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Module 912 - Financial Analysis

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Module 912 - Financial Analysis

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Advocis Core

Curriculum Program
Course 912 | Edition 2020

FINANCIAL ANALYSIS
Module 2: Financial Analysis

Advocis Core Curriculum Program for

CFP® and QAFPTM Certification
Important disclaimer
This publication is designed to provide accurate and authoritative
information about the subjects covered. While every precaution has been
taken in the preparation of this material, the authors and Advocis assume
no liability for damages resulting from the use of the information contained
in this publication. Advocis is not engaged in rendering legal, accounting,
or other professional advice. If legal, accounting, or other professional
advice is required, the services of an appropriate professional should be
sought.

About the Advocis Core Curriculum Program

Advocis is a proud founding member of FP Canada™ (formerly known as
Financial Planning Standards Council), which was established in November
1995 with the core mission of “promoting and enforcing professional
standards in financial planning through the Certified Financial Planner®
certification, and raising Canadians’ awareness of the importance of
financial planning.” Advocis continues to support and uphold this
commitment — to promote competency and ethical standards among
financial advisors and planners.

Working with industry experts, Advocis has developed an FP Canada

approved education program leading to both the QAFP and CFP
Certification. The Advocis Core Curriculum Program for QAFP and CFP
Certification is offered through 12 distinct modules, aligned with FP

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Module 2: Financial Analysis

Canada’s Body of Knowledge. The Advocis Advanced Curriculum Program

for CFP Certification consists of one course with a final integrative
comprehensive exam. By focusing on the most important concepts and
required skills, practitioners are provided with a high degree of education
in the delivery of competent financial planning advice and service.

CFP designation holders are highly regarded for their ability to provide
clients with comprehensive financial planning services. They put clients’
interests first and ensure clients’ financial needs and objectives are being
met through the financial planning process.

About the Certified Financial Planner (CFP) Certification

The CFP Certification is an internationally recognized designation held by
more than 175,000 people in 26 territories around the world. FP Canada, a
member of the Financial Planning Standards Board (FPSB), has licensed
more than 16,500 individuals in Canada.

Qualifying to take FP Canada’s CFP Examination is a demanding process,

yet the professional rewards for successful candidates are significant. On
average, CFP professionals who have achieved this coveted certification
report a substantial increase in gross income and preferred clients in
comparison to non-designation holders.

This Advocis Core Curriculum Program is an accredited qualifying program

of study designed with the CFP Certification requirements in mind. By
successfully completing this program of study, students gain both the
knowledge and confidence needed to succeed in obtaining the designation,
and in building a thriving financial planning practice.

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Module 2: Financial Analysis

Advocis Core Curriculum Program, 2020 Edition

CFP®, Certified Financial Planner® and are trademarks owned by Financial Planning
Standards Board Ltd. (FPSB) and used under license. All other trademarks are those of FP
Canada™.

Copyright © 2020 The Financial Advisors Association of Canada. All rights reserved.
Unauthorized reproduction of any images or content without permission is prohibited.

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Module 2: Financial Analysis

Acknowledgements

First Edition, 2020

Written by:

Michael Callahan, B.Sc., CHS, CIM, CFP

With contributions from:

Ray McHarg, MBA, CFP, FMA, CIM, FCSI

James W. Kraft, CPA, CA, MTAX, TEP, CFP, CLU, FEA

Deborah Kraft, MTAX, LLM, TEP, CFP, CLU, CH.F.C.

Jamie Aldcorn, CPA, CA, CFP, MBA, M.Ed.

John McIlroy, BA (Hons), MA, MBA

Robert Ransom, CLU, ChFC

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Module 2: Financial Analysis

Module Requirements

For more information on the requirements of this module (course outline,

instructions and assessments), please refer to the Syllabus, accessible
from the module homepage of the learning environment.

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Module 2: Financial Analysis

Table of Contents
LEARNING OBJECTIVES .................................................................... 1

TIME VALUE OF MONEY .................................................................... 3

Financial calculator ................................................................................................ 5

Rates of return ....................................................................................................... 6

Interest rates ......................................................................................................... 6

Present value ....................................................................................................... 14

Future value ......................................................................................................... 17

Using a financial calculator .................................................................................. 19

2ND key .............................................................................................................. 21

BGN and END mode .............................................................................................. 21
Set the decimal place ............................................................................................ 22
Change the sign .................................................................................................... 23
Clear TVM ............................................................................................................ 23
Helpful hints ......................................................................................................... 23
TVM prerequisites ................................................................................................. 24

Application of TVM calculations ............................................................................ 25

Present value of a single sum ................................................................................. 25

Future value of a single sum................................................................................... 29
Present value of a periodic payment stream ............................................................. 33
Future value of a periodic payment stream ............................................................... 40
Interest rate conversion ......................................................................................... 47
Determine interest rate.......................................................................................... 49
Determine payment amount ................................................................................... 56
Determine time (compounding periods) ................................................................... 61
Differences in compounding frequency and payment frequency (C/Y not equal to P/Y) ... 65
Annuities ............................................................................................................. 70
Bonds .................................................................................................................. 77

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Retirement calculations ....................................................................................... 83

Accumulations ...................................................................................................... 84
Target interest rate ............................................................................................... 85
Reasonableness of time horizon .............................................................................. 87

Loan payments/repayments ................................................................................ 88

Determine loan interest rate ................................................................................... 89

Determine loan amount ......................................................................................... 90
Determine loan payment ........................................................................................ 91
Determine loan period ........................................................................................... 92

Leasing calculations ............................................................................................. 93

Real rate of return ................................................................................................ 94

After-tax rate of return ........................................................................................ 96

Real after-tax rate of return ................................................................................. 98

Calculation for perpetuity ................................................................................... 100

Cash flow applications........................................................................................ 101

Net present value................................................................................................ 102

Internal rate of return ......................................................................................... 108

Summary of formulas ......................................................................................... 111

PERSONAL FINANCIAL STATEMENTS ............................................ 113

Money management ........................................................................................... 114

Budgeting process ............................................................................................... 114

Income .............................................................................................................. 115
Expenses ........................................................................................................... 115
Net income available for saving ............................................................................ 115
Emergency fund .................................................................................................. 116

Personal net worth statement ............................................................................ 117

Assets ............................................................................................................... 117

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Liabilities ........................................................................................................... 119

Equity................................................................................................................ 119
Monitoring progress by tracking net worth ............................................................. 119

Personal cash flow statement ............................................................................ 126

Cash flow ........................................................................................................... 126

Monitoring progress by tracking net cash flow ........................................................ 127

Bringing it all together: the relationship between net worth and cash flow ....... 133

Personal savings rate ......................................................................................... 133

CORPORATE FINANCIAL STATEMENTS .......................................... 134

Role of corporate financial statements ............................................................... 134

Who uses financial information? ............................................................................ 134

Importance of standardization .............................................................................. 135
Accounting concepts ............................................................................................ 135
Statement selection ............................................................................................ 136
Statement form .................................................................................................. 136
Accounting principles ........................................................................................... 137

Balance sheet (statement of financial position) ................................................. 138

Income statement .............................................................................................. 141

Cash flow statement .......................................................................................... 143

Statement of management discussion and analysis ........................................... 145

Additional considerations ................................................................................... 146

Compiled ........................................................................................................... 146

Reviewed ........................................................................................................... 147
Audited .............................................................................................................. 147

Accompanying reports ....................................................................................... 148

Notice to reader report ........................................................................................ 148

Review engagement report .................................................................................. 148

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Auditor’s report .................................................................................................. 149

Business valuation ............................................................................................. 149

Going concern .................................................................................................... 149

Liquidation ......................................................................................................... 150
Discounted future earnings .................................................................................. 150
Market value ...................................................................................................... 150

RATIO ANALYSIS FOR INVESTMENT PLANNING ........................... 151

Financial ratios ................................................................................................... 151

Liquidity ratios ................................................................................................... 153

Current ratio ...................................................................................................... 153

Quick ratio ......................................................................................................... 155
Working capital ................................................................................................... 156

Leverage (debt) ratios ....................................................................................... 157

Debt-to-equity ratio ............................................................................................ 158

Debt-to-asset ratio .............................................................................................. 160
Interest coverage ................................................................................................ 162

Profitability ratios .............................................................................................. 164

Gross profit margin ............................................................................................. 164

Operating profit margin ....................................................................................... 166
Net profit margin ................................................................................................ 168
Return on common equity .................................................................................... 170
Return on total assets ......................................................................................... 172

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APPENDIX 1: APEX BALANCE SHEET ............................................. 175

APPENDIX 2: APEX INCOME STATEMENT & STATEMENT OF

RETAINED EARNINGS ................................................................... 177

APPENDIX 3: APEX CASH FLOW STATEMENT ................................ 179

APPENDIX 4: COMPASS BALANCE SHEET ...................................... 181

APPENDIX 5: COMPASS INCOME STATEMENT & STATEMENT OF

RETAINED EARNINGS ................................................................... 183

APPENDIX 6: COMPASS CASH FLOW STATEMENT ......................... 184

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List of Figures and Tables

Table 1: The Effect of Compounding Interest More Frequently ....................................... 10
Table 2: Explanation of Financial Calculator Abbreviations ............................................. 20
Table 3: Examples of Bond Pricing .............................................................................. 79
Figure 1: How Bond Prices React to Current Market Interest Rates ................................. 79
Table 4: Example of Cash Flow Analysis .................................................................... 144

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Learning Objectives
This module explores the fundamentals of the time value of money and
financial statements for individuals and businesses, as required by
candidates in their role as financial planners. It provides candidates with
knowledge they need to clearly document, analyze, project and present
financial information as it relates to individual and business goals, needs
and priorities. The module exposes candidates to key topics such as how to
make financial projections to determine whether goals are achievable and
how to evaluate the impact individuals’ and businesses’ current and
projected cash flow may have on their ability to meet financial goals. After
completing the coursework for this module, the learner will be able to:

 Calculate and interpret time value of money computations, including:

 Present value of a single sum

 Present value of a deferred single sum
 Future value of a single sum
 Future value of a deferred single sum
 Present value of an immediate periodic payment stream
 Present value of a deferred periodic payment stream
 Future value of a periodic payment stream
 Future value of a deferred periodic payment stream
 Interest rate
 Internal rate of return for cash flows
 Value of cash flows
 Frequency of cash flows
 Number of compounding periods

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 Frequency of compounding
 Net present value for a cash flow

 Calculate current and projected net cash flow

 Evaluate the impact on net cash flow of:

 Purchase of assets
 Sale of assets
 Change in income
 Change in expenses
 Debt servicing
 Lifestyle expenses
 Savings

 Interpret a change in net cash flow over a period of time

 Calculate and interpret a personal savings rate
 Evaluate the ability to financially sustain an emergency
 Calculate current and projected net worth from personal financial
statements and net worth statements
 Evaluate the impact on net worth over a period of time of:

 Asset values
 Liability values
 Cash flow surpluses/deficits
 Growth in asset values
 Reduction in asset values
 Growth in liability values
 Reduction in liability values

 Interpret a change in net worth over a period of time

 Compare the levels of assurance service provided for a business’s
financial statements

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Time Value of Money

Financial planning, at its most basic level, requires two core skills:

 A thorough understanding of the concept of the time value of money

(TVM) and its application

 The ability to use a financial calculator to factor the time value of money
into various financial planning calculations

Understanding the time value of money allows the planner to identify

issues, interpret results, explore alternatives and counsel a client on
appropriate planning strategies. This is true whether the planner is
exploring wealth accumulation opportunities, developing a retirement plan
or assessing the financial risk of a taxpayer’s death. For this reason, an
entire module is dedicated to the presentation of the time value of money
concept and its application using a financial calculator.

The time value of money is a basic but powerful concept. In simple terms,
it is reasonable to say that with money comes opportunity, and with
opportunity comes cost over time. The best way to understand the time
value of money is with an example.

EXAMPLE
Jasmine lends her friend $100 over the weekend, with an agreement that the friend
will pay her back on Monday. Jasmine has given her friend the “opportunity” to use
her money for a day or two. Jasmine, in turn, has foregone the opportunity to use the
money for the same period. Having lent the money to a friend, and because the
period is so short, it is unlikely that Jasmine would expect any payment or return for
the “opportunity” she has temporarily transferred to her friend.

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The opportunity cost describes the benefits an individual forgo when

choosing one alternative over the other. In the example, the opportunity
cost for Jasmine is the return she could have generated if she had invested
her $100 or used it for some other purpose. Let’s now examine what might
happen next.

EXAMPLE
In the previous example, the small sum and short time period translate into a very
small opportunity cost — one that is most often ignored.

However, imagine if Jasmine’s friend approaches her on Monday about extending the
repayment term. He now offers to pay her back the $100 in exactly one year. Apart
from being slightly annoyed, Jasmine might instantly recognize that her lost
opportunity is now significantly greater. She will lose the ability to use the money to
generate a return for an entire year. Since she realizes that money has value over
time, Jasmine might ask to be compensated for that lost opportunity. She would
probably impress upon her friend that he is no longer simply borrowing money; he is
now, in effect, asking her to give him money outright. Jasmine’s friend resists that
notion and says that he is going to pay her back in full — the whole $100 — and is not
asking her to give him anything.

To explain the time value of money concept as simply as possible, Jasmine reminds
her friend that if he rents a house for a year, he will have to pay rent and return the
house “as found” at the end of the year. She explains that the same principle holds
true for the money he wants to borrow. He must return it in whole and pay for its use.
If he agrees to pay Jasmine for her lost opportunity, she will need to go through an
exercise to determine the value of the lost opportunity, which in effect will determine
the return that she realizes. However, in principle, to ensure she’s compensated for
the lost opportunity, Jasmine should charge her friend interest on the $100 he is
borrowing for a one-year period.

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The time value of money- concept acknowledges that it’s necessary to

place a value on the passage of time. It recognizes that $100 received in
one year is not a large enough amount to satisfy a $100 obligation due
today. The time value of money is deeply integrated into our entire
financial system and used in a variety of ways, as demonstrated
throughout this module.

The module begins with simple interest, works through various other
financial functions, and concludes with discounted cash flows, net present
value (NPV) and internal rates of return (IRR).

Financial calculator
This module, along with many others in the Advocis CFP Core Curriculum
Program, requires learners to have access to a financial calculator. We
recommend the Texas Instruments BA II Plus, since helpful hints and
calculator instructions within the course material refer to specific features
of this calculator.

Can you use another financial calculator? Yes, provided that your financial
calculator is capable of calculating internal rates of return, the net present
value of a stream of future cash flows, and time value of money problems.
If you choose to use another financial calculator, make sure you are
familiar with the keystrokes it requires to perform these calculations.

For FP Canada examinations, your financial calculator must be noiseless

and non-programmable.

It is essential for all financial planners to be comfortable with a financial

calculator and know how to calculate and solve financial problems quickly.

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Module 2: Financial Analysis

Rates of return

Interest rates
Interest rates apply to loans or debt. An individual who borrows money is
required to pay for the use of that money by paying interest at a specified
rate to the person or institution who lent him or her the money. This
section describes four types of interest rates:

 Simple interest

 Compound interest

 Nominal interest

 Effective interest

Simple interest
Simple interest, expressed as a percentage, is the rate of return a lender
earns for lending funds to someone else. If someone deposits money in a
bank account, he or she might expect the bank to provide compensation,
in the form of simple interest, for the use of the funds.

The formula for calculating simple interest is:

Interest = Amount Invested (Principal) x Interest Rate per Year x Time Period

I=PxRxT

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EXAMPLE
Assume that John deposits $1,000 in an account that pays 6% interest annually. At
the end of the year, John still has his $1,000, plus the bank owes him $60 in simple
interest:

Interest = $1,000 x 6% per Year x 1 Year = $60

Now assume that after the 12 months, John withdraws the $60 of interest he earned.
He decides to leave the $1,000 — the principal — in the bank account. The $1,000
earns $60 in simple interest in the second year.

What is the total value of John’s investment at the end of two years?

Accumulated Total
Principal Interest
Interest Amount

Year 1 (6%) $1,000 $60 $60 $1,060

Year 2 (6%) $1,000 $60 $120 $1,120

The simple interest John earns and withdraws is $60 in year one ($1,000 x 6%) and
$60 in year two ($1,000 x 6%). The interest he earns over two years is $120. As a
result, at the end of 24 months, he has a total of $1,000 principal + $120 interest =
$1,120.

In the example above, the bank calculates and pays interest at the end of
the year. However, interest can be calculated and paid over any time
period. For example, many financial institutions offer daily interest bank
accounts, with interest calculated and paid at the end of every day.

Regardless of when the borrower calculates and pays interest, the

distinguishing feature of simple interest is that it does not include the
reinvestment of any interest earned in a previous period in the calculation
of principal and interest amounts in subsequent periods.

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Module 2: Financial Analysis

Compound interest
Compound interest is an important financial concept. It describes a
situation in which interest earned during a preceding period is added to the
principal amount when calculating interest earned in a subsequent period.

Principal amounts that earn compound interest over a long period can
increase dramatically, especially when interest rates are high.

EXAMPLE
Assume that Samantha makes an initial deposit of $1,000 in a bank that offers a
compound interest account paying 6% interest annually.

At the end of the first year, the bank credits Samantha’s account with $60 ($1,000 x
6%). Compound interest increases the principal amount on which Samantha earns
interest in the second year by the amount of interest she earned in the first year. In
other words, in the second year, she earns 6% interest on the $1,060 compounded
amount ($1,000 of original principal + $60 of interest earned in the first year). With
compound interest, assuming that she withdraws nothing, Samantha has $1,123.60 at
the end of two years, instead of the $1,120 she would have had using a simple
interest calculation.

Accumulated Total
Principal Interest
Interest Amount
Year 1 (6%) $1,000.00 $60.00 $60.00 $1,060.00
Year 2 (6%) $1,060.00 $63.60 $123.60 $1,123.60

Allowing interest to compound (i.e., allowing interest added to the principal to earn
“interest on interest” in subsequent years) gives Samantha an additional $3.60 over
the two-year period.

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The additional amount of $3.60 may seem small and insignificant but the
effect of compound interest is much more powerful and dramatic at higher
interest rates over longer periods.

EXAMPLE
Consider two scenarios. In the first, Tom deposits a principal amount of $1,000 in an
investment that pays 10% in simple interest. He invests for 25 years, withdrawing the
interest annually. In the second, Tom deposits the same principal amount of $1,000
for the same period of 25 years, but this time the investment pays 10% in interest that
is compounded annually.

In the first scenario, with simple interest, Tom enjoys $2,500 in total interest payments
(25 years x $100/year = $2,500). In the end, his investment returns $3,500 after 25
years — an amount that includes his original $1,000 plus $2,500 in interest.

In the second scenario, with compound interest, Tom’s investment returns $10,835.70
after 25 years — an amount calculated as $1,000 x (1 + 0.10)25. We will look more
closely at the components of this calculation later in this module. At this point, it is
sufficient to understand the concept of compound interest and how powerful it is as a
wealth-creation vehicle.

With simple interest, the value of Tom’s investment is $3,500; with compound interest,
the value of Tom’s investment is $10,835.

It is worth considering one additional feature of compound interest. In the

example about Samantha, interest compounded at the end of 12 months,
or on an annual basis. What is the effect of compounding the interest twice
a year, instead of only once? Table 1 provides the answer.

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Table 1: The Effect of Compounding Interest More Frequently

Accumulated
Principal Interest Total Amount
Interest

Year 1 (3%
every six
months
instead of
6% every
year)

First six
$1,000.00 $30.00 $30.00 $1,030.00
months
Second six
$1,030.00 $30.90 $60.90 $1,060.90
months

Year 2 (3%
every six
months
instead of
6% every
year)

First six
$1,060.90 $31.82 $92.72 $1,092.72
months
Second six
$1,092.72 $32.78 $125.50 $1,125.51
months

Changing the frequency of compounding, while leaving interest rates the

same, increases the amount Samantha has from $1,123.60 to $1,125.51.

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EXAMPLE
How does changing the frequency of compounding affect returns over a longer time
period? Consider $1,000 invested at a 10% interest rate, compounded annually,
quarterly, monthly and daily, over a 10-year period.

Initial Investment Amount After 10 Years

10% compounded annually $1,000.00 $2,593.74

10% compounded quarterly $1,000.00 $2,685.06
10% compounded monthly $1,000.00 $2,707.04
10% compounded daily $1,000.00 $2,717.91

It’s clear that, even with identical interest rates, changing the frequency of
compounding has a significant impact on the overall return or future value
of an investment.

Nominal interest rate versus effective interest rate

Because of the impact the frequency of compounding has on total returns,
it can be difficult to communicate to investors the interest amount earned
in a given situation. Consider the earlier example that compared the
results of different compounding frequencies while the actual interest
percentage remained constant. Clearly, telling investors that an
investment will generate a 10% return is not sufficient when different
compounding frequencies generate different total returns.

One solution is to include the compounding frequency in the quoted rate.

For example, sophisticated investors know that a 10% rate compounded
annually generates less overall than a 10% rate compounded quarterly.
Unfortunately, this still does not tell investors the difference in interest
earned at the two compounding frequencies.

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A comparison of nominal interest rates and effective interest rates can help
communicate differences resulting from changing the frequency of
compounding.

The nominal interest rate indicates the basic rate charged or earned for
any compounding period.

EXAMPLE
If Bob has an investment that earns a 10% nominal interest rate compounded
quarterly, that means his investment earns 2.5% for three months (10% ÷ 4). For the
second three-month period, the new principal is the original principal from the first
quarter plus the interest earned during the first quarter. In the second three-month
period, Bob’s investment earns 2.5% on the new principal amount. For the third three-
month period, the new principal is the principal from the second three-month period
plus the interest earned during the second quarter. Finally, the interest rate for the last
three-month period remains 2.5%, but it applies to a new principal amount comprising
the principal from the third three-month period plus the interest earned during the third
quarter.

The table shows Bob’s initial investment of $1,000 with a 10% nominal interest rate,
compounded quarterly.

Year 1 (2.5% every three months

Principal Interest Total
instead of 10% every year)
First three months $1,000.00 $25.00 $1,025.00
Second three months $1,025.00 $25.63 $1,050.63
Third three months $1,050.63 $26.27 $1,076.90
Fourth three months $1,076.90 $26.92 $1,103.82

In this example, $1,000 invested at an annual 10% nominal interest rate

compounded quarterly results in a total return of $1,103.82, compared to
$1,100 if interest were paid only once every year. Increasing the

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compounding frequency increases the total return. Thus, at the end of one
year, Bob earns a rate of return greater than 10%.

