 A Capital Recovery Factor (CRF) converts a present value into a stream of equal

annual payments over a specified time, at a specified discount rate (interest).

 The value of an equal payment (A) to be made in each of n periods here is given by:

A = P [i(1+i)n]/[(1+i)n-1]

That is, A = P x CRF

Where, CRF= capital recovery factor = [i(1+i)n]/[(1+i)n-1]

 The capital recovery factor can be interpreted as the amount of equal (or uniform)
payments to be received for n years such that the total present value of all these equal
payments is equivalent to a payment of one dollar at present, if int

Present Value of Annuities

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals.
Leases and rental payments are examples. The payments or receipts occur at the end of
each period for an ordinary annuity while they occur at the beginning of each
period.for an annuity due.

Present value of an annuity:

P = the amount that needs to be invested now to give an annuity paying N at the end of
each year for n years, beginning in one year. Assumes that money not yet paid out earns
interest at...

r = the interest rate, as a decimal (5%, for example, is r = 0.05)

P = (N/r)( 1 - (1 + r)-n )

For example, if the plan is to get paid $20,000 a year for 20 years and do it with an
annuity when the interest rate is 5%, the amount you'd need to invest in the annuity is

P = (20000/0.05)( 1 - (1 + 0.05)-20 ) = 400000(1 - .37689) = $249,244

What Does Cash Flow Mean?
1. A revenue or expense stream that changes a cash account over a given period. Cash
inflows usually arise from one of three activities - financing, operations or investing -
although this also occurs as a result of donations or gifts in the case of personal finance.
Cash outflows result from expenses or investments. This holds true for both business and
personal finance.

2. An accounting statement called the "statement of cash flows", which shows the amount
of cash generated and used by a company in a given period. It is calculated by adding
noncash charges (such as depreciation) to net income after taxes. Cash flow can be
attributed to a specific project, or to a business as a whole. Cash flow can be used as an
indication of a company's financial strength.

Investopedia explains Cash Flow

1. In business as in personal finance, cash flows are essential to solvency. They can be
presented as a record of something that has happened in the past, such as the sale of a
particular product, or forecasted into the future, representing what a business or a person
expects to take in and to spend. Cash flow is crucial to an entity's survival. Having ample
cash on hand will ensure that creditors, employees and others can be paid on time. If a
business or person does not have enough cash to support its operations, it is said to be
insolvent, and a likely candidate for bankruptcy should the insolvency continue.

2. The statement of a business's cash flows is often used by analysts to gauge financial
performance. Companies with ample cash on hand are able to invest the cash back into
the business in order to generate more cash and profit.
What Does Bond Valuation Mean?
A technique for determining the fair value of a particular bond. Bond valuation
includes calculating the present value of the bond's future interest payments, also known
as its cash flow, and the bond's value upon maturity, also known as its face value or par
value. Because a bond's par value and interest payments are fixed, an investor uses bond
valuation to determine what rate of return is required for an investment in a particular
bond to be worthwhile.

Investopedia explains Bond Valuation

Bond valuation is only one of the factors investors consider in determining whether to
invest in a particular bond. Other important considerations are: the issuing company's
creditworthiness, which determines whether a bond is investment-grade or junk; the
bond's price appreciation potential, as determined by the issuing company's growth
prospects; and prevailing market interest rates and whether they are projected to go up or
down in the future.
What Does Annuity Mean?
A financial product sold by financial institutions that is designed to accept and grow
funds from an individual and then, upon annuitization, pay out a stream of payments to
the individual at a later point in time. Annuities are primarily used as a means of securing
a steady cash flow for an individual during their retirement years.
Watch: What is An Annuity

Investopedia explains Annuity

Annuities can be structured according to a wide array of details and factors, such as the
duration of time that payments from the annuity can be guaranteed to continue. Annuities
can be created so that, upon annuitization, payments will continue so long as either the
annuitant or their spouse is alive. Alternatively, annuities can be structured to pay out
funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant
lives.

Annuities can be structured to provide fixed periodic payments to the annuitant or

variable payments. The intent of variable annuities is to allow the annuitant to receive
greater payments if investments of the annuity fund do well and smaller payments if its
investments do poorly. This provides for a less stable cash flow than a fixed annuity, but
allows the annuitant to reap the benefits of strong returns from their fund's investments.

