Executive Financial Planning Flashcards

Question 1

What are the three primary financial statements that executives review?

Accepted Answer

The three primary financial statements are the income statement, the balance sheet, and the statement of cash flows. The income statement reports revenues and expenses over a period. The balance sheet shows assets, liabilities, and equity at one point in time. The cash flow statement tracks cash by activity type.

Question 2

What does gross margin measure, and why do executives track it closely?

Accepted Answer

Gross margin measures the percentage of revenue left after subtracting the cost of goods sold. It shows how efficiently a company produces or delivers its products before overhead costs. Executives watch it because a falling margin can signal rising input costs or pricing pressure.

Question 3

What is the difference between accrual accounting and cash basis accounting?

Accepted Answer

Accrual accounting records revenues when they are earned and expenses when they are incurred, regardless of when cash changes hands. Cash basis accounting records transactions only when money is received or paid. Most large organizations use accrual accounting because it better matches income with the activity that produced it.

Question 4

What does return on equity reveal about how a company uses shareholder capital?

Accepted Answer

Return on equity divides net income by shareholders' equity, showing profit generated for each dollar of owners' capital. A higher figure suggests management is using invested funds effectively. However, high returns can also result from heavy borrowing, which increases risk. Executives therefore read return on equity alongside leverage ratios and cash flow measures.

Question 5

Why is working capital important when judging a company's short term financial health?

Accepted Answer

Working capital equals current assets minus current liabilities, and it shows whether a company can cover obligations due within one year. Positive working capital suggests a cushion for paying suppliers, employees, and lenders. Negative working capital is not always a problem, since some retailers collect cash before paying suppliers.

Question 6

Why do analysts use common size financial statements in comparative analysis?

Accepted Answer

Common size statements express each line item as a percentage of a base figure, such as total revenue for the income statement or total assets for the balance sheet. This standardization lets analysts compare companies of different sizes. It also reveals shifts in cost structure over time.

Question 7

How do horizontal and vertical analysis differ when reviewing financial statements?

Accepted Answer

Horizontal analysis compares line items across multiple periods, showing dollar or percentage changes over time. Vertical analysis expresses each item as a percentage of one base figure within the same period. Horizontal analysis reveals growth trends, while vertical analysis shows the internal mix.

Question 8

What does an auditor's unqualified opinion signal about financial statements?

Accepted Answer

An unqualified opinion means the independent auditor concluded that the statements present fairly, in all material respects, the company's financial position and results under the applicable accounting framework. It does not guarantee the company is well managed or free of fraud. Readers should still study the notes.

Question 9

What is the main purpose of a budget in an organization?

Accepted Answer

A budget is a financial plan that sets expected revenues and planned spending for a future period. It translates strategy into measurable targets for each department. Budgets also create accountability, because managers can compare actual results against approved figures. They serve as a baseline for control, performance review, and resource allocation decisions.

Question 10

How does zero based budgeting differ from incremental budgeting?

Accepted Answer

Incremental budgeting starts from last year's spending and adjusts it up or down by a percentage. Zero based budgeting requires every expense to be justified from scratch each period, as if starting with a blank sheet. This forces managers to examine priorities rather than repeat old patterns.

Question 11

What is a rolling forecast and when is it useful?

Accepted Answer

A rolling forecast extends a set number of future periods and updates continuously as each period closes. Adding a new period as the current one ends keeps the planning horizon constant. It is useful in volatile markets, where static annual plans quickly become outdated.

Question 12

Why do executives prefer driver based forecasting over simple trend extrapolation?

Accepted Answer

Driver based forecasting links financial results to measurable operating drivers such as unit volume, price, headcount, or conversion rate. Simple trend extrapolation assumes past patterns will continue without explaining why. Drivers let leaders test scenarios and see the effect on results.

Question 13

What is the difference between a budget and a forecast?

Accepted Answer

A budget is a financial plan that management approves and commits to achieve, whereas a forecast is a best estimate of likely results. A forecast is revised frequently as new information arrives. Budgets set expectations and accountability, while forecasts inform decisions about resources and actions.

Question 14

What is a flexible budget and how does it help with variance analysis?

Accepted Answer

A flexible budget adjusts planned costs and revenues to match the actual activity level achieved during the period. Comparing actual results with this adjusted plan isolates the effect of spending efficiency from the effect of volume changes. A static budget does not change with volume and can make variances look misleading.

