Common Financial and Accounting Ratios & Formulas

( SOURCE: http://www.accountingscholar.com ) Part 10.1 - Common Financial & Accounting Ratios and Formulas Part 10.2 - Working Capital & Current Ratio Part 10.3 - Acid Test (Quick) Ratio Part 10.4 - Accounts Receivable Turnover Ratio

Accounting ratios are among the most popular and widely used tools of financial analysis because if properly analyzed, they help us identify areas that require further analysis on financial statements of corporations. A ratio can help us uncover conditions and trends that are difficult to find by inspecting individual components making up the ratio. For instance, knowing how much cash a company has in the bank might be a little useful, but working out a ratio to determine how much cash a company has, versus how much short term debt it has coming up is a lot more useful. Accounting ratios help us do just that. In fact, accountants admit that interpreting financial data is the most challenging aspect of ratio analysis. First of all, what is a ratio? A ratio is a mathematical relation between two quantities expressed as a percentage, a rate or proportion. For example a ratio can derive the answer $900 or can be expressed a 100% or 9:1 or just 9 In this tutorial, we will go over 4 major categories of accounting ratios that are known as the 4 building blocks of financial statement analysis. They are i) liquidity & efficiency ratios ii) solvency ratios iii) profitability ratios and iv)market value ratios. A) Short Term Solvency or Liquidity Ratios 1. Current ratio = Current assets / Current liabilities 2. Quick ratio = (Current assets inventory) / Current liabilities 3. Cash ratio = Cash / current liabilities 4. Net Working Capital = Net working capital / total assets 5. Internal measure = Current assets / average daily operating costs B) Long Term Solvency or Financial Leverage Ratios 1. Total debt ratio = (Total assets total equity) / Total assets 2. Debt to Equity ratio = Total debt / total equity 3. Equity Multiplier = Total assets / total equity 4. Long term debt ratio = Long term debt / (Long term debt + total equity) 5. Times interest earned = Earnings before Interest & Taxes / Interest 6. Cash coverage ratio = (Earnings before Interest & Taxes + Depreciation) / Interest C) Asset use or turnover ratios 1. Inventory turnover = Cost of goods sold / Inventory 2. Days sales in Inventory = 365 days / Inventory turnover 3. Receivables turnover = Sales / Accounts receivable 4. Days sales in receivables = 365 days / Receivables turnover 5. Net Working Capital (NWC) turnover = Sales / Net Working Capital 6. Fixed asset turnover = Sales / net fixed assets 7. Total asset turnover = Sales / total assets

D) Profitability Ratios 1. Profit margin = Net income / Sales 2. Return on Assets (ROA) = Net income / total assets 3. Return on Equity (ROE) = Net income / Total equity 4. ROE = (Net Income / Sales) x (Sales / Assets) x (Assets / Equity) E) Market Value Ratios 1. Price to Earnings ratio = Price per share / Earnings per share 2. Market-to-book ratio = Market value per share / book value per share Working Capital & Current Accounting Ratio 1. Part 10.1 - Common Financial & Accounting Ratios and Formulas 2. Part 10.2 - Working Capital & Current Ratio 3. Part 10.3 - Acid Test (Quick) Ratio 4. Part 10.4 - Accounts Receivable Turnover Ratio

The amount of current assets less current liabilities is called the working capital, or net working capital. A company needs an adequate amount of working capital on hand to meet its current or short term debts, carry sufficient inventories for resale and take advantage of cash discounts that suppliers might offer. A company that runs low on working capital is less likely to meet current debt liabilities and obligations. Current assets are those assets that can be readily or easily converted in to cash including cash, accounts receivable, inventories, short term investments, prepaid expenses and other assets that can be readily turned in to cash. Current liabilities on the other hand are those liabilities that are expected to be repaid within 1 year; examples include accounts payable, short term debts such as bank overdraft, accrued expenses such as wages payable, taxes payable and current payments on long term debt, such as bond interest.

To evaluate working capital of a company, we must look beyond the dollar values of current assets & current liabilities and we must consider the relationship between these 2 variables. The current ratio was designed to help us do just this. The current ratio is meant to describe a companys ability to meet its short term obligations. The formula for current ratio is:

Current Ratio = Current Assets / Current Liabilities

To calculate the current ratio, we will work off a simulated balance sheet of Juakali Corp. as of December 31st, 2004 and 2005 years. Juakali Corp. Balance Sheet As of December 31st, 2004 and 2005 Assets Current Assets - Cash & Short Term Investments - Accounts Receivable - Merchandise Inventory - Prepaid Expenses Total Current Assets - Trucks & Equipment - Other long term assets (Capital) Total Assets Liabilities Current Liabilities - Accounts Payable - Accrued Liabilities - Income Taxes Payable Total Current Liabilities - Long Term Debt Total Liabilities Shareholder's Equity - Common Shares - Retained Earnings Total shareholder's equity Total liabilities & shareholder's equity 2004 $92,124.00 $65,425.00 $102,335.00 $4,500.00 $264,384.00 $203,654.00 $324,146.00 $792,184.00 2005 $118,256.00 $83,641.00 $93,222.00 $3,100.00 $298,219.00 $183,542.00 $300,000.00 $781,761.00

$65,231.00 $6,895.00 $7,000.00 $79,126.00 $325,000.00 $404,126.00 $265,000.00 $123,058.00 $388,058.00 $792,184.00

$84,521.00 $7,800.00 $3,200.00 $95,521.00 $357,000.00 $452,521.00 $208,000 $121,240.00 $329,240.00 $781,761.00

The area we are interested in is the Current assets & Current liabilities area. Assets Total Current Assets Total Current Liabilities Working Capital Current Ratios $264,384 / $79,126 ............. $298,219 / $95,521 ........... 2004 $264,384.00 $79,126.00 $185,258.00 3.341303743 3.122025523 2005 $298,219.00 $95,521.00 $202,698.00

A high current ratio means the company is in a strong liquidity position and should easily be able to pay its suppliers, short term debts and pay its employees salaries, rent expenses, etc. Sometimes a company can have a very high current ratio, which means they are hoarding cash that could be put to better use such as acquiring value-added investments & companies, equipment or spend on research and development. Since current assets do not generate much additional revenue other than a measly 3% bank interest, an excessive investment in current assets is not preferable for companies. Most investors like to see a ratio of at least 2 to 1, meaning for every $1 of short term current liability, there is $2 of cash available to pay for it. A company with a 2 to 1 ratio is also thought to be of a good credit risk in the short term. The type of business a company is in also plays a large role in maintaining a good current ratio. For instance, a service company that has little or no credit and carries no inventories other than suppliers can easily operate on a 1:1 ratio provided it generates cash in time to make its rent and other fixed cost payments. On the other hand, a company selling high priced clothes, perfumes or furniture store requires a higher current ratio of at least 2:1 because of the uncertainty in customer demand, judgement and the economy. For example, if demand for furniture drops in the economy, the companys inventories will not generate as much cash as expected, which means the current ratio number will be skewed higher because remember, inventories (furniture) are included as current assets. Therefore, banks and creditors as well as investors prefer to have a ratio of at least 2:1 for such companies. Acid Test (Quick) Ratio Part 10.1 - Common Financial & Accounting Ratios and Formulas Part 10.2 - Working Capital & Current Ratio Part 10.3 - Acid Test (Quick) Ratio Part 10.4 - Accounts Receivable Turnover Ratio

The way current assets are structured is important in determining the companys short term ability to pay its debts. For instance, cash, cash and equivalents and temporary investments are more liquid than accounts receivable, notes receivable and merchandise inventory. We know that cash and short term investments can be used to pay off debts, pay suppliers, employees wages, etc. However, merchandise inventory and accounts receivable must be converted in to cash before they are any good to the company. Thus, an excessive amount of receivables and inventory weakens a companys ability to pay its current liabilities. One way to test the strength of a companys current assets is to evaluate the acid-test ratio. The acid-test ratio is also known as the quick ratio and it conducts a more thorough test of a companys ability to pay its short term debts by excluding inventory and prepaid expenses from the calculation. Thus, only quick assets are included in the calculation. The quick assets are cash, cash & equivalents, accounts receivable and notes receivable. Thus, the formula for acid-test ratio is: Acid-test Ratio = (Cash + Temporary Investments + Accounts Receivables) / Current Liabilities

Assets Current Assets - Cash & Short Term Investments - Accounts Receivable Total Quick Assets Total Current Liabilities Acid-test ratio: $157,549 / $79,126 $201,897 / $95,521

2004 $92,124.00 $65,425.00 $157,549.00 $79,126.00 1.991115436

2005 $118,256.00 $83,641.00 $201,897.00 $95,521.00

2.113639933

Notice that the current ratio in 2004 was 3.34 to 1 and it dropped to 1.99 to 1 in the acid-test ratio, a decline of almost 1.34 points which is significant! This is the reason why the acid-test ratio gives us a much more precise outlook of the companys strength in meeting its short term debt obligations and stay afloat as well as have enough cash on hand to operate effectively. A rule of thumb for evaluating the acid-test ratio is that it must be 1:1 and not less than 1. However, investors prefer this ratio to be as high as possible, even about 1.8 to 1. Accounts Receivable Turnover Ratio Part 10.1 - Common Financial & Accounting Ratios and Formulas Part 10.2 - Working Capital & Current Ratio Part 10.3 - Acid Test (Quick) Ratio Part 10.4 - Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio measures how frequently a company converts its receivables in to cash. We know that accounts receivable is a current asset; however it may not be liquid enough if the debtors are in a bad financial position and cannot pay their dues. If this happens, then this means the companys current assets will be grossly overvalued because it is not expecting to collect a majority of its receivables (these will have to be written off from AR). The accounts receivable turnover ratio is calculated as follows: Accounts Receivable Turnover = Net Sales / Average Accounts Receivable The net sales number is derived from the income statement; however a better number to report on the numerator would be Credit sales. However, most companies do not record credit sales, thus this information is not available. In the denominator, the average accounts receivable also includes short-term notes receivables from customers. Average accounts receivable are estimated by averaging the beginning and ending receivable balances for the period. If this data is not available, then an average of quarterly or monthly receivables can be used. Also some companies prefer to simplify things by substituting the ending accounts receivable balance as the average balance, and thus not having to worry about calculating the beginning balance. Juakali Corp. Comparative Income Statement As of December 31st, 2004 Assets Sales Less: Cost of Goods Sold Gross Profit Expenses: - Advertising & Marketing Expense - General & Admin expense - Research & Development - Amortization expense - Loss (gain) on foreign exchange Total Expenses Income from Continuing Operations - Interest Income Less: Interest Expense Income from Continuing Operations before taxes - Income Taxes Net Income

2004 $236,589.00 $56,900.00 $179,689.00 $102,335.00 $21,630.00 $54,550.00 $20,000.00 $6,521.00 $2,000.00 $104,701.00 $74,988.00 $9,750.00 $4,000.00 $80,738.00 $28,000.00 $52,738.00

To calculate the accounts receivable turnover ratio, we need to reference the income statement to derive the Net sales number. Thus, here is the AR turnover ratio calculation: To calculate the accounts receivable turnover ratio, we need to reference the income statement to derive the Net sales number. Thus, here is the AR turnover ratio calculation:

Accounts Receivable Turnover = Net Sales / Average Accounts Receivable Accounts Receivable Turnover = $236,589 / ( ($65,425 + $83,641) / 2) Accounts Receivable Turnover = $236,589 / $74,533 Accounts Receivable Turnover = 3.174

This number means Juakali Corp. collects all its average accounts receivable 3.174 times in a year; the higher this number, the better it is for the company and its investors. A high AR turnover ratio is warranted because this means the company is not having problems collecting its receivables, thus it does not need as many employees for making collection calls and chasing the customers. However to get a true picture of whether this ratio is good, always compare it with how companies within that industry are doing.

Part 7.1 Assets, Liabilities & Shareholder's Equity Introduction - Advantages & Disadvantages of Shareholder's Equity - Taxation & Control Issues, Limited Liability, Capital Accumulation & Transfer of Shares/Ownership Part 7.2 Difference between Private & Public Corporations, Classes of Common Shares & Share Capital Part 7.3 Explanation of Common & Preferred Shares - Par Value & No Par Value Shares, Fundamentals of Share Equity Concepts Part 7.4 Authorized Share Capital, Journal Entries for Issuance of Non Par Value Shares, Journal Entries for Shares Sold on Subscription Basis Part 7.5 Non-Cash Sales of Share Capital, Proportional & Incremental Methods of Share Issuance & Accounting Part 7.6 Costs of Share Issues & Accounting for Retirement of Shares & Corresponding Rules Part 7.7 Conversion of Shares & Accounting for Treasury Stocks - Buying & Selling Treasury Stocks & Its Effects on Shareholder's Equity - Contributed Capital Part 7.8 Explanation of Retained Earnings - Dividends & Dividend Dates & Cash Dividends Recording Journal Entries for Declaration of Dividends Part 7.9 Cumulative Dividends on Preferred Shares - Increases & Decreases of Contributed Capital & Types of Dividends - Stock, Liquidating, Scrip Dividends

Chapter 7.1
Assets, Liabilities & Shareholder's Equity Introduction Advantages & Disadvantages of Shareholder's Equity Taxation & Control Issues, Limited Liability, Capital Accumulation & Transfer of Shares/Ownership

The definition of Shareholder's equity is the difference between the assets and the liabilities of an entity is called Shareholders Equity. The term Equity is a very important meaning in it. The way we describe in a simplest form is there is no asset, no equity. If you remember the accounting equation that we all have studied that Assets Liabilities = Equities. Also, we all know the abbreviation, ALPER, which makes easier to remember the foundation of accounting. ALPER stands for: ALPER stands for: A L P E R = = = = = Assets Liabilities Proprietorship / Equity Expenses Revenue

All the above mentioned are the pillars of the accounting. And equity is among one of them. Advantages & Disadvantages: The corporate entity has advantages and disadvantages as compared to sole proprietor or partnership entities. Now, lets take a look advantages first: Limited Liability In the corporate entity world, every shareholder has a limited liability as per the ratio of shares. In the event of dissolution or insolvency, the shareholders loose their amount invested only. The creditors of the corporation has no authority to challenge the personal assets of the shareholders. But, creditors might ask for personal guarantees against the loans and other financial arrangements from each shareholder or a director. Capital Accumulation The corporate entities may have an option of capital accumulation. In this event, the companies may invest the funds in the large portfolios to maintain the companys cash flows and demands for upgradations as per the needs. Most of the companies invest in the open market and big chip companies so that they can earn good profits which reduces their demand to obtain the loans from the financial institutions. Transfer of Shares / Ownership The share capital can be transferred after following the corporate requirement. This is the most attractive part in the corporate environment where you can transfer your ownership.

Issue of shares A very interesting attitude of the corporate companies is to issue shares to the public where public becomes a part of the management as per the ratio of theor investments. It gives an opportunity to a company to expands their productivity and meet the demand / supply demands. Voting Rights All the shareholders have right to vote. They can select the CEO and directors by doing a voting. This gives every body an independence to select their CEO or directors. Now lets talk about the disadvantages of the corporate forms whereas: Higher Taxation: The corporate entities pay tax on the profits or equity and shareholders pay tax on the dividends which they get from the corporate entity. So, here, if you think, a shareholder is absorbing a burden of double-taxation. However, in the case of private corporation, CCPC (Canadian controlled private corporations, get lower tax rate which is good in compare to the corporate entities. But the private companies have to proof that they qualify for the reduced tax rules. Otherwise, the the combined effect of corporate tax and individual tax will exceed the rate of the tax bracket that would be assessed to the owners of sole proprietors or partnerships. In the event where entity incurs losses, a sole proprietor or a partner may claim those losses which offset with their income. But in corporate world, the losses may be accumulated and carry forward until they are completely utilized. So, in the corporate entities, no immediate tax benefit. Controlling issues This is the hurdle if a large number of shares have been bought by a family or a group. Why is that? The reason is very simple. The more shares of the corporation you possess, more influence you have. So, if the major shares of the company is with a specific group, this will increase the influence of the group of people and will affect the decision of the corporate matters. Financial & Legal Costs: The financial and legal costs are always higher for the corporations in comparing with the partnership and sole proprietorship entities.

Chapter 7.2
Difference between Private & Public Corporations, Classes of Common Shares & Share Capital Federal and provincial Governments control the operations of the corporation. A corporation can be formed either by federally or provincially. There is no difference forming a company under federally or provincially. The businesses can perform their activities within Canada or internationally by incorporating through federally or provincially. Federally incorporated companies can be prestigious if business activities are conducted outside the country. Survey: As per the survey by Financial Reporting in Canada 2000, it has been noted that about half of the 200 Canadian public companies are incorporated federally.

Private Companies: The corporate entities may be private or public. Here are some important characteristics of private companies which are as follows:

be traded publicly. The private companies have a shareholders agreement. The shareholder agreement describes the ways in which a shareholder can transfer the shares as well as other rights and obligations. The shareholder agreement provides first opportunity to acquire any shares offered for sale. The private companies have a limited number of shareholders. The maximum number of shareholders are restricted to 50 by the provincial securities act. The shares cannot

The majority of the corporation in Canada are private. Private companies are highly prominent among even the largest corporations in Canada. As per the survey, by Financial Post, half of the list of the 500 largest companies are private. Although, the private companies cannot trade their securities in the open market. But they do have an access to additional share capital through private placement.

Private Placements: The private placement is a process where the corporation offers shares to an individual or institutional investors. The securities Act in the various provinces stipulates that if an investor invests capital of at least a certain amount, the investor is considered to be a good investor and the issuance of the shares in a private placements are not included in the maximum count of 50 shareholders permitted to a private corporation. Also, the private companies may adopt differential disclosure, with unanimous shareholder consent. Even the shares that are normally non-voting must agree to differential disclosure. The policy can be replaced if the cost is higher than the benefits derived. The policy may be replaced with a more simple alternative.

Public Companies: The public companies can be defined whose securities either debt or equities are traded on stock exchange. These companies may be incorporated under federally or provincially. The public companies follow some statutory requirements by GAAP. They also have a requirements like audits and other interim financial reporting etc.

Share Capital: The share capital is an amount to be invested or proportion invested in the company. Example: Mr. A has invested $100,000 in DDD Company. The DDD company will issue a $100,000 share certificate to Mr. A as a share capital owned by Mr. A The share capital can be transferred to any one without the consent of the corporation in which the investment has been made. Example: Mr. A, now wants to transfer his shares under his wifes name. Mr. A can transfer all or part of his shares under his wifes name without the permission of the corporation. Now, we have some different classes of shares issue to the public. Classes of the Shares: A corporation may be authorized to issue several classes of shares. Following are the important and common classes of shares: Common Shares Preferred Shares

Chapter 7.3
Explanation of Common & Preferred Shares - Par Value & No Par Value Shares, Fundamentals of Share Equity Concepts Common Shares: At least one class of shares has the right to vote, and receives the dividend in the assets if the company is liquidated or dissolved. This class of share normally is described as the Common Shares. The voting rights include the power to vote for the members of the board of directors, who administer the matters of the company. The common shares may be given additional rights in the corporations articles of incorporation. Example: The right to purchase shares on a pro rata, or proportionate, basis cab be awarded to common shareholders. This right is designed to protect the proportionate interest of each shareholder. The common shareholders are entitled to dividends only as declared, and they are at risk if the management of the company chooses to reduce or eliminate a dividend. Preferred Shares: The preferred shares are so designated because they confer certain preferences, or differences, over common shares. Preferred shares are not always titled preferred and may have a variety of names. For example, Class A shares.

The most common feature of the preferred shares is a priority claim on dividends, usually at a stated rate or amount. The dividend rate on preferred shares must be specified, usually as a dollar amount per share, such as $1.20 per share. This preference does not guarantee a dividend but means that, when the board of directors does declare a dividend, preferred shareholders must get their $1.20 preferred dividend before common shareholders receive any dividends. In exchange for the dividend preference, the preferred shareholder often sacrifices voting rights and the right to dividends beyond the stated rate or amount. Some companies issue a class of common shares that has no voting rights or limited voting rights. This type of share is generally called restricted shares or special shares. Example: Samad Khan & Company has two types of common shares, variable voting and limited voting. The limited voting shares have one vote each, while the variable voting shares had in 2007, 23 votes each. Difference Between Par Value & Non-Par Value Shares: Par Value Shares: The Par Value Shares have a designated dollar amount per share, as stated in the articles of incorporation and as printed on the face of the share certificates. Par value shares may be either common or preferred. If the par value shares are sold below the par/ face value, it is called discount. Par value shares sold above the par / face value is called premium. When par value shares are issued at a premium, the par value is assigned to the share account, and any excess to the premium on share capital account, a component of contributed capital. The pat value are usually set very low, and thus a major portion of the proceeds on issuance is classified as the premium. No-Par Shares: These types of shares do not carry a designated or assigned value per share. This allow for all consideration received on sale of the securities to be classified in the share capital account, and it avoids the need to divide the consideration into two essentially artificial components, par value and excess over par. Fundamental of Share Equity Concepts: The fundamental concepts that underlie the accounting and reporting of shareholders equity may be: Separate Legal Entity Sources of Shareholders Equity Contributed capital from Shareholders Retained Earnings Cost based Accounting No impact on Income

Chapter 7.4
Authorized Share Capital, Journal Entries for Issuance of Non Par Value Shares, Journal Entries for Shares Sold on Subscription Basis This represents the maximum number of shares that can be legally issued. In Canada, under the Canada Business Corporation Act, a corporation can issue unlimited number of shares. Also, the corporation may choose to place a limit on authorized shares. This limit must be stated in the articles of incorporation, which can be changed at the later date. EXAMPLE OF SHAREHOLDERS EQUITY SECTION CENTRAL MINARA BANK (In Millions $) Shareholder's Equity 2008 2007 Capital Stock - Preferred $1,047 $1,020 - Common $2,000 $3,000 Retained Earnings $5,032 $4,100 Ending Shareholder's Equity $8,079 $8,120 Accounting For Share Capital at Issuance: If a corporation has more than one class of share, separate accounts should be maintained for each class. If there is only one share class, an account title share capital usually is used. Non-Par Value Shares Issues for Cash: When share are issued, a share specifying the number of shares represented, is prepared for each shareholder.. For example, 1,000 common shares were issued at no-par for cash $10.20 per share would be recorded as follows: December 31st, 2009 Account Name Debit Credit Dr. Cash $10,200 Cr. Common Shares $10,200 To record the issuance of 1000 common no par value shares @ $10.20 each. Explanation: We debited cash by $10,200 (1,000 shares X $10.20) and credited the Common Share account by $10,200. Remember the concept i.e. (Debit and Credit must be equal). Shares Sold on a Subscription Basis Prospective shareholders sign a contract to purchase a specified number of shares on credit. The payment gets due at one or more specified future dates. These contractual agreements are known as stock subscriptions, and shares involved are called subscribed share capital. The shares are not typically issued until the entire subscription amount is received. Lets assume that 1,200 no-par common shares are subscribed for at $10 by Mr. A.

December 31st, 2009 Account Name Debit Credit Dr. Stock Subscription $12,000 Receivable Cr. Common Shares $12,000 To record the issuance of 1200 common shares @ $10.20 each (on a subscription basis). The receivable will be paid in four $3,000 instalments. Now, assume that after the 4th instalment has been paid and the entry of which will be as: December 31st, 2010 Account Name Dr. Cash

Debit $12,000

Credit

Cr. Stock Subscription $12,000 Receivable To record the collection of cash for 1200 shares sold on a subscription basis. Payment Not Received: If a subscriber unable to pay the remaining instalments, some problems may arise. In this scenario, the corporation has to decide whether; 1) return all payment to the subscriber; 2) issue the shares for payment already received; or 3) keep the all payment The above two options are in favor to the subscriber where no loss is falling on the shoulders of the subscriber. But on the other hand, option three has disadvantages where corporation is keeping all the money and paying no consideration. The third option is not generally enforceable.

Chapter 7.5
Non-Cash Sales of Share Capital, Proportional & Incremental Methods of Share Issuance & Accounting If a corporation issues shares for non-cash assets or services or to settle debt, the transaction should be recorded at fair value. But keeping in mind that that there are two fair values present, the fair value of the asset received and the fair value of the shares issued. Now, you will think, which one we should use? The answer is the cost assigned to asset received is the fair value of the consideration given.

Example: Salees Corporation privately placed 150,000 preferred shares and 500,000 common shares, primarily in exchange for real estate. Suppose the value of the land was $620,000 assessed. And the value of shares were assessed as $650,000. January 1st, 2009 Account Name Debit Credit Dr. Land $620,000 Cr. Capital Stock $620,000 Entry to record acquistion of land worth $620k in exchange for issuance of Capital stock. Basket Sale of Share Capital: When a corporation sells more than one class of shares for one lump-sum amount is called basket sale. In addition, a corporation may issue two or more classes of its share capital in exchange for non-cash consideration. When two or more classes of securities are sold and issued for a single lump sum, the total proceeds must be allocated logically among the several classes of securities. Two method are used in such scenarios: 1) the Proportional Method 2) the Incremental Method In the proportional method, the lump sum received is allocated proportionately among the classes of shares on the basis of the relative market value of each security. In the incremental method, the market value of one security is used as basis for that security and the remainder of the lump sum is allocated to the 0ther class of security. If there is no market value for any of the issued securities, proceed may be allocated arbitrarily. Examples: A) Proportional Method: The common shares were selling at $40 per share and the preferred at $20. Assume the total cash received is $48,000. Because reliable market values are available for both share classes, the proportional method is preferable as a basis for allocating the lump-sum amount as follows:

Proportional Allocation Market value of common (1,000 shares X $40) Market value of preferred (500 shares X $20) Total Market Value Allocation of the lump-sum sale price of $48,000 Common ($48,000 X 4/5) Preferred ($48,000 X 1/5) Total January 1st, 2009 Account Name Dr. Cash

$40,000 = 4/5 of total 10,000 = 1/5 $50,000 = 5/5

$38,400 $9,600 $48,000

Debit $48,000

Credit

Cr. No-Par Common Shares (1000 shares) $38,400 Cr. No-Par Preferred Shares (500 shares) $9,600 To record the issuance of 1000 common shares at $38,400 & 500 preferred shares at $9,600 B) Incremental Method The common shares were selling at $40; a market for the preferred has not been established. Because there is no market for the preferred shares, the market value of the common ($40,000) must be used as a basis for the following entry: January 1st, 2009 Account Name Debit Credit Dr. Cash $48,000 Cr. No-Par Common Shares (1000 shares) $40,000 Cr. No-Par Preferred Shares (500 shares) $8,000 To record the issuance of 1000 common shares at $40,000 & 500 preferred shares at $8,000 Arbitrary Allocation: When there is no established market for either class of shares, neither the proportional method nor the incremental method of allocation can be used. In this case, an arbitrary allocation is used. In the absence of any other any other logical basis, a temporary allocation may be made by the board of directors. If a market value is established for one of the securities in the near future, a correcting entry based on such value would be made. When the issue involves only a mix of equity, the arbitrariness of an allocation does not really matter; the classification of the proceeds between different classes of shares does not affect anyones rights or interests.

