Essential Learning for CTP Candidates TEXPO Conference 2016 Session #03

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1 TEXPO Conference 2016: Essential Learning for CTP Candidates Session #3 (Mon.1:45 3:00 pm) Overview of Basic CTP Math from ETM4 Chap 07: Earnings Credits Chap 09: Working Capital Chap 18: Fin. Statements Chap 19: Financial Analysis Essentials of Treasury Management, 3rd Ed. (ETM4) is published by the AFP which holds the copyright and all rights to the related materials. As a prep course for the CTP exam, significant portions of these lectures are based on materials from the Essentials text. 1 ETM4: Calculations Chapters 7, 9, 18 & 19 These slides cover most of the basic calculations in ETM4 Examples include both those from the text and additional problems. Due to time constraints, we will NOT be able to cover all of the examples in this session. Students are encouraged to spend some time on their own reviewing these problems at a later date. 2 ETM4: Chapter 7 Calculations Managing Relationships with Service Providers Earnings Credit Collected Balance Required 3 All Rights Reserved 1

2 Earnings Credit D EC = CB (1 RR) ECR 365 Where: EC = Earnings credit CB = Average collected balances RR = Reserve requirement ECR = Earnings credit rate D = Number of days in the month 4 Earnings Credit Assume the following scenario: Average ledger balance $250,000 Deposit float $ 30,000 Reserve requirement 10% Earnings credit rate 5% Service charges for the month $ 1,000 Days in month 30 Average Collected Balance Calculation: Average ledger balance $250,000 Less: Deposit float ($30,000) Equals: Average collected balance $220,000 D EC = CB (1 RR) ECR = $220,000 (1 0.10) = $220, = $ Collected/Available Balances Required SC CB = D ECR (1 RR) 365 SC AB = D ECR 365 Where: CB = Average collected balances required to pay service charges AB = Average available balances required to pay service charges SC = Service charges ECR= Earnings credit rate RR = Reserve requirement D = Number of days in the month 6 All Rights Reserved 2

3 Collected/Available Balances Required Assume the following scenario: Monthly service charges $1,000 Earnings credit rate 5% Reserve requirement 10% Days in month 30 SC CB = D ECR (1 RR) 365 $1,000 = (1 0.10) 365 = $270,373 SC AB = D ECR 365 $1,000 = = $243,333 7 ETM4: Chapter 7 Managing Relationships with Service Providers Additional Calculations 8 Assume ledger balance = $1.2M, deposit float = $0.4M, R/R = 10%, ECR = 0.5%, 31 days in the month. Calculate the earnings credits. A. $ B. $ C. $ D. $3, The Treasury Academy, Inc. - All Rights Reserved 9 All Rights Reserved 3

4 Earnings Credit Assume the following scenario: Average ledger balance $1,200,000 Deposit float $ 400,000 Reserve requirement 10% Earnings credit rate 0.5% Days in month 31 Average Balance Calculations: Average ledger balance $1,200,000 Less: Deposit float ($400,000) Equals: Average collected balance $800,000 Less: Reserve Requirement ($80,000) Equals: Average available balance $720,000 D D EC = CB (1 RR) ECR EC = AB ECR = $800,000 (1 0.10) = $720, = $ = $ Assume ledger balance = $1.2M, deposit float = $0.4M, R/R = 10%, ECR = 0.5%, 31 days in the month. Calculate the earnings credits. A. $ B. $ C. $ D. $3, days rather than 31 No reserve requirement Used 5% rather than 0.5% The Treasury Academy, Inc. - All Rights Reserved 11 Assume R/R = 10%, ECR = 0.4%, 30 days in the month. Calculate the collected balance required to support $1,200 in services. A. $392,473 B. $405,555 C. $3,650,000 D. $4,055, The Treasury Academy, Inc. - All Rights Reserved 12 All Rights Reserved 4

