Financial Terms and Ratios: Definitions and Applications

Posted on Dec 9, 2024 in Economy

Liquidity Definition

Liquidity refers to the immediate provision of financial and monetary funds to deal with all types of commitments. In credits, securities, or banking, liquidity means the property of being readily convertible into cash.

Profitability

A more precise definition of profitability is that it is an index that measures the relationship between earnings or profits and the investment or resources that were used to obtain them.

1. What is a Budget?

It is a plan to meet a target, expressed in financial terms and values that must be met by a certain time and under certain conditions laid down. This concept is applied to each responsibility center of the organization.

2. Functions of Budgeting

1. The main function of the budget relates to the financial control of the organization.
2. Budgetary control is the process of discovering what is being done by comparing the results with budgeted data corresponding to verify or counteract the achievements.
3. Budgets can play both preventive and corrective roles within the organization.

Monthly Index of Economic Activity: IMACEC

The IMACEC is measured by the Central Bank and aims to estimate the evolution of the net output of goods and services by the Chilean economy during one month. It is an approximation of the behavior of the gross domestic product (GDP) in the short term.

1. What is the CPI?

The Consumer Price Index (CPI) measures price changes of a basket of goods and services consumed by an urban household in Greater Santiago. Its purpose is to estimate inflation (or deflation, as the case may be) domestically. The new CPI has a base of December 2008 = 100.

2. What is the CPI Used For?

The CPI is used for two purposes:

1. Monitor changes in the cost of living. Although technically not a cost-of-living index, it is widely regarded as a rough measure of this. The CPI is also used in the indexing of different types of contracts, i.e., it is used to correct the effects of inflation on the value of the contracts.
2. Monitor the evolution of prices of household consumption over time. The course of the CPI impacts monetary policy defined by the relevant authority, the evolution of the Unidad de Fomento (UF), Monthly Tax Unit (UTM), fluctuations in regulated utility rates, and the deflation of household consumption in national accounts, among other uses.

11. What Does it Mean When the CPI Goes Up or Down?

When the CPI rises, it means that the average prices of the average basket of household consumption rose. That is, the basket is now more expensive than in the reference period, usually the previous month. The opposite situation occurs when the CPI is low.

12. How Does the CPI Affect Households?

In Chile, there is a high level of indexation of the economy. Many prices are fixed in monetary units other than the peso, for example, in Unidades de Fomento (UF). The UF varies according to how the CPI varies. All payments made in UF vary with the CPI. The rates for electricity, water, and others are adjusted for the CPI. On the other hand, household savings are adjusted by the CPI.

15. Where are Prices Collected for the CPI?

Prices that are incorporated into the CPI calculations are based on various sources of information. The most numerous are direct inquiries made by INE officials in establishments that sell products from the basket. Prices are also collected in private households (for rent and domestic service). Additionally, prices are collected from public sources of information: newspapers, Internet portals, administrative records, and other public agencies.

13. What Does Cumulative CPI Mean?

The CPI measures the price change compared to the previous month. To find out how much inflation there has been so far this year (i.e., until May), a calculation of price variation is made comparing May to December of the previous year. This is called cumulative CPI.

Definition of the UF

The Unidad de Fomento (UF) is a readjusted measure based on the change in the Consumer Price Index. According to Central Bank guidelines and by agreement 05-03-900105 of January 8, 1990, the UF continues to be readjusted on a daily basis. It is calculated at the beginning of each month for the period from the 10th of that month to the 9th of the next month, according to the geometric average rate of change in the CPI for the previous month. The change in the CPI of the previous month shall be determined monthly by the National Statistics Institute (INE), or whichever agency may replace it in the future.

What is the Balance Sheet?

It is a summary of everything that the company has, everything it owes, what it should be paid, and what actually belongs to its owner, as of a certain date. In short, it is a clear and simple picture of what an employer has on the date on which it is made.

Retained Earnings

These are the profits that the entrepreneur has invested in their business.

Previous Period Utilities

The value of the company’s profits in the immediately preceding period. This value must match the utilities listed in the last statement of retained earnings.

