Reading 24: Financial Analysis Techniques

Question 1

List the business risk ratios.

Answer 1

Coefficient of variation of operating income

Coefficient of variation of net income

Coefficient of variation of revenues

Question 2

List the insights financial ratios provide.

Answer 2

Microeconomic relationships within the company that are used by analysts to project the company’s earnings and cash flows.

A company’s financial flexibility.

Management’s ability.

Changes in the company and industry over time.

How the company compares to peers and the industry overall.

Question 3

Give the dividend payout ratio and the retention ratio.

Answer 3

Dividend Payout Ratio

Common share dividends / Net income

The percentage of earnings that a company pays out as dividends to shareholders. The per-share dividend paid by companies is typically fixed, so this ratio fluctuates as a percentage of earnings.

Retention Ratio

1 ‒ Dividend Payout Ratio or 1 ‒ Common share dividends / Net income

Question 4

Name the components for the two-, three-, and five-way DuPont Composition.

Answer 4

Two-Way

1. ROA
2. Leverage

Three-Way

1. Net Profit Margin
2. Asset Turnover
3. Leverage

Five-Way

1. Tax Burden
2. Interest Burden
3. EBIT Margin
4. Asset Turnover
5. Leverage

Question 5

Give the ratio to calculate the following:
Receivables Turnover (and Days of Sales Outstanding (DOS))
Working Capital Turnover
Fixed Asset Turnover
Total Asset Turnover

Answer 5

Receivables Turnover: Revenue / Average receivables

Days of Sales Outstanding (DOS)

No. of days in period / Receivables turnover

Working Capital Turnover

Revenue / Average working capital

Fixed Asset Turnover

Revenue / Average net fixed assets

Total Asset Turnover

Revenue / Average total assets

Question 6

What do the working capital, fixed asset, and total asset turnover ratios indicate?

Answer 6

The working capital turnover ratio indicates how efficiently the company generates revenue from its working capital.

The fixed asset turnover ratio measures how efficiently a company generates revenues from its investments in long-lived assets.

The total asset turnover ratio measures the company’s overall ability to generate revenues with a given level of assets.

Question 7

Classify the ratio categories.

Answer 7

Activity ratios measure how productive a company is in using its assets and how efficiently it performs its everyday operations.

Liquidity ratios measure the company’s ability to meet its short-term cash requirements.

Solvency ratios measure a company’s ability to meet long-term debt obligations.

Profitability ratios measure a company’s ability to generate an adequate return on invested capital.

Valuation ratios measure the quantity of an asset or flow associated with ownership of a specific claim.

Question 8

Define solvency and explain what solvency ratios measure.

Answer 8

Solvency refers to a company’s ability to meet its long-term debt obligations.

Solvency ratios measure the relative amount of debt in a company’s capital structure and the ability of earnings and cash flows to meet debt-servicing requirements.

Question 9

Describe common-size analysis, and how is it used on the income statement and balance sheet.

Answer 9

Common-size analysis allows an analyst to compare a company’s performance with that of other firms. It also allows the analyst to evaluate performance over time.

A common-sized income statement is constructed by dividing all items on the statement by revenue, yielding a percentage that can be compared against other income statements.

A common-sized balance sheet is constructed by dividing all items on the balance sheet by total assets yielding a percentage that can be compared against other balance sheets.

Question 10

Give the ratios for the following items
Debt-to-Capital
Financial Leverage

Answer 10

Total debt / (Total debt + Total shareholders’ equity)

Average total assets / Average total equity

Question 11

Give the ratio used to determine interest coverage, and explain the meaning of the ratio.

Answer 11

Interest Coverage Ratio

EBIT / Interest payments

The interest coverage indicates the number of times a company’s operating earnings (earnings before interest and tax, or EBIT) cover its annual interest payment obligations. This ratio is widely used to gauge a company’s ability to meet its debt-servicing requirements from operating profits.

Question 12

Name two retail ratios, two service company ratios, and two hotel ratios.

Answer 12

Retail Ratios

1. Same store sales
2. Sales per square foot (meter)

Service Company Ratios

1. Revenue per employee
2. Net income per employee

Hotel Ratios

1. Average daily rate
2. Occupancy rate

Question 13

Give the formula used to calculate the cash conversion cycle, and explain what it measures?

Answer 13

DOH + DSO – Number of days of payables

CCC provides length of time between the point a company invests in working capital and the point the company collects cash proceeds from sales.

It is the time between outlay of cash and the collection of cash.

A shorter cycle is desirable (indicates greater liquidity).

A longer cash conversion cycle indicates lower liquidity. It implies that the company finances its inventory and accounts receivable for a longer period of time.

Question 14

Give the calculation for purchases and the ratio used to calculate payables turnover.

Answer 14

Purchases

Ending inventory + COGS − Opening inventory

Payables Turnover

Purchases / Average trade payables

Question 15

Explain the significance of the debt-to-asset ratio.

Answer 15

This ratio shows the proportion of the firm’s total assets that have been financed by debt.

Question 16

Give the ratio for the following items:
Operating Profit Margin
Return on Capital
Return on Common Equity

Answer 16

Operating Profit Margin

Operating profit / Revenue

Return on Capital

EBIT / (Short- and long-term debt and equity)

Return on Common Equity

Net income / Average total Equity

OR

(Net income ‒ Preferred dividends) / Average common equity

Question 17

Give the ratio used to calculate:
Inventory Turnover
Days of Inventory on Hand (DOH)

Answer 17

Inventory Turnover Ratio

Cost of goods sold / Average inventory

This ratio measures the effectiveness of a company’s inventory management and is benchmarked against the industry average.

Days of Inventory on Hand (DOH)

No. of days in period / Inventory turnover

Question 18

Identify the limitations of ratio analysis.

Answer 18

Companies may have divisions that operate in different industries.

One set of ratios may suggest that there is a problem, but another may indicate that the potential problem is only short term.

There are no set ranges within which particular ratios for a company must lie.

Firms enjoy significant latitude in the choice of accounting methods that are acceptable given the jurisdiction in which they operate.

Comparing ratios of firms across international borders is even more difficult, in that most countries use IFRS.

Question 19

Differentiate between a sensitivity analysis and a scenario analysis.

Answer 19

Sensitivity analysis shows the range of possible outcomes as underlying assumptions are altered.

Scenario analysis shows the changes in key financial quantities that result from given events such as a loss of supply of raw materials or a reduction in demand for the firm’s products.