CFA Flashcards
L2
5 steps of financial analysis?
- Identify economic characteristics of an industry
- Identify strategies that a firm pursues
- Assess quality of financial statements
- Analyse future profitability and risk
- Value the firm
L2
How do we identify economic characteristics of an industry?
Overview of profit and loss and balance sheet
Common size statements
Three tools:
- Value chain analysis
- Porters analysis
- Economic attributes
L2
How do we create common size financial statements?
What is true of the balance sheet vs the income statement
Divide all numbers by total revenue
OR for the balance sheet you can divide by total assets
Balance sheet = possible to be greater than 100%
Income statement = everything less than 100%
L2
Outline porters five forces
threat of new entrants = barriers of entry = horizontal Intensity of rivalry = horizontal Bargaining power of suppliers = vertical Bargaining power of buyers = vertical Threat of substitutes = horizontal
L2
What is the HHI?
How do we calculate the HHI?
What are the post merger HHI values?
HHI = measure of concentration within industry and is used to evaluate effects of a merger on competition
Calculate = sum of squared market shares before and after merger = convert market share (0.2 or 20%) into 100s (0.2 becomes 20) and square it and add them all together
less than 100 = no action
between 1000 and 1800 = change of 100 or more = possible action
more than 1800 = change of 50 or more = challenge
L2
What are the 4 Macroeconomic influences on industry growth, profitability and risk?
what is the difference between nominal and real growth rates?
Economic growth
Interest rates
Availability of credit
Inflation
Nominal = include inflation Real = subtract inflation
L2
The Michael porter approach specifies selecting an attractive industry (by using porter five forces), developing competitive advantage, and then developing an attractive value chain.
How do you develop competitive advantage?
Cost leadership
Product differentiation
Focus (on niche markets)
L3
Who are the users of financial statements (4)?
Customers
Suppliers
Financiers
Employees
L3
What must we consider when looking at financial statements?
Consider that all information is historical
Consider the accounting principles used
Consider that results may be affected by seasonality
L3 Profitability ratios: How profitable a firm is Return on sales or net profit margin Gross margin operating profit / sales EBIT/sales EBITDA/sales
How do we calculate Return on X ratios?
Return on sales = Net income / net sales
Gross margin = gross profit / net sales = reveals amount used to cover costs of production
operating profit / sales = operating profit / net sales = reveals amount used to cover costs of production (excluding taxes)
EBIT/sales = reveals amount used to cover costs of production (excluding taxes and financing costs)
EBITDA/sales = proxy for cash earnings = eliminates outside influence on profitability
Return on X ratios = Simply use Net income as numerator and then whatever X is for the denominator e.g. return ofn assets = Net income / Assets
L3
Asset utilisation or efficiency ratios: how effectively a firm uses its assets
TATO
Inventory turnover
A/R to sales
A/P to purchases
What is the tip for any period ratios (i.e. days inventory, account receivable period)
TATO = net sales / assets = asset turnover
- For assets use an average of beginning and ending
Net sales = total sales - sales allowances - sales discounts - sales returns
Inventory turnover = cost of sales / inventory
A/R to sales = net sales / A/R
A/P to purchases = cost of sales / A/P
Period ratios = simply flip the numerator and denominator and multiple by 365
L3:
First, what is a key determinant of how much leverage a company uses?
Financial leverage ratios
what are the various ratios we look at here?
Debt service ratios
EBIT coverage
CF coverage
Debt-service coverage
Key determinant = variability of return on assets
Financial leverage ratios = we look at things like debt / equity and short term debt / equity and long term debt / assets = basically understand the capital structure
EBIT coverage = EBIT / interest expense = ability to repay interest
CF coverage = EBIT + depreciation / interest expense
Debt-service coverage = EBIT / (interest +(principal payments/(1 - tax rate))
L3
Liquidity ratios: If leverage is a concern, can they pay their most immediate obligations?
Current ratio
Quick ratio
Current ratio = CA/CL
Quick ratio = CA - Inv / CL OR Cash and marketable securities + A/R / CL
L3
Market ratios
EPS
P/E
EPS = net income / number of shares outstanding P/E = price per share / earnings per share = how much are investors willing to pay for one dollars worth of earnings
L3
When analysing ratios, what are two things you need to consider?
Consider = the companies strategy i.e. its competitive advantage AND the industry it operates in
L3
Dupont analysis, what is it?
What is the formula?
How can we extend it to measure the sustainable growth rate of a company? and what is the SGR?
How do we use the SGR?
