Module 1


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Module 1

  1. 1. Module 1 Key Terms & Financial Ratios Module 1 Chapter 1: Business The key operating and financial strategies the corporation uses to Strategy compete in its industry. Corporate The qualitative analysis of specific corporations to identify key industry Overview and business strategy characteristics. Detailed The analysis of financial statements and other sources of information to Accounting further evaluate how corporations compete in complex environments. Analysis Particularly important are identifying earnings management potential and “deconstructing” financial information to make better comparisons across firms. Earnings The incentives of corporate managers to manipulate earnings for their Management own best interests. Accounting techniques include accruals to boost earnings (e.g., to increase bonuses) or smooth earnings over time. Financial The process of evaluating financial and other information for specific Analysis recommendations or decisions. Quantitative A host of ratios, models, time series and forecasts to identify key Financial financial characteristics, which can be compared to competitors or other Analysis standards. Industry Identify the industry a corporation competes in and evaluate the key Analysis characteristics and prospects of that industry. Standardized Comprehensive standards to identify specific industries, based on one to Industry four digit codes. In the process of being replaced by the North American Classification Industry Classification System (NAICS). (SIC) Codes Chapter 2: 10-K Annual report submitted to the SEC 10-Q Quarterly report submitted to the SEC Accounting Discretionary alternatives for reporting various financial items, such as Choice depreciation or inventory method Agency Contracting becomes more costly when agency costs exist, which Costs include information asymmetries, adverse selection & moral hazard Agency All contracts have a principal (e.g., owners) and an agent (e.g., Theory managers). Principals will attempt to write efficient contracts to maximize wealth and minimize agency and other transaction costs Beta Beta comes from the slope coefficient of the market model, which can Analysis be used to analyze relative systematic risk for stock selection Bounded Individuals are intendedly rational but limited in their knowledge and Rationality ability to process information Capital Asset Relationship of individual security return to the market return, based on Pricing the model E(Ri) = Rf + ß [E (Rm) – Rf ]
  2. 2. Model Due Process FASB (& others) procedures to allow public input during the various phases of the standard setting process Earnings Operating and discretionary accounting methods to adjust earnings to a Management desired outcome Earnings Opportunistic use of earnings management to effectively “misstate” Manipulation earnings to benefit managers Economic Changing regulations (or other factors) lead to actions by individuals Consequences and organizations that result in unintended consequences Efficient Writing contracts to maximize principal wealth and minimize Contracting transactions costs Efficient Capital markets are efficient if prices adjust quickly to new information Markets in an unbiased fashion Financial Private sector standards setting body, responsible for promulgating new Accounting financial accounting standards using due process Standards Board Generally The entire body of accounting standards that are in effect at any given Accepted point in time for financial accounting Accounting Principles Income Earnings management to smooth out erratic revenue and earnings Smoothing behavior Market Financial model to compare individual equity return with the market Model return for the same period, based on the model Rit = αi + βi Rmt + eit Opportunism Individual behavior associated with self interest with guile; that is, beyond the standard ethical norms Portfolio The concept that financial risk is reduced in a large portfolio of Theory securities relative to a single security Primary Capital market where new securities are initially issued Market Random The concept that random selection of a securities portfolio is as effective Walk as a professionally selected portfolio Secondary Capital market where previously issued securities can be bought or sold Market Securities & Federal agency charged with regulating the capital markets and the Exchange related financial accounting and reporting Commission Transaction Cost of issuing and completing contracts, including agency costs Cost Chapter 3: Activity Financial calculation to evaluate how effective corporate operations are Ratio Benchmarks Comparison analysis of specific ratios & other techniques, based on rules of thumb, industry averages, etc.
