HOCK CMA Part 2 - Strategic Financial Management PDF

CMA Part 2 Volume 1: Sections A and B Strategic Financial Management Version 22.01 HOCK international books are licensed only for individual use and may not be lent, copied, sold or otherwise distributed without permission directly from HOCK international. If you did not download this book directly from HOCK international, it is not a genuine HOCK book. Using genuine HOCK books assures that you have complete, accurate and up-to-date materials. Books from unauthorized sources are likely outdated and will not include access to our online study materials or access to HOCK teachers. Hard copy books purchased from HOCK international or from an authorized training center should have an individually numbered orange hologram with the HOCK globe logo on a color cover. If your book does not have a color cover or does not have this hologram, it is not a genuine HOCK book. 2022 Edition CMA Preparatory Program Part 2 Volume 1: Sections A and B Strategic Financial Management Brian Hock, CMA, CIA and Lynn Roden, CMA HOCK international, LLC P.O. Box 6553 Columbus, Ohio 43206 (866) 807-HOCK or (866) 807-4625 (281) 652-5768 www.hockinternational.com [email protected] Published October 2021 Acknowledgements Acknowledgement is due to the Institute of Certified Management Accountants for permission to use questions and problems from past CMA Exams. The questions and unofficial answers are copyrighted by the Certified Institute of Management Accountants and have been used here with their permission. The authors would also like to thank the Institute of Internal Auditors for permission to use copyrighted questions and problems from the Certified Internal Auditor Examinations by The Institute of Internal Auditors, Inc., 247 Maitland Avenue, Altamonte Springs, Florida 32701 USA. Reprinted with permission. The authors also wish to thank the IT Governance Institute for permission to make use of concepts from the publication Control Objectives for Information and related Technology (COBIT) 3rd Edition, © 2000, IT Governance Institute, www.itgi.org. Reproduction without permission is not permitted. © 2021 HOCK international, LLC No part of this work may be used, transmitted, reproduced or sold in any form or by any means without prior written permission from HOCK international, LLC. ISBN: 978-1-934494-72-1 Thanks This textbook is for personal use only by Prateek Yadav ([email protected]). The authors would like to thank the following people for their assistance in the production of this material: § Kevin Hock for his work in the formatting and layout of the material, § All of the staff of HOCK Training and HOCK international for their patience in the multiple revisions of the material, § The students of HOCK Training in all of our classrooms and the students of HOCK international in our Distance Learning Program who have made suggestions, comments and recommendations for the material, § Most importantly, to our families and spouses, for their patience in the long hours and travel that have gone into these materials. Editorial Notes Throughout these materials, we have chosen particular language, spellings, structures and grammar in order to be consistent and comprehensible for all readers. HOCK study materials are used by candidates from countries throughout the world, and for many, English is a second language. We are aware that our choices may not always adhere to “formal” standards, but our efforts are focused on making the study process easy for all of our candidates. Nonetheless, we continue to welcome your meaningful corrections and ideas for creating better materials. This material is designed exclusively to assist people in their exam preparation. No information in the material should be construed as authoritative business, accounting or consulting advice. Appropriate professionals should be consulted for such advice and consulting. Dear Future CMA: Welcome to HOCK international! You have made a wonderful commitment to yourself and your profession by choosing to pursue this prestigious credential. The process of certification is an important one that demonstrates your skills, knowledge, and commitment to your work. We are honored that you have chosen HOCK as your partner in this process. We know that this is a great responsibility, and it is our goal to make this process as efficient as possible for you. To do so, HOCK has developed the following tools for your use: A PassMap that guides you unit by unit through the study process. The Textbook that you are currently reading. This is your main study source and contains all of the information necessary to pass the exam. This textbook follows the exam contents and provides all necessary background information so that you don’t need to purchase or read other books. The Flash Cards include short summaries of main topics, key formulas and concepts. You can use them to review whenever you have a few minutes, but don’t want to take your textbook along. ExamSuccess contains original questions and questions from past exams that are relevant to the current syllabus. Answer explanations for the correct and in- correct answers are also included for each question. Practice Essays taken from past CMA Exams that provide the opportunity to practice the essay-style questions on the Exam. A Mock Exam enables you to make final preparations using questions that you have not seen before. Teacher Support via our online student forum, e-mail, and telephone through- out your studies to answer any questions that may arise. Videos using a multimedia learning platform that provide the same coverage as a live-taught course, teaching all of the main topics on the exam syllabus. We understand the commitment that you have made to the exams, and we will match that commitment in our efforts to help you. Furthermore, we understand that your time is too valuable to study for an exam twice, so we will do everything possible to make sure that you pass the first time. I wish you success in your studies, and if there is anything I can do to assist you, please contact me directly at [email protected]. Sincerely, Brian Hock, CMA, CIA President and CEO CMA Part 2 Table of Contents Table of Contents Introduction to CMA Part 2................................................................................................1 Section A – Financial Statement Analysis.......................................................................2 Study Unit 1: A.1. Basic Financial Statement Analysis..................................................3 Measures of Income 3 Comparative Financial Statement Analysis 5 Vertical Common-Size Financial Statements 6 Horizontal Trend Analysis 8 Study Unit 2: A.2. Introduction to Financial Ratio Analysis...........................................9 Study Unit 3: A.2. Liquidity Ratios.................................................................................. 11 Net Working Capital 11 Liquidity Ratios 12 Study Unit 4: A.2. Leverage and Coverage Ratios........................................................ 16 Financial Leverage 17 Operating Leverage 22 Capital Structure and Solvency Ratios 27 Earnings Coverage Ratios 28 Study Unit 5: A.2. Activity Ratios.................................................................................... 33 Accounts Receivable Activity Ratios 33 Inventory Activity Ratios 35 Accounts Payable Activity Ratios 37 The Operating Cycle and the Cash Cycle 39 Total Asset Turnover Ratio 39 Fixed Asset Turnover Ratio 39 Study Unit 6: A.2. Market Ratios..................................................................................... 40 Book Value Per Share 40 Market-to-Book Ratio 41 Price/Earnings (P/E) Ratio 42 Earnings Yield 42 Dividend Yield 43 Dividend Payout Ratio 43 Shareholder Return 43 Study Unit 7: A.2. Basic Earnings Per Share................................................................. 44 Study Unit 8: A.2. Diluted Earnings Per Share.............................................................. 53 EPS Disclosures 64 Study Unit 9: A.2. Profitability Ratios............................................................................. 65 Gross Profit Margin Percentage 65 Operating Profit Margin Percentage 66 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. i Table of Contents CMA Part 2 Net Profit Margin Percentage 66 EBITDA Margin Percentage 67 Return on Invested Capital 68 Study Unit 10: A.3. Profitability Analysis....................................................................... 71 Analyzing Return on Assets 71 Analyzing Return on Equity 73 “Equity,” “Assets,” and “Return” in ROA and ROE 74 Factors in Measuring Income 77 Sustainable Growth Rate 80 Benefits and Limitations of Ratio Analysis 82 Study Unit 11: A.4. Foreign Currency in Financial Statement Analysis...................... 84 Study Unit 12: A.4. Accounting for Foreign Operations............................................... 86 Study Unit 13: A.4. Inflation and Financial Ratios......................................................... 91 Study Unit 14: A.4. Impact of Accounting Changes on Financial Ratios.................... 92 Study Unit 15: A.4. Book/Market Value and Accounting/Economic Profit.................. 