Ifsa Chapter7

CHAPTER 7
FINANCIAL ANALYSIS TECHNIQUES
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FINANCIAL ANALYSIS TOOLS:

DESCRIPTION
Graphics
Regression
Common-Size Analysis
Financial Ratio Analysis
Copyright 2013 CFA Institute
GRAPHICS: EXAMPLE
Operating Profit by Geographic Segment
22%
21%
19%
38%
North America
Europe/South Pacific
Latin America
Greater Asia/Africa
GRAPHICS: EXAMPLE
2011
2010
2009
2008
2007
Greater Asia/Africa
Europe/South Pacific
Latin America
North America
0
200
400
600
800
1000
1200
1400
1600
$ millions
GRAPHICS: EXAMPLE
Operating profit margin
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
REGRESSION: EXAMPLE
14.0
12.0
10.0
f(x) = 0.12x + 5.82

8.0
R = 0.27
6.0
GDP Change
4.0
2.0
0.0
-40.0
-30.0
-20.0
-10.0
0.0
10.0
20.0
30.0
40.0
-2.0
-4.0
Sales Growth
COMMON-SIZE ANALYSIS
Common-size analysis: Express financial data, including entire financial
statements, in relation to a single financial statement item or base.
Vertical common-size
- Balance sheet: Each item as a percent of total assets.
- Income statement: Each item as a percent of total net revenues.
- Cash flow: Each line as a percent of sales, assets, or total in and out.
- Highlights composition and identifies whats important.
Horizontal common-size
- Percentage increase or decrease of each item from the prior year or
showing each year relative to a base year.
- Highlights items that have changed unexpectedly or have
unexpectedly remained unchanged.
COMMON-SIZE BALANCE SHEET EXAMPLE:

SINGLE COMPANY, TWO PERIODS
Partial common-size balance sheet
COMMON-SIZE BALANCE SHEET EXAMPLE:

CROSS-SECTIONAL, TWO COMPANIES, SAME TIME
Partial common-size balance sheet
Assets
Cash
Receivables
Inventory
Fixed assets net of depreciation
Investments
Total Assets
Company 1 Company 2
% of Total % of Total
Assets
Assets
38
12
33
55
27
24
1
2
1
7
100
100
USE OF COMPARATIVE GROWTH

INFORMATION: EXAMPLE
Sunbeam, Inc. 1997 vs.1996
Revenue +19%
Receivables +38%
Inventory +58%
Why are receivables growing so much faster than revenue?
Why is inventory growing so much faster than revenue?
10
FINANCIAL RATIOS
Ratios
- Express one number in relation to another.
- Standardize financial data in terms of mathematical
relationships expressed as percentages, times, or days.
- Facilitate comparisonstrends and across companies.
Ratios are interrelated
11
RATIO ANALYSIS
How profitable was Company X?
15.26%
A ratio is NOT the answer (except sometimes on
an exam).
A ratio is an indicatorfor example, an indicator
of relative activity, profitability, liquidity, solvency.
12
RATIO ANALYSIS
How profitable was company X?
COMPANY XS PROFITABILITY
HAS IMPROVED. ITS NET
PROFIT MARGIN WAS 15.3%,
UP FROM 14.9% LAST YEAR.
A ratio is NOT the answer (except sometimes on an exam).

A ratio is an indicatorfor example, an indicator of relative
activity, profitability, liquidity, solvency.
Interpretation generally involves comparison. Furthermore,
analysis will address the question of why.
13
RATIO ANALYSIS
How profitable was Company X?
COMPANY X WAS MORE PROFITABLE THAN
COMPANY Y AS EVIDENCED BY ITS NET
PROFIT MARGIN. COMPANY XS MARGIN OF
15.3% WAS HIGHER THAN COMPANY YS
MARGIN OF 12.0%.
A ratio is NOT the answer (except sometimes on an exam).

A ratio is an indicatorfor example, an indicator of relative
activity, profitability, liquidity, solvency.
Interpretation generally involves comparison. Furthermore,
analysis will address the question of why.
14
USING FINANCIAL ANALYSIS TOOLS

Computation Analysis
Analysis goes beyond collecting data and computing numbers.
Analysis encompasses computations and interpretations.
Where practical, directly experience the companys business.
Analysis of past performance:
What aspects of performance are critical to successfully competing
in the industry?
How well did the company perform (relative to own history and
relative to competitors)?
Why? What caused the performance?
Does the performance reflect the companys strategy?
15
USING FINANCIAL ANALYSIS TOOLS

