Part 6. Financial Analysis Techniques Flashcards
Ratio analysis
These are useful tools for expressing relationships among data that can be used for internal comparisons and comparisons across firms.
Uses of ratio analysis
- 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.
Limitations of ratios
- 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.
Common size statements
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.
Uses of common size statements
- Quickly viewing certain financial ratios, i.e. gross profit margin, operating profit margin, net profit margin.
- Studying trends in costs and profit margins.
Stacked column graph
This shows changes in items from year to year in graphical form.
Other forms of graphical analysis:
- Line Graph
- Regression Analysis
Activity ratios
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.
Liquidity Ratios
The ability to pay short-term obligations/liabilities as they come due.
Solvency ratios
These give analyst information on the firms financial leverage and ability to meet its LT obligations.
Profitability ratio
These provide information on how well the company generates operating profits and net profits from its sales.
Valuation ratios
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.
Operating profitability ratios
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.
DuPont system of analysis
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.
Price to earnings ratio (P/E)
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.
Diluted EPS
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.
Other per share
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.
Dividends
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.
Sustainable growth rate
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).
Specific industry ratios
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.
Capital adequacy
This is the ratio of some dollar measure of risk, both operational and financial of the firm to its equity capital.
Value at risk
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.
Reserve requirements
The ratios of various liabilities to the central banks reserves must be above the minimums.
Liquid asset requirement
The ratio of a banks liquid assets to certain laibilities.
Net interest margin
The performance of financial companies that lend funds; which is interest income divided by firms interest-earning assets.
