CFA 28: Financial Analysis Technique

Question 1

activity ratios

Common Ratios Used in Financial Analysis

Answer 1

Measure how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory.

Question 2

liquidity ratios

Common Ratios Used in Financial Analysis

Answer 2

Measure the company’s ability to meet its short-term obligations.

Question 3

solvency ratios

Common Ratios Used in Financial Analysis

Answer 3

Measure a company’s ability to meet long-term obligations. Sub sets of thses ratios are also known as “leverage” and “long-term debt” ratios.

Question 4

profitability ratios

Common Ratios Used in Financial Analysis

Answer 4

Measure the company’s ability to generate profits from its resources (assets).

Question 5

valuation ratios

Common Ratios Used in Financial Analysis

Answer 5

Measure the quantity of an asset or flow (e.g. earnings) associated with ownership of a specified claim (e.g. a share or ownership of the enterprise).

Question 6

asset utilization ratios (operating efficiency ratios)

Common Ratios Used in Financial Analysis

Answer 6

a

Question 7

working capital

Common Ratios Used in Financial Analysis

Answer 7

current assets - current liabilities

Question 8

defensive interval ratio

Common Ratios Used in Financial Analysis

Answer 8

Measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in.

A defensive interval ratio of 50 would indicate that the company can continue to pay its operating expenses for 50 days before running out of quick assets, assuming no additional cash inflows. A higher defensive interval ratio indicates greater liquidity. If a company’s defensive interval ratio is very low relative to peer companies or to the company’s own history, the analyst would want to ascertain whether there is sufficient cash inflow expected to mitigate the low defense interval ratio.

Daily cash expenditures

Question 9

cash conversion cycle

Common Ratios Used in Financial Analysis

Answer 9

A financial metric not in ratio form, measures the length of time required for a company to go from cash paid (used in operations) to cash received (as a result of its operations). The cash conversion cycle is sometimes expressed as the length of time funds are tied up in working capital. During this period of time, the company needs to finance its investment in operations through other sources (i.e. through debt or equity).

Question 10

current ratio

Common Ratios Used in Financial Analysis

Answer 10

This ratio expresses the current assets in relation to current liabilities. A higher ratio indicates a higher level of liquidity (i.e. a greater ability to met short-term obligations). A current ratio of 1.0 would indicate that the book value of its current assets exactly equals the book value of its current liabilities.
A lower ratio indicates less liquidity, implying a greater reliance on operating cash flow and outside financing to meet short-term obligations. Liquidity affects the company’s capacity to take on debt. The current ratio implicitly assumes that inventories and accounts receivable are indeed liquid (which is presumably not the case when related turnover ratios are low).

Question 11

quick ratio

Common Ratios Used in Financial Analysis

Answer 11

The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets (sometimes referred to as “quick assets”) in relation to current liabilities. Like the current ratio, a higher quick ratio indicates greater liquidity.

The quick ratio reflects the fact that certain current assets - such as prepaid expenses, some taxes, and employee-related prepayments - represent costs of the current period that have been paid in advance and cannot usually be converted back into cash. This ratio also reflects the fact that inventory might not be easily and quickly converted into cash, and furthermore, that a company could probably not be able to sell all of its inventory for an amount equal to its carrying value, especially if it were required to sell the inventory quickly. In situations where inventories are illiquid (as indicated, for example, by low inventory turnover ratios), the quick ratio may be a better indicator of liquidity than is the current ratio.

Question 12

cash conversion cycle (net operating cycle)

Common Ratios Used in Financial Analysis

Answer 12

This metric indicates the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash. In the typical course of events, a merchandising company acquires inventory on credit, incurring accounts payable. The company then sells that inventory on credit, increasing accounts receivable.

Afterwards it pays out cash to settle its accounts payable, and it collects cash in settlement of its accounts receivable. The time between the outlay of cash and the collection of cash is called the “cash conversion cycle”. A shorter cash conversion cycle indicates greater liquidity. A short cash conversion cycle implies that the company only needs to finance its inventory and accounts receivable for a short period of time.