How much greater? Bob earned $103.82 on his original $1,000

investment, equivalent to a rate of return of 10.38%: ($103.82 ÷ $1,000)
x 100. The effective rate of return is 10.38%.

The formula for calculating the effective rate of return, or effective yield,
is:

Effective Yield =

((Total Future Value – Original Investment) ÷ Original Investment) x 100

Using this formula, Bob’s effective yield is calculated as (($1,103.82 –

$1,000) ÷ $1,000) x 100, which equals 10.38%.

Nominal rates with compounding frequencies accurately communicate

detailed information on the expected yield of an investment. It would be
impossible, for example, to present an accurate and detailed table tracking
the dollar growth of an investment without knowing the nominal rate and
compounding frequency. However, it is common practice, and practical, to
convert a nominal yield into an effective yield when comparing investment
alternatives. Effective yields allow investors to examine different
investments using a common point of reference: the total annual return.

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Present value
Present value defines the value of a sum of money received in the future in
today’s dollars.

EXAMPLE
Imagine that Nancy comes across ABC Financial Institution, which offers her an
investment that pays $1,000 in three years. The cost today is $900. She isn’t sure if
this is a good investment.

The financial institution is stable and well-recognized. The amount of risk appears to
be no more than what she would incur if she deposited the money with any other
typical Canadian deposit-taking financial institution, such as a bank.

Before looking at mathematical formulas, Nancy tries to reason out the answer. She
recognizes that she could invest her $900 in another financial security paying market
interest rates. If she does, she wants to know if she would have more or less than
$1,000 in three years.

Nancy checks prevailing interest rates and discovers that 5%, compounded annually,
is the market rate for a three-year fixed-term investment. So, she asks, what principal
amount invested today at 5% annually will have a value of $1,000 in three years?

Without using any financial formulas, and with patience to endure a long trial-and-
error guesstimating process, Nancy could eventually discover the precise amount she
would need to invest today at 5% interest with annual compounding to return $1,000
in three years. She could then determine if that amount is more or less than $900.

Fortunately, Nancy can skip the trial-and-error process and use a mathematical
formula or her calculator to get the right answer immediately. The steps to compute
this with a calculator appear later in this module.

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Module 2: Financial Analysis

The mathematical formula for present value is:

Present Value = Future Value ÷ (1 + Nominal Interest Rate)Number of Periods Expressed in Years

PV = FV ÷ (1 + i)n

EXAMPLE
In Nancy’s case, the factors can be entered into the formula as:

Present Value = $1,000 ÷ (1 + 0.05)3 = $863.84

The present value is $863.84. What does this mean? It means that if Nancy invests
$863.84 for three years at 5% interest, compounded annually, she will have $1,000
after three years ($863.84 x 1.05 x 1.05 x 1.05 = $1,000). Using a 5% interest rate (or
discount rate), $1,000 received in three years has a current or present value of
$863.84.

If Nancy can invest $863.84 in a security that pays $1,000 in three years, why would
she pay ABC Financial Institution $900 for a security that will generate the same
$1,000 after three years?

If Nancy pays the $900 asking price for this investment, she will generate a return
below the market interest rate of 5%. In effect, ABC is asking for $900 in current value
for something that is only worth (i.e., has a present value of) $863.84 in current value.

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The same formula works equally well for assessing the present value of a
series of future payments, instead of just one.

EXAMPLE
Assume that Harvey has been promised a payment of $500 at the end of each year,
for the next four years, as part of an investment program he is considering. The cash
flow over the period is $2,000 (4 x $500/year = $2,000). However, the time value of
money concept means the lost opportunity cost associated with waiting to receive
each payment makes each $500 worth less than $500 in current value. Obviously, the
further into the future that Harvey goes, the bigger the lost opportunity cost and the
bigger the drop in present value to compensate for the loss.

Now assume that the market interest rate is 8% for similar investments with similar
risk profiles. With this information, Harvey can calculate the present value of this cash
flow stream.

Present Value = ($500 ÷ (1 + 0.08)1) + ($500 ÷ (1 + 0.08)2) + ($500 ÷ (1 + 0.08)3) +

(500 ÷ (1 + 0.08)4)
Present Value = $463 + $429 + $397 + $368 = $1,657

For Harvey, receiving $1,657 now would have the same economic benefit as
receiving $500 at the end of four consecutive years, based on the assumptions.

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Future value
The concept of future value is closely tied to the concept of present value
and uses some of the same elements. This module touched on aspects of
the future value calculation while discussing compound interest. The term
future value refers to the terminal or final value of an investment if the
investment compounds at a given rate of return for a given period. The
future value calculation can determine how much $1,000 invested at 7%,
compounded annually, will be worth at the end of three years.

Here is the basic formula:

Future Value = Present Value x (1 + Nominal Interest Rate)Number of Periods Expressed in Years

FV = PV x (1 + i)n

Use n/12 if the number of periods is expressed in months.

EXAMPLE
Ted wants to determine how much $1,000, invested at 7% compounded annually, will
be worth at the end of three years. Using the future value formula, he determines that
the future value is $1,225.04: $1,000 x (1 + 0.07)3.

This formula, too, works to calculate the future value of a series of

investments made over a period of time.
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EXAMPLE
Betty wants to calculate the future value, or terminal value, of investing $500 at the
beginning of each year for four consecutive years, with an annual return of 11%,
compounded annually.

Future Value = $500 x (1 + 0.11)1 + $500 x (1 + 0.11)2 + $500 x (1 + 0.11)3 + $500 x (1

+ 0.11)4
Future Value = $555 + $616.05 + $683.82 + $759.04
Future Value = $2,613.91

Using the formula, Betty calculates the future value of her investment to be $2,613.91.

The formulas up to this point help to demonstrate the concepts of present

and future value. It is not necessary to memorize the formulas, because
the sections that follow explain how to use a financial calculator to work
out time value of money solutions. Candidates are permitted to use a
noiseless, non-programmable financial calculator when writing tests or
exams for all courses in this CFP education program, and when writing CFP
exams offered through the Financial Planning Standards Council (FPSC).

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Using a financial calculator

For financial planners, it is critical to become adept at understanding and
calculating values that incorporate time value of money (TVM) elements.
This section introduces the basic elements of TVM calculations and the
corresponding keystrokes for the Texas Instruments BA II Plus calculator.
It includes a list of calculator buttons and spells out abbreviations, as well
as defining each abbreviation.

The Texas Instruments BA II Plus locates the main function keys used in
TVM calculations in the third row of buttons. Most calculators, including the
Texas Instruments BA II Plus, include a second function for most keys. The
third row of five buttons on the Texas Instruments BA II Plus has five first
functions (white text) devoted to TVM calculations (left to right: N, I/Y,
PV, PMT and FV). These same keys also have second functions (yellow
text) devoted to TVM-related calculations (left to right: xP/Y, P/Y,
AMORT, BGN and CLR TVM).

Table 2 explains what each button’s abbreviation means.

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Table 2: Explanation of Financial Calculator Abbreviations

First function (white text)

N Number of payments or compounding periods

I/Y Annual nominal interest rate

PV Present value

PMT Amount of the periodic payment

FV Future value

Second function (yellow text)

Optional shortcut for storing N; multiplies the number entered in

xP/Y
the display by the value in P/Y

Number of payments per year. Press the up or down arrow keys

to toggle between P/Y (number of payments per year) and C/Y
(number of compounding periods per year). Note that you must
P/Y press [ENTER] to enter the numeric value into either P/Y or
C/Y. Also, entering a value for P/Y automatically updates C/Y
with the same value, but updating C/Y does NOT automatically
update P/Y.

AMORT Access the amortization function

Toggle between BGN and END for timing of periodic payments or

BGN
withdrawals

CLR Clear the TVM variables (N, I/Y, PV, PMT, FV); does not clear
TVM P/Y and C/Y

It’s also important to understand other relevant keys and functions when
using the Texas Instruments BA II Plus calculator for TVM calculations.
Other calculators have similar functions, although they may operate using
a different series of keystrokes.

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2ND key
The yellow 2ND key is on the far left of the second row from the top. Use
it to access the second function of buttons with second functions in yellow
text. In this module, [2ND] indicates that the 2ND key must be pressed.

To access the second functions in the chart above, press [2ND], followed
by the desired function. For example, to access the xP/Y function, press
[2ND], followed by [N] (which has the second function xP/Y in yellow
text above it).

To minimize confusion, when this module references a second function, it

names the second function rather than referring to the white text on the
button itself. For example, to access the AMORT function, press [2ND]
[AMORT]. There is no AMORT button, but AMORT is the second function
of the PV button.

BGN and END mode

Before starting a TVM calculation involving periodic payments or
withdrawals, it is important to identify whether the first periodic payment
occurs at the beginning or end of the first period. The result of your
calculation will differ slightly depending on whether you select beginning of
the period or end of the period. If the first payment occurs at the end of
the first period, the calculator must be in END mode.

END mode is the calculator’s default mode. When the calculator is in END
mode, the display does not specifically indicate this. However, when the
calculator is in BEGIN mode, the letters BGN are visible in the top right
hand corner of the display.

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If the first payment occurs at the beginning of the first period, the
calculator must be set to BEGIN mode. This is done by pressing [2ND]
[BGN] to access the second function BGN, and then pressing
[2ND][SET] to SET the calculator to BEGIN mode. The calculator should
now show BGN in the top right-hand corner of the display.

To put the calculator back to END mode, use the same keystrokes: [2ND]
BGN, [2ND] SET.

The BEGIN or END mode only affects the result if there is a series of
periodic payments associated with the TVM calculation. When the
calculator is in BEGIN mode, the letters BGN appear on the display screen.
When the calculator is in END mode, no words appear on the display
screen.

Set the decimal place

You can select the number of decimal places the calculator displays for a
calculation. To change the decimal setting, press [2ND] [FORMAT] to
access the FORMAT function. The calculator displays DEC=, along with a
value indicating the current decimal setting. Input the number of decimal
places you would like the calculator to display (0 to 9) and press [ENTER].
For example, use the following keystrokes to set nine decimal places:

 [2ND]

 [FORMAT]

 9

 [ENTER]

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Change the sign

You can change the sign of any number the calculator displays. If you
enter 100 and would like to change it to -100, use the change sign key —
[+/-] — on the right side of the bottom row. The display now shows -100.
For example, use the following keystrokes to enter -100:

 100

 [+/-]

Clear TVM
The calculator retains entries in memory so, before beginning any new
TVM calculation, it is important to clear all of the TVM registers. Use the
following keystrokes:

 [2ND]

 CLR TVM

Helpful hints
Consider these hints as you get started using the calculator:

 When you enter an annual interest rate (e.g., 7%), enter it as a whole
number (7), not a percentage (7%) and not as a decimal (0.07).
 IMPORTANT! TVM calculations are naturally concerned with the inflow
and outflow of money. The rule of thumb for using the [+/-] button is
to enter amounts paid or invested as a negative number and amounts
accumulated or received as a positive number. Cash inflows are
positive, and cash outflows are negative.

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 When you see Error 5 on the display screen, it is usually because of an

error entering positive or negative values for cash inflows or outflows.
Re-check the positive and negative values assigned to the variables.
 When calculating interest rates or compounding periods, do not round
the decimal places. Input each factor and let the calculator do the
calculations. The calculator calculates decimals to up to 15 decimal
places, which is more accurate than using manually rounded decimal
places in calculations. For example, use 4 ÷ 12, not 0.333.
 As already described, use BGN mode if amounts occur at the beginning
of the period and END mode if amounts occur at the end of the period.

TVM prerequisites
The Texas Instruments BA II Plus calculates TVM based on several
assumptions or prerequisites:

 Payments occur at regular intervals

 The amount of each payment is the same

 The payment period must coincide with the interest compounding

period

 There must be at least one positive and one negative cash flow in each
calculation (either in the numbers entered or in the resulting outcome)

If there are irregular payments of differing amounts, you must use the
cash flow [CF] function, instead of the basic TVM calculation. We describe
the cash flow calculation later in this module.

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Application of TVM calculations

The basic premise of a TVM calculation is that if any four of the following
five values are known, the calculator can solve for the fifth value:

N: Number of payments or compounding periods

I/Y: Annual nominal interest rate

PV: Present value

PMT: Amount of the periodic payment

FV: Future value

To solve for any of these variables after entering the known information,
press [CPT], followed by the variable you want to compute. For example,
to solve for future value, after entering information for the four other
variables, press [CPT] [FV].

The following sections move through a variety of examples demonstrating

the calculation of all five variables, starting with present value.

Present value of a single sum

The present value (PV) of a single sum describes how much a lump-sum
amount of money received in the future is worth in current dollars. It’s a
way to work out how much less than the future face value someone would
pay now, taking into account a given interest rate. In this case, the
problem solves for PV, which means you must first identify values for N,
I/Y, PMT and FV.

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EXAMPLE 1
As part of the negotiations for the sale of a cottage property, a potential buyer offers
Raymond, the vendor of the property, $10,000 payable four years after the deal
closes.

Raymond must calculate the present value of the future payment in order to make an
informed decision. Assume an annual nominal interest rate of 10%, compounded
annually.

Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N=4

I/Y = 10

PMT = 0

FV = 10,000

Keystrokes:

[2ND] [CLR TVM]

[2ND] [P/Y] 1 [ENTER]

[CE/C]

4 [N]

10 [I/Y]

0 [PMT]

10,000 [FV]

[CPT] [PV]

Display shows -6,830.134554

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This present value calculation shows that, given a prevailing interest rate of 10%,
$10,000 received at the end of four years is equivalent to $6,830.13 received today.
Stated another way, $6,830.13 invested today at 10% would grow to $10,000 in four
years.

EXAMPLE 2
Harriett has just leased a new car that her brother-in-law has agreed to purchase from
her for $12,000 at the end of the five-year lease period. Using an annual interest
assumption of 7%, compounded annually, calculate the present value of the $12,000
that Harriett will receive in five years.

Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N=5

I/Y = 7

PMT = 0

FV = 12,000

Harriett explains to her brother-in-law that, using a 7% annual interest rate, she can
consider the $12,000 received after five years to be equivalent to $8,555.83 today.

EXAMPLE 3
As part of the payment for the purchase of her business, Donna is offered a
promissory note for $135,000, which is due at the end of two years. Assuming an
annual return of 6%, compounded annually, what is the present value of this
promissory note? (Disregard taxes.)

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Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N=2

I/Y = 6

PMT = 0

FV = 135,000

The present value of Donna’s promissory note is $120,149.52.

EXAMPLE 4
Tiffany has received an offer from a corporation that wants to buy her company for
$3,500,000, payable in full after 18 months. Tiffany wonders what the $3,500,000
offer represents in today’s dollars. Assuming an annual return of 9%, compounded
annually, calculate the present value of the offer. (Disregard taxes.)

Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N = 1.5 (18 months = 1.5 years)

I/Y = 9

PMT = 0

FV = 3,500,000

The present value of the offer Tiffany has received is $3,075,588.99.

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Future value of a single sum

The future value (FV) calculation mirrors the present value calculation,
except this time the missing variable is the future value (or terminal value)
of an investment made today. The calculation process uses the same keys
used for present value calculations, but solves for FV instead of PV.

EXAMPLE 1
Ashley received a $1,000 investment certificate from her great aunt on her 12th
birthday. The certificate pays a 3% annual interest rate, compounded once each year,
and matures on her 27th birthday. What is the maturity value of Ashley’s investment
certificate? (Disregard taxes.)

Given the following information, solve for FV:

P/Y = 1

C/Y = 1

N = 15 (27 –12 = 15)

I/Y = 3

PMT = 0

PV = -1,000

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Keystrokes:

[2ND] [CLR TVM]

[2ND] [P/Y] 1 [ENTER]

[CE/C]

15 [N]

3 [I/Y]

0 [PMT]

1,000 [+/-] [PV]

[CPT] [FV]

Display shows 1,557.9674

Ashley’s investment certificate will be worth $1,557.97 at maturity, when she turns 27.

EXAMPLE 2
Sheila’s parents deposited $500,000 into an account on her 22 nd birthday, but she is
unable to access the funds until her 30th birthday. The account in which the money
sits pays an annual interest rate of 8%, compounded once each year. How much will
Sheila’s investment be worth when she reaches her 30th birthday? (Disregard taxes.)

Given the following information, solve for FV:

P/Y = 1

C/Y = 1

N = 8 (30 – 22 = 8)

I/Y = 8

PMT = 0

PV = -500,000

Sheila’s investment will be worth $925,465.11 on her 30th birthday.

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EXAMPLE 3
Liam, age 55, has been offered a retirement package that includes a $50,000
settlement, payable today. If Liam accepts the offer, he would like to invest this lump-
sum amount for the next five years and then use the money towards the purchase of
an annuity. If Liam receives an annual interest rate of 8%, compounded annually, for
each of the next five years, how much will he have accumulated? (Disregard taxes.)

Given the following information, solve for FV:

P/Y = 1

C/Y = 1

N=5

I/Y = 8

PMT = 0

PV = -50,000

Liam will have $73,466.40 to use towards the purchase of an annuity.

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EXAMPLE 4
Anthony has been asked to calculate the future value of three scenarios. Each has
the same present value, but has a different interest rate and investment period. Which
scenario has the greatest future value? (Disregard taxes.)

Option A

$100,000, invested for 3.5 years at an annual interest rate of 23.3%, compounded
quarterly.

Given the following information, solve for FV:

P/Y = 4

C/Y = 4 (4 compounding periods per year)

N = 14 (3.5 x 4)

I/Y = 23.3

PMT = 0

PV = -100,000

Option B

$100,000, invested for seven years at an annual interest rate of 12%, compounded
annually.

Given the following information, solve for FV:

P/Y = 1

C/Y = 1 (1 compounding period per year)

N=7

I/Y = 12

PMT = 0

PV = -100,000

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Option C

$100,000, invested for 18 years at an annual interest rate of 4.4%, compounded

monthly.

Given the following information, solve for FV:

P/Y = 12

C/Y = 12 (12 compounding periods per year)

N = 216 (18 x 12)

I/Y = 4.4

PMT = 0

PV = -100,000

The results are $220,920.43 for Option A, $221,068.14 for Option B and $220,461.20
for Option C. While close, Option B results in the highest future value.

Present value of a periodic payment stream

A periodic payment stream is money received in a series of payments over
time. In an earlier example, the calculation focused on the present value of
$10,000 received at the end of four years with a 10% annual interest rate.
That resulted in a present value of $6,830. What if the circumstances are
adjusted and the $10,000 lump-sum amount is instead a periodic payment
stream?

EXAMPLE 1
What is the present value of a periodic payment stream that provides Raymond with
$2,500 at the end of each year for the next four years? Assume that the interest rate
is 10%, compounded annually. (Disregard taxes.)

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Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N=4

I/Y = 10

PMT = 2,500

FV = 0

Mode = END (the payments are made at the end of each year)

Keystrokes:

First, verify that BGN is not visible on the calculator display; if it is, press [2ND] BGN,
[2ND] SET to switch to END mode. Then press:

[2ND] [CLR TVM]

[2ND] [P/Y] 1 [ENTER]

[CE/C]

4 [N]

10 [I/Y]

2,500 [PMT]

0 [FV]

[CPT] [PV]

Display shows -7,924.6636

Now, recalculate PV to see how it changes if Raymond receives a payment of $2,500

at the beginning of each period, rather than at the end of each period. (Disregard
taxes.)

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Keystrokes:

Without clearing the calculator, simply change from END to BGN mode. Press [2ND]
BGN, [2ND] SET. BGN should now be visible on the calculator display. Now press:

[CPT] [PV]

Display shows -8,717.129977

There is a significant effect on present value — an increase of almost $800 — when

payments are made at the beginning of each period rather than the end of each
period. Part of the reason the difference is so substantial is that payments are made
only once a year.

To look at how monthly payments change the value, assume a monthly payment of
$208.33 ($2,500 ÷ 12), at the beginning of each month. Remember, the number of
payments per year must be adjusted to reflect a monthly stream. Assume that interest
is compounded monthly to align with the payments.

Given the following information, solve for PV:

P/Y = 12

C/Y = 12

N = 48

I/Y = 10

PMT = 208.33

FV = 0

Mode = BGN

The present value decreases to $8,282.52, compared with the present value of
$8,717.13 when payments are annual. This example provides a good illustration of
the interplay between beginning of period payments and end of period payments, and
yearly versus monthly payments, when it comes to calculating present value.

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Another use of the present value calculation is to determine what the

original investment must be to fund yearly payments of a given amount for
a given period.

EXAMPLE 2
Alfred would like to set up an account to pay his grandson $5,000 at the end of each
year for the next 25 years. Using an interest assumption of 5%, compounded
annually, how much should Alfred invest today? (Disregard taxes.)

Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N = 25

I/Y = 5

PMT = 5,000

FV = 0

Mode = END

Alfred must invest $70,469.72 to meet his objective.

EXAMPLE 3
Billy has a $13,000 student loan. He has approached his parents, asking them to pay
off the loan now and offering to pay them back at a rate of $1,200 at the end of each
year for the next 15 years. Billy’s parents feel he must accept some financial
responsibility, so they would like to charge him an annual interest rate of 5%,
compounded once each year. Using these assumptions, determine if the present
value of Billy’s payback proposal results in the full repayment of $13,000 to his
parents. (Disregard taxes.)

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Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N = 15

I/Y = 5

PMT = -1,200

FV = 0

Mode = END

Accounting for the 5% interest rate charged by Billy’s parents, the stream of payments
that Billy proposed has a present value of $12,455.59, compared with the $13,000
that Billy’s parents must pay now. This means Billy’s proposed payment stream falls
short of providing the return that his parents have requested.

EXAMPLE 4
As part of her retirement package, Nelly expects to receive $6,000 at the beginning of
each quarter, for the next 15 years. Assuming an annual 7% return, compounded
quarterly, what is the present value of this stream of payments? (Disregard taxes.)

Given the following information, solve for PV:

P/Y = 4

C/Y = 4

N = 60 (4 x 15)

I/Y = 7

PMT = 6,000

FV = 0

Mode = BGN (payments are made at the beginning of each quarter)

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Based on the assumptions, Nelly’s retirement package is equivalent to receiving

$225,665.13 today.

