CMA USA Part 2 Full Book IMA

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Contents
> VI
1 Candidate Study Information. iv How to Use the CMA Learning System™ vii 1
Create a Study Plan x 1
Part 2 Introduction 1 a Section A: Financial Statement Analysis
Topic 1: Basic Financial Statement Analysis
Topic 2: Financial Performance Metrics-Financial Ratios
Topic 3: Profitability Analysis
Topic 4: Analytical Issues in Financial Accounting
Practice Questions: Financial Statement Analysis
2
3 15 1
33
56 11 75
Section B: Corporate Finance
Topic 1: Risk and Return
Topic 2: Managing Financial Risk
Topic 3: Financial Instruments
Topic 4: Cost of Capital...
Topic 5: Managing Current Assets
Topic 6: Raising Capital
Topic 7: Corporate Restructuring
Topic 8: International Finance
Practice Questions: Corporate Finance.
93
94 ;l 113
121
160
179
216
235
243
261
Section C: Decision Analysis and Risk Management
Topic 1: Cost/Volume/Profit Analysis
Topic 2: Marginal Analysis ...
Topic 3: Pricing
Topic 4: Risk Assessment
Practice Questions: Decision Analysis and Risk Management.
279 280 I
301
315 341 I
355
SectionD: InvestmentDecisions I
Topic 1: Capital Budgeting Process
Topic 2: Discounted Cash Flow Analysis
Topic 3: Payback and Discpunted Payback ...
Topic 4: Ranking Investment Projects
Topic 5: Risk Analysis in Capital Investment
Topic 6: Valuation
Practice Questions: Investment Decisions
375
376
391
404 II 410
418 §
427
452 f
Section E: Professional Ethics
Topic 1: Ethical Considerations for the Organization.
Practice Questions: Professional Ethics
..... 470 r;:
471 i, 485 rfi;
ii CMALS Part 2: Financial Decision Making, Version 3.0 h
©2009 Institute of Management Accountants. All rights reserved. I
Essay Exam Support Materials .487 I
Essay Exam Study Tips
Examples of Essay Question Answers
Practice Essay Questions
489 I 490
501
Bibliography. .546
.550 Index b1
Appendix A: Present Value Tables .554
Appendix B: ICMA Learning Outcome Statements-Part 2 as of December 1, 2009. .558
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CMALS Part 2: Financial Decision Making, Version 3.0 in
© 2009 Institute of Management Accountants. All rights reserved. I
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I CMA Candidate Study Information
CMA Certification from ICMA
The Certified Management Accountant (CMA) certification provides accountants and
financial professionals with an objective measure of knowledge and competence in the
field of management accounting. The CMA designation is recognized globally as an
invaluable credential for professional accountancy advancement inside organizations
and for broadening professional skills and perspectives.
The two-part CMA exam is designed to develop and measure critical-thinking and
decision-making skills and to meet the following objectives:
To establish management accounting and financial management as recognized
professions by identifying the role of the professional, the underlying body of
knowledge, and a course of study by which such knowledge is acquired.
To encourage higher educational standards in the management accounting and
financial management fields.
To establish an objective measure of an individual’s knowledge and competence in
the fields of management accounting and financial management.
To encourage continued professional development.
Individuals earning the CMA designation benefit by being able to:
Communicate their broad business competency and strategic financial mastery.
Obtain contemporary professional knowledge and develop skills and abilities that are
valued by successful businesses.
Convey their commitment to an exemplary standard of excellence that is grounded
on a strong ethical foundation and lifelong learning.
Enhance their career development, salary qualifications, and professional promotion
opportunities.
The CMAcertification is granted exclusively by the Institute of Certified
Management Accountants. __
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CMA.Learning Outcome Statements (LOS) II
The Certified Management Accountant exam is based upon a series of Learning
Outcome Statements (LOS) developed by the Institute of Certified Management
Accountants (ICMA). The LOSdescribes the knowledge and skills that make up the
CMA body of knowledge, broken down by part, section, and topic. The CMA
Learning System (CMALS) supports the LOSby addressing the subjects they cover.
Candidates should use the LOS to ensure they can address the concepts in different
ways or through a variety of question scenarios. Candidates should also be prepared to
perform calculations referred to in the LOS in total or by providing missing
components of a calculation. The LOS should not be used as proxies for exact exam
questions; they should be used as a guide for studying and learning the content that
will be covered on the exam.
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© 2009 Institute of Management Accountants. All rights reserved. a
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A copy of the ICMA Learning Outcome Statements is included at the end of this book.
Candidates are also encouraged to visit the IMA website to find other exam-related
information at www.imanet.org.
CMA Exam Format r The content tested on the CMA exams is at an advanced level—which means that the
passing standard is set for mastery, not minimum competence. Thus, there will be test
questions for all major topics that require the candidate to synthesize information,
evaluate a situation, and make recommendations. Other questions will test subject
comprehension and analysis. However, compared to previous versions, this CMA
exam will have an increased emphasis on the higher-level questions.
The content is based on a series of Learning Outcome Statements that define the
competencies and capabilities expected of a management accountant.
There are two exams, taken separately: Part 1: Financial Planning, Performance and
Control; and Part 2: Financial Decision Making. Each exam is four hours in length
and includes multiple-choice and essay questions. One hundred multiple-choice
questions are presented first, followed by two essay questions. All of these questions—
multiple-choice and essay—can address any of the LOS for the respective exam part.
Therefore, your study plan should include learning the content of the part as well as
practicing how to answer multiple-choice and essay questions against that content. The
study plan tips and the final section of this CMA Learning System book contain
important information to help you learn how to approach the different types of
questions.
Note on Candidate Assumed Knowledge
The CMA exam content is based on a set of assumed baseline knowledge that
candidates are expected to have. Assumed knowledge includes economics, basic
statistics, and financial accounting. Examples of how this assumed knowledge might
be tested in the exam include:
How to calculate marginal revenue and costs, as well as understand the relevance of
market structures when determining prices
•.How to calculate variance when managing financial risk
How to construct a cash flow statement as part of an analysis of transactions and
assess their impact on the financial statements
Please note this knowledge content is not covered in the CMA Learning System.
Therefore, prior courses in accounting and finance are highly recommended to ensure
this knowledge competency when preparing for the exam.
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Overall Expectations for the CMA Candidates
Completing the CMA exams requires a high level of commitment and dedication of up
to 150 hours of study for each part of the CMA exam. Completing the two-part exam
is a serious investment that will reap many rewards, helping you to build a solid
foundation for your career, distinguish yourself from other accountants, and enhance
your career in ways that will pay dividends for a lifetime.
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CMALS Part 2: Financial Decision Making, Version 3.0
© 2009 Institute of Management Accountants. All rights reserved. t
Your success in completing these exams will rest heavily on your ability to create a
solid study plan and to execute that plan. IMA offers many resources, tools, and
programs to support you during this process—the exam content specifications,
assessment tools to identify the content areas you need to study most, comprehensive
study tools such as the CMA Learning System, online practice tests, classroom
programs, and online intensive review courses. We encourage you to register as a
CMA candidate as soon as you begin the program to maximize your access to these
resources and tools and to draw on these benefits with rigor and discipline that best
supports your unique study needs. We also suggest candidates seek other sources if
further knowledge is needed to augment knowledge and understanding of the ICMA
LOS.
For more information about theCMAcertification, theCMAexams, or the exam
preparation resources offered through EMA, visit www.imanet.org.
