Fundamentals

Question 1

What are the two categories of performance ratios?

Answer 1

Profitability ratios and efficiency ratios.

Question 2

What are do financial leverage ratios demonstrate?

Answer 2

The liquidity and solvency of a company.

Question 3

What do profitability ratios demonstrate?

Answer 3

Profitability ratios are an analysis of a company’s income statement. They evaluate the company’s ability to generate income relative to revenue.

Question 4

How do you carry out vertical (profitability) analysis of the income statement?

Answer 4

Take every line of the income statement and divide it by revenue. This shows each expense as proportion of a revenue. In other words, for every dollar earned how many cents of a cost line do we have incur to generate that dollar.

Question 5

What do efficiency ratios demonstrate?

Answer 5

Efficiency ratios evaluate how well a company is using assets.

Question 6

What do financial leverage ratios demonstrate?

Answer 6

Financial leverage ratios evaluate the amount of the company’s capital comes from debt in relation to equity.

Question 7

What is vertical analysis of the income statement?

Answer 7

Vertical analysis calculates each expense line relation to revenue in a single period, normally a year.

Question 8

What is horiztonal analysis?

Answer 8

Horizontal analysis compares profitability, efficiency and financial leverage ratios over a period of time, normally 5 years, to detect trend. Horizontal analysis can also be called trend analysis.

Question 9

What are the three key profitability ratios and how are they calculated in a vertical analysis of the income statement?

Answer 9

Gross profit margin tells us, for every dollar earned from sales, how much is taken up by direct costs. Or how much is left over, after paying direct costs. Gross profit margin is calculated by dividing gross profit by sales. The higher the number, the more profitable the company is.

Operating profit margin tells us, for every dollar earned, how much is taken up direct and indirect costs. Or, how much is left over, to pay taxes and interest. Operating profit is calculate by divided operating profit by sales. The higher the number, the more profitable the company is.

Net profit margin tells us, for every dollar earned from sales how much is income is generated. Or, how much is taken up by expenses. Net profit margin is calculated by divided net profit by sales. The higher the number, the more profitable the company is.

Question 10

What is the key efficiency ratio calculated in a vertical analysis of the income statement?

Answer 10

Tax ratio tells how good management is at managing tax. Tax ratio calculated by divided the company’s tax expense on the income statement by the earning before tax. if a company’s tax ratio **

Question 11

What is the key financial leverage ratio calculated in a vertical analysis of the income statement and what are the two ways it can be calculated?

Answer 11

Interest coverage ratio tells us how easily a company can service the interest it has to pay on outstanding debt. it is calculated by EBIT divided by interest expense. It is a measure of solvency. This formula provides a more conservative metric through which to analyse a company’s ability to service interest.

It can also be calculated by dividing EBITDA by the interest expense. This formula considered depreciation and amortisation non cash expenses and add them back to earnings. It helps company’s have a higher, more optimistic ratio.

Question 12

How do financial analysts use benchmarking?

Answer 12

We can only determine the health of ratios if we can compare them to the ratios of competitors or industry averages.

Question 13

What is horizontal analysis?

Answer 13

Horizontal analysis is usually completed after vertical analysis is carried out. It is also known as trend analysis, it enables analysis to look at ratios over time, usually 5 years to see if a trend will emerge. It is a time of trend analysis as it allows analysts to use past performance/trends to make projections and forecasts into the future. Different types of trend analysis can be carried out such as regression and multiple regression.

Question 14

What are the types of trend which can emerge?

Answer 14

If we take revenue as an example, Linear growth or decline, shows consistently rising or declining revenue. Concave or convex curves on the other hand show a major strategic/ industry shift, as they demonstrate accelerating or decelerating revenue. Lastly, we can see plateau which show that revenue is flatlining or curves which show volatility.

Question 15

What the benefits of trend analysis? (Declining profit margins examples)

Answer 15

Trend analysis allows us to answer important questions. For instance a business may be able to see that profit margins are falling over time. This might mean that, production volumes are decreasing over time, or that expenses have risen over time or even that sales are declining. All these phenomenons can be seen with trend analysis.

Question 16

Why are M&A reports important to look at when carrying out trend analysis?

