Ratio Analysis. Liquidity Index. Part 3.
Liquidity Index is a weighted-average measure of the liquidity of current assets stated in days. Liquidity Index is the amount of time it is expected to take for Current Assets to be converted into cash. Liquidity Index equals the sum of weighted noncash Current Assets divided by Current Assets.
What does "weighted-average" mean? We want to find the average number of "days until cash", and we need to take into account the weight of each component of Current Assets (Cash, Cash Equivalents, Net Accounts Receivables, Marketable securities, Inventories and Prepaid Items).
For example, if a company has $1000 cash (0 days until cash) and $100 accounts receivable with average collection period 20 days, that the weighed-average is 1000*0 + 100 * 20 = 2000, where 1000 and 100 are "weights". Liquidity Index is 2000 / 1100 = 1.82 days
The numerator of Liquidity Index formula includes only noncash items because it takes zero days to convert Cash into cash. The assumption for the Cash equivalents and Marketable securities is the same.
Continue reading "Ratio Analysis. Liquidity Index. Part 3."
Posted by mazoo at 2:30 PM | Comments (2)
June 24, 2005
Ratio Analysis. Short-term liquidity. Part 2.
Accounts receivable turnover ratio (AccRTurn) equals Net Credit Sales divided by Average Accounts Receivable (AvAccR). If credit sales data is not available, we will use Net Sales.
Note that the Balance Sheet component (Accounts Receivable) and the Income Statement component (Net Credit Sales) meet in the same ratio, hence the Balance Sheet amount should be an average for the period (if the average of the beginning and ending receivables is not representative because of cyclical factors, a monthly or quarterly average is preferable).
AvAccR = (AccR1 + AccR2)/2,
where AccR1 - beginning Accounts Receivable, AccR2 - ending Accounts Receivable.
Days sales in receivables, also called the average collection period, is the average number of days to collect a receivable. Days sales in receivables (DaysR) equals Average Accounts Receivable divided by Average daily sales (AvDailySales). The identical definition: Days sales in receivables equals the number of days in the period (365, 360 or 300) divided by the Account receivable turnover.
The Inventory turnover ratio (InvTurn) equals Cost of Sales divided by Average Inventory (AvInv). Note that numerator is Cost of Sales, not Net Credit Sales. The calculation of average inventory is analogous to calculation of average receivables.
AvInv = (Inv1 + Inv2)/2,
where Inv1 - beginning Inventory, Inv2 - ending Inventory. You should use monthly or quarterly average inventory if it is necessary.
Days sales in inventory (DaysInv) is the average number of days that inventory is held before sale. Days sales in inventory equals the number days in the year (365, 360 or 300) divided by the Inventory turnover ratio. Days sales in inventory may also be computed as Average Inventory divided by the Average daily cost (AvDailyCost)
Operating cycle, which is also known as the cash-to-cash cycle, is the length of time for a company to acquire materials, produce the product, sell the product, and collect the proceeds from customers. Therefore, operating cycle may be estimated by adding Days sales in inventory to Days sales in receivables.
Operating cycle = Days sales in inventory + Days sales in receivables
In the final chapter we will consider the definition and calculation of the Liquidity Index.
Posted by mazoo at 4:25 PM | Comments (1)
June 17, 2005
Treasury Stock. The Par Value Method.
The accounting for Treasury Stock transactions under the Par value Method is a little more involved than under the Cost Method because journal entry for the acquisition of Treasury Stock uses Additional paid-in capital - Common Stock account.
Assume that XYZ Corp. uses the Par value Method to account for treasury stock transactions. XYZ Corp. issued 1 000 shares of 10$ par common stock at 15$ per share.
Dr Cash..........15*1000 = 15 000$
Cr Common stock.....................................10*1000 = 10 000$
Cr APIC-CS......................................(15 - 10) *1000 = 5 000$
The Par Value Method:
1) XYZ Corp. acquires 200 shares for 13$ each. The first step is to debit Treasury Stock account for the amount of the par value of the reacquired shares and APIC – Common Stock account for the amount related to the first issuance of these reacquired shares.
Dr Treasury stock........10*200 = 2 000$
Dr APIC - CS.................5*200 = 1 000$
Cr Cash.........................................................13*200 = 2 600$
Cr APIC-TS (APIC-Treasury stock).......2000 + 1000 - 2600 = 400$
The balancing amount of the first three lines appears on credit side, therefore it is going to APIC-TS account. The credit means the gain (and this is a gain, because purchase price 13$ is less than original sales price 15$). Note, that Retained Earnings account can never be credited from treasury stock transactions.
