RISK 5

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Financial Concepts for Risk Management

Learning Objectives

1. Discuss the difference between accounting and finance. (p. 2)

2. Describe the types of accounting systems and who uses financial information. (p. 3)

3. Discuss how financial statement analysis is used as a risk identification method. (p. 6)

4. Explain the purposes and components of an income statement, balance sheet and statement of cash flows. (p. 12)

5. Discuss the definition of cost of capital and the sources of capital to the organization. (p. 36)

6. Discuss the purposes and formulas of common financial ratios in time series and cross section analysis. (p. 41)

Learning Objective #1: Discuss the difference between accounting and finance.

I. Accounting vs. Finance

A. Accounting – a process to help quantify an organization’s

assets, liabilities, stakeholder equities, and cash flows at a point in time.

1. Multiple sets of books for legitimate and specific uses –

financial reporting, regulation, tax, internal management

2. Generally prepared on an accrual basis where revenues

are matched, sometimes arbitrarily, with expenses 3. Historical cost of an asset is adjusted for accounting

depreciation (book value of asset) and has no real relationship to replacement cost or “insurance” depreciation

B. Finance – a process of managing an organization’s assets,

liabilities, and cash flows to maximize shareholder (or stakeholder) wealth

Learning Objective #2: Describe the types of accounting systems and who uses financial information.

II. Accounting System

A. Definition – organized set of accounting methods, procedures, and controls to collect, record, classify, and present accurate and timely financial data for use in management decision making

B. Types of accounting systems

1. Financial accounting under generally accepted accounting principles (GAAP)

2. Statutory accounting under generally accepted statutory

accounting principles (STAT or SAP, also sometimes referred to as RAP, Regulatory Accounting Principles)

3. Tax accounting under Internal Revenue Service rules

and guidelines 4. Governmental or fund accounting that is not performed

with a dual entry system 5. Managerial accounting, under a broad set of guidelines

that differs from organization to organization, intended for internal use only

III. Types of Accounting Systems a Risk Manager Might Encounter

A. GAAP, particularly if the organization is publicly held, or

Fund Accounting, if the organization is a governmental body

B. STAT, SAP, or RAP, if the risk manager is concerned about the financial status of any insurance companies providing coverage or if the organization is operating or participating in a captive insurance company

C. Tax (the risk manager for a 501 (c) (3) organization needs to

be aware of the tax rules)

D. Managerial accounting – the use of financial statements for purely internal uses

Commentary Most publicly held corporations simultaneously use GAAP financial statements for their public reports to regulatory agencies like the SEC and to their stockholders in quarterly and annual reports, tax-based financial statements to prepare tax reports and pay taxes, and managerial accounting statements to conduct day-to-day operations. The so-called “bottom lines” or total values of assets, liabilities, and net worth may be entirely different for each of the three sets of financial statements.

IV. Users of Financial Information

A. Creditors

B. Investors and stockholders

C. Management team

1. Internal 2. External

D. Regulatory bodies – SEC, IRS, state agencies, etc.

E. Risk managers

1. Identify sources of funds for retention plans 2. Identify exposures 3. Quantify exposure valuations 4. Determine total cost of risk 5. Allocate total cost of risk 6. Compliance

Learning Objective #3: Discuss how financial statement analysis is used as a risk identification method.

V. Financial Statements

A. Financial statements important to the risk manager: (These will be reviewed in detail in the following material.)

1. Balance sheet – summary of the organization’s assets, liabilities and owner’s equity as of a specific point in time

2. Income statement – a report of the organization’s financial performance for a stated time period

3. Statement of cash flows – a report summarizing the effects of cash on the operating, investing and financial activities of an organization for a specific period of time

B. Notes to the financial statements – explain the contents of the above statements

C. Outside or independent auditor’s opinion letter – an external opinion of the fairness and accuracy of the information contained in the financial statements and the conformity to stated standards.

D. Financial statement analysis is used as a risk identification method to:

1. Assess asset valuation: those assets useful for determining an organization’s values exposed to loss, e.g., inventory, accounts receivable, plant and equipment

2. Assess net income loss potential

a. Identify sources of income

b. Identify sources of expenses

c. Understand how profit is affected by a loss and

the financial impact of a loss on profit

d. Determine when and where a loss occurs – low or high season, before or after a season

e. Determine the expenses that will continue in the event of a loss

f. Determine which expenses are controllable

g. Identify hidden assets and liabilities, e.g., undisclosed assets, leased assets, off balance sheet liabilities

3. Evaluate expansion plans

4. Assess liquidity and cash flows

5. Determine management’s tolerance for risk

6. Determine risk assumed by contract, e.g., leases, hold harmless agreements, etc.

7. Determine financial ability to qualify for surety bonds

8. Identify outstanding and previous litigation

9. Create financial projections (pro-forma statements)

10. Identify key suppliers and customers

E. Broad issues when using financial statements 1. Many users lack sufficient accounting expertise and can

be innocently misled by the information

2. Accounting is not the same as bookkeeping. In simple terms, bookkeeping is procedural, focusing on the “how” approach, while accounting is conceptual, addressing the “why” or providing a reason or justification.