The different ways in which annuities can be structured provide individuals seeking
annuities the flexibility to construct an annuity contract that will best meet their needs.
Any discussion of portfolio returns must also include the variety of ways that bond
income may influence a portfolio's rate of return. While the stated (nominal) interest rate
on a bond might appear to be the only measure of a bond yield, it is only accurate if you
buy a bond at par and hold it until the bond matures. However, many investors buy a
bond at a price above or below par, and many sell prior to maturity. The following
measures are used to reflect these circumstances:

• Yield to maturity - This is the return based on the actual purchase price of the
bond. It takes any premium or discount over par into account and uses the actual
time to maturity for the number of compounding periods. If the bond was
purchased at par, the yield to maturity will equal the stated coupon rate.

• Yield to call - This is a similar calculation, but it uses the call date for the number
of compounding periods and incorporates any call premium into the future value.

• Current yield - This is simply the annual income divided by the market value of
the bond. If the bond is trading at a premium, the current yield will be less than
the nominal yield. If the bond is trading at a discount, the current yield will be
greater than the nominal yield.

• Real interest rate - The investor receives this rate after inflation is taken into
account. In essence, the nominal interest rate = the real interest rate plus an
 inflation premium. The inflation premium is typically higher for bonds with
longer maturities.

What Does Weighted Average Cost Of Capital - WACC Mean?

A calculation of a firm's cost of capital in which each category of capital is
proportionately weighted. All capital sources - common stock, preferred stock, bonds and
any other long-term debt - are included in a WACC calculation. All else equal, the
WACC of a firm increases as the beta and rate of return on equity increases, as an
increase in WACC notes a decrease in valuation and a higher risk.

The WACC equation is the cost of each capital component multiplied by its proportional
weight and then summing:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Businesses often discount cash flows at WACC to determine the Net Present Value
(NPV) of a project, using the formula:

NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Investopedia explains Weighted Average Cost Of Capital - WACC

Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the
average of the costs of these sources of financing, each of which is weighted by its
respective use in the given situation. By taking a weighted average, we can see how much
interest the company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is
often used internally by company directors to determine the economic feasibility of
expansionary opportunities and mergers. It is the appropriate discount rate to use for cash
flows with risk that is similar to that of the overall firm.
What Does Cost Of Debt Mean?
The effective rate that a company pays on its current debt. This can be measured in either
before- or after-tax returns; however, because interest expense is deductible, the after-tax
cost is seen most often. This is one part of the company's capital structure, which also
includes the cost of equity.

Investopedia explains Cost Of Debt

A company will use various bonds, loans and other forms of debt, so this measure is
useful for giving an idea as to the overall rate being paid by the company to use debt
financing. The measure can also give investors an idea as to the riskiness of the company
compared to others, because riskier companies generally have a higher cost of debt.

To get the after-tax rate, you simply multiply the before-tax rate by one minus the
marginal tax rate (before-tax rate x (1-marginal tax)). If a company's only debt were a
single bond in which it paid 5%, the before-tax cost of debt would simply be 5%. If,
however, the company's marginal tax rate were 40%, the company's after-tax cost of debt
would be only 3% (5% x (1-40%)).

What Does Cost Of Equity Mean?

In financial theory, the return that stockholders require for a company. The traditional
formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange
for owning the asset and bearing the risk of ownership.

Investopedia explains Cost Of Equity

Let's look at a very simple example: let's say you require a rate of return of 10% on an
investment in TSJ Sports. The stock is currently trading at $10 and will pay a dividend of
$0.30. Through a combination of dividends and share appreciation you require a $1.00
return on your $10.00 investment. Therefore the stock will have to appreciate by $0.70,
which, combined with the $0.30 from dividends, gives you your 10% cost of equity.

The capital asset pricing model (CAPM) is another method used to determine cost of
equity
What Does Internal Rate Of Return - IRR Mean?
The discount rate often used in capital budgeting that makes the net present value of all
cash flows from a particular project equal to zero. Generally speaking, the higher a
project's internal rate of return, the more desirable it is to undertake the project. As such,
IRR can be used to rank several prospective projects a firm is considering. Assuming all
other factors are equal among the various projects, the project with the highest IRR
would probably be considered the best and undertaken first.

IRR is sometimes referred to as "economic rate of return (ERR)".

Investopedia explains Internal Rate Of Return - IRR

You can think of IRR as the rate of growth a project is expected to generate. While the
actual rate of return that a given project ends up generating will often differ from its
estimated IRR rate, a project with a substantially higher IRR value than other available
options would still provide a much better chance of strong growth.

