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April 27, 2005

Ratio Analysis. Introduction.

This is the preliminary article of the Financial Statements Analysis series. The Ratio Analysis is a heavily tested topic in CMA Part 1 (new syllabus) and you should expect 25-30 questions during the exam on this topic. Truly, I am very glad that I've passed it already!

I'll consider the formulas for computing problems. This type of questions must be solved very quickly because of the time pressure.

Some of the parameters may be defined in various ways. For example, the numerator of the Return on Investment ratio (ROI) is the Net Income after Interest and Taxes, but may be adjusted in some cases by adding back minority interest in the income of a consolidated subsidiary or adding back interest expense. We'll consider the basic formulas because the exam questions contain only these ratios with high probability. If the question suggests using of additional parameters then you'll find all necessary data in the statement of a question.

Let us use the following notations:

ACommEquity - Average common equity
AccP - Accounts Payable
AccR - Accounts Receivable
AccRTurn - Accounts receivable turnover ratio
ATA - Average total assets
CA - Current Assets
CL - Current Liabilities
DaysInv - Days sales in inventory
DaysR - Days sales in receivables
EBIT - Earnings before interest and taxes
EPS - Earnings per share
FLR - Financial Leverage ratio also called Equity Multiplier         (leverage factor)
I - interest expenses
InvTurn - Inventory turnover ratio
NI - Net income after interest and taxes
PrefDiv - Preferred dividends
QA - Quick Assets
ROE - Return on common equity ratio
ROI - Return on invested capital ratio
Tax - Taxes
TAssetsTurnover - Total assets turnover ratio
WorkCap - Working Capital

Posted by mazoo at 10:25 PM | Comments (1)

April 19, 2005

Money multiplier. How does it work?

Banks must have on reserve a certain percentage (the legal reserve requirement) of its total deposits. Banks keep these amounts (required reserves) on deposit at a Federal Reserve Bank.
If a bank's actual reserves exceed the required reserves, the difference is the excess reserves with which bank can extend loans. Therefore, the single bank creates money supple equal to its excess reserves.
The interesting fact is that money creation for the banking system as a whole (D) is a product of excess reserves by the Money Multiplier. D = E*m
So, the Money Multiplier is the maximum amount of money that the banking system generates with each dollar of excess reserves. The formula for money multiplier is

m = 1/r,

where r is the legal reserve requirement.

The answer is simple.

Assuming a required reserve ratio r=20%. The old woman deposited d=100$ in First bank. With a 20% requirement, the First bank has d*r = 20$ reserve requirement. The amount of excess reserves is

E1 = d*(1-r)
E1 = 100*(1-0.2)=80 $

The First Bank lends out this amount to the Second Bank. So, the Second Bank’s excess reserves is
E2 = E1*(1-r)
E2 = 80*(1-0.2) = 64$

Redeposited E2 creates excess reserves in the Third Bank E3:

E3 = E2*(1-r) = E1*(1-r)2
E3 = 80*(1-0.2) 2 = 51.2$

and so on.

The total increase in the money supply D is:

D = E1*(1 + (1-r) + (1-r)2 + (1-r)3 +… +(1-r)n+ ...)

Let's multiply D by the term (1 - r) and subtract this from D:

D - D*(1-r) =
     E1*(1 + (1-r) + (1-r)2 + ... +*(1-r)n+ ...)
        – E1*((1-r) + (1-r)2 +...+*(1-r)n+ ...) = E1

D * r= E1

D= E1/r
D= E1*m

in our case

m = 1/r = 5

D = 80*5 = 400 - the increase in the money supply for the banking system as a whole.

And the old woman don't suspect that her 100$ deposit has 400$ macroeconomic effect :-)

Posted by mazoo at 9:24 PM | Comments (3)