1. Definition of the Income Statement or Profit and Loss

The Profit and Loss statement is an accounting document that shows in detail and in an orderly manner how the profit or loss for the period was obtained. The Profit and Loss statement is also considered a complementary statement to the Balance Sheet, since the latter only shows the amount of profit gained or loss, while the Statement of Profit or Loss details how this result was obtained. (See examples of these financial statements summarized below).

Liquidity Ratios

The liquidity of an organization is judged by its ability to repay short-term obligations as they become due. They refer not only to the company’s overall finances but also to its ability to convert certain assets and liabilities into cash.

• NET WORKING CAPITAL (NWC): This ratio is obtained by deducting all of the firm’s current obligations from its current rights.

  NWC = Current Assets – Current Liabilities

• SOLVENCY INDEX (SI): This considers the true extent of the company at any instance of time and is comparable with different entities of the same activity.

  SI = Current Assets / Current Liabilities

• ACID TEST INDEX: This test is similar to credit ratings, but within current assets, the inventory of products is not taken into account, since this is the least liquid asset.

  Acid Test = (Current Assets – Inventory) / Current Liabilities

• INVENTORY TURNOVER (IT): This measures the liquidity of inventory through its movement during the period.

  IT = Cost of Goods Sold / Average Inventory

• AVERAGE INVENTORY PERIOD (AIP): Represents the average number of days that an article remains in the company’s inventory.

  AIP = 360 / Inventory Turnover

• ACCOUNTS RECEIVABLE TURNOVER (ART): Measures the liquidity of accounts receivable by means of their rotation.

  ART = Annual Credit Sales / Average Accounts Receivable

• AVERAGE COLLECTION PERIOD (ACP): It is a ratio that indicates the evaluation of the company’s credit and collection policy.

  ACP = 360 / Accounts Receivable Turnover

• ACCOUNTS PAYABLE TURNOVER (APT): Allows you to calculate the number of times accounts payable are converted to cash during the year.

  APT = Annual Credit Purchases / Average Accounts Payable

• AVERAGE PAYMENT PERIOD (APP): Allows a glimpse of the company’s payment rules.

  APP = 360 / Accounts Payable Turnover

Debt Ratios

These ratios indicate the amount of money from others that is used to generate profits. They are of great importance since they bind the debt over time.

• DEBT RATIO (DR): This measures the proportion of total assets contributed by the company’s creditors.

  DR = Total Liabilities / Total Assets

• DEBT-TO-EQUITY RATIO (DER): Indicates the relationship between long-term funds provided by creditors and those provided by business owners.

  DER = Non-current Liabilities / Equity

• TOTAL LIABILITIES TO CAPITAL RATIO (TLCR): Has the same objective as the previous ratio, but also serves to calculate the percentage of long-term funds provided by creditors, including long-term debt as equity.

  TLCR = Long-term Debt / Total Capitalization

Profitability Ratios

These ratios analyze and evaluate the company’s profit with respect to a given level of sales, assets, or the owners’ investment.

• GROSS MARGIN (GM): Indicates the percentage of sales remaining after the company has paid for its inventory.

  GM = (Sales – Cost of Goods Sold) / Sales

• OPERATING PROFIT MARGIN (OPM): Represents the net earnings gained by the business on each sale. These should be taken into account by deducting financial or governmental charges, as the utility determines only the operation of the company.
• NET PROFIT MARGIN (NPM): Determines the percentage of each sale that remains after deducting all expenses, including taxes.
• ASSET TURNOVER (AT): Indicates how efficiently the company can use its assets to generate sales.

  AT = Annual Sales / Total Assets

• RETURN ON INVESTMENT (ROI): Determines the overall effectiveness of management in making a profit with the available assets.

  ROI = Net Profits After Taxes / Total Assets

• RETURN ON COMMON EQUITY (ROE): Indicates the yield achieved on the book value of equity.

  ROE = (Net Profits After Taxes – Preferred Dividends) / (Stockholders’ Equity – Preferred Capital)

• EARNINGS PER SHARE (EPS): Represents the total revenue obtained by each existing ordinary share.