IRRs can also be compared against prevailing rates of return in the securities market. If a
firm can't find any projects with IRRs greater than the returns that can be generated in the
financial markets, it may simply choose to invest its retained earnings into the market.

What Does Net Present Value - NPV Mean?

The difference between the present value of cash inflows and the present value of cash
outflows. NPV is used in capital budgeting to analyze the profitability of an investment
or project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or
project will yield.

Formula:

In addition to the formula, net present value can often be calculated using tables, and
spreadsheets such as Microsoft Excel.

Investopedia explains Net Present Value - NPV

NPV compares the value of a dollar today to the value of that same dollar in the future,
taking inflation and returns into account. If the NPV of a prospective project is positive, it
should be accepted. However, if NPV is negative, the project should probably be rejected
because cash flows will also be negative.

For example, if a retail clothing business wants to purchase an existing store, it would
first estimate the future cash flows that store would generate, and then discount those
cash flows into one lump-sum present value amount, say $565,000. If the owner of the
store was willing to sell his business for less than $565,000, the purchasing company
would likely accept the offer as it presents a positive NPV investment. Conversely, if the
owner would not sell for less than $565,000, the purchaser would not buy the store, as the
investment would present a negative NPV at that time and would, therefore, reduce the
overall value of the clothing company.

What Does Payback Period Mean?

The length of time required to recover the cost of an investment.

Calculated as:

Investopedia explains Payback Period

All other things being equal, the better investment is the one with the shorter payback
period.

For example, if a project costs $100,000 and is expected to return $20,000 annually, the
payback period will be $100,000 / $20,000, or five years.

There are two main problems with the payback period method:

1. It ignores any benefits that occur after the payback period and, therefore, does not
measure profitability.
2. It ignores the time value of money.

Because of these reasons, other methods of capital budgeting like net present value,
internal rate of return or discounted cash flow are generally preferred.
What Does Tax Shield Mean?
A reduction in taxable income for an individual or corporation achieved through claiming
allowable deductions such as mortgage interest, medical expenses, charitable donations,
amortization and depreciation. These deductions reduce taxpayers' taxable income for a
given year or defer income taxes into future years.

Tax shields vary from country to country, and their benefits will depend on the taxpayer's
overall tax rate and cash flows for the given tax year.
Investopedia explains Tax Shield
For example, because interest on debt is a tax-deductible expense, taking on debt can act
as a tax shield. Tax-efficient investing strategies are a cornerstone of investing for high-
net-worth individuals and corporations, whose annual tax bills can be very high. The
ability to use a home mortgage as a tax shield is a major benefit for many middle-class
people whose homes are a major component of their net worth.
What Does Tax Deferred Mean?
Investment earnings such as interest, dividends or capital gains that accumulate tax free
until the investor withdraws and takes possession of them. The most common types of
tax-deferred investments include those in individual retirement accounts (IRAs) and
deferred annuities.

Investopedia explains Tax Deferred

By deferring taxes on the returns of an investment, the investor benefits in two ways. The
first benefit is tax-free growth: instead of paying tax on the returns of an investment, tax
is paid only at a later date, leaving the investment to grow unhindered. The second
benefit of tax deferral is that investments are usually made when a person is earning
higher income and is taxed at a higher tax rate. Withdrawals are made from an investment
account when a person is earning little or no income and is taxed at a lower rate.
What Does Working Capital Mean?
A measure of both a company's efficiency and its short-term financial health. The
working capital ratio is calculated as:

Positive working capital means that the company is able to pay off its short-term
liabilities. Negative working capital means that a company currently is unable to meet its
short-term liabilities with its current assets (cash, accounts receivable and inventory).

Also known as "net working capital", or the "working capital ratio".

Watch: Working Capital

Investopedia explains Working Capital

If a company's current assets do not exceed its current liabilities, then it may run into
trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A
declining working capital ratio over a longer time period could also be a red flag that
warrants further analysis. For example, it could be that the company's sales volumes are
decreasing and, as a result, its accounts receivables number continues to get smaller and
smaller.

Working capital also gives investors an idea of the company's underlying operational
efficiency. Money that is tied up in inventory or money that customers still owe to the
company cannot be used to pay off any of the company's obligations. So, if a company is
not operating in the most efficient manner (slow collection), it will show up as an
increase in the working capital. This can be seen by comparing the working capital from
one period to another; slow collection may signal an underlying problem in the
company's operations.