  3. 3. Common- The conversion of balance sheet and income statement numbers to size percentages of total assets and sales, respectively Analysis Du Pont Model to decompose return on equity relative to profit, activity and Model solvency (leverage) Growth Multiple period (usually by year) comparisons of specific financial Analysis statement items (or ratios) to calculate periodic growth rates Leverage Financial calculation to evaluate relative mix of equity to debt; also Ratio called solvency Liquidity Financial calculation to analyze cash and other current assets to Ratio determine if enough cash or current assets exist to pay off current liabilities Profitability Financial calculation to evaluate profitability of the firm; also called Ratio performance ratio Quarterly Financial analysis on a quarterly rather than an annual basis, almost Analysis always using a multiple-period approach Trend Multiple period analysis by setting a base year equal to 100 and Analysis comparing financial statement items relative to the base year Working Current assets less current liabilities, a widely used indicator of liquidity Capital Liquidity Ratio Calculation Discussion Current Current Assets / Current Standard ratio to evaluate working Liabilities capital. Quick (Acid Test) (Cash + Marketable This ratio eliminates inventory and Securities + Net other current assets from the Receivables) / Current denominator, focusing on “near Liabilities cash” and receivables. Cash (Cash + Marketable Only cash and cash equivalents Securities) / Current considered for payment of current Liabilities liabilities. Operating Cash Cash Flows from Evaluates cash-related Flow Operations / Current performance (as measured from Liabilities the Statement of Cash Flows) relative to current liabilities. Activity Ratio Calculation Discussion Inventory Turnover COGS / Average Measures inventory management. Inventory Inventory should be turned over rapidly, rather than accumulating in warehouses. Receivables Sales / Average Measures the effectiveness of credit Turnover Accounts policies and needed level of receivables Receivables investment for sales. Payables Turnover Sales / Average Payables represent a financing source for
  4. 4. Accounts Payables operations. Working Capital Sales / Average Measures how much working (operating) Turnover Working Capital capital is needed for sales. Fixed Asset Sales / Average Measures the efficiency of net fixed asset Turnover Fixed Assets (property, plant & equipment after accumulated depreciation) investments. Total Asset Sales / Average Represents the overall (comprehensive) Turnover Total Assets activity measure of assets to sales. Leverage (Solvency) Ratio Calculation Discussion Debt to Equity Total Liabilities / Total Direct comparison of debt to equity Stockholders’ Equity stakeholders and the most common measure of capital structure. Debt Ratio Total Liabilities / Total A broader definition, stating debt as Assets a percent of assets. Interest Coverage (Net Income + Interest This is a direct measure of the (Times Interest Expense + Tax firm’s ability to meet interest Earned) Expense) / Interest payments, indicating the protection Expense provided from current operations. Long-term Debt to Long-term Liabilities / A long-term perspective of debt and Equity Total Stockholders’ equity positions of stakeholders Equity Debt to Market Total Liabilities at Book Market valuation may represent a Equity Value / Total Equity at better measure of equity than book Market Value value. Most firms have a market premium relative to book value. Profitability (Performance) Ratio Calculation Discussion Gross Margin (Sales – COGS) / Sales This captures the relationship between sales and manufacturing (or merchandising) costs. Return on Sales Net Income / Sales Measures the relationship of the bottom line to sales and thus captures sales to total costs of sales. Return on Assets Net Income / Average Measures the firm’s efficiency in Total Assets using assets to generate earnings. Alternatively stated, it captures earnings to all providers of capital Pretax Return on Earnings Before Interest Measures earnings from operations Assets & Taxes / Average Total on a pretax and pre-interest Assets expense basis. Return on Total Net Income / Average Measures earnings to owners as Equity Total Stockholders’ measured by net assets.
  5. 5. Equity Dividend Payout Common Dividends / Net Measures the percent of earnings Income paid out to common stockholders. Chapter 9: Altman’s Z- Financial ratio model used to evaluate bankruptcy potential; can also be Score used to assess relative financial health Bankruptcy The probability that a firm will file for bankruptcy in the near future Risk Bond Relative grades of “financial health” from highest (AAA for Standard & Ratings Poor’s, Aaa for Moody’s) to lowest (D for Standard & Poor’s, C for Moody’s) Credit Risk The probability that a firm will either or both default on paying liabilities or declare bankruptcy Default Risk The probability that a firm will not pay interest and principal when they come due Failure Signals of potential default such as troubled debt restructurings or going Events concern audit qualifications Investment The four highest bond rating categories (Standard & Poor’s AAA to Grade Bond BBB), considered to have relatively low credit risk Rating Chapter 10: Credit The financial analysis process associated with evaluating the investment Analysis prospects of an investment in a debt instrument Credit- Analysis of credit risk and other factors to determine if the customer is worthiness acceptable for a loan (or other debt instrument) and under what terms Collateral Physical assets that the borrower pledges to the creditor in case of loan default Debt Contract terms mandated by the creditor to protect against possible loan Covenants default, such as minimum financial ratios or limitations on dividends Prime Rate Bank lending rate to the “best” (or most credit-worthy) corporate customers Module 2 Chapter 4: Analysts’ Specialist predictions of EPS (or other definitions of performance) for Forecasts the forthcomings quarters and years Basic EPS EPS measured as net income / (weighted average number of common shares outstanding) Closing The ending (last) stock price of the day for a security trading on a stock Stock Price exchange Diluted EPS EPS with number of shares adjusted for potential dilution (e.g., from stock options), which reduces EPS Dividend Dividends per share divided by stock price, a measure of direct cash