5 Collected/Available Balances Required Assume the following scenario: Monthly service charges $1,200 Earnings credit rate 0.4% Reserve requirement 10% Days in month 30 SC CB = D ECR (1 RR) 365 $1,200 = (1 0.10) 365 = $4,055,555 SC AB = D ECR 365 $1,200 = = $3,650, Assume R/R = 10%, ECR = 0.4%, 30 days in the month. Calculate the collected balance required to support $1,200 in services. A. $392,473 B. $405,555 C. $3,650,000 D. $4,055,555 Used 4% rather than 0.4% & 31 days Used 4% rather than 0.4% Calculated Available Balance The Treasury Academy, Inc. - All Rights Reserved 14 Practicing the Calculations The more times you work through a calculation, the more comfortable you will be with it Develop your own versions of the calculations and double check your math Share calculations with others that are studying for the exam Make a list of Study Buddies!! 15 All Rights Reserved 5

6 ETM4: Chapter 9 Calculations Working Capital Metrics Float Neutral Calculation Cost of Discount Cash Conversion Cycle (CCC) Days Sales Outstanding Aging Schedule A/R Balance Pattern Netting Calculation 16 Focus of Treasury on Cash Flow Timeline Treasury focus is on the payment portion of the cycle Calculation: Float Neutral Calculation TD = total days difference in payment timing r = Opportunity cost as an annual rate 1 Discount 1 r 1 TD Float Neutral Calculation Assume r = 12% and TD = 3 days 1 Discount 1 12% (Rounded) or 0.10% If the buyer is allowed to take a discount of 0.10 %, they would be indifferent (in present value terms) between paying by check or by electronic transfer (a speedup of 3 days in loss of value) 18 All Rights Reserved 6

7 Cost of a Buyer Not Taking a Cash Discount D 365 Discount Cost = 100 D N T = = = =.3723 or 37.23% Where D = Discount percentage is 2% N = Net period is 30 days T = Discount period is 10 days The cost of not taking the discount can be compared with the organization s opportunity cost to borrow short-term funds. If we assume a rate of 8% for this example, then borrowing cost would be less than the cost of not taking the discount so the organization should borrow the funds and take the discount. 19 When Should a Buyer Forgo an Offered Discount? Short-term investment rates above annualized discount rate Buyer s cost of short-term borrowing greater than annualized discount rate Buyer can stretch payables enough to sufficiently lower annualized discount rate 20 Benefit to Seller of Offering a Cash Discount Assume credit terms of 2/10, net 30 and opp. cost = 15% Present Value of Receiving Discounted Payment Amount PV PV Disc Pmt Disc Pmt Total Amount of Full Pmt 1 Disc Rate Annual Opp Cost 1 Days in Disc Period 365 $100, $98, $98,000 $97, All Rights Reserved 7

8 Benefit to Seller of Offering a Cash Discount Assume credit terms of 2/10, net 30 and opp. cost = 15% Present Value of Receiving Full Payment Amount Total Amount of Full Pmt PV PV Full Pmt Full Pmt Annual Opp Cost 1 Days in Net Period 365 $100,000 $100, $100,000 $98, NPV = PV Day 10 PV Day 30 = $97, $98, = $1, Cash Conversion Cycle (CCC) Days Inventory Days Receivables Days Payables Calculations of the Cash Conversion Cycle (CCC) Cash Turnover Ratio Days Inventory Days Payables Days Receivables Cash Conversion Cycle Working Capital Gap 23 Cash Conversion Cycle Elements in the cash conversion cycle: Days Inventory Inventory Cost of Goods Sold 365 Days Receivables Accounts Receivable Sales 365 Days Payables Accounts Payable Cost of Goods Sold All Rights Reserved 8

9 Cash Conversion Cycle Elements in the cash conversion cycle: Days Inventory Days Receivables Days Payables Inv 2, Days COGS 9,200 A/R 1, Days Sales 15,000 A/P 1, Days COGS 9, Cash Conversion Cycle (CCC) Calculates the time required to convert cash outflows (necessary to produce goods) into cash inflows (through the collection of accounts receivable) CCC Days' Inv. Days' Rec. - Days' Pay Days 365 Days Cash Turnover = Cash Conversion Cycle 365 = = 4.5 Times Days 26 Days Sales Outstanding (DSO) Assume that a company has outstanding receivables of $285,000 at the end of the first quarter and credit sales of $310,000 for the quarter. Using a 90-day averaging period, the DSO for this company can be computed as follows: Sales During Period $310,000 Avg. Daily Credit Sales = = = $3, Number of Days in Period 90 Outstanding A/R $285,000 DSO = = = Days Avg. Daily Credit Sales $3, If the company s credit terms are net 60, the average past due is computed as follows: Average Past Due = DSO Avg. Days of Credit Terms = Days 60 Days = Days 27 All Rights Reserved 9