3. Financial statements are based on historical data that

may not be relevant in a current circumstance 4. Unless financial statements are audited by an outsider,

there may be concerns about the accuracy of the information contained in the reports

5. Organizations may be unwilling to share financial

statements with external risk management team members such as brokers, underwriters, and consultants

VI. Loss Exposures from the Logical Classifications of Risk

A. Property – items with accounting estimates of “value” listed on balance sheet

B. Human Resources – salaries and benefit costs from income

statements and tax schedules C. Liabilities – from balance sheet and income statement D. Net income – business interruption, profit, and continuing

exposures found on the income statement (or statement of revenues and expenses, for fund accounting)

1. Gross and net sales

2. Cost of goods sold

3. Gross profit

4. Operating expenses

5. Operating income

6. Interest expense

7. Income taxes

8. Net income

9. Earnings per share

Diamond Creek Resorts International, Inc.

Consolidated Income Statements For the years ended December 31, FYX1 and FYX0

($ in thousands) FYX1 FYX0 Revenue $ 350,000 $ 325,000 Less: Operating expenses 312,500 285,000 Less: Depreciation expenses1 15,000 15,000 Net operating income (EBIT) $ 22,500 $ 25,000 Less: Interest expense 10,000 11,000 Earnings before taxes $ 12,500 $ 14,000 Less: Income taxes 5,000 5,600 Net income (net profit after tax) $ 7,500 $ 8,400 Less: Dividends to common 3,500 3,500 shareholders Addition to retained earnings $ 4,000 $ 4,900 Earnings per share $1.50 $1.68 (5,000,000 shares outstanding)

Notes to the Financial Statements 1. Depreciation is taken on a straight-line basis. Buildings and structures are depreciated over a useful life of 30 years. Improvements to the grounds on all golf courses (tee boxes, greens, hazards, landscaping) are depreciated over a 20-year period. Ski area structures and improvements, including runs and lifts, are depreciated on a 10-year period. 2. Inventory is valued on a First In, First Out basis. The company does not foresee a change in inventory valuation in the near future. 3. Management is aware that certain liabilities may be incurred with respect to public liability and strict liability. Management is aware that litigation has been filed, but believes that amounts in excess of deductibles and retentions will be fully insured. Payments made within deductibles or under retention levels will be treated as period expenses in the accounting period when paid. Note: The choice of inventory valuation depends upon a number of

considerations, one of which is tax management. A finance person and a tax management person may have different opinions as to which method to use. The risk manager needs to identify which method was used as part of the process of determining appropriate limits of coverage for business interruption and inventory.

Learning Objective #4: Explain the purposes and components of an income statement, balance sheet and statement of cash flows.

VII. Income Statement

A. Purpose – a report of the organization’s financial performance for a stated time period

B. Revenue or sales

1. Operating revenue, e.g., sales of goods and services 2. Non-operating revenue, e.g., interest income 3. Gains, e.g., sale of a long-term asset

C. Expenses

1. Operating expenses associated with operating revenue 2. Non-operating expenses, e.g., interest expense, a

financing function 3. Losses, e.g., sale of long-term assets

D. Credit or recognize revenue and expense when

1. The financial event has occurred, and 2. The amount of revenue or expense is measurable

E. Cost of Goods Sold (COGS)

1. Definition: labor, material and overhead expenses including inventory shrinkage; purchasing or production costs and expenses, both direct and indirect, of the merchandise sold during a certain period. These expenses include raw materials, direct and indirect labor costs, plant costs (such as depreciation), electricity, water, and shipping costs.

2. The COGS is subtracted from revenue to calculate the net income of the organization. The items that have a COGS value are first stored in inventory and then removed from inventory through processing or sales, so various types of inventory are added to and reduced during the process.

3. Understanding the calculation of the COGS is essential for valuation of business interruption exposures and claims and for properly insuring inventory.