EXAMPLE 5
Gail has received an annuity that pays her $10,000 at the beginning of each year for
12 years. Gail would like to sell it now in the open market for its fair market value
(FMV). Assuming an annual interest rate of 6.5%, compounded annually, calculate
the present value to determine what the payment stream represented by the annuity
is worth today. (Disregard taxes.)

Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N = 12

I/Y = 6.5

PMT = 10,000

FV = 0

Mode = BGN

The present value of this future revenue stream is $86,890.42.

EXAMPLE 6
Robert would like to purchase a 20-year annuity that pays him $4,000 at the
beginning of each year. Payments would begin immediately. Assuming an annual
interest rate of 7.2%, compounded annually, how much would the annuity cost
Robert? (Disregard taxes.)

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Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N = 20

I/Y = 7.2

PMT = 4,000

FV = 0

Mode = BGN

The annuity would cost Robert $44,729.47.

EXAMPLE 7
Shiam has an investment that pays her $200 at the beginning of each month. There
are exactly four years of payments remaining, after which there is no value. Assuming
an annual interest rate of 6.6%, compounded monthly, what is the present value of
Shiam’s payment stream? (Disregard taxes.)

Given the following information, solve for PV:

P/Y = 12

C/Y = 12

N = 48

I/Y = 6.6

PMT = 200

FV = 0

Mode = BGN

Shiam’s payment stream has a present value of $8,463.41.

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Future value of a periodic payment stream

Now, let’s look at the calculation of the future value of a series of
payments made over time. When considering the future value of a periodic
payment stream, the payments can be made at the end of the period
(END mode) or at the beginning of the period (BGN mode).

EXAMPLE 1
Wilson plans to save $6,000 at the end of every year for the nine years remaining
before he retires. He believes he can achieve an annual return of 4.4%, compounded
annually. How much will Wilson have when he reaches retirement? (Disregard taxes.)

Given the following information, solve for FV:

P/Y = 1

C/Y = 1

N=9

I/Y = 4.4

PMT = -6,000

PV = 0

Mode = END

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Keystrokes:

[2ND] [CLR TVM]

[2ND] [P/Y] 1 [ENTER]

[CE/C]

9 [N]

4.4 [I/Y]

6,000 [+/-] [PMT]

0 PV]

[CPT] [FV]

Display shows 64,547.06137

Given the following information, solve for FV:

P/Y = 12

C/Y = 12

N = 69 (5.75 x 12)

I/Y = 9

PMT = -112.91

PV = -16,212

Mode = BGN

Mahood will accumulate $37,380.38 after 5.75 years.

EXAMPLE 6
Ian, a high school teacher, wants to demonstrate to his class the power of compound
interest. He explains that an individual who deposits $100 at the beginning of each
month for the next 55 years into an investment paying 7.6% annual interest,
compounded monthly, will accumulate a very large amount. How much exactly will
this investment accumulate? (Disregard taxes.)

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Given the following information, solve for FV:

P/Y = 12

C/Y = 12

N = 660 (55 x 12)

I/Y = 7.6

PMT = -100

PV = 0

Mode = BGN

Based on these assumptions, after 55 years, the individual will have $1,009,139.15.

EXAMPLE 7
If Heba deposits $1,000 at the beginning of every year for seven years into an
account with an initial balance of $1,000, what is the value of her account at the end
of seven years? Assume that she earns a return of 2.5%, compounded annually.
(Disregard taxes.)

Given the following information, solve for FV:

P/Y = 1

C/Y = 1

N=7

I/Y = 2.5

PMT = -1,000

PV = -1,000

Mode = BGN

At the end of seven years, Heba will have $8,924.80 in the account.

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Interest rate conversion

The rates of return section included a detailed discussion of nominal versus
effective rates of return. The calculator can convert interest rates from
nominal to effective rates and back again by pressing the [2ND] and
[ICONV] keys. Within the ICONV function, use the up and down arrows
on the top row of the calculator to toggle between the three variables:
NOM, EFF and C/Y. As usual, enter the data for known variables, and
then press [CPT] to compute the unknown. Note that you must press
[ENTER] to enter the data for the variables and [CPT] to solve for the
unknown.

Just as it is important to clear the TVM variables before starting any TVM
calculations, it is important to clear the ICONV function before starting
any interest rate conversion calculations. To do this, press [2ND] [CLR
WORK]. CLR WORK is the second function of the [CE/C] button in the
bottom left corner of the keypad.

Knowing the nominal interest rate allows for conversion to the

corresponding effective interest rate, and vice versa.

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EXAMPLE 1
A bank account pays a 3% annual nominal interest rate, compounded monthly. What
is the annual effective interest rate?

Keystrokes:

[2ND] [ICONV] (display shows NOM = )

[2ND] [CLR WORK] (display shows NOM = 0)

3 [ENTER] (display shows NOM = 3)

Up arrow (display shows C/Y = )

12 [ENTER] (display shows C/Y = 12)

Up arrow (display shows EFF = )

[CPT]

Display shows EFF = 3.041595691

EXAMPLE 2
An investment certificate pays 6.7% annual nominal interest rate, compounded daily.
What is the annual effective interest rate?

Keystrokes:

[2ND] [ICONV] (display shows NOM = )

6.7 [ENTER] (display shows NOM = 6.7)

Up arrow (display shows C/Y = )

365 [ENTER] (display shows C/Y = 365)

Up arrow (display shows EFF = )

[CPT]

Display shows EFF = 6.928890356

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EXAMPLE 3
Dorothy’s bank manager explains that the annual effective interest rate on her bank
account is 3.9%. If the compounding period is quarterly, what is the annual nominal
interest rate?

Keystrokes:

[2ND] ICONV] (display shows NOM = )

Up arrow (display shows C/Y = )

4 [ENTER] (display shows C/Y = 4)

Up arrow (display shows EFF = )

3.9 [ENTER] (display shows EFF = 3.9)

Up arrow (display shows NOM = )

[CPT]

Display shows NOM = 3.844226298

Determine interest rate

Sometimes, in a TVM calculation, you may know the payment stream and
future value but need to determine what interest rate will produce that
future value. This type of TVM calculation follows the same pattern as
previous calculations, except that the process solves for I/Y, rather than
PV or FV.

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EXAMPLE 1
Mark invests $1,000 in an account and, at the end of six years, he has accumulated a
total of $1,500. Assuming interest is compounded annually, what annual nominal
interest rate did he receive to produce an account balance of $1,500? (Disregard
taxes.)

Given the following information, solve for I/Y:

P/Y = 1

C/Y = 1

N=6

PMT = 0

PV = -1,000

FV = 1,500

Keystrokes:

[2ND] [CLR TVM]

[2ND] [P/Y] 1 [ENTER]

[CE/C]

6 [N]

0 [PMT]

1000 [+/-] [PV]

1500 [FV]

[CPT I/Y

Display shows I/Y = 6.991319393

Mark’s $1,000 investment earned an annual nominal interest rate of 6.99%,

compounded annually, over the six-year holding period.

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This simple example looked at lump-sum amounts six years apart. With
TVM calculations, the process can also solve for I/YR when there is a
periodic payment stream.

EXAMPLE 2
Stefanie invests $150 in mutual funds at the end of each month for five years. At the
end of the five years, her investment has accumulated to $12,400. Assuming monthly
compounding, what annual nominal return did the investment earn? (Disregard taxes.)

Given the following information, solve for I/Y:

P/Y = 12

C/Y = 12

N = 60 (5 x 12)

PMT = -150

PV = 0

FV = 12,400

Mode = END

Stefanie earned an annual nominal return of 12.45% during the five years.

EXAMPLE 3
Steve started with an initial balance of $12,500 in an investment and added $200 at
the end of each month for 3.5 years. If his balance is $22,875 at the end of the period,
what annual nominal rate of return did Steve earn? Assume monthly compounding.
(Disregard taxes.)

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Given the following information, solve for I/Y:

P/Y = 12

C/Y = 12

N = 42 (3.5 x 12)

PMT = -200

PV = -12,500

P/Y = 12

C/Y = 12

N = 72 (6 x 12)

PMT = -519

PV = 32,000

FV = -8,000

Mode = END

Max is paying an annual nominal interest rate of 10.41%.

That interest rate seemed high to Max, so he asked the lender to sharpen his pencil
and do a little better. The lender offered to lower the monthly payment from $519 to
$489 if that will help close the deal. Before accepting, Max wants to recalculate the
annual nominal interest rate. Without clearing the calculator from the previous
example, it is easy to adjust the calculation to reflect the new information.

Given the following information, solve for I/Y:

PMT = -489

Max learns that payments of $489 per month reflect an annual nominal interest rate of
8.8%, compounded monthly, which is more in line with his expectations.

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EXAMPLE 7
Barbara is seeking a $15,000 loan on which she plans to make $400 payments at the
end of each month for five years, after which the loan will be fully repaid. What annual
nominal interest rate is she paying?

Given the following information, solve for I/Y:

P/Y = 12

C/Y = 12

N = 60 (5 x 12)

PMT = -400

PV = 15,000

FV = 0

Mode = END

Barbara is paying an annual nominal interest rate of 20.3%. What annual effective
interest rate is she paying?

NOM = 20.31

C/Y = 12

Compute EFF

Display shows EFF = 22.31144289

Barbara is paying an annual effective interest rate of 22.31%.

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Determine payment amount

Solving for the payment amount is an important TVM function of the
calculator given that, in most cases, the payment acts as the constraint for
a client.

EXAMPLE 1
Monique financed the cost of her education by making a payment at the beginning of
each month for 3.75 years to her uncle, who prepaid her $12,000 tuition fees. Her
uncle wants a 7% annual return, compounded monthly, on the money he paid on her
behalf. Calculate the monthly payments Monique must make to her uncle. (Disregard
taxes.)

Given the following information, solve for PMT:

P/Y = 12

C/Y = 12

N = 45 (3.75 x 12)

I/Y = 7.0

PV = 12,000

FV = 0

Mode = BGN

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Keystrokes:

[2ND] CLR TVM

[2ND] P/Y 12 ENTER

45 N

7 I/Y

12,000 PV]

0 [FV]

Ensure calculator is in BGN mode

[CPT] [PMT]

Display shows -302.2058835

Monique’s monthly payments are $302.21.

Another common example of solving for the payment occurs in a sinking

fund situation, where it is known in advance that a specific future sum is
required. In this situation, the calculation might involve solving for the size
of the payments required to ensure the correct amount is on hand when
needed.

EXAMPLE 2
Tompkin Enterprises needs $25,000,000 at the end of 10 years to construct a facility.
If the company can earn an annual return of 5.8%, compounded annually, how much
does it need to save at the end of each year to have $25,000,000 at the end of 10
years? (Disregard taxes.)

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Given the following information, solve for PMT:

P/Y = 1

C/Y = 1

N = 10

I/Y = 5.8

PV = 0

FV = 25,000,000

Mode = END

Tompkin Enterprises must save $1,914,586.79 every year for 10 years to accumulate
the $25,000,000 it needs at the end of 10 years.

EXAMPLE 3
Tony wants to buy a car, but he would like to save up the cash before making the
purchase. He feels he can earn an annual rate of return of 6.9%, compounded
annually, and would like to accumulate sufficient funds over a five-year period. Tony
figures he will need $27,800 at the end of five years to purchase the car and currently
has savings of $10,500. What amount does Tony need to save at the end of each
year if he wants to have sufficient funds to purchase the car? (Disregard taxes.)

Given the following information, solve for PMT:

P/Y = 1

C/Y = 1

N=5

I/Y = 6.9

PV = -10,500

FV = 27,800

Mode = END
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Under this scenario, Tony needs to save $2,289.82 each year to meet his $27,800
target.

EXAMPLE 4
Baha works for a company that allows employees to deduct a portion of their monthly
paycheque to fund a sabbatical year at some time in the future. Baha’s employer pays
3% interest, compounded monthly, on this deducted money. Baha, who currently
earns $84,000 annually, wants to accumulate an amount equal to two-thirds of his
present salary to fund his sabbatical year, which will begin in five years. How much
does Baha need to instruct his employer to deduct from his monthly paycheque during
the next five years, if he is to accumulate the required amount by the beginning of his
sabbatical? Assume that the monthly deduction is made at the end of each month.
(Disregard taxes.)

Given the following information, solve for PMT:

P/Y = 12

C/Y = 12

N = 60 (5 x 12)

I/Y = 3

PV = 0

FV = 56,000 (2/3 of $84,000)

Mode = END

Baha needs to deduct $866.25 from his month-end pay to accumulate $56,000 by the
beginning of his sabbatical year.

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EXAMPLE 5
Calculate the investment required, at the end of each month, to generate $50,000 by
the end of five years, assuming a 5.5% annual rate of return, compounded monthly.

Given the following information, solve for PMT:

P/Y = 12

C/Y = 12

N = 60 (5 x 12)

I/Y = 5.5

PV = 0

FV = 50,000

Mode = END

With these assumptions, monthly investments of $725.89 will generate $50,000 by the
end of five years.

EXAMPLE 6
Karen and Daryl are considering a tropical vacation that will cost $5,500. Although
they do not have the money on hand, they know they can borrow from Karen’s
parents if they agree to pay the loan back within two years. If the couple plans to pay
an annual interest rate of 2.75%, compounded monthly, how much must they repay at
the beginning of each month? (Disregard taxes.)

Given the following information, solve for PMT:

P/Y = 12

C/Y = 12

N = 24 (2 x 12)

I/Y = 2.75

PV = 5,500
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FV = 0

Mode = BGN

Karen and Daryl must make monthly payments of $235.25, under this scenario.

Determine time (compounding periods)

So far, we have solved TVM problems for PV, FV, I/Y and PMT. Last in
the series is the number of periods it takes to either pay off an amount or
accumulate an amount. This section solves for N.

EXAMPLE 1
Xavier earned $3,500 this summer working as a camp counsellor. He wants to buy a
new road bicycle with this money. He invested the $3,500 in a short-term savings
account that earns 4% compounded annually. The road bicycle Xavier wants costs
$6,000. How long will it take for Xavier’s summer earnings to grow to $6,000?

Given the following information, solve for N:

P/Y = 1

C/Y = 1

I/Y = 4

PV = -3,500

FV = 6,000

It will take 13.74 years for Xavier’s summer earnings to grow to $6,000.

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EXAMPLE 2
Ru wants to buy a car. She expects to be able to buy a good-quality used car for
$25,000. She has not set aside anything yet for the purchase, but is able to save
$600 at the end of each month. How long will it take Ru to save enough to buy a car if
she earns a nominal rate of 6%, compounded monthly?

Given the following information, solve for N:

Mode = END

P/Y = 12

C/Y = 12

I/Y = 6

PV = 0

PMT = -600

FV = 25,000

Since P/Y and C/Y are set to 12, the problem and solution are denominated in
months. Ru will save enough to buy a car in 37.94 months, which is equivalent to
three years and nearly two months.

EXAMPLE 3
Aesha inherited $32,000 from her grandfather. She would like to buy a Recreational
Vehicle (RV) with the money to travel across Canada. However, $32,000 is not
enough money. She needs $88,000 to purchase the RV of her dreams. If Aesha
invests her inheritance in a savings account that pays an annual nominal rate of 5.5%,
compounded monthly, and she contributes $800 at the end of each month, when will
she have enough money to buy her RV?

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Given the following information, solve for N:

Mode = END

P/Y = 12

C/Y = 12

I/Y = 5.5

PV = -32,000

PMT = -800

FV = 88,000

It will take Aesha 52.46 months, or 4 years and 4.46 months, to save enough to buy
her RV.

EXAMPLE 4
Pierre is 45 years old and has saved only $32,000 for his retirement. He has
determined that he needs $1,000,000 in retirement savings to fund his desired
lifestyle. He can save $1,200 at the beginning of each month towards his retirement
goal. How many years will it be before he can retire if his retirement savings and his
monthly contributions are invested at a rate of 6% per year, compounded monthly?

Given the following information, solve for N:

Mode = BGN

P/Y = 12

C/Y = 12

I/Y = 6

PV = 32,000

PMT = 1,200

FV = -1,000,000

Pierre can retire in 303.48 months, or 25.29 years (25 years and 3.5 months).
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EXAMPLE 5
Sangeeta is 65 years old and retires tomorrow. She has $275,000 in retirement
savings and wants to receive payments of $36,000 per year at the beginning of each
year. How many years will it take her to run out of money if she invests her retirement
savings at an annual nominal rate of 8.25%, compounded annually.

Given the following information, solve for N:

Mode = BGN

P/Y = 1

C/Y = 1

I/Y = 8.25

PV = -275,000

PMT = 36,000

FV = 0

Sangeeta will run out of money in 11 years.

EXAMPLE 6
Maddie just bought a new car and financed it with a $33,500 loan at an annual
interest rate of 7.95%, compounded monthly. She pays $550 at the beginning of each
month towards the loan. How long will it be before Maddie’s car loan is fully repaid?

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Given the following information, solve for N:

Mode = BGN

P/Y = 12

C/Y = 12

I/Y = 7.95

PV = 33,500

PMT = -550

FV = 0

Maddie’s car loan will be fully repaid in 77.6 months, or six years and 5.6 months.

Differences in compounding frequency and payment

frequency (C/Y not equal to P/Y)
As previously stated, most financial calculators, including the Texas
Instruments BA II Plus, assume that the compounding period matches the
number of periods when making TVM calculations. If a payment is made or
received annually, the calculator assumes that the compounding period is
annual. If the payment is made or received at a different frequency, the
calculator assumes that the compounding period matches that frequency.
If there is a discrepancy between the payment frequency and the
compounding frequency, it is necessary to make adjustments to the
calculation. The following examples look at how changing the basic
compounding period changes the future value of a stream of future
payments.

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EXAMPLE 1
To see the impact of different compounding periods, Christine calculates the future
value of three options. In each scenario, the total amount invested is $24,000 over a
10-year period, but the compounding and payment frequency differ. (Disregard taxes.)

Option A

Invest $2,400 at the end of each year for 10 years, assuming an annual 4.9% return,
compounded annually.

Given the following information, solve for FV:

P/Y = 1

C/Y = 1

N = 10

I/Y = 4.9

PV = 0

PMT = -2,400

Mode = END

The future value is $30,046.42.

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Option B

Invest $600 at the end of each quarter for 10 years, assuming an annual 4.9% return,
compounded quarterly.

Given the following information, solve for FV:

P/Y = 4

C/Y = 4

N = 40 (4 x 10)

I/Y = 4.9

PV = 0

PMT = -600

Mode = END

The future value is $30,732.94.

Option C

Invest $200 at the end of each month for 10 years, assuming an annual 4.9% return,
compounded monthly.

Given the following information, solve for FV:

P/Y = 12

C/Y = 12

N = 120 (12 x 10)

I/Y = 4.9

PV = 0

PMT = -200

Mode = END

The future value is $30,890.86.

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As expected, Christine’s calculations show that, although the same total amount was
invested at the same nominal interest rate under all three scenarios, the result is
almost $850 more when the investment compounds monthly compared to when it
compounds annually.

The next example looks at situations in which there is a discrepancy

between the payment frequency and the compounding frequency.
Payments are monthly, but compounding is daily.

EXAMPLE 2
Every month, Rex deposits $169 into a bank account that offers daily compounding.
The annual nominal interest rate is 4%. He wants to know what his bank balance will
be in five years. (Disregard taxes.)

Given the following information, solve for FV:

P/Y = 12

C/Y = 365

(Enter P/Y, then change C/Y by pressing down arrow.)

N = 60 (12 x 5)

I/Y = 4

PV = 0

PMT = -169

Mode = END

With daily compounding, the future value of this payment stream is $11,206.36.

To illustrate the effects of daily compounding, you can calculate this same
example using monthly periods and monthly compounding, and yearly
periods and yearly compounding. No adjustment is necessary because, in
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both cases, the payment period and the compounding period match.
Assume payments at the end of the periods. Most of the questions in this
course have matching payment and compounding periods.

EXAMPLE 3
Option 1: Annual

Given the following information, solve for FV:

P/Y = 1

C/Y = 1

N=5

I/Y = 4

PV = 0

PMT = -2,028 (12 x 169)

Mode = END

The future value is $10,984.30.

Option 2: Monthly

Given the following information, solve for FV:

P/Y = 12

C/Y = 12

N = 60 (12 x 5)

I/Y = 4

PV = 0

PMT = -169

Mode = END

The future value is $11,204.53.

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As this series of examples clearly illustrates, daily compounding increases

the future value of the investment only a little bit, compared to monthly
compounding. However, both daily and monthly compounding generate
more than $200 in additional future value, compared to annual
compounding.

Annuities
An annuity is a set of payments made over time. Annuities can be
categorized as ordinary annuities, which make payments at the end of the
period, and annuities due, which make payments at the beginning of the
period. This section reviews how to calculate the present value of a series
of uniform annuity payments made over time and the future value of
annuity payments received over a given period.

Present value formula

Here is the present value formula for an ordinary annuity:
Present Value =
Periodic Payment Amount x ((1 – (1+interest rate per period)-number of periods in years)
÷ interest rate per period
or
PV = PMT x ((1 – (1+i)-n) ÷ i)

The effect of switching to an annuity due is to move all of the cash flows
ahead by one period. Therefore, calculating the present value requires one
less compounding period. To achieve this mathematically, add one term
(l+i) to the formula:

PV = PMT x ((1–(1+i)-n) ÷ i) x (1+i)

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Future value formula

Here is the future value formula for an ordinary annuity:

FV = PMT x (((1+i)n – 1) ÷ i)

Using the calculator for annuity applications

There is no need to memorize the present value or future value formulas,
since the TVM capabilities of a financial calculator work well for annuity
calculations. While a number of earlier examples featured annuity
calculations, the following examples look specifically at ordinary annuities
and annuities due.

EXAMPLE 1
Marie inherited an ordinary annuity that will pay her $300 monthly for another 2.5
years. What is the present value of this ordinary annuity, assuming an annual interest
rate of 4%, compounded monthly? (Disregard taxes.)

Given the following information, solve for PV:

P/Y = 12

C/Y = 12

N = 30 (2.5 x 12)

I/Y = 4

PMT = 300

FV = 0

Mode = END

The present value of this ordinary annuity is $8,551.09.

