R28 Financial Analysis Techniques IFT Notes PDF

Financial Analysis
Techniques
2014 Level I Financial Reporting and Analysis
IFT Notes for the CFA exam
Financial Analysis Techniques
Irfanullah.co
Contents
1. Introduction ....................................................................................................................................... 3
2. The Financial Analysis Process ....................................................................................................... 3
3. Analytical Tools and Techniques .................................................................................................... 5
4. Common Ratios Used in Financial Analysis .................................................................................. 8
5. Equity Analysis ............................................................................................................................... 18
6. Credit Analysis ............................................................................................................................... 21
7. Business and Geographic Segments .............................................................................................. 21
8. Model building and forecasting ..................................................................................................... 22
Summary ............................................................................................................................................. 22
Next Steps ........................................................................................................................................... 23
This document should be read in conjunction with the corresponding reading in the 2014 Level I
CFA Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality
of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and
Chartered Financial Analyst are trademarks owned by CFA Institute.
Copyright Irfanullah Financial Training. All rights reserved.
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1. Introduction
Financial analysis is a useful tool in evaluating a companys performance and trends. The primary
source of data is a companys annual report, financial statements, and MD&A. Although the
financial statements contain data about a companys past performance and current financial
condition, they do not contain all the information required to forecast future performance.
An analyst must be capable of using a companys financial statements along with other information
such as economy/industry trends to make projections and reach valid conclusions. An analyst
converts data into financial metrics like ratios that help in decision making.
2. The Financial Analysis Process

Objective: Before beginning any financial analysis, an analyst must clarify the purpose and context
of why it is needed. The following questions help in defining the purpose:
What is the purpose of the analysis? What questions will this analysis answer?
What level of detail will be needed to accomplish this purpose?
What data are available for the analysis?
What are the factors or relationships that will influence the analysis?
What are the analytical limitations, and will these limitations affect the analysis?
Once the purpose is defined, the analyst can choose the right techniques for the analysis. For
example, the level of detail required for a substantial long term investment in equities will be
higher than one needed for a short term investment in fixed income.
2.1 Financial Analysis Framework

This reading focuses on steps 3 and 4 of the financial analysis framework in detail: how to adjust
financial statements, compute ratios, and produce graphs and forecasts. The processed data is then
analyzed to arrive at a conclusion.
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Financial Analysis Framework

Phase
Output of the analysis
1. Define purpose and context based on

analysts function, client input and organizational
guidelines.
Objective
Questions to be answered
Nature and content of report to be provided
Timetable and budget
2. Collect data: financial statements, other

financial data, industry/economic data,
discussions with management, suppliers,
customers, and competitors.
Organized financial statements

Financial tables
Completed questionnaires
3. Process data
Adjusted financial statements

Common-size statements
Ratios and graphs
Forecasts
4. Analyze and interpret processed data
Analytical results
5. Develop and communicate conclusions and

recommendations
Report answering questions from phase 1

Recommendation regarding the purpose of the
analysis
6. Follow-up
Updated recommendations
2.2 Distinguishing between Computation and Analysis

An effective analysis comprises both calculations and interpretations. A good analysis is not just
a compilation of various pieces of information put together. It should address how the company
performed and the reasons behind its good/bad performance.
Some of the key questions to address for past performance include:
What aspects of performance are critical to success?
Did the company fare well on these critical aspects?
What were the key factors for this performance?
Questions to include for a forward looking analysis include:
What is the likely impact of a trend/events in the company, industry and the economy on
the companys future cash flows?
How will the management respond to this trend?
What are the risks involved?
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3. Analytical Tools and Techniques

Various tools and techniques such as ratios, common size analysis, graphs and regression analysis
help in evaluating a companys data. Evaluations require comparisons, but to make a meaningful
comparison of a companys performance, the data needs to be adjusted first. An analyst can then
compare a companys performance to other companies at any point in time (cross-section analysis)
or its own performance over time (time-series analysis).
3.1 Ratios
A ratio is an indicator of some aspect of a companys performance like profitability or inventory
management. Ratio analysis helps in analyzing the current financial health of a company, evaluate
its past performance, and provide insights for future projections.
Note: Although there are some widely accepted ratios like net profit margin, there is no
standardized set of ratios. Furthermore, names and formulas for computing ratios often differ from
analyst to analyst.
Uses and Limitations of Ratio Analysis

