R28 Financial Analysis Techniques

CFA® Level I - Financial Reporting and Analysis

Financial Analysis Techniques

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Contents

1. Introduction

2. The Financial Analysis Process

3. Analytical Tools and Techniques

4. Common Ratios Used in Financial Analysis

5. Equity Analysis

6. Credit Analysis

7. Business and Geographic Segments

8. Model Building and Forecasting

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1. Introduction

• Financial analysis is a useful tool in assessing a company’s performance and trends.

• The primary source of data is company’s annual reports, financial statements and MD&A.

• An analyst must be capable of using financial statements in conjunction with other information to make projections and reach valid conclusions.

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2. The Financial Analysis Process

Prior to beginning any financial analysis, the analyst should clarify the purpose and context, and clearly understand the following:

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 impair the analysis?

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Purpose and Context

Techniques

Financial Analysis Framework

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1. Articulate purpose and context based on your function, client input and organizational guidelines

Objective Questions to be answered Content 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, graphs, forecasts

4. Analyze and interpret processed data

Analytical results

5. Develop and communicate conclusions and recommendations

Report answering questions from Phase 1, conclusions and recommendations

6. Follow up Updated recommendations

Distinguishing Between Computation and Analysis

Effective analysis encompasses computations and interpretations

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3. Process data Adjusted financial statements; common-size statements, ratios, graphs, forecasts

4. Analyze and interpret processed data

Analytical results

Questions related to analysis of past performance:

What aspects of performance are critical to success?

How did company perform on these aspects?

Forward looking analysis:

What is the likely impact of trends/events in the company, industry and economy?

What are the risks?

3. Analytical Tools and Techniques

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• Ratios

• Common Size Analysis

• Graphs

• Regression Analysis

• Tools and techniques facilitate evaluation of company data

• Evaluations require comparison

• Need to make adjustments so data is comparable

• Can perform cross-sectional and time-series analysis

Ratios • Ratio is an indictor of some aspect of a company’s performance

• Ratios can help predict investment returns

• Some widely accepted ratios but no authoritative body which provides exact formulas

• Ratios help us 1) evaluate past performance, 2) assess current financial position of the company, and 3) gain insights useful for projecting future results

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Specifically ratios allow us to evaluate 1. Operational efficiency 2. Financial flexibility 3. Changes in company/industry over time 4. Company performance relative to industry

Factors to consider when using ratios 1. Need to use judgment 2. Use of alternate accounting methods 3. Heterogeneity of a company's operating

activities 4. Consistency of results

Common Size Analysis

• Balance Sheet

Vertical

Horizontal

• Income Statement

• Cash Flow Statement

• Relationship Among Financial Statements

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Time-Series (Trend) Analysis

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Horizontal Common-Size Balance Sheet Highlights structural changes in a business

Period 1 2

Cash 1.00 0.80 Marketable Securities 1.00 1.00 Accounts Receivables 1.00 1.30 Inventory 1.00 1.20 Net Fixed Assets 1.00 0.90 Total Assets 1.00 1.20

Current Assets 2011 2012

Cash 0.3% $ 10 0.3% $ 12

Marketable Securities 2.6% $ 90 2.8% $ 95

Accounts Receivables 5.8% $ 200 7.3% $ 250

Inventory 8.7% $ 300 10.2% $ 350

Prepaid Expenses 0.6% $ 20 0.3% $ 10

Total Current Assets 18.0% $ 620 20.8% $ 717

Vertical Common-Size Balance Sheet All assets shown as percentage of total assets Highlights composition of the balance sheet

Cross Sectional (Relative) Analysis


Current Assets Comp. A Comp. B

Cash 0.3% $ 10 0.3% $ 12 Marketable Securities 2.6% $ 90 2.8% $ 95 Accounts Receivables, Net 5.8% $ 200 7.3% $ 250 Inventory 8.7% $ 300 10.2% $ 350 Prepaid Expenses 0.6% $ 20 0.3% $ 10

Total Current Assets 18.0% $ 620 20.8% $ 717

Fixed Assets Buildings and Equipment 29.0% $1,000 29.0% $1,000 Less Accumulated

Depreciation 5.8% $ 200 8.7% $ 300

Net Buildings and Equipment 23.2% $ 800 20.3% $ 700 Land 58.0% $2,000 58.0% $2,000