4. Inventory accounting systems – difference is the timing of record

a. Periodic – an accounting of goods sold and their corresponding costs performed at specified points during the accounting period; the most common method

b. Perpetual – a record is made of every sale and

continuous costs of each item sold are transferred from inventory asset to the cost of goods sold expense on an ongoing basis

Commentary Periodic inventory is commonly used by most organizations. Once during the accounting period (usually a year), a physical count of all items in inventory is made and adjustments for shrinkage are entered into the books. During the accounting period, interim (usually monthly) adjustments are made based upon an estimate of the number of items sold or used multiplied by the cost as determined by the chosen inventory cost assumptions. The cost of sales (and ultimately profit) and the remaining value of inventory are determined at the end of each interim accounting period, and the financial statements are adjusted accordingly. Perpetual inventory is not as commonly used. Two typical users of this inventory system are an organization that sells a low number of high- value items, such as earthmoving equipment or other expensive items bearing a unique serial number (like a Rolls Royce or a CAT scanner), or a very large retailer who uses a just-in-time inventory ordering system based on a computer-driven sales registration system. Sold items are scanned at the register using the bar codes and an item count is immediately subtracted from the known inventory (those items scanned into inventory after purchase and delivery to await sales). The cost of sales is immediately computed using the assumed inventory cost assumption, inventory values are adjusted, and inventory reorders are assembled. In both cases, the item count and value of inventory are thereby perpetually maintained.

5. Inventory cost assumptions

a. First In, First Out (FIFO) – the total inventory cost shown on the income statement is based on the cost of the earliest items removed from inventory.

Conceptually, this assumption works like a

pipeline. The first item (gallon of oil, water, sausage) into the pipeline is the first item forced or taken out.

COGS, net income, and inventory are affected as follows:

Period of Rising costs Decreasing costs

COGS Lower priced items come out first and decrease COGS

Higher priced items come out first and increase COGS

Net Income

Rising income because expenses are lower

Decreasing income because expenses are higher

Inventory Values

Values increase as higher priced items go in and lower priced items go out

Values decrease as lower priced items go in and higher priced items go out

b. Last In, First Out (LIFO) – the total inventory cost shown on the income statement is based on the most recent cost of the earliest items removed from inventory.

Conceptually, this assumption works like a barrel.

The first item (gallon of oil, water, sausage) into the barrel is the last item taken out.

COGS, net income and inventory are affected as follows:

Period of Rising costs Decreasing costs

COGS Higher priced items come out first and increase COGS

Lower priced items come out first and decrease COGS

Net Income

Decreasing income because expenses are higher

Increasing income because expenses are lower

Inventory Values

Values decrease as lower priced items go in and higher priced items go out

Values increase as higher priced items go in and lower priced items go out

c. Weighted average – this method applies the costs of individual items as items are sold throughout the accounting period. Through the weighting process, the effect of changing costs is dampened, so the same effects are lessened.

d. Specifically identified items (low volume, high

value, such as large pieces of equipment or unique items) – this method generally applies the actual costs associated with that item to its sale and to the value of inventory

Calculation of Cost of Goods Sold (COGS)

EQUATION

BEGINNING INVENTORY 10 units

+ PURCHASES AND COST OF PRODUCTION 30 units

= AVAILABLE FOR SALE 40 units

LESS ENDING INVENTORY 15 units

UNITS OF GOODS SOLD 25 units

EXAMPLE LIFO FIFO BEGINNING INVENTORY 10  $40 = $ 400 10  $40 = $ 400 UNITS COST UNITS COST PURCHASES DURING PERIOD 10  $42 = $ 420 10  $42 = $ 420 10  $44 = $ 440 10  $44 = $ 440 10  $45 = $ 450 10  $45 = $ 450 LIFO FIFO COST OF GOODS SOLD (25 units) 10 x $45 = $ 450 10 x $40 = $ 400 10 x $44 = $ 440 10 x $42 = $ 420 5 x $42 = $ 210 5 x $44 = $ 220 TOTAL 25 $1,100 25 $1,040 REMAINING INVENTORY LIFO FIFO 5 x $42 = $ 210 5 x $44 = $ 220 10 x $40 = $ 400 10 x $45 = $ 450 TOTAL 15 $ 610 15 $ 670 SALES 25 UNITS AT $55 LIFO FIFO SALES $1,375 $1,375 Less COST OF GOODS SOLD $1,100 $1,040 GROSS PROFIT $ 275 $ 335 Observations: In a time of increasing inventory costs, LIFO increases the Cost of Goods Sold, reduces profit (and taxes) and decreases the book value of inventory. Similarly, FIFO decreases the Cost of Goods Sold, increases profit (and taxes) and increases the book value of inventory.