Question 15

What is a top down budget and what risk does it carry?

Accepted Answer

A top down budget starts with overall targets set by senior leaders, which are then divided among departments. It is fast and aligns spending with strategic priorities. The main risk is that frontline managers may lack buy in, and their operational needs may be ignored. Combining top down targets with bottom up input often produces more realistic plans.

Question 16

How can scenario planning improve the reliability of a budget?

Accepted Answer

Scenario planning builds several versions of the budget based on different assumptions, such as optimistic, base, and adverse economic conditions. Each scenario shows how revenues, costs, and cash would respond to changes in key drivers. It also reveals which assumptions matter most to the overall result.

Question 17

What is the weighted average cost of capital and why does it matter?

Accepted Answer

The weighted average cost of capital, often called WACC, is the blended rate a company pays to finance its assets from debt and equity. It weights each financing source by its share of total capital. Executives use it as a hurdle rate for new projects.

Question 18

How does the tax deductibility of interest affect the cost of debt?

Accepted Answer

Interest paid on debt is generally deductible for tax purposes, which lowers the effective after tax cost of borrowing. If the stated rate is 6 percent and the tax rate is 25 percent, the after tax cost is 4.5 percent. This tax shield is one reason debt is cheaper.

Question 19

What is the capital asset pricing model used to estimate?

Accepted Answer

The capital asset pricing model estimates the required return on equity by linking it to the risk free rate, the market risk premium, and the stock's beta. Beta measures how sensitive the stock's returns are to overall market movements. Its inputs are estimates, so results depend heavily on the assumptions chosen.

Question 20

What is financial leverage and how does it affect shareholder risk?

Accepted Answer

Financial leverage is the use of borrowed money to finance assets, with the goal of magnifying returns to equity holders. When operating returns exceed the cost of debt, leverage raises earnings per share. When returns fall short, losses are magnified and fixed interest payments remain due.

Question 21

What tradeoffs does a company weigh when choosing between debt and equity financing?

Accepted Answer

Debt carries fixed repayment obligations and can create covenant restrictions, but it does not dilute existing owners. Equity has no required repayment and absorbs losses, but issuing new shares dilutes ownership. Managers also weigh tax benefits, credit ratings, and the company's capacity to absorb shocks.

Question 22

What is a debt covenant and why do lenders include them?

Accepted Answer

A debt covenant is a contractual condition in a loan agreement that limits certain actions or requires the borrower to maintain specified financial ratios. Lenders use covenants to limit risk after funds are advanced. Common examples include minimum interest coverage and maximum leverage ratios.

Question 23

Why might a company choose to repurchase shares instead of paying a larger dividend?

Accepted Answer

Share repurchases return cash to shareholders and give management more flexibility than regular dividends. Repurchases can also reduce the share count, which may raise earnings per share. Buybacks are sometimes used when managers believe the stock is undervalued. However, excessive repurchases can deplete cash needed for investment or resilience during downturns.

Question 24

How does dividend policy relate to a company's growth opportunities?

Accepted Answer

Companies with abundant high return projects often retain more earnings to fund growth, paying smaller dividends or none. Mature firms with fewer investment opportunities usually distribute a larger share of profits. Dividend policy therefore reflects the tradeoff between funding internal projects and returning cash.

Question 25

What is net present value and what decision rule does it support?

Accepted Answer

Net present value is the sum of all expected future cash flows, discounted to today's value, minus the initial investment. The decision rule is to accept a project when its net present value is positive, since it adds value above the required return. It accounts for time value of money.

Question 26

How is the internal rate of return defined and what is its main weakness?

Accepted Answer

The internal rate of return is the discount rate that makes a project's net present value equal to zero. Projects are typically accepted when this rate exceeds the required return. Its main weakness is that it can give misleading rankings for mutually exclusive projects of different sizes.

Question 27

What is the payback period and why do some managers use it despite its limits?

Accepted Answer

The payback period is the time required for a project's cash inflows to recover the initial investment. It is simple to calculate and easy to explain to nontechnical audiences. However, it ignores cash flows beyond the payback point and does not account for the time value of money.

Question 28

How do executives use the profitability index when capital is rationed?