96 The Difference Between Book Value and Market Value 96 Economic Profit and Accounting Profit 96 Study Unit 16: A.4. Earnings Quality.............................................................................. 99 Section B – Corporate Finance..................................................................................... 103 Study Unit 1: B.1. Risk and Return and Types of Risks.............................................. 104 Risk 105 Types of Risk 105 Return 107 The Relationship Between Risk and Return 108 Study Unit 2: B.1. Capital Asset Pricing Model (CAPM).............................................. 109 Using the Security Market Line 114 Study Unit 3: B.1. Portfolio Risk and Return............................................................... 117 Study Unit 4: B.2. Introduction to Long-Term Financial Management...................... 119 Capital Structure 119 Determining the Capital Structure – Issuing Debt or Equity 120 Study Unit 5: B.2. Introduction to Cost of Capital....................................................... 121 Overall Cost of Capital and the Weighted-Average Cost of Capital 122 Study Unit 6: B.2. Debt Financing (Bonds).................................................................. 123 The Bond Instrument 123 Bonds and Rating Agencies 129 Study Unit 7: B.2. Cost of Capital – Cost of Debt........................................................ 129 Study Unit 8: B.2. Term Structure of Interest Rates.................................................... 132 Study Unit 9: B.2. Bond Duration.................................................................................. 134 ii © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. CMA Part 2 Table of Contents Study Unit 10: B.2. Equity Financing............................................................................ 136 Common Stock 136 Par Value of Shares 137 Preferred Stock 138 Possible Characteristics of Preferred Shares 139 Dividends on Preferred Stock 140 Study Unit 11: B.3. Dividend Policy and Treasury Stock............................................ 141 Dividends, Dividend Policy, and Stock Splits 141 Treasury Stock 146 Study Unit 12: B.2. Stock Rights, Warrants, and ADRs.............................................. 147 Study Unit 13: B.2. Calculation of the Value of a Share.............................................. 150 The Theoretical (or Intrinsic) Value of a Share of Stock 150 Study Unit 14: B.2. Cost of Capital – Cost of Preferred Stock................................... 158 Study Unit 15: B.2. Cost of Capital – Cost of Common Equity................................... 160 Study Unit 16: B.2. Cost of Capital – Capital Structure and WACC........................... 164 Marginal Cost of Capital 167 Study Unit 17: B.2. Introduction to Derivatives........................................................... 169 Study Unit 18: B.2. Forward and Future Contracts..................................................... 170 Study Unit 19: B.2. Interest Rate and Foreign Currency Swaps................................ 174 Study Unit 20: B.2. Options........................................................................................... 175 Study Unit 21: B.2. Hedging Strategies with Puts and Calls...................................... 181 Study Unit 22: B.3. Raising Capital In Privately-Held Companies............................. 185 Commercial Bank or Finance Company Loans 185 Lease Financing 185 Lease Versus Purchase Analysis 186 Venture Capitalists 186 Study Unit 23: B.3. Raising Capital In Publicly-Held Companies............................... 187 Equity (Common Stock) Issues 187 Debt (Bond) Issues 189 Study Unit 24: B.3. Financial Markets........................................................................... 189 Trading Shares After the IPO – The Secondary Markets 189 Market Efficiency and the Efficient Market Hypothesis 190 Insider Trading 191 Study Unit 25: B.4. Working Capital Introduction....................................................... 192 The Operating Cycle and the Cash Cycle 192 Working Capital 194 Components of Working Capital 196 Study Unit 26: B.4. Cash Management......................................................................... 196 Cash Flow Management 197 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. iii Table of Contents CMA Part 2 Study Unit 27: B.4. Marketable Securities Management............................................. 202 Study Unit 28: B.4. Accounts Receivable Management.............................................. 206 Study Unit 29: B.4. Inventory Management.................................................................. 208 Study Unit 30: B.4. Trade Credit Financing.................................................................. 214 Study Unit 31: B.4. Bank Loans.................................................................................... 215 Short-Term Commercial Bank Loans 215 Effective Interest Rate on a Short-Term Bank Loan 216 Study Unit 32: B.4. Factoring Receivables and Short-Term Financing..................... 218 Maturity Matching Approach to Working Capital Management 222 This textbook is for personal use only by Prateek Yadav ([email protected]). Study Unit 33: B.5. Corporate Restructuring, Business Combinations.................... 223 Study Unit 34: B.5. Takeover Defenses........................................................................ 226 Study Unit 35: B.5. Divestitures.................................................................................... 227 Study Unit 36: B.5. Discounted Cash Flow Valuation................................................. 229 Study Unit 37: B.6. International Finance, Foreign Direct Investment....................... 232 Foreign Direct Investment 232 Multinational Corporations (MNCs) 233 Study Unit 38: B.6. Foreign Currency Exchange Rates.............................................. 235 Listing Currency Exchange Rates 235 The Exchange Rate Changes Over Time 237 The Effect of Appreciation and Depreciation of a Currency 238 The Discount or Premium of a Currency in the Forward Market 240 Determination of Exchange Rates 242 1) Floating Exchange Rates 243 2) Fixed Exchange Rates 245 3) Managed Float Exchange Rates 248 4) Pegged Exchange Rate System 248 Managing Exchange Rate Risk 248 Study Unit 39: B.6. Using Foreign Financing............................................................... 252 Use of Foreign Financing to Reduce Costs 252 International Payment and Financing 254 Appendix A – Present Value Factors............................................................................ 256 Appendix B – Amortization of Bond Discount by Issuer............................................ 258 iv © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Introduction CMA Part 2 Introduction to CMA Part 2 The CMA Part 2 exam has six main sections. The six sections and their approximate weights on the exam are: 1) Financial Statement Analysis: 20% 2) Corporate Finance: 20% 3) Decision Analysis: 25% 4) Risk Management: 10% 5) Investment Decisions: 10% 6) Professional Ethics: 15% The questions on the CMA exams focus on understanding, in-depth thinking on business strategy, and problem-solving ability, not just number crunching. In order to be successful, candidates need to under- stand the concepts and be able to apply them to situations that are brand new. HOCK can provide the tools for understanding in these study materials but cannot teach in-depth thinking and problem solving. A can- didate’s ability to put this information into practice to pass this exam will depend on the effort put into preparing for the exam. Section A, Financial Statement Analysis, represents 20% of the exam. Financial Statement Analysis includes ratios, interpretation of ratios, and other financial statement analysis topics. Section B, Corporate Finance, constitutes 20% of the exam. Corporate Finance includes several topics in- cluding risk and return, long-term financial management, raising capital, working capital management, corporate restructuring, and international finance. Section C, Decision Analysis, is 25% of the exam. Topics covered in this section include cost-volume-profit analysis (or breakeven analysis), marginal analysis, and pricing. Section D, Risk Management, is 10% of the exam. It covers enterprise risk, risk assessment, and managing risk. Section E, Investment Decisions, comprises 10% of the exam. Investment Decisions is concerned with capital budgeting. Section F, Professional Ethics, represents 15% of the exam. Ethics is tested in two contexts: ethical con- siderations for professionals and ethical considerations for the organization. The exam will consist of 100 multiple-choice questions and 2 essay scenarios, each with several questions. The multiple-choice questions will not be presented in order according to sections. Thus, an exam might begin with a capital budgeting question, then follow that with a financial statement analysis question, and so forth. Only candidates who score a minimum of 50% correct on the multiple-choice portion of the exam will be eligible to take the essay section of the exam. © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 1 Section A Introduction CMA Part 2 Section A – Financial Statement Analysis Introduction to the Financial Statement Analysis Section The Financial Statement Analysis