F. Depreciation, depletion, and amortization

1. Depreciation – lowers income and lowers tax liability; thereby, generating positive cash flows

Note: Depreciation in this context is not the same as depreciation used in insurance settlements. Accounting depreciation is a tax-management concept that allows for the setting aside of funds to replace assets as they wear out and provides an expense to reduce income.

a. Straight-line depreciation – most commonly used method

annual depreciation = historical cost less estimated salvage value divided by years of estimated useful life

b. Units of production

depreciation charged per unit of production = historical cost less estimated salvage value divided by number of units to be produced

c. Double-declining balance depreciation – an accelerated depreciation method used for tax management purposes. In the short run, cash flow will be increased as tax liability is reduced

d. Modified Accelerated Cost Recovery System (MACRS) – depreciation by IRS schedule according to the type of asset. Each MACRS class has a predetermined schedule used to determine the percentage of the asset’s cost to be written off each year

Commentary

Examples of Depreciation Calculations

You have a machine that produces springs. The original cost was $10,000 with a salvage value of $0. The normal useful life of this machine is 10 years. The machine can produce 10,000,000 springs before it must be replaced. Last year, the machine produced 500,000 springs. According to the IRS MACRS schedule, the property class has a 3-year life.

Straight-line depreciation: $10,000/10 = $1,000 depreciation per year, each of the first 10 years

Units of production: $10,000/10,000,000 = $0.001 per spring 500,000 springs x $0.001 = $500 depreciation for last year, with the amount varying by units of production until the machine is completed depreciated, regardless of how long it takes

Double-declining balance: 10 years = 10% per year, then double that for 20% annual rate of depreciation Depreciation for the first year is calculated by multiplying the original value of $10,000 by 20% , or $2,000 depreciation for the first year. Subtract $2,000 from $10,000, and multiple the remaining book value of $8,000 by 20%, or $1,600 depreciation for the second year. Subtract $1,600 from $8,000, and multiple the remaining book value of $6,400 by 20%, or $1,280 deprecation for the third year. Repeat until the accumulated depreciation reaches the original purchase price.

MACRS depreciation: 3-year property class. In first year, 33.33% depreciation; in second year, 44.45%, in third year, 14.81%, and 7.41% in fourth year, or $3333, $4445, $1481, and $741 respectively.

2. Depletion – reduction in inventory and a charge against income for the use of natural resources, e.g., oil, coal, forest growth

3. Amortization

a. Expensing (short-term) or capitalizing (long-term)

of intermediate term costs (development costs) b. Examples:

1) Expense of unsuccessful drilling efforts

2) New product marketing costs 3) Interest during construction phase 4) Development of new software programs

c. Expensing or capitalizing with a periodic

amortization of the value reduces income and generates a positive cash flow

G. Interest expense

1. Maturity structure of interest rates – the longer the

maturity, the higher the rate of interest to allow for the greater risk over time

2. Variable versus fixed

H. Taxes

1. Effective rate

2. Deferred rate – legal tax avoidance doesn’t exist, only deferral

3. Investment tax credits – loss carry-backs and carry- forwards

I. Profitability measures

1. Gross profit = sales revenue less COGS

Gross profit margin as a percentage of sales = gross profit ÷ sales

2. Operating income = gross profit less operating expenses

Operating income as a percentage of sales = operating income ÷ sales

3. Net income = operating income less interest expense and taxes

Net income margin as a percentage of sales = net income ÷ sales

4. Earnings per share = after-tax net income ÷ number of common shares of stock outstanding

Diamond Creek Resorts International, Inc. Consolidated Balance Sheet at December 31, FYX1 and FYX0

($ in thousands)

Assets FYX1 FYX0 Current assets Cash $147,000 $122,000 Inventories2 26,000 32,000 Accounts receivable 13,000 15,000 Total current assets $186,000 $169,000 Fixed assets Property $344,000 $344,000 Less: Accumulated depreciation1 67,000 52,000 Net fixed assets $277,000 $292,000 Total assets $463,000 $461,000 Liabilities and Stockholders’ Equity Current liabilities Accounts payable $ 11,000 $ 9,000 Notes payable 25,000 25,000 Other current liabilities 3,000 3,000 Total current liabilities $ 39,000 $ 37,000

Long-term debt 289,000 293,000 Total liabilities3 $328,000 $330,000

Stockholders’ equity Common stock 50,000 50,000 (5,000,000 shares outstanding at par of $10) Retained earnings 85,000 81,000 Total stockholder equity $135,000 $131,000 Total liabilities and equity $463,000 $461,000

Notes to the Financial Statements

1. Depreciation is taken on a straight-line basis. Buildings and structures are depreciated over a useful life of 30 years. Improvements to the grounds on all golf courses (tee boxes, greens, hazards, landscaping) are depreciated over a 20-year period. Ski area structures and improvements, including runs and lifts, are depreciated on a 10-year period.

