CMA Part 2: Financial Decision Making

CMA Part 2
Financial Decision Making

Study Tip
• Look at your weekly routine (schedule) and see what can be
eliminated or at least suspended for a while. I.e. watching a TV
show that you can really live without. Once you have created more
time in your schedule, see about rearranging your schedule to allow
for some quality study time (and place).
• Find a comfortable and quiet place to study with good lighting and
little distractions (try avoiding your own bed; it is very tempting to
just lie down and take a nap).
• If you have a family, you will need to make them a part of this
process. They need to be supportive of what you are doing.
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Remember the exam topics
• Part 2 – Financial Decision Making
• 4 hours, 100 multiple-choice questions and two 30-
minute essay scenarios
• Financial statement analysis (25%)
• Corporate finance (25%)
• Decision analysis and risk management (25%)
• Investment decisions (20%)
• Professional ethics (5%)
3
Ratio Analysis
“While financial statements summarize the past
performance of an organization, they also can
provide users with valuable insights into future
performance. Financial statement analysis is
performed by stockholders and creditors and is also
an important tool for management accountants and
financial analysts to use to better understand their
company’s competitive position.”
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Ratio Analysis
Remember the exam tests all the ratios and
other analytical tools used to evaluate an
organization’s financial health, including
coverage of analytical issues in financial
accounting, such as foreign currency
fluctuations, off -balance sheet financing, U.S.
GAAP versus. IFRS, and fair value accounting
5
Remember
Common-size statement s recast all items in a particular financial statement as a
percentage of a selected (usually the largest and most important) item on the
statement.
These statements can be used to:
• Compare elements in a single year’s financial statements.
• Analyze trends across a number of years for one business.
• Compare businesses of differing sizes within an industry (such as Wal-Mart to
Target).
• 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.
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Also about cash
Cash is a company’s most liquid resource, and therefore it affects
liquidity, operating capability, and financial flexibility. According to the
Financial Accounting Standards Board (FASB) Statements of Financial
Accounting Standards (SFAS) No. 95, 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 still can have a negative cash flow.
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SU 6.1 Qualities of Ratio Analysis
• Ratios are not useful unless they are

“compared” to:
– Industry norms
– Economy as a whole
– Firms past performance
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• Different “Users” use ratio analysis for different purposes,
such as:
– Credit analysis
– Performance
– Actual vs. Budget
– Efficient use of resources
– Identify weak areas
– Help plan
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• Limitations of ratios
– Based on accounting data subject to estimation
– Accounting profit ( does not consider cost of investor capital) vs.
economic profit
– Manipulation by managers
– “Window dressing”
– Lack of comparability due to “size differentials” or capital/labor
intensive firms
– Loose usefulness due to earnings variability
Continued
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– Earnings variability
• Determine usefulness of earnings as performance indicators
• Wide earnings fluctuations = low level of earnings quality = ratios are not good
indicator of long-term outlook
– Effects of inflation on fixed assets and depreciation, inventory cost,
long-term debt.
Example: If LIFO is used with high inflation fixed assets/depreciation and inventory will
be understated. Also, assets are booked at historical cost which distorts the balance
sheet with high inflation.
Continued
11
– Accounting policies – i.e. depreciation period and inventory valuation
differences
– Seasonal affects – consider holidays sales and retailing
– Geographical locations create comparable challenges
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• Analysis ineffective because
– Failing to use averages or weighted average, also consider moving averages as a way to
see trends
– Data source differences can distort comparisons, therefore cause misleading or incorrect
conclusions
– One ratio does not tell it all, and in some cases apparent “excessive” positive (i.e. quick)
ratios can distort other issues (in this case too much cash on hand)
– Different ratios may indicate opposite conclusions; consider the “net effects” of ratios
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SU6.2 – Liquidity Ratios-Calculations
Remember - A ratio is a comparative relationship
between two (or more) financial statement amounts.
Ratios provide incremental information about the
financial health of the company beyond the raw amounts
presented in the financial statements. Financial ratios are
commonly used for three types of inferences:
– Inferences on liquidity, solvency, and operations
– Inferences on capital structure
– Inferences on profitability
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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.
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• Liquidity is the firm’s ability to pay its current obligations as
they come due
– Short run
– How easy is it to convert assets to cash.
• Liquidity ratios relates liquid assets to current liabilities.
– Current assets are assets which can be converted to cash within
1 year or operating cycle.
• Current asset ratios show a firm’s ability to operate in short term.
• Current assets/liabilities are shown in descending order of liquidity.
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Ref. data shown on page 176 used for examples

