CHAPTER 7 FINANCIAL ANALYSIS TECHNIQUES Presenters name Presenters title dd Month yyyy.

CHAPTER 7FINANCIAL ANALYSIS TECHNIQUES

Presenter’s namePresenter’s titledd Month yyyy

Copyright © 2013 CFA Institute 2

FINANCIAL ANALYSIS TOOLS:DESCRIPTION

• Graphics

• Regression

• Common-Size Analysis

• Financial Ratio Analysis


GRAPHICS: EXAMPLE

21%

38%

19%

22%

Operating Profit by Geographic Segment

North America Latin AmericaEurope/South Pacific Greater Asia/Africa


GRAPHICS: EXAMPLE

North America

Latin America

Europe/South Pacific

Greater Asia/Africa

0 200 400 600 800 1000 1200 1400 1600

20072008200920102011

$ millions


GRAPHICS: EXAMPLE

2006

1

2006

2

2006

3

2006

4

2007

1

2007

2

2007

3

2007

4

2008

1

2008

2

2008

3

2008

4

2009

1

2009

2

2009

3

2009

4

2010

1

2010

2

2010

3

2010

4

2011

1

2011

2

2011

3

2011

40.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Operating profit margin


REGRESSION: EXAMPLE

-40.0 -30.0 -20.0 -10.0 0.0 10.0 20.0 30.0 40.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

f(x) = 0.117565973870053 x + 5.81768507372527R² = 0.268720817275207

Sales Growth

GD

P C

ha

ng

e

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.


COMMON-SIZE BALANCE SHEET EXAMPLE: SINGLE COMPANY, TWO PERIODS

Period 1 % of Total

Assets

Period 2 % of Total

Assets Cash 25 15 Receivables 35 57 Inventory 35 20 Fixed assets, net of depreciation

5 8

Total assets 100 100

Copyright © 2013 CFA Institute

Partial common-size balance sheet

8

COMMON-SIZE BALANCE SHEET EXAMPLE:CROSS-SECTIONAL, TWO COMPANIES, SAME TIME

Assets Company 1% of Total

Assets

Company 2% of Total

AssetsCash 38 12Receivables 33 55Inventory 27 24Fixed assets net of depreciation 1 2Investments 1 7Total Assets 100 100


Partial common-size balance sheet

9


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?

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



RATIO ANALYSIS

15.26%• 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.

How profitable was Company X?


RATIO ANALYSIS

COMPANY X’S 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 indicator—for example, an indicator of relative

activity, profitability, liquidity, solvency.• Interpretation generally involves comparison. Furthermore,

analysis will address the question of why.

How profitable was company X?


RATIO ANALYSIS

COMPANY X WAS MORE PROFITABLE THAN COMPANY Y AS EVIDENCED BY ITS NET

PROFIT MARGIN. COMPANY X’S MARGIN OF 15.3% WAS HIGHER THAN COMPANY Y’S

MARGIN OF 12.0%.

• 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.

How profitable was Company X?


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?


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.

CATEGORIES OF FINANCIAL RATIOS

Category DescriptionActivity 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?



PROFITABILITY AND OVERVIEW





Profitability Profitability ratios. How much and how is the firm achieving returns on its investments?


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:

• Applied to shareholders’ equity:

Rate of return =Amount of returnAmount invested

ROE =Net income

Average equity


DECOMPOSE ROE

=Net income

×Average assets

Average assets Average equity

ROE =Net income

Average equity

= ROA × Leverage


DECOMPOSE ROE

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.

ROE = ROA × Leverage


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:

Two variants of ROA computation:

Rate of Return =Amount of returnAmount invested

(1) ROA =Net income

Average assets

(2) ROA =Net income adjusted for interest

Average assets

=Net income + [Interest expense × (1 – Tax rate)]

Average assets


PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY

In other words, ROA can be thought of as:

ROA =Net income

Average assets

ROA =Net income

×Revenue

Revenue Average assets


Profit margin × Turnover (efficiency)

DECOMPOSINGRETURN ON EQUITY

ROE =Net income

×Revenue

×Average assets

Revenue Average assets Average equity

ROE = Profit margin × Turnover × Leverage


DECOMPOSINGRETURN ON EQUITY

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)

Du Pont Analysis



DECOMPOSING RETURN ON EQUITY:STYLIZED COMPARATIVE ANALYSIS MINI-CASE

Co. A Co. B Co. C

Average

Sales ($) 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

Average liabilities ($) 0 1,000 500 500

ROE (NI/Equity)