Answer 16

Management reports can shed light on factors which are affecting the company. For instance an increase in cost of sales may be occurring for a number of reasons, such as increased competition causing an increase in the cost of manufacturing, less volume sold and lower sale prices. Or cost of sales may be rising due to scarcity in availability of raw materials.

Question 17

What do we need to consider when doing a benchmarking exercise?

Answer 17

Analysts need to know how items on a company’s financial statements are categorised in order to ensure a true comparison. Without an understanding of a company’s accounting principles, you cannot have truly comparable data. You can access company’s filings, Edgar, Sedar or RNS. Alternatively MNS money, google finance have pre-calculated information, or finally if you are working for a large IB, you might have access to Bloomberg, capital IQ and equity research reports.

Question 18

What do balance sheet demonstrate? (vertical analysis)

Answer 18

Ratios calculated from the balance sheet show how items on the asset side and liability side of the balance sheet relate to sales, in other words how many assets or how much liabilities are needed generate sales. If a company is having cashflow issues, these ratios will act as an early warning sign, they need to be calculated often.

Question 19

What are the balance sheet efficiency ratios?

Answer 19

Sales divided by total assets
sales divided by capital assets
sales divided by working assets
sales divided by inventory
sales divided by receivables
sales divided by land and buildings
sales divided by plant and machinery
sales divided by cash
sales divided by pauables

Question 20

What do balance sheet liquidity ratios demonstrate? (vertical analysis)

Answer 20

Liquidity ratios show how much of companies assets can be turned into cash. The balance sheet liquidity ratios are the current ratio and the quick ratio.

The current ratio is calculated by current assets divided by current liabilities. As a general if the ratio is 2:1, it is considered a good ratio but this depends on the industry and life cycle of the company.

The quick ratio or asset test ratio is calculated by current assets - inventory divided by current liabilities. As a general rule if the ratio is 1:1 it is considered a good ratio since, we have removed the considered harder to sell item, i.e inventory and therefore there is less need for a buffer. The quick ratio would normally be used for a company that cannot turn inventory into cash quickly and if a lot of its assets are tied to its inventory. The higher the number the more liquid a company however if the number is too high, we might consider the company to have idle assets which can be used to invest.

Question 21

What ratio requires both the balance sheet and income statement and what does it show?

Answer 21

The asset turnover ratio. It is calculated by taking sales and dividing it by total or net assets. This ratio tells how efficiently a company can generate revenue from assets. For every dollar of assets how much revenue can a company generate.

Question 22

What is working capital and how do you calculate it?

Answer 22

Working capital is the lifeblood of a company, it represents the capital during the period of time between cash going out, purchasing inventory and cash coming in, receivables account being cleared. it is so important because it represents the cash available to continue to pay for operating activities and therefore it needs to be carefully managed.

Question 23

Why is it important for a company to reduce the working capital funding gap and what are the strategies to do so?

Answer 23

The working capital funding gap is the name given to the period of time between cash going out, purchasing inventory and cash coming in. Cash is king, a company wants to keep cash on the balance sheet for as long as possible, so that it can fund its operating, investing and financing activities.

It is calculated by taking the results of the days ratios. Meaning, inventory days + receivable days - accounts payable. This will give a company the working capital as days.

To reduce the period where that occurs, a business can negotiate better terms with suppliers so that it has more time to pay suppliers and implement strategies/incentives so that it receives receivables quicker as well as improve its inventory management.

Question 24

What are the working capital efficiency ratios and how are they calculated?

Answer 24

The inventory turnover ratio show how quickly you sell inventory, generally the higher the better. It is calculated by: cost of sales divided by inventory. (The inventory can be the average inventory during the period or the end of year balance)
The inventory days ratio shows how long (in days) a company keeps inventory on the balance sheet before selling it. It is calculated by: inventory + 365 divided by cos of sales. Generally the lower the better.

Accounts receivable turnover ratio shows how quickly the company is able to clear accounts receivables, generally the higher the better. It is calculated by: cost of sales divided by receivables, If it’s too low the company could be extending too much credit to customers.
Accounts receivable days ratio show how many days, on average it takes for a company to recieve payment, again here the lower the number the better. It is calculated by receivables + 365 divided by cost of sales.

