Part 6. Financial Analysis Techniques

Question 1

Ratio analysis

Answer 1

These are useful tools for expressing relationships among data that can be used for internal comparisons and comparisons across firms.

Question 2

Uses of ratio analysis

Answer 2

• Project future earnings and cash flow
• Evaluate firms flexibility (ability to grow and meet obligations when unexpected circumstances arise).
• Assess management performance
• Evaluate changes in firm and industry overtime.
• Compare firm with industry competitors.

Question 3

Limitations of ratios

Answer 3

• Not useful when viewed in isolation, they are only informative compared to those of other firms or to the company’s historical performance.
• Comparisons with other companies made more difficult by different accounting treatments, essential when comparing US firms to non-US firms.
• Difficult to find comparable industry ratios when analyzing companies that operate multiple industries.
• Conclusions cannot be made by calculating a single ratio, where all ratios should be viewed relatively to one another.
• Determining target or comparison value for ratio is difficult, requires a range of acceptable values.

Question 4

Common size statements

Answer 4

These normalise balance sheets and income statements and allow analysts to more easily compare performance across firms and for a single firm overtime.

e.g. vertical common size balance sheet/income statement expresses all items as a percentage of total assets/sales.

Question 5

Uses of common size statements

Answer 5

• Quickly viewing certain financial ratios, i.e. gross profit margin, operating profit margin, net profit margin.
• Studying trends in costs and profit margins.

Question 6

Stacked column graph

Answer 6

This shows changes in items from year to year in graphical form.

Other forms of graphical analysis:

• Line Graph
• Regression Analysis

Question 7

Activity ratios

Answer 7

This includes several ratios referred to as asset utilisation or turnover ratios.

These are often indications of how well a firm utilises various assets such as inventory and fixed assets.

Question 8

Liquidity Ratios

Answer 8

The ability to pay short-term obligations/liabilities as they come due.

Question 9

Solvency ratios

Answer 9

These give analyst information on the firms financial leverage and ability to meet its LT obligations.

Question 10

Profitability ratio

Answer 10

These provide information on how well the company generates operating profits and net profits from its sales.

Question 11

Valuation ratios

Answer 11

Used in the analysis for investment in common equity.

Most widely used is price to earnings ratio (P/E).

Sales per share, earnings per share and price to cash flow per share are examples of ratios used in comparing the relative valuation of companies.

Question 12

Operating profitability ratios

Answer 12

These look at how good management is at turning efforts into profits, where they compare the top of income statements (sales) to profits.

These different ratios are designed to isolate specific costs.

Question 13

DuPont system of analysis

Answer 13

An approach used to analsye return of equity (ROE), bu breaking down ROE into a function of different ratios, to see the impact of leverage, profit margins and turnover on shareholder returns.

Question 14

Price to earnings ratio (P/E)

Answer 14

The ratio of the current market price of a share of stock divided by the company’s earnings per share.

Related measures are based on price per share are the price to cash flow, the price to sales and the price to book value ratios.

Per share valuation measures include earnings per share (EPS).

Basic EPS = the net income available to common divided by the weighted average number of common shares outstanding.

Question 15

Diluted EPS

Answer 15

The ‘what if’ value.

This is calculated as the lowest possible EPS that could have been reported if all firm securities that can be converted into common stock, and would decrease if basic EPS if they had been converted.

Includes:

• convertible debt
• convertible preferred stock
• options
• warrants issued by company

numerator - increased by the after-tax interest savings on any dilutive debt securities, and by dividends on any dilutive convertible preferred stock.

denominator - increased by common shares that would result from conversion or exchange of dilutive securities into common shares.

Question 16

Other per share

Answer 16

This includes cash flow per shares, EBIT per share and EBITDA per share.

The per shares measure are not comparable as the number of outstanding shares differ among firms.

e.g. assume Firm A and B both report net income of $100, if firm A has 100 shares outstanding, its EPS is $1 per share, if Firm B has 20 shares outstanding, its EPS is $5 per share.

Question 17

Dividends

Answer 17

Declared on a per-common share basis.

Total dividends on firm wide basis are referred to as dividends declared, where neither EPS not net income is reduced by payment of common stock dividends.

Retained earnings = net income - dividends declared, the earnings that are used to grow the corporation rather than being distributed to equity holders.

Question 18

Sustainable growth rate

Answer 18

This is how fast the firm can grow without additional external equity issues while holding leverage constant.

The proportion of firms nets income that is retained to fund growth.

To estimate this value for a firm, the rate of return on resources is measured as return on equity capital or ROE; where the proportion of earnings reinvested is known as retention rate (RR).

Question 19

Specific industry ratios

Answer 19

Net income per employee/sales per employee = valuation of service and consulting companies.

Growth in same-store sales = used in restaurant and retail industries to indicate growth without the effects of new locations that have been opened; a measure of how well firm is doing at attracting and keeping existing customers and in case of location with overlapping markets may indicate new locations are taking customers from existing.

Sales per square foot = in retail industry.

Question 20

Capital adequacy

Answer 20

This is the ratio of some dollar measure of risk, both operational and financial of the firm to its equity capital.

Question 21

Value at risk

Answer 21

An estimate of the dollar size of the loss that a firm will exceed only some specific percent of the time, over a specific period of time.

Question 22

Reserve requirements

Answer 22

The ratios of various liabilities to the central banks reserves must be above the minimums.

Question 23

Liquid asset requirement

Answer 23

The ratio of a banks liquid assets to certain laibilities.

Question 24

Net interest margin

Answer 24

The performance of financial companies that lend funds; which is interest income divided by firms interest-earning assets.

Question 25

Credit analysis

Answer 25

This assess the companys ability to service and repay its debt, ratios include interest coverage ratios, return on capital, and debt to asset ratios.

This is used to analyse and predict firm bankruptcies, i.e. Z-score; a predictive model based on firms working capital to assets, retained earnings t assets, EBIT to assets, market to book value of share of stock, and revenue to assets.

Question 26

Business segment

Answer 26

A portion of larger company accounts for more than 10% of companies revenues, assets or income is distinguishable from companies other lines of business in terms of risk and return characteristics of segment.

Boeing example of business segments:

5 principle categories:

1. Commerical Airplanes
2. Our defense, Space & Security (BDS) business comprises 3 segments;
   * Boeing Military Aircraft (BMA)
   * Network & Space Systems (N&SS)
   * Global Services & Support (GS&S)
3. Boeing Capital (BCC)

Question 27

Geographic segment

Answer 27

This is identified when they meet the size criterion given previously and geographic unit has a business environment different from other segments or remainder of companies business.

Question 28

3 methods examining variability of financial outcome around point estimates:

Answer 28

1. Sensitivity Analysis - based on ‘what if’ questions: What will be the effect on net income if sales increase by 3% rather than estimated 5%?
2. Scenario analysis - based on specific scenarios (a specific set of outcomes for key variables), and will yield a range of values for financial statement items.
3. Simulation - a technique in which probability distributions for key variables are selected and a computer used to generate a distribution of values for outcomes based on repeated random selection of values for key variables.