Working Capital Ratio (Current Ratio)

Current Assets
=
Current Liabilities
Indicates if a firm has enough short-term assets to cover its immediate liabilities.

Things to remember
• If the ratio is less than one then they have negative working capital.

• A high working capital ratio isn't always a good thing, it could indicate that
they have too much inventory or they are not investing their excess cash.

[Click on the image(s) above to see the financial statements]

For Cory's Tequila Co.

$4,615
= 1.54
$3,003

This ratio indicates whether a company has enough short term assets to cover its short term debt.
Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the
company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is
sufficient, Cory's Tequila Co. seems to be comfortably in this area.

If you wanted to take this ratio a step further then you could try the Acid Test/Quick Ratio - it is a
more strenuous version of the W/C, indicating whether liabilities could be paid without selling
inventory.

Ratio Analysis: Conclusion

There is a lot to be said for valuing a company, it is no easy task. I hope that we have helped
shed some light on this topic, and that you will use this information to make educated investment
decisions. If you have any other questions about fundamental analysis please don't hesitate to
contact us.

Let's recap what we've learned:

 • Financial reports are published quarterly and annually.
• Ratios on their own don't really tell us a whole lot, but when we compare them against
previous years numbers, other companies, industry averages, or the economy in general
it can reveal a lot!
• Every ratio has it's variations, some people exclude things that others include. Use what
you feel comfortable with, but be sure to have consistency when comparing against other
companies.

Expressed as an indicator (days) of management performance efficiency, the operating

cycle is a "twin" of the cash conversion cycle. While the parts are the same -
receivables, inventory and payables - in the operating cycle, they are analyzed from the
perspective of how well the company is managing these critical operational capital assets,
as opposed to their impact on cash.

Formula:

Components:

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DIO is computed by:

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day
figure;
2. Calculating the average inventory figure by adding the year's beginning (previous
yearend amount) and ending inventory figure (both are in the balance sheet) and
dividing by 2 to obtain an average amount of inventory for any given year; and
 3. Dividing the average inventory figure by the cost of sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DIO would be computed with these
figures:

(1) cost of sales per 739.4 ÷ 365 =

day 2.0
536.0 + 583.7 =
(2) average
1,119.7 ÷ 2 =
inventory 2005
559.9
(3) days inventory 559.9 ÷ 2.0 =
outstanding 279.9

DSO is computed by:

1. Dividing net sales (income statement) by 365 to get net sales per day figure;
2. Calculating the average accounts receivable figure by adding the year's beginning
(previous yearend amount) and ending accounts receivable amount (both figures
are in the balance sheet) and dividing by 2 to obtain an average amount of
accounts receivable for any given year; and
3. Dividing the average accounts receivable figure by the net sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DSO would be computed with these
figures:

(1) net sales per 3,286.1 ÷ 365 =

day 9.0
(2) average 524.8 + 524.2 =
accounts 1,049 ÷ 2 =
receivable 524.5
(3) days sales 524.5 ÷ 9.0 =
outstanding 58.3
DPO is computed by:

• Dividing the cost of sales (income statement) by 365 to get a cost of sales per day
figure;
• Calculating the average accounts payable figure by adding the year's beginning
(previous yearend amount) and ending accounts payable amount (both figures are
in the balance sheet), and dividing by 2 to get an average accounts payable
amount for any given year; and
• Dividing the average accounts payable figure by the cost of sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DPO would be computed with these
figures:
 (1) cost of sales 739.4 ÷ 365
per day =2.0
(2) average 131.6 + 123.6 =
accounts payable 255.2 ÷ 125.6
(3) days payable
125.6 ÷ 2.0 = 63
outstanding

Computing OC
Zimmer Holdings' operating cycle (OC) for FY 2005 would be computed with these
numbers (rounded):

DIO 280
DSO +58
DPO -63
OC 275

Variations:
Often the components of the operating cycle - DIO, DSO and DPO - are expressed in
terms of turnover as a times (x) factor. For example, in the case of Zimmer Holdings, its
days inventory outstanding of 280 days would be expressed as turning over 1.3x annually
(365 days ÷ 280 days = 1.3 times). However, it appears that the use of actually counting
days is more literal and easier to understand.

