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Accounting ® - Free Financial Accounting Principles Guide

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> What is a Contingent Liability? - Accounting Questions Answered

A contingent liability is, as the name suggests, contingent or dependent upon a future event and if that event happens or does not happen. For example, if a company thinks it will face a potential lawsuit in the future, this is a contingent liability because it could win the case, or lose it, if it happens. Another example is if your parents guarantee the mortgage on your home, then if you make all your payments on time and do not default on your mortgage, there is no contingent liability on your parents. If you fail to make the payments, your parents will incur a liability. Another example is when a company is sued for $50,000 by a former employee for harassment or discrimination; the company will have a contingent liability. If the company wins the case, they will not have a liability but if they lose, they will incur a liability.

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> Economic Value Added (EVA) - How to Calculate Economic Viability of a Corporation

Economic Value Added is a performance ratio that determines the true economic profitability of a corporation because it factors in net operating income after taxes & interest minus the opportunity cost of capital deployed to earn that net operating income. In other words, Economic Value Added shows whether the financial performance of a company exceeds or is below the minimum required rate of return for shareholders or business lenders. Economic Value Added tells investors whether the amount of capital they have invested in to the business is generating them higher return than their minimum, or if it is better to invest the capital elsewhere. Here is how Economic Value Added (EVA) is used by financial analysts:

i) Economic Value Added is used as a performance evaluation tool of higher level managers, directors, VPs and CEOs of a corporation because the performance of the organization depends on the human resources deployed.

ii) Economic Value Added is used at sub-division level & entire organizational level of the business, unlike other methods such as Market Value Added that only focuses on the big picture of a corporation.

iii) Economic Value Added factors in to performance evaluation that the operating net income of a corporation must cover both operating costs of the organization as well as the capital costs (opportunity cost of capital). This is unlike other accounting methods such as EBIT or EBITDA or Net Income that look at total revenues generated by the business minus total expenses as a performance evaluation tool.

How to Calculate Economic Value Added

Net Sales
Operating Expenses
Operating Profit (EBIT)

- Taxes
Net Operating Profit After Tax (NOPAT)

- Capital Costs (Total Capital x Cost of Capital)

Economic Value Added

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> EBITDA - Earnings Before Interest, Taxes, Depreciation & Amortization Expense

EBITDA stands for Earnings before Interest, Taxes, Depreciation & Amortization expense. EBITDA is a tool to measure the value of a firm based on its net earnings before non-cash expenses (depreciation & amortization) are recorded, as well as dilutive expenses such as interest expense & taxes. EBIDTA is used by financial valuation experts to measure the true value of a business, especially for private capital firms. Here is why private capital banks like the EBITDA formula:

i) Interest & Taxes - Replace current tax rates & Interest rates with their own tax & interest rates based on the current & new capital structure of the corporation, new debt convenants or refinancing with the banks.

ii) Amortization & Depreciation - These are excluded because they are non-cash expenses for capital or intangible assets which were acquired in prior periods, and do not represent a cash outlay of the organization.

Financial advisors recommend using EBITDA as a way to measure the cash generation activities of an organization. The formula for Earnings before Interest, Taxes, Depreciation & Amortization is:

EBITDA = Net Sales - Operating Expenses = Operating Profit

EBITDA = Operating Profit + Deprecation Expense + Amortization Expense + Taxes

As an example, let's calculate the EBITDA for Checkpoint Software Technology Ltd... (View Full)

> How to Calculate Return on Investment (ROI)

Return on Invesment as the name suggests is a financial valuation method that determines the percent of return investors are getting from their portfolio of investments. Return on Investment is probably one of the most important ratios that companies need to keep track of in order to determine the viability & continuity of their business.Measuring profit margins of products being sold is not enough to continue doing business, companies have to ensure the amount of capital that is being put in to the business is attracting sufficient sales & providing a good return on capital invested.

