3.6 Financial Analysis Techniques Flashcards
Equity analysis focuses on?
Growth
Credit analysis focuses on?
risk
The following steps could be used for financial statement analysis:
- Articulate the purpose and context of the analysis.
- Collect input data.
- Process data.
- Analyze/interpret the processed data.
- Develop and communicate conclusions and recommendations.
- Follow up.
there are several important limitations to consider when using ratios:
Industry-specific ratios may not be applicable to companies with heterogeneous operations in multiple industries.
Different ratios can give inconsistent indications about a company.
Ratio analysis requires considerable judgment about, for example, macroeconomic and industry factors.
Comparing companies can be complicated by the use of different accounting standards or different choices that are allowed within the same set of accounting standards.
A vertical analysis of the balance sheet
is done with only one reporting period, dividing all items by the total assets
A horizontal analysis of the balance sheet
involves multiple time periods or companies.
It focuses on the percentage increase or decrease in each item.
A vertical analysis of the income statement
will divide everything by revenue, or, less commonly, by total assets (especially in the case of financial institutions).
Cross-sectional analysis
sometimes called relative analysis
compares a specific metric of one company to another
This is more easily done with a common-sized statement.
Trend Analysis
Trends are as important as the absolute or relative levels.
A horizontal common-size balance sheet will show everything in relation to the same base year.
The Use of Graphs as an Analytical Tool
Graphs can highlight changes in business operations.
They can also be used to effectively communicate the conclusions. Pie graphs are good at decomposing total value, while line graphs are more suited for analyzing changes over time.
Regression Analysis
Regression analysis can help identify and explain linear relationships between variables.
This technique is recommended for analysis that is more complex than, for example, observing changes in a particular ratio over time.
It is useful to categorize the large universe of financial ratios into manageable categories based on what they indicate about a company.
In this reading, we consider the following categories of ratios:
Activity ratios (operational efficiency)
Liquidity ratios (ability to meet short-term obligations)
Solvency ratios (ability to meet long-term obligations)
Profitability ratios (efficiency in using assets to generate profits)
Valuation ratios (relative price of ownership claims)
Activity Ratios
are also called asset utilization ratios or operating efficiency ratios.
They are indicators of ongoing operational efficiency.
They usually combine an income statement item in the numerator with a balance sheet item in the denominator
Inventory turnover
COGS / Average Inventory
A high ratio could indicate effective inventory management or inadequate inventory.
A high ratio combined with high revenue growth likely indicates good efficiency.
Days of inventory on hand (DOH)
Number of days in period / Inventory turnover
This (along with inventory turnover ratio) can be used to measure inventory effectiveness.
Receivables turnover
revenue / average receivables
A high ratio could indicate efficient credit and collection or that the company’s credit standards are too stringent.
Days of sales outstanding (DSO)
Number of days in period / receivables turnover
This represents the time between the sale and cash collection.
It would be better if the receivables turnover was only based on credit sales, but that data is not often available.
Payables turnover
Purchases / average trade payables
Number of days of payables
Number of days in period / Payables turnover
This reflects how many days it takes the company to pay suppliers.
A high ratio could indicate the company is taking advantage of credit opportunities, or perhaps missing out on early payment discounts.
Working capital turnover
revenue / average working capital
This ratio measures how effectively a company generates revenue from its working capital.
working capital
current assets minus current liabilities.
fixed asset turnover
revenue / average net fixed assets
This measures how effective a company is using its fixed assets.
A low ratio could indicate inefficiency or just that the company operates in a capital-intensive industry.
The ratio is normally greater for a company with older assets that have been marked down with depreciation.
total asset turnover
revenue / average total assets
This ratio measures the ability to generate revenue with total assets.
Liquidity Ratios
Liquidity analysis focuses on the ability to meet short-term obligations
Current ratio
current assets / current liabilities
A higher ratio indicates more liquidity, which means more capacity to take on debt.
quick ratio
(cash + short-term marketable securities + receivables) / current liabilities
This is more conservative than the current ratio, acknowledging some current assets like prepaid expenses cannot be converted back into cash.
defensive interval ratio
(cash + short-term marketable securities + receivables) / daily cash expenditures
measures how long a company can pay its daily cash expenditures with only existing liquid assets (i.e., no additional cash inflows).
cash ratio
(cash + short-term marketable securities) / current liabilities
This is the appropriate ratio during a crisis situation.
Solvency Ratios
relate to a company’s ability to meet its long-term debt.
The amount and type of debt will influence the future risk and return of the company.
Leverage results from?
fixed costs
can either come from operating leverage or financial leverage.
Operating leverage
comes from the use of fixed costs in the business operations
It will cause operating income to increase faster than revenues
financial leverage
arises from fixed financing costs
It will magnify the earnings flowing to equity holders
The use of leverage could signal management’s confidence in future profitability.
