1. business and industrial
2. company
3. earnings

CHAPTER 7
FINANCIAL ANALYSIS TECHNIQUES
Presenter’s name
Presenter’s title
dd Month yyyy
FINANCIAL ANALYSIS TOOLS:
DESCRIPTION
• Graphics
• Regression
• Common-Size Analysis
• Financial Ratio Analysis
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GRAPHICS: EXAMPLE
Operating Profit by Geographic Segment
22%
21%
19%
38%
North America
Europe/South Pacific
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Latin America
Greater Asia/Africa
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GRAPHICS: EXAMPLE
2007
2008
2009
2010
2011
Greater Asia/Africa
Europe/South Pacific
Latin America
North America
0
200
400
600
800
1000
1200
1400
1600
$ millions
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GRAPHICS: EXAMPLE
Operating profit margin
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
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REGRESSION: EXAMPLE
14.0
y = 0.1176x + 5.8177
R² = 0.2687
12.0
GDP Change
10.0
8.0
6.0
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
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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 what’s 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.
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COMMON-SIZE BALANCE SHEET EXAMPLE:
SINGLE COMPANY, TWO PERIODS
Partial common-size balance sheet
Cash
Receivables
Inventory
Fixed assets, net of
depreciation
Total assets
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Period 1
Period 2
% of Total % of Total
Assets
Assets
25
15
35
57
35
20
5
8
100
100
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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
Copyright © 2013 CFA Institute
Company 1 Company 2
% of Total % of Total
Assets
Assets
38
12
33
55
27
24
1
2
1
7
100
100
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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?
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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 comparisons—trends and across companies.
• Ratios are interrelated
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RATIO ANALYSIS
How profitable was Company X?
• A ratio is NOT the answer (except sometimes on
an exam).
• A ratio is an indicator—for example, an indicator
of relative activity, profitability, liquidity, solvency.
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RATIO ANALYSIS
How profitable was company X?
• A ratio is NOT the answer (except sometimes on an exam).
• A ratio is an indicator—for example, an indicator of relative
activity, profitability, liquidity, solvency.
• Interpretation generally involves comparison. Furthermore,
analysis will address the question of why.
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RATIO ANALYSIS
How profitable was Company X?
• A ratio is NOT the answer (except sometimes on an exam).
• A ratio is an indicator—for example, an indicator of relative
activity, profitability, liquidity, solvency.
• Interpretation generally involves comparison. Furthermore,
analysis will address the question of why.
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USING FINANCIAL ANALYSIS TOOLS
Computation ≠ Analysis
• Analysis goes beyond collecting data and computing numbers.
• Analysis encompasses computations and interpretations.
• Where practical, directly experience the company’s 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 company’s strategy?
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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.
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CATEGORIES OF FINANCIAL RATIOS
Category
Activity
Description
Activity ratios. How efficient are the firm’s operations
and the firm’s 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 firm’s performance or
financial position relate to its market value?
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PROFITABILITY AND OVERVIEW
Category
Activity
Description
Activity ratios. How efficient are the firm’s operations
and the firm’s 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 much and how is the firm
achieving returns on its investments?
Valuation
Valuation ratios. How does the firm’s performance or
financial position relate to its market value?
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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 =
Copyright © 2013 CFA Institute
Net income
Average equity
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DECOMPOSE ROE
ROE =
Net income
Average equity
=
Net income
Average assets
×
Average assets
Average equity
=
ROA
×
Leverage
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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.
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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 =
=
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Net income adjusted for interest
Average assets
Net income + [Interest expense × (1 – Tax rate)]
Average assets
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PROFITABILITY, COMPETITION,
AND BUSINESS STRATEGY
ROA =
Net income
Average assets
ROA =
Net income
Revenue
×
Revenue
Average assets
In other words,
ROA can
be thought
Profit margin × Turnover (efficiency)
of as:
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DECOMPOSING
RETURN ON EQUITY
ROE =
ROE =
Profit margin
Net income
Revenue
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×
×
Turnover
Revenue
Average assets
×
×
Leverage
Average assets
Average equity
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DECOMPOSING
RETURN ON EQUITY
Du Pont Analysis
What was the source of the firm’s return on equity?