section comprises 20% of the CMA Part 2 Exam. Part 2 is a four-hour exam that will contain 100 multiple-choice questions and 2 essay scenarios. Topics within an examination part and the subject areas within topics may be combined in individual questions. Therefore, the number of multiple-choice questions on Financial Statement Analysis in any one exam cannot be predicted, nor can it be predicted whether or not an individual exam will have any essay questions on the topic. The best approach to preparing for the exam is to know and understand the concepts very well and be ready for anything. In studying for the following section, make certain to know all of the ratios listed, what each one means, and what each one is used for. Candidates need to be able to interpret the ratios, not just calculate them. The flash cards that are a part of the HOCK Questions can be useful for studying the ratios more than for studying other topics because the ratios all need to be memorized. Using the flash cards will definitely help to memorize the ratios. A knowledge of financial accounting is needed for the Financial Statement Analysis portion of the exam. 2 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Section A Study Unit 1: A.1. Basic Financial Statement Analysis Study Unit 1: A.1. Basic Financial Statement Analysis Measures of Income Earnings Before Interest and Taxes (EBIT) and Earnings Before Taxes (EBT) are terms frequently used in financial statement analysis. Earnings Before Interest and Taxes and Earnings Before Taxes Defined The standard multiple-step income statement format includes the following sections: Revenues $XXXXX Cost of goods sold XXXX Gross profit $XXXXX Selling, general, and administrative expenses XXX Operating income $XXXXX Interest and dividend income XXX Interest expense XXX Non-operating gains/(losses) XXXX Income from continuing operations before income taxes $XXXXX Provision for income taxes on continuing operations XXXX Income from continuing operations $ XXXX Discontinued operations: Gain/(loss) from operations of discontinued Component X (including gain/[loss] on disposal of $XXX) XXXX Income tax benefit or (income tax expense) XXX Income (loss) on discontinued operations XXXX Net Income $ XXXX Note: “Income from continuing operations” on a multi-step income statement is not the same thing as “operating income.” Operating income includes revenues and expenses generated by the company’s core business. Operating income does not include financial income (interest and dividend income) or financial expense (interest expense), nor does it include non-operating gains and losses or the provision for income taxes on con- tinuing operations. Income from continuing operations, on the other hand, does include financial income, financial expense, non-operating gains and losses, and income taxes on continuing operations, in addition to revenues and expenses generated by the company’s core business. Income from continuing operations refers to gain or loss that the company generated on all of its activ- ities that are expected to continue in the future. It is called income from continuing operations to distinguish it from gains and losses on discontinued operations. Income from continuing operations does not include income from discontinued operations because income from discontinued operations repre- sents income or loss that is not expected to continue in the future. The potential buyer of a company should look at income from continuing operations instead of net income because income from continuing operations will continue in the future. The line “Income from continuing operations” appears on an income statement only if the firm is reporting results of discontinued operations. © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 3 Study Unit 1: A.1. Basic Financial Statement Analysis CMA Part 2 Earnings Before Interest and Taxes (EBIT) is not the same as operating income, though in some cases the two things may be the same. A line titled “EBIT” does not appear on a standard, multi-step income statement because EBIT is a calculated amount used in financial statement analysis and other types of analysis. Earnings Before Interest and Taxes is equivalent to net income adjusted to add back any deduction for interest expense and any deductions for taxes. EBIT can be calculated in more than one way. Beginning with operating income, it would be calculated as follows, excluding any deductions for interest expense or income tax expense: Operating income $XXXXX + Interest and dividend income XXX +/− Non-operating gains/(losses) XXXX +/− Gain/(loss) from operations of discontinued Component X including gain/(loss) on disposal of $XXXX (before tax) XXXX = Earnings Before Interest and Taxes (EBIT) $XXXXX In summary, the differences between operating income and EBIT are: Operating income does not include interest and dividend income, whereas EBIT does include inter- est and dividend income. Operating income does not include non-operating gains and losses on acquisitions or investments, whereas EBIT does include non-operating gains and losses on acquisitions or investments. Operating income does not include pre-tax gains and losses on discontinued operations, whereas EBIT does include pre-tax gains and losses on discontinued operations. Neither EBIT nor operating income include any deductions for interest expense or for taxes. Therefore, if the company has gains and/or losses on acquisitions or investments, interest, or dividend income, and/or income/losses from discontinued operations, its Earnings Before Interest and Taxes will not be the same as its operating income. All of those items constitute the difference between operating income and EBIT. If the company has none of those items, its operating income will be the same as its EBIT, but that will be true only because the items that would create the difference do not exist. Note: Non-operating gains and losses and interest and dividend income earned on investments may be excluded from EBIT if the analyst prefers. However, interest income earned on credit extended to cus- tomers should always be included in EBIT. Exam Tip: Despite the fact that operating income and EBIT are not the same thing, they may be used interchangeably, even on an exam, under the assumption that the income statement contains no gains/losses on acquisitions or investments, no interest or dividend income, and no income/losses from discontinued operations. 4 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Section A Study Unit 1: A.1. Basic Financial Statement Analysis Earnings Before Taxes (EBT) is Earnings Before Interest and Taxes (EBIT) minus Interest Expense. Operating income $XXXXX + Interest and dividend income XXX +/− Non-operating gains/(losses) XXXX +/− Gain/(loss) from operations of discontinued Component X including gain/(loss) on disposal of $XXXX (before tax) XXXX = Earnings Before Interest and Taxes (EBIT) $XXXXX − Interest expense XXX = Earnings Before Taxes (EBT) $ XXXX This textbook is for personal use only by Prateek Yadav ([email protected]). Comparative Financial Statement Analysis One of the main difficulties in the comparison of financial statements between companies or between periods of time for the same company is the difference in size. When comparing two companies, one company may have a higher net income simply because it is bigger and not because it is more efficient, effective or sells a better product. When comparing financial statements for the same company over several accounting periods, the income statements may report significant sales growth during one of the periods, making compar- ison difficult. One of the ways to deal with these size differences is through comparative financial statement analysis. Comparative financial statements state each item of the financial statement not as a numerical amount, but rather as a percentage of a relevant base amount. Comparative financial statements can be either vertical or horizontal. Vertical analysis, also called common-size financial statements, makes it possible to compare the performance of companies of different sizes during the same period of time. Horizontal or trend analysis, also called common-base year statements, enables comparison of data for a single company or a single industry over a period of time. © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 5 Study Unit 1: A.1. Basic Financial Statement Analysis CMA Part 2 Vertical Common-Size Financial Statements A simple vertical common-size financial statement covers one year’s operating results and expresses each component as a percentage of a total. Line items on the income statement are usually presented as a percentage of sales revenue. Line items on the balance sheet are usually presented as a percentage of total assets. For example, fixed assets will not be stated as a dollar amount but rather will be stated as a percentage of total assets. Each expense item will be stated as a percentage of total revenue. However, common-size financial statements do not need to relate each balance sheet item to total assets only. For example, the analysis might focus on the company’s inventory and calculate percentages of raw materials, work in process, and finished goods in total