in study unit 6
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• Net 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 shown:
Current assets – Current liabilities
– How much capital is left after paying current
obligations.
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• Net Working Capital “Ratio”
Current Assets - Current Liabilities
Total Assets
– Most conservative of working capital ratios.
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Question 1
Given an acid test ratio of 2.0, current assets of $5,000,
and inventory of $2,000, the value of current liabilities is
A $1,500
B $2,500
C $3,500
D $6,000
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SU 6.2 Question 1 Answer
Correct Answer: A
The acid test, or quick, ratio equals the quick assets (cash, marketable securities, and
accounts receivable) divided by current liabilities. Current assets equal the quick
assets plus inventory and prepaid expenses. (This question assumes that the entity has
no prepaid expenses.) Given current assets of $5,000, inventory of $2,000, and no
prepaid expenses, the quick assets must be $3,000. Because the acid test ratio is 2.0,
the quick assets are double the current liabilities. Current liabilities therefore are
equal to $1,500 ($3,000 quick assets ÷ 2.0).
Incorrect Answers:
B Dividing the current assets by 2.0 results in $2,500. Current assets includes inventory,
which should not be included in the calculation of the acid test ratio.
C Adding inventory to current assets rather than subtracting it results in $3,500.
D Multiplying the quick assets by 2 instead of dividing by 2 results in $6,000.
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SU 6.2 Liquidity Ratios-Calculations
Question 2
A company has a current ratio of 1.4, a quick, or acid test, ratio of 1.2, and
the following partial summary balance sheet:
Cash $ 10
Accounts receivable ___
Inventory ___
Fixed assets ___
Total assets $100
Current liabilities $___
Long-term liabilities 40
Stockholders’ equity 30
Total liabilities and equity $___
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Question 2 (continued)
The company has an accounts receivable
balance of
A $26
B $36
C $66
D $100
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Question 2 Answer
Correct Answer: A
Total assets equal total liabilities and equity. Hence, if total assets
equal $100, total liabilities and equity must equal $100, and current
liabilities must equal $30 ($100 – $40 – $30). Because the quick ratio
equals the quick assets (cash + accounts receivable) divided by current
liabilities, the quick assets must equal $36 ($30 × 1.2 quick ratio), and
the accounts receivable balance is $26 ($36 – $10 cash).
Incorrect Answers:
B: The quick assets equal $36.
C: The sum of the quick assets and current liabilities equals $66.
D: Total assets equal $100.
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Remember
Current assets are defined as cash or other liquid investments, such as
inventory and accounts receivable (A/R), 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 compared to previous measures to determine if
there has been a change that should cause concern.
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SU 6.2 – Liquidity Ratios-Calculations
• 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.
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• Current Ratio
Current assets
Current liabilities
• Most common liquidity measurement
– Low ratio = Possible liquidity problems
– High ratio = Management not investing assets
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• Current Ratio should be proportional to the
operating cycle.
– Shorter operating cycles may justify lower ratio.
• Converting to cash quicker.
• Evaluate A/R and inventory turn
• LIFO lowers ratio.
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Remember
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 assets can be converted
to cash readily.
For example, if prepaid expenses compose most of the current assets, the current
ratio overstates the liquidity of the company because the prepaid expenses cannot be
converted to cash to settle the liabilities.
Also, the current ratio cannot predict or indicate patterns of future cash flows, nor can
it measure the adequacy of future liquidity. If there is a significant amount of A/R
from one customer and that customer files for bankruptcy, there would be significant
delay in receiving the payment. Even though the 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.
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• Quick (Acid test) Ratio =
Cash + Marketable securities + Net receivables
Current liabilities
– Avoids inventory valuation issues.
– Conservative approach.
The quick ratio , or acid-test ratio, examines liquidity from a more
immediate aspect 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.
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• Cash Ratio
Cash + Marketable securities
Current liabilities
The cash ratio analyzes liquidity in a more conservative
manner than the quick ratio, by 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.
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• Cash Flow Ratio
Cash flow from operations
Current liabilities
The cash flow ratio measures a company’s ability to
meet its debt obligations with cash generated in the
normal course of business.
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• Liquidity of Current Liabilities
– The ease of issuing new debt or structured (convertible,
puttable, callable, etc.) funds.
– Firms ability to borrow is usually a function of size,
reputation, creditworthines, and capital levels.
– Usually a combination of asset liquidity and liability
liquidity
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• Net Working Capital Ratio
Current assets – Current liabilities
Total assets
This is the most conservative of the working capital
ratios.
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Question 3
Bond Corporation has a current ratio of 2 to 1 and a quick ratio (acid test) of 1
to 1. A transaction that would change Bond’s quick ratio but not its current
ratio is the
A Sale of inventory on account at cost.
B Collection of accounts receivable.
C Payment of accounts payable.
D Purchase of a patent for cash.
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Question 3 Answer
Correct Answer: A
The quick (acid test) ratio equals the quick assets (cash, marketable securities, and
accounts receivable) divided by current liabilities. The current ratio is equal to current
assets divided by current liabilities. The sale of inventory (not a quick current asset)
on account increases accounts receivable (a quick asset), thereby changing the quick
ratio. The sale of inventory on account, however, replaces one current asset with
another, and the current ratio is unaffected.
Incorrect Answers:
B Neither ratio is changed.
C The current, not the quick, ratio changes.
D Both decrease.
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Question 4
Fact pattern: Depoole Company is a manufacturer of industrial products that uses a calendar
year for financial reporting purposes. Assume that total quick assets exceeded total current
liabilities both before and after the transaction described. Further assume that Depoole has
positive profits during the year and a credit balance throughout the year in its retained earnings
account. Depoole’s payment of a trade account payable of $64,500 will
A Increase the current ratio, but the quick ratio would not be affected.
B Increase the quick ratio, but the current ratio would not be affected.
C Increase both the current and quick ratios.
D Decrease both the current and quick ratios
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Question 4 Answer
Correct Answer: C
Current assets consist of more assets than quick assets; thus, if quick assets exceed
current liabilities, then current assets do also. It can also be concluded that both ratios
are greater than 1. An equal reduction in the numerator and the denominator, such as
a payment of a trade payable, will cause each ratio to increase.
Incorrect Answers:
A The current ratio and the quick ratio will increase.
B The current ratio and the quick ratio will increase.
D The current ratio and the quick ratio will increase.
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Question 5
The following transactions occurred during a company’s first year of operations:
I. Purchased a delivery van for cash
II. Borrowed money by issuance of short-term debt
III. Purchased treasury stock
Which of the items above caused a change in the amount of working capital?
A I only.
B I and II only.
C II and III only.
D I and III only.
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Question 5 Answer
Correct Answer: D
Working capital is computed by deducting total current liabilities from total current assets. The
purchase of a delivery van for cash reduces current assets and has no effect on current
liabilities. The borrowing of cash by incurring short-term debt increases current assets by the
same amount as it increases current liabilities; hence, it will have no effect on working capital.
The purchase of treasury stock decreases current assets but has no effect on current liabilities.
Thus, the purchases of the van and treasury stock affect working capital.
Incorrect Answers:
A The purchases of the van and treasury stock affect working capital.
The purchases of the van and treasury stock but not the issuance of short-term debt affect
B
working capital.
The purchases of the van and treasury stock but not the issuance of short-term debt
C
affect working capital.
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Sensitivity Analysis
“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 inferences made.”
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Remember
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.
• An equal increase in both the numerator and the
denominator of the ratio would worsen the ratio, if the
ratio is greater than 1.
• An equal decrease in both the numerator and denominator
would improve a ratio that is greater than 1.
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Most of all! (SU 6.3)
CMA questions will focus on the “effects” that
typical transactions will have on liquidity (and
other ratios) than on the mechanics of
calculating them
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SU 6.4 – Profitability Ratios - Calculations
• Our next studies will focus on the following types of
Financial Ratios
– Activity: how efficiently a company performs day-to-day tasks
such as collection of receivables and management of inventory
– Liquidity: company’s ability to meet its short-term obligations
– Solvency: ability to meet long-term obligations
– Profitability: company’s ability to generate profitable sales from
its resources (assets)
– Valuation: quantity of an asset or flow (earnings) associated
with ownership of a specified claim (Share)
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• Profitability is a firm’s ability to generate earnings over a
period of time with a given set of resources. It is analyzed by
examining the elements of revenues, the cost of sales, and
operating and other expenses.
• There are a number of ways an investor can look at return on
his or her investment.
• Some returns involve the price of the stock as it trades in the
securities markets.
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• Although there are actions a company can take to make its
stock more attractive to investors, return on market price
depends on when each investor purchases and sells the stock.
Thus, the analyst of a company’s financial and operating
performance cannot make this calculation for the individual
investor. An analyst, can, however, examine how the investor’s
contribution to the company performed on a per-share basis.
This can be done by measuring earnings per share and the
dividend yield.
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• The numerator of the return ratio is some measure of
earnings or profits. The measure selected for the numerator
should match the investment base in the denominator. For
example, if total assets are used in the denominator, the
income to all providers of the capital ought to be included in
the numerator, which includes interest. Thus, interest usually
is added back to the net income when computing the ROA.
This leads to a popular measure known as earnings before
interest, taxes, depreciation, and amortization (EBITDA).
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• When return on common equity capital is computed, net income after
deductions for interest and preferred dividends is used. The final ROI
always must reflect all applicable costs and expenses, including income
taxes, particularly when the return on shareholders’ equity is computed.
Profit, or “the profit motive,” is realized when an organization is
generating more resources than it consumes during the course of a year.
That is, profit is the amount by which revenue from sales exceeds the
costs required to achieve those sales. And the profit margin is the
percentage of revenues represented by that excess of revenues over costs.
Revenues and costs, however, are measured by diverse criteria.
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Profit margins commonly are calculated using one of
three different profit measures:
• Gross profit equals net sales revenue minus the cost of
goods sold (COGS).
• Operating income equals gross profit minus various
administrative expenses, not including interest or taxes
(because they are not part of operations). Operating
income is sometimes called earnings before interest and
taxes (EBIT).
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• Net income reduces revenues by all expenses - cost
of goods, operating expenses, and interest and taxes.
• EBITDA, earnings before interest, taxes, depreciation,
and amortization is a performance measure that
approximates cash-basis profits from ongoing
operations.
– Add back two major noncash expenses to EBIT
– Shows performance if fixed costs are ignored
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Gross profit margin is what percentage of gross revenues that remains
with the firm after paying for merchandise.
Revenue – COGS = GP
As with all financial ratios, the gross margin derives its meaning by comparison
to performance of the company in past years as well as by comparison to
industry averages. One of the things an analyst looks for is the trend of the
gross profit margin: Is it increasing, decreasing, or remaining steady?
The key is that the percentage of GP remains constant, or increases as sales