A longer cash conversion cycle indicates lower liquidity; it implies that the company must finance its inventory and accounts receivable for a longer period of time, possibly indicating a need for higher level of capital to fund current assets.

Question 13

operating leverage

Common Ratios Used in Financial Analysis

Answer 13

Results form the use of fixed costs in conducting the company’s business. Operating leverage magnifies the effect of changes in sales on operating income. Profitable companies may use operating leverage because when revenues increase, with operating leverage, their operating income increases at a faster rate. The explanation is that, although variable costs will rise proprtionally with revenue, fixed costs will not.

Question 14

financial leverage

Common Ratios Used in Financial Analysis

Answer 14

When financing a company (i.e. raising capital for it), the use of debt constitutes financial leverage because interest payments are essentially fixed financing costs. As a result of interest payments, a given percent change in EBIT results in a larger percent change in earnings before taxes (EBT). Thus financial leverage tends to magnify the effect of changes in EBIT on returns flowing to equity holders.

Assuming that a company can earn more on funds than it pays in interest, the inclusion of some level of debt in a company’s capital structure may lower a company’s overall cost of capital and increase returns to equity holders. However, a higher level of debt in a company’s capital structure increases the risk of default and results in higher borrowing costs for the company to compensate lenders for assuming greater credit risk.

Question 15

debt-to-assets ratio

Common Ratios Used in Financial Analysis

Answer 15

This ratio measures the percentage of total assets financed with debt. For exmaple, a debt-to-assets ratio of .40 or 40 percent indicates that 40 percent of the company’s assets are financed with debt. Generally, higher debt means higher financial risk and thus weaker solvency.

Question 16

debt-to-capital ratio

Common Ratios Used in Financial Analysis

Answer 16

Measures the persncetage of a company’s capital (debt plus equity) represented by debt. As with the previous ratio, a higher ratio generally means higher financial risk and thus indicates weaker solvency.

Question 17

debt-to-equity

Common Ratios Used in Financial Analysis

Answer 17

Measures the amount of debt capital relative to equity capital. Interpretation is similar to the preceding two ratios (i.e. a higher ratio indicates weaker solvency). A ratio of 1.0 would indicate equal amounts of debt and equity, which is equivalent to a debt-to-capital ratio of 50 percent. Alternative definitions of this ratio use the market value of stockholders’ equity rather than its book value (or use the market values of both stockholders’ equity and debt).

Question 18

financial leverage ratio

Common Ratios Used in Financial Analysis

Answer 18

This ratio (often called just the “leverage ratio”) measure the amount of total assets supported for each one money unit of equity. For example, a value of 3 for this ratio means that each $1 of equity supports $3 of total assets. The higher the financial leverate ratio, the more leveraged the comany is in the sense of using debt and other liabilities to fnance assets. This ratio is often defined in terms of average total assets and average total equity and pals an importatnt role in the DuPont decomposition of return on equity.

Question 19

interest coverage

Common Ratios Used in Financial Analysis

Answer 19

Ths ratio measures the number of times a company’s EBIT could cover its interest payments. Thus, it is sometimes referred to as “times interest earned”. A higher interest coverage ratio indicates stronger solvency, offering greater assurance that company can serverice its debt (i.e. bank debt, bonds, notes) from operating earnings.

Question 20

fixed charge coverage

Common Ratios Used in Financial Analysis

Answer 20

This ratio relates fixed charges, or obligations, to the cash flow generated by the company. It measures the number of times a company’s earnings (before interest, taxes, and lease payments) can cover the company’s interest and lease payments. Similar to the interest coverage ratio, a higher fixed charge coverage ratio implies stronger solvency, offering greater assurance that the company can service its debt (i.e. bank debt, bonds, notes and leases) from normal earnings. The ratio is sometimes used as an indication of the quality of the preferred dividend, with a higher ratio indicating a more secure preferred dividend.