inventories. Or the analysis might focus on the composition of the company’s investments, both current and noncurrent. A vertical common-size income statement might state each classification of sales revenue or expenses as a percentage of total revenues. Alternatively, it might state general and administrative expenses and selling expenses each as a percentage of total operating expenses. A common-size financial statement can be anything the analyst wants to see or analyze. The analyst might also compare a company’s common-size income statement with industry common-size income statements to potentially reveal a problem. For instance, if cost of goods sold as a percentage of total sales revenue is significantly higher than the norm for other firms in the same line of business, it could indicate that “inventory shrinkage” (in other words, theft) is taking place. In addition, common-size financial statements for one company can be arranged side by side for a period of several years to reveal trends over time in individual line items as percentages of sales revenue. Common-size financial statements by industry are available in published form from several sources. Two of them are: 1) A book called Annual Statement Studies is published by the Risk Management Association (formerly Robert Morris Associates), a bankers’ trade association. The statement studies information is pro- vided by RMA member banks from the financial statements of their small and medium-size business customers. The information covers more than 300 industries and is broken down by asset size and sales size, so that a particular company’s common-size statement can be compared with those of businesses in its industry that are approximately its own size. The Annual Statement Studies can be purchased either in hard copy or as online access through RMA’s website at www.rmahq.org. 2) Dun & Bradstreet® Key Business Ratios on the Web (KBR), published by Mergent, Inc., provides industry benchmarks compiled from Dun & Bradstreet's database of public and private companies. KBR provides common-size financial statements and 14 key ratios developed from actual company income statements and balance sheets. The sources above contain data on both public and nonpublic companies, though the vast majority of the information in the Annual Statement Studies is on nonpublic companies. Much more information is available for public companies than for nonpublic companies. Various Internet sites provide data on public companies that is already in a form that can be easily analyzed. Some of this information is free and some is on a subscription basis. In the U.S., information on any company that files reports with the SEC (Securities Exchange Commission) is available for free at www.sec.gov. 6 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Section A Study Unit 1: A.1. Basic Financial Statement Analysis Example: A common-size vertical statement. Following is a balance sheet and income statement for a company with the actual numbers in the first column and the common size vertical numbers in the second column (in thousands, 000 omitted). Each individual balance sheet item has been divided by the total assets and each individual income statement item has been divided by the total net revenues. This common-size vertical statement can be compared with common-size statements for other companies, regardless of their sizes or can be prepared for several years for the same company to enable side-by-side comparison. 20X3 Actual 20X3 Common Size Balance Sheet: ASSETS Current Assets: Cash & cash equivalents $ 2,895 10.9% Marketable securities - current 14,100 53.2% Accounts receivable, net 700 2.7% Inventories 400 1.5% Other current assets 300 1.1% Total current assets $ 18,395 69.4% Noncurrent Assets: Intangible assets $ 4,500 17.0% Property, plant & equipment, net 2,400 9.1% Other noncurrent assets 1,200 4.5% Total assets $ 26,495 100.0% LIABILITIES Current Liabilities: Accounts payable $ 600 2.3% Accrued liabilities 500 1.9% Other current liabilities 1,700 6.4% Total current liabilities $ 2,800 10.6% Noncurrent Liabilities: Long-term debt $ 5,000 18.8% Other noncurrent liabilities 4,300 16.2% Total liabilities $ 12,100 45.7% STOCKHOLDERS’ EQUITY Preferred stock $ 100 0.4% Common stock 1,685 6.4% Paid-in capital 5,780 21.8% Retained earnings 6,830 25.8% Total stockholders’ equity $ 14,395 54.3% Total liabilities and stockholders’ equity $ 26,495 100.0% Income Statement: Revenues: Net revenues $ 10,400 100.0% Cost of goods sold 3,200 30.8% Gross profit $ 7,200 69.2% Operating expenses: Research and development $ 3,000 28.9% Selling, general and administrative 1,500 14.4% Total operating expenses $ 4,500 43.3% Operating income $ 2,700 25.9% Non-operating income and expenses: Gains (losses) on equity securities ( 344) ( 3.3%) Financial income: Interest and dividend income 177 1.7% Earnings before interest and taxes (EBIT) $ 2,533 24.3% Interest expense ( 400) ( 3.8%) Earnings before tax (EBT) $ 2,133 20.5% Income tax expense ( 533) ( 5.1%) Net income $ 1,600 15.4% © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 7 Study Unit 1: A.1. Basic Financial Statement Analysis CMA Part 2 Horizontal Trend Analysis Horizontal trend analysis is used to evaluate trends for a single business over a period of several years. In analyzing the income statement, changes in revenues or expenses over time can indicate, for example, the effectiveness of a company’s change in pricing strategy or its efforts to improve operations. Horizontal trend analysis can be in the form of common-base year financial statements or as a variation analysis, a presentation of the annual growth rates of line items. Common-base year financial statements use the first year as the base year. Financial statement amounts for subsequent years are presented not as dollar amounts but as percentages of the base year amount, with the base year assigned a value of 100% or 100. For example, each year’s inventory balance is stated as a percentage of the base year’s inventory and each year’s fixed assets are stated as a percentage of the base year’s fixed assets. New Line Item Amount Common Base Year Statements = × 100 Base Year Line Item Amount Horizontal analysis can also be done in the form of a variation analysis by calculating the annual growth rate of each individual line item. For each line item, the percentage of change year-over-year is calculated. Each year’s value is compared with that of the previous year. New Line Item Amount Annual Growth Rate of Line Items = −1 Old Line Item Amount The percentage of change year-over-year can also be calculated as follows: New Line Item Amount − Old Line Item Amount Annual Growth Rate of Line Items = Old Line Item Amount 8 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Section A Study Unit 2: A.2. Introduction to Financial Ratio Analysis Study Unit 2: A.2. Introduction to Financial Ratio Analysis Financial ratio analysis is used to analyze a company’s financial statements. Ratio analysis is the process of looking at the relationships between different numbers in the financial statements to see if they indicate positive or negative trends developing within a company. A firm’s equity investors, potential equity investors and stock analysts as well as its creditors use ratios calculated from the firm’s financial statements to make investment and credit decisions. While the ultimate purpose of ratio analysis is to enable evaluation of risk and return, different users need different information. Short-term creditors, such as banks and trade creditors, use ratios to determine the firm’s immediate li- quidity, which is the ability of the company to pay its short-term obligations as they come due. Longer- term creditors such as bondholders use ratios to determine a firm’s long-term solvency, which is the company’s ability to pay its long-term obligations as they come due. Both short-term and long-term credi- tors use financial statement analysis to gain assurance that the firm has the necessary resources to be able to pay its interest and principal obligations. Equity investors use ratios to determine the firm’s long-term earning power. The equity investors’ analysis needs to be more in-depth than the creditors’ analysis because equity investors bear the residual risk of the company. In the event of bankruptcy, the equity investors’ claims on the company’s funds are settled only after the claims of suppliers and lenders are settled. A calculated ratio is only a number. In order for this number to be meaningful, the analyst needs to put it into some kind of context by comparing it with another number. These comparisons can be made through: Trend analysis of a single company by comparing its current financial ratios to its previous years’ ratios. Trends can be particularly useful in analyzing a firm’s financial condition. For example, ratios that are becoming less favorable over time may be an indication of financial difficulty. The financial difficulty may not yet be apparent, but if the ratios do not improve, it will manifest itself in the future. Ratio analysis can thus provide an early warning of trouble ahead. Comparison with other companies in the same industry or with industry averages after any necessary adjustments have