Not every ratio is relevant in every situation.
- Some ratios are irrelevant for certain companies.
- Some ratios are redundant.
- Industry-specific ratios can be as important as general
financial ratios.
- Different users and questions (e.g., creditors, investors)
focus on different ratios.
Different sources categorize some ratios differently and
include different ratios.
Differences in accounting standards can limit comparability.
16
CATEGORIES OF FINANCIAL RATIOS

Category
Activity
Description
Activity ratios. How efficient are the firms operations
and the firms management of assets?
Liquidity
Liquidity ratios. How well is the firm positioned to

meet short-term obligations?
Solvency
Solvency ratios. How well is the firm positioned to

meet long-term obligations?
Profitability
Profitability ratios. How and how much is the firm

achieving returns on its investments?
Valuation
Valuation ratios. How does the firms performance or

financial position relate to its market value?
17
PROFITABILITY AND OVERVIEW

Category
Activity
Description
Liquidity
Liquidity ratios. How well is the firm positioned to

meet short-term obligations?
Solvency
Solvency ratios. How well is the firm positioned to

meet long-term obligations?
Profitability
Profitability ratios. How much and how is the firm

Valuation

18
MEASURE OF PROFITABILITY:
RETURN ON EQUITY (ROE)
What rate of return has the firm earned on the shareholders
equity it had available during the year?
The general form of the rate of return computation:

Rate of return =
Amount of return
Amount invested
Applied to shareholders equity:

ROE =
Net income
Average equity
19
DECOMPOSE ROE
ROE =
Net income
Average equity
Net income
Average assets
Average assets
Average equity
ROA
Leverage
20
DECOMPOSE ROE
ROE =
ROA
Leverage
A company can increase its ROE

1. With a business strategy, by increasing its ROA
and/or
2. With a financial strategy, by increasing its use of leverage
as long as returns on the incremental investment exceed
the cost of borrowing.
21
RETURN ON ASSETS
What rate of return has the firm earned on the assets it had available to
use during the year?
The general form of this computation is the same:
Amount of return
Rate of Return =
Amount invested
Two variants of ROA computation:
Net income
(1) ROA =
Average assets
(2)
ROA =
=
Net income adjusted for interest

Average assets
Net income + [Interest expense (1 Tax rate)]
Average assets
22
PROFITABILITY, COMPETITION,
AND BUSINESS STRATEGY
ROA =
Net income
Average assets
ROA =
Net income
Revenue
Revenue
Average assets
In other words,
ROA can
be thought
of as:
Profit margin Turnover (efficiency)
23
DECOMPOSING
RETURN ON EQUITY
ROE =
ROE =
Profit margin
Net income
Revenue
Turnover
Revenue
Average assets
Leverage
Average assets
Average equity
24
DECOMPOSING
RETURN ON EQUITY
Du Pont Analysis
What was the source of the firms return on equity?

To what extent
. . . was it derived from selling a high margin product or keeping

expenses lowderiving more profits from each $1 of sales? (return
on sales, net profit margin)
. . . was it derived from generating higher sales from a lower

investment in assets? (efficient use of assets, also known as
turnover or efficiency)
. . . was it derived from investing a lower amount of equityby

using more debt in its capital structure? (financial leverage)
25
DECOMPOSING RETURN ON EQUITY:

STYLIZED COMPARATIVE ANALYSIS MINI-CASE
Sales ($)
Net income (NI) ($)
Average assets ($)
Average equity ($)
Average liabilities ($)
Co. A
2,000
200
1,000
1,000
0
Co. B
4,000
200
2,000
1,000
1,000
Co. C
6,675
200
1,500
1,000
500
Averag
e
4,225
200
1,500
1,000
500
ROE (NI/Equity)
Net profit margin
(NI/Sales)
Turnover
(Sales/Assets)
Leverage
(Assets/Equity)
26

STYLIZED COMPARATIVE ANALYSIS MINI-CASE
Co. A
Co. B
2,000
4,000
6,675
4,225
200
200
200
200
Average assets ($)
1,000
2,000
1,500
1,500
Average equity ($)
1,000
1,000
1,000
1,000
1,000
500
500
ROE (NI/Equity)
20.0%
20.0%
20.0%
20.0%
Net profit margin

(NI/Sales)
10.0%
5.0%
3.0%
4.7%
Turnover (Sales/Assets)
4.45
2.82
Leverage (Assets/Equity)
1.5
1.50
Sales ($)
NI ($)
Average liabilities ($)
Co. C
Average
27

COMPARATIVE
AAPL
ROE
HPQ
27.19% 21.50%
Net income/Sales
Net profit
margin
DELL
61.19%
14.88%
7.04%
4.06%
Sales/Average assets
Asset
turnover
1.00
1.17
2.26
Average assets/
Average equity
Financial
leverage
1.83
2.61
6.67
28
DUPONT ANALYSIS :
FURTHER DECOMPOSITION
ROE = Net income/Average equity