10 Aging Schedule Separates A/R into current and past-due receivables in 30-day increments (on a customer or aggregate basis) and can determine the percent past due Age of A/R Amount of A/R % of Total A/R Current $1,750,000 70% 1-30 Days Past Due 375,000 15% Days Past Due 250,000 10% Over 60 Days Past Due 125,000 5% Total $2,500, % 28 A/R Balance Pattern for March 29 Before Netting 30 All Rights Reserved 10

11 With Multilateral Netting 31 ETM4: Chapter 9 Calculations Working Capital Metrics Additional Calculations 32 Assume a company is offered a 1.3% discount for paying on day 30 rather than day 90. At what opportunity cost would the company be indifferent between these two payment dates? A. 4% B. 6% C. 8% D. 10% 33 All Rights Reserved 11

12 Assume a company is offered a 1.3% discount for paying on day 30 rather than day 90. At what opportunity cost would the company be indifferent between these two payment dates? A. 4% B. 6% C. 8% D. 10% Example of just trying all the answers to find the correct one. Alternative approach is to use discount cost formula 34 Float Neutral Calculation Assume: r = 8% and TD = 60 days 1 Discount 1 8% = 1.3% (Rounded) If the buyer is allowed to take a discount of 1.3 %, they would be indifferent (in present value terms) between paying electronically today or on day 60 by check (a speedup of 60 days in loss of value) 35 A company is offered terms of 1/10, Net 40, but routinely takes 50 days to pay without incurring any penalties. What is the cost of not taking this discount? A. 7.4% B. 7.9% C. 9.2% D. 12.3% 36 All Rights Reserved 12

13 Cost of a Buyer Not Taking a Cash Discount D 365 Discount Cost = 100 D N T = = = = or 9.2% Where D = Discount percentage is 1% N = Net period is 50 days T = Discount period is 10 days The cost of not taking the discount can be compared with the organization s opportunity cost to borrow short-term funds. If we assume a rate of 8% for this example, then borrowing cost would be less than the cost of not taking the discount so the organization should borrow the funds and TAKE the discount. 37 A company is offered terms of 1/10, Net 40, but routinely takes 50 days to pay without incurring any penalties. What is the cost of not taking this discount? A. 7.4% B. 7.9% C. 9.2% D. 12.3% Used 40 day net period Did not take out discount period Example of being sure to read the problem. Use the actual days taken, not the stated terms. 38 ETM4: Chapter 18 Financial Accounting & Reporting 39 All Rights Reserved 13

14 Sample Balance Sheet Snapshot Assets: Current assets Fixed assets Depreciable fixed assets Intangible assets Liabilities: Current liabilities Long-term liabilities Equity Assets = Liabilities + Shareholders Equity 40 Sample Income Statement A record of revenues and expenses Shows the net change in shareholders equity from operations over a specified period 41 Sample Statement of Cash Flows Shows sources and uses of cash Sections: Operating Investing Financing Cash from operations calculated by adding back non-cash charges (e.g., depreciation) Cash, not earnings, repays debt This example shows the indirect format 42 All Rights Reserved 14

15 ETM4: Chapter 19 Calculations Financial Planning and Analysis Time Value (PV & FV) Breakeven Point NPV, IRR, PI Ratios & Ratio Analysis Liquidity, Efficiency, Debt Management, Performance, DuPont Return vs. Residual Income Measures 43 Future Value What is the future value of $100 if it can be invested for two years, compounded annually, at a rate of 10% per year? n Future Value = PV (1 + i) = $100 (1 +.10) = $ = $121 2 Where: FV = Future value PV = Present value i = Periodic interest rate n = Number of periods $100 x (1.10) 5 $100 x (1.10)(1.10)(1.10)(1.10)(1.10) $100 x 44 Present Value What is the present value of $2,382 to be received after three years, discounted at a rate of 6.00% annually? FV Present Value = = Where: FV = Future value i = Periodic interest rate n = Number of periods $2, i n 3 $2,382 = = $2, All Rights Reserved 15