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vi CMALSPart 2: Financial Decision Making, Version 3.0
©2009 Institute of Management Accountants. All rights reserved. i
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How to Use the CMA Learning
System'
CMALS
1 TM fl; i This product is based on the CMA body of knowledge developed by the Institute of
Certified Management Accountants (ICMA). This material is designed for learning
purposes and is distributed with the understanding that the publisher and authors are
not offering legal or professional services. Although the text is based on the body of
knowledge tested by the CMA exam and the published Learning Outcome Statements
covering the two part exams, CMA Learning System program developers do not have
access to the current bank of exam questions. It is critical that candidates understand
all Learning Outcome Statements published by the ICMA, learn all concepts and
calculations related to those statements, and have a solid grasp of how to approach the
multiple-choice and essay exams in the CMA program.
Some exam preparation tools provide an overview of key topics, others are intended to
help you practice one specific aspect of the exams such as the questions. The CMA
Learning System is designed as a comprehensive exam preparation tool to help you
study the content from the exam LOS, learn how to write the CMA exams, and
practice answering exam-type questions.
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Study the Book Content
The table of contents is set up using the CMA exam content specifications established
by ICMA. Each section, topic, and subtopic is named according to the content
specifications and the Learning Outcome Statements (LOS) written to correspond to
these specifications. As you go through each section and major topic, refer to the
related LOS found in Appendix B. Then review the CMALS book content to help
learn the concepts and formulas covered in the LOS.
The knowledge checks are designed to be quick checks to verify that you understand
and remember the content just presented by presenting questions and correct answers.
The answers refer to the appropriate page in the book for you to review the content
and find the answer yourself.
The practice questions are a sampling of the type of exam questions you will
encounter on the exam and are considered complex and may involve extensive written
and/or calculation responses. Use these questions to begin applying what you have
learned, recognizing there is a much larger sample of practice questions available on
the Online Practice Multiple-choice Test Questions (described below).
The CMALS also contains a bibliography in case you need to find more detailed
content on an LOS. We encourage you to use published academic sources. While
information can be found online, we discourage the use of open-source, unedited sites
such as Wikipedia. 7
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CMALS Part 2: Financial DecisionMaking, Version 3.0 vii
© 2009 Institute of Management Accountants. All rights reserved. [PI
Suggested Stud)r Process Using the CMALS
ml s m M m ?
Review LOS and study
book content by section understanding with topics in section questions at the end
and topic knowledge checks of a section
Evaluate Complete all Complete all Take Online
Practice Test
for section
Proceed to
next section
Start Course 1 (After the completion of
knowledge checks and
practice tests, if further
review is needed, return to
the associated section/topic.) 1
i <- 1
Complete Comprehensive Complete all sections
Online Part Test. B
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Register for
CMA exam
Take exam Ir
CMALS Book Features m- The CMALS books use a number of features to draw your attention to certain types of
content:
Key terms are bolded where they appear in the text with their definition, to allow you
to quickly scan through and study these.
Key formulas are indicated with this icon. Be sure you understand these formulas and
practice applying,them.
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Knowledge checks at the end of each topic are review questions that let you check
your understanding of the content just read. (They are not representative of the type of
questions that appear on the exam.)
Study tips offer ideas and strategies for studying and preparing for the exam. O i § GJ i i
Practice questions are examples of actual exam questions. Presented at the end of each
section, these questions help you solidify your learning of that section and apply it to
the type of questions that appear on the exam. I I
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viii CMALS Part 2: Financial Decision Making, Version 3.0
© 2009 Institute of Management Accountants. All rights reserved.
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Online Practice Multiple-choice Test Questions
Included in your purchase of the CMA Learning System Part 2 book is an online Part
2 practice test course made available to you through the IMA’s Learning Center. This
course includes five section-specific tests that randomize questions from a selected
section only. The course also includes a comprehensive Part 2 test that emulates the
percentage weighting of each section on the actual Part 2 exam. All questions are
drawn from a bank of more than 780 questions, so that each time you repeat the test,
you will receive a different set of questions covering all the topics in the section. All the
multiple-choice questions provide feedback in response to your answers. Your scores
will be recorded so that you can track your progress over time. Also included is a
Resources section that contains additional study documents.
It is suggested that you integrate the online tests throughout your study program
instead of leaving them until the end. The section-specific tests are designed for you to
practice questions related to the section content—read and leam a section and then
practice the online questions related to the section. This will also help identify if further
studying of the section content is required before moving to the next section.
The comprehensive part test is designed to help you simulate taking the actual CMA
exam. Try the comprehensive part test after you have studied all the Part 2 content.
You can take this exam multiple times. Each time you will receive a different
combination of questions. It is recommended that you set up your own exam
simulation—set aside three hours in a room without interruption, do not have any
reference books open, and work through the comprehensive part exam as though you
were taking the real exam. This will prepare you for the exam setting and give you a
good idea of how ready you are.
The Resources section of the CMALS online practice tests contains example essay
questions and answers. Use this document to practice the questions related to the essay
portion of the exam. Be sure to review the sample grading guide in the CMALS book
to understand how the essay questions are graded.
You are strongly encouraged to make full use of all online practice and review features
as part of your study efforts. Please note that these features are subscription based and
only available for a specific number of months from the time of purchase (for more
information on this feature and the terms of use, visit www.leamcma.coml.
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Learn to Write the CMAExam i The four-hour CMAexam will test your understanding of each part’s content using
both multiple-choice and essay questions. This means you must leam to write two
types of tests in-one sitting. The CMA Learning System books contain tips, instruction,
and examples to help you leam to write an essay exam. Be sure to study the Essay
Exam Support Materials section so that in addition to practicing the online multiplechoice
questions, you also learn to respond to the part content in essay format.
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CMALS Part 2: Financial Decision Making, Version 3.0 ix
©2009 Institute of Management Accountants. All rights reserved. r
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Si Create a Study Plan
Each part of the two-part CMA exam uses a combination of a multiple-choice format
and an essay format to test your understanding of the part concepts, terms, and
calculations. Creating a study plan is an essential ingredient to planning a path to
success. Managing your plan is critical to achieving success. The following tips and
tactics are included to help you prepare and manage your study plan.
Study Tips
There are many ways to study and the plan you create will depend on things such as
your lifestyle (when and how you can schedule study time), your learning style, how
familiar you are with the content, and how practiced you are at writing a formal exam.
Only you can assess these factors and create a plan that will work for you. Following
are some suggestions that other exam candidates have found helpful.
Schedule regular study times and stay on schedule.
Avoid cramming by breaking your study times into small segments. For example,
you may want to work intensely for 45 minutes with no interruptions, followed by a
15-minute break during which time you do something different. You may want to
leave the room, have a conversation, or exercise.
When reading, highlight key ideas, especially unfamiliar ones. Reread later to ensure
comprehension.
Pay particular attention to the terms and equations highlighted in this book, and be
sure to learn the acronyms in the CMA body of knowledge.
Create personal mnemonics to help you memorize key information. For example:
CCIC to remember the four ethical standards: Competence, Confidentiality,
Integrity, and Credibility.
Create study aids such as flash cards.
Use index cards and write a question on one side and the answer on the other. This
helps reinforce the learning because you are writing the information as well as
reading it. Examples:What is_? List the five parts of_.
In particular, make flash cards of topics and issues that are unfamiliar to you, key
terms and formulas, and anything you highlighted while reading.
Keep some cards with you at all times to review at unexpected times, such as in an
elevator, while waiting for an appointment, and so on.
Use a flash card partner. This person does not need to understand accounting. He or
she only needs the patience to sit with you and read the questions off the flash card.
As test time approaches, start to eliminate the questions you can easily answer from
your stack so you can concentrate on the more challenging topics and terms.
If particular topics are difficult, tap into other resources such as the Internet, library,
accountant colleagues, or professors, to augment your understanding.
•Use your study plan—treat it as a living document and update it as you learn more
about what you need to do to prepare for the exam.
•Use the Knowledge Checks in the book to assess how well you understand the
content you just completed.