Chapter 7.6
Costs of Share Issues & Accounting for Retirement of Shares & Corresponding Rules Share Issue Costs: The expenditures include registration fees, underwriter commissions, legal and accounting fees, printing costs, clerical costs and promotional costs are called Shares issue Costs. Two methods of accounting for share issue costs are found in practice: 1) Offset method 2) Retained Earnings Method Both methods are found in practice. Retirement of Shares: Some preferred shares are retractable, which means that, at the option of the shareholder, and at a contractually arranged price, a company is required to buy back its shares. Other preferred shares are callable, or redeemable, which means that there are specific buy-back provisions, at the option of the company. In these transactions, the company deals directly with the shareholder. However, a company can buy back any of its shares, preferred or common, at any time, if they are offered for sales. Such a sales can be a private transaction, or a public transaction. Reasons for Shares Retirement: - Increase Earning Per Share - Provide cash flow to shareholders in lieu of dividends - Acquire shares when they appear to be undervalued - Buy out one or more particular shareholders and to thwart takeover bids - Reduce future dividends payments by reducing the shares outstanding Retirement Accounting Rules: When shares are purchased and immediately retired, all capital items relating to the specific shares are removed from the accounts. If cumulative preferred shares are retired and there are dividends in arrears, such dividends are paid and charged to retained earnings in the normal manner. Where the reacquisition cost of the acquired shares is different from the average original issuance price, the cost be allocated as follows for non-par shares: When the reacquisition cost is lower than the average price per share issued to date, the cost should be charged; a) first, to share capital, at the average price per issued share; and then b) any remaining amount, to a separate contributed capital account.

 When the reacquisition cost is higher than the average price per share issued to date, the cost should be charged in this sequence: a) first, to share capital, at the average price per issued share; b) second, to any contributed capital that was created by earlier cancellation or resale transactions in the same class of shares; and then c) any remaining amount, to retained earnings. Example: Lets assume that Fresco has 200,000 no-par common shares outstanding, and that there is $1 million in the common share account, which yields an average issuance price per share of $5. The contributed capital account from previous retirement transactions of common shares has a $7,200 credit balance. The corporation acquired and retired 10,000 shares at a price of $6.25 per share. The shareholder who sold these shares back to Fresco had originally paid $4 per share. The transaction would be recorded as: January 10th, 2009 Account Name Dr. Common Shares ([{$1,000,000 / $200,000} X 10,000 shares Dr. Contributed capital, common share retirement Dr. Retained earnings ($62,500 - $50,000 - $7,200) Cr. Cash (10,000 X $6.25)

Debit $50,000

Credit

$7,200 $5,300 $62,500

The first step in constructing this journal entry is to compare the cost to retire the shares ($62,500) with the average initial issuance price to date ($50,000). The specific issue price of these shares ($4) is irrelevant. The corporation paid $12,500 more to retire these shares than the average original proceeds. The $12,500 is debited first to contributed capital from prior share retirements until that account is exhausted. This account may never have a debit balance. Retained earnings is debited for the balance. The effect of this transaction is to reduce paid-in capital by $57,200, retained earnings by $5,300 and total shareholders equity by $62,500. Assets are reduced by $62,500.

If the shares were reacquired for $4.25 per share, the entry to record the transaction would be: January 10th, 2009 Account Name Dr. Common Shares [($1,000,000 / 200,000) X 10,000 Cr. Contributed capital, common share retirement ($50,000 - $42,500) Cr. Cash (10,000 X $4.25)

Debit $50,000

Credit

$7,500

$42,500

Chapter 7.7
Conversion of Shares & Accounting for Treasury Stocks - Buying & Selling Treasury Stocks & Its Effects on Shareholder's Equity - Contributed Capital Shares of any class may include the provision that they may be converted, at particular times and /or in particular quantities, into shares of another class. Example: Preferred shares may be convertible into common shares. Conversions are accounted for at book value, with an equal decrease to one share class and increase to another. If 20,000 preferred shares, issued for an average of $36.70 per share, were to convert per the terms of their share certificates to 60,000 common shares (that is, 3-for-1): January 1st, 2009 Account Name Dr. Preferred shares (20,000 X $36.70)

Debit $734,000

Credit

Cr. Common Shares $734,000 Entry to record conversion of 20,000 preferred shares to common shares @ $36.70 per share. Treasury Stocks: A firm may also buy its own shares and hold them for eventual resale. These shares are called treasury stocks. Accounting for the Treasury Stocks: When a company buys treasury stocks, the cost of the shares acquired is debited to a treasury stock account which appears a deduction at the end of the shareholders equity section. When the shares are resold, the treasury stock account is credited for the cost, and the difference, which is the gain or loss, affects various equity accounts. The gain or loss is not reported on the income statements. A firm cannot improve reported earnings by engaging in capital transactions with their own shareholders. The balance in the treasury stock account is logically shown as a deduction from the total of shareholders equity.

Accounting Method: This method of accounting for treasury stock is called the single-transaction method. The treatment is the same as that used for share retirement. An example will illustrate the sequence of entries. a) Record initial sale and Issuance of 10,000 Common Shares at $26 per share June 30th, 2009 Account Name Dr. Cash (10,000 shares X $26)

Debit $260,000

Credit

Cr. Common shares $260,000 (10,000 shares) Entry to record the initial sale and issuance of 10,000 common shares at $26 per share b) Record the acquisition of 2,000 common treasury shares at $28 per share June 30th, 2009 Account Name Debit Credit Dr. Treasury stock, common $56,000 (2,000 shares X $28) Cr. Cash $56,000 Entry to record the acquisition of 2,000 common treasury shares at $28 per share Note: The cash price paid is always the amount debited to the treasury stock account. c) Record sale of 500 treasury shares at $30 per share (above cost) June 30th, 2009 Account Name Dr. Cash (500 shares X $30)

Debit $15,000

Credit

Cr. Treasury stock, common $14,000 (500 shares at cost, $28) Cr. Contributed capital from $1,000 Treasury stock transaction Entry to record sale of 500 treasury shares at $30 per share (above cost) Note: Had this sale been at cost ($28 per share), no amount would have been entered in the contributed capital account. If treasury shares are bought in a series of acquisitions at different prices, weighted average cost is used on disposition.

d) Record the sale of another 500 treasury shares at $19 per share (below cost) June 30th, 2009 Account Name Debit Credit Dr. Cash $9,500 (500 shares X $19) Dr. Contributed Capital from $1,000 treasury stock transactions Dr. Retained Earnings $3,500 Cr. Treasury stock, common $14,000 (500 shares at cost, $28) Entry to record the sale of another 500 treasury shares at $19 per share (below cost) Assuming entries (1) through (4) above, and a beginning balance in retained earnings of $40,000, the balance sheet would reflect the following: Shareholders Equity -- Contributed capital Common shares, 10,000 shares issued, $260,000 of which 1,000 are held as treasury stock Retained earnings ($40,000 - $3,500) $36,500 Total contributed capital and retained earnings $296,500 Less: Treasury stock, 1,000 shares at cost $28,000 $268,500 Total shareholders equity

Chapter 7.8
Explanation of Retained Earnings - Dividends & Dividend Dates & Cash Dividends Recording Journal Entries for Declaration of Dividends Retained earnings represent accumulated net income or net loss (including all gains and losses), error corrections, and retroactive changes in accounting policy, if any, less accumulated cash dividends, property dividends, stock dividends, and other amounts transferred to contributed capital accounts. If the accumulated losses and distributions of retained earnings exceed the accumulated gains, a deficit will exist. Decrease (Debits) - Net loss - Error correction - Effect of a change in accounting policy - Cash and other dividends - Stock dividends - Share retirement and treasury stock transactions - Share issue costs

Increase (Credits) - Net Income - Removal of deficit in a financial reorganization - Unrealized appreciation of investments valued at market Reporting Retained Earning: The statement of retained earnings may include the following: - beginning balance of retained earnings - restatement of beginning balance for error corrections - restatement of beginning balance for retroactively applied accounting changes - net income or loss for the period - dividends declared for the period - appropriations and restrictions - adjustments made pursuant to a financial reorganization - adjustment s resulting from some share retirements - ending balance of retained earnings Dividends: Nature of Dividends: A dividend is a distribution of earnings to shareholders in the form of assets or shares. Relevant Dividend Dates: Prior to payment, dividends must be formally declared by the board of directors of the corporation. Subsequent to the declaration date, there are three other dates relating to dividends that are important for the investing community. Date of Declaration: On the declaration date, the corporations board of directors formally announces the dividend declaration. Date of Record: The date of the record is the date on which the list of shareholders of record is prepared. EX-Dividend Date: The Ex-dividend date is the day following the date of record. Date of Payment: The date of payment follows the declaration date by four to six weeks. Legality of Dividends: The requirement that there be retained earnings or certain elements of contributed capital before dividends can be declared.

- Dividends may not be paid from legal capital - Retained earnings available for dividends unless there is a contractual or statutory restriction. Cash Dividend: Cash dividends are the usual form of distributions to shareholders. Before a cash dividend can be paid to common shareholders, appropriate preference dividends, if any, must be paid. Example: Lets assume that the board of directors of BA company, at its meeting on January 2009, declared a dividend of $0.50 per common share, payable 20 March 2009, to shareholders of record on 1 March 2009. We assume that 10,000 no-par common shares are outstanding. January 31st, 2009 Account Name Dr. Retained earnings * - 10,000 shares X $0.50 Debit $5,000 Credit

Cr. Cash dividend payable $5,000 Entry to record payable of dividends on March 20th, 2009 at $0.50 per common share. * Or cash dividends declared, which is later closed to retained earnings. January 31st, 2009 Account Name Debit Dr. Cash Dividend Payable $5,000 Cr. Cash Entry to record actual payment of cash dividends declared on March 1st, 2009 to shareholders.

Credit $5,000

The cash dividends payable is reported on the balance sheet as a current liability if the duration of the dividend liability is current; otherwise it is a long-term liability.

Chapter 7.9
Cumulative Dividends on Preferred Shares - Increases & Decreases of Contributed Capital & Types of Dividends - Stock, Liquidating, Scrip Dividends Cumulative preferred shares provide that dividends not declared in a given year accumulate at the specified rate on such shares. This accumulated amount must be paid in full if and when dividends are declared in a later year before any dividends can be paid on the common. If the cumulative preference dividends are not declared in a given year, they are said to have been passed and are called dividends in arrears on the cumulative preferred shares.

Participating Dividends on Preferred Shares: Participating preferred shares provide that the preferred shareholders participate above the stated preferential rate on a pro rata basis in dividend declarations with the common shareholders. First, preferred shareholders receive their preference rate. Second, the common shareholders receive a specified matching dividend. Then, if the total declared dividend is larger than these two amounts, the excess id divided on a pro rata basis between the two share classes. Shares may be partially participating or fully participating. If partially participating, preferred shares may participate in dividend declaration in excess of their preference rate, but the participation is capped at a certain level. Property Dividends & Spin-Offs: Corporations occasionally pay dividends with non-cash assets. Such dividends are called property dividends or dividends in kind. Liquidating Dividends: Liquidating dividends are distributions that are a return of the amount received when shares were issued, rather than assets acquired through earnings. Liquidating dividends are appropriate when there is no intention or opportunity to conserve resources for asset replacement. Scrip Dividend: A corporation that has a temporary cash shortage might declare a dividend to maintain a continuing dividend policy by issuing a scrip dividend. A scrip dividend (also called a liability dividend) occurs when the board of directors declares a dividend and issues promissory notes, called scrips, to the shareholders. Stock Dividends: A stock dividend is proportional distribution to shareholders of additional common or preferred shares of the corporation. A stock dividend does not change the assets, liabilities, or total shareholders equity of the issuing corporation. It does not change the proportionate ownership of any shareholder. It simply increase the number if shares outstanding. Special Stock Dividends: A special stock dividend is a dividend in a share class different from the class held by the recipients, such as a stock dividend consisting of preferred shares issued to common shareholders. In this case the market value of the dividend should be capitalized. Stock Splits A stock split is a change in the number of shares outstanding with no change in the recorded capital accounts. A stock split usually increases the number of shares outstanding by a significant amount, such as doubling or tripling the number of outstanding shares. In contrast reverse sock split decreases the number of shares. It results in a proportional reduction in the number of shares issued and outstanding and an increase in the average book value per share.

Additional Contributed Capital: Transactions that may change additional contributed capital are: Increase: - receipt of donated assets - retirement of shares at a price less than average issue price to date - issue of par value shares at a price or assigned value higher than par - treasury stocks transactions, shares reissued above cost Decrease: - retirement of shares at a price greater than average issue price to date, when previous contributed capital has been recorded - treasury stock transactions, shares issued below cost, when previous contributed capital has been recorded - financial restructuring

 Part 11.1 Summary of Qualitative Characteristics of GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) Part 11.2 How and When to Recognize Revenues & Expenses in Accrual Accounting Part 11.3 Functions in the Purchasing Process and how to Segregate Purchasing Duties Part 11.4 Three Steps to Determining and Applying Materiality Part 11.5 Assertions of Management about Economic Events in the Business Part 11.6 Bank Accounting - Types of Bank Accounts, Cash Receipts & Disbursements, Disclosures Required for Cash Accounting Part 11.7 Objectives of Internal Controls set by Management Part 11.8 How to Test Internal Controls of an Organization Part 11.9 Positive Accounting Theory (PAT) Part 11.11 Accounting Information - Complex Commodity & Information Asymmetry

Part 11.1
Summary of Qualitative Characteristics of GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) Understandability a basic level of understandability is assumed to assist both the preparer and users of financial information Relevance if information has the ability to make a difference in a decision scenario, it is relevant predictive value: Help prevent financial impact of past, present and future event. Feedback value Helps confirm or correct minor expectations Reliability information is reliable if it can be depended upon verifiable representational faithfulness neutral conservative Comparability when different firms use the same accounting principles Consistency

 when firms use the same account principles and methods from year to year Economic (Business) Entity Concept personal transactions of owners/shareholders recorded separately from business entity's transactions economic entity not necessarily legal entity Objectivity (Reliability) accounting information must be capable of third party verification free from bias supported by evidence (source documents) Historical Cost (Cost Principle) assets and services acquired are recorded at original cost, and not subsequently changed to market/appraised value (value upwards). Going Concern Assumption assumes a business will continue as a viable operations indefinitely financial statements are prepared on assumptions that company will expect in the foreseeable future. Monetary Unit Principle monetary unit is stable; transaction is as recorded, not adjusted for inflation. Time Period (Periodicity) life of a business entity can be broken up into distinctive periods (years, months, quarters) and report financial performance by period Matching Principles expenses are incurred to generate revenue and these expenses must be matched with the revenue earned in the same period. Revenue Realization (Revenue Recognition) Principle revenue is recognized as earned when a product sold or a service is provided Not contingent on when cash is received. Full Disclosure Principles all relevant facts useful to interpreting financial statements must be disclosed (either in notes or body of statement). Consistency Principle accounting practices and methods should be consistent from year to year this assists in making comparisons, trend analysis, and forecasts if change is necessary, the impact of the change must be shown on all statement. Conservatism when two or more accounting alternatives are equally acceptable, the one with the least favorable impact on assets and income is chosen.

Materiality involves professional judgment refers to the significance of an omission if not significant, no adjustment required if you mess out, it's not material Benefit/Cost Relationships cost must be compared to benefits to determine desirability of producing information easier to quantify costs vs benefit. Unit of Measure All information is expressed in $ (or medium of exchange).

Part 11.2
How and When to Recognize Revenues & Expenses in Accrual Accounting What is Information? It is a COMPLEX commodity Investors are demanders/managers the suppliers Should we let the rules of supply and demand determine the amount of information provided (no regulation)? Should there be regulation to protect investors as market forces fail to ensure investors have adequate information? Currently, we have regulation= standard setting But how much regulation is required? How much is too much?

Information impacts not only individual decision making but the efficiency of the market Currently we report most assets and liabilities at historical but there has been movement
towards more market values- therefore we have a mixed measurement system. Investors prefer current values as they are more relevant- they provide the best available indication of future firm performance and investment returns. Management prefers not to include unrealized gain/ losses as it increases volatilityand they do not believe this reflect their performance

So as accountants our role is to manage the expectations of many parties- and to have a
critical awareness of the impact of financial reporting on investors, managers and the economy. We need to design and implement concepts and standards that best trade off the investor informing and manager performance evaluating roles for accounting information Information Asymmetry When one party has an information advantage over another. 1. Adverse Selection where by one or more parties have an info advantage over others

 Occurs because insider of the firm (Managers) know more about the current condition and future prospect of the firm than investors They can exploit this advantage by managing the info released to investors often to increase/maintain the value of the stock options they hold i.e. Enron management were selling their stock and telling employees to hold on to theirs..... Called Adverse as it reduces an investors ability to make good investment decisions and impairs the functioning of Capital markets Example: Insider Trading i.e. Martha Stewart- her friend Sam Walker from Imclone knew that an important cancer drug was rejected by the FDA- this was a huge blow to Imclone and once announced it was expected the share price would drop- Martha wasnt hurt by the decline because she sold her shares before the info became public....therefore information asymmetry!

No-Trades by insiders can be legal if reported to the securities exchange commissions

within a predetermined time frame. This way if it is reported to the public, it can be interpreted as a signal Studies show that the buying and selling by insiders is valuable information. When an insider buys or sells, they may know something the public doesnt generally when an exec purchases the co. shares, the co. outperforms the market by approx. 10% over a 12 month period. Conversely when execs sold, co. performed 5-6% below market. 2. Moral Hazard Where one or more parties observe their actions but other parties cannot Caused by separation of ownership/ control Consider, if there were no exams, how hard would you study? How would instructor be able to evaluate effort? This is very popular in insurance industry. If car insurance covered 100% of your car- with no cost to you- what would stop you from not leaving it running with the doors open? If you dont suffer any consequences- why mitigate any loss--- this is why there is a deductible= moral hazard I.e. how do shareholders know management is working hard on their behalf since they cannot observe their behaviour on a day to day basis? Management net income, like insurance deductables, is usually considered a measure of management performance to control moral hazard- first net income is usually used as an input to management compensation contracts and second it can inform the labour market if a manager shirks and he/ she will suffer a loss on income/ reputation.

Clarification: Is all Insider Trading illegal?

Part 11.3
Functions in the Purchasing Process and how to Segregate Purchasing Duties 1) Requisition An authorized individual makes a request for the required good/Service within his/her authorization limit via a purchase requisition

 Each company should have a policy, which requires different levels of authorization for different dollar values of purchases (higher dollar purchases should require higher level of approval). 2) Purchasing Purchases are coordinated through the purchasing department to ensure goods are acquired in the right quantities at the lowest possible prices and documented on the Purchase order 3) Receiving Responsible for receiving counting and inspecting goods from venders as documented on the receiving report 4) Invoice Processing AP department processes the invoices by recording the asset/expense/ liability- A/P obligations are recorded when the purchaser receives the goods or services ordered. This department matches the PO to the receiving reports to the invoices for terms, quantities, prices and extensions Disbursements- responsible for preparing and signing cheques to vendors Cheques are signed by a person authorized by management or the board of directors Generally dual signatures on cheques over a certain amount are required Vouchers should be stamped paid so they are not paid twice General Ledger- ensure all purchases, cash disbursements, and payables are properly accumulated/classified in the f/s accounts Segregation of Duties Segregationneed to separate custody of assets, authorization and recordkeeping of assets (C.A.R. principle) Key Segregation of Duties in the Purchasing Process 1) Purchasing function should be segregated from requisition and receiving functions Possible error: fictitious or unauthorized purchases may be made resulting in theft of goods and payment for unauthorized purchases 2) Invoice Processing should be segregated from the AP function Possible error: Purchase transactions can be processed at the wrong price/term or payments made for items not received- so overpayment of goods and theft of cash 3) Disbursement function should be segregated from the AP function Possible error: unauthorized cheques supported by fictitious documents may be issued and unauthorized transactions recorded 4) AP function should be segregated from the GL function Possible error: concealment of defalcation which would be detected during the reconciliation of the subsidiary ledger to the GL control account.

Part 11.5
Assertions of Management about Economic Events in the Business

Three Steps to Determining and Applying Materiality

What is Materiality? Materiality is an amount that makes a difference to the users- an audit never provides 100% assurance- only reasonable assurance." For instance, if a company has overstated its revenues by $5million when its total revenues are $4 billion, then this $5 million is considered 'immaterial.' However, if the company's total revenues are only $50 million, then this $5 million overstatement is considered 'Material." 1) Determine a base and calculate a number. MATERIALITY GUIDELINES: 5% of income from continuing operations (normalized) 5% of net income before bonus, to 2% of revenues or expenses for non-for profit entities, to 1% of net asset value for the mutual fund industry, or 1% of revenue for the real estate industry. Note: Materiality is a matter of Professional Judgement so: When profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as gross profit or total revenues but for most for profit enterprises, income from continuing operations is the most appropriate. Once a preliminary figure is calculated- then consider qualitative items i.e. Misstatements due to fraud/ illegal acts Amounts that may violate contractual covenants Amounts that may affect earnings trends Misstatements that may increase management compensation Amounts that may result in an entity missing its forecast Industry conditions Past number of misstatements 2) During the audit, auditors track the misstatements on the SUE- Summary of Unadjusted Errors 3) Estimate the likely misstatement and compare the total to the preliminary materiality. If the estimate misstatement is less than materiality- then the auditor can generally conclude the financial statements are fairly presented. If the estimate is greater than materiality then the adjustments should be recorded by the client- if the client refuses then the auditor cannot issue a clean audit report Unadjusted amounts from prior years should be carried forward in assessing the misstatement

Preliminary materiality may be revised if the auditor feels it is necessary due to information obtained during the audit

Materiality Allocation auditors generally assign a lower level of materiality to each account balance in performing their audit procedures rationale is that several errors could exist within the account that together would result in a material misstatement to the financial statements may also use a lower level of materiality for testing balances that have a higher risk of misstatement (results in more testing) there are a variety of methods used to do this i.e. may say tolerable error for account balances is 10% of materiality.

Part 11.5
Assertions of Management about Economic Events in the Business Management is responsible for preparing the financial statements of the organization. Each journal entry & transaction recorded in the books has at least 1 of these assertions applied. The 5 major assertions can be shortened to ECOVP - Existence, Completeness, Ownership, Valuation, Presentation and Disclosure. Below are managements assertions about economic actions and events

Existence or Occurrence used to establish that assets, liabilities and equities actually exist
and that revenue and expense transactions actually occurred. Occurence refers to controls surrounding the purchase/sale of any investment must be properly initiated by an authorized individual. Here are some important points to consider: Adequate documentation must support the purchase/sale of each security to ensure the process was properly initiated and approved Commitment of resources to investment activities should be approved by the board of directors or by an executive with board-designated authority Board of directors should establish general policies to guide the entitys investment activities Completeness all transactions and accounts that should be presented in financial reports are included. Completeness refers to adequate controls should exist to ensure that all securities transactions are recorded. Securities ledger should be maintained to record all securities owned by the client ?this sub ledger should be reconciled to the general ledger periodically Regular review procedures should exist to ensure that all dividends and interest earned on investments are recorded regularly by the entitys records Accuracy all account balances have been recorded correctly. Accuracy refers to 3 types of investment holdings that must be accurately recorded in the books. Held to Maturity Securities the entity has the positive intent and ability to hold the investment to maturityreported at amortized cost Held for Trading Securities debt and equity securities that are bought and held for the purpose of selling them in the near termreported at fair value with unrealized gains and losses reported in earnings.

Management Assertions

 Available for Sale Securities debt or equity securities not classified as either of the above, reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders equity called other comprehensive income Cutoff all transactions should be recorded in proper period (purchases, revenue accruals etc) Ownership (rights and obligations) amounts reported as assets of the company represent property rights and amounts reported as liabilities reflect its actual obligations. Valuation ensuring proper application of GAAP especially with respect to assets/ Accuracyused to establish evidence that transactions for all account balances have been recorded correctly in financial records. Presentation and Disclosureensuring accounting principles are properly selected to reflect economic nature of the transactions and applied and whether note disclosures are adequate. Cutoff all transactions recorded in proper period Classification transactions are recorded in the correct accounts. Management Assertions fall into 3 Categories: 1) Classes of Transaction and events for the period under audit (Income Statement) Occurrence, Completeness, Accuracy, Cut Off, Classification 2) Assertions about account balances at the end of the period (Balance Sheet) Existence, Rights and Obligations, Completeness, Valuation and Allocation 3) Assertions about Presentation and disclosure Occurrence and rights and obligations, completeness, classification and understandability, accuracy and valuation

Part 11.6
Bank Accounting - Types of Bank Accounts, Cash Receipts & Disbursements, Disclosures Required for Cash Accounting

Bank account involves accounting for cash transactions including organization-wide cash
receipts, cash disbursements, payroll disbursements, vendor payments, rent payments, employee salary payments, etc. Cash refers to: Currency on hand Cash on deposit in bank accounts (including certificates of deposit, time deposits and savings accounts) May also include cash equivalents, which are short-term, highly liquid investments that are readily convertible into cash or are so close to maturity that there is little risk of change in their value (e.x. T-bills, commercial paper, money market funds, may also include demand loans)

Virtually all accounting transactions that flow through the organization pass through the cash
account Sources of Cash (Cash Receipts) Cash receipts from the sale of goods/services Sale of property, plant and equipment

Why is Cash Critical to Accounting?