To what extent
•
. . . was it derived from selling a high margin product or keeping
expenses low—deriving more profits from each $1 of sales? (return
on sales, net profit margin)
•
. . . was it derived from generating higher sales from a lower
investment in assets? (efficient use of assets, also known as
turnover or efficiency)
•
. . . was it derived from investing a lower amount of equity—by using
more debt in its capital structure? (financial leverage)
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DECOMPOSING RETURN ON EQUITY:
STYLIZED COMPARATIVE ANALYSIS MINI-CASE
Co. A
Sales ($)
Co. B
Co. C
Average
2,000
4,000
6,675
4,225
Net income (NI) ($)
200
200
200
200
Average assets ($)
1,000
2,000
1,500
1,500
Average equity ($)
1,000
1,000
1,000
1,000
0
1,000
500
500
Average liabilities ($)
ROE (NI/Equity)
Net profit margin
(NI/Sales)
Turnover
(Sales/Assets)
Leverage
(Assets/Equity)
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DECOMPOSING RETURN ON EQUITY:
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
0
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)
2
2
4.45
2.82
Leverage (Assets/Equity)
1
2
1.5
1.50
Sales ($)
NI ($)
Average liabilities ($)
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Co. C
Average
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DECOMPOSING RETURN ON EQUITY:
COMPARATIVE
AAPL
ROE
Net income/Sales
Sales/Average assets
Average assets/
Average equity
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HPQ
27.19% 21.50%
Net profit
margin
Asset
turnover
Financial
leverage
DELL
61.19%
14.88%
7.04%
4.06%
1.00
1.17
2.26
1.83
2.61
6.67
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DUPONT ANALYSIS :
FURTHER DECOMPOSITION
• ROE = Net income/Average equity
• Decompose ROE into five factors
ROE =
Net income
EBT
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×
EBT
EBIT
×
EBIT
Revenue
×
Revenue
Average assets
×
Average assets
Average equity
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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.
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DISCUSSION BY CATEGORY
Category
Activity
Description
Activity ratios. How efficient are the firm’s operations
and the firm’s management of assets?
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
Profitability ratios. How much and how is the firm
achieving returns on its investments?
Valuation ratios. How does the firm’s performance or
financial position relate to its market value?
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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.
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ACTIVITY RATIOS
Also known as asset utilization or operating efficiency ratios
Working capital turnover
Fixed asset turnover
Total asset turnover
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Numerator
Revenue
Revenue
Revenue
Denominator
Average working capital
Average net fixed assets
Average total assets
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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
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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.
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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
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DISCUSSION BY CATEGORY
Category
Activity
Description
Activity ratios. How efficient are the firm’s operations
and the firm’s management of assets?
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
Profitability ratios. How much and how is the firm
achieving returns on its investments?
Valuation ratios. How does the firm’s performance or
financial position relate to its market value?
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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 firm’s ability to pay interest.
• EBIT interest coverage = (EBT + Interest payments)/Interest
payments
• Fixed charge coverage = (EBIT + Lease payments)/(Interest
payments + Lease payments)
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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
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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
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DISCUSSION BY CATEGORY
Category
Activity
Description
Activity ratios. How efficient are the firm’s operations
and the firm’s management of assets?
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
Profitability ratios. How much and how is the firm
achieving returns on its investments?
Valuation ratios. How does the firm’s performance or
financial position relate to its market value?
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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 firm’s 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.
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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
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DIVIDEND-RELATED QUANTITIES
Dividend payout ratio
=
Dividends per share
Earnings per share
Dividend yield
=
Dividends per share
Price
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SELECTED CREDIT RATIOS USED BY
STANDARD & POOR’S AS PART OF CREDIT ANALYSIS
Ratio
EBIT and EBITDA
interest coverage
FFO interest coverage
FFO to debt
Numerator
Denominator
Gross interest (prior to
EBIT or EBITDA
deductions for capitalized
interest or interest income)
FFO plus interest
Gross interest (prior to
paid minus operating deductions for capitalized
lease adjustments
interest or interest income)
FFO
CFO (adjusted)
minus capital
expenditures
CFO minus capital
Discretionary cash flow
expenditures minus
to debt
dividends paid
Free operating cash
flow to debt
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Total debt
Total debt
Total debt
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SELECTED CREDIT RATIOS USED BY
STANDARD & POOR’S 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
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Total debt
EBITDA
Total debt
Total debt plus equity
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SEGMENT ANALYSIS EXAMPLE:
L’ORÉAL
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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
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RATIOS IN MODEL BUILDING
• Sales forecast
Forecast
Debt
Forecast
Interest
Expense
Forecast
Cash Flow
Forecast
Income and
Taxes
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• Expenses
• Gross Profit
• Operating Profit
• Assets
• Liabilities
• Cash Flow
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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
comparisons—trends and cross-sectional.
• A ratio is an indicator of
- Activity
- Profitability
- Liquidity
- Solvency
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