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I Use the online section tests to test your capability to answer multiple-choice practice I
questions on each section’s content as you finish it. After completing the first 40
questions presented, review areas in the book that you were weak on in the practice
test. Then try the section test again.
Be sure to learn how to write a multiple-choice question exam—there are many
online resources with tips and guidance that relate to answering multiple-choice
exams.
•Make an attempt to answer all questions. There is no penalty for an incorrect
answer—if you don’t try, even when you are uncertain, you eliminate the
potential of getting a correct answer.
•Create your own “simulated” multiple-choice trial exam using the full part online
practice test.
Learn to write an effective essay answer
•Use the “Essay Exam Support Materials” segment on page 487 of this book. This
content shows a sample grading guide and includes a sample of a good, a better,
and a best answer in addition to some helpful tips for writing an essay answer.
•Learn how points are awarded for an essay answer so that you can ensure you get
the most points possible for your answers, even when you are very challenged by
a question.
•Practice essay responses using the questions in the CMALS book and in the
Resources section of the online practice tests.
Be sure to access the Online Practice Multiple-choice Test Questions and Essay
Questions in the Resource Section until you are comfortable with the content.
Ensure you are both well rested and physically prepared for the exam day as each
exam is four hours in length with no break for meals. Learning how to answer a
multiple-choice and essay exam and being mentally and physically prepared can
improve your grade significantly. Know the content and be prepared to deal with
challenges with a focused, confident, and flexible attitude.
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Be sure to check the Resources section of your Online Practice Test course on a
regular basis (i.e., weekly). This section will be used to post new study resource
documents for CMALS students, errata sheets for the CMALS books, and any
other important exam study update information. m tt
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CMALS Part 2: Financial Decision Making, Version 3.0 xi
© 2009 Institute of Management Accountants. All rights reserved. f
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Intro Part 2 Introduction
Welcome to Part 2:Financial Decision Making ofthe Institute ofManagement
Accountants’CMA Learning System™.
Thispart is composed offive sections: Section A, FinancialStatement Analysisfocuses on
important ratios and other analytical tools used to evaluate an organization’sfinancial
health, including coverage ofanalytical issues infinancialaccounting, such asforeign
currencyfluctuations, off-balancesheetfinancing, US GAAPvs. IFRS, andfair value
accounting.
Section B, Corporate Finance, examines key concepts in corporatefinance, including risk
and return, cost ofcapital, managing currentassets, raising capital, corporate
restructuring, and internationalfinanceissues.
Section C, Decision Analysis andRisk Management, reviewsfundamentalinformation
about the decision-makingprocess, including relevant cost analysis, cost/volume/profit
analysis, pricing concepts, and marginalanalysis. It also addresses the assessment and
managementofrisk—risk identification andexposure, risk mitigation strategies, and
enterprise risk management.
Section D, InvestmentDecisions begins with an overview ofthe capital budgetingprocess
and then reviewsprinciples and usedto evaluateinvestment alternatives—discounted
cashflowanalysis, payback and discountedpayback, ranking investmentprojects, and
risk analsyis.
Section E, ProfessionalEthics,focuses on ethicalconsiderationsforthe organization, with
discussion oftheprovisions ofthe U.S. Foreign Corrupt PracticesAct and IMA's
Statement ofManagement Accounting "Values andEthics:From Inception to Practice."
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i CMALS Part 2: Financial Decision Making, Version 3.0
© 2009 Institute of Management Accountants. All rights reserved.
Section A:FinancialStatementAnalysis
S< >n Financial Statement Analysis
A
Whilefinancialstatements summarize thepastperformance ofan organization, they can
alsoprovide users with valuable insights intofutureperformance. Financial statement
analysis isperformance by stockholders and creditors, and is also an important toolfor
management accountants andfinancialanalysts to use to better understand their
company’s competitiveposition.
Financialstatements can be analyzed to identify trends in keyfinancial data, compare
financialperformance across companies, and to calculatefinancialratios which can be
used to assess a company’s currentperformance as well as itsprospectsfor thefuture. In
addition, the management accountant should befamiliar with the analytical techniques
used by externalinvestors to evaluate their company.
This sectionfocuses on important ratiosandother analytical tools used to evaluatean
organization’sfinancial health, including coverage ofanalytical issues infinancial
accounting, such asforeign currencyfluctuations, off-balancesheetfinancing,fair value
accounting, and U.S. Generally AcceptedAccounting Principles (GAAP) vs.
InternationalFinancialReporting Standards (IFRS).
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CMALS Part 2: Financial Decision Making, Version 3.0 2
© 2009 Institute of Management Accountants. All rights reserved.
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Section A, Topic1: BasicFinancialStatement Analysis
Topic1 Basic Financial Statement Analysis
In order to evaluate companies,financialanalysts examinefinancialstatements in
different ways; they may create variants offinancialstatements, such as common-size
statements, andconsider other issues that may affect the company’sperformance.
Moreover, afinancialanalyst is expected to be able toprepare baseyear statements to
enable trendanalysis and review thegrowth rates ofthe various elements ofthefinancial
statement. In addition, the cashflowstatement, a requirement under FASB, provides
usefulinformation regarding thefinancialperformance ofa company.
Read the Learning Outcome Statements (LOS) for this topic as found in Appendix B
and then study the concepts and calculations presented here to be sure you
understand the content you could be tested on in the CMA exam. Q
Common-Size Statements
Common-size statements recast all items in a particular financialstatement as a
percentage of a selected (usually the largest and most important) item on the statement.
This can be used in several ways:
To compare elements in a single year’s financial statements
To analyze trends across a number of years for one business
To compare businesses of differing sizes within an industry (such as Wal-Mart to
Target)
To compare the company’s performance and position with an industry average
Common-size statements are useful when comparing businesses of different sizes
because the financial statements of a variety of companies can be recast into the
uniform common-size format regardless of the size of individual elements. The analyst
must use judgment to resolve the issue of actual comparability between individual
companies in different industries where common-size statements reflect the
fundamental differences in conducting business in these industries.
Comparing common-size statements of companies within an industry or with
common-size composite statistics of that industry can bring to light variations in
account structure or distribution that require the analyst to explore and explain the
reasons for differences.
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% If Vertical Common-Size Statements
In vertical common-size statements, a base amount (generally total assets on the
balance sheet and net sales on the income statement) is valued at 100% and the
elements within the statement are expressed as a percentage of the base amount.
Figures 2A-1 and 2A-2 are sample vertical common-size statements for the balance
sheet (statement of financial position) and income statement of ABC Company.
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3 CMALS Part 2: Financial Decision Making, Version 3.0
© 2009 Institute of Management Accountants. All rights reserved. I
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Section A:FinancialStatementAnalysis
Section Financial Statement Analysis
A
Whilefinancialstatements summarize thepastperformance ofan organization, they can
alsoprovide users with valuable insights intofutureperformance. Financial statement
analysis isperformance by stockholdersandcreditors, and is also an important toolfor
management accountantsandfinancialanalysts to use to better understand their
company’scompetitiveposition.
Financialstatements can be analyzed to identify trends in keyfinancial data, compare
financialperformance across companies, and to calculatefinancialratios which can be
used to assess a company’s currentperformanceas wellas itsprospeefsfor thefuture. In
addition, the management accountant should befamiliar with theanalytical techniques
used by externalinvestors to evaluate theircompany.
This sectionfocuses on important ratiosand other analytical tools used to evaluatean
organization’sfinancialhealth, including coverage ofanalytical issues infinancial
accounting, such asforeign currencyfluctuations, off-balancesheetfinancing,fair value
accounting, and US. Generally Accepted Accounting Principles (GAAP) vs.
InternationalFinancialReporting Standards (IFRS). II
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I CMALS Part 2: Financial Decision Making, Version 3.0 ;
© 2009 Institute of Management Accountants. All rights reserved.