2. Inventory is valued on a First In, First Out basis. The company does not foresee a change in inventory valuation in the near future.

3. Management is aware that certain liabilities may be incurred with respect to public liability and strict liability. Management is aware that litigation has been filed, but believes that amounts in excess of deductibles and retentions will be fully insured. Payments made within deductibles or under retention levels will be treated as period expenses in the accounting period when paid.

VIII. Balance Sheet

A. Purpose – a summary of the organization’s assets, liabilities and owner’s equity as of a specific point in time

B. Current assets (short-term – one year or less)

1. Cash

2. Accounts receivable

3. Inventory

a. Types

1) Raw materials

2) Work-in-process (unfinished inventory)

3) Finished goods

b. Alternatives for maintaining inventory levels can complicate inventory and business interruption evaluations

1) Just-in-time (JIT) inventory

2) Synchronous production with suppliers

4. Marketable securities – highly liquid securities that have a low but positive yield, normally publicly traded stocks and bonds

C. Fixed assets (long-term – longer than one year)

1. Property, plant and equipment – net of depreciation

2. Investments – consolidated and unconsolidated

3. Intangible assets – patents and goodwill (subject to amortization)

4. Other assets

D. Current liabilities (short-term – expected to be paid within one year)

1. Accounts payable or trade credit

2. Accruals

3. Short-term notes payable and current portion of long- term debt

E. Long-term liabilities (not expected to be paid within one year)

1. Mortgages

2. Deferred income tax liability

3. Long-term debt

F. Stockholder’s equity (or stakeholder’s interest)

1. Common stock

2. Preferred stock

3. Additional paid-in capital

4. Retained earnings (or excess of revenues over expenses)

Notes

Diamond Creek Resorts International, Inc. Consolidated Statement of Cash Flows

For Year Ended 12/31/200X ($ in thousands)

Inflows Outflows

Cash inflows from operating activities1 $ 32,500 Cash outflows from operating activities $ 0 Cash inflows from investing activities 0 Cash outflows from investing activities 0 Cash inflows from financing activities 0 Cash outflows from financing activities2 7,500 Total inflows $ 32,500 Total outflows $ 7,500 Net increase in cash $ 25,000 Beginning cash 122,000 Ending cash $ 147,000 Net increase in cash $ 25,000

Notes to the Statement of Cash Flows 1Cash inflows from operating activities Net income $ 7,500 Change in accounts receivable 2,000 Change in inventory 6,000 Change in accounts payable 2,000 Change in depreciation 15,000 Total $ 32,500 2Cash outflows from financing activities Payment of dividends $ 3,500 Retirement of long-term debt 4,000 Total $ 7,500 Note: In the “real world,” it would be unusual to have no cash flow from investing activities. The example is designed to provide a simple illustration of a Statement of Cash Flows, its information content, and its relationship to the Income Statement and Balance Sheet.

IX. Statement of Cash Flows

A. Purpose – a report summarizing the effects of cash on the operating, investing, and financial activities of an organization for a specific period of time

B. Operating activities

1. Cash received from

a. Sales of goods or services b. Interest revenue c. Dividend revenue d. Other sources that are not investment or finance

activities

2. Cash paid for

a. Raw materials or inventory b. Salaries and wages c. Taxes, duties, fines, penalties d. Interest expense e. Other expenses that are not investment or finance

activities

C. Investing activities

1. Cash received from

a. Collections or sales of loans b. Sale of equity investments and return of

investments from those instruments c. Sale of property, plant, equipment

2. Cash paid for

a. Loans made and payments made to acquire debt b. Purchase of equity investments of other entities c. Purchase of property, plant, equipment

D. Financing activities

1. Cash received from

a. Issuing equity investments b. Sale of bonds, mortgages, notes

2. Cash paid for a. Cash dividends b. Purchase of treasury stock c. Repayment of loans

E. Other non-cash expenses or transactions requiring an

adjustment to the statement of cash flows

1. Deductions from revenue that do not require a cash outlay and are added back to income

a. Depreciation b. Depletion expensed c. Amortization of intangible assets (patents and

goodwill) d. Amortization of discount on bonds payable e. Losses from disposal of non-current assets

2. Non-cash revenues or credits that require a deduction from net income

a. Gains from disposals of non-current assets

b. Income from investments carried under equity method

c. Amortization of premium on bonds payable

Learning Objective #5: Discuss the definition of cost of capital and the sources of capital to the organization.