 Proceeds from issuing long-term debt or capital stock Uses of Cash (Cash Disbursements) Purchasing inventory and supplies Payment of payroll expenses Purchase of property, plant and equipment Payment on long-term debt and repurchase of stock Types of Bank Accounts 1) General cash accounts principal cash account used by the organization for cash receipts from the revenue process and cash disbursements from the payroll and purchasing processes 2) Imprest cash accounts contains a stipulated amount of money and the account is used for limited purposes (for example disbursing payroll and dividend cheques). When used for payroll, the total amount of the net payroll is drawn from the general account and then the individual cheques are drawn from the imprest cash account. The payroll account serves as a clearing account and maintains adequate control over cash). 3) Branch accounts used by companies with branches in multiple locations. Each branch is able to pay local expenses and maintain a banking relationship in the local community. May be in the form of an imprest account with designated amounts transferred based on cash reports submitted to headquarters. Disclosures required for Cash Accounting Accounting policy for defining cash and cash equivalents Restrictions on cash (funds allocated for a specific purpose by the board of directors) Contractual obligations to maintain compensating balances (debt covenant restrictions) Cash balances restricted by foreign exchange controls Letters of credit Restriction on the use of specific funds of cash for NPOs

Part 11.7
Objectives of Internal Controls set by Management Internal controls are a systems capability to prevent or detect material data processing errors or fraud and provide for correction on a timely basis. Common internal controls include segregation of accounting & operations duties, two signatures on every check, 2 approvals on any recquisitions, etc. The objectives of Internal controls are as follows: 1) Optimize use of Company Resources Prevent unnecessary duplication and waste Possible conflict between safeguarding of assets and providing reliable information and optimizing use of resources 2) Prevent and detecting error and fraud 3) Safeguard company's assets

 Adequate controls necessary to prevent theft, misuse or accidents

4) Maintain reliable control systems Necessary to produce accurate information to carry out operations Information must be timely and reliable More specifically Management needs to ensure the following: 1) Validity recorded transactions are valid and documented (purchases are supported by purchase orders, receiving documents, and invoices) 2) Completeness all valid transactions are recorded and none are omitted (all receiving documents are matched to purchase orders) 3) Authorization transactions are authorized according to company policy (purchases greater than $500 must be signed off by department head) 4) Accuracy transaction dollar amounts are properly calculated (receipts of inventory are correctly recorded in the accounting system) 5) Classification transactions are properly classified in accounts (purchases of assets are correctly capitalized and amortized, purchases of inventory are correctly recorded as inventory) 6) Accounting transaction accounting is complete (all purchase orders are captured in the system, are matched to receiving documents and invoices as the goods are received) 7) Proper period transactions are recorded in the proper period (goods that have been received and there is no invoice yet received are accrued for at year end) 5 Components of Internal Control 1. Control Environment Management Philosophy and Operating Style BoD, Audit Committee independent, level of involvement Organizational Structure reporting relationships Management Control Methods ability to delegate, supervise, overall budgets, performance evaluation system Assigning of authority and responsibility conflicts of interest Systems development methodology, update of computer files/programs Personnel policies hiring, terminations, training, performance evaluation, compensation Internal audit 2. Entitys Risk Assessment Process How management identifies and responds to risks Should consider internal and external events and circumstances, their significance, likelihood of occurrence, and how they should be managed Risks can arise or change due to the following: Changes in the operating environment i.e. increased competition New personnel New info systems New Technology Rapid Growth New business products/activities

 Corporate Restructuring International Operations New Accounting Pronouncements 3. Information and Communication Must consider the info system relevant to financial reporting how does the system ensure all transactions are recorded (completeness) valid, accurate and timely with all appropriate disclosures Need to understand how and when all information is captured for both regular and unusual transactions Consider extent of IT and E-Commerce 4. Control Procedures Policies and procedures are required- this ensures people know what they are supposed to do, when and how. Information processing controls are general (controls over the data centre/ server) and application controls (processing of individual transactions) Physical controls- security over assets Segregation of duties- must segregate CAR (Custody/ Authorization/ Recording) 5. Monitoring Controls Assesses the quality of internal controls over time Take corrective action as required

Part 11.8
How to Test Internal Controls of an Organization What are Testing Procedures of Internal Controls for Organizations? Procedures designed to evaluate the effectiveness of the design and operation of internal controls Auditor assesses whether the control has been properly designed to prevent or detect a material misstatement in the financial statements Auditor then assesses the operational effectiveness of the control, which determines whether the control is applied consistently through the period and by whom is it applied Examples of tests of controls: Inspecting documents/reports for evidence the control has been performed. Example: HR manager signs the payroll as evidence of her/his review before the payroll is finalized and the cheques are issued. Observation of the application of specific controls. Example: auditor observes the cashier perform sales transactions and notes that the cash register will not open unless a sale has occurred. Walkthroughs tracing a transaction from its point of origin to its inclusion in the financial statements. Involves several audit procedures: enquiry, observation, inspection.

Example: the purchase of a capital asset is traced from the purchase order to the inclusion on the financial statements, ensuring required approvals, categorization of asset, and amortization policies are applied. Reperformance of the application of the control by the auditor test ensures the integrity of the control. Example: recalculating the sales commissions paid on a sample of sales transactions. Substantive Tests Two Key Categories of Substantive Tests: Substantive Tests of Transactions test for fraud or errors in individual transactions. Provides evidence on occurrence, completeness and accuracy assertions. Tests of Account Balances establish whether there are any material misstatements in accounts or disclosures included in the financial statements by concentrating on the details in an account balance. Example sending A/R confirmations to specific customers in the A/R listing to confirm the amounts outstanding. Substantive Analytical Procedures Substantive analytical procedures include evaluating financial information made by studying plausible relations among financial and non-financial data. Requires knowledge of clients business and industry Key procedures used include: Trend analysis examines changes in an account balance over time. Example: compare current year budgeted insurance expense to current year actual insurance expense. Ratio analysis compares balances either across time or to a benchmark, of relationship between financial statement accounts or between an account and non-financial data. Example: compare current year inventory turnover to prior year inventory turnover. Reasonableness analysis develops a model to form an expectation using financial data, non-financial data or both to test account balances or changes in account balances. Example: calculate average purchase price *number of units sold to estimate cost of goods sold. Purposes of Analytical Procedures: 1) To assist auditor in planning the nature, timing and extent of other audit procedures 2) As a substantive test to obtain evidence about particular assertions Steps: a) Develop an expectations b) Define an acceptable difference based on significance of the account, degree of reliance on the procedure, level of potential disaggregation in the amount being tested and precision of the expectation c) Compare expectation to actual recorded amount d) Investigate differences greater than acceptable difference threshold

1) 2) 3) 4)

Quantify portion of the difference that can be explained Corroborate explanations of unexpected difference by substantiating the information supporting the explanation is reliable Evaluation using professional skepticism If the desired level of assurance is not obtained from the procedure, perform additional test of details or substantive analytical tests to achieve the required assurance levels

3) As an overall review of the financial statements in the final review stage of the audit Dual-Purpose Tests Include both tests of controls, which assess errors in the design and application of controls, and substantive tests of transactions, which are concerned with monetary errors. Example: Check for agreement of a sample of purchase invoices to receiving documents and purchase order for approval signatures, product types, price and quantity. Recalculate the total purchase and ensure the purchase is recorded in the correct account (capitalized as an asset, vs expensed as operating expenditure).

Part 11.9
Positive Accounting Theory (PAT) Positive Accounting Theory tries to make good predictions of real world events and translate them to accounting transactions. While normative theories tend to recommend what should be done, Positive Theories try to explain and predict Actions such as which accounting policies firms will choose How firms will react to newly proposed accounting standards Its overall intention is to understand and predict the choice of accounting policies across differing firms. It recognizes that economic consequences exist. Under PAT, firms want to maximize their prospects for survival, so they organize themselves efficiently. Firms are viewed as the accumulation of the contracts they have entered into. In relation to PAT, because there is a need to be efficient, the firm will want to minimize costs associated with contracts. Examples of contract costs are negotiation, renegotiation, and monitoring costs. Contract costs involve accounting variables as contracts can be stipulated in terms of accounting information such as net income, and financial ratios. The firm will choose the accounting policies that best acknowledge the need for minimization of contract costs. PAT recognizes that changing circumstances require managers to have flexibility in choosing accounting policies. This brings forward the problem of opportunistic behavior. This occurs when the actions of management are to better their own personal interests. With this in mind, the optimal set of accounting policies are described as a compromise between fixing accounting policies to minimize contract costs and providing flexibility in times of changing circumstances (considering the effects of opportunistic behavior). The Three Hypotheses of Positive Accounting Theory Positive Accounting Theory has three hypotheses around which its predictions are organized.

1) Bonus plan hypothesis Managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period. By doing so, they can increase their bonuses for the current year. 2) Debt covenant hypothesis The closer a firm is to violating accounting-based debt covenants, the more likely the firm manager is to select accounting procedures that shift reported earnings from future periods to the current period. By increasing current earnings, the company is less likely to violate debt covenants, and management has minimized its constraints in running the company 3) Political cost hypothesis

The greater the political costs faced by the firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods. High profitability can lead to increased political heat, and can lead to new taxes or regulations esp. for large firms which may be held to higher reporting standards
How to Achieve Positive Accounting Theory Changing accounting policies Managing discretionary accruals Timing of adoption of new accounting standards Changing real variables--R&D, advertising, repairs & maintenance SPEs (Enron), capitalize operating expenses (WorldCom)

Part 11.11
Accounting Information - Complex Commodity & Information Asymmetry What is Information?
It is a COMPLEX commodity

Investors are demanders/managers the suppliers Should we let the rules of supply and demand determine the amount of information provided (no regulation)? Should there be regulation to protect investors as market forces fail to ensure investors have adequate information? Currently, we have regulation= standard setting But how much regulation is required? How much is too much? Information impacts not only individual decision making but the efficiency of the market Currently we report most assets and liabilities at historical but there has been movement towards more market values- therefore we have a mixed measurement system. Investors prefer current values as they are more relevant- they provide the best available indication of future firm performance and investment returns. Management prefers not to include unrealized gain/ losses as it increases volatilityand they do not believe this reflect their performance

 So as accountants our role is to manage the expectations of many parties- and to have a critical awareness of the impact of financial reporting on investors, managers and the economy. We need to design and implement concepts and standards that best trade off the investor informing and manager performance evaluating roles for accounting information Information Asymmetry When one party has an information advantage over another. 1. Adverse Selection where by one or more parties have an info advantage over others Occurs because insider of the firm (Managers) know more about the current condition and future prospect of the firm than investors They can exploit this advantage by managing the info released to investors often to increase/maintain the value of the stock options they hold i.e. Enron management were selling their stock and telling employees to hold on to theirs..... Called Adverse as it reduces an investors ability to make good investment decisions and impairs the functioning of Capital markets Example: Insider Trading i.e. Martha Stewart- her friend Sam Walker from Imclone knew that an important cancer drug was rejected by the FDA- this was a huge blow to Imclone and once announced it was expected the share price would drop- Martha wasnt hurt by the decline because she sold her shares before the info became public....therefore information asymmetry! Clarification: Is all Insider Trading illegal? No- Trades by insiders can be legal if reported to the securities exchange commissions within a predetermined time frame. This way if it is reported to the public, it can be interpreted as a signal Studies show that the buying and selling by insiders is valuable information. When an insider buys or sells, they may know something the public doesnt generally when an exec purchases the co. shares, the co. outperforms the market by approx. 10% over a 12 month period. Conversely when execs sold, co. performed 5-6% below market. 2. Moral Hazard Where one or more parties observe their actions but other parties cannot Caused by separation of ownership/ control Consider, if there were no exams, how hard would you study? How would instructor be able to evaluate effort? This is very popular in insurance industry. If car insurance covered 100% of your carwith no cost to you- what would stop you from not leaving it running with the doors open? If you dont suffer any consequences- why mitigate any loss--- this is why there is a deductible= moral hazard I.e. how do shareholders know management is working hard on their behalf since they cannot observe their behaviour on a day to day basis? Management net income, like insurance deductables, is usually considered a measure of management performance to control moral hazard- first net income is usually used as an input to management compensation contracts and second it can inform the labour market if a manager shirks and he/ she will suffer a loss on income/ reputation.

Business & Financial Valuation Formulas

In this section, we explain in detail some of the most common financial valuation tools that businessese & investors in the Finance world use to run their businesses, acquire new businesses, issue shares of stock and other Corporate activities. Economic Value Added (EVA) - How to Calculate Economic Viability of a Corporation Economic Value Added is a performance ratio that determines the true economic profitability of a corporation because it factors in net operating income after taxes & interest minus the opportunity cost of capital deployed to earn that net operating income. In other words, Economic Value Added shows whether the financial performance of a company exceeds or is below the minimum required rate of return for shareholders or business lenders. Economic Value Added tells investors whether the amount of capital they have invested in to the business is generating them higher return than their minimum, or if it is better to invest the capital elsewhere. Here is how Economic Value Added (EVA) is used by financial analysts: 1) Economic Value Added is used as a performance evaluation tool of higher level managers, directors, VPs and CEOs of a corporation because the performance of the organization depends on the human resources deployed. 2) Economic Value Added is used at sub-division level & entire organizational level of the business, unlike other methods such as Market Value Added that only focuses on the big picture of a corporation. 3) Economic Value Added factors in to performance evaluation that the operating net income of a corporation must cover both operating costs of the organization as well as the capital costs (opportunity cost of capital). This is unlike other accounting methods such as EBIT or EBITDA or Net Income that look at total revenues generated by the business minus total expenses as a performance evaluation tool. How to Calculate Economic Value Added Net Sales Operating Expenses ___________________________ Operating Profit (EBIT) - Taxes ___________________________ Net Operating Profit After Tax (NOPAT) - Capital Costs (Total Capital x Cost of Capital) ___________________________ Economic Value Added

Economic Value Added can also be used for the following purposes: Determine management bonuses Motivate management to achieve sales objectives & goals Corporate valuation for shareholders, bankers & lenders Performance measurement of Business Capital budgeting & Investing decisions Set organizational objectives & goals 4 Steps to Calculate Economic Value Added 1) Calculate Net Operating Profit after Taxes Gross Sales = $1,000,000 Operating Expenses = $350,000 Depreciation = $100,000 Taxes = $150,000 Net Operating Income = $1m - $350k - $100k - $150k

= $400,000

2) Determine total Capital deployed in the business Total Capital = Net Working Capital + Net Fixed Assets Total Capital = $300,000 + $1.2m Total Capital = $1,500,000 3) Calculate Weighted Average Cost of Capital Assume WACC = 12% 4) Calculate Capital cost to NOPAT & Economic Value Added Capital Costs = Total Capital x Cost of Capital Capital Costs = $1,500,000 x 0.12 Capital Costs = $180,000 Economic Value Added = Net Operating Income - Capital Costs Economic Value Added = $400,000 - $180,000 Economic Value Added = $220,000

EBITDA E-Earnings B-Before I-Interest T-Taxes D-Depreciation & A-Amortization Expense EBITDA stands for Earnings before Interest, Taxes, Depreciation & Amortization expense. EBITDA is a tool to measure the value of a firm based on its net earnings before non-cash expenses (depreciation & amortization) are recorded, as well as dilutive expenses such as interest expense & taxes.

 EBIDTA is used by financial valuation experts to measure the true value of a business, especially for private capital firms. Here is why private capital banks like the EBITDA formula: 1) Interest & Taxes - Replace current tax rates & Interest rates with their own tax & interest rates based on the current & new capital structure of the corporation, new debt convenants or refinancing with the banks. 2) Amortization & Depreciation - These are excluded because they are non-cash expenses for capital or intangible assets which were acquired in prior periods, and do not represent a cash outlay of the organization. Financial advisors recommend using EBITDA as a way to measure the cash generation activities of an organization. The formula for Earnings before Interest, Taxes, Depreciation & Amortization is: EBITDA = Net Sales - Operating Expenses = Operating Profit EBITDA = Operating Profit + Deprecation Expense + Amortization Expense + Taxes As an example, let's calculate the EBITDA for Checkpoint Software Technology Ltd. In Millions of USD (except for per share items) 12 months ending 2009-12-31 Revenues $924.42 Other Revenues, Total Total Revenue $924.42 Cost of Revenue $133.27 Gross Profit Selling/General/Admin. Expenses, Total Research & Development Depreciation & Amortization Interest Expense(Income) - Net Operating Unusual Expense (Income) Other Operating Expenses, Total Total Operating Expenses Operating Income Income Taxes What is EBITDA? EBITDA = Operating Profit + Deprecation Expense + Amortization Expense + Taxes $791.15 $277.29 $89.74

$10.38 $510.68 $413.74 $88.28

EBITDA = $413.74 + $0 + $88.28 + $0 EBITDA = $502.02 EBITDA differs from Operating Income by $502.02 / $413.74 = 21.3% Drawbacks of using EBITDA EBITDA excludes Interest expense & Income taxes however these are cash expenses and obviously must be paid by the company. EBITDA does not factor in changes in Working Capital which could significantly affect Cash. EBITDA does NOT exclude all non-cash items apart from amortization & interest expense. Examples of such non-cash items include stock options warranted, Inventory markdowns, allowance for doubtful accounts, etc. EBITDA could be misleading due to the fact that a company could understate its Warranty expenses, reserve for bad debt allowances, corporate restructure costs, inventory writedowns and this will lead to a higher EBITDA. How to Calculate Return on Invesment (ROI) Return on Invesment as the name suggests is a financial valuation method that determines the percent of return investors are getting from their portfolio of investments. Return on Investment is probably one of the most important ratios that companies need to keep track of in order to determine the viability & continuity of their business.Measuring profit margins of products being sold is not enough to continue doing business, companies have to ensure the amount of capital that is being put in to the business is attracting sufficient sales & providing a good return on capital invested.

As a rule of thumb, if the ROI is too low, this means the product lines are not generating enough sales worth running the business and deploying overhead costs, thus in the long term the product line is deemed to fail. The formula for Return on Investment is: ROI = Net Income / Book Value of Assets

An alternative formula for ROI is: ROI = Net Income + Interest (1 - Tax Rate) / Book Value of Assets Another formula that small investors use to calculate ROI is: ROI = (Gain from Investment - Cost of Investment) / Cost of Investment For instance, assume you are the VP of a long distance phone company that does a marketing campaign to generate new buyers of its long distance phone cards. The company sells each phone card for $5, and does an advertising campaign on the radio/television worth $500,000. This campaign helps the company sell an additional 155,500 long distance phone cards off its distribution networks. What is the ROI?

ROI = (Gain from Investment - Cost of Investment) / Cost of Investment Gain from Investment = 155,500 cards x $5 = $777,500 Cost of Investment = $500,000 ROI = ($777,500 - $500,000) / $500,000

ROI ROI

= $277,500 / $500,000 = 55.5%

That's a pretty impressive number hey, 55.5%? Well most small business managers forget to factor in the costs they incurred to produce that extra revenue generated from the advertising campaign. For instance, say this long distance phone company incurred an extra $200,000 in costs to produce those 155,500 phone cards which includes phone network fees, vendor distribution expenses, selling & general admin expenses, etc. How will this additional information change our ROI calculation? ROI = (Gain from Investment - Cost of Investment) / Cost of Investment Gain from Investment = 155,500 cards x $5 = $777,500 Cost of Investment = $500,000 + $200,000 ROI = ($777,500 - $700,000) / $700,000 ROI = $77,500 / $700,000 ROI = 11.1% Now see how drastically our ROI number changes? It drops from a whopping 55.5% to 11.1% thanks to the additional information we input. The lesson here is always be careful when calculating your Gain from Investment because most business managers forget to include the Cost incurred to obtain that gain, in our case the additional $200,000 of fixed costs incurred on top of the $500,000 we paid to radio/broadcasting networks for the advertising campaign.

Return on Invested Capital (ROIC) Formula

Return on Invested Capital (ROIC) is a top level way to measure the historical & current performance of a corporation across all the capital it has invested in its business. This capital comes from shareholders (investors), creditors who supply loans, credit as well as shares owned by management. One of the best ways to measure how a company has performed in the past on its allocated capital resources is by the Return on Invested Capital ratio. Other similar formulas such as the Discounted Cash Flow (DCF) measures the performance of a company based on its present & future cash flows, but they are easy to manipulate. For instance, a company could easily decrease its outgoing cash flows by: Postponing marketing expenses Delaying research & development costs Cutting back on capital spending Laying off workforce

A solid Return on Invested Capital ratio indicates strong management, efficient business operations & use of capital resources as well as value creation opportunities for the organization. The ROIC formula should be used with care as it can mean negative things

for the organization such as not exploring growth opportunities for the organization, ignoring long term net positive value investments, stingy cash preservation, excessive convervatism, etc. To create growth in the future, companies must earn an ROIC above their Cost of Capital (WACC). The accounting formula for this relationship is: Future Growth = Return on Invested Capital - Weighted Average Cost of Capital There are 2 formulas we could use to calculate ROIC. 1) ROIC = EBIAT (Earnings Before Interest but After Taxes) / (Working Capital + Fixed Assets). 2) ROIC = After Tax Net Income / Capital Invested Note that the first formula does not subtract Interest in the numerator because the denominator includes debt capital. In the 2nd formula, capital invested refers to all debt financing such as long term loans, common stock, preferred stock, options & warrants. It is imperative to note that ROIC is just an accounting formula and suffers these drawbacks: 1. Can be easily manipulated by management. 2. Changes when accounting policies are modified e.g. fair value accounting of assets & capital. 3. Can be affected by currency exchange rates due to cost of capital. Let's calculate Return on Invested Capital for Check Point Software Technologies Ltd. ticker CHKP as of December 31st, 2009. By looking at the income statement here, we see this data: 2009 Income After Tax $357.52 Current Assets $1,202.21 Current Liabilities $686.17 Working Capital $516.04 Fixed Assets $0 ROIC for 2009 = After Tax Net Income / Capital Invested ROIC = $357.52 / ($516.04 + $0) ROIC = 69.28% A 69.28% of Return on Invested Capital is pretty impressive for a technology company, unless technology industry analysts can prove me wrong??

2008 $323.97 $1,194.53 $402.55 $791.98 $105.61

Operating Cash Flow -Managing Cash Flows Generated from Business Operations
The Operating Cash Flow (Cash Flows from Operations) measures how further away Cash Flow is from the company's reported Net Income or Operating Income. Under the Generally Accepted Accounting Principles (GAAP), companies can report good Net Income numbers even though their cash flows are poor due to entries such as Accrued Revenues, etc. In simpler terms, Operating Cash Flow is a verification of quality of the company's reported earnings. Some financial experts argue Operating Cash Flow is a better tool of evaluating earnings than Operating or Net Income because a company can show positive net income but still not have enough cash to meet its debt covenants & obligations such as bonds payable, rent expense, salaries expense, etc. There are 2 formulas for calculating the Operating Cash Flow: 1) Cash Flow from Operations = Income from Continuing Operations + Non-Cash Expenses - Non-Cash Sales Income from Operations 2) Cash Flow from Operations = Net Income + Non-Cash Expenses - Non-Cash Sales Net Income Differences between Operating Cash Flows and Reported Earnings indicates large amounts of non-cash expenses such as amortization expense, goodwill impairments, etc. If a company reports high earnings but with negative operating cash flows, this presents a red flag that it may be using aggressive accounting techniques that could mislead investors & public using the financial statements of the company. Operating Cash Flow is sometimes referred to as Free Cash Flow because this cash is 'Free' to be paid back to the suppliers of capital (shareholders and creditors). Accounting Procedure for Calculating Free Cash Flows 1. Start with total Annual Revenues and subtract Cash expenses & Depreciation to calculate Earnings Before Interest & Taxes (EBIT). EBIT is also referred to as operating income as it is earnings before interest expense & taxes are paid. 2. Calculate Earnings before interest and after taxes (EBIAT) by multiplying EBIT times 1 minus tax rate. For instance, if earnings is $10 and tax rate is 40%, then EBIAT will be: $10 x (1 - 0.40) = $10 x 0.60 = $6.

This $6 is your earnings before interest expense and AFTER taxes. 3. Finally to calculate free cash flow, add Depreciation expense to EBIAT less Capital Expenses (CAPEX) and less any investments in Net Working Capital (NWC). 4. Let's put this summary in to equation format: 1) 2) 3) Operating Income (EBIT) = Annual Revenues - Cash Expenses - Depreciation EBIAT = EBIT - Income Taxes FCF (Free Cash Flow) = EBIAT + Depreciation Expense - CAPEX - Increase in Net Working Capital

Earnings per Share - Measuring the Economic Value of a Stock

Financial analysts use Earnings per Share as a way to determine the relative corporate value of a stock. The dividends declared on preferred stock are subtracted from Net income, and this number is then divided by Weighted Average number of Outstanding Common shares & its equivalents. Earnings per Share is very commonly used by the media to evaluate the value of a stock, e.g. if you go to Google Finance, you will see EPS in the summary of a stock along with other measurements such as Price to Earnings ratio, dividend yield, low & high range of a stock, 52 week trading high, etc. The two most commonly used formulas for calculating Earnings per share include: 1) Earnings Per Share Net Income - Preferred Stock Dividends Weighted Average # of Common Shares & Equivalents or 2) Fully Diluted EPS Net Income - Preferred Stock Dividends # of Outstanding Common Shares & Common Share Equivalents The 2nd formula where the denominator is # of Common Shares Outstanding & Common Share Equivalents is known as the Fully Diluted EPS. It is 'fully diluted' because all convertible bonds, preferred stock, convertible warrants and stock warrants & rights are included in the calculation. How EPS is Calculated Earnings per share is a way of standardizing a company's net income left over for shareholders across all companies. For instance, two Companies A & B could earn $10 million a year, but Company A has 50,000 shares outstanding while Company B has 500,000 shares outstanding. So how would you normalize earnings per share across these two companies? Company A = $10 million / 50,000 shares = $200 / share Company B = $10 million / 500,000 shares = $20 / share

Many financial advisors feel Earnings per Share is not a good way to determine economic value of a stock because of the following reasons: 1) Business & financial risks of corporations is not measured by EPS because it is just a reported net income number; it does not provide any further information that can be found in media reports or prospectus of a company. 3) Dividend policies are not factored in to EPS and any decreases in dividends will result in a higher Net Income, thus a higher earnings per share number, which is actually detrimental to the value of a stock. 4) Earnings per Share does not factor in time value of money as this finance concept is not reflected in the EPS number produced on financial statements. 5) Corporate finance activities such as share buybacks increase the EPS as the # of shares outstanding on the capital markets is reduced; this is one strategy a corporation could use to improve its Earnings per Share number to investors. When a company earns profits, it can either give back to shareholders in i) below or it can put the money in to retained earnings and re-invest in to the company to expand operations, capture new market share, hire employees or buy plant & equipment, etc. A) Pay stock dividends to shareholders every quarter, and usually based on the dividend yield. Financial managers report Earnings per Share in 3 different formats, all of which you should be aware of: 1) Trailing EPS Current net income divided by the # of shares outstanding 2) Current EPS This year's estimated net income before year-end divided by # of shares outstanding 3) Forward EPS Estimate of future net income divided by # of current shares outstanding. This is a future projection of earnings per share.