Net profit margin (NI/Sales)

Turnover(Sales/Assets)

Leverage (Assets/Equity)

26

DECOMPOSING RETURN ON EQUITY:STYLIZED COMPARATIVE ANALYSIS MINI-CASE

Co. A Co. B Co. C Average

Sales ($) 2,000 4,000 6,675 4,225

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

Average liabilities ($) 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

27Copyright © 2013 CFA Institute


DECOMPOSING RETURN ON EQUITY:COMPARATIVE

AAPL HPQ DELL

ROE 27.19% 21.50% 61.19%

Net income/SalesNet profit margin 14.88% 7.04% 4.06%

Sales/Average assetsAsset turnover 1.00 1.17 2.26

Average assets/ Average equity

Financial leverage 1.83 2.61 6.67

DUPONT ANALYSIS :FURTHER DECOMPOSITION

• ROE = Net income/Average equity• Decompose ROE into five factors

ROE =Net income

×EBT

×EBIT

EBT EBIT Revenue

×Revenue

×Average assets

Average assets Average equity

29Copyright © 2013 CFA Institute

PROFITABILITY: RETURN ON SALES (FROM THE COMMON-SIZE INCOME STATEMENT)

Gross profit margin = Gross profit/RevenueMeasures the ability to translate sales into profit after consideration of cost of products sold.

Operating profit margin = Operating profit/RevenueMeasures the ability to translate sales into profit after consideration of operating expenses.

Net profit margin = Net profit/RevenueMeasures the ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes, and nonoperating items.


DISCUSSION BY CATEGORY








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.



ACTIVITY RATIOS

Numerator Denominator

Working capital turnover Revenue Average working capital

Fixed asset turnover Revenue Average net fixed assets

Total asset turnover Revenue Average total assets

Also known as asset utilization or operating efficiency ratios


OTHER COMMON ACTIVITY RATIOS


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 PurchasesAverage trade payables

Number of days of payablesNumber of days in period

Payables turnover

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.


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


DISCUSSION BY CATEGORY








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• Debt to equity• Debt to total capital

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)

} Lower ratio –> safer.

Higher cushion against potential creditor losses



COMMON SOLVENCY RATIOS

Solvency ratios Numerator DenominatorDebt ratios Debt-to-assets ratio Total debt Total assetsDebt-to-capital ratio Total debt Total debt + Total

shareholders’ equityDebt-to-equity ratio Total debt Total shareholders’ equityFinancial leverage ratio

Average total assets Average total equity

Coverage ratios Interest coverage EBIT Interest paymentsFixed charge coverage

EBIT + Lease payments

Interest payments + Lease payments

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.

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.

P/E =Price

Earnings per share


VALUATION RATIOS


Valuation ratios

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


DIVIDEND-RELATED QUANTITIES

Dividend payout ratio =Dividends per shareEarnings per share

Dividend yield =Dividends per share

Price



SELECTED CREDIT RATIOS USED BY STANDARD & POOR’S AS PART OF CREDIT ANALYSIS

Ratio Numerator Denominator

EBIT and EBITDA interest coverage

EBIT or EBITDA Gross interest (prior to deductions for capitalized interest or interest income)

FFO interest coverageFFO plus interest paid minus operating lease adjustments

Gross interest (prior to deductions for capitalized interest or interest income)

FFO to debt FFO Total debt

Free operating cash flow to debt

CFO (adjusted) minus capital expenditures

Total debt

Discretionary cash flow to debt

CFO minus capital expenditures minus dividends paid

Total debt


SELECTED CREDIT RATIOS USED BY STANDARD & POOR’S AS PART OF CREDIT ANALYSIS

Credit Ratio Numerator Denominator

Return on capital EBITAverage capital, where capital is equity plus noncurrent deferred taxes plus debt

Net cash flow to capital expenditures

FFO minus dividends Capital expenditures

Debt to EBITDATotal debt EBITDA

Total debt to total debt plus equity

Total debt Total debt plus equity


SEGMENT ANALYSIS EXAMPLE:L’ORÉAL


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


RATIOS IN MODEL BUILDING

Forecast Debt

Forecast Interest

Expense

Forecast Income

and Taxes

Forecast Cash Flow

• Sales forecast

• Expenses• Gross Profit• Operating

Profit

• Assets • Liabilities

• Cash Flow


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

CHAPTER 7 FINANCIAL ANALYSIS TECHNIQUES Presenters name Presenters title dd Month yyyy.

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