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Accounting® - Free financial accounting, managerial (cost) accounting & corporate finance lessons!

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> Financial Forecasting using Percent of Sales Method & How to Calculate Projected Retained Earnings

Financial forecasting is an essential part of all financial planning of a corporation as it is the basis for budgeting activities and estimating future financing needs of the company. Financial forecasting typically involves forecasting sales and expenses incurred to generate those sales. When making a financial forecast, directors typically use an estimate of various expenses, sales & liabilities and the most widely used method for making such projections is the percent-of-sales method. In the percent of sales method, assets, liabilities & total expenses are estimated as a percentage of sales that are then compared with projected sales. These numbers are then used to design a pro forma (panned or projected) balance sheet.

The steps necessary to compute a pro forma balance sheet is as follows:

1. Express balance sheet items that vary directly with sales as a percentage of sales. Any items that do not vary directly with sales e.g. long term debt, retaining earnings, common stock & property/plant/equipment are designated as not applicable (n/a).

2. Multiply the percentages from step 1 by the sales projected to obtain the amounts for future periods.

3. Where no percentage applies (e.g. for long term debt, common stock or retained earnings numbers), take the figures from the present balance sheet in the column for the future period.

4. Calculate the projected retained earnings using the below formula:

Projected Retained Earnings = Present retained earnings + Projected Net Income – Cash Dividends Paid

5. Total up the assets account to obtain a total projected assets number, then add projected liabilities & equity accounts to determine the total shortfall. This shortfall indicates the total external financing that is required to keep the company running at present operational levels.

Example of Financial Forecasting Using Percent of Sales Method

Let’s do a financial forecast for Bongo Corp. for the year 2009 assuming net income is to be 10% of sales and the dividend payout ratio is 5%. Also, projected sales are estimated to be at $60 million (using an estimate of 2 x current assets).

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> Forward Contracts on Currencies for Multinational Corporations

The forward market allows investors to trade forward contracts on currencies on the global currencies markets. A forward contract is an agreement between an organization and a commercial bank to exchange a specified amount of one currency at a specified exchange rate (also known as the forward rate) on a specified date in the future. Why would a corporation ever need a forward contract? Consider a multinational corporation operating in Finland anticipates a future receipt of foreign currency such as the Chinese Yuan from a customer in China. When such a need arises, the multinational corporation can lock in the rate at which they purchase or sell a particular foreign currency.

This is known as hedging a currency. Usually forward contracts involve very large corporations expecting merchandise from a foreign currency and expecting to pay the supplier in their local currency. Therefore, a typical forward contract is valued at a minimum of $1 million US. Thus, forward contracts are normally not used by small corporations or individual investors. When a large corporation goes to obtain a forward contract, and if the bank has a doubt in its ability to make future payments, the bank could ask for a small upfront deposit to ensure the corporation will be able to repay. This type of a deposit is known as a compensating balance and no interest is received on any sums deposited. Most common forward contracts are for 30, 60, 90, 180 or 360 days.

How International Companies Use Forward Contracts

Multinational corporations use forward contracts to hedge their expected imports. They can lock in the rate at which they will be able to obtain a currency needed to purchase imports from a foreign country. As an example, consider Mike Tee Corp. operating out of Orlando, Florida will need $1,000,000 Australian dollars to purchase their imports of raw materials. It can purchase Australian dollars, at say $0.60 per Australian dollar. At this spot rate, the firm would need:

Australian Dollars = $1,000,000

Spot rate = $0.60 per Aussie dollar

American funds needed = $1,000,000 Australian x $0.60

American funds needed = $600,000 US

However, let’s assume the company does not have $600,000 US to buy their imports now. The company can wait for 90 days and raise the cash needed, and exchange it to Australian dollars at the spot rate available during that time. But we do not know what the spot rate will be during that time. Say in 90 days, the Australian dollar rises to $0.65 for every $1 US as a result of the Aussie government increasing interest rates. When this happens, Mike Tee Corp. will need additional funds to purchase the same $1miillion Aussie dollars. Here are the calculations:

Australian Dollars = $1,000,000

Spot rate = $0.65 per Aussie dollar

American funds needed = $1,000,000 Australian x $0.65

American funds needed = $650,000 US

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> Weighted Average Cost of Capital – Examining the Capital Structure of a Corporation

Weighted Average Cost of Capital is a calculation of the overall cost of capital used by a corporation and is an average representing the total return (in percent) that is expected of an organization on all its assets, debts and owner’s equity to maintain its current stock price & valuations. Weighted Average Cost of Capital weighs in all items that play a role in the corporation’s capital structure including common and preferred shares, bonds, and other long term debts.