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1! Section A, Topic1:BasicFinancialStatement Analysis
Tc |Basic Financial Statement Analysis I
In order to evaluate companies,financialanalysts examinefinancialstatements in
different ways; they may create variants offinancialstatements, such as common-size
statements, andconsider other issues that may affect thecompany’sperformance.
Moreover, afinancialanalyst is expected to be able to prepare baseyear statements to
enable trendanalysis and review thegrowth rates ofthe various elements ofthefinancial
statement. In addition, the cashflow statement, a requirement under FASB, provides
usefulinformation regarding thefinancialperformance ofa company. 1 i Read the Learning Outcome Statements (LOS) for this topic as found in Appendix B
and then study the concepts and calculations presented here to be sure you
understand the content you could be tested on in the CMA exam. 09 I!
Common-Size Statements
Common-size statements recast all items in a particular financial statement as a I
percentage of a selected (usually the largest and most important) item on the statement.
This can be used in several ways:
To compare elements in a single year’s financial statements
To analyze trends across a number of years for one business
To compare businesses of differing sizes within an industry (such as Wal-Mart to
Target)
To compare the company’s performance and position with an industry average
Common-size statements are useful when comparing businesses of different sizes
because the financial statements of a variety of companies can be recast into the
uniform common-size format regardless of the size of individual elements. The analyst
must use judgment to resolve the issue of actual comparability between individual
companies in different industries where common-size statements reflect the
fundamental differences in conducting business in these industries.
Comparing common-size statements of companies within an industry or with
common-size composite statistics of that industry can bring to light variations in
account structure or distribution that require the analyst to explore and explain the
reasons for differences.
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I I * I i Vertical Common-Size Statements
In vertical common-size statements, a base amount (generally total assets on the
balance sheet and net sales on the income statement) is valued at 100% and the
elements within the statement are expressed as a percentage of the base amount.
Figures 2A-1 and 2A-2 are sample vertical common-size statements for the balance
sheet (statement of financial position) and income statement of ABC Company.
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3 CMALS Part 2: Financial Decision Making, Version 3.0
© 2009 Institute of Management Accountants. All rights reserved. t
Section A, Topic1: BasicFinancial Statement Analysis
Figure 2A-1: Vertical Common-Size Balance Sheet for ABC Company i
Assets
Total current assets
Net fixed assets
Total assets
$350,000
150.000
70%
30%
100% l
Liabilities and equity
Liabilities:
Total current liabilities:
Long-term liabilities:
Total liabilities
Shareholders’ equity:
Common stock, $ par value
Additional paid-in capital
Retained earnings
Total shareholders’ equity
Total liabilities and equity
$200,000
50.000
40%
10%
250,000 50%
25,000
100,000
125,000
5%
20%
25%
250.000 50%
100%
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Figure 2A-2: Common-Size Income Statement for ABC Company
i.
Sales
Cost of goods sold
Admin, expense
Other expenses
EBIT
$250 100%
120 48%
85 34%
10 4%
$35 14%
As demonstrated in Figures 2A-1 and 2A-2, common-size statements can be created
for both the balance sheet and the income statement. Analysis of common-size income
statements is useful because each item in it is related to the central value of sales. Most
expense items (except fixed costs) are affected to some extent by sales volume, and
therefore, it is helpful to know what proportion of the sales dollar each of the various
costs and expenses represents. Such common-sized statements are used to compare
two different companies.
There are salient differences between the common-sized statements across different
industries. Typically, companies within the same industry display similar traits in their
common sized statements, but companies in different industries display different traits.
Figure 2A-3 shows common-sized statements of four different industries, illustrating
the divergence in these statements across industries. As can be seen, the composition of
the assets varies widely in the example industries: computer manufacturing, retail,
pharmaceuticals, and finance.
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Section A, Topic I: Basic Financial Statement Analysis
Figure 2A-3: Common Size Balance Sheet across Industries
Assets “Computer
Manufacturer
Retailer Pharmaceutical Financial
Cash Equivalent 13.2% 2.7% 3.3% 15.8%
Marketable
Securities
22.8% 0 17.2% NA
Acc./ Notes 22.8% 1.9% 16.4% 12.8%
Receivable
Inventories 3.4% 28.2% 8.1% 0
Prepaid and Others 4.8% 6.4% 6.3% 0
Investments 23.8% 0 7.6% 68.1% s
Property, Plant and
Equipment
6.7% 46.7% 28.2% 0.7%
Goodwill and 13.4%
Intangibles
2.5% 5.4% 0
Other Assets 0 0.7% 7.5% 2.6%
Total Assets 100% 100% 100% 100%
Liability and Equity: i
Short Term Payables 45.3% 32.1% 8.1% 76.1% li-
Short Term Debt 0 3.0% 12.8% 6.5%
Other Current
Liabilities
0 1.7% 14.9% 0 :
Long Term Debt 4.5% 23.7% 5.1% 9.9%
Other Liabilities 4.0% 2.8% 11.1% 3.5%
Total Liabilities 53.8% 63.3% 52.0% 95.5%
I Total Equity 46.2% 26.7% 48.0% 4.5%
Total Liability & 100%
Equity
100% 100% 100%
The disparity in a few of the accounts is worth focusing on. For example, accounts
receivable comprises a very low percentage of the total assets for the retailer primarily
because a retailer (such as Wal-Mart or Target) has most of its sales in cash or on
credit cards. On the other hand, as expected, inventories are a significant portion of the
total assets for the retailer, much more so than in any other industry. Moreover,
companies in the financial industry (such as a bank or stock broker) possess little or no
inventory.
Investments are the most significant account for companies in the financial industry,
but this account is small or non-existent for retailers. The business model of financial
companies, and’in particular investment banks is to hold investments that yield a high
return. Therefore, it is not surprising that investments are about 70% of the total assets.
Leaders in the pharmaceutical and computer industries have investments in smaller
companies in their respective industries, though the investment amount comprises a
much smaller proportion of their total assets than for financial companies.
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1 Section A. Topic1: Basic FinancialStatement Analysis
It is interesting to note that the retailer and the pharmaceutical company have a
significant proportion of their assets in plant, property, and equipment. This signifies
that retailers own most of their stores rather than leasing them (a concept to be
addressed later under off-balance sheet financing). Similarly, the pharmaceutical
companies have a significant proportion of their assets tied up in their means of
production (plant and equipment). The investment in plant, property, and equipment is
miniscule for the financial institution, primarily because its assets are mostly composed
of investments, and they do not require manufacturing plants or machinery and
equipment to function. Normally, traditional manufacturers have a significant
proportion of their assets in plant, property, and equipment. However, in recent times
with the advent of “lean manufacturing,” the proportion of plant, property and
equipment in relation to total assets is decreasing for manufacturers': This is signified
by the relatively low amount of plant, property, and equipment account for the
computer manufacturer (for example, Dell Computers).
The common sizing of liabilities and equities provides some interesting insights as to
how these companies are financed. While the manufacturing and pharmaceutical
companies obtain approximately equal financing through debt and equity (equity being
46% for the manufacturer and 48% for the pharmaceutical), the retailer and the
financial institution obtain most of their financing through debt. The retailer obtains
approximately a quarter of its financing from equity whereas the financial institution
obtains only 5% of its financing from equity-holders.
Additionally, the financial institution obtains most of its financing—approximately
three-quarters—from short-term obligations, consisting primarily of deposits in
accounts that could be withdrawn at the customer’s discretion at any time.
The short-term obligation for the retailer in terms of accounts payable is approximately
a third of the total assets, which represents payments due to suppliers of its
merchandise. An interesting insight could be gained by comparing the amount of
inventory to the amount of accounts payable. In this case, they are approximately the
same, implying that the retailer is, on average, able to sell the merchandise around the
same time as when the supplier payment is due. This kind of analysis will be further
developed later in the section on ratio analysis, and this concept is formally referred to
as comparing inventory turnover to accounts payable turnover.