2) XYZ Corp. acquires 300 shares for 20$ each.
Dr Treasury stock.............10*300 = 3 000$
Dr APIC – CS.....................5*300 = 1 500$
Dr APIC – TS.............6 000 - 4 500 = 400$ (total possible amount)
Dr Retained Earnings...6 000 - 4 500 - 400 = 1 100$ (remaining loss)
Cr Cash.......................................................................20*300 = 6 000$
The balancing amount appears on debit side therefore it is a loss (and this is a loss, because purchase price 20$ is more than original sales price 15$). First, the loss is taken from APIC-TS account (if there is a balance on it) and the remaining amount is going to Retained Earnings.
3) XYZ Corp. reissues 100 shares for 23$ each.
Dr Cash............23*100 = 2 300$
Cr Treasury stock..........................10*100 = 1 000$
Cr APIC-TS..........................2 300 - 1 000 = 1 300$
The accounting for reissuance of Treasury Stock under the Par value Method is same as under the Cost Method. The only difference is that the Treasury Stock account is credited at par value amount of reissued shares.
Let’s resume:
1. In all stock transactions, no gains or losses are shown on the income statement.
2. The amount that goes into the Treasury Stock account is the Par value of the shares.
2. Gains are credited APIC-TS account.
4. Losses are debited APIC-TS account (if there is a balance in it) and then Retained Earnings account.
That is why Retained Earnings account cannot increase by share transactions.
Posted by mazoo at 6:43 PM | Comments (0)
June 10, 2005
Treasury Stock. The Cost Method.
This is a memorandum note for accounting of treasury stock transactions under the cost method.
Assume that ABC Corp. uses the Cost Method to account for treasury stock transactions. ABC Corp. issued 1000 shares of 10$ par common stock at 15$ per share.
Dr Cash.............15 * 1000 = 15 000$
Cr Common stock.....................................10*1000 = 10 000$
Cr APIC-CS......................................15 000 - 10 000 = 5 000$
Where APIC-CS is Additional paid-in capital - common stock
The cost method:
1) ABC Corp. acquires 200 shares for 20$ each:
Dr Treasury stock........20*200 = 4000$
Cr Cash................................................20*200 = 4000$
There is no gain and no loss when the company acquired the shares under the Cost Method.
2) ABC Corp. reissues 100 shares for 23$ each (this is a gain, because selling price 23$ is more than the purchase price 20$):
Dr Cash.................23*100 = 2 300$
Cr Treasury stock.........................................20*100 = 2 000$
Cr APIC-TS (APIC-Treasury stock).............2 300 - 2000 = 300$
Gains are recorded in Additional paid-in capital - treasury stock account.
3) ABC Corp. reissues remaining 100 shares for 12$ each (this is a loss, because selling price 12$ is less than the purchase price 20$)
Dr Cash...............................12*100 = 1 200$
Dr APIC-TS............................................300$
Dr Retaining Earnings......2000-1200-300=500$
Cr Treasury stock........................................20*100 = 2 000$
Losses are debited to APIC-TS account, reducing its balance to zero and remaining losses are debited to Retaining Earnings Account.
Let's resume:
1. In all stock transactions, no gains or losses are shown on the income statement.
2. There is no gain and no loss when the company acquired the shares under the Cost Method.
3. Gains are credited APIC-TS account.
4. Losses are debited APIC-TS account (if there is a balance in it) and then Retained Earnings account.
That is why Retained Earnings account cannot increase by share transactions.
Posted by mazoo at 6:01 PM | Comments (1)
May 27, 2005
Ratio Analysis. Short-term liquidity. Part 1.
Asset liquidity is the extent to which assets can be converted to cash quickly and at a low transaction cost. The Liquidity Index is a measure of the liquidity of Current Assets. We need some additional definitions and formulas for liquidity index calculation.
1. Current Assets (CA) include Cash, Cash Equivalents (certain held-to-maturity), Net Accounts Receivables (Accounts Receivables minus Bad Debts) (AccR), Marketable securities (MarkSec), Inventories (Inv) and Prepaid Items (PrepItems).
CA = Cash + Cash Equivalents + AccR + MarkSec + PrepItems + Inv
Quick Assets (QA) include Cash, Cash Equivalents, Net Accounts Receivables, Marketable securities.
