L2-3: Financial Statement Analysis Flashcards
What are two approaches to financial statement analysis?
- Common-size analysis
- Ratio analysis
What is common-size analysis?
Normalize balance sheets and income statements and allow the analyst to more easily compare performance across firms and for a single firm over time.
What is a vertical common-size balance sheet?
Expresses all BS accounts as a percentage of total assets.
What is a vertical common-size income statement?
Expresses all IS items as a percentage of sales.
When are ratios informative/useful?
Not in isolation, but when compared to:
1. Other firms (peer benchmarking, cross-sectional analysis): between variations.
2. The company’s historical performance (time series analysis): within variation.
3. Other benchmarks: e.g. to the company’s required rate of return.
View ratios relative to each other, don’t only look at one.
Is calculation of ratios equal to financial analysis?
No, analysis goes beyond collecting data and computing numbers, it encompasses computations and interpretations.
- credit analysis
- equity analysis
- strategic planning
What are the five groups/classifications of financial key ratios?
- Activity: How efficient are the firm’s operations and the firm’s management of assets?
- Liquidity: How well is the firm positioned to meet short-term obligations?
- Solvency: How well is the firm positioned to meet long-term obligations?
- Profitability: How and how much is the firm achieving returns on its investments? Ability to generate profits from its resources.
- Valuation: How does the firm’s performance or financial position relate to its market value?
What are some drawbacks of accounting based comparison to aware of?
- Different growth strategies (e.g. growing by acquisition → goodwill).
- Different value added strategies (e.g. competing in prices
→ Sales/Total assets) - Financed in different ways (e.g. debt intensive industries
→ Equity/Assets) - Use different accounting methods (analyze accounting principles).
- Active in different countries, vulnerable to multiple sources of shocks that ripple through their financial statements and then ratios.
How can the problems with accounting based comparison be reduced?
- Choose companies that are as similar as possible.
- Make use of techniques like clustering analysis to choose similar companies within industries.
- Matching algorithms can also be used to find comparable companies.
- Adjust accounting.
- Choose key ratios that are not affected by the problem.
What 4 concepts are connected to growth financials?
- Growth: how does growth in sales/assets/employees translate into growth in equity?
- Financial position: has a clear impact (how do we finance that growth?).
- Dividend policy (new issues): the payout policy impacts growth in equity (clean identity surplus).
- Profitability: ROE tells us how profitable shareholders investment has been, taking into account how the growth has been financed.
What is the formula for the growth relationship for equity?
∆E / E = ROE - DIV/E + NewIssue/E
What is financially balanced growth?
When the growth rate of equity is the same as the growth rate of assets
What does the gross margin measure?
Gross profit / Sales
Measures the ability to translate sales into profit after consideration of cost of products sold.
What does the operating margin measure?
EBIT / Sales
Measures the ability to translate sales into profit after consideration of operating expenses.
What does the net margin (return on sales) measure?
Net profit / Sales
Measures the ability to translate sales into profit after consideration of all expenses and revenues, including
interest, taxes, and non-operating items.
What question does ROE answer?
What rate of return has the firm earned on the shareholders’ equity it had available during the year?
What question does ROA answer?
What rate of return has the firm earned on the assets it had available to use during the year?
How do we calculate EBIE?
EBIT + interest income
What signifies cost leadership?
Low margins, high turnover.
- Stable technology
- Standard products
- High efficiency
- Cost management
What signifies differentiation?
High margins, low turnover
- Innovative technology
- Mix of products
- High quality
- Brand
What does a firm’s position in a DuPont chart indicate?
- Industry membership.
- Strategy.
- Performance.
What may movement over time in a DuPont graph indicate?
- Changed level of efficiency (cost reduction scheme, capital efficiency scheme, etc).
- Change of strategy (outsourcing production, disposal of capital intensive parts of business, etc).
- Change in the competitive landscape (import tariffs, patent expiry, etc).
- Shift in the economic climate (some industries are more exposed to macro-level shocks).
What is an industry and how can they be classified?
A group of firms.
- Fama & French: US firms divided into 12/48 industries (groups). Different level of specificity (narrowness of industry).
- US SIC: We use 4 digits, but it can be up to 8. The digits provide a specific code/grouping, the more numbers, the more specific. Like a tree, it branches out into more specific categorizations.
What is a horizontal common-size balance sheet?
Prepared by dividing the quantity of each item by a base year quantity of the item. Highlights structural changes and can be used for trend analysis. Expresses everything as a percentage of the base year
What are some questions that can be asked in common-size analysis?
- What are the important components of the company’s balance sheet?
- Have any notable changes occurred?
- What caused the changes?
- What conclusions can we draw from comparing two companies?
Dependent on judgment and interpretation
What is the clean surplus relationship equation?
∆E = NetIncome - Div + NewIssue
What are typical characteristics in a DuPont chart?
- Far left: capital intensive energy companies
- Middle: manufacturing industrial companies
- Far right: organically growing consulting companies.