16 PV of a Stream of Payments C C C C PV (1i) (1i) (1i) (1i) n n As an example, assume the following annual cash flows: $200 in year one, $400 in year two and $600 in year three. If the appropriate discount rate is 12%, then the PV of the stream would be: $200 $400 $600 PV (1.12) (1.12) (1.12) $200 $400 $ $ $ $ $ Breakeven Analysis Breakeven point: Level of activity for an operation at which costs exactly equal benefits Fixed Costs Unit B / E Point = Selling Price Per Unit Variable Cost Per Unit $10,000 = $10 $6 = 2,500 Units 47 Net Present Value (NPV) Evaluates the present value (PV) of all inflows and outflows of a project using the weighted average cost of capital as a discount rate NPV = PV of Cash Inflows PV of Cash Outflows If the only cash outflow takes place in the present : NPV = PV of Cash Inflows Cash Cost C1 C2 C3 Cn NPV = Cost n (1+ i) (1+ i) (1+ i) (1+ i) 48 All Rights Reserved 16

17 Net Present Value (NPV) Year 1 Year 2 Year 3 Year 4 Year 5 Project A $300 $300 $400 $100 $100 Project B $300 $300 $400 $1,000 $1,000 Assume an initial outlay of $1,000 and a cost of capital of 10% $300 $300 $400 $100 $100 NPV A = (1 +.10) (1 +.10) (1 +.10) (1 +.10) (1 +.10) $1,000 5 = $ $300 $300 $400 $1,000 $1,000 NPV B = (1 +.10) (1 +.10) (1 +.10) (1 +.10) (1 +.10) $1,000 = $1, Profitability Index (PI) Ratio of the PV gained to the cost required to obtain that value; shows value gained per dollar of investment Present Value of Cash Inflows Profitability Index = Present Value of Cash Outflows If the only cash outflow is in the present (period 0): $ PI A = = $1,000 $2, PI B = = $1, Internal Rate of Return (IRR) Discount rate (i) for NPV = 0 or PV of Cash Inflows = PV of Cash Outflows NPV = PV of Cash Inflow Cost = 0 $300 $300 $400 $100 $100 NPV A = $1,000 = (1 + i) (1 + i) (1 + i) (1 + i) (1 + i) i = 7.7% $300 $300 $400 $1,000 $1,000 NPV B = $1,000 = (1 + i) (1 + i) (1 + i) (1 + i) (1 + i) i = 38.1% 51 All Rights Reserved 17

18 Capital Expenditure Analysis Summary Method Project Acceptance Criterion Project A Project B Net Present Value (NPV) NPV > 0 $ $ Profitability Index (PI) Internal Rate of Return (IRR) PI > IRR > WACC* 7.7% 38.1% Source: ETM4 AFP * Weighted Average Cost of Capital (WACC) = 10% in the example 52 Liquidity or Working Capital Current Ratio Measures the degree to which current obligations are covered by current assets Total Current Assets Current Ratio = Total Current Liabilities $8,000 = = 2.35 $3, Liquidity or Working Capital: Quick Ratio Measures the degree to which a company s current liabilities are covered by its most liquid current assets (Cash) + (S-T Investments) + (A/R) Quick Ratio = Total Current Liabilities ($1,500 + $1,300 + $1,700) = = 1.32 $3, All Rights Reserved 18

19 Liquidity or Working Capital: Cash Flow to Total Debt Ratio Measures ability to repay debt (a relatively low ratio indicates an inability to repay debt and can predict financial failure; a higher ratio would imply more safety) (Net Income + Depreciation) CF to Total Debt Ratio = ($850 + $200) $1,050 = = = $1,800 + $3,900 $5,700 Short-Term Debt + Long-Term Debt 55 Liquidity or Working Capital: Working Capital Indicates the dollar amount by which current assets exceed current liabilities Working Capital = Current Assets Current Liabilities = $8,000 $3,400 = $4, Efficiency and Asset Management: Total Asset Turnover Measures how many times the asset base is turned over with the flow of revenue Revenues Total Asset Turnover = Total Assets $15,000 = = Times $15, All Rights Reserved 19