been made to assure that the financial statements are comparable. If a company’s financial ratios are less favorable than those of other companies in its industry, the company will not be able to compete successfully in its market. Comparison with management’s expectations, for example comparison with the budget. Ratios are classified into various categories based upon what they are measuring. The classifications used on the CMA exam are:1 Liquidity ratios, which measure the sufficiency of the firm’s cash resources to meet its short- term cash obligations. Leverage, capital structure, solvency, and earnings coverage ratios, which evaluate the firm’s ability to satisfy its fixed financing charges, including debt obligations and obligations to make lease payments, by looking at the mix of its financing sources and its historical earnings. Activity ratios, which provide information on a firm's ability to manage efficiently its current assets (accounts receivable and inventory) and current liabilities (accounts payable). Market ratios, including earnings per share analysis and other ratios that describe the firm’s financial condition per share of its outstanding stock. Profitability analysis, which measures the firm’s profit in relation to its total revenue or the amount of net income from each dollar of sales and its return on invested assets. Ratios are based on accounting data. Because of the fact that the accounting system uses historical costs rather than current fair market values, ratios often do not reflect the current values of the items they are measuring. 1 The ratios in the HOCK study materials for the CMA exams are presented as they appear on the ICMA’s Ratio Definitions formula sheet and are the way the ratios will be tested on the CMA exam. © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 9 Study Unit 2: A.2. Introduction to Financial Ratio Analysis CMA Part 2 Note: Two rules should always be followed when calculating ratios that include both balance sheet and income statement items: 1) Average balances of balance sheet items are used instead of ending balances whenever a ratio calculation is relating an income statement amount to a balance sheet amount. The average balance amount should be the average balance of the balance sheet item during the same period of time as is covered by the income statement item. Using the average balance of the balance sheet item over the period of time covered by the income statement item makes the relationship of the two amounts meaningful. The average balance is usually calculated as the average of the begin- ning and ending balances of the period. If a year-end balance sheet amount were used in the ratio, that amount would represent the balance sheet item’s balance only as of one moment in time, and thus it would not be comparable to an income statement figure covering a range of “moments in time.” This textbook is for personal use only by Prateek Yadav ([email protected]). Note: If both the numerator and the denominator of a ratio are balance sheet amounts, year-end balances can be used instead of average balances for both the numerator and the denominator of the ratio. 2) When the time period represented by an income statement amount in a ratio is less than one year, the goal is to annualize the income statement item by expressing it as if that same level of revenue or expense had persisted for a full year. To annualize an income statement amount that is for less than a full one-year period, annualize it as follows.  If the income statement amount is for one quarter, multiply it by 4 to annualize it.  If the income statement amount is for one month, multiply it by 12 to annualize it.  If the income statement amount is for five months, divide it by 5 months to find one month’s revenue or expense and then multiply the result by 12 months to annualize it.  If the income statement amount is for a period other than one evenly divisible by 4 or 12 or a number of months (for example, for 35 days or 54 days or any such amount), divide the income statement amount by the number of days to find one day’s revenue or expense and then multiply the result by 365 days to annualize it. However, the average balance used for the balance sheet amount in the ratio should be for only the period of time covered by the partial-period income statement, not for a full year. 10 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Section A Study Unit 3: A.2. Liquidity Ratios Study Unit 3: A.2. Liquidity Ratios Note: This is the first of five categories of Ratios. Liquidity reflects the ability of a firm to meet its short-term obligations by using assets that are most readily converted into cash without significant loss in value or the necessity of making significant price concessions. A firm’s liquidity also refers to its ability to sell assets quickly in order to raise cash. Assets that can be converted into cash within a short period of time without significant loss are referred to as liquid assets, and they are identified in financial statements as current assets. Current assets may also be referred to as working capital, since they represent the resources needed for the day-to-day operations of the firm's long-term, capital investments. Current assets should be used to satisfy current liabilities. A company needs current assets to cover its current obligations for daily operations. A company should maintain a level of current assets sufficient to pay its current obligations. At the same time, the company should not have a greater amount of current assets than necessary because current assets do not provide as much return on investment as can generally be earned from investing in long-term, productive assets. A lack of liquidity can cause a company to be unable to take advantage of prompt payment discounts and other advantages available to a company with adequate liquidity. A lack of liquidity may also cause a com- pany to be unable to pay its obligations by their due dates, leading to financial distress and even to bankruptcy. Net Working Capital Net working capital is the difference between current assets and current liabilities. A company’s net working capital bridges the gap between the production process and the collection of cash from the sale of the item. The amount of liquidity a company needs depends upon the length of its operating cycle. The operating cycle is the period from the time cash is committed for investment in goods and services (the purchase of, not the payment for, inventory) to the time that cash is received from the investment (from the collection on the sale of the inventory). For example, a firm that produces and sells goods has an operating cycle that consists of four phases: 1) Purchase raw material and produce goods, investing in inventory. 2) Sell goods, generating sales, which may or may not be cash sales. 3) Extend credit, creating accounts receivable. 4) Collect accounts receivable, generating cash. Net working capital is total current assets less total current liabilities. Net Working Capital = Total Current Assets – Total Current Liabilities Exam Tip: Working capital and net working capital are often used interchangeably to refer to cur- rent assets minus current liabilities. Net working capital can be referred to as working capital, and working capital can be referred to as net working capital. Since the term “working capital” may be used to refer either to current assets or to current assets minus current liabilities, some interpretation may be necessary if the term “working capital” appears in an exam question. © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 11 Study Unit 3: A.2. Liquidity Ratios CMA Part 2 Note: The operating cycle of a company is the amount of time between the acquisition of inventory and the receipt of cash from the sale of the product. The operating cycle is slightly different from the cash cycle. The cash cycle, or net operating cycle, is the length of time it takes to convert an invest- ment of cash in inventory back into cash, recognizing that some purchases are made on credit. Thus, the cash cycle is the time between the payment for the inventory and the receipt of cash from the sale of the inventory. The difference between the operating cycle and the cash cycle is the number of days of sales in payables. All of these will be covered in more detail later. Liquidity Ratios Several ratios are used to evaluate a company’s liquidity and the level of its net working capital. The liquidity ratios are: 1) Current Ratio 2) Quick Ratio or Acid Test Ratio 3) Cash Ratio 4) Cash Flow Ratio 5) Net Working Capital Ratio Current Ratio The current ratio is the most commonly used measure of short-term liquidity, as it relates current assets to the claims of short-term creditors. Whereas net working capital expresses this relationship as an amount of currency, the current ratio expresses the relationship as a ratio. Current Assets Current Ratio = Current Liabilities Generally, a firm’s current ratio should be proportional to its operating cycle. The shorter the operating cycle is, the lower the current ratio can be because the operating cycle will generate cash more quickly for a firm with a shorter operating cycle than it will for a firm with a longer operating