Financial Analysis - An Introduction

Welcome to the Knowledge Check. If you have prior knowledge of Financial Analysis, try the Knowledge Check. A perfect score is no guarantee that you know everything covered in the tutorial, but a less than perfect score will help you identify any knowledge gaps. If the subject of this tutorial is new to you, the Knowledge Check will indicate the level of the information that you're about to encounter. You may think you don't know much about this area, but you might surprise yourself!

Question 1 of 3
If a company is reporting profits, then its cash flow will be sufficient to fund asset growth. Inventory turnover Quick ratio Price/earnings ratio

Question 2 of 3

Which of the following companies is likely to have the largest inventory as a percentage of total assets? Commercial bank Software developer Discount retailer Airline Correct. You will learn how to analyze various financial ratios across different industries in Topic 2, Performing a Financial Analysis.

Question 3 of 3
True or False? If a company is reporting profits, then its cash flow is sufficient to fund asset growth. True False Correct. You will learn about the basics of cash flow analysis in Topic 3, Trend Analysis & Cash Flow Analysis. On completion of this tutorial, you will be able to: describe the uses of financial analysis calculate and analyze various financial ratios for a range of different companies/industries understand the drawbacks of reviewing a company's performance in the form of 'elevator analysis', an uncomplimentary term to describe how some analysts discuss companies Prerequisite Knowledge Prior to studying this tutorial, you should have a fundamental understanding of credit analysis as outlined in the following tutorial: Credit Analysis An Introduction

What is Financial Analysis?

Financial analysis is used to identify and assess all aspects of a company's performance, liquidity, and financial position. Credit analysts use financial analysis to:

compare a particular company against its peers, that is, against companies in the same or a similar industry. This helps to focus further analysis on areas where a company differs from its peers, in terms of operating performance and capital structure.

determine if a company is funding itself internally from operations, or if it needs to access external sources of cash. This is a primary means of assessing credit risk. evaluate if operating performance is real, that is, whether or not there is a chance of fraud in the accounts. Peer analysis is the way to achieve this. Historical financial performance is only the starting point for predicting future financial performance. A company's future performance is a function of many factors, including: its industry its competitive situation its past performance relative to its peers the competency of its management a comparison of its stated strategy and the analyst's view of the strategic opportunities As many sorry investors and lenders have learned, the past is not always a guide to the future. Judgments about future performance are clearly based on past performance, but must consider a number of factors that go beyond historic financial analysis. This will be the subject of a separate tutorial that examines cash flow forecasting in the context of credit analysis.

Basic Financial Ratios

Ratio analysis provides a way of summarizing a large volume of financial accounting information into simple measurements. These ratios can be used to monitor a company's financial performance compared to previous accounting periods, or to check the company's performance relative to its peers. Various types of financial ratio can be calculated, including liquidity, efficiency, leverage (gearing), and operating performance measures. However, no single ratio will provide a complete overview of a company's financial health. The ratios need to be blended together to give an overall picture of the company's financial position. Furthermore, ratios are only of value if they are used as a basis of comparison either internally (with results in previous periods) or externally (with results of other firms in similar industries). For example, the statement that a company has an inventory turnover ratio of 4 in the current period is of little use by

itself. When compared either with a previous period or with the company's peers, the ratio takes on a more meaningful value. Let's look at some frequently used financial ratios for evaluating: Liquidity

Efficiency

Leverage

Operating performance

Click each term to learn more about the financial ratios associated with it. When you have finished, click the Forward arrow to continue.

Leverage
Leverage ratios are a key indicator of financial risk. A basic measure of leverage is the ratio of total equity to total assets.

This describes the portion of total assets that are funded by equity rather than liabilities. Other typical metrics for leverage are:

Interest coverage is a metric that assesses the relationship between a company's gross cash flow and its periodic interest payments. This is a particularly important metric for highly leveraged companies. There are some arbitrary market standards for coverage, by debt rating, but it is important that all fixed obligations (interest, principal payments, taxes, and capital expenditure) are reviewed relative to a company's earnings. Gross earnings for this measurement are sometimes referred to as 'EBITDA' earnings before interest, taxes, depreciation, and amortization. EBITDA is a proxy for gross cash flow.

