BAR Area I: Business Analysis

Financial statement analysis ratios

Horizontal, vertical, and common-size analysis

• Horizontal analysis: compares a line item across periods. The change is expressed in dollars and as a percentage of a base (earliest) year. Useful for spotting trends over time.
• Vertical analysis: expresses each line item as a percentage of a single base figure within the same period. On the income statement the base is net sales; on the balance sheet the base is total assets (or total liabilities plus equity).
• Common-size statements: the output of vertical analysis. Restating everything as a percentage lets you compare firms of different sizes or one firm against industry benchmarks.

Ratio set

Memorize the formulas by category. On the exam, watch whether the prompt asks for an average balance (use beginning plus ending, divided by 2) or an ending balance.

Operating and cash conversion cycles

The operating cycle equals days sales in inventory plus days sales outstanding (DSO). The cash conversion cycle subtracts days payable outstanding: operating cycle − days payable. A shorter cycle frees up working capital.

DuPont decomposition

The DuPont model breaks ROE into three drivers, isolating whether returns come from margin, efficiency, or leverage:

Limitations of ratio analysis

• Ratios rely on historical-cost financial statements that may not reflect current values.
• Different accounting policies (LIFO vs FIFO, depreciation methods) impair comparability across firms.
• A single ratio is meaningless without a benchmark (prior period, competitor, or industry average).
• Window dressing and seasonality can distort year-end balances; averages mitigate but do not eliminate this.

Cost concepts & behavior managerial

Cost behavior

• Variable cost: total varies in direct proportion to activity; per-unit cost is constant (for example, direct materials).
• Fixed cost: total stays constant across the relevant range; per-unit cost falls as volume rises (for example, factory rent).
• Mixed (semivariable) cost: contains both a fixed and a variable component (for example, a utility bill with a base charge plus usage).
• Step cost: constant over a narrow range, then jumps to a new level (for example, hiring an additional supervisor for every shift added).

Product vs period costs

• Product (inventoriable) costs: direct materials, direct labor, and manufacturing overhead. They attach to inventory and are expensed as cost of goods sold when the product is sold.
• Period costs: selling, general, and administrative expenses. They are expensed in the period incurred and never enter inventory.

Prime cost vs conversion cost

• Prime cost = direct materials + direct labor.
• Conversion cost = direct labor + manufacturing overhead.

Direct labor appears in both; it is the only element common to the two totals.

Splitting mixed costs: the high-low method

The high-low method estimates the variable rate using only the highest-activity and lowest-activity observations:

The high-low method is simple but uses only two data points (the extremes), so it can be unrepresentative. Regression (least squares) uses all observations and is more reliable.

Cost classifications for decision making

• Direct vs indirect: direct costs trace economically to a cost object; indirect costs (overhead) are allocated.
• Controllable vs non-controllable: defined relative to a manager's authority over the cost within a period. Used in responsibility accounting.
• Sunk cost: already incurred and unrecoverable; irrelevant to any future decision.
• Opportunity cost: the benefit forgone from the next-best alternative not chosen; relevant even though never recorded in the accounts.
• Differential (incremental) cost: the change in total cost between two alternatives; only differential costs and revenues are relevant.

Costing systems managerial

Job-order vs process costing

• Job-order costing: costs accumulate by individual job or batch. Used when products are heterogeneous and identifiable (construction, custom printing, audits).
• Process costing: costs accumulate by department or process and are averaged over units. Used for mass production of homogeneous units (refining, chemicals, food).

Absorption vs variable costing

The systems differ in only one respect: the treatment of fixed manufacturing overhead.

Because absorption costing inventories fixed overhead, income reacts to the relationship between production and sales:

• Production > sales: inventory rises and fixed overhead is deferred in ending inventory, so absorption income > variable income.
• Production < sales: previously deferred fixed overhead is released from inventory, so absorption income < variable income.
• Production = sales: the two methods report equal income.

Activity-based costing (ABC)

ABC assigns overhead to cost pools based on activities, then allocates each pool to products using a cost driver that has a cause-and-effect relationship with the activity (machine setups, inspections, machine hours). ABC produces more accurate product costs than a single plant-wide rate when products consume overhead resources in different proportions. It typically reveals that low-volume, complex products were undercosted under traditional volume-based allocation.