As a rule of thumb, if the ROI is too low, this means the product lines are not generating enough sales worth running the business and deploying overhead costs, thus in the long term the product line is deemed to fail. The formula for Return on Investment is:

ROI = Net Income / Book Value of Assets

An alternative formula for ROI is:

ROI = Net Income + Interest (1 - Tax Rate) / Book Value of Assets

Another formula that small investors use to calculate ROI is:

ROI = (Gain from Investment - Cost of Investment) / Cost of Investment

For instance, assume you are the VP of a long distance phone company that does a marketing campaign to generate new buyers of its long distance phone cards. The company sells each phone card for $5, and does an advertising campaign on the radio/television worth $500,000. This campaign helps the company sell an additional 155,500 long distance phone cards off its distribution networks. What is the ROI? (View Full)

> Return on Invested Capital (ROIC) Formula

Return on Invested Capital (ROIC) is a top level way to measure the historical & current performance of a corporation across all the capital it has invested in its business. This capital comes from shareholders (investors), creditors who supply loans, credit as well as shares owned by management. One of the best ways to measure how a company has performed in the past on its allocated capital resources is by the Return on Invested Capital ratio. Other similar formulas such as the Discounted Cash Flow (DCF) measures the performance of a company based on its present & future cash flows, but they are easy to manipulate. For instance, a company could easily decrease its outgoing cash flows by:

- Postponing marketing expenses
- Delaying research & development costs
- Cutting back on capital spending
- Laying off workforce

A solid Return on Invested Capital ratio indicates strong management, efficient business operations & use of capital resources as well as value creation opportunities for the organization. The ROIC formula should be used with care as it can mean negative things for the organization such as not exploring growth opportunities for the organization, ignoring long term net positive value investments, stingy cash preservation, excessive convervatism, etc. To create growth in the future, companies must earn an ROIC above their Cost of Capital (WACC). The accounting formula for this relationship is:

Future Growth = Return on Invested Capital - Weighted Average Cost of Capital

There are 2 formulas we could use to calculate ROIC. (View Full)

> Operating Cash Flow - Managing Cash Flows Generated from Business Operations

The Operating Cash Flow (Cash Flows from Operations) measures how further away Cash Flow is from the company's reported Net Income or Operating Income. Under the Generally Accepted Accounting Principles (GAAP), companies can report good Net Income numbers even though their cash flows are poor due to entries such as Accrued Revenues, etc. In simpler terms, Operating Cash Flow is a verification of quality of the company's reported earnings. Some financial experts argue Operating Cash Flow is a better tool of evaluating earnings than Operating or Net Income because a company can show positive net income but still not have enough cash to meet its debt covenants & obligations such as bonds payable, rent expense, salaries expense, etc. There are 2 formulas for calculating the Operating Cash Flow:

1) Cash Flow from Operations =

Income from Continuing Operations + Non-Cash Expenses - Non-Cash Sales
Income from Operations

2) Cash Flow from Operations =

Net Income + Non-Cash Expenses - Non-Cash Sales
Net Income

Differences between Operating Cash Flows and Reported Earnings indicates large amounts of non-cash expenses such as amortization expense, goodwill impairments, etc. If a company reports high earnings but with negative operating cash flows, this presents a red flag that it may be using aggressive accounting techniques that could mislead investors & public using the financial statements of the company.

Operating Cash Flow is sometimes referred to as Free Cash Flow because this cash is 'Free' to be paid back to the suppliers of capital (shareholders and creditors).

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> Earnings per Share - Measuring the Economic Value of a Stock

Financial analysts use Earnings per Share as a way to determine the relative corporate value of a stock. The dividends declared on preferred stock are subtracted from Net income, and this number is then divided by Weighted Average number of Outstanding Common shares & its equivalents. Earnings per Share is very commonly used by the media to evaluate the value of a stock, e.g. if you go to Google Finance, you will see EPS in the summary of a stock along with other measurements such as Price to Earnings ratio, dividend yield, low & high range of a stock, 52 week trading high, etc.

The two most commonly used formulas for calculating Earnings per share include:

i) Earnings Per Share

(Net Income - Preferred Stock Dividends) /

Weighted Average # of Common Shares & Equivalents


ii) Fully Diluted EPS

(Net Income - Preferred Stock Dividends) /

# of Outstanding Common Shares & Common Share Equivalents

The 2nd formula where the denominator is # of Common Shares Outstanding & Common Share Equivalents is known as the Fully Diluted EPS. It is 'fully diluted' because all convertible bonds, preferred stock, convertible warrants and stock warrants & rights are included in the calculation.