X. Cost of Capital

A. Definition: the cost associated with various sources of financing to the organization and used to determine which alternative applications of funds are cost effective and should be undertaken.

B. Sources of capital to the organization

1. Long-term debt – funds borrowed from external

sources; least expensive source of capital a. Low risk to the investor

b. Interest is tax-deductible

2. Preferred stock – funds acquired from external sources

through sale of new preferred stock 3. Common stock – funds acquired from external sources

through the sale of new common stock

4. Retained earnings – internal funds retained from net income and not distributed to holders of common stock

C. The concept of the cost of capital has several different names, often used interchangeably such as:

1. Hurdle rate – the minimum accepted rate of return from

a project 2. Weighted Average Cost of Capital (WACC) –

a computation of the cost of capital from the organization’s current mix of capital sources

3. Required rate of return – the rate of return required

from an investment to compensate for the level of risk involved

Commentary

A business corporation forms itself by selling a new issue of common stock to outside investors. As the firm becomes established and requires additional financing, it may sell preferred stock (a security that combines some features of common stock and debt, e.g., the dividend is a required percentage of the par value like interest but is not tax- deductible), borrow funds from financial institutions or investors, or it may retain earnings that would otherwise be paid to holders of common stock. An organization filed as a tax-exempt organization under Section 501(c) of the Internal Revenue Code (the so-called “non-profit organization”) may sell stock, depending upon their organization or simply receive contributions that would have the same effect as selling common stock shares. Tax-exempt organizations may borrow funds from financial institutions or other outside sources. Within limits stipulated by the Internal Revenue Service, the tax-exempt organization actually can earn and retain profits. Similarly, partnerships raise funds by selling partnership shares, borrow funds, and retain partnership earnings instead of distributing those earnings to partners. The concept of cost of capital is important to all types of business organizations.

D. Using the cost of capital to make risk management decisions

1. The organization makes financial decisions and applies available funds to alternative projects using a simple decision rule:

If the project’s rate of return is equal to or greater than the organization’s cost of capital, the project should be undertaken.

2. A risk management project, such as the installation of

an automatic sprinkler system, can be evaluated on the same basis as any other capital expenditure. Using the cost of capital as the discount rate, a net present value of the inflows and outflows can be calculated resulting in a decision.

E. Providers of the cost of capital

1. Chief Financial Officer assigns the cost of capital or

discount rate 2. Chief Financial Officer provides the organization’s

WACC

Commentary Capital Structure Capital structure can be defined as the mix of capital generated by the sale of new common stock, sale of common preferred stock, long-term borrowing, and retained earnings. Common and preferred stock are equity investments, meaning the stockholder is an owner of the organization. For common stock, payment of dividends is optional, but for preferred, dividend payment is required. Dividends on either type are not tax-deductible, but are a distribution of after-tax funds. Borrowing is a contractual relationship, with repayment of principal and payment of interest required. Interest is tax-deductible to the organization. If the organization were to dissolve, the distribution of funds generated from the conversion of assets generally follow this format: secured shareholders, such as bondholders, receive funds first, followed by unsecured creditors, preferred stockholders, and finally common stockholders. Since interest on debt is the only tax-deductible payment to outsiders, the cost of capital for long-term debt is generally the lowest of the four broad categories. However, an organization needs to balance its mix of long-term debt, common shares, preferred shares, and retained earnings according to its overall financial and operational objectives.

Learning Objective #6: Discuss the purposes and formulas of common financial ratios in time series and cross section analysis.

XI. Financial Ratios

A. Purpose of financial analysis and financial ratios

1. Financial analysis assists with financial decision- making, establishing credit policies, and measuring operational efficiency and employee performance. It involves the selection, evaluation and interpretation of financial data.

2. Financial ratios are used by financial managers as indicators of financial performance and the financial health of the organization

B. Types of financial analyses

1. Time series – identifies trends over time

2. Cross section – compares the organization’s performance with that of other organizations or divisions

C. Financial ratios (by purpose) 1. Liquidity ratios measure the organization’s ability to

pay bills over the short term

a. Current ratio =

current assets : current liabilities

b. Quick ratio =

(current assets – inventory) : current liabilities

c. Net working capital = current assets – current liabilities

2. Debt ratios measure the organization’s ability to repay its creditors over the long term and assess the organization’s financial leverage

a. Debt ratio = total debt : total assets

b. Debt-to-equity ratio = total debt : stockholders equity

3. Coverage ratios measure the organization’s ability to

meet interest requirements, or how many times the interest is earned during the accounting period; a measure of the risk of default on debt obligations

