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.