20 Efficiency and Asset Management: Fixed Asset Turnover Focuses on how efficiently fixed assets, or plant and equipment, are used Revenue Fixed Asset Turnover = Net Property, Plant & Equip $15,000 = = 2.0 Times $7, Efficiency and Asset Management: Current Asset Turnover Measures how many times the stock of most liquid assets is turned over with the flow of revenue Revenues Current Asset Turnover = Current Assets $15,000 = = 1.88 Times $8, Efficiency and Asset Management: Cash Conversion Efficiency Measures the efficiency with which a company converts sales into cash Cash Conversion Cash Flow from Operations Efficiency = Sales $550 = $15,000 = 0.37 or 3.7% 60 All Rights Reserved 20

21 Debt Management: Total Liabilities to Total Assets Measures the percentage of all liabilities relative to total investments or total assets Total Liabilities Total Liabilities to Total Assets = Total Assets $7,300 = =.471 or 47.1% $15, Debt Management: Long-Term Debt to Capital L / T Debt to Capital = Measures the percentage of a company s capitalization that is provided by long-term debt Long-Term Debt Long-Term Debt + Equity $3,900 = =.322 or 32.2% $3,900 + $8, Debt Management: Debt to Tangible Net Worth Measures a company s debt as a percentage of its tangible net worth Total Debt Debt to Tangible N/W = Total Equity Intangible Assets $1,800 + $3,900 = =.695 or 69.5% $8, All Rights Reserved 21

22 Debt Management/Coverage: Times Interest Earned (TIE) Ratio Measures a firm s ability to service debt through interest payments Operating Profit TIE = Interest Expense EBIT = Interest Expense $1,600 = = 5.33 Times $ Debt Management/Coverage: Fixed Charge Coverage Ratio Measures a firm s ability to service all fixed-charge items with operating profits EBIT + Lease Pmts Fixed Charge Coverage = Interest Expense + Lease Pmts $1,600 + $500 $2,100 = = = Times $300 + $500 $800 * Assuming $500 of annual lease payments 65 Performance: Gross Profit Margin Measures the percentage of revenues remaining after the cost of goods sold is deducted from revenue it is also a typical common-size ratio measure Gross Profit $5,800 Gross Profit Margin = = Revenues $15,000 =.387 or 38.7% 66 All Rights Reserved 22

23 Performance: Operating & EBITDA Profit Margins Measures the flow of commonly used operating income measures in relation to the flow of revenue EBIT Operating Profit Margin = Revenues $1,600 = = or 10.7% $15,000 EBITDA EBITDA Margin = Revenues $1,800 = = or 12.0% $15, Performance: Net Profit Margin Measures the flow of net income in relation to the flow of revenue Net Income Net Profit Margin = Revenues $850 = $15,000 =.057 or 5.7% 68 Performance: Return on Total Assets Measures net income in relation to the stock of assets Net Income Return on Total Assets = Total Assets $850 = $15,500 =.055 or 5.5% 69 All Rights Reserved 23

24 Performance: Return on Common Equity Measures earnings available to common shareholders (net income less any preferred stock dividends) expressed as a percentage of common equity Earnings Avail. to Common S / Hs Return on Common Equity = Common Equity Net Income Preferred Dividends = Total Equity Preferred Stock $850 0 = = or 10.4% $8, Integrated Ratio Analysis: DuPont Equation Looks at the return on total assets as a product of the return on sales and total asset turnover Return on Total Assets = Return on Sales Total Asset Turnover Net Income Total Revenues = Total Revenues Total Assets = = = 5.5% 71 Performance Measurement Return on Investment (ROI) Residual Income (RI) Free Cash Flow (FCF) Economic Value Added (EVA) 72 All Rights Reserved 24