In order to calculate the weighted average cost of capital, we must first examine the capital structure of the company we are analyzing. In terms of corporate finance, capital structure refers to how a corporation finances it assets and its business operations; either through the use of long term debt, common shares or preferred stock (also known as shareholder’s equity) or other hybrid securities. Weighted Average Cost of Capital becomes especially important when the capital structure of a firm involves both debt and equity financing. In this example, we will look at the three most common types of financing included in capital structure:

i) Common shares equity

ii) Preferred shares equity

iii) Long term debt

Steps for Calculating Weighted Average Cost of Capital

There are three steps for calculating the WACC of an organization.

1) Determine the proportionate weighting of each source of capital financing based on their market value.

2) Calculate the after-tax rate of return or cost of each source.

3) Calculate the weighted average cost of all sources

The formula for WACC is:

WACC = (Ke x We) + (Kp x Wp) + Kd/pt [1 – t] x Wd)

Ke =Cost of capital -common equity

We =Percent of common equity in the capital structure, at market value

Kp = Cost of preferred equity (shares)

Wp =Percentage of preferred equity in the capital structure (at market value)

Kd/pt =Cost of debt (pre-tax)

T = Tax rate

Wd=Percentage of debt in the capital structure (at market value)


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> Accounts Payable Efficiency Ratio - How to Calculate Sales to Accounts Payable Ratio & Days' Purchases in Accounts Payable
Accounts payable ratios tell us how long it takes a company to pay its suppliers, creditors and whether the company is in a good position to obtain short term financing in the form of cost-free funds. Short-term creditors such as banks, credit unions and line of credit companies view the accounts payable ratios as indicators of a company’s financial strength.

How is Accounts Payable Ratios Computed?

i) Sales to Accounts Payable

Sales to Accounts Payable = Sales / Accounts Payable

ii) Days’ Purchases in Accounts Payable

Days’ purchases in accounts payable = Accounts Payable / (Purchases / 360 days)
Assume the following data derived from the Income statements & Balance sheets of Juakali Corp. for its 2009 year.


2009 (Year 1) 2010 (Year 2)
Accounts Payable $76,500 $71,300
Purchases $900,000 $845,000
Sales $2,100,000 $1,800,000

The relevant ratio calculations for each of the years are:


2009 (Year 1) 2010 (Year 2)
Sales to Accounts Payable $2,100,000 / $76,500 = 27.45 $1,800,000 / $71,300 = 25.25
Days’ Purchases in Accounts Payable $76,500 / ($900,000 / 360) = 30.60 days $71,300 / ($845,000 / 360) = 30.38 days

Notice that the sales to accounts payable ratio went down from 27.45 in Year 1 (2009) to 25.25 in Year 2 (2010); an improvement of 8%. This indicates the company’s improved ability in year 2 (2010) to obtain short term credit & financing in cost-free funds. This ratio simply means the company is making more sales and is lowering its accounts payable by a certain percentage, which is good for investors & the outlook for the balance sheet. Below we present the data in graphical format. (View Full)

> Dollar Cost Averaging - Calculating the Average Share Price

Dollar Cost averaging is an investment mechanism in which stocks are purchased at constant dollar amounts at regularly spaced intervals, with the most amount of stocks bought at the lowest stock prices possible. By investing a fixed amount of money each time, more shares are bought at lower prices and fewer shares are bought at higher prices. This approach results in a lower average cost per share because the investors buy more shares of the same stock at the lower prices. The formula for dollar cost averaging is: (View Full)

Dollar Cost Averaging (Average Price) = Total market price per share / Total number of Investments


An investor invests $200,000 per month in IBM shares and performs the following transactions:


Investment Market Price per Share Shares Purchased
Jan 10 $200,000 $128 1563
Feb 10 $200,000 $126 1587
March 10 $200,000 $125 1600
April 10 $200,000 $127 1575
May 10 $200,000 $126 1587
June 10 $200,000 $130 1538
July 10 $200,000 $131 1527
Aug 10 $200,000 $124 1613
Total $1,600,000 $1,017 12590

What would the average cost per share be?

