CMA - Part 2

Financial Decision Making

Study Unit 2 – Ratio Analysis

 Study Tip
• Look at your weekly routine (schedule) and see what can be
eliminated or at least suspended for a while. I.e. watching a
TV show that you can really live without. Once you have
created more time in your schedule, see about rearranging
your schedule to allow for some quality study time (and
place).

• Find a comfortable and quiet place to study with good lighting

and little distractions (try avoiding your own bed; it is very
tempting to just lie down and take a nap).

• f you have a family, you will need to make them a part of this
process. They need to be supportive of what you are doing.
2.4 – Solvency
• Solvency is a firm’s ability to pay its noncurrent obligations as
they come due…
• Long-run as opposed to liquidity which focuses on short-term
(current items)

• Firms capital structure incl.

• Liabilities (external) – Long-term and short-term debt

• Equity – (internal) – Residual

• Capital decisions have consequences

• > debt = > risk = > cost of capital
• > equity = < ret. on equity
• Which det. deg. of leverage
2.4 – Solvency
• Debt = creditors interest
• = contractual obligations
• Ret > cost of debt = > equity

• Equity = permanent capital

• Ret. uncertainty even with Pre. Stock
2.4 – Solvency
• Capital Structure Ratios
• Total Debt to Total Capital Ratio

• TTL Debt/TTL Capital (Debt & Equity) = total leverage

• Debt to Equity Ratio

• TTL Debt/Equity = total amount (X) that debt exceeds equity

• Long-term Debt to Equity Ratio

• Long-term debt/Equity

• ??? – which is better, increase or decrease of Long-term Debt to Equity Ratio, year
over year?

• Debt to Total Asset Ratio

• TTL Liabilities/ TTL Assets

• ??? – how is the same as the debt to total capital ratio?

2.4 – Solvency
• Earnings Coverage
• Times interest earned ratio

• EBIT/Interest Expense

• ??? – What does this tell a creditor

• Most common mistake – not to add back that years interest payment
to NI before taxes

• Earnings to Fixed Charges Ratio

• EBIT + Interest portion of operating leases/Int. exp. + Int. portion of
operating leases + Div. on Pre. Stock

• More conservative; shows all fixed charges

2.4 – Solvency
• Cash Flow to Fixed Charges Ratio

• Pre-tax operating cash flow/Int. exp. + Int. portion of operating

leases + Div. on Pre. Stock

• Eliminates issues associated with accrual accounting

• Quiz
 Study Tip
• Try to identify if you are missing most MC questions because
you did not know the material or because you did not
correctly understand the questions and/or answers. We need
to eliminate the later and isolate missed question largely due
to lack of material. There is a finite amount of material to
know, particularly when you narrow down most common
asked questions.
• Learn the general concepts first, don't worry about learning
the details until you have learned the main ideas.
2.5 – Leverage
• Gleim Success Tip

• Types of Leverage

• Leverage = relative of fixed cost

• ??? – which fixed cost?
• ??? – what financial statement do we find on?

• Deg. of leverage = Pre-fixed-cost income amount/Post-fixed-cost

income amount
2.5 – Leverage
• Distinguish between variable costing and full-costing

• Why do we have to have variable costing for measuring the

DOL

• Degree of Op. Lev. – Single-Period Version

• DOL = Contribution Margin/Operating Income or EBIT

• Contribution Margin = ???

• Example page 72
2.5 – Leverage
• Degree of Operating Leverage – Perc.-Change Version

• %Chng. in Op. Inc. or EBIT/%Chng. in Sales

• Example page 72

• Degree of Financial Leverage – Single-Period Version

• EBIT/EBT

• A variation is the Percentage-change Version

• Quiz
 Study Tip
• It is best to review the material right after class when it's still
fresh in your memory.