Week 2 Homework Hints

Overview

This week the homework is rather more difficult than last week. What is different this week from last week is that most questions require a calculation or the understanding of the formula. That said most of the questions are straight forward. There are a few tricky ones though!

These questions deal with:

Days receivable

Fixed Asset Turnover ratio

P/E ratio, EPS and Stock price computation

Alternative Financing Needed (AFN)

Contribution margin

Days receivable ratio (aka Days Sales Outstanding)

This ratio considers the frequency with which the company collects on its outstanding Credit Sales in terms of number of days. There are two parts to this calculation: Accounts Receivable (A/R) Turnover, and then the Days Receivable.

Step 1:

A/R Turnover = Credit Sales ÷ Average A/R

A/R turnover represents the number of times the A/R is collected in a year.

Step 2:

Days Sales = 365 days ÷ A/R turnover

Days Sales Outstanding takes the A/R turnover and restates it into the number of days.

Fixed Asset Turnover ratio

This ratio helps analysts determine how efficiently a company uses its fixed assets to generate income.

Fixed assets are things like buildings, equipment, land, etc. They are long-term assets that benefit the company for more than one year. Fixed assets re sometimes called PP&E which stands for property, plant and equipment.

Fixed Asset TO = Net sales ÷ Net PP&E

The “Net” is important in the denominator because it means that the total value of the PP&E must be adjusted for depreciation.

P/E ratio and stock price (questions #12 & 13)

The Price to Earnings ratio tells us the ratio of a company’s stock price to its per share of earnings (EPS).

EPS is the portion of Net Income that is available for each share of outstanding common stock.

EPS = (Net Income – Dividends) ÷ # of shares outstanding

and

P/E ratio = stock price / EPS

If we know the P/E ratio and the EPS, we can determine the stock price:

Stock price = P/E ratio x EPS

Additional Funds Needed (AFN) question #14

When a company is forecasting its revenue and needs into the future, it usually creates Pro Forma financial statements. These statements take the goals and expectations that the company has and turns them into dollar amounts on financial statements. If a company expects to grow at a certain rate, and have costs that are a certain amount, it must be able to predict if it can pay for all of its needs. In many cases it cannot and it must seek external financing. We can compute how much external financing is need by simply making sure that the Balance Sheet balances. Remember, Assets = Liabilities + Equity.

So, if we know the net income, the projected increase in assets and projected liabilities plus the retention ratio, we can compute the amount of Additional Funds Needed. The retention ratio is the ratio of the net income that the company keeps and does not pay out as a dividend.

AFN = [(Projected Increase in Assets/Last years sales) x Change in sales] – [(Projected increase in Liabilities/last years Sales) x change in sales] – (retention ratio x net income)

I know this looks like a crazy formula, but just plug the numbers in.

Contribution Margin per unit (question #17

Contribution margin represents the difference between the Revenue and the variable costs associated with generating that revenue.

CM = Revenue – Variable costs

or CM per unit = price per unit – variable costs

However, the question is not this straight forward. You must first compute the variable costs, and to do this you must know the order of items on a Contribution Margin Income statement.

Revenue

– Variable Costs

= Contribution Margin

– Fixed Costs

= Net Income

See next slide…

Contribution Margin continued

By plugging in the numbers given in the problem, you can compute the total variable costs.

Then, taking the price per unit information we can compute the number of units sold

# of units = Revenue ÷ $sales price/unit

Once you know the total variable costs and the number of units, you can compute the variable cost per unit.

Total Variable costs ÷ #units sold = VC per unit

Finally we can compute the Contribution margin per unit.

Price per unit – VC per unit = CM per unit