Financial Analysis Techniques Flashcards
What is a ratio?
It is a mathematical relationship between 2 quantities in terms of a percentage or proportion.
What are the insights that a financial ratio can give?
- It can give microeconomic relationships within the company that are used by analysts to project the company’s earnings and CF.
- It helps with understanding a company’s financial flexibility.
- It helps with the management’s ability.
- It helps to see the changes in the company and industry over time.
- It shows how the company compares to peer companies and the industry overall.
What is the common-size statement?
It allows one to compare a company’s performance with that of other firms and to evaluate its performance over time.
What is a common-size income statement?
It expresses all income statement items as a percentage of revenues.
What is a common-size balance sheet?
It expresses each item as a percentage of total assets. They are prepared to highlight changes in the mix of assets, liabilities, and equity.
What is a cross-sectional analysis?
It compares a specific metric for one company with the same metric for another company or group of companies over a period of time. It is also called a relative analysis.
What are horizontal common-size financial statements?
They show the account based on the dollar values of accounts divided by their base-year values to determine their common-size values.
What tool is used to facilitate comparisons of firm performance and financial structure over time?
Graphs
Why should you use a pie graph?
To illustrate the composition of a total value.
Why should you use a line graph?
To help identify trends and detect changes in direction or magnitude.
Why should you use a stacked common graph?
To illustrate the changes in various items over the period in graphical form.
Why should you use a regression analysis?
To identify relationships between variables over time and assist analysts in making forecasts.
What is the limitation of ratios?
- A same company can be in different industries which makes it hard for comparison.
- One set of ratios might suggest a general problem and another a more specific one for the same issue.
- There is no set range that the ratio must lie within
- There is a latitude in the accounting methods used by a company that changes the financial ratios.
- If a company has different divisions in another country it can be challenging to evaluate ratios because of the different accounting standards.
What is an activity ratio?
It measures how productive a company is in using its assets and how efficiently is performs its everyday operations.
What is a liquidity ratio?
It measures the company’s ability to meet its short-term cash requirements.
What is a solvency ratio?
It measures the company’s ability to meet its long-term debt obligations.
What are profitability ratios?
It measures a company’s ability to generate an adequate return on invested capital.
What are valuation ratios?
It measures the quantity of an asset or flow associated with ownership of a specific claim.
What is inventory turnover?
It evaluates the effectiveness of a company’s inventory management.
- A high inventory turnover ratio relative to industry norms might indicate highly effective management.
- A low inventory turnover relative to the rest of the industry can be an indicator of slow-moving or obsolete inventory.
What is the day of inventory on hand?
It is inversely related to the inventory turnover.
The higher the inventory turnover ratio, the shorter the length of the period that inventory is held on average.
Describe the receivables turnover ratio.
- If the ratio is high, it might indicate that the company’s credit collection procedures are highly efficient. It might also show overly stringent credit or collection policies.
- A low ratio relative to industry averages will raise questions regarding the efficiency of a company’s credit or collection procedures.
- The comparison can be dug deeper by analyzing the company’s sales growth with industry sales.
- An historical comparison can be made to evaluate if a low receivables turnover is the result of credit management issues.
What is the payable turnover ratio? Describe it.
It measures how many times a year the company theoretically pays off all its creditors.
- A high ratio indicates that the company is not making full use of available credit facilities and repaying creditors too soon.
- A low ratio can also result from a company successfully exploiting lenient supplier terms.
What is working capital turnover?
It indicates how efficiently the company generates revenue from its working capital.
The higher the working capital turnover ratio, the higher the operating efficiency is.
What is fixed asset turnover? Describe it.
It measures how efficiently a company generates revenues from its investments in long-lived assets.
- A higher ratio indicates more efficient use of fixed assets in generating revenue.
- A low ratio could be an indicator of operating inefficiency. It can also be the result of a capital-intensive business environment.
- The fixed asset turnover ratio will be lower for a firm whose assets are newer than for a firm whose assets are relatively older.
What is total asset turnover? Describe it.
It measures the company’s overall ability to generate revenues with a given level of assets.
- A high ratio indicates efficiency, while a low ratio can be an indicator of inefficiency or the level of capital intensity of the business.
- It can also identify strategic decisions by management.
What is the liquidity analysis of a company?
It is to evaluate a company’s ability to meet its short-term obligations. Liquidity measures how quickly a company can convert its assets into cash at prices that are close to their fair values.
Describe the current ratio.
- The higher, the better since it indicates higher liquidity.
- A low ratio indicates less liquidity and implies a greater reliance on operating cash flow and outside financing to meet short-term obligations.
- The current ratio assumes that inventory and accounts receivable can readily be converted into cash at close to their fair values.
What is the quick ratio? Describe it.
It recognizes that certain current assets represent costs that have been paid in advance in the current year and cannot usually be converted into cash.
- A high quick ratio indicated greater liquidity.
What is the cash ratio? Describe it.
It measures how long the company can continue to meet its daily expense requirements from its existing liquid assets without obtaining any additional financing.
- A high defensive interval ratio, the higher the liquidity.
What is the cash conversion cycle? Describe it.
It measures the length of the period between the point that a company invests in working capital and the point that the company collects cash proceeds from sales.
- A shorter cycle is desirable, as it indicates greater liquidity.
- A longer cash conversion cycle indicates lower liquidity. It implies that the company has to finance its inventory and accounts receivable for a longer period of time.
What is the debt-to-asset ratio?