Accounts payables turnover ratio shows how quickly the company is paying payables. If the ratio is to it means the company is paying the entire balance twice during the period**. it is calculated by cost of sales divided by payables.
Accounts payables days ratio shows the number of days on average it takes the company to pay bills. It is calculated by: payables + 365 divided by cost of sales. Note that if the company has payment terms which allow it to pay for supplies much later, we exclude those line items.

Question 25

What is the PPE turnover ratio?

Answer 25

The PPE turnover over ratio demonstrates how quickly a company can turn PPE into cash. It is calculated by taking sales and dividing it by PPE. If the turnover ratio is too low it means that the company is not selling enough or investing too much in PPE. The ratio is sensitive to timing and the life cycle of a company, i.e if a company starts with a low base. If a company has just purchased PPE, the ratio will be low in he short term and perhaps rise in the long term. generally the higher the better.

Question 26

How are the income statement and the balance sheet used together by financial analysts?

Answer 26

The balance sheet, for which most of the efficiency ratios are calculated, is best combined with the income statement for which more of the performance ratios are calculated. Together they can provide valuable insights on performance and efficiency.

Question 27

What are the cashflow statement ratios and what are they used for?

Answer 27

Analysing cash flow date allows analysts to determine how funds are flowing in and out of the business and evaluate management decisions. For the cash flow they are 3 lenses through which to evaluate the cash flow.

Asset management looks at a company’s commitment to growth. By looking at capital expenditure, we can see if the company is investing in the business or buying other companies. If the number which related to assessment management flows is negative it means the company is investing, if it’s positive it means the company is shrinking its asset base.

Operational management looks at the strategy of a company to do value added things such as grow margins, increase volume and operating profit (net income + non cash items and adjusted for changes in working capital). This operational cash allows the company to re-invest or hold the cash on the balance sheet or return it to investors. Low cash pushes a company to fund a shortfall with existing balance or raise money by borrowing or selling asses to find losses.

Lastly a financing strategy determines the capital structure of a company. The company wants to keep WACC down as much as possible. To get the optimal capital structure, a company has to figure out the best mix of debt and equity it is looking for.
All three parts need to have a coherent strategy that brings everything together.

Question 28

What are other ways we can analyse the balance sheet?

Answer 28

We can analyse the balance sheet by grouping things together differently. For instance we can group capital employed and net assets. Capital employed refers to debt - equity and net assets refer to total assets.- current liabilities (the current portion of long term debt might be excluded from that number).
For capital employed please note to include: non-current liabilities, shareholder’s equity + short term debt + interest bearing current liabilities and current portion of long term debt. **

Question 29

What are short term options available for debt financing?

Answer 29

The two most common way to raise short term debt funding is using an overdraft or an operating line of credit. These strategies are commonly used to fund working capital, they don’t have fixed repayment schedule.

Question 30

What are long term options available for debt financing?

Answer 30

Term loans are a common option, they usually have fixed repayment schedule which could be amortising, meaning that have equal principal repayments occurring through the term of the loan or non-amortising, with a “bullet” repayment at the end.

Bonds are another way a company can raise money by issuing a securities of its own debt. This is usually a strategy used by large public companies. The issuer of the bond, otherwise known as the borrower, agrees to repay the bond holder or otherwise known as the investor, at the term date, or called the maturity date, with interest also called a coupon. Companies may prefer to issue a bond if bank loans are not available at a reasonable payment schedule or rate of interest.

Question 31

What are the different types of bonds?

Answer 31

Fixed rate bonds are bonds where the coupon stays constant over the bond’s life regardless of market interest rates

Floating rate bonds are bonds where the coupon is linked to an underlying benchmark rate, the coupon might therefore re-set periodically.

Zero coupon bonds are bonds where the issuer doesn’t pay any interest to the bond holder. these bonds trade at a discount than their value at maturity, and the rate of return is accrued over time and paid at maturity. **

Inflation linked bonds are bonds where the amount received at the maturity date is linked to inflation, coupon stays the same over the term of the bond but the principal **

Callable bonds are where the issuer can repay the bond before the maturity date, or depending on the specific terms of the bond, where the investor has the right to put back the bond back to the company.