cycle. The cash generated can be used to settle the liabilities. The effective management of working capital requires that working capital be kept as low as possible while at the same time being balanced against the risk of illiquidity (the inability to satisfy current liabilities with current assets). Companies with an aggressive financing policy that are willing to assume more risk of illiquidity will have lower current ratios, while companies with conservative financing policies will have higher current ratios. The less risk the company’s management wants to assume, the higher its level of working capital must be. The standard for the current ratio is 2:1. A lower ratio indicates a possible liquidity problem. The quality of the accounts receivable and merchandise inventory should be considered when assessing a company’s current ratio. If the inventory and receivables can be quickly converted to cash, then a lower level of working capital and thus a lower current ratio can be maintained. However, if the receivables and inventory cannot be easily converted to cash, higher levels of working capital are necessary. The length of time required for accounts receivable and inventory to be converted to cash is measured by receivables and inventory activity ratios, both of which are covered later in this section. Greater lengths of time required for accounts receivable and inventory to be converted into cash indicate the need for a higher level of cash and cash equivalents. 12 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Section A Study Unit 3: A.2. Liquidity Ratios In interpreting a company’s current ratio, it is important to be aware of its limitations. The current ratio is actually only an indication of what would happen if cash flows were to stop completely and today’s current assets had to be liquidated to pay off today’s current liabilities. This is seldom the question an analyst wants answered. To answer the questions that an analyst needs answers to, cash flow projections are required. However, the current ratio continues to be used because it is simple and understandable and the information needed to calculate it is readily available. Quick or Acid Test Ratio The quick ratio, also called the acid test ratio, is a more conservative version of the current ratio. The quick ratio measures the firm’s ability to pay its short-term debts using its most liquid assets. Cash & Cash Equivalents + Current Marketable Securities Quick Ratio + Net Accounts Receivable = (or Acid Test Ratio) Current Liabilities Cash equivalents are very liquid, short-term investment instruments with a maturity date of less than 90 days when they were acquired that are easily converted into known amounts of cash without significant loss in value. Cash equivalents are the short-term investments a company makes in order to earn a return on excess cash for short periods until the cash is needed for operations. Current marketable securities are equity and debt securities that have an active secondary market and are classified as current assets. Note: Marketable securities may be classified as either current or non-current assets. In order to be included in the numerator of the quick ratio, marketable securities must be classified as current assets. According to ASC 210-10-45-1f, a marketable security is to be classified as a current asset if it repre- sents cash available for current operations. According to ASC 210-10-45-4b, investments in securities (whether marketable or not) or advances made for the purposes of control, affiliation, or other continuing business advantage are to be classified on the balance sheet as non-current assets. Since such assets would not be current assets, they would not be included in the numerator of the quick ratio. Whether a held-to-maturity debt security is to be classified as a current or a non-current asset is not specified in the Codification®. However, ASC 320-10-25-1c states that a debt security is to be classified as held-to-maturity only if the investor has the positive intent and ability to hold it to its maturity date. Since funds so invested would not represent cash available for current operations, they would generally not be current assets and would not be included in the numerator of the quick ratio. Inventory is not included in the numerator of the quick ratio, because the company will need to replace sold inventory, and that requires cash. If a company uses liquidation of its inventory to pay its liabilities without replacing the inventory, the company will have no means of generating future cash flows. For that reason, inventory should not be liquidated to pay off short-term liabilities. Furthermore, inventory is not as liquid an asset as, for instance, accounts receivable. Note that prepaid expenses are also not included in the numerator of the quick ratio. Prepaid expenses are not current assets in the sense that they can be converted into cash, but only in the sense that, if not paid in advance, they would require the use of current assets during the operating cycle. Therefore, they are not included. © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 13 Study Unit 3: A.2. Liquidity Ratios CMA Part 2 Accounts receivable is included in the numerator, for two reasons: 1) Receivables are only one step away from conversion to cash in contrast to inventory, which is two steps away. 2) A company can almost always collect its receivables immediately by factoring them. (Factoring is covered in detail in Working Capital Management in Section B in this volume.) The standard for the quick ratio is 1:1. Cash Ratio The cash ratio is another version of the current ratio. The cash ratio is even more conservative than the quick ratio. The cash ratio is the ratio between cash and current liabilities. Only cash and securities that are easily convertible into cash are used in the numerator, so cash equivalents and marketable securities clas- sified as current assets are included in the numerator along with cash for purposes of calculating the cash ratio. Cash & Cash Equivalents + Marketable Securities Classified as Current Assets Cash Ratio = Current Liabilities As with the quick ratio, marketable securities must be classified as current assets in order to be included in the numerator of the cash ratio. Cash Flow Ratio The cash flow ratio compares the cash flow generated by operations with current liabilities and measures how many times greater the cash flow generated by operations is than current liabilities. If a company has positive working capital but it is not generating enough cash from operations to settle its obligations as they become due, the company is probably borrowing to settle current liabilities. Over the long term, borrowing to fulfill current liabilities will lead to solvency problems, because the company is simply exchanging one current liability for another current liability and there is a limit to how much financing a company can obtain. Therefore, it is much better if the company is able to generate adequate cash flow from its operations to settle its current liabilities. Operating Cash Flow Cash Flow Ratio = Period-End Current Liabilities Operating cash flow is cash flows from operations reported on the statement of cash flows. In the cash flow ratio, the period-end balance for current liabilities is used instead of the average balance for current liabilities. An average balance incorporates past balances. The cash flow ratio is an indicator of the company’s ability to pay future obligations as they come due. Future cash flow will be required to pay off current liabilities that are outstanding as of the balance sheet date, not the average of current liabil- ities over a past period. Therefore, use of the period-end balance for current liabilities is preferred in the cash flow ratio because it is more conservative. The operating cash flow in the numerator should be annualized. “Annualized” means that if the cash flow from operations figure being used is for a period of less than a year (such as a quarter or a month), it should be annualized by multiplying it by whatever is necessary to express it in terms of the equivalent annual operating cash flow before dividing it by current liabilities as of the balance sheet date. For example, 14 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Section A Study Unit 3: A.2. Liquidity Ratios if cash flow from operations is for a period of one quarter, it should be multiplied by 4 to annualize it. If it is for a one-month period, it should be multiplied by 12. An annualized cash flow ratio of 0.40 or higher is a standard for a healthy company. Net Working Capital Ratio Net working capital (also called working capital) is current assets minus current liabilities. The net working capital ratio compares net liquid assets (net working capital) to total capitalization (total assets). The net working capital ratio measures the firm’s ability to meet its obligations and expand by maintaining sufficient working capital. Net Working Capital This textbook is for personal use only by Prateek Yadav ([email protected]). Net Working Capital Ratio = (Current Assets – Current Liabilities) Total Assets The net working capital ratio is particularly meaningful when compared with the same ratio