How EPS is Calculated

Earnings per share is a way of standardizing a company's net income left over for shareholders across all companies. For instance, two Companies A & B could earn $10 million a year, but

Company A has 50,000 shares outstanding while Company B has 500,000 shares outstanding. So how would you normalize earnings per share across these two companies?

Company A = $10 million / 50,000 shares = $200 / share

Company B = $10 million / 500,000 shares = $20 / share

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> Price to Earnings (P/E) Ratio - Calculating Earnings Growth & Relative Value of Stock Prices

The Price to Earnings ratio compares the current price of a common stock trading on the market with the Earnings per Share (EPS) that the company yields. Earnings per Share is calculated by dividing Net Income in current quarter by the total # of shares outstanding on the market. The price to earnings ratio is a widely used stock valuation tool as it indicates to investors how 'cheap' or 'expensive' a stock is and you will see analysts on Bloomberg television referring to the P/E ratio in part of their analysis & discussions about stocks. For example, assume Farhan Corp. currently has its A Class common stock trading at $45 per share and total # of shares on the market is 50,000. Net income as at February 28th, 2010 is $2million. What is the Earnings per Share?

Earnings per Share = Net Income / Total # of Shares Outstanding

Earnings per Share = $2,000,000 / 450,000 shares
Earnings per Share = 4.44 cents a share

Having this data, what will be the Price to Earnings ratio?

P/E ratio = Current Price / EPS

P/E ratio = $45 / 4.44
P/E ratio = 10.135

Earnings per share data of a stock is commonly found in Google Finance or from the annual reports of your prospective company. Another way to derive Earnings per Share is to estimate based on the EPS of last 4 quarters.

Disadvantages of using EPS

1) The price to earnings ratio is based on future estimates of earnings or net income such as the prevailing estimate of EPS of the last 4 quarters. With the high volatility in the stock markets and lots of businesses going bankruptcy, future estimates of accounting earnings or net income should be taken not very seriously as they are just estimates and could be way off from actual performance.

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> Dividend Growth Model - How to Value Common Stock with a Constant Dividend and Steady Growth

If the dividend grows at a steady rate, we do not need to forecast an infinite number of future dividends; however we just need to come up with a single growth rate which is a lot simpler. Taking D0 to be the dividend just paid and g to be the constant growth rate, the value of one share of stock can be simply written as:

P0 = [(D1 / (1 + r)1)] + [(D2 / (1 + r)2)] + [(D3 / (1 + r)3)]

This can be cut down to the following:

P0 = [D0 x (1 + g)] / (r – g) = (D1) / (r – g)

We have therefore just derived the dividend growth model which is a model that determines the current price or value of a share of stock as its dividend next period divided by the discount rate minus the dividend growth rate.

Bank of America Dividend Growth Model Application - Example

Bank of America announces its next dividend will be $2 a share and from research we know that investors typically require a 14% annual rate of return from American banks, thus this will be the required rate of return. The bank increases its dividend at a steady rate of 8% a year. Based on the dividend growth model, what is the value of the Bank of America stock today? What is the value in 4 years?

a) Since we are already given the next dividend as $2 per share, we will not multiply D1 with (1 + g) as it is given as $2. Having said this, the dividend growth formula we will use is:

P0 = D1 / (r – g)

P0 = 2 / (0.14 – 0.08)

P0 = 2 / 0.06

P0 = $33.33

b) Since we already know the dividend in one year, the dividend in four years is equal to:

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> How to Value Common Stock given Required ROI (Return on Investment) and Dividends

Shares of common stock are more difficult to value than say a bond payable because of three inherent reasons:

i) The promised cash flows from common stocks are not known in advance as opposed to bond payable where we know the cash flows.

ii) The life of common stocks is forever because they have no maturity as opposed to bonds payable that have a maturity date.

iii) There is no set way of coming up with a required rate of return as stocks fluctuate in value quite a bit.