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EXAMPLE 2
David has purchased an annuity due that pays $970 each year for the next 12 years,
starting today (i.e., at the beginning of the period). What is the present value of this
annuity due, assuming an annual interest rate of 5.3%, compounded annually?
(Disregard taxes.)

Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N = 12

I/Y = 5.3

PMT = 970

FV = 0

Mode = BGN

The present value of this annuity due is $8,901.77.

EXAMPLE 3
Joanne has a court-ordered spousal support agreement to pay her former husband
$400 at the end of each month for 7.25 years. Since the payments are uniform
amounts, this works exactly like an ordinary annuity. Assuming an annual interest rate
of 3.9%, compounded monthly, what is the present value of Joanne’s ordinary
annuity? (Disregard taxes.)

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Given the following information, solve for PV:

P/Y = 12

C/Y = 12

N = 87 (7.25 x 12)

I/Y = 3.9

PMT = 400

FV = 0

Mode = END

Joanne’s ordinary annuity has a present value of $30,270.30.

EXAMPLE 4
Dan invests $5,000 at the beginning of each year in an account that pays 6% interest,
compounded annually. What is the value of this account in 3.3 years? (Disregard
taxes.)

Given the following information, solve for FV:

P/Y = 1

C/Y = 1

N = 3.3

I/Y = 6

PMT = -5,000

PV = 0

Mode = BGN

The future value of Dan’s account is $18,728.33.

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Deferred Payments
In some calculations — for example, with deferred annuities — we must
account for situations where the payment stream does not begin
immediately, but instead at some point in the future. These calculations
typically involve two stages: the deferral stage before payments begin and
the payment phase. The following example illustrates the present value of
a deferred periodic payment stream.

EXAMPLE 5
Tom just turned 65 years old, and he has a life expectancy of 28.46 years. He is
considering buying a guaranteed life annuity product that will pay him $1,500 at the
beginning of each month starting on his 80th birthday. If the deferred annuity is
calculated based on an annual interest rate of 4.23%, compounded monthly, how
much would it cost for Tom to purchase the annuity today?

Payout period value:

P/Y = 12

C/Y = 12

Mode = BGN

N = 161.52 (months, calculated as (65 + 28.46) – 80 = 13.46 years x 12)

I/Y = 4.23

PMT = 1500

FV = 0

Solving for PV calculates the amount Tom requires at age 80 to purchase an annuity
that provides payments beginning at age 80 and continuing for the rest of his life
(13.46 years): $185,137.36. This is the payout period value. However, Tom is only 65
today, and the money isn’t required until age 80. Therefore, we must now calculate
what sum of money today (when Tom is 65) will grow to $185,137.36 in 15 years
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(when Tom is 80). Remember that, during this phase, from age 65 to 80, there are no
payments.

Given the following information, solve for PV:

P/Y = 12

C/Y = 12

N = 180 (months, calculated as (80 – 65) = 15 years x 12)

I/Y = 4.23

PMT = -0

FV = 185,137.36

It would cost Tom $98,269.50 to purchase the annuity today. This amount is known as
the present value of a deferred periodic payment stream.

In other calculations, we must account for situations where the deferral

period follows the payment stream. Again, these calculations typically
involve two stages: the payment phase and the deferral phase.

EXAMPLE 6
Jane just opened an investment account. She plans to contribute $150 to the account
at the end of each month until her daughter, Beth, turns 15. Beth just turned 6, and
Jane intends to give her the balance in the account on her 18th birthday. If Jane can
achieve a 5.2% return, compounded monthly, on the account over the full period,
what amount can she give Beth on her 18th birthday? (Disregard taxes.)

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Given the following information, solve for FV:

P/Y = 12

C/Y = 12

Mode = END

N = 108 (months, calculated as (15 – 6) = 9 x 12)

I/Y = 5.2

PV = -0

PMT = -150

Solving for FV calculates the amount that will have accumulated when Beth turns 15:
$20,602.51. This is the savings period value. However, although Jane will stop
contributing at this point, the money in the account will continue to grow for another
three years, until Beth reaches 18. Therefore, we must now calculate the amount to
which $20,602.51 will grow during those three years. Remember that, during this
phase, from age 15 to 18, there are no contributions.

Given the following information, solve for FV:

P/Y = 12

C/Y = 12

N = 36 (months, calculated as (18 – 15) = 3 years x 12)

I/Y: 5.2

PMT: -0

PV: -20,602.51

CPT FV: 24,072.64

Jane could give Beth $24,072.64 on her 18th birthday. This amount is known as the
future value of a deferred periodic payment stream.

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Bonds
Governments, corporations and other institutions issue bonds. A bond is an
interest-bearing debt of the issuer. It represents a loan by the issuer to
the lender with a promise by the issuer to repay the face value (value of
the bond at maturity) of the bond at maturity and to pay the stated
interest periodically. Generally, bonds pay interest semi-annually, which is
reflected in TVM calculations for regular bonds as P/Y = 2.

TVM calculations are relevant to determining the cost of the bond (solve
for present value), the interest or yield (solve for interest), and the value
of the bond (solve for future value).

Pricing bonds
Like most financial assets, bonds are usually negotiable, meaning they can
be sold before maturity. The price at which a bond is traded should reflect
the present value of its future payments. This present value, in turn, will
be a function of the prevailing interest rates when the bond is sold, its
original interest or coupon rate, and the payments associated with the
bond.

If a bond is issued at a face value of $10,000, with a stated coupon or

interest rate of 6% and a maturity date of 25 years, it could only be sold
for its face value if interest rates remain constant. If, after five years,
market interest rates for bonds increase to 8%, then no one will buy a
bond at face value ($10,000) if it pays only 6%. To sell, the bond will have
to trade hands at less than its face value to allow the new bondholder to
realize the prevailing 8% market interest rate on the investment. On the
other hand, if market interest rates decline to 4%, then no one will sell a
bond at face value if the bond has a coupon rate of 6%. In this case, the

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seller will demand a premium to compensate for the higher-than-market

amount of interest the bond pays.

Bond prices are quoted similar to an index number, which can be thought
of as a percentage of the bond’s face value. A bond can trade at, above or
below par:

 At par: trading at 100; the investor pays exactly the face value

 At a discount: trading below 100he investor would pay less than face value.

 At a premium: trading above 100. The investor would pay more than face
value.

Remember, the number is not the dollar amount, but rather, a percentage of
the face value. Let’s illustrate with a few examples:
 A bond with a face value of $10,000 is trading at 98.50. In this case, the
investor would pay $9,850 for the bond. This bond is trading at a
discount.

 A bond with a face value of $100,000 is trading at 104.56. In this case,

the investor would pay $104,560 for the bond. This bond is trading at a
premium.

 A bond with a face value of $250,000 is trading at 99.00. In this case, the
investor would pay $247,500 for the bond. This bond is trading at a
discount.

 A bond with a face value of $1,000,000 is trading at 101.23. In this case,

the investor would pay $1,012,300 for the bond. This bond is trading at a
premium.

 A $50,000 bond is trading at 92.00. In this case, the investor would pay
$46,000 for the bond. This bond is trading at a discount.

Table 3 summarizes these examples.

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Table 3: Examples of Bond Pricing

Bond Face Quoted Bond Price Paid by Par, Premium or
Value Price Investor Discount
$10,000 98.50 $9,850 Discount

$100,000 104.56 $104,560 Premium

$250,000 99.00 $247,500 Discount

$1,000,000 101.23 $1,012,300 Premium

$50,000 92.00 $46,000 Discount

Why do bonds trade above and below their own face values, and why
would an investor pay more than face value for a bond? In general, this is
determined by the bond’s coupon (interest) rate in comparison to
prevailing, current market interest rates. Figure 1 explains the effect
current market interest rates have on bond trading prices.

Figure 1: How Bond Prices React to Current Market Interest Rates

EXAMPLE 1
Peter owns a 25-year bond with a face value of $10,000, bearing a coupon rate of
6%. The bond matures in 20 years. If the current market rate is 8%, how much would
someone pay today for Peter’s bond? (Disregard taxes.)

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Given the following information, solve for PV:

P/Y = 2 (interest is paid two times each year)

C/Y = 2

N = 40 (2 x 20 years to maturity)

I/Y = 8 (the current market rate)

PMT = 300 (($10,000 x 0.06) ÷ 2) (interest payment is received two times each year)

FV = 10,000 (at maturity Peter will receive $10,000)

MODE = END

SOLVE FOR PV, which equals 8,020.72

Notice that the coupon rate is not related to I/Y. The coupon rate is what determines
the payment. The PMT is derived by multiplying the face value of $10,000 by the
coupon rate of 6% and dividing the result by two to reflect the semi-annual nature of
bond coupon payments. The I/Y is arrived at by using the market interest rate of 8%,
not the coupon rate of 6%. The bond has 20 years left until maturity, which is
therefore 40 payments as the payment frequency is twice per year (P/Y = 2). If a
buyer pays Peter $8,020.72 for this bond, and the bond pays the buyer $300 twice
each year for 20 years, along with a return of the face amount of $10,000 at the end
of 20 years, the bond will have generated an 8% annual nominal interest rate, which
is the prevailing market rate.

In the previous example, the price of the bond fell below the face value of
$10,000 because interest rates had increased. The market interest rate of
8% was higher than the bond coupon rate of 6%.

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EXAMPLE 2
Joan has a 15-year bond issued with a face value of $100,000 and a coupon rate of
5%. A buyer is interested in Joan’s bond at a time when the prevailing interest rate is
3.5%; therefore, Joan expects to realize a premium on the face value of the bond.
There are eight years left until the bond reaches maturity. What is the present value,
or market price, of the bond? (Disregard taxes.)

Given the following information, solve for PV:

P/Y = 2

C/Y = 2

N = 16 (8 x 2)

I/Y = 3.5 (the current market rate)

PMT = 2,500 ($100,000 x 5% ÷ 2)

FV = 100,000

MODE = END

SOLVE FOR PV, which equals -110,387.87

Joan will realize $110,387.87 on the sale of this bond. The buyer can afford to pay a
premium over face value because the additional above-market interest he can earn
will give him a nominal annual interest rate of 3.5%, which is the market rate, during
the remaining years until maturity.

Determine interest yield

The bond interest calculation uses the same fundamental information as
the bond price calculation. When you know a bond’s face value, years to
maturity and market price, you can calculate the nominal yield if an
individual purchases the bond today.

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EXAMPLE 3
Chris is considering the purchase of a bond with a $1,000,000 face value that pays a
coupon rate of 6.2% and has exactly six years remaining until maturity. If Chris pays
$925,000 for the bond, what is his annual nominal rate of return? (Disregard taxes.)

Given the following information, solve for I/Y:

P/Y = 2

C/Y =2

N = 12 (6 x 2)

PMT = 31,000 ($1,000,000 x 6.2% ÷ 2)

PV = -925,000

FV = 1,000,000

Mode = END

Since this bond is selling at a discount to its face value, it is reasonable to expect that
the annual nominal interest rate will be higher than the bond’s coupon rate. This holds
true, as the annual nominal interest rate is 7.79%, whereas the coupon rate is 6.2%.
So, if Chris purchases this bond for $925,000, receives semi-annual payments of
$31,000, and receives $1,000,000 at the end of six years, he will earn an annual
nominal interest rate of 7.79% on his investment.

EXAMPLE 4
For $642,000, Brittany purchased a bond with eight years to maturity that has a
coupon rate of 4% and a face value of $600,000. What is Brittany’s annual nominal
rate of interest? (Disregard taxes.)

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Given the following information, solve for I/Y:

P/Y = 2

C/Y = 2

N = 16 (8 x 2)

PV = -642,000

PMT = 12,000 (600,000 x 4% ÷ 2)

FV = 600,000

Mode = END

As expected, when the bond sells for a premium over face value, the annual nominal
rate of interest is less than the coupon rate. In this case, the annual nominal rate of
interest is 3.01%.

What is the annual effective yield?

NOM = 3.0089

C/Y = 2

[CPT] [EFF]

The annual effective yield is 3.0315%.

Retirement calculations
TVM calculations are very relevant in retirement planning. They can help
track capital accumulation and determine how much capital is required to
fund a future income stream, determine the appropriateness of the time
horizon over which the funds will be spent, and to support a variety of
other calculations important to retirement decisions. Retirement
calculations will be reviewed here for general understanding.

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Accumulations
Any retirement planning projection comprises two main phases: the saving
or accumulation phase and the dissaving or distribution phase. The
accumulation phase refers to the period during which an individual is
working and striving to build the value of his or her investments. The
distribution phase describes the period after the accumulation phase in
which retirees begin accessing and using their funds. TVM calculations play
a key role in both phases.

EXAMPLE 1
Mato, who has accumulated retirement savings of $41,000, would like to retire in 13
years. By that time, he hopes to have accumulated $100,000 in total retirement
savings. He estimates that he can earn an annual return of 2.8%, compounded
monthly. How much will Mato have to invest at the end of each month for the next 13
years to meet his $100,000 objective? (Disregard taxes.)

Give the following information, solve for PMT:

P/Y = 12

C/Y = 12

N = 156 (13 x 12)

I/Y = 2.8

PV = -41,000

FV = 100,000

Mode = END

If Mato invests $218.31 at the end of each month for 13 years, he will have the
$100,000 he hopes to accumulate for his retirement.

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EXAMPLE 2
Erica would like to retire with sufficient capital to provide a monthly retirement income
of $1,500 at the end of each month. She anticipates that she will need the income for
25 years during retirement and can earn an annual rate of return of 5%, compounded
monthly. How much will Erica need to fund her retirement plan? (Disregard taxes.)

Given the following information, solve for PV:

P/Y = 12

C/Y = 12

N = 300 (25 x 12)

I/Y = 5

PMT = 1,500

FV = 0

Mode = END

Erica will need $256,590.07 to fund her retirement plan.

Target interest rate

TVM calculations are also useful to help clients understand the target
interest rate they need to support their retirement plans.

EXAMPLE 1
Jamie is about to retire and has accumulated $429,000 in an RRSP. She would like to
draw a retirement income of $3,000 at the beginning of each month for 16 years.
Jamie wants to know what annual nominal interest rate she needs to earn during
retirement to support her plan, assuming monthly compounding. (Disregard taxes.)

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Given the following information, solve for I/Y:

P/Y = 12

C/Y = 12

N = 192 (16 x 12)

PV = -429,000

PMT = 3,000

FV = 0

Mode = BGN

If her retirement fund earns an annual nominal interest rate of 3.91%, compounded
monthly, Jamie will have sufficient capital to achieve her retirement goals.

EXAMPLE 2
Jack wants to have a $500,000 retirement fund when he retires in 8.5 years. At the
moment, he has $289,000 in his retirement account. He plans to contribute $750 at
the end of each month for the remaining 8.5 years that he is at work. Assuming that
Jack’s retirement account earns interest that compounds monthly, what annual
nominal rate of interest does he need to achieve to enable him to fund his retirement
goal? (Disregard taxes.)

Given the following information, solve for I/Y:

P/Y = 12

C/Y = 12

N = 102 (8.5 x 12)

PV = -289,000

PMT = -750

FV = 500,000

MODE = END
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If Jack’s retirement account earns a nominal annual return of 4.08% (or more),
compounded monthly, he will achieve his goal of accumulating $500,000.

Reasonableness of time horizon

Another TVM calculation that surfaces in retirement calculations is time
horizon, or the length of time retirement funds will last.

EXAMPLE
Louise is approaching retirement age but is unsure whether she wants to retire. She
has a retirement account balance of $377,000, and she would like to create an
income stream of $2,500 at the end of each month. She anticipates an annual return
of 4.8%, compounded monthly. Based on these assumptions, how long will Louise’s
money last? (Disregard taxes.)

Given the following information, solve for N:

P/Y = 12

C/Y = 12

I/Y = 4.8

PV = -377,000

PMT = 2,500

FV = 0

Mode = END

Louise’s retirement fund should last 231.54 months, or 19.3 years.

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Loan payments/repayments
TVM calculations are used frequently in loan calculations from a number of
different perspectives, including solving for the loan interest rate, loan
amount, loan payment and loan period.

When someone lends money, he or she generally expects that the

borrower will repay the loan. Furthermore, because the lender will forego
some opportunities by lending the money to another individual, he or she
deserves compensation. The compensation is calculated in the form of
interest. The lender will assess the risk of lending money to the borrower
and then determine an appropriate level of compensation for that risk. As
the borrower repays the loan, part of the payment satisfies the interest
charged on the loan and the rest goes towards paying down the
outstanding balance of the loan.

In addition to the interest rate, other factors impact the size of required
payments, including the length of the repayment period (because larger
payments are necessary to pay back a loan over a shorter period) and the
size of the loan (because a larger loan over a similar repayment period
requires larger payments).

The following examples illustrate how TVM calculations play a key role in
loan calculations.

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Determine loan interest rate

TVM calculations can determine the interest rate on a loan.

EXAMPLE
Harvey approaches a credit union for a $25,000 loan to finance his new car purchase.
The manager tells him that he will have to pay the debt off over five years and that his
payments will be $525, at the beginning of each month. What annual nominal interest
rate will Harvey pay, assuming monthly compounding?

Given the following information, solve for I/Y:

P/Y = 12

C/Y = 12

N = 60 (12 x 5)

PV = 25,000

PMT = -525

FV = 0

Mode = BGN

Harvey will pay an annual nominal interest rate of 9.85% for his car loan. Note that in
this example, the loan payment was due at the beginning of the month. However, in
real life, loans are most commonly calculated on a deferred payment schedule, which
means payments are due at the end of the month (mode = END).

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Determine loan amount

TVM calculations can determine the size of loan that the borrower requires.

EXAMPLE
Martin has $60,000 saved for a down payment towards a new boat. He needs to
borrow funds for the balance and anticipates an annual interest rate of 6%,
compounded monthly. Martin would like to pay off the debt over a five-year period and
feels he can afford payments of $2,000 at the end of each month. What is the
maximum loan amount Martin can afford to borrow, and what is the maximum amount
Martin can pay for the boat?

Given the following information, solve for PV:

P/Y = 12

C/Y = 12

N = 60 (5 x 12)

I/Y = 6

PMT = -2,000

FV = 0

Mode = END

Martin’s proposed repayment schedule supports a maximum loan amount of

approximately $103,451. Add Martin’s $60,000 down payment to this maximum loan
amount and he can afford to pay a maximum of $163,451 for the boat.

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Determine loan payment

TVM calculations can determine the loan payment.

EXAMPLE
Susan borrowed $19,100 from her sister for a period of 10.5 years. She promised to
pay annual interest of 7.7%, compounded monthly, and to make payments at the end
of each month. What is Susan’s monthly payment amount?

Given the following information, solve for PMT:

P/Y = 12

C/Y = 12

N = 126 (10.5 x 12)

I/Y = 7.7

PV = 19,100

FV = 0

Mode = END

Susan’s monthly payment amount is $221.50.

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Determine loan period

TVM calculations can determine the loan period.

EXAMPLE
Tim has a car loan with $10,400 still outstanding, and he is paying 8% interest,
compounded monthly. He would like to double his monthly payments to $500. How
many months will it take for Tim to pay off the remaining balance of the loan? Assume
that Tim makes payments at the end of each month.

Given the following information, solve for N:

P/Y = 12

C/Y = 12

I/Y = 8

PV = 10,400

PMT = -500

FV = 0

Mode = END

If he doubles his monthly payments to $500, Tim has 22.47 monthly payments left.

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Leasing calculations
It is possible to perform TVM calculations from the perspective of the
lessee (the person who makes lease payments) or the lessor (the person
who receives lease payment). A lease is a loan for something of value
(land, a vehicle, equipment, etc.) for a period of time, with specific pre-
arranged periodic payments. Unless otherwise stated, lease payments are
generally due at the beginning of each payment period.

It is not always obvious what interest rate a lease is charging. TVM

calculations can help determine the interest rate.

EXAMPLE
Laura leases dental equipment worth $50,000 from a finance company. The lease
runs for five years. She makes monthly payments of $930 at the beginning of each
month. In addition, she must make a $10,000 balloon payment at the end of the
lease. What annual nominal rate of interest is Laura paying on the lease?

Given the following information, solve for I/Y:

P/Y = 12

C/Y = 12

N = 60 (12 x 5)

PV = 50,000

PMT = -930

FV = -10,000

Mode = BGN

Laura is paying an annual nominal rate of interest of 10.17%.

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Real rate of return

Individuals make investments with the idea that the return will enrich
them, or make them wealthier. When assessing an investment, it is
valuable to know whether the investment will realize a real return. This is
the rate of return after adjusting for inflation. For example, if an individual
invests $100 for one year in an account paying 5% interest, at the end of
the year the individual will have $105 in his or her account. However, if
inflation is at 5%, that $105 represents exactly the same amount of
purchasing power that the $100 amount represented one year earlier. The
real return in this case is zero.

If the nominal interest rate an investment earns does not exceed the
expected inflation rate, there is no real interest rate return. The following
formula expresses the real rate of return:

Real Rate of Return = (annual nominal rate of return – annual rate of inflation) ÷

(1 + annual rate of inflation)

Real Rate of Return = (i – infl) ÷ (1 + infl)

In this formula, the annual rate of inflation is expressed as a decimal.

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EXAMPLE 1
Thomas has an investment with a nominal interest rate of 4%, while the expected rate
of inflation is 2%. If inflation runs at 2%, what is Thomas’s real rate of return?

Real Rate of Return

= (i – infl) ÷ (1 + infl)
= (0.04 – 0.02) ÷ (1 + 0.02)
= (0.02) ÷ (1.02)
= 0.0196

Thomas’s investment has a real rate of return of 1.96%.

EXAMPLE 2
Casey was quite excited to see that she could obtain a 4.75% nominal interest rate on
the renewal of her investment. However, inflation was projected at 1.5% for the
upcoming period. If inflation remains as expected, what real rate of return will Casey
experience on her investment?

Real Rate of Return

= (i – infl) ÷ (1 + infl)
= (0.0475 – 0.015) ÷ (1 + 0.015)
= (0.0325) ÷ (1.015)
= 0.0320

With an inflation rate of 1.5%, Casey’s real rate of return will be 3.2%.

To use the real rate of return in a TVM calculation, enter it as the interest
variable. Using the real rate of return effectively removes inflation from the
investment return.