Price to Earnings (P/E) Ratio Calculating Earnings Growth & Relative Value of Stock Prices
The Price to Earnings ratio compares the current price of a common stock trading on the market with the Earnings per Share (EPS) that the company yields. Earnings per Share is calculated by dividing Net Income in current quarter by the total # of shares outstanding on the market. The price to earnings ratio is a widely used stock valuation tool as it indicates to investors how 'cheap' or 'expensive' a stock is and you will see analysts on Bloomberg television referring to the P/E ratio in part of their analysis & discussions about stocks. For example, assume Farhan Corp. currently has its A Class common stock trading at $45 per share and total # of shares on the market is 50,000. Net income as at February 28th, 2010 is $2million. What is the Earnings per Share? Earnings per Share = Net Income / Total # of Shares Outstanding
Earnings per Share = $2,000,000 / 450,000 shares Earnings per Share = 4.44 cents a share

Having this data, what will be the Price to Earnings ratio? P/E ratio = Current Price / EPS
P/E ratio = $45 / 4.44 P/E ratio = 10.135

Earnings per share data of a stock is commonly found in Google Finance or from the annual reports of your prospective company. Another way to derive Earnings per Share is to estimate based on the EPS of last 4 quarters. Disadvantages of using EPS 1) The price to earnings ratio is based on future estimates of earnings or net income such as the prevailing estimate of EPS of the last 4 quarters. With the high volatility in the stock markets and lots of businesses going bankruptcy, future estimates of accounting earnings or net income should be taken not very seriously as they are just estimates and could be way off from actual performance. 2) Economic conditions change very fast and since the Earnings per Share is sometimes calculated using last 4 quarters' EPS, this may not fully represent the Current earnings of the company and could be subject to high volatility. Price to earnings ratio calculated in this manner is known as the 'Trailing P/E." The earnings per share tells us about the current profitability of the company but does not tell us anything about the future. For instance when the company sells a huge asset such as a building or land, this will result in a jump upwards in the EPS. Likewise when the company uses cash to purchase a huge capital asset such as plant & equipment or land, this will result in EPS going downwards.

3)

Understanding the Price to Earnings Ratios of Companies

= A company with no net income or earnings has a N/A P/E ratio and the stock could be a penny stock or a very high risk company 1 - 12 = The stock is moderately or significantly undervalued or the company's earnings are projected to go down. 13 - 20 = The stock is fairly valued and could be a value buy for most investors 21 - 29 = The stock is significantly overvalued or the company has significantly increased its earnings in the past quarter or few quarters. 29+ = The stock is significantly overvalued and may be subject to a speculative 'bubble' that could burst really fast. Investors buying such stocks should be cautious and look at the long term prospects of the company and if it can grow earnings at its current pace, otherwise the stock could take a huge hit and investors will lose money. N/A

Weighted Average Cost of Capital Examining the Capital Structure of a Corporation

 Weighted Average Cost of Capital is a calculation of the overall cost of capital used by a corporation and is an average representing the total return (in percent) that is expected of an organization on all its assets, debts and owners equity to maintain its current stock price & valuations. Weighted Average Cost of Capital weighs in all items that play a role in the corporations capital structure including common and preferred shares, bonds, and other long term debts. In order to calculate the weighted average cost of capital, we must first examine the capital structure of the company we are analyzing. In terms of corporate finance, capital structure refers to how a corporation finances it assets and its business operations; either through the use of long term debt, common shares or preferred stock (also known as shareholders equity) or other hybrid securities. Weighted Average Cost of Capital becomes especially important when the capital structure of a firm involves both debt and equity financing. In this example, we will look at the three most common types of financing included in capital structure: i) Common shares equity ii) Preferred shares equity iii) Long term debt Each of these components has a cost associated with it. Use of Weighted Average Cost of Capital comes usually at a time during merger and acquisition. Some financial analysts look at WACC objectively to examine the capital structure of the company and whether it is running at an optimal rate, or things could be tweaked for bettering the value provided to shareholders, as well as to optimize the value of the organizations finances. The recommendations made by financial analysts after examining capital structures include either carrying more debt, less debt or issue more common/preferred shares, pay off debt and issue more equity, or trade debts with different interest rates.

Steps for Calculating Weighted Average Cost of Capital

There are three steps for calculating the WACC of an organization. 1) Determine the proportionate weighting of each source of capital financing based on their market value. 2) Calculate the after-tax rate of return or cost of each source. 3) Calculate the weighted average cost of all sources The formula for WACC is:

WACC = (Ke x We) + (Kp x Wp) + Kd/pt [1 t] x Wd) Ke =Cost of capital -common equity We =Percent of common equity in the capital structure, at market value Kp = Cost of preferred equity (shares) Wp =Percentage of preferred equity in the capital structure (at market value) Kd/pt =Cost of debt (pre-tax) T = Tax rate Wd =Percentage of debt in the capital structure (at market value) Example of Weighted Average Cost of Capital in Tabular format
Percent of Assumed Total Value Cost of Capital (% Return)

Value i) Book Value a) Debt 300 bonds at par, or $1000/bond b) Preferred Stock 5000 shares @ $50 par value c) Common Stock 10,0000 shares outstanding @ $28 par value Total Book Value of Capital ii) Market Value a) Debt 480 bonds at par, or $1000/bond b) Preferred Stock 10,000 shares @ $65 par value c) Common Stock 120,000 shares outstanding @ $35 par value Total market value of capital Calculating Weighted Average Cost of Capital (WACC) based on Market Values

Dollar Amount

$300,000.00 $25,000.00 $2,800,000.00 $3,125,000.00

9.60% 0.80% 89.60% 100%

7.00% 12.00% 9.00%

$480,000.00 $650,000.00 $4,200,000.00 $5,330,000.00

9.01% 12.20% 78.80% 100%

7.00% 12.00% 9.00%

Sources of Financing a) Debt (1 - t) = 1 - 0.4 480 bonds at par, or $1000/bond b) Preferred Stock 10,000 shares @ $65 par value

Cost of Capital (%) 4.20% 12.00%

Market Value Weight 9.01% 12.20%

Cost of Capital x Market Value Weight (%) 0.38% 1.46%

c) Common Stock 120,000 shares outstanding @ $35 par value Weighted Average Cost of Capital (%)

9.00%

78.80% 100%

7.09%

8.93%

Below is graphical representation of the market value of the weighted average cost of capital calculations. It shows how the capital structure is divided in to 3 parts consisting of $480,000 debt (9% in blue), $650,000 of preferred stock (12% in pink) and $4,200,000 of common stock (79% in green).

Arbitrage Process of Buying/Selling Complementary Securities

Arbitrage refers to the ability of investors to trade in complementary securities (buying and selling stocks, commodities or ETFs) in two different markets at the same time. The purpose of using arbitrage is to take advantage of market inefficiencies where one stock might be trading for $500 on the NYSE while it could be trading at $450 on the London stock exchange. Investors who engage in arbitrage are known as Arbitragers. Arbitrage basically takes advantage of the price differences between two comparable commodities or securities trading simultaneously on two different secondary markets or stock exchanges. An arbitrage investor (arbitrager) buys a security on the exchange with the lower price and sells it right away on the exchange that offers a higher price, for a profit or capital gain. The formula for arbitrage is: P = (Yb Xa) x Q Where:

P = Arbitrage profit Yb = price of higher priced security on the higher trading exchange Well call it the exchange B. Xa = Price of lower priced security on the lower trading exchange Well call it the exchange A. Q = Quantity Example 1 Say for instance Binti Kiziwi Corp (ticker symbol BKC) is trading for $80 per share on the New York stock exchange (NYSE) while it is trading for $95 per share on the Toronto stock exchange (TSX). An arbitrage investor buys 2000 shares of the stock on the New York stock exchange for $80/share and sells it simultaneously on the Toronto stock exchange for $95/share, thus making a decent profit of $15/share. The arbitrage profit will therefore be: P = (Yb Xa) x Q P = ($95 $80) x 2000 shares P = $15 x 2000 shares P = $30,000 The arbitrage profit is $30,000. This transaction and similar transactions to this one will increase the value of the stock on the New York stock exchange as arbitragers will be buying and driving up demand in an attempt to lock in profit. However, the price of the security on the Toronto stock exchange will go lower because arbitragers will be dumping the stocks in that exchange in order to make their profits; for instance even if the arbitrager sells the shares at $93/share on the TSX instead of the $95 current trading price, he will still make a very good gain on his sale; this will therefore drive prices of that security on the TSX downwards. Arbitrage for Currencies Arbitrage can also be done on foreign exchange currencies markets. The formula for calculating arbitrage profit on trading currencies is: Arbitrage profits = Investment Receipts Loan Payments Example 2 Assume Binti Kiziwi Corp. borrows $1,000,000 from a bank in New York for 90 days at 8% borrowing rate and converts it to Canadian dollars at an exchange rate of 1.10, thus totalling $1,100,000 Canadian. The Canadian dollars are then invested at 10% interest for 90 days. Arbitrage profits = Investment Receipts Loan Payments Arbitrage profits = ((CAD $ 1,100,000 x 0.1) / 4) / 1.10) (($US 1,000,000 x 0.08) / 4) Arbitrage profits = ($CAD 27,500/ 1.10) ($US 80,000) / 4) Arbitrage profits = $25,000 20,000 Arbitrage profits = $5,000 CAD

What will be the arbitrage profit?

 Arbitrate is used by investors when they are seeking to exploit the price differences between two complementary securities trading on 2 different markets or exchanges in order to turn over some profits. These kinds of price differentials exist for small periods of time, thus arbitragers usually have to be very quick in order to make profits. Arbitrage is also used by international financial managers who use interest-rate differences for various currencies to take advantage of cheaper purchasing costs of foreign products. Arbitragers also use forward contracts to take advantage of such price differentials. Dollar Cost Averaging - Calculating the Average Share Price Dollar Cost averaging is an investment mechanism in which stocks are purchased at constant dollar amounts at regularly spaced intervals, with the most amount of stocks bought at the lowest stock prices possible. By investing a fixed amount of money each time, more shares are bought at lower prices and fewer shares are bought at higher prices. This approach results in a lower average cost per share because the investors buy more shares of the same stock at the lower prices. The formula for dollar cost averaging is: Dollar Cost Averaging (Average Price) = Total market price per share / Total number of Investments Example An investor invests $200,000 per month in IBM shares and performs the following transactions: Date Jan 10 Feb 10 March 10 April 10 May 10 June 10 July 10 Aug 10 Total Investment $200,000 $200,000 $200,000 $200,000 $200,000 $200,000 $200,000 $200,000 $1,600,000 Market Price per Share $128 $126 $125 $127 $126 $130 $131 $124 $1,017 Shares Purchased 1563 1587 1600 1575 1587 1538 1527 1613 12590

What would the average cost per share be? Average Price = Total Market price per share / Total number of investments Average Price = $1017 / 8 Average Price = $127.13 With this $1.6 million investment, a total of 12,590 shares have been bought at an average cost of $127.13 per share. If the investors can manage to sell their shares at a price above $140, they will easily make a gain of $140 / $127.13 = 1.10%.This is the whole purpose of dollar cost averaging, to reduce the total average cost per share.

 Dollar Cost Averaging is advantageous to investors when a stock price moves within a narrow range such that if there is a decrease in stock price, the investor will incur less of a loss with this approach. If there is an increase in the stock price, the investor will gain more. The advantages of dollar cost averaging are: i) Higher commissions or stockbroker fees ii) Dollar cost averaging doesnt tend to work when stock prices move continuous either upward or downward. Dollar cost averaging is known to be a conservative investment strategy because it avoids the investors from buying when the market is too high or sell when the market is too low. Investors buying stocks on dollar cost averaging approach buy with a long term view to stock appreciation which could benefit them immensely. Also with this approach, the investor minimizes risk because he is not stuck with too many shares bought at high prices. Another advantage is that during a bear market, more shares can be bought at even lower prices. The graph below shows the share price for each investment made from Jan to Aug 2010 and the total # of shares purchased.

This chart shows the varied stock purchase prices between January 2010 to August 2010 with prices ranging from $128 in Jan to $124 in August.

Financial Statement Analysis

Assets Current Assets / Liquid Assets Cash and cash due from Central Bank; cash on deposit in postal banking accounts; Due from Banks; Interest-bearing deposits in other banks Cash held in trust: may be on the behalf of a third party or the result of a merger/acquisition and may have restrictions encumbering its usage. Fed Funds Sold: Federal funds, or fed funds, are unsecured loans of reserve balances at Federal Reserve Banks that depository institutions make to one another. Banks keep reserve balances at the Federal Reserve Banks to meet their reserve requirements and to clear financial transactions. Transactions in the fed funds market enable depository institutions with reserve balances in excess of reserve requirements to lend them, or sell as it is called by market participants, to institutions with reserve deficiencies. Fed Funds are sold daily to various financial institutions (commercial banks, thrift institutions,

agencies and branches of foreign banks in the United States, federal agencies, and government securities dealers) throughout the United States. The most common duration or term for fed funds transaction is overnight, though longer-term deals are arranged. The rate at which these transactions occur is called the fed funds rate. Fed funds transactions can be initiated by either a funds lender or a funds borrower. An institution seeking to lend fed funds identifies a borrower directly, through an existing banking relationship, or indirectly, through a fed funds broker. The most commonly used method to transfer funds between depository institutions is for the lending institution to authorize its district Federal Reserve Bank to debit its reserve account and to credit the reserve account of the borrowing institution. Most overnight loans are booked without a contract. The borrowing and lending institutions exchange verbal agreements based on various considerations, particularly their experience in doing business together, and limit the size of transactions to established credit lines in order to minimize the lender's exposure to default risk. Overnight fed funds transactions under a continuing contract are renewed automatically until termination by either the lender or the borrower. This type of agreement is used most frequently by correspondent banks that borrow overnight fed funds from a respondent bank. Due From Banks: demand and time deposits with other banks (does not include loans to banks that may be termed time deposits due from banks) and although there is a slight element of risk involved, it is still considered cash. Negotiable Certificates of Deposit, which should be stated at the lower of cost or net realizable value. Marketable Securities: U.S. Treasury and other U.S. government agencies, States and political subdivisions, exchange listed (publicly traded) securities such as corporate bonds equities, Asset-backed securities Mortgage-backed securities. This account is also sometimes known as Securities Available-for-Sale (amortized; price movements in these securities are dependent upon the movement in market interest rate). During 2009, many banks in the United States have purchased mortgage-backed securities issued and guaranteed by the Government National Mortgage Association (Ginnie Mae / GNMA), which are also backed by the FHA, in order to improve the bank's balance sheet as they are seen as high quality compared to other securities (due to the federal government guarantee) and also because they receive a zero risk weighting under regulatory guidelines and improve the bank's capital ratios. However, it is some what manipulative of the capital ratio as the replacing FNMA, FHLMC and private label securities with GNMA securities will quickly improve the capital ratios even as loans in the bank's portfolio are deteriorating. Loans less than one year Advances to customers Accounts receivable trade Securities held under Reverse Repurchase Agreements: the financial institution "lent" out cash and took securities at a discounted value as security, which are recorded as receivables.

 Loans or Receivables (of various maturities in excess of one year) will represent one of the main business activities of the the bank and may account for the largest percentage of total assets. A loan is an extension of credit resulting from direct negotiations between a lender and a borrower. Loans may be held until maturity, may be sold in whole or a portion to third parties, and may also be obtained through purchase in whole or in portion from third parties. What is in the portfolio? Corporate / commercial loans (secured / unsecured, fixed-term / revolving)? Construction loans (this is one of the riskiest types of loan), Commercial lease financing, Mortgages (residential or commercial), secured loans, loans to public authorities, consumer loans such as credit card, home equity and personal loans; consumer lease financing? Collateralized loans mean that the grantor has in its possession (or a fiduciary, administrator, trustee) readily marketable or highly liquid instruments (cash, CDs, stocks and bonds). Sufficient margin on collateralized credits should also be provided (due to interest rate and market sensitivity). Secured loans are secured by assets that are not readily marketable and/or under the control of the recipient of the loan (UCC filings on receivables, pledges of inventory, equipment, assignment of real estate mortgages or rents, contracts). Pledge of inventory and real estate should be adequately insured and in the name the Grantor. Loans secured by real estate are loans predicated upon a security interest in real property. A loan predicated upon a security interest in real property is a loan secured wholly or substantially by a lien on real property for which the lien is central to the extension of the credit Shown net of Allowance of Losses (the reserve set aside that represents an amount considered by management to be adequate to cover estimated losses in the loan portfolio). What is the difference between Loan Loss Reserve and Loan Loss Provision? The Reserve is the balance sheet component that has already been established (to cover actual or anticipated deterioration of the loan assets). The provision is the income statement component amount that is charged against earnings and will be added to the Reserves (thus increasing the Reserve account). Due from parental holding company or related company (unsecured? rate?) What are maturities (mix should slant to the short-term). What is the performance of the portfolio? Delinquencies, charge-offs and provisioning? How quickly does the bank classify a loan as over due / delinquent. and / or nonperforming (30 days or 180 days)? If loan quality deteriorates, then the resultant for increased provisioning will result in lower earnings for the year (or coming years if deterioration continues in a recession or high interest rate environment).

Credit quality concerns are cyclical as banks over-lend to sectors experiencing growth and then that growth stops (LDC/less developed countries, commercial real estate, consumer loan/credit card portfolio). Legal lending limits: The legal lending limit for national banks is set forth at 12 U.S.C. 84. Specifically, 12 U.S.C. 84(a) indicates that loans to one borrower generally cannot exceed 15% of the banks capital and that lenders can make additional loans to a borrower totaling up to 10% of the banks capital if those additional loans are fully secured by readily marketable collateral. The legal lending limit also generally applies to Federal Deposit Insurance Corporation-insured thrift institutions. See 12 U.S.C. 1464(u). Respective state law applies legal lending limits to state-regulated banks. What does capitalized interest mean? It means that uncollected interest has been added to the principal balance of the loan. What happens when a loan goes bad? When a loan (or other investment) is deemed uncollectible, the financial institution must remove it from the asset side of the balance sheet and from the Reserve for Loan Losses Account or an appropriate expense account. Derivative Contracts for managing (positioning or hedging) exposure to market risk (including interest rate risk and foreign exchange risk), cash flow risk, and other risks in operations and for trading. The accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities are set forth in FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended. Statement No. 133 requires all derivatives to be recognized at their fair value. The accounting standard for fair value measurements that should be applied in accounting pronouncements that require or permit fair value measurements is FASB Statement No. 157, Fair Value Measurements (FAS 157), which defines fair value and establishes a framework for measuring fair value. The definition of fair value for an asset or liability is the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction between market participants (not a forced liquidation or distressed sale) in the assets or liabilitys principal (or most advantageous) market at the measurement date. The transaction is assumed to occur based on an exit price notion versus an entry price. Mortgage Servicing Rights (MSRs): Many banks that originate primary residential mortgages and then sell them into the secondary market retain the servicing rights of the mortgage. This means that for a fee the bank collects the monthly payment from the mortgagee and passes on the principal and interest components of the payment to the trust that owns the mortgage and then also makes the insurance and real estate tax payments from the escrow account that is maintained. Mortgage servicing rights represent a future stream of payments. The on-balance sheet carrying value of these MSRs is still subject to a fair value test under FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The value of the MSRs are affected by the prepayment speed of the

underlying mortgages being serviced because if they pay off faster than had been assumed then there are fewer mortgages to be serviced and a resultant lower income stream than had been anticipated. Thus, in a declining interest rate environment where home owners are refinancing to a lower rate or selling and purchasing a new home and the original MSR is rapidly losing mortgages from the original group to be serviced the bank must now write down the value of the MSR portfolio. Conversely, in a rising interest rate environment the MSRs tend to have a stable or increasing value as the maturity of the MSRs lenghten (as no one is refinancing). Federal Home Loan Bank capital stock Often a component of U.S. banks' balance sheets. Fixed Assets Leasehold and freehold land and buildings (at historical cost or at revised market value at time of statements, less depreciation and amortization). Tangible fixed assets: fixtures, equipment, motor vehicles (depreciated or amortized). Investments Brady bonds (should not be carried at a value not exceeding their secondary market value). Investments in subsidiaries. Other Assets Bank-Owned Life Insurance Other real estate owned ("OREO") Foreclosed property held by the bank. Deferred Taxes Deferred Tax Assets (DTA) - as a result of the financial crisis during 2008 through 2010, U.S. regulators have allowed banks to book losses that can be utilized to reduce future income tax payments as an asset on the bank's balance sheet. The accounting treatment of determining the asset size is somewhat discretionary, which is based on management's estimate of future earnings and projected tax liabbilities. In the event that the United States enacts tax reform, which would result in a corporate tax rate lower than the present 35% rate, then the present value of the DTA would be lower as the actual future tax liability would be lower, hence a lower tax deduction would be necessary (at a 35% tax rate, the deduction is worth $350,000 per $1.0 million in positive earnings; at a tax rate of 25%, the deduction is now only worth $250,000 per $1.0 million in positive earnings, thus the bank would be required to write-down the value of the DTA at the moment of corporate tax reform). Intangibles and Goodwill Goodwil is generated when a bank purchases a operating company in excess of its book value. U.S. Banks are required under GAAP accounting guidelines to perform goodwill impairment tests periodically. Liabilities Current Liabilities Due to customers (onsight or time deposits) / Deposits: Savings accounts, regular checking accounts, NOW accounts, money market deposit accounts, CDs. Core Deposits consist of all interest-bearing and noninterest-bearing deposits, except certificates of deposit over $100,000. They include checking interest deposits, money market deposit accounts, time and other savings, plus demand deposits.

Core deposits represent the most significant source of funding for a bank and are comprised of noninterest-bearing deposits, interest-bearing transaction accounts, nonbrokered savings deposits and non-brokered domestic time deposits under $100,000. The branch network is a bank's principal source of core deposits, which generally carry lower interest rates than wholesale funds of comparable maturities. It can be difficult for a bank to attract deposits in a mature market except by increasing savings rates. However, that action can result in a reduction of the bank's net interest income. In addition, if the bank offers a higher rate to new customer accounts then it can alienate existing customers (who may withdraw their depost permanently or seek to open a new account in order to obtain the higher rate). Another problem with deposits is that there tends to be a maturity mismatch with long-term assets. Brokered Deposits represent funds which the bank obtains, directly or indirectly, by or through any deposit broker for deposit into one or more deposit accounts. Thus, brokered deposits include both those in which the entire beneficial interest in a given bank deposit account or instrument is held by a single depositor and those in which the deposit broker sells participations in a given bank deposit account or instrument to one or more investors. Fully insured brokered deposits are brokered deposits that are issued in denominations of $100,000 or less or that are issued in denominations greater than $100,000 and participated out by the deposit broker in shares of $100,000 or less. Due to banks (on-sight or time deposits) Commercial Paper consists of short-term negotiable promissory notes issued in the United States, which rollover every 30 to 270 days and are usually not collateralized. Short-term borrowings are usually from banks, securities dealers, the Federal Home Loan Bank, unsecured federal funds borrowings, which generally mature daily. Fed Funds Purchased are short-term, unsecured borrowings. Advances from a Federal Home Loan Bank are fully collateralized by loans on the bank's asset-side of the balance sheet. Dividend payable (preferred stock dividend in arrears) Derivative Contracts for managing (positioning or hedging) exposure to market risk (including interest rate risk and foreign exchange risk), cash flow risk, and other risks in operations and for trading. The accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities are set forth in FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended. Statement No. 133 requires all derivatives to be recognized at their fair value. Long-Term Liabilities Notes payable Mortgages payable, which may have been incurred for commercial property where either the headquarters, offices or branches of the bank are located. Covered Bonds, which is bank debt backed by a pool of pledged, secured, qualifying collateral, usually bank loans. However, principal amortization and interest is usually satisfied by the cash flow of the bank, not the cash flow of the assets in the cover pool. The cover pool is usually structured to allow a revolving schedule of similar quality loans to be added to / withdrawn from the pool. The purchaser of the bond usually also has full recourse to the financial institution if the collateral assets in the pool are insufficient to redeem the principal and full interest of the bond (however, any claim will rank pari

passu with all other senior unsecured creditors). The covered bond remains an on-balance sheet obligation of the financial institution. Subordinated Note (or debenture) is a form of debt issued by a bank or a consolidated subsidiary. When issued by a bank, a subordinated note or debenture is not insured by a federal agency, is subordinated to the claims of depositors, and has an original weighted average maturity of five years or more. Such debt shall be issued by a bank with the approval of, or under the rules and regulations of, the appropriate federal bank supervisory agency. Contingent Core Tier 1 Capital / CoCos is debt that will automatically convert into equity shares of the bank if the bank's core capital ratio declines below a specific level. Accrued/deferred taxes Stockholder's Equity / Share Capital Common shares (authorized and outstanding). Is there a tier system of voting shares and common shares? Why is it a poor decision for banks to buy back shares on the open market in order to increase the market price of the common equity? Because corporate stock purchases actually reduce capital (instead of increasing retained earnings). Why is it an even worse decision of taking on debt to buy back shares on the open market? Because the bank is actually increasing leverage while it is simultaneously reducing capital. Preferred shares (restrictions?). Preferred stock is a form of ownership interest in a bank or other company which entitles its holders to some preference or priority over the owners of common stock, usually with respect to dividends or asset distributions in a liquidation. Some trust related preferred securities may have equity characteristics and are treated favorably under Tier 1 guidelines; and may have lower interest costs. The instruments are deeply subordinated (just ahead of common stock) and have long maturities although they may have call provisions. Dividend payments may have some favorable tax treatment for the issuers. However, these securities generally have debt-like characteristics. The bank is unlikely to defer dividend payments due to the message it may send to other sources of funding. Retained Earnings: equity will increase if retained earnings are increasing. Subordinated, perpetual notes Trust Preferred Securities / TruPS. TruPS were approved by the Federal Reserve in 1996 as Tier 1 capital (maximum 25.0% of tier 1 capital). The Trust issuer is usually a wholly-owned subsidiary of a bank holding company, or a direct subsidiary of the bank. The Trust sells securities to investors and then uses the proceeds from the sale to purchase subordinated debentures of the parent holding company or bank. The Trust uses the interest payments that it receives from the purchased debentures to make payments to the holders of its preferred securities. A TruPS issue is subordinate to all debt on a financial institution's balance sheet, but is senior to both preferred and common equity issues. A TruPS issue usually has a term of 30 years, and are non-amortizing instruments that pay quarterly or semi-annual interest in the form of a dividended payment (the dividend payment can be deferred for up to five years). TruPS issued by small financial

