Exam 2 Complete Review

Study Guide: Financial Analysis & Risk Management

1. Financial Analysis Concepts

• Users: Business leaders, employees, lenders, investors, competitors.

• Purpose: Turn financial statements from numbers into a narrative.

• Context Importance: Industry, business stage, seasonality are crucial.

  • Two Types of Analysis:

    • Horizontal: Trend analysis across multiple periods.

    • Vertical: Analysis within a reporting period (Income Statement as a % of revenue, Balance Sheet as a % of assets or liabilities).

  • Key Areas of Analysis:

    • Profitability: How much money the company is making.

    • Liquidity: How well the company can pay its bills.

    • Efficiency (Asset Management): How well the company uses its assets.

    • Leverage: How the company uses debt to grow.

2. Liquidity

• Focus: Balance sheet.

• Working Capital Formula: Current Assets - Current Liabilities.

• Working Capital to Sales Ratio: (Working Capital/Sales).

  • Shows if your company has enough working capital to support its sales.

• Key Ratios:

  • Current Ratio: Current Assets / Current Liabilities.

    • Ideal: At least 1:1 (solvency), but 2:1 is better.

  • Quick Ratio (Acid Test Ratio): (Cash + Receivables) / Current Liabilities.

3. Profitability

• Measure: Income Statement.

• Key Formulas:

  • Gross Margin: Revenue - COGS.

    • Higher gross margin = more money to cover operating expenses.

  • Income from Operations: Operating Income / Sales.

  • Return on Sales: Net Income / Net Sales.

  • Return on Assets: Net Income / Total Assets.

  • Return on Investment (ROI): Also known as Return on Equity (ROE): Net Income / Equity.

4. Asset Management

• Formulas:

  • Return on Assets (ROA): Net Income / Total Assets.

  • Inventory Turns: COGS / Inventory.

    • Higher turns = more efficient inventory use.

  • Asset Turns: Sales / Assets.

    • Measures efficiency of asset use in creating revenue.

  • Days Receivable: (Accounts Receivable x 365) / Annual Revenue.

    • Indicates how quickly you are collecting cash.

5. Leverage

• Key Formulas:

  • Debt to Equity: (Current + Long-Term Debt) / Equity.

  • Debt to EBITDA Ratio: (Current + Long-Term Debt) / EBITDA.

  • Interest Coverage Ratio: EBIT / Interest Expense.

    • A ratio of 1.5x or higher indicates healthy ability to pay interest expenses.

6. Financial Analysis – Decision Diagrams

• Steps:

  1. Identify decisions to be made.

  2. Identify chance events that may occur.

  3. Build a timeline of decisions and events.

  4. Create a decision diagram.

  • Diagram Sequence:

    • Determine the probability of each event.

    • Calculate expected values for each outcome.

    • Decide on the optimal strategy.

7. Financial Distress Indicators

• Signs:

  • Cash flow issues, falling margins, high-interest payments, longer payable days.

  • Formula for Days Payable: (# of Days in Period * Average Accounts Payable) / Purchases Made with Credit.

• Common Small Business Problems:

  • Liquidity: Review the current and quick ratios.

  • Working Capital: Look at the Working Capital to Sales ratio.

  • Losses: Breakeven = Fixed Expenses / (1 - Variable Expenses / Sales).

  • Payroll: Determine if it's cheaper to hire new employees or pay overtime.

8. Risk Management

• Types of Risk:

  • External: Physical, cyber, strategic, technological.

  • Internal: Fraud, embezzlement, illness, injury.

• Steps in Risk Management:

  1. Identify: Distinguish between risk and uncertainty.

  2. Analyze: Assess likelihood and impact.

  3. Rank: Prioritize risks.

  4. Mitigate: Implement controls, contracts, insurance.

  5. Review: Risk evolves over time.

9. Approaches to Risk Management

• Controls: Prevent loss, fraud, or injury.

• Contracts: Shift risk to other parties.

• Insurance: Coverage for workers, business interruption, and liabilities.

• Multiple Methods: Internal controls (audits, tip lines) and pre-employment screening.

10. Fraud & Fraud Prevention

• Fraud Definition: Deceptive activity for gain.

  • Fraud Triangle: Pressure, Opportunity, Rationalization.

  • Types:

    • Internal Fraud: Inventory theft, cash embezzlement, lying to investors.

    • External Fraud: Vendor fraud, theft of intellectual property.

  • Fraud Prevention:

    • Internal Controls: Dual signatures, audits, tip lines, code of conduct.

    • Red Flags: Recklessness, outsized spending, personal difficulties, disgruntled employees.

11. Effective Risk Management

• Clear Understanding of Risk Tolerance: Weigh likelihood vs. impact.

• Proportional Management: Avoid overkill, which can constrain business growth.

• Multiple Approaches: Combine controls with screenings and insurance.

12. Key Financial Ratios & Formulas

• Current Ratio: Current Assets / Current Liabilities.

• Quick Ratio: (Cash + Receivables) / Current Liabilities.

• Gross Margin: Revenue - COGS.

• Return on Sales: Net Income / Net Sales.

• Return on Assets: Net Income / Total Assets.

• Debt to Equity: (Current + Long-Term Debt) / Equity.

• Days Receivable: (Accounts Receivable * 365) / Annual Revenue.