increase.
GP – SG&A = Operating Profit
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• Gross Profit Margin Ratio =
Gross Profit
Net Sales
=
Net Sales – COGS
Net Sales
52
• Operating Profit Margin =
Operating Income
Net Sales
= Net Sales – COGS – G&A
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May also be defined as
• Net Profit Margin =
Net Income (EBIT)
Net Sales
Net income = Net Sales – COGS – G&A – Fixed costs – Tax –
Interest
What is left to be reinvested or distributed?
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• Net Profit Margin and Profit Margin are the

same
• Difference between Operating Income and
EBIT  OTHER
• Other Income
• Other Loss
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Considerations
Financial analyst must also look for reasons that explain changes. Here
are some reasons that gross profit margin may change:
• Sales prices have not increased at the same rate as the change in
inventory costs.
• Sales prices have declined due to competition.
• The mix of products sold has changed to more products with lower
profit margins.
• Inventory is being stolen (if this is the case, the cost of goods will be
higher against the same sales).
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• EBITDA  performance measure that

approximates accrual-basis profits from
ongoing operations
• EBITDA / Net Sales  adding back 2 major
noncash expenses to EBIT
– How the company is performing if fixed cost are
ignored? Why would we consider this?
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• ROI: what is return, and what is investment?
– ROA: how well management is deploying the firm’s assets
in the pursuit of a profit
Net income
Average total assets
• Ratio will be very low in high assets industry
(manufacturing)
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– ROE: measures the return per owner dollar invested
Net income
Average total equity
– The difference between ROA and ROE denominators is
total liabilities, which is why ROE is always larger than ROA
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– Sustainable Growth Rate measures the growth of a firm
without borrowing additional funds
ROE X (1 – Dividend payout ratio)
“Retention Ratio” which is the reciprocal is what the income

the company keeps to grow
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Key Take-Away
• CMA are expected to be able to determine the
profitability of a business by calculating ROA / ROE
using the DuPont Model and explain how it helps
analysis.
• Demonstrate:
– That you know the formulas
– That you are able to properly apply, analyze, and evaluate
– Discussion on inconsistent definitions and what factors
contribute to inconsistency
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SU 6.4 – Profitability Ratios - Calculations Question 1
Dividendosaurus has return on assets of
(use the statements on the next page)
A 21.1%
B 39.2%
C 42.1%
D 45.3%
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Balance Sheet Statement of Income and Retained Earnings
Cash Question 1 $100 Sales $ 3,000
Accounts receivable 200 Cost of goods sold -1,600
Inventory 50 Gross profit $ 1,400
Net fixed assets 600
Total $950 Operations expenses -970
Operating income $ 430
Accounts payable $140 Interest expense -30
Long-term debt 300
Capital stock 260 Income before tax $ 400
Retained earnings 250 Income tax -200
Total $950
Net income $ 200
Add: Jan. 1 retained
150
earnings
Less: dividends -100
Dec. 31 retained
$ 250
earnings
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Question 1 Answer
Correct Answer: A
The return on assets is the ratio of net income to total assets. For
Dividendosaurus, it equals 21.1% ($200 net income ÷ $950 total
assets).
Incorrect Answers:
B The ratio of net income to common equity is 39.2%.
C The ratio of income before tax to total assets is 42.1%.
D The ratio of income before interest and tax to total assets is 45.3%.
64
In the current year, Griffin, Inc., had $15 million in sales, while total fixed
costs were held to $6 million. The firm’s total assets averaged $20 million
and the debt-to-equity ratio was calculated at 0.60. If the firm’s EBIT is $3
million, the interest on all debt is 9%, and the tax rate is 40%, what is the
firm’s return on equity?
A 11.16%
B 14.4%
C 18.6%
D 24.0%
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Question 2 Answer
Correct Answer: A
The first step is to determine the amount of equity.
If the debt-to-equity ratio is .6, the calculation is .6E + E = $20 million.
Thus, E (equity) equals $12.5 million. Debt is therefore $7.5 million.
At 9%, interest on $7.5 million of debt is $675,000. Earnings before
taxes are $2,325,000 ($3,000,000 EBIT – $675,000 interest).
At a 40% tax rate, taxes are $930,000, which leaves a net income of
$1,395,000. Return on equity is calculated by dividing the $1,395,000
by the $12,500,000 of equity capital, giving an ROE of 11.16%.
66
Colonie, Inc., expects to report net income of at least $10 million
annually for the foreseeable future. Colonie could increase its
return on equity by taking which of the following actions with
respect to its inventory turnover and the use of equity financing?
Inventory Turnover Use of Equity Financing
A Increase Increase
B Increase Decrease
C Decrease Increase
D Decrease Decrease
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Question 3 Answer
Correct Answer: B
Return on equity, in the most general terms, is the ratio of net income to total equity.
Increasing inventory turnover raises the numerator, and decreasing equity financing
lowers the denominator. This combination is thus the only effective means of
increasing return on equity.
Incorrect Answers:
A: Increasing equity financing raises the denominator, lowering the overall return on equity
ratio.
C: Decreasing inventory turnover lowers the numerator, lowering the overall return on equity
ratio.
D: Decreasing inventory turnover lowers the numerator, lowering the overall return on equity
ratio.
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• Inconsistent Definitions
– Adjustments of the numerator (“RETURNS”)
• Subtracting Preferred Dividends  IACS (Income available to
Common Stockholders)
• Adding back minority interest in the income of a
consolidated subsidiary
• Adding back interest expense
• Adding back both interest expense and taxes = EBIT  Basic
Earning Power ratio
– Enhances comparability of firms with different capital structures
and tax planning strategies
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• Inconsistent Definitions (continued)
– Adjustments of the denominator (“ASSETS/EQUITY”)
• Excluding non-operating assets (investments, intangibles)
• Excluding unproductive assets (idle plant, intangible assets,
obsolete inventory)
• Excluding current liabilities to emphasize long-term capital
• Excluding debt and preferred stock to arrive at equity capital
• Stating invested capital at market value
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DuPont Analysis
• Developed in 1919 as a way to better understand return

ratios and why they change over time.
• Begin with ROA, and break it down into
– One component that focuses on income statement
– One component that focuses on the balance sheet
Net income Net Income Net Sales