Similar inferences can be drawn through common sizing of the income statement.
Different industries have different cost structures and profit margins. Comparing the
various categories of common-sized expenses, such as cost of sales, research and
development (R&D) expense, advertising expenses, and general overhead, provide
validation of the differing business models across industries. For example, a retailer
has a higher proportion of cost of sales than a pharmaceutical company, which
traditionally has a very small cost of sales relative to its total sales, signifying a high
profit margin. Similarly, while the R&Dexpenses for a pharmaceutical company are
high, they are non-existent for a retailer.
Such analysis and ability to draw inferences is critical in conducting common size
analysis. The mechanical aspect of developing common-sized statements is of limited
usefulness unless the analyst is able to make inferences and identify issues of concern
based on the expectations formed through experience and knowledge.
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SectionA, Topic1:BasicFinancialStatementAnalysis i
Horizontal Common-Size Statements
A horizontal common-size statement, also called a variation analysis or trend
analysis, compares key financial statement values and relationships for the same
company over a period of years. The increase or decrease in each of the major
accounts is shown as a percentage of the base year amount, and hence is sometimes
referred to as the base year financials. As illustrated in Figure 2A-4, such an analysis
sets the base year at a value of 100% and then shows subsequent years in relation to
increases or decreases over the base year.
Figure 2A-4: Horizontal Common-Size Statement (Variation or Trend Analysis) 1
YearO Year 1 Year 2 Year 3 Year 4
Sales $200,000 $210,000 $250,000 $260,000 $300,000 i Base year 100% 105% 125% 130% 150%
multiplier
Cost of Sales $100,000 $110,000 $130,000 $150,000 $160,000
Base year 100% 110% 130% 150% 160%
multiplier i1
Note in Figure 2A-4 how cost of sales is growing faster than sales. This can be inferred 1
through a simple computation of percentage growth in cost of sales and comparing it
to the percentage growth in sales. Horizontal or trend analysis helps the analyst
examine relationships to detect strengths and weaknesses. In this example,
management needs to focus on controlling costs. This analysis can reveal trends in the
direction, rate, and volume of change. Further analysis can also examine trends in
related areas, such as a disparity between an increase in sales and a proportionately
greater increase in receivables. Changes can be divided between year-to-year changes
and longer-term trends.
By reading across each row—the horizontal analysis—one can quickly spot any
unusual change in a particular account from the previous year. Any large changes, or a
reversal of a trend (a decrease after years of increases) signals issues that have to be
further investigated andandyzed. The horizontal analysis provides an initial and quick
Overview of the financial statements but by no means is it the final step of a thorough
analysis. The purpose of horizontal analysis is primarily attention directing, in that it
quickly and efficiently directs attention to the accounts that require further
investigation.
The analyst must use caution in interpreting results using horizontal common-size
statements. Changes between years can be expressed in actual dollar amounts but are
much more commonly expressed as percentages. When using percentages, the analyst
must keep in mind the size of the basis for comparison. For example, a 400% increase
in net income might sound remarkable until you learn that last year’s income was
$1,000.
Also, expressing change as a percentage loses meaning when the base is zero or below,
or the new value is zero. For example, if a company’s net income in year one has a
negative value and in year two has a positive value, then there is no way to express the
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Section A, Topic 1: Basic FinancialStatement Analysis
change as a percentage. In a case such as this, a comparison must be made by
examining the raw numbers.
Another use of horizontal analysis is in cost control. Often companies that are
experiencing sales growth will tend to disregard controlling expenses. As a result,
fixed expenses, which consist of overhead and other indirect expenses, may rise due to
a lax management approach. Horizontal analysis can identify the fixed expenses that
are increasing over time as sales are increasing. While it is possible that the increase in
fixed expenses is justified due to inflation or growth of operations and facilities, an
investigation could identify wastage or over-consumption of these resources and
provide a means to increase profitability by limiting these expenses.
If changes between years are expressed in actual dollar amounts, the analyst must also
bear in mind the relative conditions with which the firm started. For example, an
increase in sales of $100,000 in a year has a different meaning for a company that
began with sales of $10,000 than it does for a company that began with sales of
$2,000,000.
Data across a number of years can also be presented as averages. This method
mitigates the effect of unusual fluctuation in data for specific years. That is, a rolling
average over two or three years could be used as input to the horizontal analysis. In
that way, an unusual year that affects multiple averages and trends could be spotted
even when large variation in data are present.
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f- Statement of Cash Flows I
Cash is a company’s most liquid resource, and therefore it affects liquidity, operating S:
capability, and financial flexibility. According to Statements of Financial Accounting
Standards (SFAS) No. 95, a statement of cash flows “must report on a company’s cash
inflows, cash outflows, and net change in cash from its operating, financing, and
investing activities during the accounting period, in a manner that reconciles the
beginning and ending cash balances.” The statement helps interested parties determine
if an entity needs external financing or is generating cash flows, meeting obligations,
and paying dividends. Sometimes companies with high income could still have a
negative cash flow.
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Components and Classifications
Cash receipts and cash payments are classified in the statement of cash flows as falling
into one of three categories: operating activities, investing activities, or financing
activities.
Operating Activities
Cash flows from operating activities are those related to the normal course of business.
Examples of cash inflows include cash receipts from sales of any kind, collection of
accounts receivable, collection of interest on loans for a financial institution, and
receipt of dividends for an investment banker. Cash outflows include cash paid to
employees, suppliers, to the IRS, and to lenders for interest.
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Section A, Topic1: BasicFinancialStatement Analysis
Because GAAP and IFRS-compliant statements use accrual accounting, net income
includes noncash revenues (for example, uncollected credit sales) and noncash
expenses (for example, unpaid expenses). Other items that accrual accounting includes
are depreciation, depletion, amortization, and other costs that were incurred in prior
periods but are being charged to expense in the current period. These items reduce net
income but do not affect cash flows for the current period. Therefore, these items are
added back when determining net cash flow from operating activities.
Examples of noncash expense and revenue items that must be added back to net
income include:
Depreciation expense and amortization of intangible assets.
Amortization of deferred costs.
Changes in deferred income taxes.
Amortization of a premium or discount on bonds payable.
Income from an equity method investee.
Investing Activities
Most items in the investing activities section come from changes in long-term asset
accounts. Investing cash inflows result from sales of property, plant, and equipment
(PP&E); sales of investments in another entity’s debt or equity securities; or collections
of the principal on loans to another entity. (Interest is included in operating cash
flows). Investing cash outflows result from purchases of PP&E, purchases of other
companies’ debt or equity securities, and the granting of loans to other entities.
Financing Activities
Most items in the financing activities section come from changes in long-term liability
or equity accounts. Financing cash inflows come from the sale of the entity’s equity
securities or issuance of debt such as bonds or notes. Cash outflows consist of
payments to stockholders for dividends and payments to reacquire capital stock or
redeem a company’s outstanding debt. In other words, investing activities involve the
purchase or sale of fixed assets and investments in another company’s securities, while
financing activities involve the issuance and redemptiojiof a company’s own equity
and debt securities.
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Indirect and Direct Methods 1:•.. To determine operating cash flows, FASB SFAS No. 95 allows entities to use either
the indirect method or the direct method.
