 Hello and welcome to this session in which we would look at this BEC CPA exam simulations. The first thing you do when you look at a simulation is what type of a simulation am I dealing with? Scroll down a little and we could just overview look we need to compute some numbers. There's an amount here so it's an amount computation and drop down yes or no issue. That's the type of simulation. The next thing you want to know is what is the topic of the simulation? Well just by inspecting this I'm looking at ratios, financial ratios. So it's some computation with a drop down menu and financial ratios. Great, financial ratios this is good news for you. Why? Because if you're using forehead I teach you financial ratios inside out. So now your confidence level should go up, your stress level should go down on the exam because it's about this. Before we proceed any further I have a public announcement about my company foreheadlectures.com. forehead accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions, as well as exercises. Go ahead start your free trial today. Now what would you do next? Well I would read this real quick just see what what is it about oil, ink, a privately owned company borrowed from TH Bank in year five. Oh wow that's an unusual transaction right a company borrowing money that's very usual. The controller has asked you to calculate key matrices to determine compliance with loan covenant. Okay now I know what this what is this simulation is about. We took a bank loan and we need to compute ratios to determine whether we are in compliance or not with those bank loans with that bank loan covenant. The company generated two million and fifty thousand in cash flow from operating that's fine. Now I know what this what is the simulation is all about. What do I do next? I am going to look at the exhibits real quick not much real quick just to see what's in my exhibit. Guess what I'm not going to even look at this one. I know it's a statement of financial position. What does that mean? I have a balance sheet here. That's it. I don't even have to waste time at this point. I have an income statement statement of operations here. I have a bank loan covenants. Well I'm going to look at this. I'm going to look at this. Now I want to look at this to see what's inside that covenant because this is exactly what I need to do. I need to compare my financial ratios my current ratio to that covenant. Am I in compliance or not? That's the question. That's it. That's what this simulation is all about. So if you read it it says TH bank the lender is pleased to enter into loan agreement with you. You can read it but what you need to get is down to here. Here are the conditions of the debt covenant. The company will not be permitted a quick ratio to be less than 1.5. So what I would do on on on the side what I would do on the side I would put down for example on the side on my note I would say quick ratio 1.5. So this way because I'm going to need those numbers later. I don't want to pull it every time I'm looking at a number. Debt ratio not to exceed 0.8. So I'll copy those debt ratio 0.8. So on and so forth. This is what I would do. Now once I do this I close it and now I'm ready to compute to do some computation. Well the first ratio I'm asked to compute is the quick ratio. Well what's the quick ratio? Good news. You don't have to memorize it because the quick ratio is right here. They're giving you the ratios here so you don't have to memorize the ratios but you need to know where to get the information from. Well the quick ratio is cash and cash equivalent short-term investments receivable net divided by current libraries. That's a great they gave me the ratio. Well where do I get the information for this ratio? All these numbers are balance sheet numbers. What I would do I will go to the balance sheet statement of financial position balance sheet. I will take cash and cash equivalent account receivable. I don't have investments. I'm going to add those two and divide by divide by the current liabilities which is five million two hundred and thirty. I'm going to do this now in front of you and I want you to do it on the exam like what you should do. You should practice those. Why? Because notice the calculator is the same that you're going to be using on the exam day so it's very important that you are comfortable looking at this. It's five million five million eight hundred and seventy are the quick asset divided by five million two hundred and thirty and that's going to give me one point one two. One point one two quick ratio so my quick ratio one point one two done. That covenant compliance and the answer is no it's not. It's not that covenant compliance because remember the number was what? The number was one point five for the quick ratio was one point five. Well I know this. I know this is not going to be this is this is bad news for the company. They they violated this covenant. Total that ratio has to be point eight. Now I don't know how to compute total that ratio. I know how I know the formula but assuming I don't I'll go back to the I'll go back to the analytics and I will figure out real quick what's my total that ratio total liabilities divided by total asset. What do I look for this? Well hopefully I know that liabilities and assets are part of the balance sheet and what I would do I'll go to the balance sheet and I will divide total liabilities by total assets to figure out the ratio that ratio. Well