= X
Average total assets Net Sales Average total assets
= Net profit margin X Total asset turnover

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DuPont Model
72
DuPont Triangle
ROE
Financial
ROA
Leverage
Net Profit Total Assets Financial

Margin Turnover Leverage
Tax Interest EBIT Total Assets Financial

Burden Burden Margin Turnover Leverage
73
DuPont Analysis
• Return on equity (ROE)
– Subdivided by the DuPont Model into three
efficiency components
• Net profit margin
• Assets Turnover
• Equity Multiplier
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DuPont Model: Deep Dive
• ROE = Profit Margin X Asset Turnover X Equity Multiplier
Profitability Operating Financial

Efficiency Leverage
• High Turnover Industries = retail, groceries  volume

• High Margin Industries = fashion, luxury  rare, customized
• High Leverage Industries = financial sector, real estate
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• ROE = Net Profit / Equity
= Net Profit / Pre-tax Profit X Pre-tax Profit / EBIT
Tax Burden Interest Burden
• ROE = Tax burden X Interest burden X Margin X Turnover X Leverage

• ROE = Tax burden X ROA X Compound Leverage factor
76
White Knight Enterprises is experiencing a growth rate of 9%

with a return on assets of 12%. If the debt ratio is 36% and the
market price of the stock is $38 per share, what is the return
on equity?
A 7.68%
B 9.0%
C 12.0%
D 18.75%
77
Question 1 Answer
Correct Answer: D
Assume that the firm has $100 in assets, with debt of $36 and equity of $64.
Income (return) is $12. The $12 return on assets equates to an 18.75% return
on equity ($12 ÷ $64).
Incorrect Answers:
A This percentage is based on 64% of the ROA.
B This percentage is the growth rate, not a return.
C This percentage is the return on assets, not return on equity.
78
According to the DuPont formula, which one of the following
will not increase a profitable firm’s return on equity?
A Increasing total asset turnover.
B Increasing net profit margin.
C Lowering corporate income taxes.
D Lowering equity multiplier.
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Question 2 Answer
Correct Answer: D
Lowering the equity multiplier would not increase a profitable firm’s
return on equity. The DuPont model depicts return on assets as total
asset turnover (sales divided by average total assets) times the profit
margin (net income divided by sales).
Incorrect Answers:
A Increasing total asset turnover would increase a profitable firm’s return on equity.
B Increasing net profit margin would increase a profitable firm’s return on equity.
C Lowering corporate income taxes would increase a profitable firm’s return on equity.
80
The DuPont formula involves which combination of financial
elements in its computation?
A Net profit margin, total asset turnover, and equity multiplier.
B Total asset turnover and sales turnover profitability.
C Profit margin, sales turnover, and asset-use efficiency.

D Total asset turnover, sales turnover, and equity multiplier.
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Question 3 Answer
Correct Answer: A
The DuPont model begins with the standard equation for return on
equity (ROE) and breaks it down into three different efficiency
components.
ROE = Net profit margin × Asset turnover × Equity multiplier
Incorrect Answers:
B The DuPont model also involves net profit margin and equity multiplier.
C The DuPont model also involves total asset turnover and equity multiplier.
D The DuPont model also involves net profit margin.
82
Other Measures
• Return on Common Equity (ROCE) =
Net income – Preferred dividends
Average common equity
83
Other Measures
• ROCE = IACS / Net Sales X Net Sales / AVG Ttl Assets X Leverage
– The equity multiplier measures a company’s financial leverage
– High financial leverage means that the company relies more on debt
to finance its assets
– Raising capital with debt, the company can increase its equity
multiplier and improve its ROE
– However, on the other hand, taking on additional debt may worsen
the company’s solvency and increase the risk of going bankrupt
84
Other Measures
• Sustainable Equity Growth rate = ROCE x (1 – Dividend Payout)
Plowback rate
• Plowback rate = Net Income not distributed = reinvested in RE
• Net Profit Margin on Sales = Net Income / Sales
85
Sustainable Equity Growth
Although some companies fail because of ever-declining revenues, companies
also fail by attempting to grow too fast. Many small businesses, in particular,
go under because they take on a contract with deadlines that cannot be met
with their current staff, equipment, capital, and expertise. The sustainable
growth ratio indicates the maximum earnings growth a firm can have without
resorting to other means of financing.
The key to sustainable growth is retaining sufficient earnings to reinvest in

growth rather than paying out too much in earnings as dividends. This can be
calculated as 1 minus the dividend payout ratio multiplied by return on equity
(ROE).
86
If Company A has a higher rate of return on assets than
Company B, the reason may be that Company A has a
<List A> profit margin on sales, a <List B> asset turnover
ratio, or both.
List A List B
A Higher Higher
B Higher Lower
C Lower Higher
D Lower Lower
87
Question 1 Answer
Correct Answer: A
The DuPont model treats the return on assets as the product of the
profit margin and the asset turnover:
Return on Assets = Profit Margin X Asset Turnover
If one company has a higher return on assets than another, it may have
a higher profit margin, a higher asset turnover, or both.
88
Transnational Motors has decided to make an additional investment in its
operating assets, which are financed by debt. Assuming all other factors
remain constant, this increase in investment will have which of the
following effects?
Operating Profit Margin Total Asset Turnover Return on Assets
A Increase No Change Increase
B No Change Decrease Decrease
C No Change Increase Decrease
D Decrease Decrease Decrease
89
Question 2 Answer
Correct Answer: B
An additional investment in operating assets that are financed by debt will
cause assets and liabilities to increase proportionally. This transaction would
have no effect on income statement balances. Therefore, there will be no
change in operating profit margin (operating income ÷ sales). Both the total
asset turnover (net sales ÷ average total assets) and the return on assets
(net income ÷ average total assets) will decrease as the denominator for
both of these ratios will increase, but the numerator remains constant.
90
Question 2 Answer
Incorrect Answers:
A Operating profit margin will not be affected by the purchase of assets because
this transaction will have no effect on the income statement. However, the total asset
turnover and the return on assets will both decrease, not remain constant and
increase.
C: The total asset turnover will decrease, not increase. The denominator in this ratio
is increasing while the numerator is staying constant, causing a decrease in the total
ratio.
D: Operating profit margin will not be affected as the purchase of assets financed by
debt will not affect any income statement amounts.
91
Zoron Corporation experienced the following year-over-year changes.
Net profit margin Increased 25%
Total asset turnover Increased 40%
Total assets Decreased 10%
Total equity Increased 40%
Using DuPont analysis, what is the year-over-year change in Zoron’s return on