Uses of ratio analysis
Limitations of ratio analysis
Ratios allows analysts to:
An analyst must exercise judgment when

interpreting ratios. For example, a current ratio
of 1.1 may not necessarily be good/bad unless
viewed in perspective of company/industry.
Use of alternate accounting methods may

require adjustments before the ratios are
comparable. For example Company A might
use the LIFO method while a comparable
company might use the FIFO method.
Companies may have divisions operating in

many different industries. This can make it
difficult to find comparable ratios.
Evaluate operational efficiency.

Evaluate financial flexibility to obtain cash
required for growth.
Compare company performance relative to
industry.
Compare across companies irrespective of
size and currency.
Compare with peer companies.
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3.2 Common-Size Analysis

Common size financial statements are used to compare the performance of different companies
within an industry or a companys performance over time. Common size statements are prepared
by expressing every item in a financial statement as a percentage of a base item.
Common-Size Analysis of the Balance Sheet

There are two types of common-size balance sheets: vertical and horizontal. In a vertical
common-size balance sheet, each item on the balance sheet is divided by the total assets for a
period and expressed as a percentage. This highlights the composition of the balance sheet.
simple common-size vertical balance sheet is shown below:
2011
2012
% of total assets
% of total assets
Cash
Marketable Securities
Accounts Receivables
Inventory
10
PP&E
80
80
Total Assets
100
100
In terms of time series analysis (also called trend analysis), the vertical common-size balance
sheet indicates how a particular item is changing relative to total assets. For the data given
above, we can observe that inventory is increasing as a percentage of total assets while accounts
receivable is decreasing as a percentage of total assets.
The vertical common-size balance sheet can be used in cross-sectional analysis (also called relative
analysis) to compare a specific metric of one company with another for a single time period. As
illustrated in the table below, this method allows comparison across companies which might be of
significantly different sizes and/or operate in different currencies.
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Cross Sectional Analysis

Company A
Company B
Cash
0.3%
$10
0.3%
120
2.6%
$90
2.8%
950
Accounts Receivables, net
5.8%
$200
7.3%
2,500
Inventory
8.7%
$300
10.2%
3,500
Non-Current Assets
82.6%
$2,580
79.4%
27,400
Total Assets
100%
$3,450
100%
34,470
This presentation makes it easy to see that Company A has lower receivables as a percentage of
total assets relative to Company B. Company A also has lower inventory as a percentage of total
assets relative to Company B.
In a horizontal common-size balance sheet, each balance sheet item is shown in relation to the
same item in a base year. Consider the following balance sheet excerpt:
2011 (base year)
2012
Cash
10
12
90
99
Inventory
600
900
The corresponding horizontal common size balance sheet will look like this:
2011 (base year)
2012
Cash
1.0
1.2
1.0
1.1
Inventory
1.0
1.5
Notice that the base-year value for all balance sheet items is set to 1. This makes it easy to see the
percentage change in each item relative to the base year. For the data given above, cash increased
by 20%, marketable securities increased by 10% and inventory increased by 50%. An analysis of
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horizontal common-size balance sheets highlights structural changes that have occurred in a
business.
Relationships among Financial Statements

Comparing the trend data of a horizontal common-size analysis across financial statements will
give some insight into a companys financial standing. Consider the following percentage changes
for a company to identify some potential issues:
Revenue: +15%, Operating income: +15%, Operating cash flow: -10%, Inventory: +60%,
Receivables: +40%, Total assets: +30%
The assets are growing at a faster rate than revenue which implies the company is spending more
than the sales it is able to generate. Operating cash flow is negative whereas operating income is
+15% indicating a problem that the company is booking sales (accrual accounting) but has not
realized the cash yet. Similarly, when inventory and receivables grow at a much faster pace than
sales, it shows signs of poor inventory and receivables management.
3.3 Graphs
Graphs can be considered an extension of the financial analysis. It is a pictorial representation of
the analysis done, be it ratio analysis or trend analysis. Analysts use appropriate graphs such as
line charts, bar graphs based on the type of data to be shown. It helps in quick comparison of
financial performance and structure over time.
3.4 Regression analysis