in previous years, especially if it is decreasing. Consistent operating losses will cause net working capital to shrink relative to total assets. Net liquid assets shrinking over time relative to total assets indicates possible future business failure. If working capital is negative (current liabilities are greater than current assets), the net working capital ratio will also be negative. Negative working capital and a negative net working capital ratio are indicators of very serious problems. Liquidity of Current Liabilities The term “liquidity of current liabilities” refers to the quality of current liabilities. The quality of current liabilities includes the following considerations: How urgent is the payment of the current liabilities? Tax liabilities must be paid when due, no matter what else has to be paid, and thus they have top priority. Payroll liabilities also have a priority claim on cash inflows. Any time tax liabilities or payroll liabilities are higher than normal, they must be questioned, because the increase could indicate the company is not paying those obligations in a timely manner. Liabilities to suppliers with whom the company has a long-standing relationship may have more latitude and can sometimes be delayed for a short period if necessary. However, too much delay in paying suppliers’ invoices will result in the company’s losing its credit privileges because suppliers will require the company to pay for everything in advance. Does the company have any unrecorded liabilities that have a claim on current funds? Examples of unrecorded liabilities are purchase commitments or short-term leases that are expensed. Is the company in violation of any of its loan covenants? A violation of loan covenants constitutes a default and as such, renders a long-term debt due and payable immediately. Are the company’s loan payment obligations current? Failure to remain current with loan pay- ment obligations is also a default that renders debt immediately due and payable. Thus, the analyst has a responsibility to look beyond the numbers on the balance sheet and determine whether those numbers need to be adjusted to reflect the firm’s actual condition, because the firm’s actual condition may be quite different from what is implied by a simple ratio that is indiscriminately calculated. © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 15 Study Unit 4: A.2. Leverage and Coverage Ratios CMA Part 2 Note: A “covenant” is a condition or a requirement in a loan agreement or a bond indenture. A bond indenture is the legal contract that specifies the bond’s features such as the maturity date, the interest rate, the timing of interest payments, and all the applicable terms and conditions. Covenants may restrict the actions of the borrower or require that they meet certain ratio requirements. If the borrower fails to meet the requirements of the loan agreement, the loan becomes in default, just as if the borrower had failed to make scheduled loan payments. Study Unit 4: A.2. Leverage and Coverage Ratios Note: This is the second of five categories of Ratios. Leverage in general refers to the potential to earn a high level of return relative to the amount of cost expended. Leverage can be advantageous, but it can also be risky. Two kinds of leverage will be covered in this ratio category: financial leverage and operating leverage. Capital structure refers to the way a firm chooses to finance its business. Should the company obtain financing by borrowing (by issuing bonds or borrowing from a bank) or by issuing equity (shares)? Or if both, in what proportion? Equity represents ownership, and it does not need to be repaid. Debt must be repaid, either as interest and principal payments paid together or interest only during the term of the borrowing with all the principal due at the debt’s maturity date. The choice a company makes between debt and equity will influence the company’s flexibility and thus its ability to make certain decisions in the future. If the company chooses to use debt, it will need to service the debt in the future by making regular interest or interest and principal payments. On the other hand, additional debt does not cause the owners of the company to lose any voting control or dilute their owner- ship. In contrast, if additional equity is used, the company will not be obligated to make interest payments, but the ownership interest of the present owners will be diluted and they will lose some voting control. Though there is no one correct answer to this question of debt versus equity, the goal of the company will be to obtain the lowest-cost financing possible. Another consideration in attempting to obtain low-cost financing is the fact that the more financing (either debt or equity) a company has, the more expensive each additional amount of financing will be. The topic of debt versus equity as sources of financing will be covered in more detail later. For the topic of ratios, candidates need to be familiar with the impact that debt and equity have on a number of ratios. Solvency is the ability of the company to pay its long-term obligations as they come due. In contrast to liquidity, which is the ability to pay short-term obligations by liquidating current assets, solvency is the ability to pay long-term obligations from earnings. A firm is solvent if its assets are greater than the sum of its debt obligations. The composition of a company’s capital structure is an important part of solvency analysis. In addition to capital structure, solvency depends upon successful, profitable operations, because profits are the source of the cash to make interest and principal payments. Therefore, solvency analysis also involves analysis of earnings and the ability of those earnings to cover necessary company expenditures, including the required debt service. A company with more equity than debt is more stable and solvent than a company with more debt than equity. A company can invest equity financing in long-term assets and expose them to business risk without any risk that the financing will be recalled. Debt financing, however, may be recalled if the firm defaults on the debt. A default on a debt is not only the failure to make scheduled payments. Default can also occur without the company’s missing any interest or principal payments. If the borrowing agreement includes covenants such as a required current ratio or a required debt-to-equity ratio that must be maintained, failure to adhere to the debt covenants can result in default and cause the entire principal plus accrued interest to become due and payable. 16 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Section A Study Unit 4: A.2. Leverage and Coverage Ratios If a company has a lot of long-term debt relative to its assets, it has lower solvency than a company with less long-term debt. A company with higher long-term debt assumes more risk of default and insolvency than a company with lower long-term debt because with higher long-term debt, more of the assets of the company will be required to meet the scheduled interest and principal payments. Because these payments must be made whether the company has positive or negative future earnings, a high level of debt financing increases the risk of default and insolvency. A company can change its capital structure in several ways. If the company issues stock and uses the proceeds to pay off long-term debt, it decreases its debt while increasing its equity, thus increasing its solvency. If outstanding convertible bonds are converted to equity, solvency is also increased. On the other hand, if a company borrows in order to raise funds that are then used to purchase treasury stock 2, it increases its debt and decreases its equity, thus decreasing its solvency. Earnings coverage ratios focus on the company’s earning power because the company’s earnings are the source of its ability to make interest payments and principal repayments on debt. Financial Leverage Financial leverage is the use of debt to increase earnings. Interest is the cost of using debt to finance operations. Interest is a fixed charge because unlike dividends, interest must be paid whether or not the firm is profitable. The use of financing that carries a fixed charge is called financial leverage. Financial leverage is a part of solvency analysis. Financial leverage magnifies the effect of both managerial success (profits) and managerial failure (losses). When financial leverage is being used, an increase in earnings before interest and taxes (EBIT) will cause an even greater proportionate increase in net income, and a decrease in EBIT will cause an even greater proportionate decrease in net income. Financial leverage ratios measure a company’s use of debt to finance its assets and operations. Financial leverage can also be defined as the percentage of fixed cost financing in a firm’s overall capital structure, because the increased amount of debt causes the company’s financial costs (interest expense) to increase. Higher financial leverage indicates that shareholders are accepting greater risk because the higher the leverage, the more fixed interest costs the company will be required to pay. On the other hand, if the company generates more net income from its investment