ACFI201 -5

  1. What is Quality of Earnings and why is it important?
    • Degree of Conservatism in the firm's reported earnings. Important Because -
    • High earnings quality is considered less risky
    • High earnings quality should result in higer P/E ratio
    • Such firms are freqeuntly risk adverse
  2. Examples of Balance Sheet Quality Issues
    • Charging off assets (operating leases)
    • Hidden Liabilities (operating leases)
    • Hidden Assets (Book value < market value, intangibles)
    • Off balance sheet financing (operating leases, joint ventures)
  3. Examples of Earnings Management Tricks
    • Timing store openings and asset sales in a way that keeps earnings growing smoothly.
    • Capitalising normal OPEX in order to avoid reporting losses.
    • Increasing reserves in good times and reducing them in bad times.
  4. Advantages of Financial Ratios
    • Key points of information
    • Serve as Size deflators
    • Can compare different firms
    • Establish a trend over time
    • Comparable with Industry Averages
  5. Problems and Limitations of Ratio Analysis
    • Defining an Industry
    • Seasonality of operations may distort ratios
    • Differences in accounting policies between firms
    • Price level distort ratios
  6. Importance of Working Capital Management (WCM)
    • WCM involes the administration of current assets and current liabilities
    • Important for small firms who have limited access to long term capital markings
    • Important to ensure an entity can meet its current obligations
  7. Definition: Current Assets
    Current assets are turned over and at least partially replaced within the operating cycle of the firm.
  8. Equation: Operating Cycle
    Image Upload 1
  9. Definition & Equation: Inventory Conversion Period
    Definition: The time required to convert raw materials into finished goods and sell these goods.

    Equation: Image Upload 2
  10. Definition & Equation: Inventory Conversion Period
    • Definition: Time required to convert receivables into cash
    • Equation: Image Upload 3
  11. Equation and Definition:Payables Deferral Period
    Definition: Time between the acquisition of raw materials and labour and the payment for them.

    Equation:Image Upload 4
  12. Equation and Definition: Cash Conversion Cycle
    Definition: Period during which funds are tied up in current assets.

    Equation:Image Upload 5
  13. The Investment Decision
    Determining the appropriate level of current assets
  14. The Financing Decision
    • Determining how to finance the required level of current assets
    • a)the proportion of short term/long term funds
    • b)the mix of short term funds
  15. Three Sources of Financing
    • Spontaneous: eg trade credits, wages payable
    • Temporary: eg bank loans commercial bill
    • Permanent: eg debentures, shares, term loan
  16. Principles of Working Capital Management
    • As risk of associated working capital policy increases, associated profitability increases
    • Increased Profitability results from - investing less in working capital but risk increases because of illiquidity, forgoing credit sales
    • The firm should increase its investment until  the cost of holding one more unit exceeds the benefit of one more unit
  17. Appropriate Levels of Working Capital
    • Conservative: High C/A, lower profitability, lower risk
    • Aggresive: Less C/A, higher profitability, higher risk
  18. The Hedging Principle
    • Finance Short Term needs (temporary investment in C/A) with short term sources 
    • Finance Long Term needs (fixed asset, permanent investment) with long term sources
  19. Equation: Additional Financing Cost 
    (the cost of short term credit)
    Image Upload 6
  20. Equation: AFC - Trade Credit
    Image Upload 7
  21. 6 Major Sources of unsecured Short-term Credit
    • 1. Spontaneous financing - Trade Credit
    • 2. Spontaneous Financing - Accrued wages, accrued taxes
    • 3. Commercial Banks
    • 4.Commercial Paper
    • 5. bills of Exchange
    • 6.Leasing
  22. Definition: Financial Analysis
    The assessment of a firms past, present and anticipated future financial conditon
  23. Obejctives of Financial Analyst
    • Assess the Liquidity of a firm
    • Assess the utilisation of assets
    • Assess the profitability of a firm
    • Assess the firm's financing mix
    • Examine the shareholders returns
    • Assess the performance of management (via above)
    • Predict other useful variables.
  24. Equation: Current Ratio
    Image Upload 8
  25. Equation: Quick Ratio
    Image Upload 9
  26. Equation: Average Collection Period
    Image Upload 10
  27. Equation: Inventory Turnover
    Image Upload 11
  28. Equation: Fixed Asset Turnover
    Image Upload 12
  29. Equation: Total Asset Turnover
    Image Upload 13
  30. Equation: Debt Ratio
    Image Upload 14
  31. Equation: Debt to Equity Ratio
    Image Upload 15
  32. Equation: Times interest Earned
    Image Upload 16
  33. Equation: Fixed Charge Coverage
    Image Upload 17
  34. Equation: Gross Profit margin
    Image Upload 18
  35. Equation: Net Profit Margin
    Image Upload 19
  36. Equation: ROI
    Image Upload 20
  37. Equation:ROE
    Image Upload 21
  38. Equation: P/E Ratio
    (How much investors will pay for $1 of earnings. Higher is better. High if ROE is high, risk is low
    Image Upload 22
  39. Equation: Market to book ratio
    (How much paid for $1 of book value. higher is better)
    High if ROE is high, risk is low
    Image Upload 23
  40. Equation: Payout Ratio
    Image Upload 24
  41. Equation: Dividend Yield
    Image Upload 25
  42. Equation: Market Value Added
    Image Upload 26
  43. Equation: Economic Value Added
    Image Upload 27

    • r = return on total capital eat/total capital
    • k = weighted after tax cost of capital
  44. Common Size balance Sheet
    Common Size balance sheet shows assets, liabilities and equity as a percentage of total assets
  45. Common Size Income Statement
    Common Size Income Statement shows income and expense items as a percentage of total sales
Card Set
ACFI201 -5
Quality of Earnings, Leverage