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EXAMPLE 3
Cheryl is quite wealthy, and she would like to set aside sufficient funds to help her
mother with long-term expenses. Cheryl would like to provide her mother with $20,000
in annual income for the next 25 years, payable at the beginning of each year, and
indexed for annual inflation of 1.5%. Assuming Cheryl can earn a return of 6% on her
investment, compounded annually, how much money does she need today to fund
the annual income, payable at the beginning of each year? (Disregard taxes.)

Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N = 25

I/Y = ((0.06 – 0.015) ÷ (1 + 0.015)) x 100 = 4.433497537

PMT = 20,000

FV = 0

Mode = BGN

Cheryl needs $311,843.39 to fund the desired annual income for her mother.

Note that the calculation of the real rate of return for the I/Y value was entered directly
into the TVM register. This allows the TVM function to use the maximum number of
floating decimal places, resulting in greater accuracy.

After-tax rate of return

Until this point in the module, we have not considered tax factors in the
TVM calculations. The reality is that tax plays a significant role in assessing
investment choices and in selecting the appropriate numbers to use in TVM
calculations. Most industrialized countries have a progressive tax system in
which tax rates increase incrementally as income rises.

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If an investment is in a tax-deferred registered account (e.g., an RRSP),

no tax applies, and a 6% return on a $1,000 investment returns $60 per
year. However, if the investment is in a regular non-registered account,
then an investor will be interested in knowing the after-tax return on the
investment.

The calculations use the marginal tax rate (MTR), which is the rate of tax
paid on the next dollar of income. This is not the same as an individual’s
actual tax rate or average tax rate. The formula to calculate the after-tax
rate of return is:

After-Tax Rate of Return = Nominal Interest Rate x (1 – MTR)

While an investment generates a return, money received from the

investment will, in most cases, have a tax implication, and the after-tax
rate of return takes this into account. The after-tax rate of return allows an
individual to determine the return after accounting for taxes.

EXAMPLE
Blair has invested $100,000 in a non-registered interest-bearing investment that pays
an annual nominal interest rate of 5.5%, compounded annually. Blair’s marginal tax
rate is 42%. What is Blair’s after-tax rate of return?

After-tax rate of return

= Nominal Interest Rate x (1 – MTR)
= 0.055 x (1 – 0.42)
= 0.055 x 0.58
= 0.0319

Blair’s after-tax rate of return is 3.19%.

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What amount of after-tax income will Blair derive from this investment after one year?

After-tax income

= $100,000 x (0.055 x (1 – 0.42))

= $100,000 x 0.0319
= $3,190.00

Blair’s after-tax income from this investment will be $3,190 at the end of the first year.

Real after-tax rate of return

The next step is to combine the adjustments for inflation and taxes into
one formula. The result is a formula that adjusts the nominal interest rate
to account for both inflation and taxes, providing a real after-tax rate of
return:

Real After-Tax Rate of Return = (Annual Nominal Rate of Return x (1 – MTR) –

Annual Rate of Inflation) ÷ (1 + Annual Rate of Inflation)

Real After-Tax Rate of Return = (i x (1 – MTR) – infl) ÷ (1 + infl)

In this formula, the annual nominal rate of return, annual rate of inflation
and MTR are expressed as decimals.

EXAMPLE 1
Herbert and Myra are working with their financial planner to develop a savings
program aligned with their personal retirement objectives. At retirement, they hope to
have sufficient non-registered savings to provide an annual after-tax income of
$60,000 for 25 years, indexed for annual inflation of 2%. If, during retirement, Herbert
and Myra can earn a before-tax annual return of 7%, compounded annually, and they
anticipate a 35% marginal tax rate, what savings amount do they need at the

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beginning of retirement? Assume they want to receive their retirement income

annually, at the beginning of each year.

Given the following information, solve for PV:

P/Y = 1

C/Y = 1

N = 25

I/Y = (0.07 x (1 – 0.35) – 0.02) ÷ (1 + 0.02) x 100 = 2.5

PMT = 60,000

= 150,000

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EXAMPLE 2
Harold’s brother owes him $1,000. However, instead of repaying the entire $1,000,
Harold’s brother promises to repay him $5 at the beginning of each month for the rest
of his life. The prevailing market nominal interest rate is 5.5%, compounded monthly.
What is the present value of this perpetual?

Given the following information, solve for PV:

P/Y = 12

C/Y = 12

N = 999,999,999

I/Y = 5.5

PMT = 5

FV = 0

Mode = BGN

The value of this perpetual is $1,095.91, which is more than the $1,000 Harold’s
brother currently owes him. Again, using the formula above produces the same result:

PV = (5 x 12) ÷ 0.055 + $5 (payment is at the beginning of the month)

= 1,095.91

Cash flow applications

So far, this module has looked at TVM calculations where the cash flows
are even (consistent amounts over each period). In many situations, a
financial problem has non-uniform payments, or uneven cash flows. These
scenarios are called cash flow problems. To solve problems where cash
flows occur at regular intervals but are of varying amounts, use the Cash
Flow application on the calculator in place of the TVM calculations. Access

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the Cash Flow application using the CF key — the second key in the
second row from the top.

Net present value

The net present value (NPV) calculation, sometimes referred to as the
discounted cash flow calculation, is a well-accepted tool for assessing the
expected net monetary gain or loss from a potential investment by
discounting all future cash inflows and outflows to the present point in
time, using a nominal interest rate (or required rate of return). The NPV
function solves for the present value of a series of cash flows. To calculate
the NPV, you must know the discount factor (explained below).

For an investment to make sense financially, it must generate a series of

future cash inflows and outflows such that the present value of the cash
flows exceeds the amount contemplated as an investment. For example, it
would not make sense to invest $10,000 in a project if the present value of
all future cash flow streams was only $7,000, because you would lose
$3,000 on an NPV basis.

The guideline is that investments make financial sense only if they have a
positive NPV; that is, only if the net present value of the future revenue
streams exceeds the original investment. In essence, a positive NPV is an
indication that a project has strong enough cash flow to pay the expected
return to the investors who have put up the capital, and also have some
left over that represents an increase in wealth for those investors.

The calculation of NPV requires three values: the original investment,

future cash flow streams and an appropriate “interest” rate. The word
interest is in quotations because the financing that provides the
investment dollars for a project using NPV is not always debt. In fact, in

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NPV calculations, the “i” factor represents not merely interest (returns on
debt), but also economic returns (returns on debt and equity). For this
reason, NPV calculations and internal rate of return (IRR) calculations
(discussed later in this module) use the words “discount factor,” instead of
“interest.”

The NPV calculation uses the NPV key — the middle key in the second
row from the top. It is important to remember to input cash outflows as
negative amounts and cash inflows as positive amounts when calculating
NPV.

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EXAMPLE 1
Carmen is considering investing $12,000 in Project ABC, which will generate cash
flows as follows:

End of Year Amount

Year 1 -$20,000
Year 2 -$1,000
Year 3 $15,000
Year 4 $27,000
Year 5 $32,000

Using a discount factor of 13%, what is the net present value of this investment?

Given the following information, solve for NPV:

P/Y = 1

C/Y = 1

CF0 = -12,000

CF1 = -20,000

CF2 = -1,000

CF3 = 15,000

CF4 = 27,000

CF5 = 32,000

I = 13

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Keystrokes:

[2ND] [CLR TVM]

[2ND] [CLR WORK]

[CF] [2ND] [CLR WORK]

[2ND] [P/Y] 1 [ENTER]

[CE/C]

[CF]

12,000 [+/-] [ENTER] (enters the cash flow amount for the initial investment, CF0)

[down arrow]

20,000 [+/-] [ENTER] (enters the cash flow amount for year 1, C01)

[down arrow twice] (leave default F01 = 1 unchanged)

1,000 [+/-] [ENTER] (enters the cash flow amount for year 2, C02)

[down arrow twice] (leave default F02 = 1 unchanged)

15,000 [ENTER] (enters the cash flow amount for year 3, C03)

[down arrow twice] (leave default F03 = 1 unchanged)

27,000 [ENTER] (enters the cash flow amount for year 4, C04)

[down arrow twice] (leave default F04 = 1 unchanged)

32,000 [ENTER] (enters the cash flow amount for year 5, C05)

[down arrow twice] (leave default F05 = 1 unchanged)

[NPV]

13 [ENTER] (calculator shows I = 13)

[down arrow]

[CPT]

Display shows 13,841.4143

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The net present value of this project is a positive $13,841.41, which means Carmen
should invest in the project.

Different projects or investments compete for investor dollars. Net present

value is commonly used to compare two or more investment options from
a financial perspective. In other words, it allows the investor to make a
financial comparison of competing projects. Assuming all other factors are
equal, the winning investment tends to be the project or investment with
the highest net present value.

EXAMPLE 2
Sandra is considering investing in two different projects. Project Fireside requires an
initial investment of $50,000, while Project Logic requires an initial investment of
$125,000. The table outlines the cash flows for the two projects.

Fireside Logic

End of Year Amount End of Year Amount

Year 1 $ 5,000 Year 1 -$5,000
Year 2 $15,000 Year 2 $50,000
Year 3 $25,000 Year 3 $60,000
Year 4 $30,000 Year 4 $65,000

Using a discount rate of 10%, which of the two projects offers a stronger financial
case for investment?

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Fireside

Given the following information, solve for NPV:

P/Y = 1

C/Y = 1

CF0 = -50,000

CF1 = 5,000

CF2 = 15,000

CF3 = 25,000

CF4 = 30,000

I = 10

Logic

Given the following information, solve for NPV:

P/Y = 1

C/Y = 1

CF0 = -125,000

CF1 = -5,000

CF2 = 50,000

CF3 = 60,000

CF4 = 65,000

I = 10

Fireside has a net present value of $6,215.42 and Logic has a net present value of
$1,251.26. Based on the NPV of each project, Fireside is the better investment.

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Internal rate of return

The internal rate of return (IRR) calculation derives from the net present
value (NPV) calculation. The IRR calculation introduces no new
information; it merely changes the form of the answer. In NPV
calculations, the answer is in dollar form. In IRR calculations, the answer
is a percentage. The IRR function calculates the annual nominal interest
rate required to give an NPV of zero.

Just as projects with a positive NPV are considered economically viable,

projects with an IRR greater than the cost of capital are considered
economically viable. IRR is widely used because of the inherent
attractiveness of dealing in percentages. If a project has a positive NPV, it
will also have an IRR greater than the cost of capital or required rate of
return.

The IRR calculation takes a future cash flow stream and determines what
specific discount factor applied to it would make the present value (PV)
amount exactly equal to the original investment — which would mean the
NPV equals zero. So, instead of using a target cost of capital as the
discount rate, as in NPV calculations, IRR calculations solve for the
discount rate that makes NPV equal zero. In fact, the IRR is the discount
rate that makes NPV equal zero. The calculation burden when solving for
the discount factor in this situation is non-trivial. For this reason,
calculators or spreadsheets are essential to calculate the IRR.

When calculating an IRR, input cash flow numbers in exactly the same
way as you did for the NPV calculation. Then, instead of pressing [NPV]
as the last key, press [IRR].

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EXAMPLE 1
An earlier example calculated the net present value of two different projects: Fireside
and Logic. Using the same cash flow information, calculate the internal rate of return
for each of these projects.

Fireside

Given the following information, solve for IRR:

P/Y = 1

CF0 = -50,000

CF1 = 5,000

CF2 = 15,000

CF3 = 25,000

CF4 = 30,000

Keystrokes:

[2ND] [CLR TVM]

[2ND] [CLR WORK]

[2ND] [P/Y] 1 [ENTER]

CE/C

50,000 [+/-] [ENTER] (enters the cash flow amount for the initial investment, CF0)

[down arrow]

5,000 [ENTER] (enters the cash flow amount for year 1, C01)

[down arrow twice] (leave default F01 = 1 unchanged)

15,000 [ENTER] (enters the cash flow amount for year 2, C02)

[down arrow twice] (leave default F02 = 1 unchanged)

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25,000 [ENTER] (enters the cash flow amount for year 3, C03)

[down arrow twice] (leave default F03 = 1 unchanged)

30,000 [ENTER] (enters the cash flow amount for year 4, C04)

[down arrow twice] (leave default F04 = 1 unchanged)

[IRR]

[CPT]

Display shows 14.4351

Logic

Given the following information, solve for IRR:

P/Y = 1

CF0 = -125,000

CF1 = -5,000

CF2 = 50,000

CF3 = 60,000

CF4 = 65,000

In the earlier NPV calculation, the cost of capital was assumed to be 10%. In this
example, the IRR for the Fireside project is 14.44%, and the IRR for the Logic project
is 10.35%. In both cases, the IRR is greater than the cost of capital (10%), which
indicates that both projects are economically viable.

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Summary of formulas
Simple Interest = (Amount Invested) x (Interest Charged per Year) = Total Interest

Earned Effective Yield = ((Total Future Value – Original Investment) ÷

Original Investment) x 100

Present Value = Amount of Future Payment ÷

(1 + Nominal Rate of Interest)number of periods in years

PV = Amt ÷ (1 + i)n

Use n/12 for the number of periods in months.

Future Value = Amount of Future Payment x

(1 + Nominal Rate of Interest)number of periods in years

FV = Amt x (1 + i)n

Use n/12 for the number of periods in months.

Present Value of an Annuity = Periodic Payment Amount x

((1 – (1 + Interest Rate as Percentage)number of periods in years) ÷

Interest Rate as Percentage

PV = A x ((1 – (1 + i)-n) ÷ i)

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Future Value of an Annuity = Periodic Payment Amount x

((1 + Interest Rate as Percentage)number of periods in years – 1) ÷

Interest Rate as Percentage

FV = A x ((1 + i)n – 1) ÷ i

Real Rate of Return = (Annual Nominal Rate of Return – Annual Rate of Inflation) ÷

(1 + Annual Rate of Inflation)

Real Rate of Return = (i – infl) ÷ (1 + infl)

After-Tax Rate of Return = Nominal Interest Rate x (1 – Marginal Tax Rate)

Real After-Tax Rate of Return = (((Annual Nominal Rate of Return x

(1 – Marginal Tax Rate)) – Annual Rate of Inflation) ÷ (1 + Annual Rate of Inflation)

Real After-Tax Rate of Return = (((i x (1 – MTR)) – infl) ÷ (1 + infl)

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Personal Financial Statements

Financial planning is, by nature, forward-looking. People set financial
goals. Financial planners create a plan to meet and exceed those goals. A
good financial plan is like a road map. It provides direction for good
financial decision-making that will pay off handsomely over time. But, to
be meaningful, a map needs both a starting point and a destination. If the
financial goals of the client are the destination, how do we establish the
starting point?

Financial statements provide a financial summary for an individual or a

family unit. They give detailed information on the end results of all
financial decisions made. If the client’s financial goals are the destination,
current financial statements are the starting point. The financial planner
develops the plan that allows the client to move from the starting point to
a destination. Thus, in the context of financial planning, the information in
the financial statements is vitally important.

Personal financial reports provide a wealth of information useful to the

family, the family’s financial planner and potential creditors. While some
families are good at recordkeeping and may have the equivalent of a
statement of net worth or balance sheet readily available, in most
situations this is not the case.

An integral part of the Financial Planning Standards Council’s six-step

planning process is gathering data from the client to complete financial
statements that support the financial planning process.

How do financial planners achieve this? Every planner must have a

systematic method for gathering relevant client information. Many
professionals have developed questionnaires for clients to complete, which
ensures a methodical gathering of the required data. Meetings with the
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client, combined with materials requested from the client, can be effective
ways to collect the data needed to create financial statements.

Compiling client information into comprehensive documents gives a

planner ready access to the details required to assess the current financial
position of a client. These same financial statements can become living
documents, updated regularly as part of the monitoring and review
process — which is also essential to the six-step financial planning process.

Money management
The concept of money management is an integral part of financial
planning, because financial goals can only be established on solid ground if
there are sufficient resources to support the planned outcome. Financial
goals can be optimized by using money management strategies, and the
concept of money management ties closely to that of debt management.

Debt is inevitable at some point in most people’s lives. Without a

mortgage, purchasing a home would be unthinkable for the majority of
people. Similarly, debt is an important resource that allows individuals to
acquire assets to achieve a particular lifestyle. However, when debt
becomes overwhelming, it impacts lifestyle, either financially or
emotionally. When debt is in a controlled state, money management
becomes achievable.

Budgeting process
Personal money management involves prioritizing the cash flows in and
out of a family unit in an effort to achieve desired financial goals. This can
be accomplished through budgeting, which involves advanced planning for
a systematic allocation of net income across various expenditures.
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Income
A summary of income from all sources helps to derive the total amount of
money available to support expenditures. An examination of the timing of
cash inflows is an important part of this analysis. Make a distinction
between regular inflows of cash (e.g., monthly salary) and lump-sum
amounts received on an infrequent basis (e.g., dividend income). The
allocation of income across the monthly cash flow statement should reflect
variance in the timing of cash inflows.

Expenses
Similar to income, monthly projections should incorporate the timing of
expenses and recognize regular and lump-sum amounts. The types of
expenses will differ by family, but what’s important is to ensure that the
monthly cash flow statement captures and accounts for all expenses as
completely as possible. The budgeting exercise requires estimates, as
information is not always known in advance. However, planners should
base estimates on all realistic information available when they create a
projection. As new information arrives, planners can integrate it through a
revision process.

Net income available for saving

Once planners have entered income and expenses into a monthly
projection, they can calculate the net income available for savings by
subtracting expenses from net income. A positive result indicates funds are
available for savings, whereas a negative result indicates expenses in that
month are greater than income, resulting in a shortfall. To address a
shortfall, the family will need to access additional cash, perhaps from

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available savings or a line of credit. Keep in mind that few people

experience an equal flow of income and expenses through each month,
and the monthly picture often looks quite different from the annual picture.

Emergency fund
Everyone experiences an unexpected need for cash at some point;
however, some experience this more often than others. An emergency
fund aims to provide sufficient, readily accessible, liquid funds. In the past,
a standard rule of thumb was that a family should have an amount equal
to three to six months of living expenses set aside in a liquid asset —
money available to finance emergency needs. Expenses that should be
included in the calculation are non-discretionary expenses, including both
fixed (rent or mortgage payments, property taxes, insurance premiums,
etc.) and variable (groceries, transportation, clothing, etc.) expenses.
Discretionary expenses such as vacations, entertainment, and dining out
should not be included when calculating emergency fund requirements.

However, the increasing popularity of lines of credit has affected this

guideline. If a family has an available line of credit that is not constantly in
use or often at its upper limit, some planners feel that the amount of
money set aside for an emergency fund could be lower than three to six
months of living expenses.

Every family should still have some available funds they can access easily
(e.g., a savings account, Canada Savings Bond or modest-sized cashable
Guaranteed Investment Certificate) in a financial emergency. However, the
amount will vary depending on the family’s other easily accessible
resources.

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Personal net worth statement

A net worth statement is essentially an overview of financial health,
calculated at a single point in time. If we want to get from point A to point
B, we must first have a clear understanding of where we stand at point A.
In personal finance, this means establishing a net worth statement, also
known as a personal balance sheet.

Personal net worth is the difference between someone’s assets (what he or

she owns) and someone’s liabilities (what he or she owes). Calculating a
client’s net worth helps to determine his or her financial status at a
particular point in time. The net worth calculation is typically stated as:

Net Worth = Assets – Liabilities

Similar to a company balance sheet, a personal net worth statement is

segmented into three categories: assets, liabilities and equity.

Assets
Assets are items of monetary value purchased based on the financial
decisions of a person over time. Assets appear in the top portion of a
personal net worth statement, and may include:

 Car

 Home

 Cottage

 Marketable securities

 Cash

 Insurance policies

 Guaranteed Investment Certificates (GICs)

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 Mutual funds

 RRSP balances

 Stock portfolio

The mix of assets is governed by the personal preferences of the

individual. Some asset portfolios reflect low-risk investment preferences
using basic capital purchases, such as a home and an automobile, and
perhaps some GICs. Others reflect higher-risk preferences and include
investments with a much higher degree of risk. Nonetheless, every
individual’s asset portfolio reflects the individual’s conscious or unconscious
capital purchase preferences. The financial planner’s job is to help the
individual make more conscious, reasoned and coordinated decisions that
lead to the achievement of established financial goals.

The bottom half of the personal net worth statement has two major
sections that are similar to those on a company’s balance sheet statement:
liabilities and equity.

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Liabilities
Liabilities represent financial obligations: amounts of money that must be
paid or repaid. In other words, liabilities are amounts a person owes, and
may include:

 Credit card balances

 Department store credit card balances

 Mortgage

 Operating line of credit

 Car loan

 Other bank loans

Equity
The equity section on a personal net worth statement is often referred to
simply as “net worth.” It looks different than that of a company because
there is no share capital. In the case of either a company or an individual,
the difference between the market value of assets and the amount of
financing in place equals the owner’s equity, or net worth.

Monitoring progress by tracking net worth

Preparing a personal net worth statement is helpful – it provides an
overview of an individual’s financial health at a snapshot in time. However,
the real value emerges when you and your client perform the calculation
regularly over time. When you do this, you can start to monitor progress
towards your client’s goals.

In most cases, and for most individuals, it is sufficient to calculating net

worth annually. In addition to helping monitor progress towards goals, a
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periodic net worth calculation can also highlight areas for improvement.
Let’s look at an example of how an individual’s net worth can change from
one year to the next.

EXAMPLE 1
In Year 1, Tony owns a house worth $380,000, with a $220,000 mortgage. He has a
car worth $19,000 that he owns outright. Tony has a balance of $2,300 in his savings
account, and $950 in his chequing account. His line of credit has a limit of $30,000
and a balance of $8,500. Tony has a MasterCard with a $5,000 limit and a balance of
$0, and a Visa with a limit of $7,500 and a balance of $1,300. The book value of
Tony’s RRSP is $23,500, and its current market value is $27,000. He also has $5,000
in a non-registered GIC. Calculate Tony’s net worth.