Times interest earned =

earnings before interest and taxes (EBIT) : total interest paid during the accounting period

4. Profitability ratios measure the returns on various bases

a. Net profit margin =

net income : sales

b. Return on assets (ROA) =

net income : total assets

c. Return on equity (ROE) =

net income : stockholders’ equity

d. Earnings per share (EPS) =

after-tax net income : number of shares of outstanding common stock

5. Market ratios measure the value of an organization’s

common stock in the financial market

a. Price / earnings ratio (P/E ratio) =

market price per share of common stock : earnings per share

b. Market / book =

market price per share of common stock : book value per share

Key Financial Ratios Liquidity Current Assets Current Ratio = Current Liabilities Benchmark-Standard = 1.50 & up

Current Assets – Inventory Quick Ratio = Current Liabilities Benchmark-Standard = 1.00 & up Net working capital = Current Assets – Current Liabilities

Debt Total Debt Debt Ratio = Total Assets Benchmark-Standard = .50 & down

Total Debt Debt to Equity Ratio = Stockholders’ Equity Benchmark-Standard = 1.00 & down

Coverage EBIT Times Interest Earned = Interest Charges Benchmark-Standard = 4 to 7 and up Profitability Net Income Net Profit Margin = Sales Benchmark Standard varies by industry

Net Income

Return on Assets (ROA) = Total Assets Benchmark-Standard varies by industry

Net Income Return on Equity (ROE) = Equity Benchmark-Standard = 15% Earnings per Share = After-tax Net Income number of common shares outstanding Market Market price per share Price/earnings ratio = Earnings per share Market/book = Market price per share Book value per share

D. Risk managers must understand and use financial ratio analysis as a decision-making tool

1. Risk management initiatives may have an impact on the financial structure of the organization and the organization’s resulting financial ratios

2. Other management decisions concerning operations, investing, and financing may affect the financial structure of the organization and have an impact on risk management initiatives

3. Examples

a. Risk management initiatives may affect capital outlays (investing on cash flow statement), expenses, sales, or other items found on the financial statements

b. Capital outlays may affect current assets, fixed assets, and net income (to the extent of depreciation expense) and cash flow

c. Expenses may affect cash flow, current liabilities, and net income

d. Liability reserves may affect current and long- term liabilities, future net income and cash flow

e. Uncovered losses (retained losses) may affect net income, long-term liabilities, current assets, current liabilities and cash flow

f. The organization’s financial status may affect the ability to obtain credit or surety, to financially guarantee certain insurance programs and to obtain insurance coverage

E. Reliance on information by financial managers vs. risk managers

1. Financial managers rely upon information contained in

the financial statements. This information may be presented in the format of generally accepted accounting standards or of internally-defined managerial accounting statements. If the information is not recorded in the accounting books of the organization, regardless of the accounting standards used, it will not be used in the financial ratios.

2. Risk managers rely upon information contained in the

financial statements and in additional statements pertaining to the treatment of loss exposures, such as loss runs from insurance carriers, third-party administrators, or internal claims departments, actuarial reports, litigation reports, or other reports that describe the potential financial impact of a loss exposure on the organization before it becomes an entry in the organization’s accounting books.

3. Because of the difference in relying on source

information, financial ratios calculated by financial managers may differ from those calculated by risk managers.

Skills Application Scenario #10 – Financial Ratios

Mary Donner, the risk manager, is preparing a report on the state of the risk management department for Sarah Packer, the CFO. Mary knows that Sarah is in the process of preparing a report on the financial condition of DCRI for its board of directors, and that Sarah supports the use of financial statement ratio analysis in measuring progress of the company over time.

As she began to prepare her cost of risk report, Mary realized that the dollar amount of losses she initially identified might be incorrect. To get a better idea of the true cost of losses, Mary retained Lucas Pacioli, FAACS, chief actuary of Franciscan Actuarial Associates, LLC, of Colorado Springs, to perform actuarial services.

Pacioli provided the following information:

Ultimate values of all known and reported claims within the retentions, including IBNR $15,750,000

Dollar amount of losses expected to be paid during the current year $5,500,000

In her cost of risk report, Mary provided information to Sarah regarding the loss reserves, valued as of the end of the last fiscal year, trended and developed to their ultimate value and the expected claim payouts. Mary knows that these liabilities are contingent liabilities and are not disclosed in the balance sheet as either current liabilities or long-term liabilities; even though some will be paid out during the current accounting period and some will be paid out over a very long time period. She also knows that these will result in future expenses and will affect future net income and therefore earnings per share. She also realizes DCRI will need to have adequate cash resources to pay losses during the current year and in future years.

