Quick Answer
This is the core of Function 1 (49% of the exam). Read three linked statements, compute liquidity, profitability, and leverage ratios, then value a company three ways: comps, precedent transactions, and discounted cash flow. Master Enterprise Value, Weighted Average Cost of Capital, and accretion/dilution.
Function 1's densest sheet: ratios, valuation, and filings.
Which One-Liners Win Points?
- Net income flows three places: bottom of the income statement, top of the cash flow statement (Cash Flow from Operations (CFO) start), and retained earnings.
- Cash on the balance sheet = beginning cash + change in cash (the standard tie-out).
- Net debt subtracts cash: $5 billion debt with $4 billion cash = $1 billion net debt.
- Interest coverage uses EBIT, not net income; ROIC uses NOPAT, not net income (NOPAT = EBIT x (1 minus tax rate)).
- Precedent transactions can price higher than comps via a control premium, but not automatically; the ranges can overlap or invert.
- Schedule 13D is for active investors (intent to influence control); 13G is for passive investors.
- Going-private = Schedule 13E-3 with each filer's fairness belief; an outside opinion is disclosed only if one was obtained.
Which Numbers Matter Most?
| Item | Value |
|---|---|
| Function 1 exam weight | 49% (37 of 75 scored questions) |
| Current ratio for positive working capital | 1.0 |
| Investment-grade signal | high coverage, low debt/EBITDA |
| Leveraged (junk) credit signal | typically BB+ and below |
| Schedule 13D / 13G ownership trigger | 5% of a class |
| Activist 13D filing deadline | within 5 business days of crossing 5% |
| Form 13F filer threshold | managers with $100 million+ |
| Form 13F filing lag | quarterly, 45-day lag |
| Qualified Institutional Buyer (QIB) threshold | $100 million in securities ($10 million for broker-dealers) |
| Qualified purchaser threshold | $5 million individual / $25 million institutional |
| S corporation shareholder cap | 100 shareholders, no nonresident aliens, one class of stock |
| REIT pass-through distribution requirement | 90%+ of taxable income |
| Going-private holder-of-record threshold | fewer than 300 holders of record |
| Schedule 14D-9 (target board recommendation) deadline | within 10 business days of the tender offer |
How Do Ratios and Valuation Work?
- Cash collection cycle = DIO + DSO minus DPO; shorter recycles cash faster.
- Turnover trap: receivables turnover uses revenue; inventory and payables turnover use COGS. FCF yield = free cash flow / market cap, not EV.
Exam Tip: Gotchas
Current ratio includes inventory; quick ratio strips it out, the tougher test for inventory-heavy companies.
- EBITDA = EBIT plus D&A; it is NOT cash flow, since it ignores working-capital changes, CapEx, and taxes and interest paid.
- ROA and ROIC strip out leverage; Return on Equity (ROE) does not.
- First-In, First-Out (FIFO), during inflation: oldest, lowest-cost inventory to COGS, lower COGS, higher earnings and taxes. Last-In, First-Out (LIFO): newest, highest-cost inventory to COGS, higher COGS, lower earnings and taxes (tax deferral).
- Enterprise Value (EV): . M&A is quoted as EV.
- EV / EBITDA and EV / Sales are workhorse multiples; equity multiples include P/E, P/B (stated vs tangible), P/S, and PEG.
- DCF = PV of free cash flows at WACC, plus terminal value. DDM = PV of expected dividends.
- Weighted Average Cost of Capital (WACC): , taxing debt only.
- Terminal value: Gordon Growth = FCF x (1 + g) / (WACC - g); exit multiple = terminal EBITDA x multiple.
- Accretion/dilution: stock-funded is accretive when target P/E is below the acquirer's; cash-funded is accretive when after-tax target earnings exceed after-tax interest cost.
What Filings and Financing Structures Matter?
- Registration statements: S-1 (IPO); S-3 (seasoned issuers); S-4 (M&A and exchange offers).
- DEF 14A carries the "Background of the Merger" section, the richest M&A precedent source.
- Investor types: Qualified Institutional Buyers (QIBs, unlock 144A resales), qualified purchasers (unlock 3(c)(7) funds).
- Going-private disclosure (Schedule 13E-3) triggers when it risks dropping below the holder threshold or delisting.
Which Gotchas Trip Students Up?
- PP&E is property, plant and equipment, not "property, plant and earnings."
- DDM only works for dividend payers; a high-growth company retaining all earnings needs a DCF instead.
- Risk arbitrage means merger arbitrage (long the target, short the acquirer), not arbitrage generally.
- 300 holders of record is the standard going-private threshold; 500 applies only in narrower fact patterns.
- The target board has four Schedule 14D-9 options, not three: accept, reject, stay neutral, or decline to take a position.
- Going private (issuer or affiliate is the buyer, files Schedule 13E-3) vs issuer-purchase restriction during a third-party offer (a behavior restriction, not a schedule).
One-Breath Recap
This unit drives Function 1 (49% of the exam): three linked statements (net income ties to all three, cash ties to the cash flow statement) feed liquidity, profitability, and leverage ratios, where ROA and ROIC strip out leverage but ROE does not, and net debt, therefore EV, subtracts cash; value a company three ways, trading comps, precedent transactions that may carry a control premium, and a DCF at WACC (tax shield on debt only) to a terminal value; a stock-funded deal is accretive when target P/E is below the acquirer's; filings run 13D active, 13G passive, 13F institutional; financing runs QIB $100 million, going-private below 300 holders, Schedule 14D-9 within 10 business days.
Need more than the recap? Read the full Analysis and Evaluation of Data unit.