Debt-to-assets ratio
total debt / total assets
This is the percentage of total assets financed with debt.
debt-to-equity ratio
total debt / total shareholder’s equity
financial leverage ratio
average total assets / average total equity
This represents the amount of total assets supported by each unit of equity.
debt to EBITDA
Total debt / EBITDA
Coverage Ratios
used to show the level of income that is available to meet a company’s fixed financial obligations
interest coverage
EBIT / interest payments
Interest coverage is also called times interest earned because it represents how many times EBIT can cover the interest payments.
Fixed charge coverage
(EBIT + Lease payments) / (Interest payments + Lease payments)
The fixed charge coverage is the number of times earnings can cover interest and lease payments.
Profitability Ratios
indicate a company’s ability to use its assets to generate returns.
Analysts may be interested in returns relative to sales or returns on invested capital.
Gross profit margin
Gross profit / revenue
The gross profit margin is the percentage of revenue available to cover expenses and generate profit. This ratio is affected by competition.
Operating profit margin
operating profit / revenue
pretax margin
EBT / revenue
EBT is operating profit minus interest.
Net profit margin
net income / revenue
Often the net income is adjusted for non-recurring items.
Operating return on assets
operating income / average total assets
return on Assets (ROA)
net income / average total assets
Some analysts prefer to add back the after-tax interest expense in the numerator since the denominator represents assets financed by debt and equity.
return on capital
EBIT / (Short Term and Long Term Debt and Equity)
Return on equity (ROE)
Net Income / Average total equity
Return on common equity
(Net Income - Preferred dividends) / average common equity
DuPont analysis
examine the overall position and profitability of a company
decomposing the company’s return on equity (ROE)
Each component represents a different aspect of the company’s profitability.
according to the Dupont analysis, how can you decompose ROE?
ROE = net Income / Average Shareholders’ equity
ROE = ROA * Leverage
ROE = Net Profit Margin * Total Asset Turnover * Leverage
ROE = Tax Burden * Interest Burden * Total Asset Turnover * Leverage
The best-known valuation ratios are expressed as multiples of an equity’s market price.
They include:
P/E (price-to-earnings)
P/S (price-to-sales)
P/CF (price-to-cash flow)
P/B (price-to-book value)
The most popular valuation ratio
P/E (price-to-earnings)
which indicates the price that investors are willing to pay for one unit of a company’s net income.
P/S (price-to-sales)
can be used to analyze and compare entities that do not currently have positive net income.
P/CF (price-to-cash flow)
is often used when there are concerns about the quality of a company’s reported earnings.
P/B (price-to-book value)
provides an indication of the market’s assessment of the company’s expected future returns relative to the required rate of return.
Basic earnings per share (EPS)
the amount of earnings (net income) for each share of common stock.
If the company has issued new common stock or repurchased shares during the earnings period, the time-weighted average number of shares outstanding is used as the denominator.
diluted EPS
makes adjustments for the effect of dilutive securities (e.g., convertible debt, options).
The dividend payout ratio
the percentage of earnings the company pays out as dividends
The retention rate
the percentage of earnings that are retained by the company to be reinvested in new projects
A company with a 40% dividend payout ratio has a 60% retention rate.
A company’s sustainable growth rate
a function of its profitability (return on equity) and its retention rate
g = b * ROE
b = retention rate
Credit risk
measures the exposure to counterparties not making promised payments
Credit analysis
the evaluation of credit risk.
It could relate to a specific transaction or a borrower’s overall credit risk.
The probability of default can be determined and communicated.
EBITDA interest coverage ratio
EBITDA / interest expense (including non-cash interest)
Free funds from operations (FFO) to debt
FFO / Total debt
free operating cash flow (CFO)
CFO / total debt
EBIT margin
EBIT / total revenues
EBITDA margin
EBITDA / total revenues
Debt to EBITDA
Total Debt / EBITDA
return on capital
EBIT / average total capital
Many studies have been conducted to determine which ratios help predict bankruptcies. One study found the best six ratios were:
cash flow to total debt
ROA
total debt to assets
working capital to total assets
current ratio
no-credit interval ratio.
An operating segment
a unit of a company with its own distinct financial information
A start-up unit that has yet to begin generating revenue may be treated as a separate business unit.
Sensitivity analysis
measures the impact of changes in specific assumptions by producing a range of outcomes.
This method is also known as “what if” analysis.
Scenario analysis
models the impact of economic events, such as the loss of a key supplier.
If the possible events are mutually exclusive and collectively exhaustive, it is possible to assign probabilities and estimate expected values.
Simulation
uses computer models to run sensitivity or scenario analysis and generates a forecast based on the probability assigned to each outcome.