DuPont analysis = breaks down ROE in order to understand it better
Three stage = Net income / Net sales x Net sales / Total assets x Total assets / Equity
- Net profit margin x Asset turnover x Leverage
SGR = the maximum rate a company can grow using internally generated funds = Net profit margin x Asset turnover x Leverage x profit retention (profit retention = retained earnings / net income)
Use of SGR = compare to current growth rate. If current growth rate is under the SGR the company needs to change something (most likely dividend policy) in order to be growing faster, if reverse then something else needs to change as the growth is not sustainable.
L3
What is ROIC?
How do we calculate it?
What is NOPLAT?
ROIC = return on capital invested = combines profitability and asset utilisation to have a comprehensive view of a firms operating performance = analyses actual operating profitability
ROIC = EBITA/Revenue x (1-operating tax rate) x revenue/invested capital OR NOPLAT/invested capital
NOPLAT = earnings before interest charges and before non cash charges = EBIT x (1-T)
L3
How do we calculate EVA?
EVA = invested capital x (ROIC - WACC)
L4
Discuss the issues with a short or a long explicit forecast period and the way to overcome these issues
Short = undervaluation Long = extremely difficult to forecast individual line items = error of false precision
Overcome = use two periods, a short one and a long one. The short one has a complete model and the long one just focuses on a few important variables like revenue growth, margins, capital turnover
L4
Explain the mechanics of forecasting (6 steps)
- prepare and analyze historical financials
- Build the revenue forecast
- Forecast the income statement
- Forecast the balance sheet (invested capital)
- Forecast the balance sheet (investor funds)
- Calculate ROIC and FCF
L4
Explain the difference between a top-down and a bottom-up approach for building the revenue forecast
Top-down = estimate revenues by sizing the total market, determining market share, and forecasting prices Bottom-up = forecasts of demand from existing customers, customer churn, and the potential for new customers
L4
Forecasting the income statement
What is the driver for COGS, SG&A and R&D?
What is the driver for depreciation (also what could we do instead)
How do we forecast nonoperating income?
How do we forecast interest expense?
How do we forecast interest income?
How do we forecast operating and nonoperating taxes?
COGS SG&A and R&D use revenue as the driver
Depreciation = driven by prior year net PP&E or if we have the information we can just use the depreciation schedules
Nonoperating income = if company owns less than 20% than use historical growth. If company owns more than 20% use nonoperating income as a percentage of the appropriate nonoperating asset
Interest expense = use the prior years total debt as the driver
interest income = use the asset generating the interest income as the driver i.e. excess cash, short-term investments, customer financing, long-term investments
operating taxes = use operating tax rate
nonoperating taxes = use statutory tax rate
L4 Forecasting the balance sheet (operating working capital) What is the driver for the following: AR Inventories AP Accrued expenses PP&E
We exclude nonoperating items from our forecast, what are three nonoperating items?
How do we calculate capital expenditure
What do we do for goodwill?
AR = revenue Inventories = COGS AP = COGS Accrued expenses = Revenues PP&E = Revenues
nonoperating items = excess cash, short-term debt, dividends payable
Capital expenditure = sum the increase in net PP&E plus depreciation
Goodwill = hold constant
L4
How do we forecast retained earnings?
Retained earnings = Prior year retained earnings + net income of current year - dividends of current year
In order to forecast retained earnings we need to calculate net income (by doing all of the income statement and balance sheet forecasting) and dividends. To calculate dividends simply use the current year DPO
L4
Explain “The plugs”
How do we choose which to set to 0 out of newly issued debt and excess cash?
The plugs = different combinations of the following are used to complete the balance: excess cash, short-term debt, long-term debt, newly issued debt, common stock.
For a simple model we assume common stock remains constant and existing debt either remains constant or is retired on schedule and set either excess cash or newly issued debt to 0 to complete for the other.
Choose = test which is higher assets excluding excess cash or L&E excluding newly issued debt = for whichever one is higher set the associated account to 0 = REMEMBER “excluding” doesnt mean you need to subtract excess cash (because you dont know what the value of it is duh) it just means you sum the other figures up for assets VS L&E and see which is higher
L5
Why dont we just use the income statement instead of cash flows?
What is the change in cash formula?
What is true of net income over the long run?
How does firm life cycle influence cash needs?
dont use income statement = because it uses accrual accounting and ignores timing of cash receipts
Change in cash = Change in liabilities + Change in Equity - Change in non-cash assets
Net income = Cash over the long run
Firm life cycle = a firm in the growth stages may require extra cash flow, whereas a firm in a mature industry may already generate lots of cash and lack use for it = introduction, growth, maturity, decline