Question 21

gross profit margin

Common Ratios Used in Financial Analysis

Answer 21

The percentage of revenue available to cover operating and other expenses and to generate profit. Higher gross profit margin indicates some combination of higher product pricing and lower product costs. The ability to charge a higher price is constrained by competitition, so gross profits are affected by (and usually inversely related to) competition. If a product has a competitive advantage (e.g. superior branding, better quality, or exclusive technology,), the company is better able to charge more for it. On the cost side, higher gross profit margin can also indicate that a company has a competitve advantage in product costs.

Question 22

operating profit margin

Common Ratios Used in Financial Analysis

Answer 22

Operating profit is calcuated as gross profit minus operating costs. So, an operating proift margin increasing faster than the gorss profit margin can indicate improvements in controlling operating costs, such as administrative overheads. In contrast, a declining operating profit margin could be an indicator of deteriorating control over operating costs.

Question 23

pretax margin

Common Ratios Used in Financial Analysis

Answer 23

Pretax income (also called “earnings before tax” or EBT”) is calculated as operating profit minus interest, and the pretax margin is the ratio of pretax income to revenue. The pretax margin reflects the effects on profitability of leverage and other (non-operating) income and expenses. If a company’s pretax margin is increasing primarily as a result of increasing amounts of non-operating income, the analyst should evaluate whether this increase reflects a deliberate change in a company’s business focus and, therefore, the likelihood that the increase will continue.

Question 24

net profit margin

Common Ratios Used in Financial Analysis

Answer 24

Net profit, or net income, is calculated as revenue minus all expenses. Net income includes both recuring and non-recurring components. Generally, the net income used in calcuating the net profit margin is adjusted for non-recurring items to offer a better view of a company’s potential future profitability.

Question 25

ROA

Common Ratios Used in Financial Analysis

Answer 25

ROA measures the return earned by a company on its assets. The higher the ratio, the more income is generated by a given level of assets. Most databases compute this ratio as: Net income / Average total assets

Question 26

return on total capital

Common Ratios Used in Financial Analysis

Answer 26

Measures the profits a company earns on all of the capital that it employs (short-term debt, long-term debt, and equity). As with operating ROA, returns are measured prior to deducting interest on debt capital (i.e as operating income or EBIT).

Question 27

ROE

Common Ratios Used in Financial Analysis

Answer 27

Measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity. As noted, retun is measured as net income (i.e. interest on debt capital is not included in the retun on equity capital) A variation of ROE is retun on common equity, which measures the retun earned by a company only on its common equity.

Question 28

inventory turnover and DOH

Common Ratios Used in Financial Analysis

Answer 28

Indicates the resources tied up in inventory (i.e. the carrying costs) and can, therefore, be used to indicate inventory management effectiveness. A higher inventory turnover ratio implies a shorter period that inventory is held, and thus a lower DOH. In general, inventory turnover and DOH should be benchmarked against industry norms.

A high inventory turnover ratio relative to industry norms might indicate highly effective inventory management. Alternatively, a high inventory turnover ratio (and commesurately low DOH) could posssibly indicate the company does not carry adequate inventory, so shortages could potentially hurt revenue. To assess which explanation is more likely, the analyst can compare the company’s revenue growth with that of the industry. Slower growth combined with higher inventory turnover could indicate inadquate inventory levels. Revenue growth at or above the industry’s growth supports the interpretation that the higher tunover reflects greater inventory management efficiency.

A low inventory turnover ratio (and commensurately high DOH) relative to the rest of the industry could be an indicator of slow-moving inventory, perhaps due to technological obsolescence or a change in fashion. Again, comparing the company’s sales growth with the industry can offer insight.

