Fundamental Skills Review

Economics

Economies of Scale

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  purchasing (bulk buying of materials through long-term contracts),
  
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  managerial (increasing the specialization of managers),
  
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  financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), and
  
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  marketing (spreading the cost of advertising over a greater range of output in media markets).
  

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  Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right.
  

• Economies of Scope

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  Economies of scope are conceptually similar to economies of scale. Economies of scope refer to efficiencies primarily associated with increasing or decreasing the scope of marketing and distribution of different types of products. Economies of scope are one of the main reasons for such marketing strategies as product bundling, product lining, and family branding.
  

• Diminishing Marginal Utility

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  The proposition that the level of demand or "satisfaction" derived from a product or service diminishes with each additional unit consumed until no further benefit is perceived, within a given time frame. After the last unit of consumption, additional consumption brings no more benefit to the consumer and can actually have negative value.
  

• Diminishing Marginal Returns

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  The proposition that additional units of labor may contribute to greater production in absolute numbers, but each additional unit contributes less product than the preceding unit.
  

• Elasticity

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  Elasticity is the ratio of the proportional change in one variable with respect to proportional change in another variable. Elasticity is usually expressed as a negative number but shown as a positive percentage value. Two common forms of elasticity are price elasticity of demand and price elasticity of supply.
  
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  Value	Meaning
  n < 1	Inelastic
  n = 1	Unitary elastic
  n > 1	Elastic

• Price Elasticity of Demand

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  Price elasticity of demand (PED) is an elasticity that measures the nature and percentage of the relationship between changes in quantity demanded of a good and changes in its price.
  
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• Break Even Quantity

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  Breakeven analysis is a managerial planning technique using fixed costs, variable costs, and the price of a product to determine the minimum units of sales necessary to break even or to pay the total costs involved. The necessary sales are called the BEQ, or break-even quantity. This technique is also useful to make go/no-go decisions regarding the purchase of new equipment. The BEQ is calculated by dividing the fixed costs (FC) by the price minus the variable cost per unit (P-VC):
  
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  BEQ = FC/(P-VC)
  

• Finance

• Compound Annual Growth Rate (CAGR)

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  CAGR a frequently used method for expressing the geometric mean growth rate for a firm. It is calculated with the following formula:
  
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• Free Cash Flow

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  Free Cash Flow represents the cash a firm has generated for its shareholders, after paying its expenses and investing in its growth. Free cash flow is equal to total cash flow (earnings with noncash charges added back in) minus capital spending. Free cash flow can be very useful in assessing a company's financial health because it strips away all the accounting assumptions built into earnings. A company's earnings may be high and growing, but until you look at free cash flow, you don't know if the company's really generated money in a given year or not.
  
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  EBIT (Earnings before interest and taxes)
  
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  - Tax on operating income
  
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  =EBIAT
  
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  +Depreciation expense
  
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  -Investment in net working capital
  
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  -Investment in fixed assets
  
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  =Free cash flow
  

• Net Present Value

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  The NPV is a project's net contribution to wealth. Net present value is the present value (PV) of all incremental future cash flow streams minus the initial incremental investment. The present value is calculated by discounting future cash flows by an appropriate rate (r), usually called the opportunity cost of capital, or hurdle rate. Ct represents the cash flow at time t. (Ct can be negative, as in the initial investment, Co.) The NPV is calculated as follows:
  
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  NPV = Co + Cl/(l+r) + C2/(l+r)² + ... + Ct/(l+r)^t
  

• Common Perpetuities

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  Occasionally, it is necessary to calculate a residual value for a firm valuation in an interview. The two most common methods are the “No growth perpetuity” and the “Constant Growth Perpetuity.” The no growth perpetuity is the most conservative, and if you decide to use the “Constant Growth Perpetuity” be prepared to defend your growth rate. In general growth rates should fall somewhere between expected inflation and expected GDP growth.
  
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• Accounting

• DuPont Return on Equity

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  The mother of all performance metrics! This is most easily calculated by dividing net income by average stockholder’s equity.
  
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• Profitability Ratios

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  Gross Margin = (Sales – COGS)/Sales = 8.3/22.2 = 37%
  
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  Profit Margin (a.k.a., return on sales) = Net Income/Sales = 3.5/22.2 = 16%
  
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  EBIT Margin = EBIT/Sales
  
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  ROA = Net Income/Total Assets
  
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  ROIC = (EBIT - Tax)/(Debt + Equity)
  

• Liquidity Ratios

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  Coverage Ratio = EBIT/Interest Expense
  
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  Current Ratio = Current Assets/Current Liabilities
  
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  Quick Ratio “Acid Test” = (Current Assets – Inventory)/Current Liabilities
  

• Operational Health Ratios

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  Asset Turnover = Sales/Total Assets
  
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  Inventory Turnover = COGS/ Inventory
  
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  Days Receivable = (365 x Accounts Receivable)/Credit Sales
  
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  Days Payable = (365 x Accounts Payable)/Purchases
  

• Market Measures of Company Health

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  Earnings per Share (EPS) = Net Income/# shares outstanding
  
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  Price to Earnings Ratio (P/E) = Share Price/EPS
  
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  Firm Value/EBITDA = (Market Value Debt + Market Value Equity)/EBITDA
  
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  Market-to-Book ratio = Share Price/Book Value of Equity per Share
  

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