equity (ROE)?
A Increased 95.0%.
B Increased 63.0%.
C Increased 12.5%.
D Increased 10.0%.
92
Question 3 Answer
Correct Answer: C
The ROE using the DuPont analysis is calculated as follows: Net profit margin × Total asset
turnover × Equity multiplier (Total assets ÷ Total equity)
The best way to solve this problem is to use actual numbers for the return on equity comparison
of this year to last year. Assuming that last year Zoron had a net profit margin of .025, total asset
turnover of 1.05, total assets of $500,000, and total equity of $200,000, last year’s ROE is equal
to 6.56% [.025 × 1.05 × ($500,000 ÷ $200,000)].
By using the information given in the problem, Zoron’s current-year amounts can be calculated,
resulting in a net profit margin of .03125 (increased by 25%), total asset turnover of 1.47
(increased by 40%), total assets of $450,000 (decreased by 10%), and total equity of $280,000
(increased by 40%). Therefore, this year’s ROE is equal to 7.38% [.01325 × 1.47 × (450,000 ÷
280,000)].
The increase in ROE from last year to this year can now be calculated as 12.5% [(7.38 – 6.56) ÷
6.56].
93
SU 6.5 – Effects on Transactions
The definition of income between companies (and over

time) is just one challenge in measuring profitability.
Analyst have to consider the:
• Sources
• Trends of revenue
• Revenue relationships
• Expenses
• Costs of sales
94
SU 6.5 – Effects on Transactions
Remember that the questions you will encounter will