Total Fixed Assets 81.2% $2,800 78.3% $2,700

Goodwill 0.9% $ 30 0.9% $ 30

TOTAL ASSETS 100.0% $3,450 100.0% $3,447

Vertical Common-Size Balance Sheet All assets shown as percentage of total assets Highlights composition of the balance sheet

Relationships among Financial Statements (Examples)

• Compare growth rate of assets with growth rate of sales

• Compare growth rate of operating income with growth rate of operating cash flow

• Compare growth rate of inventory and receivables with growth rate of revenue Say revenue is up by 20%, inventory by 60% and receivables by 40%. Should you be concerned?


Graphs and Regression Analysis

• The Use of Graphs as an Analytical Tool

Comparison of performance and financial structure over time

Several types of graphs can be used

• Regression Analysis

Help identify relationships (correlation) between variables


4. Common Ratios Used in Financial Analysis

Category Measures Example

Activity ratios Efficiency Revenue / Assets

Liquidity ratios Ability to meet its short term obligations Current Assets / Current Liabilities

Solvency ratios Ability to meet long term debt obligations Assets / Equity

Profitability ratios Profitability Net Income / Assets

Valuation ratios Quantity of an asset or flow per share Earnings / Number of Shares


Single Statement Ratios: Income Statement Balance Sheet Cash Flow Statement

Mixed Ratios: Numerator from the Income Statement Denominator from the Balance Sheet

Interpret ratios in the context of: Goals and Strategy Industry Norms Economic Conditions

Activity Ratios


Activity Ratios Numerator / Dominator Interpretation

Inventory turnover Cost of good sold / Average inventory How many times per period entire inventory was sold

Days of inventory on hand Number of days in period / Inventory turnover

On average how many days of inventory kept on hand

Receivables turnover Revenue / Average receivables How quickly does a company collect cash

Days of sales outstanding Number of days in period / Receivables turnover

Elapsed time between credit sale and cash collection

Payables turnover Purchases / Average trade payables Times/year company pays suppliers

Number of days of payables Number of days in period / Payables turnover

Average number of days to pay suppliers

Working capital turnover Revenue / Average working capital How efficiently does a company generate revenue from working capital

Fixed asset turnover Revenue / Average net fixed assets How efficiently does a company generate revenue from fixed assets

Inventory Turnover Ratio



Inventory turnover Cost of good sold / Average inventory How many times per period entire inventory was sold

Income statement item in the numerator Use of average inventory Higher number shows greater efficiency Days of inventory on hand

Receivables Turnover Ratio



Receivables turnover Revenue / Average receivables How quickly does a company collect cash

More appropriate to use credit sales but this number is generally not available Higher number shows greater efficiency Days of sales outstanding

Payables Turnover Ratio



Payables turnover Purchases / Average trade payables Times/year company pays suppliers

If purchases not know we can use COGS + change in inventory Occasionally COGS is used as a proxy for purchases Relatively high number means company not making use of credit facilities Low ratio might indicate liquidity issues

Working Capital and Asset Turnover Ratios



Working capital turnover Revenue / Average working capital How efficiently does a company generate revenue from working capital

Fixed asset turnover Revenue / Average net fixed assets How efficiently does a company generate revenue from fixed assets

Total asset turnover Revenue / Average total assets How efficiently does a company generate revenue from total assets

Remembering Ratios 1) Name tells you balance sheet item 2) Balance sheet item income statement item 3) Income statement item in the numerator 4) Average value of balance sheet number in denominator

Liquidity Ratios

Liquidity Ratios Numerator Denominator

Current ratio Current assets Current liabilities

Quick ratio Cash + short term marketable investments + receivables Current liabilities

Cash ratio Cash + short term marketable investments Current liabilities

Defensive interval ratios Cash + short term marketable investments + receivables Daily cash expenditures


Additional Liquidity Ratios


Cash conversion cycle (net operating cycle) = Days of inventory on hand + days of sales outstanding – number of days of payables

Solvency Ratios (Debt Ratios)

