

What do you get when you do sales * profit margin?

You get net income

IMPORTANT
Another way to find net income:

Net ncome = dividends paid + addition to retained earnings 

Book value per share:

Total equity / # of shares outstanding

Another important way to find EBIT

EBIT = Net Income / 1 - Tax Rate

Net working capital = 

Current Assets - Current Liabilities

Net capital spending is equal to:

ending net fixed assets minus beginning net fixed assets plus depreciation.

Net new borrowing =

Ending long term debt - beginning long term debt

Total Book value of assets =

Net Fixed Assets + Current Assets

………..

………

“what would be the book value of the current assets?”

Just find the current assets regularly

COGS is an income statement item, so its common size version is:

COGS / Sales

Sophia wants to evaluate how efficiently her company uses its assets to generate sales. Which ratio should she compute?

Total Asset Turnover

Marcus wants to know what portion of his firm’s assets are financed through debt rather than equity. Which ratio should he use?

Debt Ratio

Kelly’s firm has borrowed heavily, and she wants to know how easily it can cover its interest payments from operating profits. Which ratio should she compute?

Times Interest Earned (Interest Coverage)

Current liabilities =

Total Debt - Long Term Debt

Cash flow to creditors =

Interest Paid - Net Borrowings + Loans Paid Back

Cash flow to shareholders = 

Dividends Paid - Net New Equity Raised

Total equity =

Total assets - total debt

For a problem like this “AMC Supply has total assets of $613,000. There are 21,000 shares of stock outstanding with a market value of $13 a share. The firm has a profit margin of 6.2 percent and a total asset turnover of 1.08. What is the price-earnings ratio?”

You naturally want to find EPS, which requires net income. But you need sales to calculate it. SO you do this:

Find sales with total asset turnover!

A fire has destroyed a large percentage of the financial records of the Strongwell Company. You have the task of piecing together information in order to release a financial report. You have found the return on equity to be 13.8 percent. Sales were $979,000, the total debt ratio was .42, and total debt was $548,000. What is the return on assets?

8.00%

1. Find total assets

2. Find total equity: Equity = total assets - total debt 

3. Use ROE to find net income

4. Compute ROA

A firm has net income of $197,400, a return on assets of 9.7 percent, and a debt-equity ratio of .85. What is the return on equity?

17.95%

(REMEMBER: ROE = ROA * (1 + debt equity ratio))

How to solve

The Saw Mill has a return on assets of 7.92 percent, a total asset turnover rate of 1.18, and a debt-equity ratio of 1.46. What is the return on equity?

Answer: 19.48%

How its done: Use the leverage relationship

ROE = ROA x (1 + Debt Equity Ratio)

Mercier United has net income of $128,470. There are currently 32.67 days' sales in receivables. Total assets are $1,419,415, total receivables are $122,306, and the debt-equity ratio is .40. What is the return on equity?

Answer: 12.67%

How to solve:

Step 1 find ROA

Step 2 ROE = ROA x (1 + dbet equity multiplier)

Lester had $6,270 in his savings account at the beginning of this year. This amount includes both the $6,000 he originally invested at the beginning of last year plus the $270 he earned in interest last year. This year, Lester earned a total of $282.15 in interest even though the interest rate on the account remained constant. This $282.15 is best described as:

Compound interest

By definition, a bank that pays simple interest on a savings account will pay interest:

only on the principal amount originally invested.

FV=

PV×(1+r)^t

Theodoro has just received an insurance settlement of $18,500. She wants to save this money until her daughter goes to college. If she can earn an average of 5.2 percent, compounded annually, how much will she have saved when her daughter enters college 9 years from now?

Answer: $29,195.33

Use: PV×(1+r)^t

Travis invests $4,500 today into a retirement account. He expects to earn 11 percent, compounded annually, on his money for the next 12 years. After that, he wants to be more conservative, so only expects to earn 9 percent, compounded annually. How much money will he have in his account when he retires 25 years from now, assuming this is the only deposit he makes into the account?

$48,265.05

PV = 

FV / (1 + r) ^ t 

r =

( FV / PV ) ^ ( 1 / t ) - 1

Capital budgeting

What long term investments should the firm take?

(Planning and managing a firm’s long term investments)

Capital structure

Where will the firm get its long term financing to pay for its investments?

What mixture of debt and equity should be used?

Working capital management?

How should the firm manage its everyday financing activities?

Calculate simple interest

P x R x T

You want to invest an amount of money today and receive back twice that amount in the future. You expect to earn 9 percent interest. Approximately how long must you wait for your investment to double in value?

USE RULE OF 72

Answer: 8 years

Work: 72 / 9