  6. 6. Yield return on investment Dow Jones A stock price average based on 30 of the largest industrial companies in Industrial America, the most well-known stock average Average Earnings- Model for the valuation of the firm, based on dividend payout relative to based earnings, discounted by some interest rate net of earnings growth rate Growth Models Earnings Net income (or some other measure of earnings) converted to a per Per Share share basis (annually or quarterly), which can be calculated as basic EPS (EPS) or diluted EPS Intrinsic A measure of per share value, calculated at, Value Evaluator Market-to- A comparison of market value to book value (total stockholders’ equity, Book also called net assets) Market Also called market capitalization or market cap, stock price x number of Value shares outstanding, a measure of how the stock market values companies Price Stock price divided by EPS, a measure of the “market premium” for Earnings earnings (PE) Ratio PEG Ratio PE divided by earnings growth rate, a measure of “reasonableness” of the PE ratio; a possible rule of thumb is a PEG equal to or less than one Stock Computer tool available at several internet sites to find all stocks with Screening specific investment criteria, such as all New York Stock Exchanges firms with an ROE greater than 15% Book Value Per Total Stockholders’ Equity / Equity or net assets, as measured Share Number of Shares Outstanding on the balance sheet Earnings- based P = kE / (r-g), where E=earnings, Valuation models that discount Growth Models k=dividend payout rate, earnings and dividends by a r=discount rate, & g=earnings discount rate adjusted for future growth rate earnings growth Intrinsic Value Internet calculation, based on net Per share valuation model income, earnings growth rate, available at Quicken, useful to discounted at S&P 500 long-term compare with current stock price growth rate (or other rate) Market-to-book (Stock Price x Number of Shares Measure of accounting-based Outstanding) / Total equity Stockholders’ Equity Price Earnings Stock Price / EPS Measure of market premium paid Ratio (PE) for earnings and future expectations Price Earnings PE / Earnings Growth Rate PE compared to earnings growth Growth Ratio rates, a measure of PE (PEG) “reasonableness”
  7. 7. Sales-to-market Sales / (Stock Price x Number of A sales activity ratio based on Value Shares Outstanding) market price Dividend Yield Dividends Per Share / Stock Direct cash return on stock Price investment Chapter 5: Assets Probable future economic benefits based on past transactions or events Cash from Cash flows directly associated with net income and other operating Operations transactions, as reported on the Statement of Cash Flows Comprehensive Change in equity during a period from all non-owner sources Income Conceptual FASB’s attempt to describe financial accounting theory into a coherent Framework body as stated in Statements of Financial Accounting Concepts (SFACs) Dirty Surplus Gains & losses recorded directly to equity and not in the income statements, such as marketable securities and foreign currency translations adjustments Equity Residual interest in the assets after deducting liabilities; i.e., ownership Expenses Outflows from incurring liabilities or using up assets associated with sales & other central operations Free Cash A measure of cash available for discretionary uses after certain cash Flows outlays; a common calculation of FCF is cash from operations – cash from investments (CFO-CFI) Gains Increase in net assets from peripheral transactions Hybrid Securities that have characteristics of both debt and equity, such as Securities convertible bonds Income from Operating income as measured before non-recurring items Continuing Operations Liabilities Probable future economic sacrifices from present obligations Losses Decrease in net assets from peripheral transactions Matching Recording expenses that are related to revenues recognized, both Principal product and period costs Non-recurring Gains and losses from peripheral transactions that are recorded as Items separate line items on the income statement & reported net-of-tax, such as extraordinary items and discontinued operations Period Costs Expenses that relate to specific accounting periods, such as advertising Product Costs Expenses that related to specific revenues recognized, such as cost of goods sold Red Flags Signals of particularly poor performance or other matters of grave concern Revenues Inflows & other asset enhancements from sales & other central operations Revenue Criteria for recorded revenues when revenue is (1) realized or realizable Recognition and (2) earned
  8. 8. ICO Return Income from continuing operations divided by sales, equity or total assets; alternative return ratios CI Return Comprehensive income divided by sales, equity or total assets; alternative return ratios Free Cash CFO-CFI (can then be used for other liquidity-related ratios) Flows CFO to Cash Flows from Operations / Total Liabilities Liabilities CFO per Cash Flows from Operations / # of Shares Outstanding Share Cash Flow CFO for last 3 years / (Three Years of: Capital Expenditures + Inventory Adequacy Additions + Cash Dividends) Chapter 6: Available- Marketable securities that, in the firm’s judgment, may be sold before for-Sale the maturity; these are recorded at fair value and unrealized gains and Securities losses recorded directly to stockholders’ equity Capital Long-term lease, considered the equivalent of purchasing the asset and Lease recorded by the lessee as an asset and corresponding liability Deferred The difference between the accounting calculation for tax expense and Tax what is payable to the IRS; this is recorded as an asset or liability First-in Inventory method where the first items recognized in inventory are First-out released (sold) first