most likely focus on the effects typical business
transactions have on the firm’s profitability rather than
merely on the mechanics (knowing the formula and
being able to calculate it)
95
Remember – Inherent Limitations of
Ratio Analysis
• Limitations of ratio analysis: benchmark to industry
• Compile multiple ratios to “tell a story”
• Effects of inflation (Fixed Assets, Inventory, Debt…)
• Seasonality of certain businesses
• Window dressing: companies have incentive to manipulate ratios
• Accounting Policies: distortion in comparing YOY periods
• Interpretation of ratios differs between Industries
• Earnings Quality: do earnings have a high degree of variability?
96
Remember – Inherent Limitations of
Ratio Analysis
Profit, as an economic term, is the measure of the resources generated by the firm in
excess of the resources consumed over the life of the firm. At any given time, the
economic profit of the firm are the net present value of its earnings over its lifetime.
However, this is not what gets measured as accounting income or accounting profit.
The measurement of accounting profit is based on accrual accounting. The
measurement of resources generated and consumed follow the rules set by generally
accepted accounting principles (GAAP).
The need to report on a periodic and ongoing basis, even though the business is
continuing, leads to the need to make such approximations, causing the economic
profit to be different from the accounting profit. The objective of financial accounting
is not to make the accounting profit close to the economic profit but to provide
a reasonable basis to infer the economic profit from the reported accounting profits.
97
Also!
Users of financial statements often place too much emphasis on
summary indicators and key ratios, such as the current ratio or the EPS
amount. No single ratio, or measure, is capable of capturing all
relevant or important information about a particular company. The
calculation of various ratios is merely the starting point.
Analysis requires thinking about these ratios, forming expectations,
and understanding the reasons of variances from those expectations.
There is no overarching rule of what a ratio ought to be, and it
depends on the particular industry as well as the business model.
98
Additionally!
Additionally, many financial statements contain information on non-operating items,
such as extraordinary losses or effects of discontinued operations. Ratios mean
nothing without some means of comparison: past ratios of the same business, a
predetermined standard, or ratios of other companies in the same industry. Numbers
within the financial statements must be interpreted based on an understanding of the
accounting principles employed by the business.
For a ratio to make sense, there must be a relationship between the two accounts
used in the ratio—for example, there is no relationship between shipping costs and
marketable securities. The validity of ratios also depends on the validity of the
numbers used in the calculations. If the business’s accounting system cannot be relied
on to produce reliable figures, ratios are also unreliable.
99
Additional Questions
Question 1
When calculating ratios involving income, an adjustment is most likely to
be made for
A Gross profit.
B Selling expenses.
C Nonrecurring gains and losses.
D Fixed overhead costs.
100
Question 1 Answer
Correct Answer: C
Nonrecurring gains and losses are sometimes added to or subtracted from income to
arrive at income from continuing operations. Because ratios are used to predict the
future, nonrecurring items not likely to recur should not be considered.
Incorrect Answers:
A: Income is less likely to be adjusted for recurring costs.
B: Income is less likely to be adjusted for recurring costs.
D: Income is less likely to be adjusted for recurring costs.
101
Question 2
Grand Savings Bank has received loan applications from three companies in the plastics manufacturing business
and currently has the funds to grant only one of these requests. Specific data shown below has been selected
from these applications for review and comparison with industry averages.
Springfield Reston Herndon Industry
Total sales (millions) $4.27 $3.91 $4.86 $4.30
Net profit margin 9.55% 9.85% 10.05% 9.65%
Current ratio 1.82 2.02 1.96 1.95
Return on assets 12.00% 12.60% 11.40% 12.40%
Debt/equity ratio 52.50% 44.60% 49.60% 48.30%
Financial leverage 1.3 1.02 1.56 1.33
Based on the information above, select the strategy that should be the most beneficial to Grand Savings.
A Grand should not grant any loans, as none of these companies represents a good credit risk.
B Grant the loan to Springfield, as all the company’s data approximate the industry average.
C Grant the loan to Reston, as both the debt/equity ratio and degree of financial leverage are below the
industry average.
D Grant the loan to Herndon, as the company has the highest net profit margin and degree
of financial leverage.
102
Question 2 Answer
Correct Answer: C
Grand’s primary concern is the customer’s ability to pay a loan back. Crucial in deciding the
likelihood of payback is how much of the customer’s capital structure is made up of debt
currently, that is, before the loan is made. Reston’s is well below the industry average (a few
percentage points can mean the difference between a good credit risk and a poor one) and is the
lowest of the three potential customers. Also, Reston is clearly the least leveraged of the three by
far, as revealed by its low degree of financial leverage.
Incorrect Answers:
A: Reston is a good credit risk.
B: Debt makes up more than half of Springfield’s capital structure; “approximating industry averages” is
meaningless when just a few percentage points can mean the difference between a good credit risk and a poor
one.
D: While a high profit margin may be indicative of the ability to pay back a loan, a high degree of financial
leverage indicates the opposite, and Herndon’s is well above the industry average.
103
Question 3
A retail company has experienced rapid growth in sales during the current year. An analyst has
calculated the following ratios for this company.
Prior Year Current Year
Inventory turnover 5.4 9.3
Receivables turnover 4.2 3.5
Fixed asset turnover 2.4 3.6
Quick ratio 1.5 1.2
Based on the above, the analyst may conclude that sales increased due to more
A Competitive pricing.
B Favorable credit policies.
C Stores opening in the current year.
D Control over inventory levels.
104
Question 3 Answer
Correct Answer: B
The analyst can conclude that sales increased due to more favorable credit policies. The inventory turnover ratio increased
drastically, meaning that COGS increased, average inventory decreased, or both. At the same time, the receivables turnover
decreased, meaning average accounts receivable increased. Sales did not decrease; the question stem explains that they
increased. The increase in average accounts receivable and the decrease in inventory can best be explained by a more favorable
credit policy because this would allow more customers to purchase from the company even if they lack the best credit standings.
Incorrect Answers:
A: The analyst cannot conclude that sales increased due to more competitive pricing. Competitive pricing is employed by firms
when they set the price of a product or service based on what the competition is charging. The facts in the question stem do not
provide any information as to what the competition is using as their prices. Therefore, this would not be a good conclusion as to
why the sales increased.
C: The analyst cannot conclude that sales increased due to more stores opening in the current year. If stores opened in the
current year, then the fixed asset turnover would have decreased, as the opening of a new store would require a large increase in
fixed assets.
D: The analyst cannot conclude that sales increased due to more control over inventory levels. The inventory levels decreased
because of the increase in sales. In addition, the quick ratio remains relatively the same. If there were more control over the
inventory levels, then this ratio would have shown a greater change.
105
SU 6.6 – Factors Affecting Reported
Profitability
• The definition of Income may differ depending on the
audience it is presented to: Auditors, Management, Creditors,
Regulators or Shareholders.
– Investors interested in profitability
– Creditors interested in security
• Financial statements are general purpose.
• Estimates are necessary to calculate income.
106
Profitability
• Revenues are inflows or enhancements of assets of the firm
or settlements of its liabilities
• Sources of Revenues
– Especially important in diversified firms
– Common-size analysis useful
107
Profitability
• Receivables and Inventories
– Relationship of receivables and revenues helps to assess earnings
quality
• Sales growing more slowly than receivables  consider management’s incentives,
leniency of credit policies, and collectability issues
• Materials and WIP inventories falling while finished goods inventories rising 
future output and sales likely to decline
108
Profitability
• Recognition Principles: matching principle
• COGS and gross profit: effect of price increase
• Expenses: understand variances and be able to explain impact
on business profitability (selling cost, marketing, G&A ,
depreciation, R&M, interest, amortization and income tax)
• Effect of accounting changes
109
Profitability
For example, two commonly used methods of inventory valuation are
first-in, first-out (FIFO) and last-in, first-out (LIFO). For the same
underlying economic event, use of LIFO, under certain assumptions of
increasing inventory units and prices, yields lower income than the
FIFO inventory valuation method. Thus, a firm using LIFO would report
lower income and lower inventory value than a similar firm using FIFO
inventory valuation method. Lower income and lower assets both
affect the computation of the return of asset ratio. An analyst is
required to consider such effects of accounting policy choices on
various financial ratios. The CMA exam tests the ability to evaluate
and deduce the effects of various accounting choices on common
ratios.
110
SU 6.6 – Factors Affecting Reported Profitability
Question 1
Bisbee Corporation’s abbreviated common-size income statements for Year 1’s actual results and Year 2’s
anticipated results are shown below.
Year 1 Year 2
Sales 100% 100%
Cost of goods sold 50% 50%
Selling and administrative expenses 40% ?
Operating Income 10% ?
Bisbee estimates that units sold will increase by 5% in Year 2 with no price increase to its
customers and no anticipated cost increases from its vendors. Assume selling and administrative
expenses are 5% variable and 95% fixed. If all predictions materialize, Bisbee should expect
selling and administrative expenses in Year 2 to be
A Less than 40% of sales.
B 40% of sales.
C Greater than 40% but no more than 42% of sales.
D Greater than 42% of sales.
111
Correct Answer: A
Question 1 Answer
This question is best answered using actual numbers. Assume that sales in Year 1 are $500. Because total
selling and administrative expenses are 40% of Year 1 sales, selling and administrative expenses equal $200
($500 × 40%). Given that 5% of this is variable and 95% is fixed, variable expense equals $10 ($200 × 5%) and
fixed expense equals $190 ($200 × 95%). In relation to sales, variable selling and administrative expenses are
equal to 2% ($10 variable ÷ $500 sales) of sales. This percent will help calculate the variable selling and
administrative expenses in Year 2.In Year 2, sales increase by 5%, making Year 2 sales equal to $525 ($500 Year
1 sales × 1.05 increase). The fixed portion of the selling and administrative expenses is equal to $190. The
variable portion can be solved by multiplying 2% by sales of $525, which results in $10.50. Therefore, total
selling and administrative expenses are equal to $200.50, about 38.20% ($200.50 ÷ $525) of Year 2 sales,
which is less than 40%.
Incorrect Answers:
B: Selling and administrative expenses are not the same in Year 2 as they were in Year 1.
C: Year 2 selling and administrative expenses are not greater than 40% of sales.
D: Year 2 selling and administrative expense are not greater than 42% of sales.
112
Question 2
Baldwin Corporation’s inventory expressed as a percentage of current assets increased from
25% last July to 35% this July. The factor that is least likely to cause this increase is that Baldwin
A Is a seasonal company with traditionally higher activity in the summer months.