The company posts the market price of its common stock and its P/E ratio in the lobby of the corporate office. The current market price of the common stock is $15.00 and the current earnings per share, based on 5,000,000 outstanding shares of common stock, is $1.50.

Sarah calculates the current ratio, debt ratio, net profit margin, and P/E ratio by using the most recent financial statements to measure the progress of the organization. Sarah prepares a report to share with Mary that discloses the following information:.

Current ratio 186,000/39,000 = 4.77 Debt ratio 328,000/463,000 = 70.8% Net profit margin 7,500/350,000 = 2.14% EPS 7,500/5,000,000 = 1.50 P/E ratio 15/1.50 = 10 Mary reviewed Sarah’s report and considered these ratios in light of the actuarial report on reserves, a report that Sarah has not yet seen She believes the actuarial report on reserves may affect these ratios.

Mary completed her analysis and shared her report with Sarah, disclosing the following information:

Current ratio = (186,000-5,500)/(39,000+5,500) = 180,500/44,500= 4.06 Debt ratio = (328,000+15,7500-5,500)/(463,000-5,500) = 338,250/457,500 = 73.9% Net profit margin = ((12,500-5,500)*(1-.40))/350,000 = 4,200/350,000 = 1.20% EPS = (4,200/5,000,000) = 0.84 P/E ratio = 15/0.84 = 17.86 Discuss why the actuarial report on reserves affects the ratios and the importance of this effect to DCRI.

Diamond Creek Resorts International, Inc. Consolidated Income Statements

For the years ended December 31, FYX1 and FYX0 ($ in thousands)

FYX1 FYX0 Revenue $ 350,000 $ 325,000 Less: Operating expenses 312,500 285,000 Less: Depreciation expenses1 15,000 15,000 Net operating income (EBIT) $ 22,500 $ 25,000 Less: Interest expense 10,000 11,000 Earnings before taxes $ 12,500 $ 14,000 Less: Income taxes 5,000 5,600 Net income (net profit after tax) $ 7,500 $ 8,400 Less: Dividends to common 3,500 3,500 Shareholders Addition to retained earnings $ 4,000 $ 4,900 Earnings per share $1.50 $1.68 (5,000,000 shares outstanding)

Notes to the Financial Statements 1. Depreciation is taken on a straight-line basis. Buildings and structures are depreciated over a useful life of 30 years. Improvements to the grounds on all golf courses (tee boxes, greens, hazards, landscaping) are depreciated over a 20-year period. Ski area structures and improvements, including runs and lifts, are depreciated on a 10-year period. 2. Inventory is valued on a first in, first out basis. The company does not foresee a change in inventory valuation in the near future. 3. Management is aware that certain liabilities may be incurred with respect to public liability and strict liability. Management is aware that litigation has been filed, but believes that amounts in excess of deductibles and retentions will be fully insured. Payments made within deductibles or under retention levels will be treated as period expenses in the accounting period when paid. Note: The choice of inventory valuation depends upon a number

of considerations, one of which is tax management. A finance person and a tax management person may have different opinions as to which method to use. The risk manager needs to identify which method was used as part of the process of determining appropriate limits of coverage for business interruption and inventory.

Diamond Creek Resorts International, Inc. Consolidated Balance Sheets at December 31, FYX1 and FYX0

($ in thousands)

Long-term debt 289,000 293,000 Total liabilities3 $328,000 $330,000

Diamond Creek Resorts International, Inc. Consolidated Statement of Cash Flows

For Year Ended 12/31/200X ($ in thousands)

Inflows Outflows Cash inflows from operating activities1 $ 32,500 Cash outflows from operating activities $ 0 Cash inflows from investing activities 00 Cash outflows from investing activities 0 Cash inflows from financing activities 0 Cash outflows from financing activities2 7,500 Total inflows $ 32,500 Total outflows $ 7,500 Net increase in cash $ 25,000 Beginning cash 122,000 Ending cash $ 147,000 Net increase in cash $ 25,000

Review of Learning Objectives

1. Discuss the difference between accounting and finance. (p. 2)

2. Describe the types of accounting systems and who uses financial information. (p. 3)

3. Discuss how financial statement analysis is used as a risk identification method. (p. 6)

4. Explain the purposes and components of an income statement, balance sheet and statement of cash flows. (p. 12)

5. Discuss the definition of cost of capital and the sources of capital to the organization. (p. 36)

6. Discuss the purposes and formulas of common financial ratios in time series and cross section analysis. (p. 41)