I'll take this number the total li sorry total liabilities 25,810, 25,810 divided by 45,930. Once again I want you to do this. I want you to practice those simulation and it's 0.56 if my math is right. Again I put here 0.56 yeah it's a 0.56 not 0.57 I accept. Am I in compliance? I am because it's a 0.8. I could I I can take up to 0.8 finance my assets up to 0.8 and still be in compliance. Well I am in good shape why because 0.56 is less than 0.8 times interest earned once again if you don't know the ratio you'll go to the ratio then you will times interest earned times interest earned is coming from the statement of operation or income statement which is earnings before interest and interest earnings earnings before interest and taxes which is 4,320 divided by 260,000. Once again the reason I'm doing this in front of you just to get you used to the computation divided by 260 and that's equal to 16.61 16.61 so am I in good shape? Yes because if you look at the requirement they want they want a times interest ratio of 10 I have 16.61 yes I am in compliance with this ratio in other words my earnings are covering my interest expense return on equity return on equity what is a return on equity it is net income divided by you have to be careful you have to be careful here because return is net income it's an income statement account which is which is net income two million seven two million seven hundred and thirty divided by equity equity is a balance sheet account once you are dividing an income statement with a balance sheet account remember the balance sheet is a point in time therefore what I have to do I have to take year one and year two year one and year two equity year one and year two year one plus year two find the average of those then take net income divided by dividing it by the average let me do it in front of you because it's about because I'm taking a balance sheet account and I'm comparing to a to an income statement therefore I have to take 20 million 120 20 million 100 and 20 000 plus 17 million 390 000 divide this by two and that's going to give me 18 million 755 and my net income is 2 million 730 now I'm going to take my net income divided by the average equity and as a result I will be able to compute return on equity then compare that number to the what to the to what's required so I'm going to take 2 million 730 which is my net income and 2 million not not not 27 2 million 2 million 730 divide in it by 18 million 755 that's equal to 14.56 I'm gonna round to 15 it's gonna be 15.15 0.15 0.15 0.15 and all what they require for the debt covenant if you copy it down all what they require is is 10 percent I don't know why they are concerned about return on equity but that's fine as alone they should not worry about what am I returning for my equity but that's fine operating cash flow ratio this is important this is an important figure okay an important ratio like in the real world because you're looking at your operating cash flow divided by current liabilities okay so we have we are giving the operating cash flow we're not giving the statement of cash flow this if this number is not giving then you have then statement of cash flow will be given to you well let's reset this and let's start let's clear the tape if we have cash of 2 million 50 000 2 million and 50 000 I'm gonna divide this by the current ratio and the current ratio coming from the balance sheet which is 5 million 230 000 and that's gonna give me a ratio of 0.39 0.39 0.39 am I in compliance absolutely not 0.39 why because I need to have a ratio of one this ratio is supposed to be 1.2 I am not in compliance I'm really in trouble if I was the bank I'll be worried about this company but a lot of stuff don't make any sense here or it makes sense it looks like they are generating revenues and income but it's not in cash okay profit margin what's a profit margin it's a profitability ratio and it's coming from the statement of operation which is net income divided by total sales in other words how much am I keeping how much am I keeping from my sales in profit so take it 2 million 730 divide in it by divide in it by 39 million 500 and that's gonna give me 0.6911 0.6911 I'm gonna make it 0.7 round it to 0.7 0.07 am I in compliance they're only asking for 5% return on equity I'm sorry profit margin therefore I am in compliance okay so this is how I will how I will solve how I will solve this simulation is this simulation more or less difficult than a multiple choice I would say no more no less difficult than a multiple choice I can give you this information and ask you to compute the quick ratio and ask you to give me the answer and whether you are in compliance or not give you four different options I would say here's the income statement here's the balance sheet here's that covenant let me know if the quick ratio is in compliance how much is it and if it's in compliance it will be a multiple choice but it's not a multiple choice it's a form of a simulation so don't the point is I'm trying to make don't be overwhelmed simulation is no more than a multiple choice framed differently I know some simulations will be difficult I know this is what I'm saying is easier said than done because you're working under pressure the key to work under pressure is knowledge and this is where four half lectures can help you if you understand the ratios how do they relate to each other you will be fine and this is how I can help good luck study hard and stay safe