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> Convertible Bonds – Can they be Converted to Common Shares? Also, an inspection of Bond Conversion Premiums

Most newbie investors are confused as to what convertible bonds are; they wonder are they really bonds or convertible bonds that are stocks, or both? Basically, convertible bonds are corporate bonds (bonds issue by large organizations) that are convertible in to the common stock of that issuing corporation. Convertible bonds are when bondholders can exchange their bonds for a fixed number of the issuing company’s common shares. Convertible bonds allow bondholders the potential to increase their net worth by future increases in the market value of the common shares of the issuing company. If the share prices of the company do not increase and the bonds are not converted, bondholders will continue to receive periodic interest payments and their principal amounts upon maturity.

Bond Conversion Ratio

The bond conversion ratio is also known as the conversion premium and ultimately determines how many shares can be converted from each bond outstanding. This conversion can be expressed as a ratio or as the conversion price. Usually the details regarding this are stated in the bond’s agreement or indenture.

As an example, consider Jahmani Corp. offers bonds with a conversion ratio of 32:1 for their bonds with a $1000 par value. This means each bond outstanding (with a par value of $1,000) can be exchanged for 32 shares of the issuing company’s common shares.

Let’s consider a hypothetical bond conversion example to clarify the conversion process & accounting rules. Assume that Jahmani Corp. is issuing a new bond to the market with a 6% coupon rate and 10 years to maturity. The company has other 10 year term debt that carries an 8% yield and the company’s stock price is currently trading at $41. Here is a summary of this data in tabular format

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> Annual Percentage Rate (APR) - True Measure of Interest Fees Charged by Credit Card Companies

Annual percentage rate (APR) is a true measure of the interest fees charged by credit card companies & banks. Annual percentage rate (APR) is the effective cost of credit which is the ratio of finance charges to the average amount of credit used in the life of the loan; this is expressed as a percentage per year. In this tutorial, we look at the calculation of APR for single payment loans & multiple instalment loans.

Single Payment Loans

A single payment loan is repaid in full on the maturity date and there are two ways of calculating APR on single loan payments: I) simple interest method and ii) the discount method. The difference between the simple interest method & the discount method is what the borrower actually receives in the form of a loan.

i) Simple Interest Method

Under the simple interest method, interest is calculated on the full original amount borrowed. The formula for simple interest is:

Simple interest = Principal x Rate x Time = p x r x t

Annual Percentage Rate = Average annual finance charge / Loan amount borrowed

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> Amortized Loan - How to Calculate Loan Amortization using Present Value Interest Factor

An amortized loan is one that is paid off in equal periodic instalments or payments and includes varying portions of principal & interest during its term. Examples of amortizable loans include auto loans, mortgages, business loans & others. How do you compute the periodic payments on an amortized loan?

The formula is:

Amount of loan = A = (P / PVIFA)

How to calculate the amount of loan:

1) Divide the principal loan amount (A) b PVIFA, which is a factor shown in the Present Value Interest

Factor of Annuity of $1 table, and use this formula

Amount of loan = A = (P / PVIFA)

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> Acid Test (Quick) Accounting Ratio - Calculation & Example of Current Assets divided by Current Liabilities

The acid-test or quick ratio is a variation of the current ratio that divides current assets by current liabilities to arrive at an answer. However, it is a stricter test of a company’s liquidity because it factors in to account only the most liquid assets that a company has including Cash, short term investments & accounts receivable. Inventory is not included in the acid-test ratio calculation because of the length of time needed to convert inventory to cash by making sales. However, there may be some types of inventories such as groceries, milk, eggs & meat that are more liquid than accounts receivable, however according to accounting standards; they may not be included in the acid-test ratio. Also, prepaid expenses are not included in the acid-test ratio because they cannot be converted in to cash and are not capable of covering current liabilities...

Example of Acid Test Ratio


2004 2005
Current Assets    
- Cash and Short Term investments $45,000.00 $52,500.00
- Accounts Receivable $42,000.00 $38,000.00
Total quick assets $87,000.00 $90,500.00
Total current liabilities $66,200.00 $64,300.00
Acid Test ratio
i) $87,000 / $66,200 1.314199396 (1.31)  
ii) $90,500 / $64,300   1.407465008 (1.41)

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