Equivalent units (weighted-average)

Equivalent units express partially completed work in terms of whole units. Under the weighted-average method, equivalent units = units completed and transferred out + (ending work-in-process units × percentage complete). The weighted-average method blends beginning WIP costs with current-period costs and does not separate the two layers (unlike FIFO). Cost per equivalent unit = (beginning WIP cost + current cost) ÷ equivalent units.

Joint products and by-products

Joint costs are incurred before the split-off point and benefit two or more products simultaneously. They are allocated among joint products using:

• Relative sales value at split-off: allocate joint cost in proportion to each product's sales value at the split-off point.
• Net realizable value (NRV): when products are not salable at split-off, allocate using final sales value less separable (after-split-off) processing costs.

By-products have minor value. Their NRV is commonly credited against the joint cost of the main products (or recorded as other income). Joint costs are sunk for the sell-or-process-further decision; only incremental revenue versus separable cost beyond split-off is relevant.

Cost-volume-profit (CVP) analysis managerial

Contribution margin

• Contribution margin (total) = sales − total variable costs.
• CM per unit = selling price per unit − variable cost per unit.
• CM ratio = contribution margin ÷ sales (equivalently, CM per unit ÷ price). It is the fraction of each sales dollar available to cover fixed costs and profit.

Breakeven and target profit

Margin of safety

The margin of safety is the cushion by which expected sales exceed breakeven sales: margin of safety = budgeted sales − breakeven sales. As a percentage, divide that excess by budgeted sales. A larger margin of safety means more room for sales to fall before the firm reports a loss.

Operating leverage

The degree of operating leverage (DOL) = contribution margin ÷ operating income. It measures how sensitive operating income is to a change in sales. A high DOL (cost structure heavy in fixed costs) magnifies both gains and losses: a 1% change in sales produces a DOL% change in operating income.

Assumptions and limitations

• Selling price, variable cost per unit, and total fixed costs are constant within the relevant range.
• Costs are cleanly separable into fixed and variable components (linear behavior).
• Volume is the only cost driver; the sales mix is constant in a multiproduct setting.
• Production equals sales (no change in inventory).

Variance analysis standard costs

A standard cost system compares actual results against a flexible-budget standard. A variance is favorable (F) when actual cost is below standard and unfavorable (U) when actual cost exceeds standard. Abbreviations: AQ = actual quantity, AP = actual price, SQ = standard quantity allowed for actual output, SP = standard price; AH/SH and AR/SR are the labor-hour equivalents.

Direct materials and direct labor

Overhead variances

Overhead is split into variable and fixed components, each analyzed differently:

The fixed overhead volume variance arises purely because actual production differed from the denominator (normal) capacity used to set the fixed OH rate. It does not measure spending control; it reflects over- or under-utilization of capacity. The variable OH efficiency variance is driven by the same activity-base efficiency as the direct-labor efficiency variance when labor hours are the allocation base.

Budgeting & forecasting planning

The master budget

The master budget is a comprehensive set of interlocking budgets built in sequence. The sales budget drives everything else:

1. Sales budget (forecasted units × price) is prepared first.
2. Production budget: budgeted sales + desired ending finished goods − beginning finished goods = units to produce.
3. Direct materials, direct labor, and manufacturing overhead budgets derive from planned production. The DM purchases budget adds desired ending materials and subtracts beginning materials.
4. Selling and administrative expense budget.
5. Cash budget, then the pro-forma (budgeted) income statement, balance sheet, and statement of cash flows.

Static vs flexible budgets

• Static (master) budget: prepared for a single anticipated level of activity and not adjusted afterward.
• Flexible budget: restated to the actual activity level achieved, isolating efficiency effects from volume effects.

The total static-budget variance decomposes into two pieces:

• Flexible-budget variance = actual results − flexible budget (at actual volume). It captures price and efficiency effects.
• Sales-volume variance = flexible budget − static budget. It captures the effect of selling more or fewer units than planned.

The cash budget

The cash budget schedules expected cash receipts (collections from receivables, based on a collection pattern) and disbursements (payments for purchases, payroll, overhead, taxes, capital expenditures). It identifies financing needs and excess cash to invest. Non-cash items such as depreciation are excluded.