Regression analysis, described in detail in Level II, is a statistical method of analyzing
relationships (correlations) between variables.
4. Common Ratios Used in Financial Analysis

Note: This is the most important part of this reading.
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A large number of ratios are used to measure various aspects of performance. Commonly used
financial ratios can be categorized as follows:
Category
What they measure
Example
Activity ratios
Efficiency of a company
Revenue / Assets
Liquidity ratios
Ability to meet its short term
Current assets / Current
obligations
liabilities
Ability to meet long term
Assets / Equity
Solvency ratios
obligations
Profitability ratios
Profitability
Net Income / Assets
Valuation ratios
Quantity of an asset or flow per
Earnings / Number of shares
share
Note that for some ratios, the numerator and denominator are from the same statement. Examples
of such ratios are net profit margin (net income/sales) and leverage (assets/equity). For other ratios
(called mixed ratios), the numerator is from one statement the denominator is from another
statement. An example is the asset turnover ratio (sales/assets).
4.1 Interpretation and Context

As standalone numbers, the financial ratios of a company dont make much sense. The ratios are
usually industry-specific. For instance, you cannot compare the ratios of Schlumberger with that
of Facebook. The financial ratios should be used to periodically evaluate a companys goals and
strategy, how it fares against its peers in the industry, and the effect of economic conditions on its
business.
4.2 Activity Ratios

Activity ratios measure how efficiently a company manages its assets. They are also known as
asset utilization ratios or operating efficiency ratios.
Note: In general, a high number for the turnover ratio relative to its industry means greater
efficiency.
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Activity Ratios Formulae

Activity Ratios
Numerator
Denominator
Inventory turnover
Cost of goods sold
Average inventory
Days of inventory on hand
Number of days in period
Inventory turnover
Receivables turnover
Revenue
Average receivables
Days of sales outstanding
Payables turnover
Purchases
Average trade payables
Number of days of payables
Payables turnover
Working capital turnover
Revenue
Average working capital
Fixed asset turnover
Revenue
Average net fixed assets
Total asset turnover
Revenue
Average total assets
In ratios above, average = (beginning period value + ending period value)/2. If beginning period value
is not available, then use ending period value.
Average inventory = (beginning inventory + ending inventory )/2
Average receivables = (beginning receivable + ending receivable)/2
Average payables = (beginning payable + ending payable)/2
Purchases = cost of goods sold + ending inventory beginning inventory
How to remember the ratios:

1. Name of the ratio indicates the balance sheet item. For example, in the receivables turnover ratio, the
average receivable is in the denominator.
2. The income statement item is in the numerator.
3. Average value of balance sheet in the denominator. Income statement measures an item over a period
but balance sheet indicates values of items only at the end of a period. So, always use the average value
for balance sheet items.
4. All turnover ratios except inventory turnover use revenue in the numerator. Inventory turnover uses
cost of goods sold.
Interpretation of Activity Ratios

Activity Ratios
Interpretation
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Inventory turnover
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How many times per period entire inventory was sold. Measures
the ability of a company to sell its inventory.
Higher number means greater efficiency because inventory is kept
for a shorter period. It could also mean insufficient inventory,
which in turn, might affect growth /revenue.
Days of inventory on hand
On an average, how many days of inventory kept on hand.
(DOH)
How quickly does a company collect cash.

More appropriate to use credit sales instead of revenue but it is not
readily available.
Higher number means greater efficiency in credit and collection. It
could also mean stringent cash collection policies are hurting
potential sales.
Days of sales outstanding (DSO)
Elapsed time between credit sale and cash collection.

Higher number means it takes a long time to collect receivables.
Payables turnover
Indicates how quickly a company pays suppliers. A high number

means the company is paying suppliers quickly and is possibly not
making use of credit facilities. Low number may mean the
company is facing trouble making payments on time and a sign of
liquidity issues.
Number of days of payables
On an average, how many days it takes to pay suppliers.
Working capital turnover
How efficiently does a company generate revenue from working

capital
Working capital = current assets (CA) current liabilities (CL)
Higher number means greater efficiency. If CA= CL, then working
capital would be zero making the ratio meaningless.
Fixed asset turnover
How efficiently does a company generate revenue from fixed assets

Higher number means efficient use of fixed assets. Lower number
may mean inefficiency, or newer business (higher carrying value on
B/S), or a capital intensive business.
How efficiently does a company generate revenue from total assets

(fixed + current assets)
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As with other turnover ratios, higher number means efficiency.