Question 29

receivables turnover and DSO

Common Ratios Used in Financial Analysis

Answer 29

The number of DSO represents the elapsed time between a sale and cash collection, reflecting how fast the company collects cash from customers to whom it offers credit. Although limiting the numerator to sales made on credit in the receivables turnover would b more appropriate, credit sales information is not always available to analysts; therefore, revenue as reported in the income statement is generally used as an approximation.

A relatively high receivables turnover ratio (and commensurately low DSO) might indicate highly efficient credit and collection. Alternatively, a high receivables turnover ratio could indicate that the company’s credit or collection policies are too stringent, suggesting the possibility of sales being lost to competitors offering more lenient terms. A relative low receivables turnover ratio would typically raise questions about the efficiency of the company’s credit and collections procedures. As with inventory managnement, a comparison of the company’s sales growth relative to the industry can help the analyst assess whether sales are being lost due to stringent credit policies.

In addition, comparing the company’s estimates of uncollectible accounts receivable and actual credit losses with past experience and with peer companies can help assess whether low turnover reflects credit management issues. Companies often provide details of receivables aging (how much receivables have been outstanding by age). This can be used along with DSO to understand trends in collection.

Question 30

payables turnover and the number of days of payables

Common Ratios Used in Financial Analysis

Answer 30

The number of days of payables reflects the average number of days the company takes to pay its suppliers, and the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors. For purposes of calculating these ratios, an implicit assumption is that the company makes all its purchases using credit. If the amount of purchases is not directly available, it can be computed as

cost of goods sold plus ending inventory less beginning inventory.

Alternatively, cost of goods sold is sometimes used as an approximation of purchases.

A payables turnover ratio that is high (low days payable) relative to the industry could indicate that the company is not making full use of available credit facilities; alternatively, it could result from a company taking advantage of early payment discounts. An excessively low turnover ratio (high days payable) could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms.
This is another example where it is useful to look simultanieously at other ratios. If liquidity ratios indicate that the company has sufficient cash and other short-term assets to pay obligations and yet the days payable ratio is relatively high, the analyst would favor the lenient supplier credit and collection policies as an explanation

Question 31

working capital turnover

Common Ratios Used in Financial Analysis

Answer 31

Working capital is defined as current assets minus current liabilities. Working capital turnover indicates how efficiently the company generates revenue with its working capital. For example, a working capital turnover ratio of 4.0 indciates that the company generates $4 of revenue for $1 of working capital.

A high working capital turnover ratio indicates greater efficiency (i.e. the company is generating a high level of revenues relative to working capital). For some companies, working capital can be near zero or negative, rendering this ratio incapable of being interpreted. In that situation, it is better to use “fixed asset turnover” or “total asset turnover”.

Question 32

fixed asset turnover

Common Ratios Used in Financial Analysis

Answer 32

This ratio measures how efficiently the company generates revenues from its investments in fixed assets. Generally, a higher fixed asset turnover ratio indicates more efficient use of fixed assets in generating revenue. A low ratio can indicate inefficiency, a capital-intensive business environment, or a new business not yet operating at full capacity - in which case the analyst will not be able to link the ratio directly to efficiency. In addition, asset turnover can be affected by factors other than a company’s efficiency.

The fixed asset turnover ratio would be lower for a company whose assets are newer (and, therefore, less depreciated and so reflected in the financial statements at a higher carrying value) than the ratio for a company with older assets (that are thus more depreciated and so reflected at a lower carrying value). The fixed asset ratio can be erratic because, although revenue may have a steady growth rate, increases in fixed assets may not follow a smooth pattern; so, every year-to-year change in the ratio does not necessarily indicate important changes in the company’s efficiency.

Question 33

total asset turnover

Common Ratios Used in Financial Analysis

Answer 33

Measures the company’s overall ability to generate revenues with a given level of assets. A ratio of 1.20 would indicate that the company is generating $1.20 of revenues for every $1 of average assets. A higher ratio indicates greater efficiency. Because this ratio includes both fixed and current assets, inefficient working capital management can distort overall interpretations. It is therefore helpful to analyze working captial and fixed asset turnover ratios separately.

