Reading 21: Financial Analysis Techniques Flashcards
Describe tools and techniques used in financial analysis, includig their uses and limitations.
Ratios can be used to project earnings and future cash flow, evaluate a firm’s flexibility, assess management’s performance, evaluate changes in the firm and industry over time, and compare the firm with industry competitors.
Vertical common-size data are stated as a percentage of sales for income statements or as a percentage of total assets for balance sheets. Horizontal common-size data present each item as a percentage of its value in a base year.
Ratio analysis has limitations. Ratios are not useful when viewed in isolation and require adjustments when different companies use different accounting treatments. Comparable ratios may be hard to find for companies that operate in multiple industries. Ratios must be analyzed relative to one another, and determining the range of acceptable values for a ratio can be difficult.
Identify, calculate, and interpret activity, liquidity, solvency, profitability and valuation ratios.
- Activity ratios indicate how well a firm uses its assets. They include receivables turnover, days of sales outstanding, inventory turnover, days of inventory on hand, payables turnover, payables payment period, and turnover ratios for total assets, fixed assets, and working capital.
- Liquidity ratios indicate a firm’s ability to meet its short-term obligations. They include the current, quick, and cash ratios, the defensive interval, and the cash conversion cycle.
- Solvency ratios indicate a firm’s ability to meet its long-term obligations. They include the debt-to-equity, debt-to-capital, debt-to-assets, financial leverage, interest coverage, and fixed charge coverage ratios.
- Profitability ratios indicate how well a firm generates operating income and net income. They include net, gross, and operating profit margins, pretax margin, return on assets, operating return on assets, return on total capital, return on total equity, and return on common equity.
- Valuation ratios are used to compare the relative values of stocks. They include earnings per share and price-to-earnings, price-to-sales, price-to-book value, and price-to-cash-flow ratios.
Describe relationship among ratios and evaluate a company using ratio analysis.
An analyst should use an appropriate combination of different ratios to evaluate a company over time and relative to comparable companies. The interpretation of an increase in ROE, for example, may be quite different for a firm that has significantly increased its financial leverage compared to one that has maintained or decreased its financial leverage.
Demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components.
Calculate and interpret ratio used in equity analysis and credit analysis.
Ratios used in equity analysis include price-to-earnings, price-to-cash flow, price-to-sales, and price-to-book value ratios, and basic and diluted earnings per share. Other ratios are relevant to specific industries such as retail and financial services.
Credit analysis emphasizes interest coverage ratios, return on capital, debt-to-assets ratios, and cash flow to total debt.
Explain the requirements for segment reporting and calculate and interpret segment ratios.
A business or geographic segment is a portion of a firm that has risk and return characteristics distinguishable from the rest of the firm and accounts for more than 10% of the firm’s sales or assets.
Firms are required to report some items for significant business and geographic segments. Profitability, leverage, and turnover ratios by segment can give the analyst a better understanding of the performance of the overall business.
Describe how ratio analysis and other techniques can be used to model and forecast earnings.
Ratio analysis in conjunction with other techniques can be used to construct pro forma financial statements based on a forecast of sales growth and assumptions about the relation of changes in key income statement and balance sheet items to growth of sales.