Indirect Method
The indirect method, or reconciliation method, is the most popular method of
converting net income to net cash flow from operating activities. It starts with net
income and then adjusts it by adding back noncash expenses and paper losses and
subtracting noncash revenues and paper gains that have no effect on current period
operating cash flows. Additional adjustments are made for changes in current asset and
liability accounts related to operations by adding or subtracting amounts as shown in
Figure 2A-5. For example, an increase in accounts receivable (a current asset) would
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9 CMALS Part 2: Financial Decision Making, Version 3.0
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Section A, Topic I:Basic Financial Statement Analysis
be subtracted from net income to arrive at operating cash flow because it means that
the amount of cash collected from customers is less than the amount of accrual
revenue reported.
Figure 2A-5: Cash Flows from Operating Activities—Indirect Method
Iij
Net Income
+ Noncash expenses (typically depreciation and amortization expenses)
- Gains from investing and financing activities
+ Losses from investing and financing activities
+ Decreases in current assets
- Increases in current assets
+ Increases in current liabilities
- Decreases in current liabilities
+ Amortization of discounts on bonds
- Amortization of premiums on bonds
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Operating cash flow
Direct Method
In the direct method, or income statement method, net cash provided by operating
activities is calculated by converting revenues and expenses from the accrual basis to
the cash basis. Fewer than 5% of companies use the direct method in preparing their
cash flow statements. Furthermore, when the direct method is used, the FASB requires
that the reconciliation of net income to net cash flow from operating activities be
disclosed in a separate schedule. This entails creating a schedule similar to the cash
flow statement prepared using the indirect method. Figure 2A-6 shows how a direct
method statement is arranged.
Figure 2A-6: Cash Flows from Operating Activities—Direct Method
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$100,000
(40,000)
(5,000)
(10,000)
(25.000)
Cash received from customers
Cash paid to suppliers
Cash paid for interest
Cash paid for taxes
Cash paid for operating expenses
Cash provided by operating activities
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$20.000 If
Footnotes
The statement of cash flows requires footnote disclosure of any significant non-cash
investing and financing activities such as the issuing of stock for fixed assets or the
conversion of debt to equity. In addition, when using the indirect method for cash flow
from operations, both interest paid and income taxes paid need to be disclosed.
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\ Example of a Statement of Cash Flows
The statement of cash flows shown in Figure 2A-7 illustrates the more commonly used
indirect approach for calculating operating cash flows. Cash flows from each category
CMALS Part 2: Financial Decision Making, Version 3.0 10 ;
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Section A, Topic I: Basic Financial Statement Analysis
(operating, investing, and financing) are separately classified and totaled. The sum of
cash inflows (or outflows, if negative) from these three categories is equal to the net
increase or decrease in cash for the period. This net cash inflow (outflow) is added to
(subtracted from) the cash balance at the beginning of the year to obtain the cash
balance at the end of the year. Thus, the cash flow statement explains the net change in
the amount of cash and cash equivalents (short-term, highly liquid investments that are
close to maturity) from the beginning to the ending balance sheet. Below is an example
of what a typical indirect cash flow statement would look like.
Figure 2A-7: Statement of Cash Flows—Indirect Method
1
Operating Activities
Net income
Adjustments to convert net income to a cash basis:
Depreciation and amortization charges*
Decrease (increase) in accounts receivable
Increase (decrease) in merchandise inventory
Increase (decrease) in accounts payable
Increase (decrease) in accrued wages and salaries payable
Increase (decrease) in accrued income taxes payable
Increase (decrease) in deferred income taxes
Gain on sale of store**
Net cash provided by operating activities
$151,330
75,332
(31,445)
(4,165)
6,740
4,543
3,984
(4,950)
(1.255)
200,114
Investing Activities
Additions to property, buildings, and equipment
Proceeds from sale of store
Net cash used in investing activities
(123,730)
3.980
(119,750)
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Financing Activities r
Increase (decrease) in notes payable
Increase (decrease) in additional paid-in capital
Increase (decrease) in long-term debt
Increase (decrease) in common stock
Cash dividends paid
Net cash used in financing activities
1,100
14,800
(50,500)
1,000
(33,330)
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(66.930)
I 13,434
11.194
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year $24.628
Note: Changes in various asset and liability accounts (for example, increases/decreases) can be
obtained by comparing two consecutive years’ balance sheets.
* Depreciation and amortization charges are included in the income statement as part of
administrative expenses.
**Gain on sale of store is included in the income statement as part of other revenue. r¥
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I Section A, Topic 1: BasicFinancialStatementAnalysis I
Knowledge Check: Basic Financial Statements
Thefollowing questions are intended to help you check your understanding and recall ofthe
materialpresented in this topic. They do not represent the type ofquestions that appear on
the CMA exam. %\
Directions: Answer each question in the space provided. Correct answers and page
references follow these questions.
1. In a common-sized balance sheet, the inventory account as a percentage of total
assets is expected to be highest for companies in:
1 i
( ) a. the finance industry, such as Citibank. l
( ) b. the airline industry, such as Continental Airlines.
( ) c. the retailing industry, such as Wal-Mart.
( ) d. the pharmaceutical industry, such as Pfizer.
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2. Which of the following statements regarding common-size statements is true?
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( ) a. Common-size statements for two companies, with both showing a 100%
increase in profits, show that both companies would make equally
attractive investments.
( ) b. Horizontal common-size statements can be made only for companies with
at least 10 years of operational data.
( ) c. Common-size statements can be used to compare companies of different
sizes.
( ) d. All of the above are true.
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3. In a cash flow statement prepared under the indirect method, depreciation expense I
is:
( ) a. Subtracted m the operatingÿsection.
( ) b. Added to the operating section.
( ) c. Subtracted in the investing section.
( ) d. Added in the investing section.
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Section A, Topic1: Basic Financial Statement Analysis
4. Lester Company’s comparative balance sheets included accounts receivable of
$120,000 at Dec. 31, 2008 and $160,000 on Dec. 31, 2009. Its total sales amounted
to $450,000. What is the amount of cash collection that Lester would report under
the direct method.
( ) a. $450,000
( ) b. $410,000
( ) c. $490,000
( ) d. Cannot be determined.
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Section A, Topic I: BasicFinancialStatement Analysis II
Knowledge Check Answers: Basic Financial Statements
1. In a common-sized balance sheet, the inventory account as a percentage of total
assets is expected to be highest for companies in:[Seepage 5]
1It
( ) a. the finance industry, such as Citibank.
( ) b. the airline industry, such as Continental Airlines.
(x) c. the retailing industry, such as Wal-Mart.
( ) d. the pharmaceutical industry, such as Pfizer.
i1
2. Which of the following statements regarding common-size statements is true?[See
page 3]
( ) a. Common-size statements for two companies, with both showing a 100%
increase in profits, show that both companies would make equally
attractive investments.
( ) b. Horizontal common-size statements can be made only for companies with
at least 10 years of operational data.
(x) c. Common-size statements can be used to compare companies of different
sizes.
( ) d. All of the above are true.
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3. In a cash flow statement prepared under the indirect method, depreciation expense
is:[Seepage 9]
( ) a. Subtracted in the operating section.
(x) b. Added to the operating section.
( ) c. Subtracted in the investing section.
:
4.' Lester Company’s comparative balance sheets included accounts receivable of
$120,000 at Dec. 31, 2008 and $160,000 on Dec. 31, 2009. Its total sales amounted
to $450,000. What is the amount of cash collection that Lester would report under
the direct method?[Seepage10]
I
I ( ) a. $450,000 I
(x) b.$4io,ooo
( ) c. $490,000
() d. Cannot be determined.
( ) e. Added in the investing section.
$120,000 + $450,000-$160,000 = $410,000
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CMALS Part 2: Financial Decision Making, Version 3.0
© 2009 Institute of Management Accountants. All rights reserved.
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Section A, Topic2: Financial PerformanceMetrics -FinancialRatios i
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Financial Performance Metrics -
Financial Ratios
Topic 2
1
A ratio is a comparative relationship between two (or more)financialstatement amounts.
