CFA 28: Financial Analysis Technique Flashcards
activity ratios
Common Ratios Used in Financial Analysis
Measure how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory.
liquidity ratios
Common Ratios Used in Financial Analysis
Measure the company’s ability to meet its short-term obligations.
solvency ratios
Common Ratios Used in Financial Analysis
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.
profitability ratios
Common Ratios Used in Financial Analysis
Measure the company’s ability to generate profits from its resources (assets).
valuation ratios
Common Ratios Used in Financial Analysis
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).
asset utilization ratios (operating efficiency ratios)
Common Ratios Used in Financial Analysis
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working capital
Common Ratios Used in Financial Analysis
current assets - current liabilities
defensive interval ratio
Common Ratios Used in Financial Analysis
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
cash conversion cycle
Common Ratios Used in Financial Analysis
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).
current ratio
Common Ratios Used in Financial Analysis
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).
quick ratio
Common Ratios Used in Financial Analysis
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.
cash conversion cycle (net operating cycle)
Common Ratios Used in Financial Analysis
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.
operating leverage
Common Ratios Used in Financial Analysis
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.
financial leverage
Common Ratios Used in Financial Analysis
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.
debt-to-assets ratio
Common Ratios Used in Financial Analysis
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.
debt-to-capital ratio
Common Ratios Used in Financial Analysis
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.
debt-to-equity
Common Ratios Used in Financial Analysis
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).
financial leverage ratio
Common Ratios Used in Financial Analysis
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.
interest coverage
Common Ratios Used in Financial Analysis
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.
fixed charge coverage
Common Ratios Used in Financial Analysis
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.
gross profit margin
Common Ratios Used in Financial Analysis
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.
operating profit margin
Common Ratios Used in Financial Analysis
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.
pretax margin
Common Ratios Used in Financial Analysis
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.
net profit margin
Common Ratios Used in Financial Analysis
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.