A low asset tunover ratio can be an indicator of inefficiency or of relative capital intensity of the business. The ratio also reflects strategic decisions by management - for example, the decision whether to use a more labor-intensive (and less capital-intensive) approach to its business or a more capital-intensive (and less labor-intensive) approach.

Question 34

price to cash flow

Equity Analysis

Answer 34

Because net income is generally considered to be more susceptible to manipulation tha are cash flows, analysts may use price to cash flow as an alternative measure - particularly in situaions where earnings quality may be an issue. EBITDA per share, because it is calculated using income before interest, taxes, and depreciation, can be used to eliminate the effect of different levels of fixed asset investment across companies. It facilitates comparison between companies in the same sector but at different stages of infrastructure maturity.

Question 35

price to sales

Equity Analysis

Answer 35

a

Question 36

price to book value (P/B)

Equity Analysis

Answer 36

The ratio of price to book value per share. This ratio is often interpreted as an indicator of market judgment about the relationship between a company’s required rate of return and its actual rate of return. Assuming that book values reflect the fair values of the assets, a price to book ratio of one can be interpreted as an indicator that the company’s future returns are expected to be exactly equal to the returns required by the market. A ratio greater than one would indicate that the future profitability of the company is expected to exceed the required rate of return, and values of this ratio less than one indicate that the company is not expected to earn excess returns.

Question 37

basic EPS

Equity Analysis

Answer 37

Provides information regarding the earnings attributable to each share of common stock. To calculate basic EPS, the weighted average number of shares outstanding during the period is first calculated. The weighted average number of shares consists of the number of ordinary shares outstanding at the beginning of the period, adjusted by those bought back or issued during the period, multiplied by a time-weighting factor.

Question 38

diluted EPS

Equity Analysis

Answer 38

Includes the effect of all the company’s securities whose conversion or exercise would result in a reduction of basic EPS; dilutive securities include convertible debt, convertible preferred, warrants, and options).

To calculate diluted EPS, earnings are adjusted for the after-tax effects assuming conversion, and the following adjustments are made to the weighted number of shares:

1) The weighted average number of shares for basic EPS, plus those that would be issued on conversion of all dilutive potential ordinary shares. Potential ordinary shares are treated as dilutive when their conversion would decrease net profit per share from continuing ordinary operations.
2) These shares are deemed to have been converted into ordinary shares at the beginning of the period or, if later, at the date of the issue of the shares.
3) Options, warrants (and their equivalents), convertible instruments, contingently issuable shares, contracts that can be settled in ordinary shares or cash, purchased options, and written put options should be considered.

Question 39

dividend payout ratio

Equity Analysis

Answer 39

Measures the percentage of earnings that the company pays out as dividends to shareholders. the amount of dividends per share tends to be relatively fixed because any reduction in dividends has been shown to result in a disproportionately large reduction in share price. Because dividend amounts are relatively fixed, the dividend payout ratio tends to fluctuate with earnings. Therefore, conclusions about a company’s dividend payout policies should be based on examination of payout over a number of periods. Optimal dividend policy, similar to optimal capital structure, has been examined in academic research and continues to be a topic of significant interest in corporate finance.

Question 40

retention rate

Equity Analysis

Answer 40

The retention rate, or earnings retention rate, is the complement of the payout ratio or dividend payout ratio (i.e. 1-payout ratio). Whereas the payout ratio measures the percentage of earnings that a company pays out as dividends, the retention rate is the percentage of earnings that a company retains.

Question 41

sustainable growth rate

Equity Analysis

Answer 41

A company’s sustainable growth rate is viewed as a function of its profitability (measured as ROE) and its ability to finance itself from internally generated funds (measured as the retention rate). The sustainable growth rate is ROE times the retention rate. A higher ROE and a higher retention rate result in a higher sustainable growth rate. This calculation can be used to estimate a company’s growth rate, a factor commonly used in equity valuation.