institutions were pooled / securitized in CDOs during the early to mid-2000's (larger financial institutions had issued TruPS individually since 1996). When the financial crisis and recession 2008 - 2010 commenced many financial institutions suspended the interest / dividend payment and the CDOs, which had originally been rated Triple-A, either substantially lost value or defaulted. Clarifying the value of Stockholder's Equity. Equity invested into any type of financial institution is an accounting entry. It is not a situation where there is a separate account where segregated cash and assets are held independently for an emergency of what is indicated on the balance. Rather, equity is utilized to purchase / invest in assets from which the financial institution can generate revenue. Thus, the value of Equity is only as good as the quality of the Assets that have been purchased. That is why one of the first considerations of analyzing Equity is to deduct Intangible Assets (can not be monetaized) to determine Tangible Net Worth. Then, Non-Performing Assets must be deducted, along with any other other asset they may not be able to be monetized, or then any assets that need to be discounted from the book entry value on the balance sheet (either due to questionable value, market conditions or time constraint). The first test is always to determine if there are sufficient enough Assets that could be sold quickly to cover short-term liquidity needs (anything from 72 hours to 28 days). The second test is to determine whether there are sufficient enough high quality assets, after deducting intangibles and / or discounting assets, in an amount that exceeds Liabilities by a minimum percentage (which is the same as the basic accounting equation of Assets Liabilities = Stockholder's Equity). Indicating that the financial institution has sufficient Equity based on computing a ratio without examining the quality of the Assets is a mistake. The value of Assets are always questionable, the value amount of Debt is not. Income Statement Income Interest income (gross or net?): is adversely affected by falling long and short-term interest rates. Interest expense Subtracted from Interest Income Only The cost of funds the company borrows on a short- and long-term basis, buys in the money markets, or takes in from depositors. Competition for customer funding will increase interest expense, placing pressure on margins. Some banks and financial services companies will also break out the average annual interest rate paid on the various sources of funds. If interest expense is increasing is competition forcing the bank to pay more for deposits? Is management relying on high cost funds instead of alternative lower-cost funds to meet the banks funding needs? Net Interest Income This is interest income minus interest expense. Even a small decline in net interest income can result in a large decline in net income if not offset by a decline in expenses. See how to determine Net Interest Margin below. Non-interest Income It is important that banks develop/increase revenues derived from non-interest sources (bank services, fees such service charges on deposits, trust income, mortgage servicing fees, securities processing and brokerage services, results of trading

operations) that have more stable growth rates and are not tied to loan growth cycles, and can provide an offset if loan growth slows. Other Income Dividend income: from third party investment or subsidiary/affiliate? Net/gain loss from securities trading: volatility from year to year. Foreign exchange: based on customer activity and volatility in the market. Sale of investments: is it exceptional? Net commission/fee income; based on transactions such as insurance brokering, stock-broking Related party transaction(s) Watch-out for financial institutions that utilize "gain on sale" accounting which means that the company records the sale of a loan immediately but the actual profit is received over the life of the loan. The profit is the difference between the spread that the loan is sold at to the investor and what the seller receives from the Obligor. The problem is that the application of estimated future interest rates (and default rates) is incorrect and the loans are over-valued compared to where interest rates may actually be during the life-time of the loan and whether it will prepay if rates decline, and/or if the loan will default and become un-collectible. Non-interest expense Personnel costs As part of the $787 billion U.S. economic stimulus package passed in February 2009, there is a stipulation that all banks that receive infusions from the government's $700 billion financial rescue fund must restrict executive compensation to those persons earning $1 million or more per year in salary may receive only $500,000 in additional bonus compensation. The prohibition does not apply to bonuses that were negotiated as part of an executive's compensation contract signed prior to Feb. 11, 2009. Premises / branch operating expenses (rent). Systems development costs, merger of networks: as companies must compete based on the ability to provide state-of-the art trading, retail access and information service, these costs have risen. Overseas expansion: as the percentage of non-U.S. income rises, this cost increases as facilities expand. Operating income After expenses but before provisions and taxes and extraordinary items. Extraordinary / Non-recurring Items Material events and transactions that are unusual and infrequent. Profit (gains) or loss on sale of fixed assets. Provision (for loan losses) Changing market conditions where the bank operates may result in a deterioration of loan and lease assets, which may result in actual and anticipated losses (write-down or write-off of the asset's value). The accumulated loss may exceed the existing Loan Reserve thus earnings may have to added to the Loan Reserve account to either increase or replenish the amount to meet an acutal or anticipated loss. Taxation

 Current taxation (tax payable on recognized income for the fiscal year, which was paid to federal, state and local, and foreign revenue authorities). Deferred taxation Footnotes Allowance for losses (Loan Loss Account) - is a reserve account that is set aside by management to cover an estimate of losses (charge-offs) in the loan portfolio. The loan loss account has an opening balance at the beginning of the year, it receives additional provisions based on actual losses and anticipated losses for the coming year; has actual charged-off loans subtracted from the account and then has a closing balance for the year). Classified Loans - loans that have been determined to be not collectable for the full amount due to the deteriorating performance and/or condition of the borrower. The "classification" is based upon internal examination and rating system (based on generally accepted industry practices) such as non-performing accrual, non-accrual. The Office of the Comptroller of the Currency (OCC) also rates loans are classified as substandard, doubtful, and loss. Asset & Liability Management Ideally, banks want to match the maturity of assets (loans, investments) with the maturity of liabilities (demand deposits, timed deposits, borrowed funds). Related to the maturity structure, the interest rate paid on liabilites to borrow the funding must be less than the interest rate on earned on the assets (interest rate charged to the borrower). The failure to carefully mangage this situation can result in asset liability mismatch, interest rate risk, liquidity risk. What happens to a bank when a regulator steps in and seizes a financial istitution and appoints the FDIC as Receiver of the failed institution? All creditors must submit their claim in writing, with proof of the claim, to the Receiver by a specific date (referred to as the Bar Date). The FDIC arranges for a transfer of the deposits to another insured institution (deposits normally are sold at percentage of their notional amount). U.S. Federal law 12 U.S.C. Section 1822(e) requires that depositors must claim ownership of the deposit transferred to the new institution within 18 months (failure to do so will result in the funds being transferred to the FDIC). The deposits can be claimed by simply making a deposit or withdrawal from the account, executing a new signature card and entering into a new deposit account with the new institution, providing the new institution with a change of address card, or writing to the new institution and indicating that one wishes to keep the account active. Any checks (cashier check, money order, interest check, expense check) issued by the failed institution must also be claimed within 18 months. The FDIC will attempt to sell assets, primarily outstanding loans, to the institution purchasing the deposits and / or branches (the institution purchases the real estate or the institution will assume the lease obligation for the branch and may retain some of the employees) at par or at a reasonable discount. The FDIC will allow borrowers whose loan has not been purchased by another institution the opportunity to find another bank who will take over the loan. The FDIC may bundle any left over loans and conduct an on-line auction and the loans are then sold to the highest bidder. Those borrowers who are current merely send their monthly payment to the new institution. Those borrowers who are in default under the terms of the

loan documentation may have the loan accelerated (demand for payment in full) and / or have the collateral seized if the loan cannot quickly be worked out.

CAMELS
The CAMELS approach was developed by bank regulators in the United States as a means of measurement of the financial condition of a financial institution. (Uniform Financial Institutions Rating System established by the Federal Financial Institutions Examination Council) The acronym CAMELS stands for: Capital Adequacy Asset Quality Management Earnings (Profitability) Liquidity & Funding Sensitivity to Market Risk (losses arising from changes in market prices) CAMELS analysis requires: financial statements (the last three years and interim statements for the most recent 12-month period) cash flow projections portfolio aging schedules funding sources information about the board of directors operations/staffing macroeconomic information In reviewing ratios the credit analyst needs to keep 2 concepts in mind: Level or whether the ratio for a given fiscal period is either equal to or exceeds (which can be both positive or negative depending on the ratio) the established parameters of what is considered a generally acceptable position for that specific ratio. Trend or whether the fiscal to fiscal comparison period indicates that the level of the ratio is improving or deteriorating. In addition, individual ratios must not be reviewed in isolation to other ratios and what is the present strategy of the management of the financial institution. Capital Adequacy On Septmber 3, 2009, the U.S. Department of Treasury proposed that capital requirements for all banking firms should be increased, and capital requirements for financial firms that could pose a threat to overall financial stability should be higher than those for other banking firms. www.treas.gov/press/releases/docs/capital-statement_090309.pdf

The Office of the Comptroller of the Currency along with other agencies are requesting comments regarding a proposal to modify general risk-based and advanced risk-based capital adequacy frameworks to eliminate the exclusion of certain consolidated asset-backed commercial paper programs from risk-weighted assets due to the implementation of the Financial

Accounting Standard Boards (FASB) Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140 and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R). www.occ.gov/ftp/release/2009-101a.pdf

In August 2009, the FDIC approved guidelines to allow private-equity investors to acquire the deposit liabilities and assets of failed banks operating under FDIC receivership (includes a Minimum Tier 1 leverage ratio of 10.0%). www.fdic.gov/news/board/Aug26no2.pdf Capital Adequacy is a measurement of a bank to determine if solvency can be maintained due to risks that have been incurred as a course of business. Capital allows a financial institution to grow, establish and maintain both public and regulatory confidence, and provide a cushion (reserves) to be able to absorb potential loan losses above and beyond identified problems. A bank must be able to generate capital internally, through earnings retention, as a test of capital strength. An increase in capital as a result of restatements due to accounting standard changes is not an actual increase in capital. The Capital Growth Rate, which is calculated by subtracting prior-period equity capital from current-period equity capital, then dividing the difference by prior-period equity capital, indicates that either earnings are extremely good, minimal dividends are being extracted or additional capital funds have been received through the sale of new stock or a capital infusion, or it can mean that earnings are low or that dividends are excessive. The capital growth rate generated from earnings must be sufficient to maintain pace with the asset growth rate. The 1988 Basel Committee Capital Accord established a benchmark for measuring bank capital (and for correctly calculating / risk weighting assets, which became the denominator of the capital ratio): BIS Tier 1 (core capital): total own funds (allotted, called up and fully paid, ordinary share capital/common stock net of any shares held; perpetual, non-cumulative, preferred shares, including such shares redeemable at the option of the issuer; disclosed equity reserves in the form of general and other reserves created by appropriations of retained earnings, share premiums and other surplus; published interim retained profits verified by external auditors, minority interests arising on consolidation from interests in permanent shareholder's equity; fund for general banking risks) must be at least 4% of total risk weighted positions. Germany, Belgium, the Netherlands, and the UK maintain hidden reserves. The only intangibles that the FDIC allows to be included in Tier 1 regulatory capital are purchased mortgage servicing rights and purchased credit card relationships (cannot account for more than 50% of an institution's Tier 1 capital unless those grandfathered in from February 19, 1992). BIS Tier 2 (supplemental): total own funds (plus value adjustments; reserves arising from the revaluation of tangible fixed assets and financial fixed assets; hybrid capital instruments) must be at least 8% of total risk weighted positions.

In the United States, Capital Adequacy is regulated by Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC) and the Office of Thrift Supervision (OTS). The OCC supervises the capital adequacy of national banks and federal branches of foreign banking organizations. The Federal Reserve Board supervises the capital adequacy of state-chartered banks that are members of the Federal Reserve System (state member banks). The FDIC supervises the capital adequacy of state-chartered banks that are not members of the Federal Reserve System. The Office of Thrift Supervision (OTS) supervises the capital adequacy of all federally chartered and many state-chartered savings associations. The 1988 Basel Accord serves as the basis for current U.S. capital regulations. The 1988 Accord required that internationally active banking organizations adopt the new capital rules, but some countries, including the United States, chose to apply the 1988 Basel framework to all banks and thrifts. As indicated above, in the United States Tier I capital must constitute at least 50% of a banks total capital. Total of Tier 2 capital is limited to 100% of Tier 1 capital. The add-back of the allowance for loan and lease losses is limited to 1.25% of weighted-risk assets. The Basel / U.S. baking regulation guidelines for a "Well Capitalized institution" 5% or better Tier 1 Leverage Ratio (the ratio of Tier 1 capital to average total assets) 6% or better Tier 1 risk-based ratio (the ratio of Tier 1 capital to total risk-adjusted assets, with assets categorized by risk level) 10% or better total risk-based ratio (the ratio of total capital to total risk-adjusted assets). FDIC guidelines for a "Adequately Capitalized institution" 4% or better Tier 1 Leverage Ratio 4% or better Tier 1 risk-based ratio 8% or better total risk-based ratio In the United States, a bank is expected to meet a minimum ratio of qualifying total capital to risk-weighted assets of 8.0%, of which at least 4.0% should be in the form of core capital (Tier 1). Any bank that does not meet the minimum risk-based capital ratio, or whose capital is otherwise considered inadequate, generally will be expected to develop and implement a capital plan for achieving an adequate level of capital (usually under the terms of an FDIC Order to Cease and Desist). The concept of prompt corrective action by the FDIC was introduced with the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). When a bank becomes Undercapitalized (below "Adequately Capitalized") in many cases it means that unless it can rapidly turn the operation around it will be shut down by the respective supervisors. While "Undercapitalized" a bank: must cease paying dividends is generally prohibited from paying management fees to a controlling person must file and implement a capital restoration plan cannot accept, renew or roll over any brokered deposit. Effective yield on deposits solicited by the bank cannot be more than 75 basis points or .75% over local market yields for comparable size and maturity deposits.

 When a bank becomes Critically Undercapitalized in many cases it means that unless it can rapidly turn the operation around it will be shut down by the respective supervisors. A critically undercapitalized bank must be placed in receivership within 90 days unless the FDIC and the banks primary federal regulator concur that other action would better achieve the purposes of prompt corrective action. Additionally, a "Critically Undercapitalized" bank is prohibited, unless it obtains prior written FDIC approval, from: entering into any material transaction not in the usual course of business extending credit for any highly leveraged transaction (any transaction in which the borrower has very little equity) paying excessive compensation or bonuses paying interest on new or renewed deposits that would increase the banks weighted average cost of funds significantly above prevailing interest rates in its normal markets. FDIC 2000 Rules and Regulations, Part 325 - Capital Maintenance (12 C.F.R. Part 325) www.fdic.gov/regulations/laws/rules/2000-4400.html FDIC 2000 Rules and Regulations, Appendix A to Part 325 - Statement of Policy on Risk-Based Capital www.fdic.gov/regulations/laws/rules/2000-4600.html In the United States, Supplemental or Tier 2 Capital consists, within certain specified limits, of such things as the allowance for loan losses, hybrid capital instruments, and subordinated debt. These supplemental items are often forms of debt that are subordinate to claims of depositors and the FDIC. As such, they provide depositor protection and are included in bank capital. The regulatory treatment of Tier 2 capital is such that securities issued in a subordinate position for regulatory capital purposes have their capital value amortized over the last five years of the security. This was solved in 1997 through a "10 non-call five/seven step-up." A call provision is put in from one day after year five or year seven and the bank is allowed to call it with five full years as 100% capital treatment. A coupon step-up is put in at the end of year five or seven to allow for the bond to roll over for a further five year period. The sum of Tier I and Tier 2 capital, less certain deductions, represents a banks total capital. It should be noted that in the United States, The Gramm-Leach-Bliley Act (GLB Act) currently requires a bank holding company (BHC) to keep its subsidiary depository institutions well capitalized and well managed in order to qualify as a financial holding company (FHC). FHC status allows a BHC to engage in riskier financial activities such as merchant banking, insurance underwriting, and securities underwriting and dealing. The GLB Act does not, however, require an FHC to be well capitalized or well managed on a consolidated basis. Contingent Core Tier 1 Capital / CoCos is debt that will automatically convert into equity shares of the bank if the bank's core capital ratio declines below a specific level. This is a hybird form of capital, which may be drawn upon in the event that the bank's balance sheet or earnings are under pressure. However, the amount of equity capital that is provided my be insufficient or it may send the wrong signal to the marketplace with regard to the financial health of the bank. Risk Weighting Assets The Basel I guidelines on risk weighting asset classes has been revised by the Basel II framework.

Please also see A Guide to the 2004 Capital Accord of the Basel Committee (Basel II) Capital Adequacy ratio which is calculated by dividing the bank's core capital by the bank's total risk-weighted assets, then multiply by 100. Core Capital Adequacy ratio which is calculated by dividing the bank's risk-based capital by the bank's total risk-weighted assets, then multiply by 100. The BIS Risk-weighted Assets guidelines were adopted by the Board of Governors of the federal Reserve (Code of Federal Regulations Title 12, Volume 5; Revised as of January 1, 2002). These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unused loan commitments, letters of credit, and derivative and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be "well capitalized" under Federal bank regulatory agency definitions, a bank holding company must have a Tier 1 ratio of at least 6%, a combined Tier 1 and Tier 2 ratio of at least 10%, and a leverage ratio of at least 3%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. Risk-weighted 0% 1) Cash (including domestic and foreign currency owned and held converted into U.S. dollar equivalents) 2) Securities issued by and other direct claims on the U.S. Government or its agencies (to the extent such securities or claims are unconditionally backed by the full faith and credit of the United States Government). 3) Securities issued by and other direct claims on the central government of an OECD country 4) Notes and obligations issued by either the Federal Savings and Loan Insurance Corporation or the Federal Deposit Insurance Corporation and backed by the full faith and credit of the United States Government 5) Deposit reserves at, claims on, and balances due from Federal Reserve Banks 6) The book value of paid-in Federal Reserve Bank stock 7) That portion of assets that is fully covered against capital loss and/or yield maintenance agreements by the Federal Savings and Loan Insurance Corporation or any successor agency 8) That portion of assets directly and unconditionally guaranteed by the United States Government or its agencies, or the central government of an OECD country Risk-weighted 20% 1) Cash items in the process of collection 2) That portion of assets collateralized by the current market value of securities issued or guaranteed by the United States government or its agencies, or the central government of an OECD country 3) That portion of assets conditionally guaranteed by the United States Government or its agencies, or the central government of an OECD country 4) Securities (not including equity securities) issued by and other claims on the U.S. Government or its agencies which are not backed by the full faith and credit of the United States Government

5) Securities (not including equity securities) issued by, or other direct claims on, United States Government-sponsored agencies 6) That portion of assets guaranteed by United States Government-sponsored agencies 7) That portion of assets collateralized by the current market value of securities issued or guaranteed by United States Government-sponsored agencies 8) Claims representing general obligations of any public-sector entity in an OECD country, and that portion of any claims guaranteed by any such public-sector entity 9) Bonds issued by the Financing Corporation or the Resolution Funding Corporation 10) Balances due from and all claims on domestic depository institutions. This includes demand deposits and other transaction accounts, savings deposits and time certificates of deposit federal funds sold, loans to other depository institutions, including overdrafts and term federal funds, holdings of the savings association's own discounted acceptances for which the account party is a depository institution, holdings of bankers acceptances of other institutions and securities issued by depository institutions, except those that qualify as capital 11) Deposit reserves at, claims on and balances due from the Federal Home Loan Banks 12) Claims on, or guaranteed by, official multilateral lending institutions or regional development institutions in which the United States Government is a shareholder or contributing member 13) That portion of assets collateralized by the current market value of securities issued by official multilateral lending institutions or regional development institutions in which the United States Government is a shareholder or contributing member 14) All claims on depository institutions incorporated in an OECD country, and all assets backed by the full faith and credit of depository institutions incorporated in an OECD country. This includes the credit equivalent amount of participations in commitments and standby letters of credit sold to other depository institutions incorporated in an OECD country, but only if the originating bank remains liable to the customer or beneficiary for the full amount of the commitment or standby letter of credit. Also included in this category are the credit equivalent amounts of risk participations in bankers' acceptances conveyed to other depository institutions incorporated in an OECD country. However, bank-issued securities that qualify as capital of the issuing bank are not included in this risk category 15) Claims on, or guaranteed by depository institutions other than the central bank, incorporated in a non-OECD country, with a remaining maturity of one year or less Risk-weighted 50% 1) Revenue bonds issued by any public-sector entity in an OECD country for which the underlying obligor is a public- sector entity, but which are repayable solely from the revenues generated from the project financed through the issuance of the obligations Qualifying mortgage loans and qualifying multifamily mortgage loans Privately-issued mortgage-backed securities (i.e., those that do not carry the guarantee of a government or government sponsored entity) representing an interest in qualifying mortgage loans or qualifying multifamily mortgage loans. If the security is backed by qualifying multifamily mortgage loans, the savings association must receive timely payments of principal and interest in accordance with the terms of the security. Payments will generally be considered timely if they are not 30 days past due

2) 3)

Risk-weighted 100% Consumer loans Commercial loans Home equity loans Non-qualifying mortgage loans Non-qualifying multifamily mortgage loans Residential construction loans Land loans, except that portion of such loans that are in excess of 80% loan-to-value ratio 8) Nonresidential construction loans, except that portion of such loans that are in excess of 80% loan-to-value ratio 9) Obligations issued by any state or any politica1 subdivision thereof for the benefit of a private party or enterprise where that party or enterprise, rather than the issuing state or political subdivision, is responsible for the timely payment of principal and interest on the obligations, e.g., industrial development bonds 10) Debt securities not otherwise described in this section 11) Investments in fixed assets and premises 12) All repossessed assets or assets that are more than 90 days past due 13) Indirect ownership interests in pools of assets. Assets representing an indirect holding of a pool of assets, e.g., mutual funds, are assigned to risk-weight categories under this section based upon the risk weight that would be assigned to the assets in the portfolio of the pool. An investment in shares of a mutual fund whose portfolio consists primarily of various securities or money market instruments that, if held separately, would be assigned to different risk-weight categories, generally is assigned to the riskweight category appropriate to the highest risk-weighted asset that the fund is permitted to hold in accordance with the investment objectives set forth in its prospectus Off-balance sheet items are included in determining risk-weighted assets after reduction by specific reserves. Risk-weighted 0% 1. Letters of credit, guarantees or guarantee-type instruments secured by deposits with the issuing bank Risk-weighted 20% 1. Unused, non-callable credit lines with original maturity up to one year 2. Revocable letters of credit Is the bank increasing its capital from the growth of retained earnings? Does it have the ability to raise capital? Banks, securities firms and finance companies should show increasing capital due to the growth of principal risk-taking/trading and the growth of derivatives business which results in these firms taking more off-balance sheet risk. Banks and Investment Banks must also allocate capital to new/growing international operations. Leverage is the relationship between the risk-weighted assets of a bank and its equity. Securities firms look at Net Assets divided by Equity as Leverage. 1) 2) 3) 4) 5) 6) 7)

Key Ratios for Examining Capital Adequacy

Equity Capital Equity Capital / Average Assets This is a primary measurement for judging capital strength. Equity capital is defined as the total of common stock, surplus, perpetual preferred stock, undivided profits and capital reserves before FASB 115 & 133 adjustments. Intangibles and net unrealized holding gains (losses) on available-for-sale securities are excluded from Capital. Tier 1 Leveage Ratio Tier 1 Capital / Total Tangible Assets (Total Assets less Goodwill and Intangibles) Utilized by federal and state banking agencies to determine one of the components of capital adequacy ("Well Capitalized" is equal to or greater than 5%). The greater the number the more capital there is to cover problems on the asset side of the blance sheet. For most small to medium-sized banks, Tier 1 Capital generally consists of only common equity, which is the sum of common stock, surplus and retained earnings. Tier 1 Risk-based Capital Ratio Tier 1 Capital / Total Risk-adjusted Assets Required to be a minimum 6.0% to be "Well Capitalized" Risk-adjusted assets go through the analysis and "weighting" process outlined at the top of this section.
Tier 2 Risk-based Capital Ratio or Total Risk Capital Ratio

Tier 2 Capital / Total Risk-adjusted Assets Required to be a minimum 8.0% to be "Well Capitalized" For most small banks supplemental / Tier 2 capital is usually the loan loss reserve
Texas Ratio

Delinquent Loans + Non-performing Assets / Capital + Loan Loss Reserves. If the ratio is 100% or higher then the bank may be in imminent danger of failing. If the ratio is between 50% and 100% then a capital infusion is necessary. The ratio is a quick way to determine the bank's ability to absorb losses. Asset Quality The Assets of a bank are: Cash (unrestricted) Fed funds sold Trading portfolio (securities, although banks also tend to include derivative contracts in this category) Securities (available for sale are liquid; held to term as less liquid) Loans (various counterparties, collateral and maturities; lease contracts may also be included in this category)

 Fixed assets (some banks own their headquarters and/or branches, as opposed to leasing, which can be sold to raise cash) Asset Quality evaluates risk (and there must be some risk to earn a return), controllability, adequacy of loan loss reserves, and acceptable earnings; and the affect of off-balance sheet earnings and loss. The quality of a bank's assets hinges on their ability to be collected a during and at maturity. Thus, one must examine the portfolio quality, the portfolio classification system (aging schedule and the methodology to classifying a receivable) and the fixed assets (the productivity of the long-term assets, for instance the branch network). It is also necessary to determine the liquidity and the maturity structure of various Assets. Investing in assets is how a bank primarily earns a return. How well are these assets going to perform? Earning Assets: interest bearing financial instruments which are principally commercial, real estate, and consumer loans; investment securities and trading account securities; money market investments; lease finance receivables; time deposits placed in foreign banks. Risk-based / Risk Weighted Assets: Some investments and loans are riskier than others and regulators realize that there should be a flexible scale of allocating bank reserve capital to these various types of assets. For instance, a bank that has U.S Treasury securities in its portfolio of securities does not have to assign any capital reserve for this particular asset. Risk assets: loans to affiliates, other loans, interest receivables and other assets. Loans are usually the largest asset category for a bank: Change in loan volume, why has it grown or contracted, what percentage has it grown/contract? Loan mix: what part of the portfolio is growing (consumer vs. commercial) Is the bank overly exposed in one sector (i.e. commercial real estate, industry sector, country) and what is the environment for the performance and value of the assets? Title 12 USC 85 regulates the maximum rate of interest that national banks may charge on most types of loans. Banks that charge a higher rate violate the law and may trigger the penalties for usury described in 12 USC 86. Section 85 authorizes national banks to charge interest on loans at the rates allowed by the states in which the bank is located. A national bank is considered to be located in states in which it has either its main office or a branch. If state law permits state lenders to make loans without interest rate limitations, then national banks may make the same types of loans without interest rate limitations. Section 85 also provides that on all loans, national banks may charge 1.0% more than the discount rate on 90-day commercial paper in effect at the Federal Reserve bank in the district in which the bank is located. For example, if the discount rate is 7.0%, than national banks may charge 8.0%, discounted in advance, without regard to state usury laws. Under section 85, a national bank may charge the maximum rate of interest permitted by state law for any state-chartered or state-licensed lending institution. A national bank that charges a higher interest rate on a specified class of loans, as allowed by state law, is subject to the provisions relative to that class of loans that are material to the determination of the interest rate. For example, when a state law allows finance companies to charge 20 percent on certain loans, but limits state banks to 16 percent, national banks may charge 20 percent. However, national banks would be limited to charging the higher rate only on the same size and type of loans that finance companies are allowed to make. Title 12 USC 85 permits national banks to charge interest rates as permitted by a state in which the bank is located. For an intrastate bank, that is the state where its main office is located. For an interstate bank, that also

generally will be the state in which the bank has its main office though, in some circumstances, an interstate national bank may be required, or may have the authority, to charge rates permitted by a state in which one or more of its branches is located. What percentage of loans (either separate portfolios of consumer loans and commercial loans and/or combined) are delinquent 30 day? What percentage of total loans are delinquent 90 days? What percentage of total loans are non-performing (over 90-day, non-accrual and restructured). What is the percentage of charge-offs to total loans (consumer and commercial receivbles)? What is the percentage change of charge-offs from the previous fiscal period? Loan Loss Reserve: is created and built up by placing operating income (provisions) in an account on the asset-side of the blanace sheet, and which must be a sufficiently funded amount to cover actual or anticipated losses. against identified impaired loans are specifed in Statement of Financial Accounting Standards No. 114 (Accounting by Creditors for Impairment of a Loanan amendment of FASB Statements No. 5 and 15) and tatement of Financial Accounting Standards No. 118 (Accounting by Creditors for Impairment of a LoanIncome Recognition and Disclosuresan amendment of FASB Statement No. 114) If there is a problem with the repayment of a loan, the interest will sometimes be capitalized. Interest begins accruing on a loan as soon as it is disbursed. The interest can be repaid as scheduled or it can be capitalized, which means that the interest will continue to accrue and will be added to the loan principal amount thereby increasing the loan principal amount, which is then the new balance that is used to compute interest for the next period. The net effect of capitalization is that it increases the total amount paid over the lifetime of the loan. Asset Growth Rate: computed by subtracting prior-period total assets from current-period total assets, then dividing the difference by prior-period total assets, indicates the state of economic condition and/or the philosophy (which wants to rapidly increase or slowly increase the asset side of the balance sheet).