B Is beginning to experience high growth.
C Has inventory that is becoming obsolete.
D Used a material amount of cash from selling its short-term investments to purchase land.
113
Correct Answer: A
Question 2 Answer
This statement is least likely to explain an increase in current assets from last July to this July. If Baldwin was a
seasonal company with traditionally higher activity in the summer months, it would budget similar amounts for
each summer in expectation of the high activity. The sudden increase in current assets for the following
summer would not be explained by the fact that they are a seasonal company.
Incorrect Answers:
B: If Baldwin was beginning to experience high growth, it would have to purchase more inventory in order to
meet the higher demand from the growth. This would cause the current assets account to increase.
C: Obsolete inventory refers to inventory held by a company that is at the end of its product life cycle and has
not seen any sales or usage for a set period of time. If Baldwin has inventory that is becoming obsolete, the
inventory will be held by the company instead of being sold. This would cause an increase in the current assets
on the books.
D: It can be assumed that the sale of short-term investments generated a gain, which caused a bigger cash
inflow than the outflow from the short-term investments. This means that the current assets account
increased. The fact that the company bought land with some of the cash is meant as a distractor, as the
question does not state how much of the cash was used to purchase the land.
114
Question 3
Which one of the following ratios would be most affected by miscellaneous or non-
recurring income?
A Net profit margin.
B Operating profit margin.
C Gross profit margin.
D Debt-to-equity ratio.
115
Question 3 Answer
Correct Answer: A
Net profit margin is expressed as net income over sales. Net income would include miscellaneous or non-recurring
income. This ratio would be the most affected because the amounts for miscellaneous or non-recurring income would
be included in the numerator of the ratio.
Incorrect Answers:
B: Operating profit margin is equal to operating income divided by net sales. Neither sales nor operating income
would include miscellaneous or non-recurring income. Therefore, this ratio would not be affected by those amounts.
C: Gross profit margin is expressed as gross profit divided by net sales. Gross profit is equal to revenues less the cost
of goods sold, not including miscellaneous or non-recurring income. Therefore, this ratio would not be affected by
those amounts.
D: The debt-to-equity ratio is expressed as total debt divided by stockholders’ equity. Neither debt nor stockholders’
equity would include miscellaneous or non-recurring income. Therefore, this ratio would not be affected by those
amounts.
116
SU 6.7 – Solvency
Solvency is the degree to which the current assets of an
organization exceed the current liabilities of the organization.
Solvency describes the ability of an organization to meet its
long-term fixed expenses and to meet long-term expansion
and growth.
Organizations can calculate the net liquid balance (NLB) as a
measure of solvency by adding cash and cash equivalents to
short-term investments, then subtracting notes payable.
117
SU 6.7 – Solvency
• Solvency is a firm’s ability to pay its noncurrent obligations
as they come due.
• Long-run as opposed to liquidity which focuses on short-term (current
items)
• Firms capital structure including
• Liabilities (external) – Long-term and short-term debt
• Equity – (internal) – Residual
• Capital decisions have consequences
• > debt = > risk = > cost of capital
• > equity = < ret. on equity
• Which det. degree of leverage
118
SU 6.7 – Solvency
• Debt is the creditor interest in the firm
– Contractual obligation to repay debtholder
– Return > cost of debt = > equity
– Advantage is tax deduction on interest payments
119
SU 6.7 – Solvency
• Equity is the ownership interest in a firm
– Permanent capital of an enterprise
– Ret. uncertainty even with Pre. Stock
120
SU 6.7 – Solvency
Capital Structure Ratios
• Total Debt to Total Capital Ratio

Total debt
Total capital (debt & equity)
- Total leverage
- Measures percentage of capital structure provided by
creditors
- Low ratio indicates more capital is supplied by stockholders
121
SU 6.7 – Solvency
• Debt to Equity Ratio

Total debt
Stockholders’ equity
Total amount (X) that debt exceeds equity
122
SU 6.7 – Solvency
– Long-term Debt to Equity Ratio
• Long-term debt/Equity
– Question: Which is better, increase or decrease of
Long-term Debt to Equity Ratio, year over year?
Why?
123
SU 6.7 – Solvency
• Debt to Total Asset
TTL Liabilities
TTL Assets
- Question: How is it the same as the debt to
total capital ratio?
124
SU 6.7 – Solvency
Earnings Coverage
• Earnings Coverage
– Times interest earned ratio
• EBIT/Interest Expense
• Question: What does this tell a creditor?
• Most common mistake – not to add back
that years interest payment to NI before
taxes
125
SU 6.7 – Solvency
Earnings Coverage
• Earnings to Fixed Charges
• EBIT + Interest portion of operating leases/Int. exp.
+ Int. portion of operating leases + Div. on Pre.
Stock
• More conservative; shows all fixed charges
126
SU 6.7 – Solvency
Earnings Coverage
– Cash Flow to Fixed Charges Ratio
• Pre-tax operating cash flow/Int. exp. + Int. portion of
operating leases + Div. on Pre. Stock
– Eliminates issues associated with accrual accounting
127
SU 6.7 – Solvency Question 1
Bond Corporation has a current ratio of 2 to 1 and a quick ratio (acid
test) of 1 to 1. A transaction that would change Bond’s quick ratio
but not its current ratio is the
A Sale of inventory on account at cost.
B Collection of accounts receivable.
C Payment of accounts payable.
D Purchase of a patent for cash.
128
SU 6.7 – Solvency Question 1 Answer
Correct Answer: A
The quick (acid test) ratio equals the quick assets (cash, marketable securities,
and accounts receivable) divided by current liabilities. The current ratio is
equal to current assets divided by current liabilities. The sale of inventory (not
a quick current asset) on account increases accounts receivable (a quick
asset), thereby changing the quick ratio. The sale of inventory on account,
however, replaces one current asset with another, and the current ratio is
unaffected.
Incorrect Answers:
B Neither ratio is changed.
C The current, not the quick, ratio changes.
D Both decrease.
129
Fact pattern: Depoole Company is a manufacturer of industrial products that uses a calendar year
for financial reporting purposes. Assume that total quick assets exceeded total current liabilities
both before and after the transaction described. Further assume that Depoole has positive profits
during the year and a credit balance throughout the year in its retained earnings account.
Depoole’s payment of a trade account payable of $64,500 will
A Increase the current ratio, but the quick ratio would not be affected.
B Increase the quick ratio, but the current ratio would not be affected.
C Increase both the current and quick ratios.
D Decrease both the current and quick ratios.
130
Correct Answer: C
Current assets consist of more assets than quick assets; thus, if quick assets
exceed current liabilities, then current assets do also. It can also be concluded
that both ratios are greater than 1. An equal reduction in the numerator and
the denominator, such as a payment of a trade payable, will cause each ratio
to increase.
Incorrect Answers:
A The current ratio and the quick ratio will increase.
B The current ratio and the quick ratio will increase.
D The current ratio and the quick ratio will increase.
131
The following transactions occurred during a company’s first year of operations:
I. Purchased a delivery van for cash
II. Borrowed money by issuance of short-term debt
III. Purchased treasury stock
Which of the items above caused a change in the amount of working capital?
A I only.
B I and II only.
C II and III only.
D I and III only.
132
Correct Answer: D
Working capital is computed by deducting total current liabilities from

total current assets. The purchase of a delivery van for cash reduces
current assets and has no effect on current liabilities. The borrowing of
cash by incurring short-term debt increases current assets by the same
amount as it increases current liabilities; hence, it will have no effect
on working capital. The purchase of treasury stock decreases current
assets but has no effect on current liabilities. Thus, the purchases of
the van and treasury stock affect working capital.
133
Study Tip
• Try to identify if you are missing most multiple choice
questions because you did not know the material, or
because you did not correctly understand the questions
and/or answers. We need to eliminate the latter and
isolate questions missed largely due to lack of material.
There is a finite amount of material to know, particularly
when you narrow down most common asked questions.
• Learn the general concepts first, don't worry about learning
the details until you have learned the main ideas.
134
SU 6.8 – Leverage
Types of Leverage
Read: Gleim Success Tip on page 191.
• Leverage is
– Leverage = relative of fixed cost