Solvency Ratios Numerator Denominator

Debt to assets ratio Total debt Total assets

Debt to capital ratio Total debt Total debt + Total shareholders equity

Debt to Equity ratios Total debt Total shareholders equity

Financial leverage ratios Average total assets Average total equity


Solvency Ratios (Coverage Ratios)

Solvency Ratios Numerator Denominator

Interest coverage EBIT Interest payments

Fixed charge coverage EBIT + lease payments Interest payments + lease payments


Profitability Ratios (Return on Sales) Profitability Ratios Numerator Denominator

Gross profit margin Gross profit Revenue

Operating profit margin Operating income Revenue

Pretax margin EBT (earning before tax but after interest) Revenue

Net profit margin Net income Revenue


Profitability Ratios (Return on Sales) Profitability Ratios Numerator Denominator

Gross profit margin Gross profit Revenue

Operating profit margin Operating income Revenue

Pretax margin EBT (earning before tax but after interest) Revenue

Net profit margin Net income Revenue


Profitability Ratios (Return on Investment) Profitability Ratios Numerator Denominator

Operating ROA Operating income Average total assets

ROA Net income Average total assets

Return on total capital EBIT Short and long term debt and equity

ROE Net income Average total equity

Return on common equity Net income – preferred dividend Average common equity


DuPont Analysis


Return on

Equity

Return on

Asset

Net Profit margin

Tax Burden Interest Burden

EBIT Margin

Total Asset Turnover

Financial Leverage

Example

2010 2011 2012

ROE 19% 20.0% 22.0%

Return on total asset 8.1% 8.0% 7.9%

Total asset turnover 2.0 2.0 2.1


Based only on the information above, the most appropriate conclusion is that, over the period 2010 to 2012, the company’s 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

Answer: C ROA has been decreasing over 2010 to 2012 while total asset turnover has been increasing, it must be case net profit margin has been declining. ROE has been increased despite the drop in ROA, financial leverage must have increased.

5. Equity Analysis

Steps for equity valuation:

1. Understanding the business and existing financial profile

2. Forecasting company performance

3. Selecting the appropriate valuation model

4. Converting forecasts to a valuation

5. Making the investment decision

Research has shown that ratios are useful in forecasting earnings and stock returns


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 (Per Share Quantities)

Numerator Denominator

Basic EPS Net income minus preferred dividends

Weighted average number of ordinary shares outstanding

Diluted EPS Adjusted income available shares, reflecting conversion of dilutive securities

Weighted average number of ordinary and potential ordinary shares outstanding

Cash flow per share Cash flow from operations Weighted average number of shares outstanding

EBITDA per share EBITDA Weighted average number of shares outstanding

Dividends per share Common declared dividends Weighted average number of ordinary shares outstanding


Industry-Specific Ratios

• No universally accepted definition and classification of ratios

• Ratios serve as indicators of performance and value

• Aspects of performance which are relevant in one industry might be irrelevant in another; hence the need for industry specific ratios

• Examples shown in Exhibit 19

Retail industry: same store sales changes

Banks: capital adequacy ratios


6. Credit Analysis

• Credit analysis is the evaluation of credit risk

• Ratios are used extensively in 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

7. Business and Geographic Segments Often we need to evaluate the performance of underlying business segments.

Business segments: subsidiary companies, operating units, operations in different countries

Disclosure of segment information is required by IFRS and U.S. GAAP.


Ratio 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


Forecasts Expected

Ratios

Models to Predict Future Earnings and Cash Flow

Summary


Category Measures Example

Activity ratios Efficiency Revenue / Assets

Liquidity ratios Ability to meet its short term obligations Current Assets / Current Liabilities

Solvency ratios Ability to meet long term debt obligations Assets / Equity

Profitability ratios Profitability Net Income / Assets

Valuation ratios Quantity of an asset or flow per share Earnings / Number of Shares

Remembering Ratios 1) Name tells you balance sheet item 2) Balance sheet item income statement item 3) Income statement item in the numerator 4) Average value of balance sheet number in denominator

Conclusion

• Read summary

• Review learning objectives

• Examples

• Practice problems: good but not enough

• Practice questions from other sources


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R28 Financial Analysis Techniques

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