Key Ratios for Examining Asset Quality

Loan Loss Reserves to Total Loans Ratio Loan Loss Reserves / Total Loans This is a primary measurement for judging capital strength. Traditionally the amount is a minimum 1.0% but it is not sure if it is adequate unless it is compared to Provisions/Total loans: percentage of provisions from fiscal income statement as a percentage of the portfolio. Intangibles and net unrealized holding gains (losses) on available-for-sale securities are excluded from Capital. Coverage Ratio Loan Loss Reserves / Non-Performing or Non-current Loansand leases

 Non-performing or Non-current loans consist of loans that are 90 days or more overdue and still accruing and nonaccrual loans. Also sometimes known as the coverage ratio, should be in excess of 1.5x
Overdue Loans to Total Loan Ratio

Total Loans 30-89 Days Past Due / Total Loans riate or collection procedures are inadequate. 90-Day Overdue Loans to Total Loans Ratio Total Loans 90-Days Past Due / Total Loans Indicates that the loan portfolio may be experiencing some deterioration through either poor underwriting and/or collections. Management Structure Is the bank newly privatized from government ownership? What is the ownership structure of the bank? (Government support? Independently capitalized or a branch? Can rely on parent support implicit/explicit?) Is as small branch network a constraint on business? Loan portfolio management, credit administration, policy development, employee training, loan workout Is it possible to determine Governence, Audit oversight and Strategic planning?

Earnings (Profitability)
Earnings determine the ability of a bank to increase capital (through retained earnings), absorb loan losses, support the future growth of assets, and provide a return to investors. The largest source of income for a bank is net interest revenue (interest income from lending activity less interest paid on deposits and debt). The second most important source is from investing activity. A substantial source of income also comes from foreign exchange and precious metal trading, and commissions/transaction fees and trust operations. New banks, or De Novo banks, are usually not profitable for the first two to three years as they develop their core business operations, hire employees, open branches and may also have to pay a higher interest rate to attract deposits. What the analyst should look at in this case is the "burn rate" (on a monthly and quarterly basis), which is an indication of how much of the initial equity investment (stockholder's equity) is being used up to cover operating expenses. What needs to be demonstrated is that income is increasing faster than expenses and the monthly and quaterly losses are decreasing, hence equity is not decreasing as rapidly. Overall, the issues to consider include: What is the concentration of business: retail, trade finance, corporate, mortgage, merchant, personal, investment, portfolio management, asset financing, leasing, advisory, nominee and custodial services, executor and trustee? Are the bank's core earnings in its home market only? What is the ratio between interest and non-interest income sources? Is operating income declining compared to previous periods due to insufficient revenue or higher operating expense? Is net income low due to non-accrual loans?

 Is an improvement in revenue and earnings coming from extraordinary / nonrecurring items? Would the elimination of this one-time item actually result in a loss? Is the increase in earnings derived from the adoption of new accounting standards? he need to charge provisions for loan and lease losses against earnings can also reduce profitability, at lease on a quarterly basis. The bank's management has to look at what type of loans are in the portfolio, what the preformance is of the portfolio and what is happening with national, regional and local economic conditions. For instance, recession, increase in bankruptcies, increase in unemployment, local corporate layoffs and plant closings, drought, low farm prices, and so on suggest rising numbers of delinquent loans that the bank must correctly estimate and have sufficent reserves thus provisions may be taken against earnings just as the bank's revenues may be declining. Conversely, if economic conditions are deteriorating and the bank is not provisioning for anticipated losses in order to maintain profitability then problems may develop during the next fiscal period.

Key Ratios for Examining Profitability

Net Interest Margin Net Interest Income (annualized) / Average Interest Earning Assets This is net interest income expressed as a percentage of average earning assets. Net interest income is derived by subtracting interest expense from interest income. Indicates how well management employed the earning asset base (the denominator focuses strictly on assets that generate income). May come under pressure from offering preferential rates to customer base, a low level of growth in savings and the higher percentage of more expensive wholesale funds available. The lower the net interest margin, approximately 3.0% or lower, generally it is reflective of a bank with a large volume of non-earning or lowyielding assets. Conversely, are high or increasing margins the result of a favorable interest rate environment, or are they the result of the bank moving out of safe but low-yielding, low-return securities into higher-risk, higher yielding and less liquid loans or investment securities?

Return on Average Assets (ROAA) Net operating income (annualized) after taxes (including realized gain or loss on investment securities) / Total Average Assets (assets at the previous fiscal year plus assets at this current fiscal year divided by 2) for a given fiscal year Actual net income should be examined for the inclusion of extraordinary earnings (which may be excluded). This measures how the assets are utilized by indicating the profitability of the assets base or asset mix. Ranges from approximately 0.60% to under 2.0% for U.S. Banks. Historically in the U.S. the benchmark was 1.0% or better for the bank to be considered to be doing well. De novo banks are usually below the 1.0% benchmark.

If the bank is a Subchapter S Corp. then the coporation is treated as a pass-through entity and is not subject to Federal income taxes at the corporate level. Therefore, an adjustment to net income is needed to improve the comparability between banks that are taxed at the corporate level and those that are not.

Return on Average Equity (ROAE) Net operating income after taxes (including realized gain or loss on investment securities) / Total (average) equity (common stock) for a given fiscal year This ratio is affected by the level of capitalization of the financial institution. Measures the ability to augment capital internally (increase net worth) and pay a dividend. Measures the return on the stockholder's investment (not considered an effective measure of earnings performance from the bank's standpoint). In the long run, a return of around 15% to 17% is regarded as necessary to provide a proper dividend to shareholders and maintain necessary capital strengths. Adjusted ROE or ROAE: Net income / Total equity plus loan loss reserves in excess of 10% of equity. Return on Earning Assets (ROEA) Revenue from loans, securities, cash equivalents and earning assets (including non-interest) before interest expense / Earning Assets Measures the results of operations prior to funding costs and as if the operations were totally funded by equity.

Operating Profit Margin Operating profits (before the loan loss provision and excluding gains or losses from asset sales and amortization expense of intangibles) / Net operating revenues (interest income less interest expense plus noninterest income) providing the remaining operating profit (the higher the margin the more efficient the bank).

Non-interest Income to Average Assets Ratio Non-Interest Income (annualized) / Total Average Assets Non-interest income is income derived from fee-based banking services such as service charges on deposit accounts, consulting and advisory fees, rental of safe deposit boxes and other fee income, fiduciary, brokerage and insurance activities. Realized gains on the sale of securities is excluded. It is important that a bank devlop non-interest income sources but it should become a major portion of the bank's total revenue unless it really is an annual core business operation.

Average Collection of Interest (Days) Accrued Interest Receivable / Interest Income x 365 This is a measurement of the number of days interest on earning assets remains uncollected and indicates that volume of overdue loans is increasing or repayment terms are being extended to accommodate a borrower's inability to properly service debt.

Overhead Ratio Total Non-Interest Expenses (annualized) / Total Average Assets Non-interest expenses (annualized), which are the normal operating expense associated with the daily operation of a bank such as salaries and employee benefits plus occupancy / fixed asset costs plus depreciation and amortization. These costs tend to rise faster than income in a time of inflation or if the institution is expanding by the purchase or construction of a new branches. Provisions for loan and lease losses, realized losses on securities and income taxes should not be included in non-interest expense.

Efficiency Ratio Total Non-interest expenses / Total Net Interest Income (before provisions) plus Total NonInterest Income Efficiency improves as the ratio decreases, which is obtained by either increasing net interest income, increasing non-interest revenues and/or reducing operating expenses. Non-interest expenses (expenses other than interest expense and loan loss provisions, such as salaries and employee benefits plus occupancy plus depreciation and amortization) tend to rise faster than income in a time of inflation. This is a measure of productivity of the bank, and is targeted at the middle to low 50% range. This may seem like break-even but it is not; what this is saying is that for every dollar the bank is earning it gets to keep 50 cents and it has to spend 50 cents to earn that dollar. The ratio can be as low as the mid to low 40% range, which means that for every dollar the bank earns it gets to keep 60 cents and spends 40 cents, a very efficient bank. Ratios in excess of 75% mean the bank is very expensive to operate. Liquidity & Funding Liquidity and Funding are related, however they are separate situations. Funding is what a bank relies upon to grow its business and the asset side of the balance sheet above and beyond what could be accomplished with just equity. Funding is provided by deposits, short-term debt and longer-term debt. Funding means access to capital. Liquidity is what a bank requires if Funding is interrupted and the bank must still be able to meet certain obligations (bank's ability to repay depositors and other creditors without incurring excessive costs). What is the liability structure / composition of the institutions liabilities, including their tenor, interest rate, payment terms, sensitivity to changes in the macroeconomic

environment, types of guarantees required on credit facilities, sources of credit available to the institution and the extent of resource diversification. A bank's least expensive means of funding loan growth is through deposit accounts. When this is not available, banks must rely on more expensive funding sources such as borrowing funds at wholesale rates or liquidating investment securities portfolios. The best type of deposits are "core" deposits, which are balances that are left at the bank due to convenience (the depositor resides in the area) or through loayalty. Non-core deposits / funding are sources that can be very sensitive to changes in interest rates such as brokered deposits, CDs greater than $100,000, and borrowed money. The Deposit Growth Rate, which is computed by subtracting prior-period total deposits from current-period total deposits, then dividing the difference by prior-period total deposits, indicates how a bank is funding the asset side of its balance sheet. Funding sources also include: Net earnings Issuance of common and preferred securities Trust preferred securities Commercial paper Senior debt Subordinated debt Securitizing various financial assets including credit card receivables and other receivables generally secured by collateral such as single-family residences and automobiles Monetizing investment securities Liquidity refers to reserves of cash, securities, a bank's ability to convert an asset into cash, and unused bank lines of credit. The faster the conversion the more liquid the asset. Illiquidity is a risk in that a bank might not be able to convert the asset to cash when most needed. Moreover, having to wait for the sale of an asset can pose an additional risk if the price of the asset decreases while waiting to liquidate. Thus, if loans or assets are illiquid then liquidity is also limited, especially if the loans exceed stable deposits and available lines of credit. Liquidity must be sufficient to meet all maturing unsecured debt obligations due within a one-year time horizon without incremental access to the unsecured markets. Probably the most critical issue to examine for a bank is the ability to meet obligations. If earnings are poor and liquidity is high, the bank's lending may be too conservative, with a high proportion of proceeds from deposits are invested in low yielding liquid assets. If earnings are low and liquidity is low, then the bank may have an aggressive lending policy coupled with heavy borrowing. It examines "internal" sources of funds: maturing loans and marketable securities; and "external" sources of funds: is the bank dependent on large deposits from a single source or does it have a large and stable retail funding base? (single sources should not exceed 10% of short-term liabilities).

Liquidity Gap Analysis

is an attempt to measure future funding needs of a bank by comparing the amount of assets and liabilities maturing over time. The overall goal of management in the asset/liability/capital structure of the institution is to maximize the return earned from the assets, with the lowest risk profile and default ratio, and

also minimize the cost of funds as much as possible to widen the spread between earnings and expenses (manage the net interest margin); and to utilize leverage over invested capital. Liquidity Management: "cash-out" or the risk of being illiquid when cash is needed. Sources and uses of funds approach: liquidity required for deposit withdrawals and loan demand. Structure of deposits approach: focuses on the stability of deposit liabilities. Awareness of gap management: gap analysis is a measurement of interest rate sensitivity of assets and liabilities. If a company has a negative duration gap that means that its assets are paying off faster than its liabilities. The response can either be defensive or aggressive with regard to managing the spread between the yields of the institution's assets and their income from service sales and the cost of carrying on their operations, especially the return paid to savers to attract deposits and equity investments.

Management's goal for assets:

Primary reserves Sufficient cash on hand to cover customer deposits and withdrawals or clearing and collecting check payments; and maintain contemporaneous reserve requirements. Cash in the vault is not earning interest. Cash/total assets ratio rises in relation to the size of the institution. Secondary reserves Marketable securities portfolio: short-term and liquid for cash needs and pledging collateral. U. S. Treasury: relatively short-term maturities, increasing to 20% of total assets due to favorable tax and capital reserve treatment. Securities of states and municipalities: declined due to less favorable tax and capital treatment. Loans At a rate in excess of the cost of funds, to borrower with a good credit profile. Rates on corporate loans have been declining due to disintermediation/competition. Real estate loans have the highest margin but are less liquid and riskier. Total loans tend to approximate 60% of the total assets. Liquidity Management related to assets: match maturity of assets with liquidity needs. The historical decline in liquid assets on hand is related to better management. Anticipation of deposit and loan changes. If the bank invests for yield, it will not be able to cover demands. Could be covered by liquidation of assets and borrowings. Commercial loan theory: confine loans to short-term, self-liquidating commercial loans. Money market approach: hold money market instruments such as Treasury bills, CP or banker's acceptances. Management's goal for liabilities: to also manage sources of funds (not just uses of funds/asset management) to meet liquidity requirements; and increase income potential.

Funding requirements. Customer deposits: the least expensive source of funding for the institution. The institution is seeking "core deposits," or passive accounts that stay with the institution out of loyalty or convenience (checking accounts, savings certificates and regular savings accounts). What happens if a bank experiences a credit ratings downgrade: deposits from local municipalities, state governments, escrow accounts and fiduciary deposits must be withdrawn if the downgrade results in a noninvestment grade rating. Non-deposit borrowed funds: cost more than customer deposit funds Federal funds for short-term liquidity. CDs if funding is needed for a longer period Liquidity Management related to Liabilities: Interest rates may be higher when the institution seeks to acquire funds. Requires that the financial condition of the bank be strong.
Management's goal for Capital: provide the buffer to absorb losses, must maintain adequate equity capital to satisfy regulatory requirements, and have a financial condition that allows it to borrow funds.

Must meet BIS risk assets to capital guidelines: 4% Tier one, 8% including Tier two capital; risk weighted asset categories. If condition has weakened, then funds will cost more. It is poor liquidity, as opposed to poor asset quality or inadequate capital, that leads to most bank failures.

Key Ratios for Examining Liquidity

Loans as a Percentage of Deposits Loans (gross) / Total Deposits Indicates the percentage of a bank's loans funded through deposits (measures funding by borrowing as opposed to equity) Maximum 80% to 90% (the higher the ratio the more the institution is relying on borrowed funds) However, cannot also be too low as loans are considered the highest and best use of bank funds (indicates excess liquidity). Between 70% to 80% indicates that the bank still has capacity to write new loans. A high loan-to-deposit ratio indicates that a bank has fewer funds invested in readily marketable assets, which provide a greater margin of liquidity to the bank.

Liquid Assets to Total Deposits Liquid Assets / Total Deposits Measures deposits matched to investments and whether they could be converted quickly to cover redemptions.

BOPEC BOPEC was the former bank holding company examination ratings system. Bank Holding Companies (BHC) are usually the stock-issuing entity within a banking organization and the BHC can have a number of operating subsidiaries. BOPEC was designed to examine the subsidiary operations as the condition of a BHC is closely related to the condition of its subsidiary banks. The examination of the bank holding company by federal regulators in the United States would rate banks on a scale from 1 to 5 with 1 being the highest rating and 5 being close to insolvency. The system was replaced by RFI/CD (see next below). BHC's Bank subsidiaries condition Other nonbank subsidiaries / affiliates condition Parent company condition Earnings Comsolidated poistion of the parent Capital Consolidated position of the parent RFI/CD As of January 2005, the BHC evaluation system was revised to the acronym RFI/CD which stands for: Risk management (R) such as policies, procedures, limits, risk monitoring and managment information systems. Financial condition (F) such as Capital, Asset Quality, Earnings and Liquidity. Impact (I) of the parent company and nondepository entities on subsidiary depository institutions. Composite rating (C), which is the BHC's overall evaluation and rating of its managerial and financial condition and an assessment of future potential risk to its subsidiary depository institution(s). Depository institutions (D), which is the assessment of the subsidiary depository institutions by the primary regulator. Book Value If the financial istitution had to be shut down immediately, the book value of the financial institution is equal to the Total Assets minus Liabilities, Preferred Stock, and Intangible Assets. However, this is a straight arithmetic exercise. The reality is that a distressed bank has impaired or hard to sell assets and it is not likely that another bank or investor is going to purchase them at par. Thus, the assets must be examined to determine whether there are any secured lenders who have a claim on assets, what type of securities is the financial institution holding in its portfolio and what is the present performance of the loan portfolio. The fixed assets are not going to be readily marketable and the fixtures and furniture will either disappear with employees or be of salvage value only. Liabilities usually tend to be definite in value while assets tend to have fluctuating or questionable value. Issues Affecting Banks

 Further disintermediation of bank assets: trend toward the securitization of assets by corporate customers (banks will decrease as primary suppliers of credit to high quality borrowers. This means that a higher proportion of bank's remaining credit exposure will be to less marketable credits where there is less demand and less hedging instruments available) and the increasing use of mutual funds and private pension funds by consumer customers. The continuing increase in non-bank competitors offering similar services. Continued deregulation and globalization of services. Increased technological innovation and technology costs in order to compete effectively. How to differentiate and appropriately price services such as origination, structuring and administration. Consistent risk pricing and Basle Committee capital requirements for credit risk.

Understanding the Bankers' Formula

By Linda Plater Published September 2001 Has your small business ever been turned down for a bank loan? If so, you're not alone. Did you ever find out why you weren't approved for a simple line of credit or capital loan? The truth is, many small businesses once rejected by the banks never know exactly why they've failed to secure the financing they need to grow their enterprises. Success or failure can depend heavily on your ability to inject cash into the business from non-lending sources such as personal savings or private investors. This is the first of a series of articles that will look at bank financing for small business. The series will outline the factors that a banker considers when evaluating loans. It will also reveal some balance sheet "must-haves" to help your business get in shape for lender scrutiny. Finally we'll examine some common mistakes small businesses make when applying for loans. You'll also get some tips on how to avoid making errors or oversights that can lead to a rejected loan application. Even before entrepreneurs apply for a loan, they need to understand how early decisions made during the year or even several years before applying for a loan can impact on their ability to get debt financing. The Loan Application Most business owners think loan applications are all alike. Not true! Applications vary depending on the reason you need to borrow, and the type of loan. For example, cash flow lenders look at different criteria than asset lenders, and lines of credit have different requirements than term loans. However, these days automated application processes can churn out your approval or rejection in a matter of seconds. In the past the loan review process took much longer. Still some lenders do take the time to visit a business site to better understand its inner workings and to determine loan eligibility. To prepare for the application process, go online or drop into your branch. Look over some applications so that you understand well in advance exactly what the bank is looking for from

your business. It may take you several successful quarters before you even meet the criteria outlined in the application. So, set yourself up for success before you even apply! Smart tip: Do your homework. Review several loan applications and understand the business of the bank where you plan to seek funding. Credit Rating Although some banks are moving away from scrutinising personal finances, it is still very common for them to rely on the information business owners have in their personal credit files. That's why paying all your bills and paying them on time even if it is just the minimum payment is important when it comes to keeping your credit record healthy. The way you deal with paying suppliers and other businesses can show on your credit report so it's crucial to keep on top of your payables. For most banks, maintaining a good credit record is the single most important factor in their loan decision-making. When it comes to scoring well on your credit score, the higher the number the better. Banks will verify that the business has the ability to pay down its debt. And they don't like to see individual owners of a business or a company over extending themselves. It's quite common for start-ups to rely on flexible lines of credit and personal credit cards to finance the early stages of a business. For new graduates, some banks offer introductory credit card programs that are checked through personal credit bureaus. Just because you get credit doesn't mean you'll always keep it. Remember to pay at least the minimum on your monthly statements. Smart tip: Keep your financial house in order at all times and show that you pay your bills. The Numbers Please It's no secret. Bankers like numbers, preferably positive ones. But beyond the figures on your business balance sheet, it is important for anyone applying for a loan to understand what the numbers they present to the bank really mean. Maybe your sales have increased, but you report several slow quarters. You've got to be able to explain this to your banker to stand a chance of getting the loan you may so desperately need to grow your business. Any new loan, extension or line of credit application will need to be backed by solid numbers that prove a financial need and most importantly your ability to service the loan. Bankers will also look at how long you can afford to run the business without their help. This means you need to show accounting that makes sense. Your cash flow, including net income and amortization, need to appear on the balance sheet. They'll also consider investments in the business including: retained earnings, accumulation of profit generated, shareholder equity, and payables outstanding over the equity and loan inputs. While security or collateral is also factored into the lending equation, a company's earning potential may prove more important. According to Cathy Ierullo, BDC Area Branch Manager in Mississauga, "Earnings and potential earnings in the business are more important than the security in the business." Smart tip: Understand what your numbers represent and be able to explain them to the bank. What's a Ratio? The most common way loans are evaluated involves mathematical calculations called financial ratios. Although they vary for different industries, lending institutions look your ratios to determine loan eligibility. From the ratio, they can tell if an applicant faces cash flow problems.

An acceptable debt to equity ratio for a lender to consider your loan is usually about 2:1; more than 2:1, is getting into a risky territory where most lenders don't like to venture. The more debt cuts into the business, the more difficult it is for a company to service the debt. Banks want to see in your cash flow an ability to pay off debt. Beyond the debt to equity ratio lenders can look at your current ratio, which compares current assets to current liabilities. In other words, how your accounts receivable offset your accounts payable. They look at your working capital and inventory funding compared to current liabilities. How you manage your receivables can also impact your current ratio. Well-structured business processes can ensure that you present an acceptable current ratio to the bank. Smart tip: Know how to package your financial statements to reflect a debt to equity ratio and current ratio acceptable to your lender. If your ratios look out of sync with your industry, be able to explain why. Financing, not Accounting You might not know it or your accountant might not have explained this to you, but sometimes paying less tax can negatively affect your ability to secure financing. This move, called optimization, can harm your chances of securing a loan if your profits are not reflected on your corporate balance sheet. What a tax expert can do is prepare a business statement and reconcile it with your tax strategy to show the actual net income before tax planning. Creating this type of statement prior to optimization can look more attractive to potential lenders. For companies in growth mode, reducing taxes should not be their first priority. It is important though to avoid letting your tax bills cut into your profitability and your ability to grow the business. Your financial advisor needs to understand the future expansion plans for your business. An accountant should be your strategic partner in forecasting financial planning decisions. Therefore, make sure you share all of your financial plans with your accountant because solid financial advice is key to your business growth. Ask your advisor, "What do I need to show in my cash flow, revenue wise and income wise, to demonstrate that the business is making money?" Bankers want to see equity and profits. Smart tip: Get expert financial advice to plan for financing business growth first and tax reduction second. Business History First and foremost when considering your credit application, the banker wants you to demonstrate your business viability. This factor is all about management expertise and profitability. What is the background of the people related to the business requirements? Do you have the technical and management skills and resources to make the company profitable? These details need to show up in the business plan you present to the bank. You need to prove in words and in numbers that you've got what it takes to run a profitable business.

Do you have the background and experience to run a successful business and if not, can you afford to pay for expertise that you may lack? The bank wants to see commitment, both personal and financial on behalf of the business owner, because no lender wants to finance the majority of any enterprise. Talk to the bank only when you can demonstrate a history of business processes and internal reports in ship shape. Smart tip: Focus on the people and how their contributions make the business viable in tangible, measurable terms. Strikes Against You It's true, applying all over town for a loan can spell disaster for any business looking for credit. Lenders can find out how many institutions you've applied to by simply checking your credit bureau report. In the eyes of the lender, if you've sought credit from many places, it's not a good thing because it looks like you are desperate and probably not a good risk. Similarly, it's frowned upon if many collectors check your credit. Smart tip: Don't shop around too much. Find a lender you like and trust and work with them to ensure your financial success. Pay your bills on time so collectors don't add detrimental information to your credit file. Do You Qualify for a Loan? Most banks measure your application against a rating scale. The score-sheet that determines if you are eligible for a loan is usually proprietary to the lending institution. Some lenders will explain how your application rated if you ask. If you fail to secure financing, make sure you find out why so you can stack the odds in your favour if you decide to re-apply. Smart tip: If your loan application is rejected, ask why and re-apply when you can meet bank requirements.