What is needed for ratio analysis to make sense?
Setting up benchmarks, for comparative purposes. Like industry average.
If the distribution is not standard, the reference is not the mean but either the median or the percentile intervals.
Why do we need to include a measure of dispersion in ratio analysis?
The adequacy (quality) of benchmarks will depend on factors such as the company size and the deviation from a settled standard. Even if we deflate items for comparison, ratio comparison is not optimal when comparing very large to very small firms.
What are some potential solutions when there is a lot of dispersion among firms in the same industry?
- Within comparison: using the past information of the firm to make comparisons.
- Comparison with a peer firm, i.e., a direct competitor subjected to similar shocks and characteristics, such as size, capital structure, etc.
- Use cluster analysis to find a group of peer firms within an industry.
What is cluster analysis?
- Want to see if possible to group companies, in a certain sector, that have similar characteristics.
- Similarity defined in statistical terms.
- Afterwards, we try to interpret the results in an economically meaningful way.
- Clustering is an iterative procedure. In our case, we have a number of key ratios (s) for a sample of companies (n).
Each observation (company) is a vector (point) in a s-dimensional space. The more ratios we use to calculate the similarity between forms, the more dimensions we use.
What is the curse of dimensionality and how can we minimise it?
A problem in cluster analysis.
Want to include many dimensions, but that makes it harder to find a match. Alleviate the issue by not including strongly correlated ratios (strong correlation = 20-30% in social sciences).
What are some ratios that we have seen strong correlation between?
- ROE and ROA
- Current ratio and Cash ratio
- Debt-to-equity and solvency ratio (negative corr)
- Receivables turnover and asset turnover
What are redundant ratios?
Ratios that provide very similar information within the same category.
What are diagnostic ratios?
Ratios that cannot easily be substituted by other ratios. For instance, the interest coverage ratio in the solvency category.
What can factor analysis do?
Help us reduce the number of variables without sacrificing variability. After generating the factors for profitability, liquidity, solvency and efficiency, we can perform cluster analysis.
How can we approach distress prediction?
Using ratio analysis to help us predict future bankruptcy (legal procedure, not liquidation)
What is the idea behind distress prediction and what techniques are there?
Idea: using a sample of bankrupt and non-bankrupt firms, we can try to isolate and put into a model those factors (ratios) that single out the types of firms.
- Discriminant analysis:
- Uni-variate (one ratio): Beaver 1966
- Multi-variate (array of dimensions): Altman 1968 - Logit Model: Ohlson 1980
What is the idea behind discriminant analysis?
To find one or more variables with a distribution that is (statistically) significantly different between:
- sub-sample of bankrupt companies
- sub-sample of non-bankrupt companies
This analysis uses binary classification.
How does uni-variate discriminant analysis work?
- Work out ratios for each company.
- Work out the mean for each ratio in each of the two sub-samples (bankrupt vs. non-bankrupt).
- Run a test to check whether the means are significantly different between the two sub-samples.
- Select one ratio.
- Select the discriminant level.
What can you say about Beaver’s (1966) uni-variate discriminant analysis?
79 bankrupt firms and 79 (matched) non-bankrupt firms.
Selection process based upon a paired-sample design, i.e. for each bankrupt firm in the sample, a non-bankrupt firm of the same industry and asset size was selected.
Ratios seem to be significantly different between the two subsamples:
- Cash flow to total debt
- net income to total assets
- total debt to total assets
- WC to total assets
- Current ratio
- no-credit interval
Some difference is seen already 5 years before distress, but the closer we get the more predictive power we have (larger gap).
How does multivariate discriminant analysis work?
Use a linear combination of ratios, which determines a value Z. Select cut-off values for Z to classify firms according to certain categories.
Steps:
1. Three subsamples. Two subsamples of firms (bankrupt/non-bankrupt) and another random subsample of firms to test how good our model classifies these firms into bankrupt/non-bankrupt categories.
2. Build a linear discriminant function (Z) that minimizes Type I and II errors.
3. Study the prediction power of the model.
What can you say about Alman’s (1968) multivariate discriminant analysis?
66 firms from manufacturing sector. Different weights are assigned to different ratios to find Alman’s Z-score. Depending on cutoff values for Z, we predict high or low risk of bankruptcy in the next 2 years.
Dependent variable Y=0 if the firm goes bankrupt in the following two years; 1 otherwise.
What is the idea of Logit Model analysis and what advantage does it have?
Method similar to multi-variate discriminant analysis: choose a discriminant value for the probability of bankruptcy.
Advantage: it does not need to assume normality (independent variables).
- Allows to calculate a probability of bankruptcy.
What can you say about Ohlson’s (1980) logit model analysis?
2000 firms. Dependent variable Y=1 if the firm goes bankrupt in the following year; 0 otherwise.
- Calculate the ratios.
- Obtain Y^ by plugging the ratios into the model.
- Use the Logit function to retrieve the probability of bankruptcy/non-bankruptcy.