QA = Cash + Cash Equivalents + AccR + MarkSec
Less conservative definition: Quick Assets equal Current Assets minus Inventories, but for exam purposes we will use the version above. In addition, Prepaid Items equal zero in the exam problems, therefore both definitions become the same.
Current Liabilities (CL) include Accounts Payable (AccP), Notes Payable, current maturities of long-term debt, unearned revenues, taxes and wages payables and other accruals.
The amount of Current Liabilities will be given in the problems in most cases.
Working Capital (WorkCap) is the difference between Current Assets and Current Liabilities.
WorkCap = CA – CL
2. Ratios
CA
Current Ratio = ------
CL
The higher the ratio, the more liquid the company. Low Current Ratio may indicate a solvency problem, very high Current Ratio may indicate that the management invests the assets non-productively.
Use of LIFO understates Inventories and, consequently, Current Ratio.
QA
Acid-test (Quick) Ratio = -------
CL
Cash + Cash Equivalents + MarkSec
Cash to current assets Ratio = ---------------------------------------------
CL
In the next chapters, we will consider operating cycle, days sales in receivables, days sales in inventory and the calculation of liquidity index.
Posted by mazoo at 2:32 PM | Comments (0)
May 3, 2005
Ratio Analysis. Return on Invested Capital
We have some basic formulas for the "Return on Invested Capital" exam section:
NI
ROI = ---------- - Return on invested capital (Return on investment) or Return on
ATA total assets
Invested capital may be defined in various ways: Total Assets, Long-Term Debt plus Total Equity, Total Equity and the others. But for exam purposes term "invested capital" (without additions) means Average total assets.
Note: When the Balance Sheet component (Total Assets) and the Income Statement component (Net Income) meet in the same ratio, then the Balance Sheet amount should be an average for the period.
ATA = (TA1 + TA2)/2
Where TA1 - beginning Total Assets,
TA2 - ending Total Assets.
NI - PrefDiv
ROE = ----------------------- - Return on Common Equity
ACommEquity
You will meet several questions about interrelations between ROI, ROE and the other ratios.
We need following ratios:
Profit Margin = NI / NetSales
Adjusted Profit Margin = (NI - PrefDiv) / NetSales
TAssetsTurnover = NetSales / ATA - Total Assets Turnover ratio
FLR = ATA / ACommEquity - Financial Leverage ratio also called Equity Multiplier (leverage factor)
and Du Pont equation is:
= TAssetsTurnover * Profit Margin
Therefore, Return on invested capital is equal Total Assets Turnover times Profit Margin.
If we multiply equation above by Equity Multiplier (Financial Leverage ratio or leverage factor) and will use Adjusted Profit Margin instead Profit Margin then we will receive following relation:
ROE = TAssetsTurnover * AdjustedProfitMargin * Leverage factor
In addition, you should expect several questions about Sustainable Equity Growth rate and Dividend Payout ratio (DivPayout):
DivPayout = Dividends per common share / EPS
Sustainable Equity Growth = ROE * (1 - DivPayout)
Posted by mazoo at 9:13 PM | Comments (2)
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)
February 28, 2005
Income statement - base lines and ratios
Total Revenue or Total Sales - total dollar payment from delivering or producing goods, rendering services or other activities that constitute the entity's ongoing major or central operations.
Cost of Goods Sold (COGS) - is the expense a company incurred in order to manufacture, create, or sell a product. It includes the purchase price of the raw material and the expenses of turning it into a product. Also referred to as "cost of sales".
Gross Profit = Total Revenue - Cost of Goods Sold
Gross Profit Margin = Gross Profit/Total Revenue
Operating Expense - consists of salaries paid to employees, research and development costs, selling and administrative expenses, depreciation and amortization expenses and other misc. charges that must be subtracted from the company's income.
Operating Income = Gross Profit - Operating Expense,
Operating Income = EBIT - the same things, where EBIT is Earnings Before Interest and Taxes.
Operating Margin = Operating Income/Total Revenue
Net Income from Continuing Operations = Operating Income(EBIT) - Interest Expense - Income Tax Expense
Net Income = Net Income from Continuing Operations +- Discontinued +- Extraordinary +- Accounting Changes
Net Profit Margin = Net Income/Total Revenue
Posted by mazoo at 7:40 PM | Comments (0)