of the borrowed funds than is required to service its debt costs for the borrowed funds, the shareholders will benefit from the high financial leverage because profits will increase. Financial leverage magnifies both profit and loss and therefore requires careful consideration from a financial manager. Note: Financial leverage is successful if the firm earns more by investing the borrowed funds than it pays in interest to use them. It is not successful if the firm is not able to earn more by investing the borrowed funds than it pays in interest for them. 2 Treasury stock is the company’s own stock, repurchased by the company on the market. Treasury stock is not an asset of the company but is a reduction of the company’s equity. © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 17 Study Unit 4: A.2. Leverage and Coverage Ratios CMA Part 2 Benefits of Using Financial Leverage If financial leverage is used successfully, the interest expense paid on the debt capital will be less than the return earned from investing it, and the excess return will benefit the equity investors. Interest paid on debt is tax-deductible, and its tax deductibility effectively reduces interest as an expense. Limitations of Using Financial Leverage The financial leverage may be used unsuccessfully, and if so, the return earned from investing the debt capital will be less than the interest expense paid on it, which will hurt the value of the equity investors’ investments. Too much financial leverage causes the cost of all of the company’s capital to increase because investors will perceive greater risk and will require a greater return on their investment. A company’s financial leverage is measured by its financial leverage ratio and by its degree of financial leverage. Financial Leverage Ratio, or Equity Multiplier The financial leverage ratio, also called the equity multiplier, is calculated as follows: Financial Leverage Ratio Total Assets = (or Equity Multiplier) Total Equity The financial leverage ratio indicates the amount of debt a firm is using to finance its assets. The more debt the company has, the higher its financial leverage ratio will be. As a company increases its debt, it is incurring more fixed charges of interest that must be paid. The more fixed charges in interest the company has, the less income it will have available for distribution. If a company has a high financial leverage ratio in combination with high volatility of sales or operating profit (high volatility means that they change greatly from period to period), the risk is greater that the company will not be able to service its debt and will default on it. Borrowing money to finance assets will cause total assets to increase while total equity remains unchanged. Since the financial leverage ratio is calculated as total assets divided by total equity, the company’s financial leverage ratio will increase as more money is borrowed to finance additional assets. On the other hand, issuing equity to finance assets will cause total assets and total equity to increase by the same absolute amount. Since beginning total assets are greater than beginning total equity, the pro- portional increase in total assets will be less than the proportional increase in total equity. Since the numerator of the financial leverage ratio will increase less, proportionately, than the denominator will, the result will be a decrease in the financial leverage ratio. A company with financial leverage is said to be “trading on the equity.” “Trading on the equity” is simply a term that means the company is using financial leverage (debt) in an effort to achieve increased returns. Trading on the equity, or financial leverage, may or may not be successful. If a leveraged company’s return on assets is greater than its after-tax cost of debt, and therefore return on common equity is higher, it is said to be successfully trading on the equity, and its common shareholders will benefit. If a leveraged company’s return on assets is less than its after-tax cost of debt, it is said to be unsuccessfully trading on the equity, and its common shareholders will be hurt. Remember that “trading on the equity” is only a term that is used to mean that a company is borrowing money to invest in assets. The company is borrowing to invest because it expects the investment to earn a 18 © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. Section A Study Unit 4: A.2. Leverage and Coverage Ratios greater return than the company will pay in interest, and thus the company’s profits will increase as a result of its borrowing to invest. In fact, by borrowing a portion of the funds it invests, a company can greatly increase its rate of return on the amount of its own funds that it has invested. Example of the effect of financial leverage: A company is planning a $1,000,000 capital investment project that it expects to return 15% annually after tax. At a return rate of 15%, the net return expected on the investment after tax is $150,000 per year. The company borrows half of the investment amount, or $500,000, at an interest rate of 6% after tax and thus pays interest after tax of $30,000 per year. It will have invested $500,000 of its own funds. If the expected profit materializes, the company will earn $150,000 minus $30,000 interest each year on the investment, for a net annual after-tax return of $120,000 annually on a $500,000 investment of its own funds. Until such time as the principal needs to be repaid, that represents a 24% return on its $500,000 investment. Thus, the return from borrowing to invest can actually be greater than just the difference between the investment return (here, 15%) and the interest rate on the borrowed funds (here, 6%). However, as stated above, trading on the equity may not always be so successful. Because the borrowed principal must be repaid along with interest, the company assumes risk by borrowing. The company is required to repay the obligation whether or not the expected return materializes. If the actual return is lower than expected, the repayment of the principal and interest will need to come from cash flow generated by other projects. Any loss on the company’s investment will be magnified by the debt, just as a positive return is magnified by the debt. Financial leverage has the effect of magnifying both profits and losses. Comparing the company’s return on assets with its after-tax cost of debt can give an analyst some insight into whether or not the company’s management is using financial leverage successfully. Degree of Financial Leverage (DFL) Another measure of financial leverage is the degree of financial leverage (DFL). The degree of financial leverage is the factor by which net income can be expected to change in the future in relation to a future change in earnings before interest and taxes, since interest on debt is a fixed expense. The degree of financial leverage is meaningful at only one level of income and interest expense. When those levels change, the degree of financial leverage will change as well. The degree of financial leverage at a given level of net income is: Degree of Financial Leverage % [of future] Change in Net Income = (DFL) % [of future] Change in EBIT (Earnings Before Interest and Taxes) The formula above results in the DFL for the earlier of the two periods. The above formula can be used when two periods of financial information are available or when the later period consists of projected finan- cial information. When only one period of financial information is available, the DFL for that period can be calculated using: Degree of Financial Leverage Earnings Before Interest and Taxes (EBIT) = (DFL) Earnings Before Taxes (EBT) The DFL predicts the effect on the future EBT of a given future percentage increase in EBIT. © HOCK international, LLC. For personal use by original purchaser only. Resale prohibited. 19 Study Unit 4: A.2. Leverage and Coverage Ratios CMA Part 2 For the two methods of calculating DFL to result in the same DFL, the following assumptions are required: Variable costs represent the same percentage of revenue in both periods, so the contribution mar- gin ratio (contribution margin divided by revenue) is the same for both periods. Total fixed costs are the same for both periods. Non-operating gains or losses (and discontinued operations, if applicable), interest income, and interest expense are the same in both periods. The tax rate is the same for both periods. EBIT ÷ EBT is used to calculate DFL for the earlier period only. If assumptions regarding the result of the degree of financial leverage are being applied to net income after tax as well, it must also be assumed that the income tax rate will remain the same. This textbook is for personal use only by Prateek Yadav ([email protected]). Note: For the purposes of calculating degree of financial leverage, EBIT, EBT and net income are calcu- lated as follows: Total operating revenue − Total operating expense = Operating income + Interest and dividend income +/− Non-operating gains/(losses) +/− Gains/(losses) on discontinued operations = Earnings before interest and taxes (EBIT)

HOCK CMA Part 2 - Strategic Financial Management PDF

Document Details

Tags

Related

Summary

Full Transcript

Upgrade to continue