Current Ratio
What does a very low current ratio indicate for a company? Long-term debt is too high Inventory is too high Liquidity problems exist Correct. The current ratio is the ratio between a company's current assets and its current liabilities. The ratio determines the company's ability to pay its day-to-day debts as they fall due. A very low current ratio therefore indicates that a company may have liquidity problems.

Identifying Financial Characteristics

All companies within an industry will tend to have common financial characteristics - in relation to both the balance sheet and the income statement. Competition will drive profit margins among competitors, and the operating risks of an industry will drive the composition of the balance sheet. Industry practices will determine how much funding is supplied by vendors, and how much by debt and equity. A peer analysis of companies within an industry will lead to the identification of 'outliers' - financial indicators that are different from peers - which require investigation to determine why performance is above or below average. Sometimes the answer is logical, due to the company's management or a particular situation. On other occasions, the answer is not clear, which should lead to a sense of scepticism about whether or not the situation is correctly portrayed by the financial statements and data.

Financial Detective Exercise

Let's perform an exercise to illustrate how companies in different industries have financial characteristics that are driven by the nature of their business and the industry. The purpose of this exercise is to illustrate how basic financial analysis is used to identify the operating model of a company and industry how it makes money and uses its balance sheet to do so. A set of statistics for one company in each of the following industries is given to you: Discount retailing Commercial banking Software development Pharmaceuticals Airline Electric and gas utility Your task is to match each industry to each set of statistics. You will do this based upon common knowledge of the characteristics you would expect for a company in that industry. The following are the details available to you: Financial data

Guidelines and Hints

Click each link to go through the details. When you have finished, click the Forward arrow to continue.

Trend Analysis Making Judgments and Early Warning Signs

A common mistake made by inexperienced financial analysts is to review a company's historical performance through 'elevator analysis'. This is a review that consists primarily of statements about certain parameters going up or down, but without any insights provided about why this is happening or the significance of the trend. While ratios are very useful financial analysis tools, they are also somewhat limited if the time dimension is ignored. A company's success or failure tends to occur over a period of time and standalone ratios may not be able to detect trends or patterns. In trend analysis of financial statements, the various financial ratios are calculated on a per-period basis (typically yearly) and their values tracked over time. This makes ratios an even more powerful tool. Year-to-year comparisons can highlight trends and point to the need for action. Trend analysis can also help to moderate the influence of seasonality or exceptional factors. Trend analysis of financial statements is very important, but is only useful if an analyst can identify significance to the trends, and causality. The purpose of trend analysis is to

identify factors that imply outstanding performance, or factors that are warning signs.

Cash Flow Analysis

A credit analyst will perform many of the same financial analysis tasks as an equity analyst. The goals are similar to predict future cash flow. The equity analyst looks to establish value, usually based upon the present value of future cash flows. The focus of the credit analyst is to determine the degree to which a company is able to service its debt in the near term and in the future. Cash flow forecasting is part of this task. Future net cash flow generation, after all other fixed obligations, including capital expenditure, must be compared to future interest and principal obligations. However, a credit analyst must also be able to examine current liquidity. The analyst must also be able to understand historical cash generation, and the means by which a company funds its assets. There are many cases of company failures that were missed by analysts and bankers because they overlooked a simple fact that the company's cash flow was not sufficient to fund asset growth, even though it may have been reporting profits. For example, energy company Enron appeared to be extremely profitable, almost up to the point of its bankruptcy. However, Enron was not generating sufficient cash from its operations to fund its growth. In the two years prior to its demise, Enron had negative cash flow of around USD 2 billion. This was funded by debt, and exacerbated by the fact that much of this debt was hidden from analysts and investors through off-balance sheet vehicles. Cash flow analysis for credit analysts will be covered in detail in a subsequent tutorial.

Trend Analysis
Which of the following statements is true? If net margins are growing, operating expense margins must be improving. A falling accounts receivable collection period is generally an indication of poor financial control. A high and rising inventory turnover is generally a sign of good management. Correct. Generally speaking, a high inventory turnover is a sign of good management. Efficient companies turn over their inventory rapidly and do not keep too much capital tied up in raw materials and finished goods. Declining inventory turnover could highlight products that are not selling well, and could be a signal that mark-downs or inventory write-downs will have to be recognized at some point in the near future.