It measures the proportion of the firm’s total assets that have been financed by debt.
- A higher D/A ratio is undesirable because it implies a higher financial risk and weaker solvency position.
What is the debt-to-capital ratio?
It measures the proportion of a company’s total capital (debt + equity) that is composed of debt.
- A higher ratio indicates higher financial risk and is undesirable.
What is the debt-to-equity ratio?
It measures the amount of debt capial relative to a firm’s equity capital.
- A higher ratio is undesirable and indicates higher financial risk.
What is the financial leverage ratio?
It measures the amount of total assets supported by each money unit of equity.
- The higher the leverage ratio, the more dependent on debt to finance the company.
What is the debt-to-EBITDA ratio?
It estimates how many years it would take to repay total debt with earnings before income taxes, depreciation, and amortization.
What is the interest coverage ratio?
It measures the number of times a company’s operating earnings (EBIT) cover its annual interest payment obligations.
- A higher ratio provides assurance that the company can service its debt from operating earnings.
What is the fixed charge coverage ratio?
It measures the number of times a company’s operating earnings can cover its interest and lease payments.
- A higher ratio suggests that the company is comfortably placed to service its debt and make lease payments from the earnings it generates from operations.
What is the gross profit margin?
It tells us the percentage of a company’s revenues that are available to meet operating and nonoperating expenses.
What is the operating profit margin?
- An increasing operating margin is increasing at a higher rate than the gross profit margin indicating that the company has successfully controlled operating costs.
- A decreasing operating profit margin when gross profit margins are rising indicates that the company is not efficiently controlling operating expenses.
What is the pretax margin?
If a company’s pretax margin is rising primarily due to higher non-operating income, the analyst should evaluate whether this source of income will continue to bring significant earnings going forward.
What is the net profit margin?
It shows how much profit a company makes for every dollar it generates in revenue.
- A low net profit margin indicates a low margin of safety.
What is the return on assets (ROA)?
The higher the ROA, the greater the income generated by the company, given its total assets.
What is the adjusted ROA?
It is when the interest expenses are added back at the numerator of the ROA since assets are financed not only by equity holer but also by the bondholders.
What is the operating ROA?
It reflects the return on all assets used by the company, whether financed with debt or equity.
What is the return on total capital?
It measures the profits that a company earns on all sources of capital that it employs: short-term debt, long-term debt, and equity.
What is the return on equity?
It measures the rate of return earned by a company on its equity capital.
What is the return on common equity?
It measures the return earned by a company only on its common equity.
What are the main uses of DuPont analysis?
- It facilitates a meaningful evaluation of the different aspects of the company’s performance that affect reported ROE.
- It helps in determining the reasons for changes in ROE over time for a given company.
- It also helps us understand the reasons for differences in ROA for different companies over a given time period.
- It can direct management to areas that it should focus on to improve ROE.
- It shows the relationship between various categories of ratios and how they all influence the return that owners realize on their investments.
What is the 2-way DuPont decomposition?
It expresses ROE with the ROA and the financial leverage ratio.
It shows that as long as a company is able to borrow at a rate lower than the marginal rate it can earn by investing the borrowed money in its business, taking on more debt will result in an increase in ROE.
What is the 3-way DuPont decomposition?
It expresses ROE with net profit margin, asset turnover ratio, and financial leverage ratio.
What is the 5-way DuPont decomposition?
It expresses ROE with the tax burden, interest burden, operating profitability, efficiency, and leverage.
What is the tax burden ratio?
It is 1 - average tax rate
It measures the proportion of its pretax profits that a company gets to keep. A higher tax burden ratio implies that the company can keep a higher percentage of its pre-tax profits.
What is the P/E ratio?
It expresses the relationship between the price per share of common stock and the amount of earnings attributable to a single share.
What is the dividend payout ratio?
It measures the percentage of earnings that a company pays out as dividends to shareholders.
What is the retention rate?
It measures the percentage of earnings that a company retains and reinvests in the business.
What is the sustainable growth rate?
It shows the ability to finance its operations from internally generated funds. The higher ROE and higher retention rates result in higher sustainable growth rates.
What is the credit risk?
It is the risk of loss that is caused by a debtor’s failure to make a promised payment.
What is a business segment?
It is a separately identifiable component of a company that is engaged in providing an individual product or service or a group of related products or services.
What is a geographic segment?
It is a distinguishable component of a company that is engaged in providing an individual product or service within a particular region.
What is a sensitivity analysis?
It shows the range of possible outcomes as underlying assumptions are altered.
What is a scenario analysis?
It shows the changes in key financial quantities that result from given events such as a loss of supply of raw materials or a deduction in demand for the firm’s products.
What are simulations?
They are computer-generated sensitivity or scenario analyses based on probability models for the factors that strive for outcomes.
What are the different activity ratios?
- Inventory turnover and Days of inventory on hand (DOH)
- Receivables turnover and Days of sales outstanding (DSO)
- Payables turnover and Number of days payable
- Working capital turnover
- Fixed asset turnover
- Total asset turnover
What are the different liquidity ratios?
- Current ratio
- Quick ratio
- Cash ratio
- Defensive interval ratio
What are the different solvency ratios?
- Debt-to-assets ratio
- Debt-to-capital ratio
- Debt-to-equity ratio
- Financial leverage ratio
- Interest coverage ratio
- Fixed charge coverage ratio
What are the profitability ratios?
- Gross profit margin
- Operating profit margin
- Pretax margin
- Net profit margin