How are Financial Ratios Compiled ?

The financial ratios are calculated using standardized financial methods to determine company and industry performance. USBR provides you with complete and accurate financial figures. Liquidity Ratios Current assets includes cash , marketable securities, inventory, and prepaid expenses. Current liabilities includes accounts payable ( 1 year Current Ratio or less) , current portions of long-term debt, and salaries payable. The current ratio measures the ability of the firm to pay is current bills while still allowing for a safety margin above their required amount needed to pay current obligations. Current ratio = current assets / current liabilities

Generally, the quick ratio should be lower than the current ratio because it eliminates the inventory figure from the calculation. Quick Ratio The quick ratio is similar to the current ratio but eliminates the inventory figure in the current assets section of the balance sheet. The inventory figure is thought to be the least liquid figure and should thus, be eliminated. USBR calculates the quick ratio as follows: Quick ratio = (Current Assets - Inventory) / Current Liabilities

The Net Working Capital figure simply deducts the current assets from the current liabilities on the Net Working balance sheet. USBR calculates the Net Working capital as follows: NWC = Current Assets - Current Liabilities Asset Ratios Total accounts receivable includes all outstanding credit obligations from customers. The sales figure includes sales for the prior four quarters of financial performance. The figure may also include amounts on a quarterly basis only. The accounts receivable period is a measure of a companys ability to collect accounts receivable within a timely and reasonable period. The accounts collection period varies from industry to industry. The smaller the accounts receivable period, the more effectively a company is in managing and collecting money from customers.

Days Sales Outstanding

USBR calculates the average collection period by the following formula: DSO = Accounts Receivable / (Sales / 360 days) The higher the inventory turnover rate means the more efficiently a company is able to grow sales volume. USBR compiles inventory turnover by using the cost of goods figure in the numerator since inventories are usually carried at cost. Many other compilers of financial data use sales in the numerator. However, this is usually an inaccurate barometer of financial performance to determine the inventory turnover rate. The inventory turnover ratio measures the number of times during a year that a company replaces its

Inventory Turnover

inventory. Differences in turnover rates result from differing operating characteristics within an industry. USBR calculates the inventory turnover rate as follows: Inventory Turnover = Cost of Goods / Total Inventory The fixed asset turnover can vary substantially from industry to industry. The fixed assets turnover is a measure of how efficiently a company uses its fixed assets to generate Fixed Asset Turnover sales. The higher the fixed asset ratio the better. USBR calculates the fixed assets turnover by adding all sales of the company and dividing the amount by net fixed assets for the latest four quarters of financial performance. The basic formula is as follows: FAT = ( Sales / Net Fixed Assets The total asset turnover is a measure of how efficiently and effectively a company uses its assets to generate sales. The figure is similar to the fixed Total Asset Turnover assets turnover but includes all assets . The higher the total asset turnover ratio, the more efficiently a firms assets have been used. USBR calculates the total asset turnover ratio as follows: Total Asset Turnover = Sales / Total Assets Debt Ratios Higher ratios indicate high financial leverage to the firm. USBR ignores short term obligations (e.g. current liabilities) in calculating debt ratios based on the prior four quarters of financial performance. Debt ratios measure the total amount and proportion of debt within the liabilities section of a firms balance sheet. These figures are normally appropriate for comparing a company performance from one period to another.

Deb to Equity

USBR measures the proportion of total assets provided by a company's creditors. The debt ratio is calculated by dividing the total liabilities by total assets. The higher this ratio, the greater the degree of outside financing by creditors. It indicates that the firm is more highly leveraged (debt) and highly risky for creditors. The basic formula is as follows: Debt Ratio = Total Liabilities / Total Assets

Times Interest Earned

The figure is determined from the income statement by finding the operating profit margin. The operating profit margin (discussed below) is the profits of the firm before interest and taxes are subtracted. The interest figure is the interest obligations for the prior four quarters of financial performance from the use of long term debt funds.

Times interest earned measures the ability of the firm to service all debts. The figure will indicate how many times a company can cover its fixed contractual obligations to its creditors. The higher the times interest earned , the more likely the firm can meet its obligations. USBR uses this basic formula as follows: Times Interest Earned = EBIT / Interest Profitability Ratios The DuPont method allows the firm to break down its return on investment into a profit on sales component and an asset efficiency component. Typically, a firm with a low net profit margin would have a total asset turnover. The relationship between the net profit margin and Total Asset turnover is largely dependent on the industry the firm operates.

Return on Investment

USBR uses the DuPont formula to determine the return on investment. The ROI is determined by multiplying the Total Asset turnover by the Net Profit Margin. The figure is meaningful because it shows how well a company uses its assets to generate profits,. The basic formula is as follows: ROI = Total Asset Turnover x Net Profit Margin USBR measures the ROE figure by adjusting for new equity infusion from the prior four quarters of a company. Return on Equity The return on equity measures the return earned on the owners equity in the firm. The higher the rate the better the firm has increased wealth to shareholders. The basic formula is as follows: ROE = Net Profits / Stockholders Equity This ratio is similar to return on equity. Return on capital has a tendency to be more meaningful from heavily leveraged (debt-laden) companies.

Return on Capital

Return on Capital is a measure of economic performance within a business firm. This ratio is used to measure how much capital (e.g. debt and equity) was needed to produce a firm's earnings. This ratio is also an indication of how well a company uses its capital to generate returns to shareholders. This could also provide a clue to how a company will perform in the future with its capital. The basic formula is as follows: Return on Capital = Return on Equity (ROE) / (1 + Debt to Equity Ratio) or Return on Capital = ROE x ( 1 - Debt to Capital ) The higher the GPM the better pricing flexibility and cost management controls a firm has in its operations The profitability figures measure the ability of the business firm to earn a profit from its operations through assets, sales, and equity.

Gross Profit Margin

The gross profit margin indicates the percentage of each sales dollar remaining after a firm has paid for its goods. The basic formula is calculated as follows: GPM = ( Sales - Cost of Goods Sold )/ Sales The operating profit margin indicates the profits of the company before interest and taxes are deducted from a firms operations. The higher the operating profit Operatign Profit Margin margin, the greater pricing flexibility a firm has in its operations. However, it could also indicate the degree of cost control management a firm possesses. The figure is calculated as follows: Operating Profits = Operating Profits / Sales Similar to the operating profit margin, the net profit margin measures the amount of profits available to shareholders after interest and taxes have been deducted on the income statement. The higher the profit margin, the more pricing flexibility a firm may have in its operations or the greater cost control initiated by management. The figure is determined as follows: NPM = Net Profits /Sales USBR sums the prior year earnings and divides the amount by the weighted average of shares outstanding. This assumes the most accurate information if a company distributes new shares

Net Profit Margin

Earnings Per Share

outstanding during the period which could substantially impact (or dilute) shares to current shareholders with lower per share earnings. The earnings per share measures the per share dollar return to owners of a company. The figure is calculated as follows: EPS = Total Earnings / No. of shares outstanding

What it is:
A bank efficiency ratio is a measure of a bank's overhead as a percentage of its revenue.

How it works/Example:
The formula varies, but the most common one is: Bank Efficiency Ratio = Expenses* / Revenue *not including interest expense For example, if Bank XYZ's costs (excluding interest expense) totaled $5,000,000 and its revenues totaled $10,000,000, then using the formula above, we can calculate that Bank XYZ's efficiency ratio is $5,000,000 / $10,000,000 = 50%. This means that it costs Bank XYZ $0.50 to generate $1 of revenue. As we said earlier, the formulas vary but the idea is to look at costs as a percentage of revenue. Costs include salaries, rent and other general and administrative expenses. Interest expenses are usually excluded because they are investing decisions, not operational decisions. Revenue includes interest income and fee income, though some banks exclude their provision for loan losses from revenue or add their tax equivalent net interest income to revenue when calculating the efficiency ratio. Why it Matters: The bank efficiency ratio is a quick and easy measure of a bank's ability to turn resources into revenue. The lower the ratio, the better (50% is generally regarded as the maximum optimal ratio). An increase in the efficiency ratio indicates either increasing costs or decreasing revenues. It is important to note that different business models can generate different bank efficiency ratios for banks with similar revenues. For instance, a heavy emphasis on customer service might lower a bank's efficiency ratio but improve its net profit. Banks that focus more on cost control will naturally have a higher efficiency ratio, but they may also have lower profit margins.

In addition, the more a bank generates in fees, the more it may concentrate on activities that carry high fixed costs (and thus create worse efficiency ratios). The degree to which a bank is able to leverage its fixed costs also affects its efficiency ratio; that is, the more scalable a bank is, the more efficient it can become. For these reasons, comparison of efficiency ratios is generally most meaningful among banks within the same model, and the definition of a "high" or "low" ratio should be made within this context. Interpretation of Financial Ratios 1) Profitability 2) Liquidity 3) Solvency/Capital Structure 4) Other Measures Interpretation of Financial Ratios Financial ratio analysis is one critical component of assessing a hospital's financial condition. Areas frequently examined include: Profitability This category evaluates the ability of a hospital to generate a surplus. Operating Margin (ratio of operating income to total revenue) Definition: Operating Income/Total Revenue Operating income is income from normal operations of a hospital, including patient care and other activities, such as research, gift shops, parking and cafeteria, minus the expenses associated with such activities. Operating Margin is a critical ratio that measures how profitable the hospital is when looking at the performance of its primary activities. A negative Operating Margin is usually an early sign of financial difficulty.

Non-Operating margin (ratio of non-operating income to total revenue) Definition: Non-Operating Income/Total Revenue Non-operating income includes items not related to operations, such as investment income, contributions, gains from the sale of assets and other unrelated business activities.

Total Margin (ratio of total income to total revenue) Definition: Total Income/Total Revenue This ratio evaluates the overall profitability of the hospital using both operating surplus (loss) and non-operating surplus (loss).

Liquidity

This category evaluates the ability of the hospital to generate cash for normal business operations. A worsening liquidity position is usually a primary indication that a hospital is experiencing financial distress.

Current Ratio (ratio of current assets to current liabilities) Definition: Total Current Assets/Total Current Liabilities This ratio measures the hospital's ability to meet its current liabilities with its current assets (assets expected to be realized in cash during the fiscal year). A ratio of 1.0 or higher indicates that all current liabilities could be adequately covered by the hospital's existing current assets.

Average Days in Accounts Receivable (ratio of net patient accounts receivable to total revenue/365) Definition: Net Patient Accounts Receivable/(Net Patient Service Revenue/365) This ratio measures the average number of days in the collection period. A larger number of days represent cash that is unavailable for use in operations.

Average Payment Period (ratio of current liabilities less estimated 3rd party settlements to total expenses less depreciation and amortization/365) Definition: (Total Current Liabilities-Estimated 3rd Party Settlements)/ [(Total Expenses-(Depreciation Expense + Amortization Expense))/365)] This ratio measures the average number of days it takes a hospital to pay its bills.

Solvency/Capital Structure This category evaluates the health of a hospital's capital structure, measuring how a hospital's assets are financed and how able the hospital is to take on more debt. Both measures are critical to the hospital's long-term solvency.

Debt Service Coverage Ratio-Total (ratio of total income plus interest expense plus depreciation and amortization to interest expense and current portion of long term debt) Definition: (Total Income + Interest Expense + Depreciation Expense + Amortization Expense)/(Interest Expense + Current Portion of Long-Term Debt) This ratio measures the ability of a hospital to cover current debt obligation with funds derived from both operating and non-operating activity. Higher ratios indicate a hospital is better able to meet its financing commitments. A ratio of 1.0 indicates that average income would just cover current interest and principal payments on long-term debt.

Cash Flow to Total Debt (ratio of total income plus depreciation and amortization to total current liabilities plus total long-term debt)

Definition: (Total Income + Depreciation Expense + Amortization Expense)/(Current Liabilities + Long-Term Debt) This ratio reflects the amount of cash flow being applied to total outstanding debt (all current liabilities in addition to long-term debt) and reflects how much cash can be applied to debt repayment. The lower this ratio, the more likely a hospital will be unable to meet debt payments of interest and principal and the higher the likelihood of violating any debt covenants.

Equity Financing (ratio of net assets to total assets) Definition: Total Net Assets/Total Assets This ratio reflects the ability of a hospital to take on more debt and is measured by the proportion of total assets financed by equity. Low values indicate a hospital has used substantial debt financing to fund asset acquisition and, therefore, may have difficulty taking on more debt to finance further asset acquisition.

Other Measures The following items are individual line items from the Quarterly Financial Statements.

Operating Surplus (Loss): Total dollar amount of surplus or loss derived from operating activities. Total Surplus (Loss): Total dollar amount of surplus or loss derived from all operating and non-operating activities. Total Net Assets: The difference between the Assets and Liabilities of a hospital. Comprised of retained earnings from operations and contributions from donors. Changes from year to year are attributable to two major categories (1) increases (decreases) in Unrestricted Net Assets (affected by operations) and (2) changes in Restricted Net Assets (restricted contributions). Assets Whose Use is Limited: The current and non-current monies set aside for specific purposes, such as debt repayment, funded depreciation and other board designated purposes. Board-designated funds are most readily available to the organization as the board has the ability to make these funds available if needed. This is a valuable measure because it reveals potential resources that the hospital may have available for cash flow if necessary. Net Patient Service Revenue (NPSR) including premium revenue: Revenue a hospital would expect to collect for services provided less contractual allowances. Net Patient Service Revenue is the primary source of revenue for a hospital.

Ratios and Quality Indicators

Monitoring ratios on a regular basis provides insight into how effectively a business is being managed. Investors/Lenders also evaluate risk by using several sets of ratios; ratios of assets to liabilities, and ratios of lender-investor dollars to owner-investor dollars.

Recognize that ratios are only indicators and that only management can tell the full story about a business. The more adept management is at explaining financial ratios to their Investors/Lenders, the better they will understand your business. Key Indicators with their definitions, formula and analysis comments are discussed in the following pages: Page 2 Liquidity: Financial ratios in this category measure the company's capacity to pay its debts as they come due. Current Ratio Quick Ratio Page 3 Safety: Financial ratios in this category are indicators of the businesses' vulnerability to risk. Creditors to determine the ability of the business to repay loans often use these ratios. Debt To Equity Debt Coverage Ratio Page 4 5 Profitability: The ratios in this section measure the ability of the business to make a profit. Sales Growth COGS to Sales Gross Profit Margin SG&A To Sales Net Profit Margin Return On Equity Return On Assets Page 6 - 7 Efficiency: Also called Asset Management ratios. Indicator of how efficiently the company manages its assets. Days In Receivables Accounts Receivable Turnover Days In Inventory Inventory Turnover Sales To Total Assets Days In Accounts Payable Accounts Payable Turnover LIQUIDITY Financial ratios in this category measure the company's capacity to pay its debts as they come due. Current Ratio

Definition: The ratio between all current assets and all current liabilities; another way of expressing liquidity. Formula: Current Assets / Current Liabilities Analysis: 1:1 current ratio means; the company has $1.00 in current assets to cover each $1.00 in current liabilities. Look for a current ratio above 1:1 and as close to 2:1 as possible. One problem with the current ratio is that it ignores timing of cash received and paid out. For example, if all the bills are due this week, and inventory is the only current asset, but won't be sold until the end of the month, the current ratio tells very little about the company's ability to survive. Quick Ratio Definition: The ratio between all assets quickly convertible into cash and all current liabilities. Specifically excludes inventory. Formula: (Cash + Accounts Receivable) / Current Liabilities Analysis: Indicates the extent to which you could pay current liabilities without relying on the sale of inventory -- how quickly you can pay your bills. Generally, a ratio of 1:1 is good and indicates you don't have to rely on the sale of inventory to pay the bills. Although a little better than the Current ratio, the Quick ratio still ignores timing of receipts and payments. SAFETY Financial ratios in this category are indicators of the businesses' vulnerability to risk. Creditors to determine the ability of the business to repay loans often use these ratios. Debt to Equity Definition: Shows the ratio between capital invested by the owners and the funds provided by lenders. Formula: Debt / Equity Analysis: Comparison of how much of the business was financed through debt and how much was financed through equity. For this calculation it is common practice to include loans from owners in equity rather than in debt. The higher the ratio, the greater the risk to a present or future creditor. Look for a debt to equity ratio in the range of 1:1 to 4:1 Most lenders have credit guidelines and limits for the debt to equity ratio (2:1 is a commonly used limit for small business loans). Too much debt can put your business at risk... but too little debt may mean you are not realizing the full potential of your business --

and may actually hurt your overall profitability. This is particularly true for larger companies where shareholders want a higher reward (dividend rate) than lenders (interest rate). If you think that you might be in this situation, talk to your accountant or financial advisor. Debt coverage ratio Definition: Indicates how well your cash flow covers debt and the capacity of the business to take on additional debt. Formula: (Net Profit + Non-cash expenses) / Debt Analysis: Shows how much of your cash profits are available to repay debt. Lenders look at this ratio to determine if there is adequate cash to make loan payments. Most lenders also have limits for the debt coverage ratio. PROFITABILITY The ratios in this section measure the ability of the business to make a profit. Sales Growth Definition: Percentage increase (or decrease) in sales between two time periods. Formula: (Current Year's sales - Last Year's sales) / Last Year's sales Note: substitute sales for a month or quarter for a shorter-term trend. Analysis: Look for a steady increase in sales. If overall costs and inflation are on the rise, then you should watch for a related increase in your sales... if not, then this is an indicator that your Prices are not keeping up with your costs. COGS to Sales Definition: Percentage of sales used to pay for expenses which vary directly with sales. Formula: Cost of Goods Sold / Sales Analysis: Look for a stable ratio as an indicator that the company is controlling its gross margins. Gross Profit Margin Definition: Indicator of how much profit is earned on your products without consideration of selling and administration costs. Formula: Gross Profit / Total Sales Gross Profit = Sales - Cost of Goods Sold

Analysis: Compare to other businesses in the same industry to see if your business is operating as profitably as it should be. Look at the trend from month to month. Is it staying the same? Improving? Deteriorating? Is there enough gross profit in the business to cover your operating costs? Is there a positive gross margin on all your products? SG&A to Sales Definition: Percentage of selling, general and administrative costs to sales. Formula: Selling, General & Administrative Expenses / Sales Analysis: Look for a steady or decreasing percentage indicating that the company is controlling its overhead expenses. Net Profit Margin Definition: Shows how much profit comes from every dollar of sales. Formula: Net Profit / Total Sales Analysis: Compare to other businesses in the same industry to see if your business is operating as profitably as it should be. Look at the trend from month to month. Is it staying the same? Improving? Deteriorating? Are you generating enough sales to leave an acceptable profit? Trend from month to month can show how well you are managing your operating or overhead costs. Return on Equity Definition: Determines the rate of return on your investment in the business. As an owner or shareholder this is one of the most important ratios as it shows the hard fact about the business -- are you making enough of a profit to compensate you for the risk of being in business? Formula: Net Profit / Equity Analysis: Compare the return on equity to other investment alternatives, such as a savings account, stock or bond. Compare your ratio to other businesses in the same or similar industry. Return on Assets Definition: Considered a measure of how effectively assets are used to generate a return. (This ratio is not very useful for most businesses.) Formula: Net Profit / Total Assets Analysis:

 ROA shows the amount of income for every dollar tied up in assets. Year to year trends may be an indicator ... but watch out for changes in the total asset figure as you depreciate your assets (a decrease or increase in the denominator can affect the ratio and doesn't necessarily mean the business is improving or declining. EFFICIENCY Also called Asset Management ratios. Indicator of how efficiently the company manages its assets. Days in Receivables Definition: This calculation shows the average number of days it takes to collect your accounts receivable (number of days of sales in receivables). Formula: (Average Accounts Receivable / Sales) * 360 days Analysis: Look for trends that indicate a change in your customers' payment habits. Compare the calculated days in receivables to your stated terms. Compare to industry standards. Review an Aging of Receivables and be familiar with your customers payment habits and watch for any changes that might indicate a problem. Accounts Receivable Turnover Definition: Number of times that trade receivables turnover during the year. Formula: Net Sales / Average Accounts Receivable Analysis: The higher the turnover, the shorter the time between sales and collecting cash. Compare to industry standards. Days in Inventory Definition: This calculation shows the average number of days it will take to sell your inventory (number of days sales @ cost in inventory). Formula: (Average Inventory / Cost of Goods Sold) * 360 days Analysis: Look for trends that indicate a change in your inventory levels. Compare the calculated days in inventory to your inventory cycle. Compare to industry standards. Inventory Turnover Definition: Number of times that you turn over (or sell) inventory during the year. Formula: Cost of Goods Sold / Average Inventory Analysis:

 Generally, a high inventory turnover is an indicator of good inventory management. But a high ratio can also mean there is a shortage of inventory. A low turnover may indicate overstocking, or obsolete inventory. Compare to industry standards. Sales to Total Assets Definition: Indicates how efficiently your business generates sales on each dollar of assets. Formula: Sales / Total Assets Analysis: A volume indicator that can be used to measure efficiency of your business from year to year. Days in Accounts Payable Definition: This calculation shows the average length of time your trade payables are outstanding before they are paid. (number of days sales @ cost in payables). Formula: (Average Accounts Payable / COGS) * 360 days Analysis: Look for trends that indicate a change in your payment habits. Compare the calculated days in payables to the terms offered by your suppliers. Compare to industry standards. Review an Aging of Payables and be familiar with the terms offered by your suppliers. Accounts Payable Turnover Definition: The number of times trade payables turnover during the year. Formula: COGS / Average Accounts Payable Analysis: The higher the turnover, the shorter the time between purchase and payment. A low turnover may indicate that there is a shortage of cash to pay your bills or some other reason for a delay in payment.

Financial Ratio Analysis

It is difficult to infer organizational performance from one or two simple numbers. Nevertheless, in practice a number of different ratios are often calculated in strategic planning endeavors and, taken as a whole and with some caution, these ratios do provide some information about the relative performance of an organization. In particular, a careful analysis of a combination of these ratios may help you to distinguish between firms that will eventually fail and those that will

continue to survive. Evidence suggests that, as early as five years before a firm fails, one may be able to detect trouble from the value of these financial ratios. In this note, the basic financial ratios are reviewed, and some of the caveats associated with using them are highlighted. The ratios tend to be most meaningful when they are used to compare organizations within the same broad industry, or when they are used to make inferences about changes in a particular organization's structure over time.

LIQUIDITY RATIOS
In order to survive, firms must be able to meet their short-term obligationspay their creditors and repay their short-term debts. Thus, the liquidity of the firm is one measure of a firm's financial health. Two measures of liquidity are in common: Current ratio = current assets / current liabilities Quick ratio = (cash + marketable securities + net receivables) / current liabilities

The main difference between the current ratio and the quick ratio is that the latter does not include inventories, while the former does. Which ratio is a better measure of a firm's short-term position? In some ways, the quick ratio is a more conservative standard. If the quick ratio is greater than one, there would seem to be no danger that the firm would not be able to meet its current obligations. If the quick ratio is less than one, but the current ratio is considerably above one, the status of the firm is more complex. In this case, the valuation of inventories and the inventory turnover are obviously critical. A number of problems with inventory valuation can contaminate the current ratio. An obvious accounting problem occurs because organizations value inventories using either of two methods, last in, first out (LIFO) or first in, first out (FIFO). Under the LIFO method, inventories are valued at their old costs. If the organization has a substantial quantity of inventory, some of it may be carried at relatively low cost, assuming some inflation in overall prices. On the other hand, if there has been technical progress in a market and prices have been falling, the LIFO method will lead to an overvalued inventory. Under the FIFO method of inventory valuation, inventories are valued at close to their current replacement cost. Clearly, if we have firms that differ in their accounting methods, and hold substantial inventories, comparisons of current ratios will not be very helpful in measuring their relative strength, unless accounting differences are adjusted for in the computations. A second problem with including inventories in the current ratio derives from the difference between the inventory's accounting value, however calculated, and its economic

value. A simple example is a firm subject to business-cycle fluctuations. For a firm of this sort, inventories will typically build during a downturn. The posted market price for the inventoried product will often not fall very much during this period; nevertheless, the firm finds it cannot sell very much of its inventoried product at the so-called market price. The growing inventory is carried at the posted price, but there really is no way that the firm could liquidate that inventory in order to meet current obligations. Thus, including inventories in current assets will tend to understate the precarious financial position of firms suffering inventory buildup during downturns. Might we then conclude that the quick ratio is always to be preferred? Probably not. If we ignore inventories, firms with readily marketable inventories, appropriately valued, will be undeservedly penalized. Clearly, some judicious further investigation of the marketability of the inventories would be helpful. Low values for the current or quick ratios suggest that a firm may have difficulty meeting current obligations. Low values, however, are not always fatal. If an organization has good long-term prospects, it may be able to enter the capital market and borrow against those prospects to meet current obligations. The nature of the business itself might also allow it to operate with a current ratio less than one. For example, in an operation like McDonald's, inventory turns over much more rapidly than the accounts payable become due. This timing difference can also allow a firm to operate with a low current ratio. Finally, to the extent that the current and quick ratios are helpful indexes of a firm's financial health, they act strictly as signals of trouble at extreme rates. Some liquidity is useful for an organization, but a very high current ratio might suggest that the firm is sitting around with a lot of cash because it lacks the managerial acumen to put those resources to work. Very low liquidity, on the other hand, is also problematic.

LEVERAGE
Firms are financed by some combination o debt and equity. The right capital structure will depend on tax policyhigh corporate rates favor debt, high personal tax rates favor equityon bankruptcy costs, and on overall corporate risk. In particular, if we are concerned about bankruptcy possibilities, the long-run solvency or leverage of the firm may be important. There are two commonly used measures of leverage, the debt-to-assets ratio and the debt-equity ratio; Debt-to-asset ratio = total liabilities / total assets Debt-equity ratio = long-term debt / shareholder's equity As with liquidity measures, problems in measurement and interpretation also occur in leverage measures. The central problem is that assets and equity are typically measured in terms of the carrying (book) value in the firm's financial statements. This figure, however, often has very little to do with the market value of the firm, or the value that creditors could receive were the firm liquidated.