Decompose ROE into five factors
ROE =
Net income
EBT
EBT
EBIT
EBIT
Revenue
Revenue
Average assets
Average assets
Average equity
29
PROFITABILITY: RETURN ON SALES

(FROM THE COMMON-SIZE INCOME STATEMENT)
Gross profit margin = Gross profit/Revenue
Measures the ability to translate sales into profit after consideration of
cost of products sold.
Operating profit margin = Operating profit/Revenue
Measures the ability to translate sales into profit after consideration of
operating expenses.
Net profit margin = Net profit/Revenue
Measures the ability to translate sales into profit after consideration of all
expenses and revenues, including interest, taxes, and nonoperating
items.
30
DISCUSSION BY CATEGORY
Category
Activity
Description
Liquidity
Liquidity ratios. How well is the firm positioned to meet

short-term obligations?
Solvency ratios. How well is the firm positioned to meet
long-term obligations?
Solvency
Profitability
Valuation

31
ACTIVITY RATIOS
Also known as asset utilization or operating efficiency ratios.
How efficiently is the firm using its assets? How many dollars of
sales was the firm able to generate from each dollar of assets?
Broadly
Asset turnover = Revenue/Average total assets
Low or declining ratios could mean
- Sales are sluggish,
- A heavy investment in assets (inefficient? plant modernization to
help in future? strategy shift?), and/or
- Asset mix changed.
Specifically, for fixed assets:
Fixed asset turnover = Revenue/Average net fixed assets
Can compute for any category of assets.
32
ACTIVITY RATIOS
Also known as asset utilization or operating efficiency ratios
Working capital turnover
Fixed asset turnover
Total asset turnover
Numerator
Revenue
Revenue
Revenue
Denominator
Average working capital
Average net fixed assets
Average total assets
33
OTHER COMMON ACTIVITY RATIOS

Numerator
Denominator
Inventory turnover
Cost of sales
Average inventory
Days of inventory on hand (DOH)
Number of days in
period
Inventory turnover
Receivables turnover
Revenue
Average receivables
Days of sales outstanding (DSO)
Number of days in
period
Receivables
turnover
Payables turnover
Purchases
Average trade
payables
Number of days of payables
Number of days in
period
Payables turnover
34
ACTIVITY RATIOS AND THE CASH CYCLE

(CASH CONVERSION CYCLE, A LIQUIDITY RATIO)
Cash cycle: How long does it take for the firm to go from cash to cash?
- Service company: sell service receive cash.
- Merchandising company: buy inventory sell inventory receive
cash and pay for inventory.
- Manufacturing company: buy raw materials make product sell
product receive cash and pay for materials and labor.
Cash conversion cycle (net operating cycle) = Days sales outstanding
+ Days inventory held Number of days of payables
Close link to liquidity
Working capital (current assets minus current liabilities) reflects the
investment required to support this cycle.
35
LIQUIDITY
How well positioned is the firm to meet its near-term
obligations?
Current ratio = Current assets/Current liabilities
Quick ratio = (Cash + Short-term marketable investments +
Account receivables)/Current liabilities
Cash ratio = (Cash + Short-term marketable investments)/
Current liabilities
36
Category
Activity
Description
Liquidity

Solvency
Profitability
Valuation

37
SOLVENCY: HOW WELL POSITIONED IS THE

FIRM TO MEET ITS LONGER-TERM LIABILITIES?
Debt ratios: How has the company financed itself?
Debt to total assets
Lower ratio > safer.
Debt to equity
Higher cushion against
Debt to total capital
potential creditor losses
Coverage ratios: Degree to which earnings or cash flow can

decline without affecting firms ability to pay interest.
EBIT interest coverage = (EBT + Interest payments)/Interest
payments
Fixed charge coverage = (EBIT + Lease payments)/(Interest
payments + Lease payments)
38
COMMON SOLVENCY RATIOS

Solvency ratios
Debt ratios
Debt-to-assets ratio
Debt-to-capital ratio
Debt-to-equity ratio
Financial leverage
ratio
Coverage ratios
Interest coverage
Fixed charge
coverage
Numerator
Denominator
Total debt
Total debt
Total assets
Total debt + Total
shareholders equity
Total debt
Total shareholders equity
Average total assets Average total equity
EBIT
EBIT + Lease
payments
Interest payments
Interest payments + Lease
payments
39
Category
Activity
Description
Liquidity

Solvency
Profitability
Valuation

40
VALUATION RATIOS:
PRICE-TO-EARNINGS RATIO
P/E relates earnings per common share to the market price at
which the stock trades, expressing the multiple that the stock
market places on a firms earnings.
P/E
Price
Earnings per share
High P/E indicates