Accepted Answer

The profitability index divides the present value of future cash flows by the initial investment. When capital is limited, managers rank projects by this ratio and fund the highest ratios first. This approach helps maximize total value per dollar invested. Indivisible projects can leave funds unused, so divisibility matters.

Question 29

What is sensitivity analysis and how does it help evaluate a capital project?

Accepted Answer

Sensitivity analysis changes one input at a time, such as sales volume or discount rate, and measures the effect on the project's net present value. It shows which assumptions have the greatest influence on the decision. Executives can then focus research and monitoring on the most critical variables.

Question 30

Why should capital budgeting use incremental cash flows rather than accounting profits?

Accepted Answer

Incremental cash flows measure only the changes a project causes, such as additional revenue and additional operating costs. Accounting profit includes noncash items like depreciation, and it may allocate overhead that would exist anyway. Cash flows reflect the timing of actual money moving in and out, which matters for value.

Question 31

What is the role of the discount rate in valuing a multiyear project?

Accepted Answer

The discount rate converts future cash flows into present value by reflecting the opportunity cost and risk of the investment. A higher rate shrinks the present value of distant cash flows more than near ones. Firms often use the weighted average cost of capital, adjusted for project specific risk.

Question 32

How do real options add value that a simple net present value calculation might miss?

Accepted Answer

Real options are the managerial flexibilities to expand, delay, abandon, or switch a project after new information arrives. A standard net present value calculation usually assumes a fixed plan and may undervalue these choices. Recognizing them can justify investments that look marginal on static numbers.

Question 33

What is the cash conversion cycle and why do executives watch it?

Accepted Answer

The cash conversion cycle measures the days between paying for inventory and collecting cash from customers. It adds days inventory outstanding and days sales outstanding, then subtracts days payable outstanding. A shorter cycle means cash is tied up for less time. Improving it frees cash without new borrowing.

Question 34

What does the current ratio show and what limitation should readers keep in mind?

Accepted Answer

The current ratio divides current assets by current liabilities to show short term liquidity. A ratio above one suggests current assets exceed obligations due within a year. The main limitation is that it includes inventory and receivables that may be slow to convert to cash.

Question 35

Why do treasury teams maintain a cash buffer or minimum cash balance?

Accepted Answer

A cash buffer protects the organization against unexpected outflows, delayed collections, or sudden disruptions in credit markets. It gives management time to respond without selling assets at unfavorable prices. The right size depends on cash flow volatility, access to credit lines, and obligations coming due.

Question 36

What is a revolving credit facility and how does it support liquidity planning?

Accepted Answer

A revolving credit facility is a committed bank line that a company can draw, repay, and redraw up to a set limit during the agreement term. It provides standby liquidity for seasonal needs or unexpected shortfalls. Companies often pay fees on undrawn amounts, so sizing the line is a balancing decision.

Question 37

How does a company's foreign exchange exposure create financial risk?

Accepted Answer

Foreign exchange exposure arises when revenues, costs, assets, or debts are denominated in currencies other than the company's reporting currency. Changes in exchange rates can then alter reported earnings, cash flows, and the value of foreign assets. Executives may use natural hedges, such as matching foreign revenues with foreign costs.

Question 38

What is enterprise risk management and how does it differ from siloed risk reviews?

Accepted Answer

Enterprise risk management is a structured approach that identifies, assesses, and monitors risks across the whole organization, linking them to strategy. Siloed reviews examine each function separately, which can miss risks that interact, such as a supplier failure that also strains cash. An integrated view helps leaders compare risks on a common scale.

Question 39

What is the difference between risk appetite and risk tolerance?

Accepted Answer

Risk appetite is the broad amount and type of risk an organization is willing to pursue to achieve its objectives. Risk tolerance is the acceptable variation around a specific target, often expressed as a measurable limit. For example, tolerance might set a maximum acceptable loss on one project.

Question 40

How does a company use stress testing to prepare for liquidity shocks?

Accepted Answer

Stress testing models how cash, earnings, and covenant compliance would behave under severe but plausible adverse conditions. Analysts might assume lost customers, slower collections, higher borrowing costs, or frozen credit markets. The results reveal how long cash would last and which obligations would be hardest to meet.

Executive Financial Planning Flashcards

1Financial Statement Foundations

2Budgeting and Forecasting Methods

3Cost of Capital and Financing

4Capital Investment Decisions

5Liquidity, Working Capital and Risk

Learning Resources