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Tony’s Net Worth Statement (Year 1)

Tony Smith
($)

Assets

Liquid Assets

Chequing Accounts 950

Savings Accounts 2,300

GICs 5,000

Property Assets

Principal Residence 380,000

Vehicle 19,000

Long-term Assets

RRSPs/RRIFs 27,000

TOTAL ASSETS (A) 434,250

Liabilities

Mortgage 220,000

Personal Lines of Credit 8,500

Credit Cards 1,300

TOTAL LIABILITIES (B) 229,800

NET WORTH (A – B) 204,450

Now let’s assume that one year has passed and Tony recalculates his net worth.
Some liabilities have increased and some assets have decreased, and yet Tony’s net
worth still shows an overall increase.

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Tony’s Net Worth Statement (Year 2)

Tony Smith
($)

Assets

Liquid Assets

Chequing Accounts 850

Savings Accounts 1,750

GICs 5,200

Property Assets

Principal Residence 398,000

Vehicle 17,000

Long-term Assets

RRSPs/RRIFs 28,500

TOTAL ASSETS (A) 451,300

Liabilities

Mortgage 210,000

Personal Lines of Credit 8,800

Credit Cards 1,900

TOTAL LIABILITIES (B) 220,700

NET WORTH (A – B) 230,600

Tony’s net worth increased from $204,450 in Year 1 to $230,600 in Year 2. In order
words, Tony’s net worth increased by $26,150.

EXAMPLE 2
A personal net worth statement prepared for Sharon and Max West shows that,
together, the Wests have accumulated assets of $566,600, with $244,400 in liabilities.
Since net worth equals assets ($566,600) minus liabilities ($244,400), the Wests have
a net worth of $322,200 — the number that appears at the bottom of the net worth
statement.

On the Wests’ personal net worth statement, the assets are divided into categories:
non-registered, registered, other and personal. While this categorization is not
essential, it makes the net worth statement easier to read and update as
circumstances change.

In this example, information is presented at a family unit level, as well as individually.

Separating details of the family unit into individual information for Sharon and Max is
important because, in the planning process, ownership of the assets can have a
significant impact on financial planning decisions.

Remember that the information on a net worth statement is a snapshot of a moment

in time. In this case, the planner prepared the net worth statement based on
information about the West family as of December 31, 2019.

Sharon’s and Max’s Net Worth Statement

Ms. Sharon West & Mr. Max West

Statement of Net Worth
as of December 31, 2019

Sharon Max Total

($) ($) ($)

Assets

Non-registered Assets

Cash and Equivalents 8,500 4,000 12,500

GICs 12,000 12,000

Bonds

Equities 15,500 8,000 23,500

Mutual Funds 2,000 2,000

Stock Options (Vested)

Real Estate

TOTAL NON-REGISTERED ASSETS 26,000 24,000 50,000

Registered Assets

RESP 3,300 3,300

RPP 44,000 44,000

RRSP 28,000 12,000 40,000

TOTAL REGISTERED ASSETS 31,300 56,000 87,300

Other Assets

Business Equity

Cash Surrender Value (CSV) of Life

8,000 8,000
Insurance

TOTAL OTHER ASSETS 8,000 8,000

Personal Assets

Home/Residence 265,000 265,000

Personal Effects 5,500 7,800 13,300

Cottage/Recreational Property 125,000 125,000

Vehicles 6,000 10,000 16,000

Other 1,000 1,000 2,000

TOTAL PERSONAL ASSETS 137,500 283,800 421,300

TOTAL ASSETS 194,800 371,800 566,600

Liabilities

Credit Cards/Consumer Debt 2,300 7,100 9,400

Loan – Vehicles 9,000 9,000

Business Loan

Investment Loan 2,000 4,000 6,000

Mortgage 220,000 220,000

TOTAL LIABILITIES 4,300 240,100 244,400

NET WORTH 190,500 131,700 322,200

Note: Assets at market value could be subject to income tax consequences not
accounted for in this net worth statement.

Personal cash flow statement

Cash flow
Unlike a net worth statement, which is an overview of financial health
calculated at a single point in time, a cash flow statement is a detailed
description of cash inflows and outflows over a stated period.

Bank and credit card statements sometimes surprise us when we see the
amount of money we’ve spent. That’s because, without proper accounting
or recordkeeping, it’s easy to lose track of expenses. The most effective
way to address this problem is to construct a personal cash flow
statement.

A personal cash flow statement is a detailed measure of cash inflows and

outflows over a period of time – typically, one month.

Cash inflows may include:

 Salary

 Interest and dividends from investment and savings accounts

 Rental income

 Royalties

Cash outflows, which generally represent personal expenses, may include:

 Groceries

 Insurance (home, auto, life, etc.)

 Mortgage or rent

 Gas for automobile

 Utilities (electricity, water, heat, etc.)

 Cable, internet, phone

 Clothing

 Fitness (gym membership, yoga, etc.)

 Personal care (haircut, etc.)

 Vacations

 Entertainment (movies, restaurants, etc.)

 Alcohol and/or cigarettes

It is a best practice to separate cash outflows into discretionary and non-

discretionary expenses, which can also be described as wants and needs.
Expenses such as mortgage or rent, gas and utilities are generally
classified as non-discretionary expenses, or needs. On the other hand,
expenses such as vacations and entertainment fall under discretionary
expenses, or wants.

Monitoring progress by tracking net cash flow

A detailed description of cash inflows and outflows makes it possible to
calculate an overall cash flow, or net cash flow, which is simply the
difference between cash inflows and outflows:

Net Cash Flow = Cash Inflow – Cash Outflow

A positive net cash flow results from having more cash inflows than
outflows — that is, making more than you spend. If cash outflows exceed
inflows, net cash flow is negative.

As with net worth statements, the true value in preparing a cash flow
statement emerges when you perform the calculation at regular intervals
over time. This can highlight areas of excess spending and areas for
improvement, as well as identifying times when there are cash surpluses,
which can be used for investing or other purposes.
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EXAMPLE 1
Jenna works as an associate advisor at an investment management firm, where she
has an after-tax annual income of $48,000. Jenna recently purchased a condo, and
her mortgage is $230,000. Her monthly mortgage payment is $1,100, and the monthly
condo fee is $230. Every month, she spends about $120 for her cable and internet
package, $90 for electricity and $85 for her cell phone. Jenna spends roughly $100
per week on groceries, and another $100 per week at restaurants. Her gym
membership costs $55 per month, and her yoga classes cost $75 per month. Jenna
also recently purchased a new car, and she has a car loan. Her car payment is $290
per month, and she spends an additional $150 per month on gas and $85 per month
for auto insurance. Construct a cash flow statement for Jenna.

Jenna’s Cash Flow Statement

Amount
($)

Cash Inflows

Income 4,000

TOTAL CASH INFLOWS 4,000

Cash Outflows

Mortgage 1,100

Condo Fee 230

Cable/Internet 120

Electricity 90

Phone 85

Groceries 433.33

Dining Out/Restaurants 433.33

Car Payment 290

Car Insurance 85

Gas for Car 150

Gym Membership 55

Yoga Classes 75

TOTAL CASH OUTFLOWS 3,146.67

NET CASH FLOW 853.33

EXAMPLE 2
A sample cash flow statement for Sharon and Max West demonstrates that this type
of statement normally begins with all income items grouped together, followed by all
expenses. In this case, money allocated to registered savings is in a separate
category. The difference between inflows (income items) and outflows (expenses and
savings) is labelled unallocated cash flow. Similar to net worth statements, cash flow
statements normally show information at a family unit level, as well as individually. In
contrast to businesses, individuals are less concerned with formal accrual accounting
and depreciation treatment.

The Wests had income of $107,200 during 2019, from a variety of sources that
included salary for both Max and Sharon, self-employment earnings for Sharon, and
dividend and interest income for Max.

Expenses for the West family totalled $76,800, including outflows for mortgage
payments, property taxes, expenses associated with the family automobiles, and a
range of other expenses.

Sharon’s and Max’s Cash Flow Statement

Ms. Sharon West & Mr. Max West

Cash Flow Statement
for the year ended December 31, 2019

Max Total
Sharon ($)
($) ($)

Income

Salary 54,200 98,500 152,700

Self-employment Earnings 12,000 12,000

Dividend Income 1,200 1,200

Interest Income 500 500

Other/Miscellaneous 800 800

(Less) Source Deductions: Income Tax (17,000) (35,000) (52,000)

(Less) Source Deductions: CPP/QPP (1,500) (2,800) (4,300)

(Less) Source Deductions: EI (1,200) (2,500) (3,700)

TOTAL NET INCOME 47,300 59,900 107,200

Expenses

Mortgage 28,000 28,000

Property Taxes 4,000 4,000

Utilities 1,000 1,000

Food 4,000 4,000

Gym Membership 1,200 1,200

Vehicle — Loan/Lease 4,800 4,800

Vehicle — Gasoline and Repairs 1,500 3,000 4,500

Insurance — Life 1,200 1,500 2,700

Insurance — General 800 1,500 2,300

Insurance — Vehicle 1,400 2,200 3,600

Personal 2,500 3,000 5,500

Entertainment 900 1,000 1,900

Vacations 4,000 4,000

Consumer Debt 2,500 2,500 5,000

Donations 500 500 1,000

Recreational Property Expenses 2,300 2,300

Other/Miscellaneous 500 500 1,000

TOTAL EXPENSES 18,000 58,800 76,800

Net Available for Savings 29,300 1,100 30,400

Non-registered Savings 2,000 4,000 6,000

RRSP Contributions 7,000 12,000 19,000

TOTAL SAVINGS AND

9,000 16,000 25,000
REINVESTMENTS

UNALLOCATED CASH FLOW 20,300 -14,900 5,400

Bringing it all together: the relationship between

net worth and cash flow
Although it may appear that the net worth statement and the cash flow
statement are two separate financial documents, the statements are
related. Positive net cash flow (that is, when income exceeds expenses)
should result in an increase of overall net worth, as excess cash flow
results in a cash surplus, and subsequently in an increase in net worth. On
the other hand, negative net cash flow (that is, when expenses exceed
income) typically results in a decrease in personal net worth.

Personal savings rate

An individual’s personal savings rate (PSR) is defined as the ratio of
personal savings to personal disposable income. In other words, the PSR is
the percentage of net income an individual saves.

Note that the calculation for the PSR uses net income, not gross income.
That is, it uses the amount of income actually received, after income tax
deductions, Canada Pension Plan (CPP) and Employment Insurance (EI)
deductions, Registered Pension Plan (RPP) contributions, union dues and
any other deductions from gross pay.

EXAMPLE
Corinne has a gross income of $60,000 per year, or $5,000 per month. After taxes
and deductions, her net monthly pay is $3,450. Corinne saves $100 per month to her
Tax-Free Savings Account (TFSA). Calculate Corinne’s personal savings rate.

PSR = $100 ÷ $3,450 = 0.347826

Corinne’s personal savings rate is approximately 3.48%.

Corporate Financial Statements

Role of corporate financial statements

Corporate financial statements provide a financial summary of a company.
They are historical, or backward-looking, and give detailed information on
the result of all financial decisions a company has made. This section of
the module introduces basic corporate financial statements, and then
discusses financial ratios used to analyze financial performance.

Who uses financial information?

Corporate financial statements are similar to a financial scorecard.
Generally, anyone interested in the financial performance of a company
will want to review the appropriate financial statements. Lenders use
financial statements to assess creditworthiness. Investors use financial
statements to assess investment potential. Owners use financial
statements to measure managerial performance. Regulators use financial
statements to help evaluate legal compliance in different areas. Tax
authorities consult financial statements to help determine tax obligations.

These stakeholders, most of whom are non-insiders, are all reviewing

financial statements prepared to provide financial information about a
corporation. This area of accounting is called financial accounting. Another
area of accounting, called management accounting or cost accounting,
relates to the use of internal accounting information by managers to plan,
direct and control activities within an organization. This section of the
module focuses on financial statement analysis based on financial
accounting.

Importance of standardization
For financial statements to be useful, they have to be meaningful.
Safeguarding the meaningfulness of financial reports is more complicated
than one might expect. The desired goal is that readers should be able to
determine the financial position of two companies merely by comparing
their financial statements. However, comparisons are meaningless if
Company A believes certain financial metrics are important and has strong
feelings about the way those metrics are calculated, while Company B uses
different metrics or calculates the same metrics differently. For this
reason, standardization is a very important principle in financial accounting
and reporting.

Personal and corporate financial statements differ in their level of

formality. For corporate statements, standardization of accounting
principles, statement selection, statement form and accounting provisions
is critical to make comparisons valid. At the same time, accounting
standards are constantly evolving. Luca Pacioli, an Italian monk and friend
of Leonardo da Vinci, first described double-entry bookkeeping in 1494.
Refinements in accounting standards have been developing ever since. In
Canada, all corporate financial statements should be presented according
to the Chartered Professional Accountants (CPA) Handbook standards.

Accounting concepts
Readers of corporate financial statements expect them to be prepared
according to well-established accounting principles. Without going into
great detail, an example of these principles is the use of accrual accounting
instead of simple cash accounting. Another example is customarily
reporting assets at historical costs rather than at fair market value, and

closely matching expenses with revenue. Although many take these and
other similar principles for granted, they form the cornerstone of
standardized reporting. These principles are important to recognize
because, in spite of their contribution to standardization, they also
contribute to the very real limitations of financial analysis — a topic we will
explore in the discussion of financial ratios.

Statement selection
Typically, all the financial information of a company is compiled into three
financial statements that reflect the company’s financial position:

 Balance sheet

 Income statement

 Cash flow statement

The nature of these statements stays the same for individuals, but in
practice personal financial statements are usually called:

 Cash flow statement

 Net worth statement (analogous to the balance sheet)

As already mentioned, individuals are less concerned with formal accrual

accounting and depreciation treatment, which means that not all of the
rules normally followed when completing corporate financial statements
are relevant for personal financial statements.

Statement form
Careful observation of multiple financial statements reveals another
important element of standardization: the balance sheets and income
statements of different companies, even in different industries, have many
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Module 2: Financial Analysis

of the same categories. On the balance sheet, for example, every company
has categories for cash, marketable securities, accounts receivable, capital
or fixed assets, and more. Furthermore, not only will each company have
an accounts receivable amount, but readers can have confidence it was
calculated according to similar accounting principles.

Standardization of categories is important to financial analysis because it

allows analysts and outside observers to combine and compare categories
in different ways to assess business performance. This combining and
comparing process is called financial ratio analysis. Financial analysts
sometimes calculate dozens of different ratios as they attempt to analyze
the business performance of a firm. Later in this section, we’ll describe
how to calculate some of the more popular ratios, and look at how
different financial stakeholders interpret them.

Accounting principles
Over the years, accountants have developed hundreds of accounting rules
to create meaningful and standardized corporate financial statements. The
two methods of accounting used in Canada are Generally Accepted
Accounting Principles (GAAP) and International Financial Reporting
Standards (IFRS). These provisions, in combination with the broader
accounting principles described above, contain the guidelines accountants
use to measure, process and communicate financial information. They help
accountants prepare financial statements that are understandable,
comparable, relevant and consistent.

According to the Canada Revenue Agency (CRA), the Canadian Accounting

Standards Board (AcSB) has adopted the mandatory use of IFRS by all
Publicly Accountable Enterprises (PAEs). IFRS replaces GAAP as the

acceptable set of accounting standards for PAEs. While the CRA does not
specify that financial statements must be prepared following any particular
type of accounting principles or standards, the AcSB requires PAEs to use
IFRS in the preparation of all interim and annual financial statements.

While some private companies still use GAAP, most also have the option to
adopt IFRS for financial statement preparation.

Note that neither IFRS nor GAAP apply to personal financial statements.

The next section looks at each corporate financial statement in detail,

starting with the balance sheet.

Balance sheet (statement of financial position)

The balance sheet lists three items as at a specific date: assets, liabilities
and owner’s equity. Assets are the items the company or individual owns,
resulting from investment decisions made over time. Assets include cash,
marketable securities, accounts receivable and vehicles. Liabilities are
items the company or individual owes to other people. Liabilities include
accounts payable, mortgages payable and bank loans. Owner’s equity
represents the historical value of the owner’s investment, or simply the
difference between what a company or individual owns (assets) and owes
(liabilities).

By definition on a balance sheet, the accounting equation is:

Assets = Liabilities + Owner’s Equity

Note that owner’s equity may also be referred to as net worth or

shareholder’s equity.

We’ve included examples of balance sheets in Appendix 1 (Apex

Manufacturing) and Appendix 4 (Compass Retail).

From a financial analysis perspective, the balance sheet reflects the status
of a company in terms of three major activities: investing, financing and
operating.

If assets reflect “what” the organization spent its money on, then liabilities
and owner’s equity reflect “where” the organization got the money to
acquire the assets. This reflects the fact that the investment made in
assets must be financed either by borrowing the money (liability section)
or using the owner’s own money (owner’s equity section). Linking
investments with financing decisions makes it evident why assets must
equal liabilities and owner’s equity, or why a balance sheet must balance:
the investments are exactly offset by the financing used to acquire them.

The owner’s equity section of a balance sheet includes share capital (the
money invested by owners in the business) and retained earnings (the
cumulative money earned by the company over the years that has not yet
been distributed to shareholders).

A statement of changes in equity summarizes the changes in owner’s

equity over a given period. It reconciles owner’s equity with respect to the
beginning and ending balances.1 Besides capturing information related to
investing and financing decisions, the balance sheet also captures year-to-
year changes in operating performance through changes in the retained
earnings (RE) account of the firm. The integration between the balance
sheet and the income statement works this way:

RE (End of Year) = RE (Beginning of Year) + Net Income – Dividends

1
Hughes, John, and Fisher, Alex. “Reading Financial Statements: What Do I Need to
Know?” Chartered Professional Accountants Canada, www.cpacanada.ca/en/business-and-
accounting-resources/financial-and-non-financial-reporting/international-financial-
reporting-standards-ifrs/publications/reading-financial-statements-what-do-i-need-to-
know-faq (accessed May 2, 2019)
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Module 2: Financial Analysis

The difference in the RE account from one year to the next year is the net
income of the firm minus any dividends paid. The RE account, especially in
firms that pay no dividends, is a running total of the cumulative total
profitability of the firm.

Intuitively, it’s clear that one must calculate a balance sheet as of one
specific calendar date. While it will balance on any day it is calculated, the
specific accounts may vary considerably from one day to the next. It is,
therefore, appropriate to talk about balance sheet items and the financial
ratios derived from them as of the one specific calendar date for which
they were prepared — usually, the end of an accounting period.

EXAMPLE: APEX MANUFACTURING

The Apex balance sheet in Appendix 1 shows $1,345,080 in total assets and
$616,920 in total liabilities as of December 31, 2019. The difference between the
assets and the liabilities equals the owner’s equity ($1,345,080 – $616,920 =
$728,160).

The balance sheet, in this case, captures information at two points in time: December
31, 2018, and December 31, 2019. This is helpful for comparison purposes. Apex’s
total assets increased by $296,880 ($1,345,080 – $1,048,200) between December
31, 2018, and December 31, 2019.

The retained earnings at December 31, 2018, equaled $319,800, a number that
represents the cumulative amount Apex earned over the years that it had not yet
distributed to shareholders. Shareholders had invested a total of $132,000 in Apex
($12,000 in common shares + $120,000 in preferred shares).

The retained earnings of $596,160 at December 31, 2019, were $276,360 higher than
at December 31, 2018 ($596,160 – $319,800 = $276,360).

Notice that the ending retained earnings balance of $596,160 comprises 2018’s end-
of-year retained earnings of $319,800 plus 2019’s net income of $288,360 minus the
$12,000 of dividends paid.

EXAMPLE: COMPASS RETAIL

Compass’s assets totaled $915,960 as of December 31, 2019, which was $199,080
higher than the company’s total assets one year earlier. The owner’s equity at the end
of 2019 was $563,640, comprising $120,000 in share capital and $443,640 in retained
earnings. Liabilities increased by $40,440 to a total of $352,320 at the end of 2019. At
December 31, 2019, Compass’s assets equal liabilities plus owner’s equity ($352,320
+ $563,640 = $915,960).

Income statement
The income statement summarizes revenue and expenses and calculates
the net income or net loss of a company or individual for a period of time,
such as a year or a month. The income statement may also be called a
statement of earnings or profit and loss statement.

A company’s net income or net loss is its sales revenue minus its
expenses. Sales revenue represents the value of the goods or services the
company has sold to its customers. Expenses represent the costs the
company incurred to generate the sales revenue. Appendix 2 shows Apex
Manufacturing’s income statement for the year ended December 31, 2019.

EXAMPLE: APEX MANUFACTURING

In 2019, Apex’s sales were $1,705,680, representing an increase of 13.3% over the
previous year’s sales of $1,504,800 ((1,705,680 – 1,504,800) ÷ 1,504,800 = 13.3%).

The cost of goods sold was $567,240. Subtracted from sales of $1,705,680, that left
Apex with a gross profit of $1,138,440.

While sales increased 13.3% from one year to the next, net income increased by only
1.6% ((288,360 – 283,800) ÷ 283,800 = 1.6%).

The income statement for a company usually appears straightforward, but

some issues must be resolved through specific accounting policies. In fact,
each account on the income statement — whether it’s revenue,
depreciation, tax or another account — generally requires IFRS or GAAP
policies to ensure standardized financial reporting.

Preparing an income statement generates the statement of comprehensive

income “earnings.” It summarizes a company’s net assets and includes net
income and other comprehensive incomes. This statement reveals the
financial performance of the company for a specified period.2

As a simple example of the issues that may arise in income statements,

Apex states that its revenue for 2019 is $1,705,680. To a non-accountant,
revenue represents total goods or services sold. However, different
companies might have different opinions on when a sale takes place. One
may record a sale when it receives the order. Another may record a sale
when it delivers the product or service. Yet another may wait until the
customer has paid for the product or service. It would be difficult to
compare these three companies. Fortunately, IFRS and GAAP have well-

developed principles that specify when a company can recognize revenue

for the purpose of financial reporting.

Each account on the income statement has its own set of issues to resolve
using carefully thought-out accounting policies.

Cash flow statement

The last major financial statement is the cash flow statement (CFS).
Companies routinely prepare this statement alongside the balance sheet
and the income statement; in fact, it is tightly integrated with both. It is
rarely prepared for individuals.

The goal of the cash flow statement is to track and analyze the changes
that occur in a single balance sheet account — the cash account — from
one period to the next. Appendix 3 shows Apex’s cash flow statement for
the year ending December 31, 2019, with a comparison for the year
ending December 31, 2018.