Higher number for turnover ratios = greater efficiency
4.3 Liquidity Ratios

Liquidity ratios measure a companys ability to meet short term obligations. It also indicates how
quickly it turns assets into cash.
Liquidity Ratios Formulae

Liquidity Ratios
Numerator
Denominator
Current ratio
Current assets
Current liabilities
Quick ratio
Cash + short term marketable
Current liabilities
investments + receivables
Cash ratio
Current liabilities
investments
Defensive interval ratio
Daily cash expenditures
investments + receivables
Additional Liquidity Ratios
Cash conversion cycle (net operating cycle) = Days of inventory on hand (DOH)
+ days of sales outstanding (DSO)
number of days of payables
Interpretation of Liquidity Ratios

Liquidity Ratios
Interpretation
Current ratio
Higher number implies greater liquidity
Quick ratio

More conservative than current ratio as only more liquid current
assets are included.
Cash ratio
This is the most conservative liquidity ratio, and a good measure

of a companys ability to handle a crisis situation.
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Defensive interval ratio
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Measures the number of days a company can operate before it runs

out of cash.
Cash conversion cycle
The time between cash paid (to suppliers) and cash collected (from
customers)
Lower the number, better for the company as it means high
liquidity
Long cash conversion cycle = low liquidity
The example below for ABC Corp. illustrates cash conversion cycle better. The timeline for
various events is illustrated below:
4.4 Solvency Ratios

Solvency ratios measure a companys ability to meet long term obligations. In simple terms, it
provides information on how much debt the company has taken and if it is profitable enough to
pay the interest on debt in the long term. It has to be analyzed within an industrys perspective.
Certain industries such as real estate use a higher level of leverage.
Solvency Ratios Formulae

Solvency Ratios
Numerator
Denominator
Total debt
Total assets
Debt ratios
Debt to assets ratio
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Debt to capital ratio
Total debt
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Total debt + total shareholders
equity
Debt to equity ratio
Total debt
Total shareholders equity
Financial leverage ratio
Average total equity
Interest coverage ratio
EBIT
Interest payments
Fixed charge coverage ratio
EBIT + lease payments
Interest payments + lease
Coverage Ratios
payments
Note that there are two categories of solvency ratios: debt (or leverage) ratios and coverage ratios.
In general, a high debt (or leverage) ratio implies a high level of debt, high risk and low solvency.
With coverage ratios, a high number is good because this indicates high income relative to interest
payments.
Interpretation of Solvency Ratios

Solvency Ratios
Interpretation
Debt to assets ratio
Measures the amount of debt in total assets.

Higher debt means low solvency and higher risk. A ratio of 0.5
implies 50% of assets are financed with debt.
Debt to capital ratio
Measures the amount of debt as a percentage of capital (debt +

shareholders equity).
Debt to equity ratio
Measures the amount of debt as a percentage of equity.
Financial leverage ratio
Measures the amount of assets per unit of equity.

Higher value means company is leveraged more.
Interest coverage ratio
Measures the companys ability to make interest payments (how

many times the company can make interest payments with its
EBIT).
Unlike the other solvency ratios, higher value for this ratio is
better as it means stronger solvency.
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Fixed charge coverage ratio
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Measures the ability of a company to pay interest on debt.

Here, lease payments are added to EBIT as they are an obligation
like interest payments. Like interest coverage ratio, higher value for
this ratio implies stronger solvency.
4.5 Profitability Ratios

Profitability Ratios Formulae
Profitability Ratios
Numerator
Denominator
Gross profit margin
Gross profit
Revenue
Operating profit margin
Operating income
Revenue
Pretax margin
EBT (earnings before tax but
Revenue
Return on Sales
after interest)
Net profit margin
Net profit
Revenue
Operating ROA
Operating income
Return on assets (ROA)
Net income
Return on total capital
EBIT
Short and long term debt and
Return on Investment
equity
Return on equity (ROE)
Net income
Average total equity
Return on common equity
Net income preferred dividend
Average common equity
How to remember the profitability ratios:

