Reading 38: Measures of Leverage
Define and explain leverage, business risk, sales risk, operating risk, and financial risk, and classify a risk, given a description
- Leverage:
- Is the use of fixed costs in a company’s cost structure (cost structure is the mix of variable and fixed costs)
- Fixed costs that are operating costs (such as depreciation or rent) are operating leverage
- Fixed costs that are financial costs (such as interest expense) create financial leverage
- Business Risk:
- Is the risk associated with operating earnings. Operating earnings are risky because total revenue and costs are risky (because many factors effect revenue and costs). Business risk is: Sales risk + Operating risk.
- Sales Risk:
- This refers to the uncertainty with respect to the price and quantity of goods and services.
- Operating Risk
- This is the risk attributed to the operating cost structure, in particular the use of fixed costs in operations (e.g. more fixed costs in relation to variable costs = more operating risk).
Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage
- Degree of Operating Leverage:
- % change in operating income / % change in units sold OR
- Quantity * (Price-variable cost) / Quantity(P-V) – Fixed costs
- Degree of financial leverage:
- % change in NI / % change in operating income
- NI = operating income – interest – taxes
- Degree of total leverage:
- Q(P-V) / Q(P-V) – F – C
Describe the effect of financial leverage on a company’s net income and return on equity
Calculate the breakeven quantity of sales and determine the company’s net income at various sales levels
- Breakeven point: where revenues = costs
- Q = (F+C) / (P-V)
Calculate and interpret the operating breakeven quantity of sales
- Q = F / (P-V)
Reading 39: Dividends and Share Repurchases: Basics
Describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios
- Cash Dividends
- Extra or Special Dividends
- Dividends that are given by a company that normally does not issue dividends or a dividend in addition to the regularly scheduled dividends
- Stock Dividends
- When the company pays in stock rather than cash
- Cost per share is reduced (since you now have more stock for the same price that you paid for ‘less’ stock)
- EPS goes down b/c you have the same earnings being divided by more shares
- Stock Splits
- Have no economic effect on the company and the shareholders
- # of shares goes up, stock price goes down, EPS goes down, dividend goes down
- Reverse Stock Splits
- Does the opposite of a stock split
Describe dividend payment chronology, including the significance of declaration, holder-of-record, ex-dividend, and payment dates
- Dividend payment chronology
- Declaration Date: This is the first date on the timeline
- Ex-dividend: usually 2-days before the holder-of-record date. It’s the first date that the stock trades without the dividend
- Holder-of-record: if you own shares on this date then you’ll be eligible to receive the dividend
- Payment dates: when the company actually pays its shareholders
Compare share repurchase methods
- Buy in the open market:
- Buy back a fixed number of shares at a fixed price:
- Dutch auction:
- The company gives a range of prices they are willing to buy the stock for
- The shareholders who agreed to selling at the lower bid, gets their order filled first. The company moves “up the ladder” until their target shares have been purchased.
- Repurchase by negotiation
- A company might negotiate with a large shareholder to buy-back their shares (usually at a premium to market)
Calculate and compare the effects of a share repurchase on earnings per share when 1) the repurchase is financed with the company’s excess cash and 2) the company uses funded debt to finance the repurchase
- Financed with excess cash:
- EPS will increase because the number of shares dividing the same amount of earnings has decreased
- Financed with debt:
- Depending on the cost of debt the EPS could stay the same or decrease
Calculate the effect of a share repurchase on book value per share
Explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders’ wealth, all else being equal
Reading 40: Working Capital Management
Describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position
- Primary sources (using these sources is not likely to affect normal business operations)
- Ready cash balances
- Short-term funds (trade credit, bank lines of credit, short-term investment portfolios)
- Cash flow management
- Secondary sources:
- Negotiating debt contracts, relieving pressures from high interest or principal repayments
- Liquidating assets
- Filing for bankruptcy protection and reorganization
- Factors that influence a company’s liquidity position
- Drag on liquidity (when receipts lag creating pressure from the decreased available funds)
- Uncontrolled receivables: long outstanding receivables
- Obsolete inventory: long unused inventory (slow inventory turnover ratios can indicate obsolete inventory)
- Tight credit: if capital is scarce, short-term debt is more expensive
- Pull on liquidity (when disbursements are paid too quickly requiring companies to expend funds before they receive funds from sales that could cover the liability)
- Making payments early
- Reduced credit limits
- Limits on short-term lines of credit
- Low liquidity positions
- Drag on liquidity (when receipts lag creating pressure from the decreased available funds)
Compare a company’s liquidity measure with those of peer companies
- Ratios:
- Current
- Quick
- AR turnover
- Inventory turnover
- # of days of receivables
- # of days of inventory
- Operating cycle
- Cash Conversion cycle
Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company’s effectiveness with that of peer companies
- Shorter cash conversion cycle is better
Explain the effect of different types of cash flows on a company’s net daily cash position
Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines
- Money Market Yield
- Bond Equivalent Yield
- Discount-basis Yield
Evaluate a company’s management of accounts receivable inventory, and accounts payable over time and compared to peer companies
Evaluate the choices of short-term funding available to a company and recommend a financing method