The cash flow statement reviews the cash impact of the three major
activities of the firm: investing, financing and operating. Conceptually,
think about the statement as changes in cash caused by:

Cash gain (loss) from operating activities +/(–)

Cash gain (loss) from investing activities +/(–)

Cash gain (loss) from financing activities +/(–)

Dividends received or paid

= Net change in cash during the year

+ Cash at the beginning of the year

= Cash at the end of the year

Note that the cash at the end of the year should be equal to the cash on
the balance sheet.

Using information from Appendix 3, Table 4 shows the conceptual analysis

for the 2019 year.

Table 4: Example of Cash Flow Analysis

(+) Cash gain from operating activities $230,280

(–) Cash loss from investing activities $162,960

(–) Cash loss from financing activities $6,120

(–) Dividends paid $12,000

(=) Net change in cash during the year $49,200

(+) Cash at the beginning of the year1 $92,760

(=) Cash at the end of the year2 $141,960

Notes:
1
From cash account on 2018 balance sheet.
2
Balances with cash account on 2019 balance sheet.

This statement focuses exclusively on cash flow. Therefore, it ignores

accrual accounting and other allocation decisions that show up in the
income statement but have no cash flow associated with them. The cash
flow statement, in essence, compares the cash on hand at the beginning of
the year with the cash on hand at the end of the year. It also provides
information about how operating, investing and financing activities
contributed to increases or decreases in the company’s cash position
throughout the year. Like the income statement, the cash flow statement
covers a period — typically, the accounting period.

Although it is rare to prepare a cash flow statement for an individual,

understanding cash flow is still a critical part of the analysis any financial
planner undertakes when working with a client. Where individuals and
companies differ most is in the area of depreciation and accrual
accounting. Individuals typically use neither. The result is that the cash
flow statement for an individual, if it were prepared, would be calculated
entirely on a cash basis.

One last detail: the cash flow statement looks at a company’s cash
changes during the period on a comprehensive basis, factoring in the
impact of operations, investments and financing on the ending cash
position. However, readers of financial statements are often interested in
understanding how much cash the company generates purely from
operations, or the “cash earnings” of a business. They want to know how
much cash a business generates from operations before including interest,
taxes and non-cash charges. This calculation is referred to as EBITDA
(earnings before interest, taxes, depreciation and amortization), and it is
becoming increasingly popular among financial analysts and the financial
press as a metric for comparing different companies on a cash flow basis.

Statement of management discussion and analysis

Management discussion and analysis (MD&A) appears in a company’s
annual report and is one of the most closely reviewed sections. It is the
place where a company’s high-ranking officers and key executives discuss,
among other things, the company’s past period performance and projected
future results.

The MD&A provides an overview of issues, opportunities, challenges, risks

and key performance indicators. Further, it offers explanations for

developments such as changes in company revenue, the cost of goods

sold, assets and liabilities.

In particular, the MD&A offers:

 A narrative explanation of the financial statements, as seen from the

perspective of the company’s executive management team

 An opportunity for management to further explain the numerical

disclosures in the financial statements, and the proper context
within which to review the statements

 An opportunity for management to discuss the quality and possible

variability of the company’s earnings and cash flows

As such, the MD&A is an important source of information for analysts,

potential investors and anyone else who wants to closely review a
company’s financial fundamentals and management performance.

Additional considerations
So that a company’s financial statements are reliable and meaningful, they
are compiled, reviewed and audited according to specific standards.

Compiled
Compiling does not provide any assurance with respect to the financial
statements. When engaged to compile financial statements, the
practitioner receives information from the client and compiles it in the form
of financial statements. The practitioner does not perform any other
procedures on the financial statements. Furthermore, the form of the
financial statements does not necessarily have to comply with a financial
reporting framework.

Reviewed
Reviewing provides some assurance, but less than auditing. When engaged
to review financial statements, the practitioner provides limited assurance
primarily by performing inquiry and analytical procedures, unless he or she
becomes aware of a matter that may indicate the financial statements
have material misstatements. When this happens, the practitioner designs
and performs additional procedures based on the situation. Reviewed
financial statements are prepared in accordance with a financial reporting
framework (e.g., IFRS or Canadian Accounting Standards for Private
Enterprises (ASPE)), and the practitioner applies the concept of materiality
when evaluating misstatements and forming a conclusion.

Audited
Audited financial statements provide readers with the highest level of
assurance. However, this assurance is not absolute. The auditor’s
conclusion indicates whether the financial statements are prepared
materially in accordance with the respective financial reporting framework
(e.g., IFRS or ASPE). When performing their work, auditors obtain
reasonable assurance that the financial statements are free from material
misstatement, whether due to fraud or error. As in a review, auditors
apply the concept of materiality when planning and executing their audit to
ensure that any misstatements identified, individually or in aggregate, are
not material. The materiality the auditor applies depends on the needs of
those who will use the financial statements and is subject to the auditor’s
judgement.

Accompanying reports
One of the following three reports may accompany an organization’s
financial statements.

Notice to reader report

A notice to reader report accompanies compiled financial statements. The
practitioner clearly indicates that this type of engagement does not provide
any level of assurance. To avoid any misinterpretation, the report specifies
that public accountants have compiled the financial statements based on
information prepared by management and cautions users that the financial
statements may not be appropriate for their needs.

Review engagement report

A review engagement report accompanies reviewed financial statements.
It indicates that nothing has come to the attention of the practitioner that
causes him or her to believe the financial statements do not present
information fairly, in all material respects, in accordance with the indicated
financial reporting framework. It also includes information on
management’s responsibility for the financial statements, the practitioner’s
responsibility and the conclusion. As well, the practitioner may include
additional information that must be communicated to users. If the
practitioner is unable to form a conclusion, the report will indicate this and
explain why.

Auditor’s report
An auditor’s report accompanies audited financial statements. It
communicates the auditor’s conclusion, providing the auditor’s opinion as
to whether the financial statements are presented in all material respects
in accordance with the applicable financial reporting framework (e.g., IFRS
or ASPE). If the auditor is unable to obtain sufficient appropriate evidence
to form an opinion, he or she will provide a modified opinion rather than an
unmodified opinion.

The auditor’s report includes both the auditor’s opinion and the basis for
that opinion. Additionally, it includes information on the entity’s going
concern (see next section), management’s and the auditor’s
responsibilities with respect to the financial statements, and any other key
audit matters or other information the auditor determines must be
communicated.

Business valuation
Many different methods and techniques help to determine how much a
company is worth. Here are some of the most common.

Going concern
The going concern method determines the value of a business based on
the stream of cash flow it is capable of producing in the future. A business
that can generate higher cash flows in the future is worth more today. A
key characteristic of this approach is that it uses past revenues to
extrapolate and predict future revenues.

Liquidation
Analysts often use the liquidation approach for businesses facing solvency
issues and being sold to cover outstanding debts to creditors. This method
assigns values to all assets, such as land, facilities, inventory and accounts
receivable. Note that in times of duress and hardship, assets often sell for
less than their fair market value. In addition, the liquidation value does not
include intangible assets, such as goodwill.

Discounted future earnings

Also known as discounted cash flow, this method is often considered the
most accurate way to determine a business’s valuation. A firm’s forecasted
future earnings are discounted (reduced) back to today (the present) using
an appropriate discount rate. Discounting accounts for the fact that, since
future cash flows are not available in the present, an investor could
generate a return by investing elsewhere.

Market value
For publicly traded companies, the market generally refers to market value
— also known as market capitalization — calculated by multiplying the
current share price by the number of shares outstanding. For example, if a
firm has a share price of $5.25 and two million shares outstanding, the
market value of the firm is $5.25 x 2,000,000 = $10,500,000. This means
the company has a market value of $10.5 million.

Ratio Analysis for Investment Planning

Before investing in a company, potential investors are interested in
assessing the business performance of the company. While there are a
number of different ways to assess business performance, one valuable
strategy is to look at the relationship between different items on the
balance sheet and income statement. These relationships are called
financial ratios.

Financial ratios
Financial statements capture a wide range of financial information about a
company. However, it is difficult for analysts to draw conclusions about a
company’s performance based on a specific line on a statement, unless
they can relate that number to other reported numbers in a meaningful
way. This is why analysts use financial ratios when examining a company’s
financial statements.

For example, assume that a company reports a net income of $100,000 for
its fiscal year. Is that a good or bad result? Has management used its
assets effectively? How well has the company managed pricing and
merchandising? By itself, the $100,000 reported net income does not tell
an outside observer very much about the performance of the company.

However, a comparison of net income to sales makes it possible to

calculate the net profit margin. Then it’s easy to see whether the current
profit margin is higher or lower than the one reported last year. In
addition, analysts can compare this company’s profit margin to the profit
margins of other companies in the same industry. Through these

comparisons, analysts can begin to assess the overall business

performance of a company.

Generally, we group financial ratios into categories that focus on different

aspects of business performance. Note that activity/operations ratios and
value ratios are beyond the scope of this module. We will focus on financial
ratios in the following categories:

 Liquidity

 Leverage/debt

 Profitability

Throughout this section, the financial ratio examples use information from
the financial statements for two companies: Apex Manufacturing and
Compass Retail. We will point out distinctions that affect the ratios for
manufacturing firms and retail firms. To highlight differences in the ratios,
the financial statements assume that both companies have exactly the
same revenue in each of the two years. Find complete sets of financial
statements for Apex Manufacturing and Compass Retail in the Appendices:

 Appendix 1: Apex Balance Sheet

 Appendix 2: Apex Income Statement & Statement of Retained Earnings

 Appendix 3: Apex Cash Flow Statement

 Appendix 4: Compass Balance Sheet

 Appendix 5: Compass Income Statement & Statement of Retained

Earnings

 Appendix 6: Compass Cash Flow Statement

Liquidity ratios
Liquidity ratios measure a company’s ability to pay its current debts or
obligations. Companies are considered to have good liquidity, or to be
strong in terms of solvency, when they have sufficient cash or near-cash
assets on hand to meet their short-term financial liabilities. Creditors have
a special interest in liquidity ratios, but they are useful to anyone with an
interest in determining the overall liquidity of a firm.

Current ratio
The most widely used liquidity ratio is the current ratio, calculated as:

Current Ratio = Current Assets ÷ Current Liabilities

The major asset categories in the asset portion of the current ratio are:

 Cash

 Cash equivalent or near-cash marketable securities

 Accounts receivable

 Inventory

The current ratio’s rationale is that all of these assets will be converted
into cash (or already are cash) during the normal business cycle.
Therefore, they give an indication of how much cash a company could
generate, if necessary, in the short term.

It is difficult to determine an ideal current ratio that applies to every

company in every industry. Factors such as the stability of cash flow and
liquidity of inventory impact the appropriateness of the current ratio for
any given situation. However, many financial analysts consider two to be a
suitable current ratio, subject to the anomalies of a given company or

industry. With a current ratio of two, a company could liquidate 50% of its
current assets and still meet its short-term financial obligations.

Analysts consider companies with a current ratio of less than one to be

technically insolvent. It is not unusual to come across audit reports for
companies on the junior financial exchanges (TSX Venture Exchange in
Canada and NASDAQ in the United States) that include a “going concern”
qualification based on a current ratio that is under one.

EXAMPLE: APEX MANUFACTURING

Using information from the balance sheet, the current ratio calculation for Apex is:

Current Ratio = Current Assets ÷ Current Liabilities

2018 Current Ratio = $541,680 ÷ $436,560 = 1.24

2019 Current Ratio = $810,360 ÷ $471,360 = 1.72

The current ratio improved from 2018 to 2019, but is still below an “ideal” of two. By
themselves, these ratios would not be cause for concern.

EXAMPLE: COMPASS RETAIL

Using information from the balance sheet, the current ratio calculation for Compass is:

2018 Current Ratio = $589,680 ÷ $311,880 = 1.89

2019 Current Ratio = $773,280 ÷ $352,320 = 2.19

In both years, Compass has a stronger current ratio than Apex. It’s tempting to
conclude that Compass is more solvent and has stronger liquidity than Apex.
However, as a retailer, most of Compass’s current assets are tied up in inventory.
This underscores why it is important to avoid jumping to conclusions about liquidity
without first looking at supporting ratios, such as the quick ratio.

Quick ratio
Analysts calculate the quick ratio, often called the acid test, to determine a
company’s ability to meet its current financial liabilities using current
assets other than inventory. It is a more conservative current ratio in that
it recognizes an outsider may find it difficult to gauge the liquidity of
inventory on hand. Instead of making assumptions about the saleability of
inventory that may or may not reflect reality, the quick ratio simply
ignores the inventory number.

The quick ratio calculation is:

Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities

Because it removes inventory from the calculation, the quick ratio will be
smaller than the current ratio. For a company that holds inventory, a quick
ratio is considered strong if it is greater than one.

Looking at the current ratio or quick ratio in isolation may indicate that a
company has serious problems. However, analysts generally also take into
consideration these ratios for the same company over multiple periods, or
these ratios for competitors in the same industry during the same period,
to assess the financial health of a company.

EXAMPLE: APEX MANUFACTURING

Using information from the balance sheet, the quick ratio calculation for Apex is:

2018 Quick Ratio = ($541,680 – $163,680) ÷ $436,560 = 0.87

2019 Quick Ratio = ($810,360 – $207,000) ÷ $471,360 = 1.28

Apex’s quick ratio is quite strong in both years. For example, in 2019 the value and
saleability of Apex’s inventory would not be a serious factor in determining liquidity
because of the size of the safety margin (quick ratio > 1).

EXAMPLE: COMPASS RETAIL

Compass’s current ratio was better than Apex’s. How does its quick ratio compare?
The quick ratio calculation for Compass is:

2018 Quick Ratio = ($589,680 – $436,800) ÷ $311,880 = 0.49

2019 Quick Ratio = ($773,280 – $612,000) ÷ $352,320 = 0.46

Compass’s quick ratio is much lower than Apex’s. This is typical in the financial
reports of retailers that sell their products primarily for cash; however, a quick ratio of
less than 0.5 suggests it would be useful to examine an activity ratio to help determine
the quality and saleability of the inventory. Compass clearly has significant resources
tied up in inventory. Whether the investment is too much, or whether it acquired
products that will not sell, can become clearer by calculating additional ratios.

Working capital
Working capital is necessary for all companies that must either extend
credit to their customers or finance the direct inputs required to build or
buy the products they sell. In contrast, a company that bills out service
personnel on an hourly basis, and gets paid in cash immediately, would
have very low working capital requirements.

Although technically not a liquidity ratio, working capital is useful in

determining the liquidity of a company. The amount of working capital
calculation is:

Working Capital = Current Assets – Current Liabilities

The amount of working capital required for a given business can vary
greatly depending on seasonal factors, industry specifics and the stage of
the business cycle. One thing that companies sometimes overlook is the
need to increase working capital as the company grows.

EXAMPLE: APEX MANUFACTURING

The working capital calculation for Apex is:

2018 Working Capital = $541,680 – $436,560 = $105,120

2019 Working Capital = $810,360 – $471,360 = $339,000

EXAMPLE: COMPASS RETAIL

The working capital calculation for Compass is:

2018 Working Capital = $589,680 – $311,880 = $277,800

2019 Working Capital = $773,280 – $352,320 = $420,960

Securing adequate working capital is an essential element in managing any

organization. Growing organizations need to continually increase their
working capital. Like most ratios, working capital needs to be evaluated in
conjunction with other ratios. What appears to be adequate working capital
can actually be underfunded if a significant portion of the working capital is
tied up in obsolete inventory. In addition, the comfortable level of working
capital that Apex generated in 2019 may be inadequate if the company
plans to hold the marketable securities as portfolio investments, rather
than converting them into cash when needed.

Leverage (debt) ratios

Leverage ratios, also known as debt ratios, provide information regarding
the extent to which debt, rather than equity, finances a company’s capital.

Two types of leverage can be important in assessing business performance

and reviewing investment potential. The first type, which is outside the
scope of this module, is operating leverage. In simple terms, a high degree

of operating leverage indicates that a firm has made a large investment

(and taken on significant debt) associated with the company’s production
equipment or automation equipment in order to decrease variable costs.
These companies tend to have high fixed costs and high break-even
volumes. However, when business activity is strong and sales volumes are
high, the company’s margins are very strong due to its relatively low
variable cost component. The second type, financial leverage, is a key
element of financial analysis. Financial leverage measures the amount of
debt a company uses to finance investments made in corporate assets.

Another aspect of leverage is a firm’s ability to service its debt.

Debt-to-equity ratio
The debt-to-equity ratio is one of the most commonly used metrics for
assessing financial leverage, calculated as:

Debt-to-Equity Ratio = Total Debt ÷ Shareholders’ Equity

Creditors look at the debt-to-equity ratio to determine how much the

equity on the balance sheet cushions creditors. It is largely a measure of
risk. The lower the debt-to-equity ratio, the better the company looks to
creditors. Conversely, a high debt-to-equity ratio is an indication that the
company obtained financing through debt sources that increase risk for
creditors. Creditors rank above equity investors in the distribution of
assets following a company’s dissolution. Therefore, creditors feel more
secure when they know they will have access to a significant number of
equity dollars, in the event the company defaults on any loans the
creditors have made to the company.

Investors are also interested in the debt-to-equity ratio. They use it to help
assess the risk of investing in the common shares of the company. All

other things being equal, the more financial leverage a company uses, the
riskier the common shares are and the higher the financial return common
shareholders expect.

It is difficult to peg an ideal debt-to-equity ratio. The amount of leverage

investors will accept in the capital structure of a firm varies based on a
number of factors. The most important is the stability of cash flow. For
example, utilities tend to have very stable cash flows and, for that reason,
investors generally accept more leverage from them. Companies with
highly volatile cash flows are much more susceptible to credit default and,
for this reason, investors generally accept only a modest degree of
financial leverage from them.

The numbers used for both the numerator and denominator of the debt-to-
equity ratio change depending on the interested party’s perspective. For
example, do preferred shares belong in either the numerator or
denominator of the ratio? It depends on your perspective. Senior secured
lenders might view preferred shares as equity since they rank below senior
debt and, therefore, form part of the “cushion” available to lenders to
satisfy or settle their debt. For this reason, a senior lender may include
preferred shares in the denominator. On the other hand, common
shareholders, who rank below preferred shareholders, may view preferred
shares as “debt” since they have to be satisfied in whole before any money
accrues to common shareholders following a company’s dissolution.
Therefore, common shareholders may include preferred shares in the
numerator. In financial analysis, perspective is everything.

For simplicity, calculations in the examples follow the ratio exactly as

stated above, without adjusting for a specific perspective.

EXAMPLE: APEX MANUFACTURING

Using information from the balance sheet, the debt-to-equity ratio for Apex is:

2018 Debt-to-Equity Ratio = $596,400 ÷ $451,800 = 1.32

2019 Debt-to-Equity Ratio = $616,920 ÷ $728,160 = 0.85

There is a fairly significant change in this ratio from 2018 to 2019, with 2019 having
the more favourable number. The calculation shows that the proportion of total debt to
shareholder equity decreased, which creditors view positively.

EXAMPLE: COMPASS RETAIL

Using information from the balance sheet, the debt-to-equity ratio for Compass is:

2018 Debt-to-Equity Ratio = $311,880 ÷ $405,000 = 0.77

2019 Debt-to-Equity Ratio = $352,320 ÷ $563,640 = 0.63

Compass’s debt-to-equity ratio is much lower than Apex’s because Compass has no
long-term debt.

Debt-to-asset ratio
The debt-to-asset ratio derives from the debt-to-equity ratio and has some
of the same uses, but it expresses the leverage of the company differently.
The debt-to-asset ratio calculation is:

Debt-to-Asset Ratio = (Total Debt ÷ Total Assets)

The debt-to-asset ratio provides a number, often expressed as a

percentage, which tells financial analysts to what extent debt finances the
firm’s investment in assets. As the number approaches 100%, the risk of
insolvency increases substantially. When the debt-to-assets ratio is very
high, it indicates that the amount of money owners have at risk is quite
small, so the prospect of high potential rewards may encourage them to

take unnecessary risks. There is often an unspoken ceiling on the level of

this ratio that creditors find acceptable. That ceiling may be as low as 40%
in some industries and as high as 75% in other industries.

EXAMPLE: APEX MANUFACTURING

Using information from the balance sheet, the debt-to-asset ratio for Apex is:

2018 Debt-to-Asset Ratio = ($596,400 ÷ $1,048,200) = 57%

2019 Debt-to-Asset Ratio = ($616,920 ÷ $1,345,080) = 46%

These are fairly conservative debt-to-asset ratios, for both years. It is an open
question whether Apex could apply more financial leverage to increase shareholder
returns. Part of the answer depends on the degree of operating leverage currently in
place. Risks increase when companies achieve operating leverage through
aggressive debt financing. One positive sign is that the ratio decreased year over
year, which means creditors now have more of a cushion of equity support to protect
their debt investment in Apex.

EXAMPLE: COMPASS RETAIL

Using information from the balance sheet, the debt-to-asset ratio for Compass is:

2018 Debt-to-Asset Ratio = ($311,880 ÷ $716,880) = 44%

2019 Debt-to-Asset Ratio = ($352,320 ÷ $915,960) = 38%

These numbers are similar to Apex’s.

When examining debt-to-asset ratios, keep in mind that companies list

assets at their historical cost. The fair market value could be entirely
different and give an entirely different message.

Interest coverage
Interest coverage, also called the times-interest-earned ratio, measures
the extent to which earnings can decline without impacting the company’s
ability to meet its debt service obligations. In other words, it measures the
extent to which the company’s operating income covers its interest
expense. The times-interest-earned ratio calculation is:

Times-Interest-Earned Ratio =

(Earnings Before Interest and Taxes)* ÷ (Interest Expense)

* Note that this specific item may not appear on an income statement; to calculate it,
find net income and add back interest and taxes.

Creditors use the times-interest-earned ratio to assess risk. The closer the
ratio is to one, the higher the risk of default. This ratio, or one very similar
to it, is often incorporated into the debt covenants a lender negotiates with
a borrower when negotiating a debt facility. If the borrower reports a
times-interest-earned ratio that does not meet the terms of the pre-
negotiated covenant, this triggers remedies that may include the borrower
requiring additional security, charging a higher interest rate or declaring an
outright deemed default of the loan.