Debt-to-equity ratios vary considerably across industries, in large measure due to other characteristics of the industry and its environment. A utility, for example, which is a stable business, can comfortably operate with a relatively high debt-equity ratio. A more cyclical business, like manufacturing of recreational vehicles, typically needs a lower D/Ea reminder that cross-industry comparisons of these ratios is typically not very helpful. Often, analysts look at the debt-equity ratio to determine the ability of an organization to generate new funds from the capital market. An organization with considerable debt is often thought to have little new-financing capacity. Of course, the overall financing capacity of an organization probably has as much to do with the quality of the new product the organization wishes to pursue as with its financial structure. Nevertheless, given the threat of bankruptcy and the attendant costs, a very high debt-equity ratio may make future financing difficult. It has been argued, for example, that railroads in the 1970s found it hard to find funds for new investments in piggybacking, a large technical improvement in railroading, because the threat of bankruptcy from prior poor investments was so high.

RATES OF RETURN
There are two measures of profitability common in the financial community, return on assets (ROA) and return on equity (ROE). ROA = net income / total average assets ROE = net income / total stockholders equity Assets and equity, as used in these two common indexes, are both measured in terms of book value. Thus, if assets were acquired some time ago at a low price, the current performance of the organization may be overstated by the use of historically valued denominators. As a result, the accounting returns for any investment generally do not correlate well with the true economic internal rate of return for that investment. Difficulties with using either ROA and ROE as a performance measure can be seen in merger transactions. Suppose we have an organization that has been earning a net income of $500 on assets with a book value of $1000, for a hefty ROA of 50 percent. That organization is now acquired by a second firm, which then moves the new assets onto its books at the acquisition price, assuming the acquisition is treated using the purchase method of accounting. Of course, the acquisition price will be considerably above the $1,000 book value of assets, for the potential acquirer will have to pay handsomely for the privilege of earning $500 on a regular basis. Suppose the acquirer pays $2,000 for the assets. After the acquisition, it will appear that the returns of the acquired firm have fallen. The firm continues to earn $500, but the asset base is now $2,000, so the ROA is reduced to 25 percent. Indeed, the ROA may be less as a result of other factors, such as increased depreciation of the newly acquired assets. Yet in fact nothing has happened to the earnings of the firm. All that has changed is its accounting, not its performance.

Another fundamental problem with ROA and ROE measures comes from the tendency of analysts to focus on performance in single years, years that may be idiosyncratic. At a minimum, one should examine these ratios averaging over a number of years to isolate idiosyncratic returns and try to find patterns in the data.

STOCK MARKET RATIOS

Several ratios are calculated not from the income statements and balance sheets of organizations, but from data associated with their stock market performance. The three most common ratios are earnings per share (EPS), the price-earnings ratio (P/E), and the dividend-yield ratio: EPS = (net income - preferred dividends) / common shares outstanding P/E = market price per share / earnings per share Dividend yield = annual dividends / price per share EPS is one of the most widely used statistics. Indeed, it is required to be given in the income statements of publicly traded firms. As we can see, the ratio tells us how much the firm has earned per share of stock outstanding. As it turns out, this is not generally a very helpful statistic. It says nothing about how many assets a firm used to generate those earnings, and hence nothing about profitability. Nor does it tell us how much the individual stockholder has paid per share for the rights over that annual earning. Further, accounting practices in the calculation of earnings may distort these ratios. And finally, the treatment of inventories is again problematic. The P/E is another ratio commonly cited. Indeed, P/Es are reported in daily newspapers. A high P/E tends to indicate that investors believe the future prospects of the firm are better than its current performance. They are in some sense paying more per share than the firm's current earnings warrant. Again, earnings are treated differently in different accounting practices. Finally, from the perspective of some stockholders at least, dividend policy may be important. The dividend-yield ratio tells us how much of its earnings the firm pays out in dividends versus reinvestment. Rapidly growing firms in new areas tend to have low dividendyield ratios; more mature firms tend to have higher ratios.

SUMMARY
In this note, we have briefly reviewed a variety of ratios commonly used in strategic planning. All of these ratios are subject to manipulation through opportunistic accounting practices. Nevertheless, taken as a group and used judiciously, they may help to identify firms or business units in particular trouble. Finding profitable new ventures requires rather more work.

Ratios and Formulas in Customer Financial Analysis

Financial statement analysis is a judgmental process. One of the primary objectives is identification of major changes in trends, and relationships and the investigation of the reasons underlying those changes. The judgment process can be improved by experience and the use of analytical tools. Probably the most widely used financial analysis technique is ratio analysis, the analysis of relationships between two or more line items on the financial statement. Financial ratios are usually expressed in percentage or times. Generally, financial ratios are calculated for the purpose of evaluating aspects of a company's operations and fall into the following categories:

liquidity ratios measure a firm's ability to meet its current obligations. profitability ratios measure management's ability to control expenses and to earn a return on the resources committed to the business. leverage ratios measure the degree of protection of suppliers of long-term funds and can also aid in judging a firm's ability to raise additional debt and its capacity to pay its liabilities on time. efficiency, activity or turnover ratios provide information about management's ability to control expenses and to earn a return on the resources committed to the business. A ratio can be computed from any pair of numbers. Given the large quantity of variables included in financial statements, a very long list of meaningful ratios can be derived. A standard list of ratios or standard computation of them does not exist. The following ratio presentation includes ratios that are most often used when evaluating the credit worthiness of a customer. Ratio analysis becomes a very personal or company driven procedure. Analysts are drawn to and use the ones they are comfortable with and understand.

Liquidity Ratios
Working Capital Working capital compares current assets to current liabilities, and serves as the liquid reserve available to satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is unable to borrow on short notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its current liabilities when due. Formula Current Assets - Current Liabilities Acid Test or Quick Ratio A measurement of the liquidity position of the business. The quick ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities. The primary difference between the current ratio and the quick ratio is the quick ratio does not include inventory and prepaid expenses in the calculation. Consequently, a business's quick ratio will be lower than its current ratio. It is a stringent test of liquidity. Formula Cash + Marketable Securities + Accounts Receivable Current Liabilities Current Ratio

Provides an indication of the liquidity of the business by comparing the amount of current assets to current liabilities. A business's current assets generally consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses that are due within one year. In general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio significantly higher than the industry average could indicate the existence of redundant assets. Conversely, a current ratio significantly lower than the industry average could indicate a lack of liquidity. Formula Current Assets Current Liabilities Cash Ratio Indicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or the analyst suspects severe liquidity problems with inventory and receivables. Formula Cash Equivalents + Marketable Securities Current Liabilities

Profitability Ratios
Net Profit Margin (Return on Sales) A measure of net income dollars generated by each dollar of sales. Formula Net Income * Net Sales * Refinements to the net income figure can make it more accurate than this ratio computation. They could include removal of equity earnings from investments, "other income" and "other expense" items as well as minority share of earnings and nonrecuring items. Return on Assets Measures the company's ability to utilize its assets to create profits. Formula Net Income * (Beginning + Ending Total Assets) / 2

Operating Income Margin A measure of the operating income generated by each dollar of sales. Formula Operating Income Net Sales Return on Investment Measures the income earned on the invested capital. Formula

Net Income * Long-term Liabilities + Equity Return on Equity Measures the income earned on the shareholder's investment in the business. Formula Net Income * Equity Du Pont Return on Assets A combination of financial ratios in a series to evaluate investment return. The benefit of the method is that it provides an understanding of how the company generates its return. Formula Net Income * Sales Assets x x Sales Assets Equity Gross Profit Margin Indicates the relationship between net sales revenue and the cost of goods sold. This ratio should be compared with industry data as it may indicate insufficient volume and excessive purchasing or labor costs. Formula Gross Profit Net Sales

Financial Leverage Ratio

Total Debts to Assets Provides information about the company's ability to absorb asset reductions arising from losses without jeopardizing the interest of creditors. Formula Total Liabilities Total Assets Capitalization Ratio Indicates long-term debt usage. Formula Long-Term Debt Long-Term Debt + Owners' Equity Debt to Equity Indicates how well creditors are protected in case of the company's insolvency. Formula Total Debt Total Equity Interest Coverage Ratio (Times Interest Earned)

Indicates a company's capacity to meet interest payments. Uses EBIT (Earnings Before Interest and Taxes) Formula EBIT Interest Expense Long-term Debt to Net Working Capital Provides insight into the ability to pay long term debt from current assets after paying current liabilities. Formula Long-term Debt Current Assets - Current Liabilities

Efficiency Ratios
Cash Turnover Measures how effective a company is utilizing its cash. Formula Net Sales Cash Sales to Working Capital (Net Working Capital Turnover) Indicates the turnover in working capital per year. A low ratio indicates inefficiency, while a high level implies that the company's working capital is working too hard. Formula Net Sales Average Working Capital Total Asset Turnover Measures the activity of the assets and the ability of the business to generate sales through the use of the assets. Formula Net Sales Average Total Assets Fixed Asset Turnover Measures the capacity utilization and the quality of fixed assets. Formula Net Sales Net Fixed Assets Days' Sales in Receivables Indicates the average time in days, that receivables are outstanding (DSO). It helps determine if a change in receivables is due to a change in sales, or to another factor such as a change in selling terms. An analyst might compare the days' sales in receivables with the company's credit terms as an indication of how efficiently the company manages its receivables.

 Formula Gross Receivables Annual Net Sales / 365 Accounts Receivable Turnover Indicates the liquidity of the company's receivables. Formula Net Sales Average Gross Receivables Accounts Receivable Turnover in Days Indicates the liquidity of the company's receivables in days. Formula Average Gross Receivables Annual Net Sales / 365 Days' Sales in Inventory Indicates the length of time that it will take to use up the inventory through sales. Formula Ending Inventory Cost of Goods Sold / 365 Inventory Turnover Indicates the liquidity of the inventory. Formula Cost of Goods Sold Average Inventory Inventory Turnover in Days Indicates the liquidity of the inventory in days. Formula Average Inventory Cost of Goods Sold / 365

Operating Cycle Indicates the time between the acquisition of inventory and the realization of cash from sales of inventory. For most companies the operating cycle is less than one year, but in some industries it is longer. Formula Accounts Receivable Turnover in Days + Inventory Turnover in Day Days' Payables Outstanding Indicates how the firm handles obligations of its suppliers.

 Formula Ending Accounts Payable Purchases / 365 Payables Turnover Indicates the liquidity of the firm's payables. Formula Purchases Average Accounts Payable Payables Turnover in Days Indicates the liquidity of the firm's payables in days. Formula Average Accounts Payable Purchases / 365

Additional Ratios
Altman Z-Score
The Z-score model is a quantitative model developed in 1968 by Edward Altman to predict bankruptcy (financial distress) of a business, using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis. The Z-score is known to be about 90% accurate in forecasting business failure one year into the future and about 80% accurate in forecasting it two years into the future. Formula Z = 1.2 x (Working Capital / Total Assets) +1.4 x (Retained Earnings / Total Assets) +0.6 x (Market Value of Equity / Book Value of Debt) +0.999 x (Sales / Total Assets) +3.3 x (EBIT / Total Assets) Probability of Failure less than 1.8 Very High greater than 1.81 but less than 2.99 Not Sure greater than 3.0 Unlikely Bad-Debt to Accounts Receivable Ratio Bad-debt to Accounts Receivable ratio measures expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs. Formula Bad Debts Accounts Receivable Z-score

Bad-Debt to Sales Ratio Bad-debt ratios measure expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs. Formula Bad Debts Sales Book Value per Common Share Book value per common share is the net assets available to common stockholders divided by the shares outstanding, where net assets represent stockholders' equity less preferred stock. Book value per share tells what each share is worth per the books based on historical cost. Formula (Total Stockholders' Equity - Liquidation Value of Preferred Stocks - Preferred Dividends in Arrears) Common Shares Outstanding Common Size Analysis In vertical analysis of financial statements, an item is used as a base value and all other accounts in the financial statement are compared to this base value. On the balance sheet, total assets equal 100% and each asset is stated as a percentage of total assets. Similarly, total liabilities and stockholder's equity are assigned 100%, with a given liability or equity account stated as a percentage of total liabilities and stockholder's equity. On the income statement, 100% is assigned to net sales, with all revenue and expense accounts then related to it. Cost of Credit The cost of credit is the cost of not taking credit terms extended for a business transaction. Credit terms usually express the amount of the cash discount, the date of its expiration, and the due date. A typical credit term is 2 / 10, net / 30. If payment is made within 10 days, a 2 percent cash discount is allowed: otherwise, the entire amount is due in 30 days. The cost of not taking the cash discount can be substantial. Formula % Discount 360 x 100 - % Discount Credit Period - Discount Period Example

On a $1,000 invoice with terms of 2 /10 net 30, the customer can either pay at the end of the 10 day discount period or wait for the full 30 days and pay the full amount. By waiting the full 30 days, the customer effectively borrows the discounted amount for 20 days. $1,000 x (1 - .02) = $980 This gives the amount paid in interest as: $1,000 - 980 = $20 This information can be used to compute the credit cost of borrowing this money. % Discount 360 x 100 - % Discount Credit Period - Discount Period = 2 360 x = .3673 98 20 As this example illustrates, the annual percentage cost of offering a 2/10, net/30 trade discount is almost 37%. Current-Liability Ratios Current-liability ratios indicate the degree to which current debt payments will be required within the year. Understanding a company's liability is critical, since if it is unable to meet current debt, a liquidity crisis looms. The following ratios are compared to industry norms. Current to Non-current = Current Liabilities Non-current Liabilities Current to Total = Current Liabilities Total Liabilities

Rule of 72 A rule of thumb method used to calculate the number of years it takes to double an investment. Formula 72 Rate of Return Example Paul bought securities yielding an annual return of 9.25%. This investment will double in less than eight years because, 72 = 7.78 years 9.25 SOURCE: Copyright 1999 Credit Research Foundation

Financial Ratio Analysis

Table of Contents Introduction The Ratios Profitability Sustainability Ratios Operational Efficiency Ratios Liquidity Ratios Leverage Ratios Other Ratios Introduction A sustainable business and mission requires effective planning and financial management. Ratio analysis is a useful management tool that will improve your understanding of financial results and trends over time, and provide key indicators of organizational performance. Managers will use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can be formed. Funders may use ratio analysis to measure your results against other organizations or make judgments concerning management effectiveness and mission impact. For ratios to be useful and meaningful, they must be:

Calculated using reliable, accurate financial information (does your financial information reflect your true cost picture?) Calculated consistently from period to period Used in comparison to internal benchmarks and goals Used in comparison to other companies in your industry Viewed both at a single point in time and as an indication of broad trends and issues over time Carefully interpreted in the proper context, considering there are many other important factors and indicators involved in assessing performance.

Ratios can be divided into four major categories: Profitability Sustainability Operational Efficiency Liquidity Leverage (Funding Debt, Equity, Grants) The ratios presented below represent some of the standard ratios used in business practice and are provided as guidelines. Not all these ratios will provide the information you need to support your particular decisions and strategies. You can also develop your own ratios and indicators based on what you consider important and meaningful to your organization and stakeholders.

The Ratios
Profitability Sustainability Ratios
How well is our business performing over a specific period, will your social enterprise have the financial resources to continue serving its constituents tomorrow as well as today?

Ratio Sales Growth =

What does it tell you? Percentage increase (decrease) in sales between two time periods.

Current Period Previous Period Sales If overall costs and inflation are increasing, then you Previous Period Sales should see a corresponding increase in sales. If not, then may need to adjust pricing policy to keep up with costs. Measures the composition of an organizations revenue sources (examples are sales, contributions, grants). The nature and risk of each revenue source should be analyzed. Is it recurring, is your market share growing, is there a long term relationship or contract, is there a risk that certain grants or contracts will not be renewed, is there adequate diversity of revenue sources? Organizations can use this indicator to determine long and short-term trends in line with strategic funding goals (for example, move towards self-sufficiency and decreasing reliance on external funding). Measures the degree to which the organizations expenses are covered by its core business and is able to function independent of grant support Operating Self-Sufficiency = Business Revenue Total Expenses For the purpose of this calculation, business revenue should exclude any non-operating revenues or contributions. Total expenses should include all expenses (operating and non-operating) including social costs. A ratio of 1 means you do not depend on grant revenue or other funding. How much profit is earned on your products without considering indirect costs. Is your gross profit margin improving? Small changes in gross margin can significantly affect profitability. Is there enough gross profit to cover your indirect costs. Is there a positive gross margin on all products? How much money are you making per every $ of sales. This ratio measures your ability to cover all operating costs including indirect costs Percentage of indirect costs to sales.

Reliance on Revenue Source = Revenue Source Total RevenueTotal Revenue

Gross Profit Margin = Gross Profit Total Sales Total Sales Net Profit Margin = Net Profit Sales SGA to Sales =

Indirect Costs (sales, general, admin) Look for a steady or decreasing ratio which means you Sales are controlling overhead

Measures your ability to turn assets into profit. This is a very useful measure of comparison within an industry. Return on Assets = Net Profit Average Total Assets A low ratio compared to industry may mean that your competitors have found a way to operate more efficiently. After tax interest expense can be added back to numerator since ROA measures profitability on all assets whether or not they are financed by equity or debt Rate of return on investment by shareholders. This is one of the most important ratios to investors. Are you making enough profit to compensate for the risk of being in business? How does this return compare to less risky investments like bonds?

Return on Equity = Net Profit Average Shareholder Equity

Operational Efficiency Ratios

How efficiently are you utilizing your assets and managing your liabilities? These ratios are used to compare performance over multiple periods. Ratio Operating Expense Ratio = Operating Expenses Total Revenue Accounts Receivable Turnover = Net Sales Average Accounts Receivable Days in Accounts Receivable = Average Accounts Receivable Sales x 365 Inventory Turnover = Cost of Sales Average Inventory Days in Inventory = Average Inventory Cost of Sales x 365 What does it tell you? Compares expenses to revenue. A decreasing ratio is considered desirable since it generally indicates increased efficiency. Number of times trade receivables turnover during the year. The higher the turnover, the shorter the time between sales and collecting cash. What are your customer payment habits compared to your payment terms. You may need to step up your collection practices or tighten your credit policies. These ratios are only useful if majority of sales are credit (not cash) sales. The number of times you turn inventory over into sales during the year or how many days it takes to sell inventory. This is a good indication of production and purchasing efficiency. A high ratio indicates inventory is selling quickly and that little unused inventory is being stored (or could also mean inventory shortage). If the ratio is low, it suggests overstocking, obsolete inventory or selling

Accounts Payable Turnover = Cost of Sales Average Accounts Payable Days in Accounts Payable = Average Accounts Payable Cost of Sales x 365 Total Asset Turnover = Revenue Average Total Assets Fixed Asset Turnover = Revenue Average Fixed Assets

issues. The number of times trade payables turn over during the year. The higher the turnover, the shorter the period between purchases and payment. A high turnover may indicate unfavourable supplier repayment terms. A low turnover may be a sign of cash flow problems. Compare your days in accounts payable to supplier terms of repayment.

How efficiently your business generates sales on each dollar of assets. An increasing ratio indicates you are using your assets more productively.

Liquidity Ratios
Does your enterprise have enough cash on an ongoing basis to meet its operational obligations? This is an important indication of financial health. Ratio What does it tell you? Measures your ability to meet short term obligations with short term assets., a useful indicator of cash flow in the near future. A social enterprise needs to ensure that it can pay its salaries, bills and expenses on time. Failure to pay loans on time may limit your future access to credit and therefore your ability to leverage operations and growth. A ratio less that 1 may indicate liquidity issues. A very high current ratio may mean there is excess cash that should possibly be invested elsewhere in the business or that there is too much inventory. Most believe that a ratio between 1.2 and 2.0 is sufficient. The one problem with the current ratio is that it does not take into account the timing of cash flows. For example, you may have to pay most of your short term obligations in the next week though inventory on hand will not be sold for another three weeks or account receivable

Current Ratio = Current Assets Current Liabilities (also known as Working Capital Ratio)

collections are slow. A more stringent liquidity test that indicates if a firm has enough short-term assets (without selling inventory) to cover its immediate liabilities. Quick Ratio = Cash +AR + Marketable Securities Current Liabilities This is often referred to as the acid test because it only looks at the companys most liquid assets only (excludes inventory) that can be quickly converted to cash). A ratio of 1:1 means that a social enterprise can pay its bills without having to sell inventory. WC is a measure of cash flow and should always be a positive number. It measures the amount of capital invested in resources that are subject to quick turnover. Lenders often use this number to evaluate your ability to weather hard times. Many lenders will require that a certain level of WC be maintained. Determines the number of months you could operate without further funds received (burn rate)

Working Capital = Current Assets Current Liabilities Adequacy of Resources = Cash + Marketable Securities + Accounts Receivable Monthly Expenses

Leverage Ratios
To what degree does an enterprise utilize borrowed money and what is its level of risk? Lenders often use this information to determine a businesss ability to repay debt. Ratio What does it tell you? Compares capital invested by owners/funders (including grants) and funds provided by lenders. Lenders have priority over equity investors on an enterprises assets. Lenders want to see that there is some cushion to draw upon in case of financial difificulty. The more equity there is, the more likely a lender will be repaid. Most lenders impose limits on the debt/equity ratio, commonly 2:1 for small business loans. Too much debt can put your business at risk, but too little debt may limit your potential. Owners want to get some leverage on their investment to boost profits. This has to be balanced with the ability to service debt. Measures your ability to meet interest payment obligations with business income. Ratios close to 1 indicates company having difficulty generating enough

Debt to Equity = Short Term Debt + Long Term Debt Total Equity (including grants)

Interest Coverage = EBITDA Interest

Expense

cash flow to pay interest on its debt. Ideally, a ratio should be over 1.5

Other Ratios
You may want to develop your own customized ratios to communicate results that are specific and important to your organization. Here are some examples. Operating Self-Sufficiency = Sales Revenue Total Costs (Operating and Social Costs) % Staffing Costs spent on Target Group = Target Staff Costs Total Staffing Costs Social Costs per Employee = Total Social Costs Number of Target Employees % Social Costs covered by Grants = Grant Income Total Social Costs

Financial Ratio Analysis

What is ratio analysis? The Balance Sheet and the Statement of Income are essential, but they are only the starting point for successful financial management. Apply Ratio Analysis to Financial Statements to analyze the success, failure, and progress of your business. Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them.

Balance Sheet Ratio Analysis Formula

Important Balance Sheet Ratios measure liquidity and solvency (a business's ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors' funding). They include the following ratios: Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working Capital. Current Ratios. The Current Ratio is one of the best known measures of financial strength. It is figured as shown below: Current Ratio = Total Current Assets ____________________ Total Current Liabilities The main question this ratio addresses is: "Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts?" A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. The minimum acceptable current ratio is obviously 1:1, but that relationship is usually playing it too close for comfort. If you decide your business's current ratio is too low, you may be able to raise it by: Paying some debts. Increasing your current assets from loans or other borrowings with a maturity of more than one year. Converting non-current assets into current assets. Increasing your current assets from new equity contributions. Putting profits back into the business. Quick Ratios. The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best measures of liquidity. It is figured as shown below: Quick Ratio = Cash + Government Securities + Receivables ______________________________________ Total Current Liabilities The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding inventories, it concentrates on the really liquid assets, with value that is fairly certain. It helps answer the question: "If all sales revenues should disappear, could my business meet its current obligations with the readily convertible `quick' funds on hand?" An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets" are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities. Working Capital. Working Capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. It is calculated as shown below:

Working Capital = Total Current Assets - Total Current Liabilities Bankers look at Net Working Capital over time to determine a company's ability to weather financial crises. Loans are often tied to minimum working capital requirements. A general observation about these three Liquidity Ratios is that the higher they are the better, especially if you are relying to any significant extent on creditor money to finance assets. Leverage Ratio This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant on debt financing (creditor money versus owner's equity): Debt/Worth Ratio = Total Liabilities _______________ Net Worth Generally, the higher this ratio, the more risky a creditor will perceive its exposure in your business, making it correspondingly harder to obtain credit.

Income Statement Ratio Analysis

The following important State of Income Ratios measure profitability: Gross Margin Ratio This ratio is the percentage of sales dollars left after subtracting the cost of goods sold from net sales. It measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the company. Comparison of your business ratios to those of similar businesses will reveal the relative strengths or weaknesses in your business. The Gross Margin Ratio is calculated as follows: Gross Margin Ratio = Gross Profit _______________ Net Sales (Gross Profit = Net Sales - Cost of Goods Sold) Net Profit Margin Ratio This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold and all expenses, except income taxes. It provides a good opportunity to compare your company's "return on sales" with the performance of other companies in your industry. It is calculated before income tax because tax rates and tax liabilities vary from company to company for a wide

variety of reasons, making comparisons after taxes much more difficult. The Net Profit Margin Ratio is calculated as follows: Net Profit Margin Ratio = Net Profit Before Tax _____________________ Net Sales Management Ratios Other important ratios, often referred to as Management Ratios, are also derived from Balance Sheet and Statement of Income information. Inventory Turnover Ratio This ratio reveals how well inventory is being managed. It is important because the more times inventory can be turned in a given operating cycle, the greater the profit. The Inventory Turnover Ratio is calculated as follows: Inventory Turnover Ratio = Net Sales ___________________________ Average Inventory at Cost Accounts Receivable Turnover Ratio This ratio indicates how well accounts receivable are being collected. If receivables are not collected reasonably in accordance with their terms, management should rethink its collection policy. If receivables are excessively slow in being converted to cash, liquidity could be severely impaired. The Accounts Receivable Turnover Ratio is calculated as follows: Net Credit Sales/Year __________________ = Daily Credit Sales 365 Days/Year Accounts Receivable Turnover (in days) = Accounts Receivable _________________________ Daily Credit Sales Return on Assets Ratio This measures how efficiently profits are being generated from the assets employed in the business when compared with the ratios of firms in a similar business. A low ratio in comparison with industry averages indicates an inefficient use of business assets. The Return on Assets Ratio is calculated as follows: Return on Assets = Net Profit Before Tax ________________________ Total Assets

Return on Investment (ROI) Ratio. The ROI is perhaps the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the company, put the money in such a savings instrument, and avoid the daily struggles of small business management. The ROI is calculated as follows: Return on Investment = Net Profit before Tax ____________________ Net Worth These Liquidity, Leverage, Profitability, and Management Ratios allow the business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. The owner may thus determine the business's relative strengths and weaknesses.