1. Return on sales ratios are single statement ratios i.e. both numerator and denominator are from income
statement. As the name margin implies, denominator is always the revenue.
2. Return on investment ratios are mixed statement ratios. The earlier rule discussed for activity ratios
apply here. From the name, you can predict the numerator. The numerator comes from the income
statement. For instance, in return on assets, return implies net income.
3. The denominator is from the balance sheet which is again present in the name itself but the average
value has to be used. So, in return on equity, average total equity becomes the denominator.
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Interpretation of Profitability Ratios

Interpretation
Gross profit margin
Higher value means higher pricing and lower costs
Operating profit margin
Operating profit = gross profit - operating costs.

Good sign if operating profit margin grows at a faster rate than
gross profit margin.
Pretax margin
Pretax profit = operating profit - interest related expenses.

Needs further analysis if pretax income increases only because of
non-operating income.
Net profit margin
Net profit = revenue all expenses
Operating ROA/ Return on
For return, either net income or operating income (EBIT) can be
Assets (ROA)
used.
Return on total capital
Like operating ROA, EBIT is used. Measures return on capital

before deducting interest.
Return on Equity (ROE)
A very important measure of return earned on equity capital.

Unlike return on common equity, it includes minority and
preferred equity.
Return on common equity
Money available to common shareholders
4.6 DuPont Analysis

Note: This section is important from a testability perspective.
Why is DuPont analysis important?

Return on equity (ROE) measures the return a company generates from stockholders equity. Lets
say a companys ROE is 20%. It is important to understand what is driving this growth low
interest, low taxes, or high revenue? Some factors may be positive, some neutral and some
negative. DuPont analysis decomposes the return on equity into various components listed below.
This insight will help understand the companys performance better and focus on areas that need
improvement.
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Return on Equity
Return on assets
Financial Leverage
Net profit margin
EBIT margin
Interest burden
Tax burden
Note: From exam perspective the following two forms of return on equity are important.
Return on equity = Net income/ equity = (Net income/assets) * (assets/equity)
Return on equity = Net income/equity = (Net income/revenue) * (revenue/assets) *
(assets/equity)
The five point DuPont formula can be decomposed into:

Return on equity = (Net income/EBT) * (EBT/EBIT) * (EBIT/revenue) * (revenue/average
total assets) * (average total assets/equity)
which translates into
Return on equity = Tax burden * Interest burden * EBIT margin * total asset turnover *
leverage
Say you are given the follow data for a particular company:
2010
2011
2012
ROE
19%
20%
22%
ROA
8.1%
8%
7.9%
2.1
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Based only on the information above, the most appropriate conclusion is that over the period
2010 to 2012, the companys
A. Net profit margin and financial leverage have decreased
B. Net profit margin and financial leverage have increased
C. Net profit margin has decreased but its financial leverage has increased
Solution: A quick glance at the data says profitability is going up and asset turnover has
slightly increased from 2010 to 2012. ROA is going down from the second year.
Steps: 1. Break down ROE into: (return on assets) * (assets/equity) = (ROA) * financial
leverage. ROE is going up (first row). Since ROA is going down, leverage must increase for
ROE to increase. So A is incorrect.
2. To determine if net profit margin increased or decreased, break down ROA into (net
income/sales) * (sales/assets). Since (sales/assets) or asset turnover is increasing, net profit
margin has to decrease for return on assets to decrease. So, the correct answer is C.
5. Equity Analysis
One of the most common applications of financial analysis is that of selecting stocks. An equity
analyst uses various tools (such as valuation ratios) before recommending a security to be included
in an equity portfolio. The valuation process consists of the following steps:
(i)
Understanding the companys business and existing financial profile
(ii)
Forecasting company performance such as revenue projections
(iii)
Selecting the appropriate valuation model
(iv)
Converting forecasts to a valuation
(v)
Making the investment decision to buy or not to buy
This section, in particular, focuses on the ratios used to value equity. Research has shown that
ratios are useful in forecasting earnings and stock returns. Note that this material is covered in
more detail in the equity segment of the curriculum.
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5.1 Valuation Ratios