The ratiosprovide incremental information about thefinancialhealth ofthe company
beyond the raw amountspresented in thefinancialstatements. Financial ratios are
commonly usedfor three types ofinferences: inferences on liquidity, solvency and
operations; inferences on capital structure; andinferences on profitability. I1
Read the Learning Outcome Statements (LOS) for this topic as found in Appendix B
and then study the concepts and calculations presented here to be sure you
understand the content you could be tested on in the CMA exam. m i Liquidity/Solvency Ratios
Solvency is the ability of a company to pay its creditors when the amounts become
due, or it is the debt-paying ability of the company, in the long term. Liquidity is a
relative measure of the proximity to cash of the assets and liabilities of the company
and is an indication of company’s ability to meet its short-term obligations. Since most
of the liabilities of a company (except unearned revenue) are paid in cash, a good
measure of this ability is how rapidly a company could convert its other assets into
cash, if the need arises.
Various account combinations, primarily ratios, are used to measure liquidity, and in
essence they measure the company’s ability to pay debts as they come due. Given the
time horizon of when the debt has to be paid, financial analysts focus on short-term,
medium-term and long-term liquidity. When the time horizon is short, only a few
types of assets can be quickly converted to cash, hence only those are used in
computing the short-term liquidity ratios. As the time horizon increases, more and
more assets could be sold and converted to cash, hence those are incorporated in the
computation of medium- and long-term liquidity.
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*6 Working Capital Analysis it
Working capital is a measure of a company’s ability in the short run to pay its
obligations. It looks at short-term financial health. Working capital is calculated as
follows: I1Working Capital = Current Assets-Current Liabilities E |
r Current assets are defined as cash or other liquid investments, such as inventory and t
accounts receivable, that can be converted to cash within a year. Current liabilities are
obligations that will be paid within a year, such as accounts payable and notes and
interest payable. A positive value of working capital indicates that there are enough
current assets to cover current obligations. Current measures of working capital can be
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Section A, Topic2:Financial PerformanceMetrics-FinancialRatios f
compared to previous measures to determine if there has been a change that should
cause concern.
To examine working capital, we will compare two companies:
AEW, Inc., has $1,000,000 in current assets and $500,000 in current liabilities.
AEW’s working capital is $500,000 ($1,000,000 current assets-$500,000 current
liabilities).
KF, Inc., has $20,000,000 in current assets and $19,500,000 in current liabilities.
KF’s working capital is also $500,000 ($20,000,000 current assets-$19,500,000
current liabilities).
Obviously, there is a difference between working capital of $500,Q0flffor AEW, Inc.,
with $1,000,000 in current assets, and KF, Inc., with $20,000,000 in current assets. In
order to understand what working capital of $500,000 means for a company’s liquidity,
the analyst should study the following ratios to examine relationships between current
assets and current liabilities: current ratio, quick (acid-test) ratio, and cash ratio.
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Current Ratio
The current ratio measures the degree to which current assets cover current liabilities.
A higher ratio indicates greater ability to pay current liabilities with current assets, thus
greater liquidity. I
l% E Current Ratio = Current Assets : Current Liabilities
Using the numbers from the example:
AEW has a current ratio of 2 ($1,000,000-$500,000). AEW has sufficient current
assets to pay its current liabilities twice.
KF’s current ratio is 1.026 ($20,000,000 -$19,500,000); KF has sufficient current
assets to pay current liabilities only once.
AEW and KF have the same working capital, but AEW is better positioned against
uncertainty if it is not able to obtain additional assets (via sales) in the near-term future.
KF must generate additional current assets before the next cycle of debt obligations is
due. It appears that AEW is more liquid than KF.
There are limitations to using the current ratio to assess liquidity. Because cash is the
only acceptable means of payment, it is important to consider the composition of
current assets and determine whether those listed as current asset can readily be
converted to cash.
For example, if pre-paid expenses compose most of the current assets, the current ratio
overstates the liquidity of the company because the pre-paid expenses cannot be
converted to cash to settle the liabilities.
Further, the current ratio cannot predict or indicate patterns of future cash flows, nor
can it measure the adequacy of future liquidity. For example, if there is a significant
amount of accounts receivable from one customer and that customer files for
bankruptcy there would be significant delay in receiving the payment. Even though the
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Section A, Topic2: Financial PerformanceMetrics-FinancialRatios f
current ratio is high because of the receivables, the debt-paying ability of the company
is compromised due to the non-collection of a significant receivable.
The current ratio examines only the current relationship between current assets and
current liabilities. Problems with liquidity will affect other aspects of the company’s
financial situation and may ultimately affect the company’s ability to pay long-term
obligations (solvency) or use its assets efficiently (operating activity). Traditionally, for
a company in the manufacturing industry, a current ratio of 2.0 or above is considered
healthy. However, in the current economic environment of e-business, a lower current
ratio is acceptable. I
Quick (Acid-Test) Ratio ! The quick ratio, or acid-test ratio, examines liquidity from a more immediate aspect 1 1
than does the current ratio by eliminating inventory from current assets. The quick
ratio removes inventory because it turns over at a slower rate than receivables or cash,
and assumes that the company will be able to sell the items to a customer and collect
cash. While there are a few different ways to compute the quick (acid-test) ratio (by
making adjustments to the numerator), the formula listed here is the one that is used
on the CMA exam.
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_ ij Current Assets - Inventory
Current Liabilities
Quick (Acid-Test) Ratio
Current assets include cash equivalents and marketable securities. Cash equivalents
include money in petty cash, checking accounts, passbook savings accounts, etc.
Marketable securities are highly liquid short-term investments, which can generally
become cash in a very short time (several minutes).A usual guideline for a reasonable
quick ratio is 1 or greater, but this may vary by industry. The quick ratio, like all ratios,
should be judged by comparing it to the firm’s past values for the ratio and to the
values for similar companies and industry averages. Although the quick ratio is a better
indicator of short-term solvency, it is not perfect. In reality, qualitative information
such as credit terms with suppliers and customers is useful.
The current ratio, quick ratio, and working capital calculations are by far the most
common liquidity measures; however, several other ratios give analysts further
information. Among these are the cash ratio and the cash flow ratio.
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Cash Ratio [ The cash ratio analyzes liquidity in a more conservative manner, looking at a
company’s immediate liquidity. The cash ratio compares only cash and marketable
securities to current liabilities, eliminating receivables and inventory from the asset
portion. I f
Cash Ratio = Cash + Marketable Securities Current Liabilities a;- To apply the cash ratio to AEW’s and KFs financial information: l-
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5 Section A, Topic2: Financial Performance Metrics-FinancialRatios II
Of its $1,000,000 in current assets, AEW has $250,000 in cash and $300,000 in
marketable securities. The remaining current assets include receivables and
inventory. AEW’s cash ratio is calculated as follows: _ $250,000 + $300,000 _ $550,000
$500,000
KF’s cash and cash receivables total $2,000,000, and its marketable securities total
$9,000,000. Remaining current assets represent receivables and inventory. KF’s cash
ratio is calculated as follows:
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AEW Cash Ratio $500,000 !
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_ $2,000,000 + $9,000,000 _ $11,000,000
$19,500,000 $19,500,000
A firm is generally not expected to have enough cash equivalents and marketable
securities to cover current liabilities. Although this limits the usefulness of the cash
ratio, the ratio is helpful for companies that have slow inventory turnover or slow
collection of receivables. A cash ratio that is too high may indicate that a company is
not using its resources productively in its operations. A cash ratio that is too low,
however, could indicate a problem with meeting current liabilities. Another limitation
of cash ratio is that it contains marketable securities and those may have to be
liquidated to pay the debt. As the value of marketable securities is volatile (changes day
to day), this ratio (computed based on year-end prices), may not be valid over a longer
time horizon.