• Question: Which fixed cost?
• Question: What financial statement do we find on?
135
SU 6.8 – Leverage
Types of Leverage
A company uses leverage in two ways
• Financial leverage is raising capital through debt rather than equity. While
debt holders 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.
The focus on leverage in this section is on financial leverage. The cost of
financial leverage is interest costs, which must be paid regardless of sales.
136
SU 6.8 – Leverage
• Degree of leverage =
Pre-fixed-cost income amount

Post-fixed-cost income amount
137
SU 6.8 – Leverage
• Distinguish between variable costing and full-
costing
– Variable
– Full
• Why do we have to have variable costing for
measuring the degree of leverage?
138
SU 6.8 – Leverage
• Degree of Operating Leverage - Single-Period
Version
Contribution Margin
Operating Income or EBIT
• Contribution Margin = ?
Example page 191
139
SU 6.8 – Leverage
• Degree of Operating Leverage, Percent Change
Version
Percent change in operating income or EBIT
Percent change in sales
Example page 192
140
SU 6.8 – Leverage
• Degree of Financial Leverage, Single-Period
Version
EBIT
EBT
- A variation is the Percentage-change Version
141
SU 6.8 – Leverage
• Degree of Financial Leverage, Percent Change
Version
EBIT
EBT
- A variation is the Percentage-change Version
142
Capital Structure - Other Considerations
Consider that increases in debt create higher fixed costs for interest
and principal payments. It also results in a higher debt to equity ratio
and, therefore, a less favorable position for long-term debt-paying
ability.
Decreases in equity, as a result of redemption of stock or losses from
operations, also would result in a higher debt to equity ratio and
higher risk for the company’s ability to pay long-term debt.
Increases in equity, such as those from profits, without corresponding
increases in debt would lower the debt to equity ratio, increasing the
company’s position for long-term debt-paying ability.
143
Management takes much care to manage the
capital structure and its disclosure because of
the direct impact it has on the cost of capital
and thus on the profitability of the firm.
144
What is Off-Balance Sheet Financing, and how does it affect financial
rations?
• Off -balance sheet financing is a form of financing in which large
capital expenditures are kept off an organization’s balance sheet
through various classification methods.
• Organizations often use off-balance sheet financing to keep their
debt to equity and leverage ratios low, especially if the inclusion of
a large expenditures would violate debt covenants.
• Four of the common techniques employed to achieve off-balance
sheet financing are: factoring of A/Rs, special-purpose entities,
leases, and joint ventures.
145
Special-Purpose Entities
Many firms create special-purpose entities (SPEs) for a “special,”
sometimes undisclosed, business purpose. For example:
• SPEs may be created to facilitate leasing activities, loan
securitizations, R&D activities, or trading in financial derivatives (i.e.
Enron).
• Because these were created as “separate” entities from the parent
corporation, the financials and business transactions of these SPEs
were not consolidated with that of the parent.
• By excluding such ventures from consolidation, the company is
“hiding” significant business risk from investors
146
Leases
• Firms usually use leases to get use of an asset without having to show it on the balance sheet
as an asset and the corresponding liability. If the firm were to purchase the asset, it might
have to use cash, thus converting short-term assets into long-term assets and worsening
short-term liquidity ratio. Purchasing the asset on credit would increase the firm’s accounts
payable, again worsening its short-term liquidity ratios. If the firm were to use long-term
financing to purchase, it would worsen the debt to equity or other solvency ratios.
• A way to avoid any of these adverse consequences on the balance sheet, firms sometimes
lease the asset. Generally accepted accounting principles require that a determination be
made on whether the lease is an operating lease or a capital lease. When the lease meets
one of the four conditions established for capital leases, the lease payments are accounted
for as a long-term liability.
• However, sometimes firms are able to structure a lease so as not to meet any of the four
conditions. It can then classify the lease as an operating lease. With an operating lease, the
firm is able to obtain the use of the asset without having to record its obligation to pay, thus
obtaining off-balance sheet financing.
147
Joint Ventures
A joint venture is a business entity that is owned, operated, and jointly controlled
by a small group of investors with a specific business purpose.
• Sometimes a corporation is a partner in a venture, which allows it to be active in
management and involved in decision making but not report the venture on the
financial statement of the corporation.
• An investment in a corporate joint venture that exceeds 50% of the venture’s
outstanding shares must be treated as a subsidiary investment, leading to
consolidation in the financial statement. However, firms sometimes are careful to
hold less than 50% (say 48.5%) of outstanding shares to avoid such consolidation—
providing off -balance sheet financing.
148
Study Tip
• It is best to review the material right after
class when it's still fresh in your memory.
149

CMA Part 2: Financial Decision Making

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CMA Part 2

Financial Decision Making

• Ratios are not useful unless they are

Ref. data shown on page 176 used for examples

A positive value of working capital indicates that there are enough

B Collection of accounts receivable.

C Payment of accounts payable.

D Purchase of a patent for cash.

The key is that the percentage of GP remains constant, or increases as sales

= Net Sales – COGS – G&A

• Net Profit Margin and Profit Margin are the

• EBITDA  performance measure that

ROE X (1 – Dividend payout ratio)

“Retention Ratio” which is the reciprocal is what the income

• Developed in 1919 as a way to better understand return

Net income Net Income Net Sales

= Net profit margin X Total asset turnover

Net Profit Total Assets Financial

Tax Interest EBIT Total Assets Financial

Profitability Operating Financial

• High Turnover Industries = retail, groceries  volume

= Net Profit / Pre-tax Profit X Pre-tax Profit / EBIT

Tax Burden Interest Burden

• ROE = Tax burden X Interest burden X Margin X Turnover X Leverage

White Knight Enterprises is experiencing a growth rate of 9%

B Increasing net profit margin.

C Lowering corporate income taxes.

D Lowering equity multiplier.

B Total asset turnover and sales turnover profitability.

C Profit margin, sales turnover, and asset-use efficiency.

The key to sustainable growth is retaining sufficient earnings to reinvest in

Return on Assets = Profit Margin X Asset Turnover

Using DuPont analysis, what is the year-over-year change in Zoron’s return on

The definition of income between companies (and over

Remember that the questions you will encounter will

A Is a seasonal company with traditionally higher activity in the summer months.

• Total Debt to Total Capital Ratio

• Debt to Equity Ratio

Total amount (X) that debt exceeds equity

B Collection of accounts receivable.

C Payment of accounts payable.

D Purchase of a patent for cash.

C Increase both the current and quick ratios.

D Decrease both the current and quick ratios.

Working capital is computed by deducting total current liabilities from

– Leverage = relative of fixed cost

Pre-fixed-cost income amount

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