25 Performance Measurement Return on investment (ROI) ROI over a partial period may be misleading. ROI does not include charge for cost of capital. Positive NPV project can be rejected if it lowers overall ROI Net Income Net Income ROI = = Invested Capital Long-Term Debt + Equity $850 $850 = = = or 7.02% $3,900 + $8,200 $12,100 Residual Income (RI) Assigns charge for invested capital. RI is a dollar amount, and any profitable project after deducting cost of capital will increase RI. RI = Net Income Invested Capital Cost of Capital = $850 $12, = $850 $1,210 = $ Performance Measurement: Free Cash Flow Free Cash Flow (FCF) A type of RI analysis, but also includes adjustments for noncash items, operating working capital investments and capital expenditures (CAPEX) There are many different formulas used for FCF Considered a better representation of the value of the firm to shareholders FCF = Net Income + (D&A) Change in Op W/C CAPEX = $850 + $200 $500 $900 = $ Economic Value Added (EVA) A measure of the incremental value that a company s investments add. What is the EVA for the following company? Long-term debt of $3,900,000 Equity of $8,200,000 Marginal tax rate of % Weighted average cost of capital (WACC) of 10% Operating income (EBIT) of $1,600,000 EVA = EBIT (1Tax Rate) (WACC)(Long-term Debt + Equity) = $1,600,000 ( ) (.10)($3,900,000 + $8,200,000) = $1,046,160 (.10)($12,100,000) = $1,046,160 $1,210,000 = $163, All Rights Reserved 25

26 ETM4: Chapter 19 Financial Planning and Analysis Additional Calculations 76 Liquidity or Working Capital: Quick Ratio Measures the degree to which a company s current liabilities are covered by its most liquid current assets A company currently has Cash of $200,000, ST Investments of $500,000, A/R of $600,000, and Inventory of $700,000. If their bank has imposed a loan covenant which requires the company maintain a quick ratio of 1.5 or better, what is the maximum level of current liabilities they can have? A. $666,667 B. $866,667 C. $1,333,333 D. $2,000, This Slide Intentionally Blank 78 All Rights Reserved 26

27 Liquidity or Working Capital: Quick Ratio (Cash) + (S-T Investments) + (A/R) Quick Ratio = Total Current Liabilities ($200,000 + $500,000 + $600,000) = = 1.50 Total Current Liabilities $1,300, = Total Current Liabilities 1.50 (Total CL) = $1,300,000 $1,300,000 Total CL = = $866, Liquidity or Working Capital: Quick Ratio Measures the degree to which a company s current liabilities are covered by its most liquid current assets A company currently has Cash of $200,000, ST Investments of $500,000, A/R of $600,000, and Inventory of $700,000. If their bank has imposed a loan covenant which requires the company maintain a quick ratio of 1.5 or better, what is the maximum level of current liabilities they can have? A. $666,667 B. $866,667 C. $1,333,333 D. $2,000,000 Subtracted Cash from Result B Included Inventory Just added all items in problem 80 Practice Calculation A company has a Return on Total Assets of 20%, Return on Sales of 10% and Net Income of $100,000. What is the level of Total Assets for this company? A. $ 250,000 B. $ 500,000 C. $ 750,000 D. $1,000, All Rights Reserved 27

28 Practice Calculation A company has a Return on Total Assets of 20%, Return on Sales of 10% and Net Income of $100,000. What is the level of Total Assets for this company? A. $ 250,000 B. $ 500,000 C. $ 750,000 D. $1,000, Integrated Ratio Analysis: DuPont Equation Return on Total Assets = Return on Sales Total Asset Turnover Net Income Total Revenues = Total Revenues Total Assets $100,000 Total Revenues 20% = Total Revenues Total Assets 20% = 0.10 TATO => TATO = 2.0 $100,000 Return on Sales = 0.10 = Total Revenues Total Revenues = $1,000,000 Total Revenues $1,000,000 TATO = 2.0 = = Total Assets Total Assets Total Assets = $500, Session Wrap-up What did we learn in this session? What topics do we need to learn more about? 84 All Rights Reserved 28

29 TEXPO Conference 2016 Essential Learning for CTP Candidates End of This Session We will reconvene at 3:45 pm today. The topic will be Let s Go to the Markets Money & Capital Markets S-T & L-T Investing & Capital 85 All Rights Reserved 29