Forecasting techniques

• Regression (least squares): fits a line minimizing the sum of squared deviations; uses all data points and reports goodness of fit (R-squared).
• High-low method: estimates cost behavior from only the highest and lowest activity points (less reliable).
• Sensitivity analysis: varies one assumption (a "what-if" on a single input) to gauge its effect on the outcome.
• Scenario analysis: evaluates complete sets of assumptions (best case, base case, worst case) together.

Budgeting approaches

• Incremental budgeting: starts from the prior period's budget and adjusts. Fast but perpetuates existing spending.
• Zero-based budgeting (ZBB): every line starts at zero and must be justified each period. More rigorous and time-consuming.

Capital budgeting & valuation TVM

Time value of money

A dollar today is worth more than a dollar in the future because of its earning capacity. Present value (PV) discounts future cash flows back to today; future value (FV) compounds present cash forward. An annuity is a stream of equal payments at equal intervals: an ordinary annuity pays at period-end, an annuity due pays at period-beginning (and has a higher present value because each payment is discounted one fewer period).

Capital-budgeting methods

NPV vs IRR conflicts

For independent projects with conventional cash flows, NPV and IRR agree. They can conflict for mutually exclusive projects that differ in scale or in the timing of cash flows. The conflict stems from the reinvestment assumption: NPV assumes reinvestment at the cost of capital (realistic), while IRR assumes reinvestment at the IRR (often unrealistic). Non-conventional cash flows (sign changes) can also produce multiple IRRs.

Cost of capital

• WACC = (weight of debt × after-tax cost of debt) + (weight of equity × cost of equity). Weights are based on target capital structure (often market values).
• After-tax cost of debt = pre-tax interest rate × (1 − tax rate), because interest is tax-deductible.
• Cost of equity via CAPM = R_f + β(R_m − R_f), where R_f is the risk-free rate, β is the stock's systematic risk, and (R_m − R_f) is the market risk premium.
• Cost of equity via dividend-growth (Gordon) model = (D₁ ÷ P₀) + g, where D₁ is next year's dividend, P₀ is the current price, and g is the constant growth rate.

Business valuation approaches

• Income approach (DCF): value equals the present value of expected future cash flows discounted at a risk-adjusted rate. A terminal value captures cash flows beyond the explicit forecast.
• Market approach (multiples): applies valuation multiples (price/earnings, EV/EBITDA) from comparable companies or transactions.
• Asset-based approach: value equals the fair value of assets less liabilities; most relevant for asset-heavy or liquidating entities.

Enterprise risk management & financial risk COSO ERM 2017

COSO ERM 2017 components

The 2017 framework, Enterprise Risk Management – Integrating with Strategy and Performance, organizes ERM around five interrelated components supported by 20 principles:

Risk responses

• Avoid: exit the activity that gives rise to the risk.
• Reduce / mitigate: take action to lower likelihood or impact.
• Share / transfer: shift part of the risk to a third party (insurance, hedging, outsourcing).
• Accept: take no action because the risk falls within risk appetite.

Financial risks

• Interest-rate risk: exposure of value or cash flows to changes in market rates.
• Foreign-exchange risk: exposure to fluctuations in currency exchange rates (transaction, translation, and economic exposure).
• Credit risk: the risk a counterparty fails to meet its obligations.
• Liquidity risk: inability to meet short-term obligations or to sell an asset without a significant price concession.
• Market (price) risk: exposure to broad movements in market prices of securities or commodities.

Hedging and derivatives

Derivatives derive their value from an underlying asset, rate, or index and are used to hedge identified exposures:

• Forward: a customized, over-the-counter agreement to buy or sell at a set price on a future date.
• Future: a standardized, exchange-traded forward, marked to market daily through a clearinghouse.
• Option: the right, not the obligation, to buy (call) or sell (put) at a strike price; the buyer pays a premium.
• Swap: an exchange of cash-flow streams, such as an interest-rate swap trading fixed for floating payments.

Capital structure and leverage

Capital structure is the mix of debt and equity financing. Financial leverage (using debt) magnifies returns to equity holders when returns exceed the cost of debt, but it also increases financial risk and the chance of default. The degree of financial leverage and the degree of operating leverage combine into total leverage, which measures how a change in sales flows through to earnings per share.