Valuation ratios aid in making investment decisions. They help us determine if a stock is
undervalued or overvalued.
Valuation Ratios Formulae
Valuation Ratios
Numerator
Denominator
P/E
Price per share
Earnings per share
P/CF
Price per share
Cash flow per share
P/S
Price per share
Sales per share
P/BV
Price per share
Book value per share
Per share Quantities

Basic EPS
Diluted EPS
Cash flow per share
Net income minus preferred
Weighted average number of
dividends
ordinary shares outstanding
Adjusted income available
shares, reflective conversion of
ordinary and potential ordinary
dilutive securities
shares outstanding
Cash flow from operations

shares outstanding
EBITDA per share
EBITDA

shares outstanding
Dividends per share
Common declared dividends

shares outstanding
Interpretation of Valuation Ratios

Interpretation
P/E
Most often used valuation measure. Prone to earnings

manipulation. Non-recurring earnings may distort the ratio.
P/CF
Less manipulative than P/E
P/S
Used when net income is not positive
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P/BV
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An indicator of what the market perceives. A value greater than 1

means future rate of return is higher than required rate of return.
5.2 Dividend related ratios

Dividend-related formulae
Dividend Ratios
Numerator
Denominator
Dividend payout ratio
Dividend
Earnings
Retention rate = 1- payout rate

Sustainable growth rate = retention rate *ROE
Interpretation of Dividend-related Ratios

Dividend-related ratios
Interpretation
Dividend payout ratio
Measures the percentage of earnings a company pays out as

dividends to equity shareholders
Retention Rate
Measures the percentage of earnings a company retains
Sustainable growth rate
Measures how much growth a company is able to finance from its

internally generated funds. Higher retention rate and ROE result in
higher sustainable growth rate.
5.3 Industry-Specific Ratios

Ratios serve as indicators of some aspect of a companys performance and value. Aspects of
performance that are important in one industry may be irrelevant in another. These differences are
reflected through industry-specific ratios. For example, companies in the retail industry may report
same-store sales changes because, in the retail industry, it is important to distinguish between
growth that results from opening new stores and growth that results from generating more sales at
existing stores.
Another example is the inventory turnover ratio which is useful in the
manufacturing industry but is not relevant for the financial services industry. Exhibit 15 in the
curriculum identifies some common industry and task specific ratios.
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6. Credit Analysis
Credit risk is the risk that the borrower will default on a payment when it is due. For example, if
you are a bondholder, credit risk is the risk that the bond issuer will not pay you the interest on
time. Credit analysis is the evaluation of this credit risk. Just as ratio analysis is useful in valuing
equity, it can also be applied to analyze the creditworthiness of a borrower. Some of the ratios
commonly used in credit analysis are listed below:
Credit Analysis Ratios Formulae

Credit Analysis Ratio
Numerator
Denominator
EBIT interest coverage
EBIT
Gross interest
EBITDA interest coverage
EBITDA
Gross interest
Debt to EBITDA
Total debt
EBITDA
Total debt to total debt plus equity
Total debt
Total debt plus equity
High coverage ratios would imply good credit quality. Similarly low debt/EBITDA and low debt
/ (debt + equity) would imply good credit quality.
7. Business and Geographic Segments

To get a holistic understanding of a companys businesses, analysts often study the performance
of its underlying business segments. A business segment may be a subsidiary company, operating
units or operations in the same business at different locations across the world. For example,
General Electric is involved in various businesses ranging from electrical appliances to aircraft
engines across geographies. An analyst deciding whether or not to buy GE stock might want to
study each business segment separately. To facilitate this type of analysis both U.S. GAAP and
IFRS require companies to provide segment information.
Some of the key segment ratios are listed below:
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Segment related Ratios
Numerator
Denominator
Segment margin
Segment profit
Segment revenue
Segment turnover
Segment revenue
Segment assets
Segment ROA
Segment profit
Segment assets
Segment debt ratio
Segment liabilities
Segment assets
8. Model building and forecasting