While different creditors may set different appropriate thresholds for the
times-interest-earned ratio, almost all are interested in how this ratio
changes over time. A steadily decreasing times-interest-earned ratio can
be an early warning sign of substantial problems. This ratio often serves as
a barometer of excessive financial leverage for outside observers. As long
as it falls within a pre-arranged “safety range,” creditors tend to remain
confident of a company’s ability to service its debt.

EXAMPLE: APEX MANUFACTURING

Using information from the income statement, the times-interest-earned ratio for Apex
Manufacturing is:

2018 Times-Interest-Earned Ratio = $407,520 ÷ $29,160 = 13.98 times

2019 Times-Interest-Earned Ratio = $417,840 ÷ $33,360 = 12.53 times

This is one area where there would be no concern for Apex’s lenders. The amount of
net income available to service the debt obligations of the organization is very strong
in both years. The more volatile Apex’s income becomes, the smaller the margin of
safety for lenders, and the larger this ratio needs to be for lenders to feel comfortable.

EXAMPLE: COMPASS RETAIL

Using information from the income statement, the times-interest-earned ratio for
Compass is:

2018 Times-Interest-Earned Ratio = $164,880 ÷ $11,760 = 14.02 times

2019 Times-Interest-Earned Ratio = $223,800 ÷ $12,240 = 18.28 times

The times-interest-earned ratios are also very strong for Compass.

Profitability ratios
Profit margins measure how much a company earns in relation to its
overall sales. Generally, a company with a higher profit margin than its
competitors is more efficient. The three profit margin ratios are gross profit
margin, operating profit margin and net profit margin. All three compare a
profit figure to the overall revenue or sales number.

Gross profit margin

The gross profit margin calculation is:

Gross Profit Margin = (Gross Profit* ÷ Sales)

* Gross Profit = Sales – Cost of Goods Sold

The gross profit margin measures how much of each sales dollar the
company uses to finance the direct inputs required to manufacture or
merchandise the product it sells. If the company provides services instead
of products, substitute the “cost of revenue or direct expenses” for the
“cost of goods sold” and calculate the ratio in the same way.

The gross profit margin gives good information on a company’s pricing

policy and mark-up practices. Be cautious, however, when looking at the
gross profit margin of a company with multiple product lines. When a
company has multiple product lines, its gross profit margin is nothing more
than the weighted average of the gross profit margin of all of the different
products the company produces.

Gross profit margins vary dramatically from industry to industry. Where

the cost of direct inputs to produce a product is low, as in the shrink-wrap
software or pharmaceutical industries, gross profit margins can be as high
as 96% or 97%. In those industries, very little of the selling price is

needed to cover the costs of producing an incremental unit of the product.

In the packaged goods industry, where companies produce products such
as soft drinks or laundry detergent, there also tend to be high gross profit
margins. These companies require high gross profit margins to have
sufficient resources available to fund advertising and promotion costs, the
major value-added input in the packaged goods industry.

On the other hand, commodity producers tend to have the lowest gross
profit margins. A large proportion of the selling price of a barrel of refined
oil is required to cover the direct input costs, and this translates into a
lower gross profit margin for the oil refinery industry as a whole. For this
reason, it is not useful to compare the gross profit margin of an oil refinery
firm with that of a pharmaceutical firm. Gross profit margins are most
useful when comparing companies within the same industry and when
analyzing the trend of a specific company over time.

EXAMPLE: APEX MANUFACTURING

Using information from the income statement, the gross profit margin for Apex is:

2018 Gross Profit Margin = ($1,042,800 ÷ $1,504,800) = 69%

2019 Gross Profit Margin = ($1,138,440 ÷ $1,705,680) = 67%

Apex’s gross profit margin is fairly stable year over year, in the two-thirds range.

It is impossible to gauge the appropriateness of a gross profit margin in

absolute terms. A gross profit margin in Apex’s range is very typical of a
manufacturing company. Gross profit margins tend to decrease when input
costs increase through higher commodity prices, higher negotiated labour
rates or perhaps higher production overhead costs associated with the
depreciation of new equipment. Most companies are mindful of their gross
profit margin performance, since it represents their production efficiency.
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It is sometimes possible to strip out redundant operating costs to improve

bottom line performance, but it is much more difficult to quickly change
gross profit margins because of the deeper structural nature of those
costs.

Extending this thought, many competitors may have similar direct material
input costs and be subject to similar direct labour costs. Where companies
can differ substantially is in the third component used to calculate the cost
of goods sold: production overhead. In this area, different production
volumes and different operating leverages can produce significantly
different gross profit margins. For this reason, it is always necessary to use
care when analyzing the gross profit margin of a company.

That said, financial analysts generally expect that a retailer will have lower
gross profit margins than a manufacturer.

EXAMPLE: COMPASS RETAIL

Using information from the income statement, the gross profit margin for Compass is:

2018 Gross Profit Margin = ($722,400 ÷ $1,504,800) = 48%

2019 Gross Profit Margin = ($791,160 ÷ $1,705,680) = 46%

Operating profit margin

Many financial analysts also find the operating profit margin useful as a
measure of operating efficiency. The operating profit margin calculation is:

Operating Profit Margin = (Operating Profit* ÷ Sales)

* If operating profit is not listed, look for the term earnings before interest and taxes
(EBIT).

Operating profit specifically excludes:

 Interest

 Taxes

 Gains (losses) on foreign currency exchanges

Operating profit is also sometimes referred to as Earnings Before Interest

and Taxes (EBIT). The benefit of focusing on the operating profit margin is
that non-operational factors, such as financing decisions, tax anomalies
and non-hedged currency swings, do not affect the results of the
calculation.

Operating profit margin is especially interesting to firms considering an

acquisition. They may have a sophisticated hedging program to neutralize
currency gains or losses, a different tax profile and an entirely different
financing plan than their acquisition targets. The operating profit margin
lets them ignore everything but pure operational results when assessing
the attractiveness of various acquisition targets.

EXAMPLE: APEX MANUFACTURING

Using information from the income statement, the operating profit margin for Apex is:

2018 Operating Profit Margin = ($407,520 ÷ $1,504,800) = 27%

2019 Operating Profit Margin = ($417,840 ÷ $1,705,680) = 25%

Apex’s operating profit margin is fairly stable over both years.

While the gross profit margin looks at the efficiency associated with direct
production costs — direct materials, direct labour and production overhead
— the operating profit margin broadens the metric to include all operating
costs. The operating profit margin looks at the business results
independent of the non-operating decisions the company makes.
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EXAMPLE: COMPASS RETAIL

Using information from the income statement, the operating profit margin for Compass
is:

2018 Operating Profit Margin = ($164,880 ÷ $1,504,800) = 11%

2019 Operating Profit Margin = ($223,800 ÷ $1,705,680) = 13%

As might be expected, Compass has lower operating profit margins than Apex. The
operating profit margin of a retailer depends on what part of the market it serves.
Retailers in the premium end of the market tend to have higher operating profit
margins, while discount retailers tend to have lower operating profit margins.
However, lower volume often accompanies higher operating profit margins in the
premium end of the market.

Net profit margin

The final profitability margin is the net profit margin of the firm, calculated
as:

Net Profit Margin = (Net Profit* ÷ Sales)

* If net profit is not listed, look for the term net income.

Net profit margin considers the firm’s results as a whole for the given
accounting period, whereas the operating profit margin separates out the
non-operating factors, such as interest, taxes and foreign currency
accounting gains/losses, to focus exclusively on operating results. The net
profit margin of a company indicates how much of each sales dollar falls to
the bottom line in after-tax profit. This ratio is important to shareholders
and investors because it combines both operating and non-operating
factors to determine the final profit number of the company. Keep in mind

that this ratio is not useful for companies losing money, since they have no
profit.

Companies that have lots of transactions and strong sales volume often
operate with small net profit margins. It is not uncommon, for example, to
see net profit margins in the retail grocery industry averaging between 1%
and 5%. Companies with the highest net profit margins have usually been
successful in erecting substantial barriers to competition. Sometimes the
barriers are based on intellectual property ownership through copyright or
patents (as may be the case for a drug company), successfully
standardizing a market with proprietary corporate technology (as may be
the case for a major software provider) or exploiting low extraction costs
of natural resources (as may be the case for companies that source oil
from abroad).

Some industries have inherently lower net profit margin potential than
other industries. For example, it has been more than 100 years since air
travel began. In the intervening century, the collective net profit margin of
the entire airline industry has been very close to zero, even though
individual companies have managed at times to sustain positive net profit
margins. The airline industry has a very high ratio of fixed costs to total
costs, which makes net profit margins highly volatile as air travel demand
changes throughout a business cycle.

Remember that net profit margin looks at accounting profit as a

percentage of sales, and therefore does not reflect the cash flow potential
of the business. Companies with heavy investments in equipment to
modernize and automate their production environment, for example, may
have lower net profit margins because of substantial depreciation charges
that do not affect cash flow. While net profit margins are important
metrics, use them with care when drawing conclusions about performance.
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EXAMPLE: APEX MANUFACTURING

Using information from the income statement, the net profit margin for Apex is:

2018 Net Profit Margin = ($283,800 ÷ $1,504,800) = 19%

2019 Net Profit Margin = ($288,360 ÷ $1,705,680) = 17%

Apex’s net profit margins are in the high teens, respectable numbers for many
manufacturing companies. The net profit margin is of interest to shareholders
because it is the after-tax amount that accrues to them as common shareholders.

EXAMPLE: COMPASS RETAIL

Using information from the income statement, the net profit margin for Compass is:

2018 Net Profit Margin = ($114,840 ÷ $1,504,800) = 8%

2019 Net Profit Margin = ($158,640 ÷ $1,705,680) = 9%

Like many retailers, Compass reports single-digit net profit margins.

Return on common equity

Another measure of profit that interests investors is the return on common
equity, calculated as:

Return on Common Equity = (Net Income ÷ Shareholders’ Equity)

If the corporation has preferred shares, the formula is adjusted:

Return on Common Equity =

(Net Income – Preferred Dividends) ÷ (Shareholders’ Equity – Preferred Shares)

Return on common equity measures the amount of earnings that accrue to

common shareholders as a percentage of their equity in the company.
From the perspective of common shareholders, the higher the return, the
better. This ratio depicts the return that a company generates on the
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investment of the owners. It is calculated by dividing the after-tax income

(less the preferred share dividends paid out) by the common shareholders’
equity. The denominator of the ratio is the net worth that, for practical
purposes, is the share capital of the common shareholders, plus the
cumulative retained earnings of the company.

Several factors directly affect the return on common equity. The most
important is the amount of leverage a company employs. If the company’s
capital structure comprises primarily debt, the equity base is small so that
even modest profit generates a substantial return on common equity.
However, large amounts of debt also increase the debt service
requirements, making profit more difficult to achieve.

EXAMPLE: APEX MANUFACTURING

The return on common equity for Apex is:

2018 Return on Common Equity = ($283,800 ‒ $12,000) ÷ ($451,800 – $120,000)

= 82%

2019 Return on Common Equity = ($288,360 ‒ $12,000) ÷ ($728,160 – $120,000)

= 45%

Apex’s return on common equity drops sharply from one year to the next. This ratio
parallels the drop in the debt-to-equity ratio. The net worth of the company is the sum
of the common share capital and the retained earnings. In the case of Apex, retained
earnings dominate the denominator of this ratio because the share capital amount is
small. Therefore, as the retained earnings of the company grow from year to year,
similar income creates only half the return on common equity, due to the steadily
increasing denominator. Sometimes, this ratio is calculated with only share capital in
the denominator, but that tends to distort the picture because investors are interested
not only in the return on share capital, but also in the return on the retained earnings
left in the business. The cautionary note in this analysis is that it is important to

examine all ratios carefully in conjunction with other ratios to draw appropriate and
valid conclusions. On its own, Apex’s drop in return on common equity could easily be
misinterpreted.

EXAMPLE: COMPASS RETAIL

The return on common equity for Compass is:

2018 Return on Common Equity = ($114,840 ÷ $405,000) = 28%

2019 Return on Common Equity = ($158,640 ÷ $563,640) = 28%

Compass shows a stable return on common equity from year to year. Compass had a
much larger cash infusion than Apex in terms of the original share capital of the
company ($120,000 versus $12,000). In addition, Compass showed stronger year-
over-year earnings growth. Supported by those two factors, the return on common
equity is identical from one year to the next.

Return on total assets

The return on total assets is an important investment metric and a good
indicator of operational efficiency. It measures the sales generated by each
dollar invested in tangible assets. The return on total assets calculation is:

Return on Total Assets = (Net Income ÷ Total Assets)

Return on total assets is similar to return on investment. It highlights the

reality that it’s only possible to properly assess income performance when
you also consider the capital invested to generate that income. If return on
total assets is too low, investors will consider whether there is a better
place for their investment dollars in other financial securities.

It is also important to interpret this ratio carefully, because it is susceptible

to management manipulation. For example, Company A may have a higher
return on total assets because management is not replacing major
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equipment on a timely basis. Since fully depreciated equipment has no

balance sheet asset value, the return on total assets will be higher in
Company A compared to Company B, if Company B makes regular
investments to upgrade operating equipment.

A second issue sometimes surfaces that can make it difficult to compare

two companies using the return on total assets. If Company A borrows
money to buy equipment, it may have a less favourable ratio than
Company B, which uses off-balance-sheet financing to lease equipment.
The companies may be in exactly the same economic position, yet
Company A will have a lower return on assets.

EXAMPLE: APEX MANUFACTURING

Using information from the balance sheet and income statement, the return on total
assets for Apex is:

2018 Return on Total Assets = ($283,800 ÷ $1,048,200) = 27%

2019 Return on Total Assets = ($288,360 ÷ $1,345,080) = 21%

The return on total assets for both years is in the low to mid twenties, within the
expected range for a manufacturer. This is one of the most important financial ratios
when it comes to evaluating management performance, especially in a divisional or
subsidiary business structure. By compensating divisional managers based on return
on total assets, it focuses management’s attention on maximizing income and
minimizing the investment needed to generate the income. The ratio decreases from
year to year for Apex, primarily because management has invested close to $200,000
in marketable securities. If that investment generates no income, then return on total
assets will decrease. For that reason, subsidiary managers in a real situation would
likely either invest that $200,000 in an income-producing asset or dividend that
amount back to the parent company to decrease the asset base.

A significant issue with this ratio is that it uses accounting numbers (book
value of total assets) to assess management performance, rather than
economic numbers (fair market value of assets) that may more closely
correspond to shareholder wealth creation.

EXAMPLE: COMPASS RETAIL

Using information from the balance sheet and income statement, the return on total
assets for Compass is:

2018 Return on Total Assets = ($114,840 ÷ $716,880) = 16%

2019 Return on Total Assets = ($158,640 ÷ $915,960) = 17%

Typically, retailers do not have the same investment in plant and equipment that
manufacturers such as Apex have, so their return on total assets is generally higher.
However, retailers often have a substantial investment in inventory on hand, which
also affects this ratio. Generally, a return on total assets of less than 20% is
considered low for a retailer and could suggest a build-up of inventory. That said,
accepted norms vary significantly from one industry to the next.

Appendix 1: Apex Balance Sheet

Apex Manufacturing
Balance Sheet
at December 31, 2019 and 2018

2019 ($) 2018 ($)

ASSETS

Current Assets

Cash 141,960 92,760

Marketable Securities 239,400 107,040

Accounts Receivable 222,000 178,200

Inventory 207,000 163,680

Total Current Assets 810,360 541,680

Capital Assets

Land 321,360 321,360

Building 90,000 105,000

Equipment 106,080 54,240

Furniture & Fixtures 34,080 40,320

Total Capital Assets 551,520 520,920

Accumulated Amortization (16,800) (14,400)

Net Capital Assets 534,720 506,520

TOTAL ASSETS 1,345,080 1,048,200

LIABILITIES

Current Liabilities

Accrued Liabilities 287,400 264,480

Income Taxes Payable 30,720 27,000

Term Loan 132,240 121,080

Note Payable 21,000 24,000

Total Current Liabilities 471,360 436,560

Long-Term

Liabilities 145,560 159,840

TOTAL LIABILITIES 616,920 596,400

SHAREHOLDERS’ EQUITY

Issued and Paid: 300,000 Common Shares 12,000 12,000

Preferred Shares 120,000 120,000

Retained Earnings 596,160 319,800

TOTAL SHAREHOLDERS’ EQUITY 728,160 451,800

TOTAL LIABILITIES & SHAREHOLDER

1,345,080 1,048,200
EQUITY

Appendix 2: Apex Income Statement &

Statement of Retained Earnings
Apex Manufacturing
Income Statement
for the years ended December 31, 2019 and 2018

2019 ($) 2018 ($)

Sales 1,705,680 1,504,800

Cost of Goods Sold 567,240 462,000

Gross Profit 1,138,440 1,042,800

Operating Expenses

General and Administration 301,200 252,000

Sales and Marketing 321,720 293,040

Development 97,680 90,240

Total Operating Expenses 720,600 635,280

Earnings Before Interest and Taxes (EBIT) 417,840 407,520

Interest 33,360 29,160

Taxes 96,120 94,560

NET INCOME 288,360 283,800

Apex Manufacturing
Statement of Retained Earnings
for the years ended December 31, 2019 and 2018

2019 ($) 2018 ($)

Retained Earnings, Beginning of Year 319,800 48,000

Net Income 288,360 283,800

Preferred Dividend Paid (12,000) (12,000)

RETAINED EARNINGS, END OF YEAR 596,160 319,800

Appendix 3: Apex Cash Flow Statement

Apex Manufacturing
Cash Flow Statement
for the years ended December 31, 2019 and 2018

2019 ($) 2018 ($)

Operating Activities

Net Income (Loss) for the Year 288,360 282,800

Adjustments to Reconcile Net Income to Cash (from

2,400 360
Operating Activities) Amortization

Changes in Non-Cash Working Capital 290,760 284,160

(Increase) Decrease in Accounts Receivable (43,800) (7,560)

(Increase) Decrease in Inventory (43,320) (26,640)

(Increase) Decrease in Prepaid Expenses 0 (16,920)

Increase (Decrease) in Income Taxes Payable 3,720 6,000

Increase (Decrease) in Accrued Liabilities 22,920 2,760

CASH FROM (USED BY) OPERATIONS 230,280 241,800

Investing Activities

Marketable Securities (132,360) (106,800)

Purchase of Capital Assets (30,600) (26,760)

(162,960) (133,560)

Financing Activities

Increase (Decrease) in Note Payable (3,000)

Increase (Decrease) in Term Loan 11,160

Increase (Decrease) in Mortgage Payable (14,280) (39,840)

(6,120) (39,840)

Dividend Paid to Shareholders (12,000) (12,000)

Net Change in Cash During the Year 49,200 56,400

Cash at the Beginning of the Year 92,760 36,360

CASH AT END OF YEAR 141,960 92,760

Appendix 4: Compass Balance Sheet

Compass Retail
Balance Sheet
at December 31, 2019 and 2018

2019 ($) 2018 ($)

ASSETS

Current Assets

Cash 135,960 134,640

Accounts Receivable 25,320 18,240

Inventory 612,000 436,800

Total Current Assets 773,280 589,680

Fixed Assets

Leasehold Improvements 85,680 78,240

Equipment 12,480 11,400

Furniture & Fixtures 46,440 39,000

Total Fixed Assets 144,600 128,640

Accumulated Amortization (1,920) (1,440)

Net Capital Assets 142,680 127,200

TOTAL ASSETS 915,960 716,880

LIABILITIES

Current Liabilities

Accrued Liabilities 254,880 219,000

Term Loan 97,440 92,880

TOTAL LIABILITIES 352,320 311,880

SHAREHOLDERS’ EQUITY

Issued and Paid: 500,000 Common Shares 120,000 120,000

Retained Earnings 443,640 285,000

TOTAL SHAREHOLDERS’ EQUITY 563,640 405,000

TOTAL LIABILITIES & SHAREHOLDERS’ EQUITY 915,960 716,880

Appendix 5: Compass Income Statement &

Statement of Retained Earnings
Compass Retail
Income Statement
for the years ended December 31, 2019 and 2018

2019 ($) 2018 ($)

Sales 1,705,680 1,504,800

Cost of Sales 914,520 782,400

Gross Profit 791,160 722,400

Operating Expenses

General and Administration 217,680 212,640

Sales and Marketing 349,680 344,880

Total Operating Expenses 567,360 557,520

Earnings Before Interest and Taxes (EBIT) 223,800 164,880

Interest 12,240 11,760

Taxes 52,920 38,280

NET INCOME 158,640 114,840

Compass Retail
Statement of Retained Earnings
for the years ended December 31, 2019 and 2018

2019 ($) 2018 ($)

Retained Earnings, Beginning of Year 285,000 170,160

Net Income 158,640 114,840

RETAINED EARNINGS, END OF YEAR 443,640 285,000

Appendix 6: Compass Cash Flow Statement

Compass Retail
Cash Flow Statement
for the years ended December 31, 2019 and 2018

2019 ($) 2018 ($)

Operating Activities

Net Income (Loss) for the Year 158,640 114,840

Adjustments to Reconcile Net Income to Cash (from

480 360
Operating Activities) Amortization

Changes in Non-Cash Working Capital 159,120 115,200

(Increase) Decrease in Accounts Receivable (7,080) (5,160)

(Increase) Decrease in Inventory (175,200) (105,600)

Increase (Decrease) in Accrued Liabilities 35,880 37,200

CASH FROM (USED BY) OPERATIONS 12,720 41,640

Investing Activities

Purchase of Capital Assets (15,960) (26,760)

Financing Activities

Increase (Decrease) in Term Loan 4,560 (2,400)

Net Change in Cash During the Year 1,320 12,480

Cash at the Beginning of the Year 134,640 122,160

CASH AT END OF YEAR 135,960 134,640

184
Copyright © 2020 The Financial Advisors Association of Canada
FINANCIAL ANALYSIS
Financial Services professionals are expected to possess the knowledge that will allow them
to clearly document, analyze, project and present financial information related to an
individual’s goals, needs and priorities. Such knowledge will aid professionals to:

• explain the time value of money;

• make financial projections to determine the achievability of goals; and
• evaluate how an individual’s current and projected cash flow, including that from their
business, may impact their ability to meet their goals.

Financial Analysis is one of twelve modules in the Advocis Core Curriculum Program for CFP®
and QAFP™ Certification.

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