CMA - Part 2
Financial Decision Making
Study Unit 2 – Ratio Analysis
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).
• f 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.
2.4 – 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 incl.
• 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. deg. of leverage
2.4 – Solvency
• Debt = creditors interest
• = contractual obligations
• Ret > cost of debt = > equity
• Equity = permanent capital
• Ret. uncertainty even with Pre. Stock
2.4 – Solvency
• Capital Structure Ratios
• Total Debt to Total Capital Ratio
• TTL Debt/TTL Capital (Debt & Equity) = total leverage
• Debt to Equity Ratio
• TTL Debt/Equity = total amount (X) that debt exceeds equity
• Long-term Debt to Equity Ratio
• Long-term debt/Equity
• ??? – which is better, increase or decrease of Long-term Debt to Equity Ratio, year
over year?
• Debt to Total Asset Ratio
• TTL Liabilities/ TTL Assets
• ??? – how is the same as the debt to total capital ratio?
2.4 – Solvency
• Earnings Coverage
• Times interest earned ratio
• EBIT/Interest Expense
• ??? – What does this tell a creditor
• Most common mistake – not to add back that years interest payment
to NI before taxes
• Earnings to Fixed Charges Ratio
• EBIT + Interest portion of operating leases/Int. exp. + Int. portion of
operating leases + Div. on Pre. Stock
• More conservative; shows all fixed charges
2.4 – Solvency
• 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
• Quiz
Study Tip
• Try to identify if you are missing most MC 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 later and isolate missed question 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.
2.5 – Leverage
• Gleim Success Tip
• Types of Leverage
• Leverage = relative of fixed cost
• ??? – which fixed cost?
• ??? – what financial statement do we find on?
• Deg. of leverage = Pre-fixed-cost income amount/Post-fixed-cost
income amount
2.5 – Leverage
• Distinguish between variable costing and full-costing
• Why do we have to have variable costing for measuring the
DOL
• Degree of Op. Lev. – Single-Period Version
• DOL = Contribution Margin/Operating Income or EBIT
• Contribution Margin = ???
• Example page 72
2.5 – Leverage
• Degree of Operating Leverage – Perc.-Change Version
• %Chng. in Op. Inc. or EBIT/%Chng. in Sales
• Example page 72
• Degree of Financial Leverage – Single-Period Version
• EBIT/EBT
• A variation is the Percentage-change Version
• Quiz
Study Tip
• It is best to review the material right after class when it's still
fresh in your memory.