Financial Analysis Techniques Flashcards
Because of the variety of reasons for performing financial analysis, the numerous available techniques, and the often substantial amount of data, it is important that the analytical approach be tailored to the specific situation. Prior to beginning any financial analysis, the analyst should clarify the purpose and context, and clearly understand the following:
- What is the purpose of the analysis? What questions will this analysis answer?
- What level of detail will be needed to accomplish this purpose?
- What data are available for the analysis?
- What are the factors or relationships that will influence the analysis?
- What are the analytical limitations, and will these limitations potentially impair the analysis?
Describe 6 phases of a financial statement analysis framework.
- Articulate the purpose and context of the analysis.
- Collect input data.
- Process data.
- Analyze/interpret data.
- Develop and communicate conclusions and recommendations.
- Follow-up.
Evaluations require comparisons. It is difficult to say that a company’s financial performance was “good” or “bad” without clarifying the basis for comparison. In assessing a company’s ability to generate and grow earnings and cash flow, and the risks related to those earnings and cash flows, the analyst draws comparisons to other companies at the same point in time or over the same range of time (cross-sectional analysis) and over time (trend or time-series analysis). Hence, we have to ensure a comparable format, be it in the same currency, same ratios etc.
What are activity, liquidity, solvency and profitability ratios?
Activity ratios measure the efficiency of a company’s operations, such as the collection of receivables and management of inventory.
Liquidity ratios measure the company’s ability to meet its short-term obligations.
Solvency ratios measure a company’s ability to meet long-term obligations. Subsets of these ratios are also known as “leverage” and “long-term debt” ratios.
Profitability ratios measure the company’s ability to generate profits from its resources (assets) or sales.
What are “Inventory Turnover” and “Days of Inventory on Hand “ and how to calculate it?
COGS / Average Inventory
Number of Days in Period / Inventory Turnover
Inventory turnover indicates the resources tied up in inventory (i.e., the carrying costs) and, therefore, can be used to indicate inventory management effectiveness. A high inventory turnover ratio relative to industry norms might indicate highly effective inventory management. Alternatively, a high inventory turnover ratio (and commensurately low DOH) could possibly indicate the company does not carry adequate inventory, so shortages could potentially hurt revenue.
What are “Receivables Turnover” and “Days of Sales Outstanding “ and how to calculate?
Revenue / Average Receivables
Number of Days in Period / Receivables Turnover
The number of DSO (days of sales outstanding) reflects 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 be more appropriate, credit sales information is usually not available to analysts; therefore, revenue as reported in the income statement is generally used.
What are “Payables Turnover” and “Number of Days of Payables” and how to calculate?
COGS / Average Payables
Number of Days in Period / Payables Turnover
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.
What is “Working Capital Turnover” and how to calculate it?
Revenue / Average Working Capital
Working capital turnover indicates how efficiently the company generates revenue with its working capital.
What is “Fixed Asset Turnover” and how to calculate it?
Revenue / Average Fixed Assets
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.
What is “Total Asset Turnover” and how to calculate it?
Revenue / Average Total Assets
The total asset turnover ratio measures the company’s overall ability to generate revenues with a given level of assets.
How to calculate the current, quick and cash ratio?
Current Assets / Current Liabilities
Cash + Marketable Securities + Receivables / Current Liabilities
Cash + Marketable Securities / Current Liabilities
What is the Defensive Interval Ratio?
Cash + Marketable Securities + Receivables / Daily Cash Expenditures
The defensive interval ratio measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in. This ratio is similar to the “burn rate” often computed for early-stage companies that are funded by venture capital funds and company insiders.
What is the Cash Conversion Cycle?
DOH + DSO - Number of Days of Payables
What is the Financial Leverage Ratio?
Average Total Assets / Average Total Equity
What is the Interest Coverage Ratio?
EBIT / Interest Payments
What is the Fixed Charge Coverage?
EBIT + Lease Payments / Interest Payments + Lease Payments
What is Operating Return on Assets?
Operating Income / Average Total Assets
What is Return on Assets?
Net Income / Average Total Assets
What is Return on Invested Capital?
EBIT * (1 - Effective Tax Rate) / Average Total Debt + Equity
What is Return on Equity?
Net Income / Average Total Equity
What is Return on Common Equity?
Net Income - Preferred Dividends / Average Common Equity
Describe the five-way decomposition of Return on Equity and how to calculate each post individually?
Tax Burden * Interest Burden * EBIT Margin * Asset Turnover * Leverage
Tax Burden = Net Income / EBT
Interest Burden = EBT / EBIT
EBIT Margin = EBIT / Revenues
Asset Turnover = Revenue / Total Assets
Leverage = Total Assets / Total Equity
ROE = ROA * Leverage
ROE = Net Profit Margin * Asset Turnover * Leverage
ROE = Tax Burden * Interest Burden * EBIT Margin * Asset Turnover * Leverage
How to calculate the coefficient of variation for industry business risk?
Standard deviation / average operating income (or net income or revenue)