Fixed Property, plant and equipment, the basic infra-structure of the Assets corporation Held-to- Marketable securities that will be held to maturity and recorded at cost Maturity (or amortized cost) Securities Interperiod Deferred tax items recorded as separate assets or liabilities on the Tax balance sheet Allocation Intraperiod The tax effect associated with specific non-recurring items; these items Tax are reported net of tax (i.e., the intraperiod tax allocation) on the income Allocation statement Last-in Inventory method where the last items recognized in inventory are First-out released (sold) first Leases Contract agreement for the use of assets on a rental or fee basis for a set period of time Marketable Debt and equity securities that are market traded & typically held for a Securities short period of time as a cash equivalent Off- Contractual arrangements so that assets and liabilities are not recorded balance- on the balance sheet; a likely source of earnings management sheet Financing Operating Short-term lease, with lease payments recorded as a periodic expense Lease and obligation is off-balance-sheet
  9. 9. Permanent A difference between financial accounting and tax accounting that never Tax washes out and not recorded on the balance sheet Difference Temporary A tax difference between financial accounting and tax accounting that Tax represents a timing difference and is recorded on the balance sheet (see Difference deferred tax) Trading Marketable securities that are held (usually by a financial institution) for Securities resale to another organization or individual; holding gains & losses are recognized on the income statement Average Age Accumulated Depreciation / Depreciation Expense, an estimate of how long the average fixed asset has been held Average Age % Accumulated Depreciation / Ending Gross Investment, an estimate of the relative amount of fixed asset depreciation Average Ending Gross Investment / Depreciation Expense, an estimate of Depreciable Life the average useful life of the average fixed asset Effective Tax Rate Income Tax Expense / Pretax Income, a measure of the effective accounting tax rate (included local and foreign taxes) Taxes Paid Rate Income Tax Paid / Pretax Income, a measure of the amount of tax paid in cash this year to the IRS and other taxing authorities Taxes Payable Rate Income Tax Payable to IRS and other taxing authorities Chapter 7: Accumulated Pension calculation under defined benefit plan: present value of amounts Benefit employer expects to pay retired employees based on employee service Obligation to date and current salary levels Defined Pension plan committing employer to pay specific benefits at Benefit Plan employees’ retirement Defined Pension plan committing employer to make specific cash payment to the Contribution employees’ retirement accounts Plan Derivatives Financial contract derived from another financial instrument, including options, futures, and swaps Fluctuating All currencies “float”; that is, their value is based on current market Currencies conditions compared to all other currencies Foreign Amount of gains and losses based on relative currency values of foreign Currency operations of financial statement items and reported directly to Translation stockholders’ equity Geographic Foreign operation footnote disclosure, including sales and identifiable Segments assets Gold Historical system (no longer in use) where currencies were pegged to Standard gold by weight and currencies were redeemable in gold Industry Industry or department segment disclosure for major divisions, Segments including sales, operating income and identifiable assets Monetary Assets and liabilities that are denominated in dollars (or other Items currencies) such as accounts receivable and corporate bonds
  10. 10. Nonmonetary Assets and liabilities that are not denominated in currency such as Items inventory or fixed assets Other Post- Contractual obligations to retired or terminated employees, such as employment health insurance; must be recognized as liabilities Benefit Obligations Pensions Retirement plans to provide employees income after retirement Projected Pension calculation under defined benefit plan: present value of amounts Benefit employer expect to pay retired employees based on employee service to Obligation date and expected salary at retirement Segment Footnote disclosures on industry and geographic segments Reporting Stock Employee benefits that allow employees to acquire a set number of Options shares or firm stock at a set price; options will be exercised only is stock price is higher than the exercise price Chapter 8: Acquisition Acquiring the right to manage a company through a business combination or acquisition of enough voting shares to have effective management Conglomerate Acquisition of a firm from an entirely different industry Merger Goodwill Acquisition price of a target company less the fair value of the net assets of the target, used with the purchase method Horizontal Acquisition of a direct competitor, thus increasing market share and Merger reducing direct competition Merger A combination of two companies into a single corporate entity Pooling of Accounting procedures for business acquisition meeting specific Interests criteria; no longer allowed by GAAP Purchase Accounting procedures now required for all business acquisition; target Method is stated as actual market price Vertical Acquisition of an “indirect” competitor; that is, in the same basic Merger industry but generally in a different market segment Chapter 11: Diversification Investment portfolio holding a broad base of securities, attempting to maximize the risk-return tradeoff. Dow Jones Stock price index of 30 industrial firms used as the indicator of stock Industrial market performance. Average Executive Brief but formal overview of the 6-step financial analysis process to Summary stress the key points for decision making. Investment A specific set of investments owned or managed by the specific Portfolio individual or entity. Mutual Funds Professionally managed investment portfolios, subject to SEC and other regulations & widely available as investment vehicles.