Analysts use several methods to forecast future performance. One commonly used method is to
project sales and to combine the forecasted sales numbers with expected values for key ratios. For
example, by using sales numbers and gross profit margin, one can determine cost of goods sold
and gross profit. A similar approach is followed for other financial statements as well to arrive at
a valuation for company under analysis.
Summary
Note: This summary has been adapted from the CFA Program curriculum.
Financial analysis techniques, including common-size and ratio analysis, are useful in
summarizing financial reporting data and evaluating the performance and financial position of a
company. The results of financial analysis techniques provide important inputs into security
valuation. Key facets of financial analysis include the following:
Common-size financial statements and financial ratios remove the effect of size, allowing
comparisons of a company with peer companies (cross-sectional analysis) and comparison of
a companys results over time (trend or time-series analysis).
Activity ratios measure the efficiency of a companys operations, such as collection of

receivables or management of inventory. Major activity ratios include inventory turnover, days
of inventory on hand, receivables turnover, days of sales outstanding, payables turnover,
number of days of payables, working capital turnover, fixed asset turnover, and total asset
turnover.
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Liquidity ratios measure the ability of a company to meet short-term obligations. Major
liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio.
Solvency ratios measure the ability of a company to meet long-term obligations. Major
solvency ratios include debt ratios (including the debt-to-assets ratio, debt-to-capital ratio,
debt-to-equity ratio, and financial leverage ratio) and coverage ratios (including interest
coverage and fixed charge coverage).
Profitability ratios measure the ability of a company to generate profits from revenue and
assets. Major profitability ratios include return on sales ratios (including gross profit margin,
operating profit margin, pretax margin, and net profit margin) and return on investment ratios
(including operating ROA, ROA, return on total capital, ROE, and return on common equity).
Ratios can also be combined and evaluated as a group to better understand how they fit together
and how efficiency and leverage are tied to profitability.
ROE can be analyzed as the product of the net profit margin, asset turnover, and financial
leverage. This decomposition is sometimes referred to as DuPont analysis.
Valuation ratios express the relation between the market value of a company or its equity (for
example, price per share) and some fundamental financial metric (Ex: earnings per share).
Ratio analysis is useful in the selection and valuation of debt and equity securities and is a part
of the credit rating process.
Ratios can also be computed for business segments to evaluate how units within a business are
performing.
The results of financial analysis provide valuable inputs into forecasts of future earnings and
cash flow.
Next Steps
Work through the examples in the curriculum.
Solve the practice problems in the curriculum.
Solve the IFT Practice Questions associated with this reading.
Review the learning outcomes presented in the curriculum. Make sure that you can perform
the implied actions.
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Financial Analysis

IFT Notes for the CFA exam

Financial Analysis Techniques

Copyright Irfanullah Financial Training. All rights reserved.

Financial Analysis Techniques

2. The Financial Analysis Process

What level of detail will be needed to accomplish this purpose?

What data are available for the analysis?

2.1 Financial Analysis Framework

Copyright Irfanullah Financial Training. All rights reserved.

Financial Analysis Techniques

Financial Analysis Framework

Output of the analysis

1. Define purpose and context based on

2. Collect data: financial statements, other

Organized financial statements

Adjusted financial statements

4. Analyze and interpret processed data

5. Develop and communicate conclusions and

Report answering questions from phase 1

2.2 Distinguishing between Computation and Analysis

What aspects of performance are critical to success?

Did the company fare well on these critical aspects?

What were the key factors for this performance?

Questions to include for a forward looking analysis include:

How will the management respond to this trend?

What are the risks involved?

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Financial Analysis Techniques

3. Analytical Tools and Techniques

Uses and Limitations of Ratio Analysis

Limitations of ratio analysis

Ratios allows analysts to:

An analyst must exercise judgment when

Use of alternate accounting methods may

Companies may have divisions operating in

Evaluate operational efficiency.

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Financial Analysis Techniques

3.2 Common-Size Analysis

Common-Size Analysis of the Balance Sheet

simple common-size vertical balance sheet is shown below:

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Financial Analysis Techniques

Cross Sectional Analysis

Accounts Receivables, net

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Financial Analysis Techniques

Relationships among Financial Statements

3.4 Regression analysis

4. Common Ratios Used in Financial Analysis

Copyright Irfanullah Financial Training. All rights reserved.

Financial Analysis Techniques

What they measure

Ability to meet its short term

Current assets / Current

Ability to meet long term

Net Income / Assets

Quantity of an asset or flow per

Earnings / Number of shares

4.1 Interpretation and Context

4.2 Activity Ratios