- Firm is valued highly by market, possibly because of growth
expectations, or
- That a firm may have very low earnings per share.
41
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
Valuation ratios
42
DIVIDEND-RELATED QUANTITIES
Dividend payout ratio
Dividends per share

Earnings per share
Dividend yield
Dividends per share

Price
43
SELECTED CREDIT RATIOS USED BY

STANDARD & POORS AS PART OF CREDIT ANALYSIS
Ratio
Numerator
EBIT and EBITDA

interest coverage
EBIT or EBITDA
FFO interest coverage
FFO plus interest

Gross interest (prior to
paid minus operating deductions for capitalized
lease adjustments
interest or interest income)
FFO to debt
FFO
Total debt
Free operating cash

flow to debt
CFO (adjusted)
minus capital
expenditures
Total debt
CFO minus capital

Discretionary cash flow
expenditures minus
to debt
dividends paid
Denominator
Gross interest (prior to
deductions for capitalized
interest or interest income)
Total debt
44
SELECTED CREDIT RATIOS USED BY

STANDARD & POORS AS PART OF CREDIT ANALYSIS
Credit Ratio
Numerator
Denominator
Return on capital
EBIT
Average capital, where capital is

equity plus noncurrent deferred
taxes plus debt
Net cash flow to capital

expenditures
FFO minus dividends Capital expenditures
Debt to EBITDA
Total debt to total debt
plus equity
Total debt
EBITDA
Total debt
Total debt plus equity
45
SEGMENT ANALYSIS EXAMPLE:

LORAL
46
MODEL BUILDING:
EXAMPLES OF POSSIBLE USES OF RATIOS
Sales forecast (percent change from horizontal common-size
income statement)
Expenses (from common-size income statement)
Gross profit (gross profit margin)
Operating profit (operating profit margin)
Assets (days receivable, days payable, PP&E turnover)
Liabilities (leverage ratios)
Cash flow
47
RATIOS IN MODEL BUILDING
Sales forecast
Forecast
Debt
Forecast
Interest
Expense
Forecast
Cash Flow
Forecast
Income and
Taxes
Expenses
Gross Profit
Operating Profit
Assets
Liabilities
Cash Flow
48
SUMMARY: FINANCIAL ANALYSIS TOOLS

Graphics facilitate comparisons, and regressions quantify statistical
relationships.
Common-size analysis expresses financial data, including entire
financial statements, in relation to a single financial statement item or
base.
Ratios, which express one number in relation to another, facilitate
comparisonstrends and cross-sectional.
A ratio is an indicator of
- Activity
- Profitability
- Liquidity
- Solvency
49

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CHAPTER 7

FINANCIAL ANALYSIS TECHNIQUES

FINANCIAL ANALYSIS TOOLS:

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

f(x) = 0.12x + 5.82

Copyright 2013 CFA Institute

COMMON-SIZE BALANCE SHEET EXAMPLE:

Copyright 2013 CFA Institute

COMMON-SIZE BALANCE SHEET EXAMPLE:

Copyright 2013 CFA Institute

USE OF COMPARATIVE GROWTH

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

A ratio is NOT the answer (except sometimes on an exam).

Copyright 2013 CFA Institute

A ratio is NOT the answer (except sometimes on an exam).

Copyright 2013 CFA Institute

USING FINANCIAL ANALYSIS TOOLS

Copyright 2013 CFA Institute

USING FINANCIAL ANALYSIS TOOLS

Copyright 2013 CFA Institute

CATEGORIES OF FINANCIAL RATIOS

Liquidity ratios. How well is the firm positioned to

Solvency ratios. How well is the firm positioned to

Profitability ratios. How and how much is the firm

Valuation ratios. How does the firms performance or

Copyright 2013 CFA Institute

PROFITABILITY AND OVERVIEW

Liquidity ratios. How well is the firm positioned to

Solvency ratios. How well is the firm positioned to

Profitability ratios. How much and how is the firm

Valuation ratios. How does the firms performance or

Copyright 2013 CFA Institute

The general form of the rate of return computation:

Applied to shareholders equity:

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

A company can increase its ROE

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

Net income adjusted for interest

Profit margin Turnover (efficiency)

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

What was the source of the firms return on equity?

. . . was it derived from selling a high margin product or keeping

. . . was it derived from generating higher sales from a lower

. . . was it derived from investing a lower amount of equityby

Copyright 2013 CFA Institute

DECOMPOSING RETURN ON EQUITY:

DECOMPOSING RETURN ON EQUITY:

Average assets ($)

Average equity ($)

Net profit margin

Average liabilities ($)

Copyright 2013 CFA Institute

DECOMPOSING RETURN ON EQUITY:

Copyright 2013 CFA Institute