Deriving the Common Stock Valuation Formula

Having said this, how can we value common stocks and discount them for the present values? Imagine that you buy a share of common stock today and plan to sell the stock in one year. From insider knowledge, you know that the stock will be worth $80 in one year. You also think that the stock will pay $8 per share dividend at the end of the year. If you require a 15% return on your investment, what is the most you would pay for this stock as of now? In other words, what is the present value of the $8 dividend along with the $80 ending value of the stock at 15% required rate of return? Here’s how to calculate this:

Present Value = ($8 + $80) / 1.15

Present Value = $76.52

Therefore, the perceived present value of this investment will be $76.52 today. This formula can be put in more explicit terms as follows:

P0 = (D1 + P1) / (1 + r)


P0 = Current price of the stock

P1 = Price of the stock in 1 year (or one period)

D1 = Dividend expected to be paid at the end of the period (year)

R = required rate of return on this investment in the market today

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> Applied Predetermined Overhead Rate - How to Compute total Production Costs using Estimated Labor & Machine Hours

Applied predetermined overhead rate is a cost accounting method that applies estimated labour or machine cost per hour to total # of actual hours in a given period, to derive the total cost of production, whether it is machine use or physical labour hours. This method is commonly used to apply factory overhead to a given job or product. The formula for applied predetermined overhead rate is:

Applied Overhead Rate = Budgeted annual overhead / Budgeted annual activity hours*

* Budgeted annual activity hours include direct labour & machine hours.


Assume a factory calculates its predetermined overhead rate based on machine use or hours. Budgeted overhead is estimated at $600,000 while budgeted machine hours are estimated at 150,000. The applied overhead rate is calculated as:

Applied Overhead Rate = Budgeted annual overhead / budgeted annual activity hours

Applied Overhead Rate = $600,000 / 150,000 hours

Applied Overhead Rate = $4 per machine hour

During the course of the year, actual machine hours used to output the same amount of products is 145,000 hours. Thus, what is the actual overhead?

Actual Overhead = Applied overhead rate x Actual machine hours

Actual Overhead = $4 x 145,000 hours

Actual Overhead = $580,000

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> Arbitrage – Process of Buying/Selling Complementary Securities

Arbitrage refers to the ability of investors to trade in complementary securities (buying and selling stocks, commodities or ETFs) in two different markets at the same time. The purpose of using arbitrage is to take advantage of market inefficiencies where one stock might be trading for $500 on the NYSE while it could be trading at $450 on the London stock exchange. Investors who engage in arbitrage are known as Arbitragers. Arbitrage basically takes advantage of the price differences between two comparable commodities or securities trading simultaneously on two different secondary markets or stock exchanges. An arbitrage investor (arbitrager) buys a security on the exchange with the lower price and sells it right away on the exchange that offers a higher price, for a profit or capital gain. The formula for arbitrage is:

P = (Yb– Xa) x Q


P = Arbitrage profit

Yb = price of higher priced security on the higher trading exchange – We’ll call it the exchange B.

Xa = Price of lower priced security on the lower trading exchange – We’ll call it the exchange A.

Q = Quantity

Example 1

Say for instance Binti Kiziwi Corp (ticker symbol BKC) is trading for $80 per share on the New York stock exchange (NYSE) while it is trading for $95 per share on the Toronto stock exchange (TSX). An arbitrage investor buys 2000 shares of the stock on the New York stock exchange for $80/share and sells it simultaneously on the Toronto stock exchange for $95/share, thus making a decent profit of $15/share.

The arbitrage profit will therefore be:

P = (Yb– Xa) x Q

P = ($95 – $80) x 2000 shares

P = $15 x 2000 shares

P = $30,000

The arbitrage profit is $30,000. This transaction and similar transactions to this one will increase the value of the stock on the New York stock exchange as arbitragers will be buying and driving up demand in an attempt to lock in profit. However, the price of the security on the Toronto stock exchange will go lower because arbitragers will be dumping the stocks in that exchange in order to make their profits; for instance even if the arbitrager sells the shares at $93/share on the TSX instead of the $95 current trading price, he will still make a very good gain on his sale; this will therefore drive prices of that security on the TSX downwards.

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