Commentary:
As we mentioned in its definition, the operating cycle has the same makeup as the cash
conversion cycle. Management efficiency is the focus of the operating cycle, while cash
flow is the focus of the cash conversion cycle.

To illustrate this difference in perspective, let's use a narrow, simplistic comparison of

Zimmer Holdings' operating cycle to that of a competitive peer company, Biomet.
Obviously, we would want more background information and a longer review period, but
for the sake of this discussion, we'll assume the FY 2005 numbers we have to work with
are representative for both companies and their industry.

Days Sales Outstanding (DSO):

Zimmer 58 Days
Biomet 105 Days

Days Inventory Outstanding

(DIO):
Zimmer 280 Days
 Biomet 294 Days

Days Payable Outstanding

(DPO):
Zimmer 63 Days
Biomet 145 Days

Operating Cycle:
Zimmer 275 Days
Biomet 254 Days

When it comes to collecting on its receivables, it appears from the DSO numbers, that
Zimmer Holdings is much more operationally efficient than Biomet. Common sense tells
us that the longer a company has money out there on the street (uncollected), the more
risk it is taking. Is Biomet remiss in not having tighter control of its collection of
receivables? Or could it be trying to pick up market share through easier payment terms
to its customers? This would please the sales manager, but the CFO would certainly be
happier with a faster collection time.

Zimmer Holdings and Biomet have almost identical days inventory outstanding. For most
companies, their DIO periods are, typically, considerably shorter than the almost 10-
month periods evidenced here. Our assumption is that this circumstance does not imply
poor inventory management but rather reflects product line and industry characteristics.
Both companies may be obliged to carry large, high-value inventories in order to satisfy
customer requirements.

Biomet has a huge advantage in the DPO category. It is stretching out its payments to
suppliers way beyond what Zimmer is able to do. The reasons for this highly beneficial
circumstance (being able to use other people's money) would be interesting to know.
Questions you should be asking include: Does this indicate that the credit reputation of
Biomet is that much better than that of Zimmer? Why doesn't Zimmer enjoy similar
terms?

Shorter Is Better?
In summary, one would assume that "shorter is better" when analyzing a company's cash
conversion cycle or its operating cycle. While this is certainly true in the case of the
former, it isn't necessarily true for the latter. There are numerous variables attached to the
management of receivables, inventory and payables that require a variety of decisions as
to what's best for the business.

For example, strict (short) payment terms might restrict sales. Minimal inventory levels
might mean that a company cannot fulfill orders on a timely basis, resulting in lost sales.
Thus, it would appear that if a company is experiencing solid sales growth and reasonable
profits, its operating cycle components should reflect a high degree of historical
consistency.

What Does Free Cash Flow - FCF Mean?

A measure of financial performance calculated as operating cash flow minus capital
expenditures. Free cash flow (FCF) represents the cash that a company is able to generate
after laying out the money required to maintain or expand its asset base. Free cash flow is
important because it allows a company to pursue opportunities that enhance shareholder
value. Without cash, it's tough to develop new products, make acquisitions, pay dividends
and reduce debt. FCF is calculated as:

It can also be calculated by taking operating cash flow and subtracting capital
expenditures.

Investopedia explains Free Cash Flow - FCF

Some believe that Wall Street focuses myopically on earnings while ignoring the "real"
cash that a firm generates. Earnings can often be clouded by accounting gimmicks, but
it's tougher to fake cash flow. For this reason, some investors believe that FCF gives a
much clearer view of the ability to generate cash (and thus profits).

It is important to note that negative free cash flow is not bad in itself. If free cash flow is
negative, it could be a sign that a company is making large investments. If these
investments earn a high return, the strategy has the potential to pay off in the long run.
What Does Operating Cash Flow - OCF Mean?
The cash generated from the operations of a company, generally defined as revenues less
all operating expenses, but calculated through a series of adjustments to net income. The
OCF can be found on the statement of cash flows.

Also known as "cash flow provided by operations" or "cash flow from operating
activities".

One method of calculated OCF is:

Investopedia explains Operating Cash Flow - OCF
Operating cash flow is the cash that a company generates through running its business.

It's arguably a better measure of a business's profits than earnings because a company can
show positive net earnings (on the income statement) and still not be able to pay its debts.
It's cash flow that pays the bills!

You can also use OCF as a check on the quality of a company's earnings. If a firm reports
record earnings but negative cash, it may be using aggressive accounting techniques.