  EPS = Earnings Available for Common Stock / Number of Shares Outstanding

• DIVIDEND PER SHARE (DPS): This represents the amount paid to each shareholder at the end of the operating period.

  DPS = Dividends Paid / Number of Existing Ordinary Shares

Coverage Ratios

These ratios assess the company’s ability to cover certain fixed charges. These interact more frequently with fixed charges for the company’s debts.

• TIMES INTEREST EARNED (TIE): Calculates the company’s ability to make contractual interest payments.

  TIE = Earnings Before Interest and Taxes / Annual Interest Expense

• TOTAL LIABILITY COVERAGE (TLC): This ratio looks at the company’s ability to meet its obligations for interest and its ability to repay the principal of loans or make credits to sinking funds.

  TLC = Earnings Before Interest and Taxes / (Interest + Principal Payments on Liabilities)

• TOTAL COVERAGE RATIO (TCR): This ratio includes all types of obligations, both temporary and fixed, and determines the company’s ability to cover all financial charges.

  TCR = Earnings Before Lease Payments, Interest, and Taxes / (Interest + Principal Payments on Liabilities + Lease Payments)

1. In a corporation that is dedicated to producing and marketing products and services, a series of decisions must be made in order to give added value to the company. The decision to borrow from a bank for the purchase of fixed assets shall be the basis of:

   A) Investment.

2. In a corporation that is dedicated to the production and marketing of agricultural products, which of the following transactions corresponds to an investment decision?

   A) Purchase of machinery.

3. Which of the following functions performed by the financial manager in a company is short-term?

   D) Investment in marketable securities.

4. In a corporation that is dedicated to producing and marketing products and services, a series of decisions must be made in order to give added value to the company. The decision to borrow from a bank (to 36 months with payment of principal and interest at the end of the term) for the purchase of fixed assets shall be a function of:

   C) Long Term

5. Identify the indices that will be affected if a company makes a large purchase of equipment and machinery, financing the operation with a long-term bank loan (consider only the immediate effects).

   B) Only debt.

6. Identify the indices that will be affected if a company makes a payment to suppliers.

   A) Only cash.

7. A corporation has its Balance Sheet as of 12/31/2008:

   ASSETS 600 / CURRENT LIABILITIES 500 = 1.2

   According to the above, the Current Ratio relates to:

   B) 1.2

8. A corporation’s income statement presented as of 12/31/2008:

   Operating Income 200

   Operating Cost 110

   Margin 90

   According to the above, the operating margin on the sale corresponds to:

   D) 45%

9. A trading company has an acid test equivalent to 0.4 and a turnover of 0.8. According to the above, one can interpret that this company:

   C) Has no ability to pay in the short term.

10. A trading company has an average payment period equivalent to 30 days. According to the above, it can be interpreted that this company pays its debts to:

    A) Suppliers every 30 days.

11. A commercial company has a return on assets of 10%. According to the above, it may interpret the results:

    D) After taxes, equivalent to 10% of total assets.

12. A commercial company has an accounts receivable turnover equivalent to 10 times. According to the above, on the basis of a year equivalent to 360 days, you can interpret that the company:

    A) Recovers its accounts receivable during the period, every 36 days. (360/10 = 36)

A company submits the following information:

According to the above, the main solution to this issue would be to reduce:

C) Income from Operations.

The projected balance sheet, cash budget, and projected income statement are classified as:

B) Financial.

20. To make the projected income statement, you must have the following information:

    B) Net sales projected, cost of projected sales, operating expenses, and non-operating expenses projected.

21. To make the production budget, consider the following information:

    D) Projected sales in units, the initial and final inventory of finished goods.

22. To make a budget of expenditures for purchases of raw materials, the following estimates should be developed first:

    A) Sales and Production.

23. A production company projected a production of 1500 articles for January 2010. It is known that to produce an article, 2 kilos of MPD are used, and the kilo of MPD has a value of $238 gross. According to the above, the use of MPD in kilos and pesos corresponds to:

    D) 3,000 kilos, $714,000

24. Of the total annual projected sales of merchandise during the year, 100% will be paid in cash. What financial budget(s) will be directly affected by this economic fact?

    C) Only cash budget and projected income statement.