KF Cash Ratio = 0.564
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Cash Flow Ratio
The cash flow ratio measures a firm’s ability to meet its debt obligations with cash
generated in the normal course of business.
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_ Operating Cash Flow
Current Liabilities
E Cash Flow Ratio
Higher ratios of operating cash flow to liabilities indicate a higher likelihood that the r
firm will be able to meet its obligations with cash generated from normal business
operations. This ratio measures the ability of the company to meet its short-term
obligations based on cash generated in the normal course of business. A deteriorating
cash flow ratio, over time, indicates impending liquidity problems.
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Sensitivity Analysis on the Liquidity Ratios i
In analyzing the ratios, it is important to gauge how sensitive these ratios are to
changes in their components. An increase in the numerator of a ratio will increase the
value of the ratio, whereas an increase in the denominator of a ratio will reduce the
value of the ratio, and vice versa. Since a higher number is preferable for these ratios, a
decrease in the numerator or an increase in the denominator adversely affects the ratio
and the consequent inferences.
Thus, an increase in liabilities would adversely affect the ratio, whereas an increase in
current assets or cash flows (the term in the numerator) would improve the ratios. The
amount of increase or decrease in a particular ratio depends on the value of the ratio.
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Section A, Topic2: Financial PerformanceMetrics -FinancialRatios !
It should be noted that an equal increase in both the numerator and denominator of
the ratio would worsen the ratio, if the ratio is greater than 1. Similarly, an equal
decrease in both the numerator and denominator would improve a ratio that is greater
than 1.
Sometimes companies use this mathematical fact to improve the appearance of the
liquidity ratios. As an example, paying off current liabilities right before the balance
sheet date would improve the current and the quick ratios.
For example. Company Qhas current assets of $1,000,000 and current liabilities of
$600,000 yielding a current ratio of 1.67.
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E Current Ratio = Current Assets Current Liabilities
Current Ratio = $1,000,000/$600,000
= 1.67
If the company were to pay off $200,000 of current liability just prior to preparing its
financials, the current assets will reduce to $800,000 and current liability will reduce to
$400,000, improving the current ratio to 2.0.
Current Ratio = ($1,000,000-$200,000)/ ($600,000-$200,000)
= $800,000/$400,000
= 2.0
It is important to note that when companies engage in such activities for the sole
purpose of improving the financial ratios, it is called “window dressing” and the
behavior may be ethically questionable.
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Measuring tlie Ability to Fay 1 Any judgment regarding payment of current liabilities should be made in the fight of
the degree of urgency of payment. There are several measurements that can be made to
assess the company’s policy in paying off current liabilities. Such analysis could be
used by new suppliers to assess the timeliness and credit-worthiness of the company. I
Days’ Purchases in Accounts Payable
Measurement of days’ purchases in accounts payable usually indicates the payment
terms that the company has with its suppliers, assuming that the company is not in
default on their payments.
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Days’ Purchases in Accounts Payable = Avera9e Accounts Payable x365
Credit Purchases E
; i Determining credit purchases may be impossible for an outside analyst. A reasonable
approximation is to substitute total purchases instead of credit purchases. Total
purchases can be determined by adjusting the cost of goods sold by the changes in
inventory balance. A large ratio would indicate that either the company has good
relationship with its suppliers and enjoys liberal payment plan, or is delinquent in
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i) Section A, Topic 2:Financial PerformanceMetrics-FinancialRatios
making payments. Further investigation of the credit terms with its major suppliers
would provide a reasonable assessment of which of these is true for a particular
situation. A larger number than the firm’s credit terms would indicate past due
obligations.
The formula also uses average accounts payable, which is the current year plus the
prior year ending accounts payable divided by 2 (assuming even purchasing patterns
throughout the year). However, sometimes this formula is calculated simply using
ending accounts payable.
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Capital Structure Analysis
In addition to assessing a firm’s ability to meet its short-term obligation, it is important
to evaluate its ability to pay long-term debts as they mature. This requires comparing
the amount of long-term obligations and the company’s ability to generate cash in the
long term. This ability is greatly affected by the amount of long-term debt the company
has in relation to equity.
Capital structure is the mix of long-term debt, on which interest and principal
payments must be made, and equity, in the form of common and preferred stock,
which the firm uses to finance operations. The capital structure affects both the risk
and returns of the firm and is directly related to leverage.
Financial leverage is the use of debt (fixed cost funds) to increase returns to owners
(stockholders). Debt that is too low may result in a company not being able to take full
advantage of opportunities. Debt that is too high may affect the company’s ability to
weather difficult economic times and continue to pay its obligations as debt or interest
payments come due. There is no standard guideline or optimal leverage number; this
varies by industry and firm.
Firms have a mix of debt and equity financing. Debtholders, including financial
institutions and corporate bond investors, are often, but not always, promised a return
based on the stated interest rate for the debt. There are costs associated with issuing
debt and equity. (Debt is usually cheaper but will increase as the firm’s ratio of debt to
equity increases). Most companies maintain a balance of debt and equity based on the
cost of capital for each and the level of risk they wish to maintain.
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Debt as Leverage
A company uses leverage in two ways: financial and operating.
Financial leverage is raising capital through debt rather than equity. While debtholders
are entitled to interest, the owners share the earnings of the company. Hence, when a
company can earn a higher rate of return on its invested capital through its operations
than the interest rate on its debt, it could increase the return for its investors by
financing the growth of company operations through borrowed capital.
Operating leverage is the existence of fixed operating costs. Because these costs are
fixed, the higher the percentage of operating leverage, the greater the effect changes in
sales revenues have on operating income.
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i i Section A, Topic 2: Finaticial Performance Metrics -FinancialRatios
The focus on leverage in this section will be on financial leverage. The cost of financial
leverage is interest costs, which must be paid regardless of sales.
Financial Leverage Ratio 1
On the CMA exam, financial leverage is computed as: m Financial Leverage Ratio = Assets s Equity 1 A higher ratio implies that the assets of the company are financed primarily through
debt. A financial leverage ratio of 2.0 reflects that the liabilities of the company are
equal to the equity. A ratio of greater than 2.0 implies that liabilities are larger than
equity and a ratio of less than 2.0 implies higher equity than the liabilities of the
company.
Financial leverage has a magnifying effect on earnings. When the earnings are
positive, a marginal percentage change in revenue translates to a greater percentage
change on earnings per share or on return on equity measures.
Correspondingly, however, as debt represents fixed costs, leverage also has a
magnifying effect on losses. If the financial leverage ratio, for example, is 3.0 and the
company experiences a loss, it will experience a greater percentage loss in net income
than the percentage decline in revenue. An increase in the financial leverage ratio,
therefore, represents not only increased opportunity for leveraging returns but also an
increased risk of magnifying any losses and of its inability to meet long-term debt. In
summary, the potential loss or profit being magnified belongs to the stockholder. So if
a firm is profitable, the benefit realized from a high net income with a high financial
leverage ratio goes to stockholders.in the income statement, the financial leverage ratio
must be adjusted accordingly.
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l Ratio Analysis on Debt/Liabilities Analysts can examine capital structure by comparing debt to assets (asset-based i
analysis) or to equity.(equity-based analysis). Various stakeholders evaluate capital
structure ratios (also known as leverage ratios) in different ways. For example,
creditors or potential creditors wish to see low debt ratios, whereas stockholders and
managers seek optimal debt levels, using as much debt in a firm’s capital structure as
can be managed effectively. Optimal debt ratios vary by industry. Firms in non-cyclical
industries, for example, tend to have higher debt ratios than those in cyclical
industries. When performing cross-sectional analysis, therefore, one should compare
only firms in the same industries.
The three primary ratios used to measure leverage are: debt to total assets ratio, debt to
equity