2015, Study Session # 8, Reading # 28

FINANCIAL ANALYSIS TECHNIQUES

BS
LTD
SG&A
R&D

=
=
=
=

STD
RR
CV
EBITDA

=
=
=
=

Balance Sheet
Long-Term Debt
Selling, General & Admin
Research &
Development
Short-Term Debt
Retention Ratio
Coefficient of Variation
Earnings before Interest,
Tax, Depreciation &
Amortization

28.a

Common size statements allow the analyst to more easily compare performance.
Vertical common-size B.S express as % of total assets.
Vertical common-size I.S express as a % of sales.
Common size I.S ratios are useful in studying trends in costs & profit margins, I.S
account / sales.
B/S accounts can also be converted to common-size ratio as, B.S account/ total
assets.
Stacked column graph shows in items from year to year in graphical form.
Ratios are used in internal comparisons & comparisons across firms.
Their limitations are:
Different accounting treatment & divisions of one firm operating in multiple
industries.
Not useful when viewed in isolation or one set of ratios.
Need to use judgment when analyzing the results of ratio analysis.

28.b

GP
NP
PV
ROE
TA
TE
SD
IS
EBIT

=
=
=
=
=
=
=
=
=

Gross Profit
Net Profit
Present Value
Return On Equity
Total Assets
Total Equity
Standard Deviation
Income Statement
Earnings before Interest
& Tax

Pure B/S Ratios

Liquidity Ratios

Debt Solvency Ratios

Firms ability to satisfy short term obligations.

Current Ratio =

  


 

if <, 1   
 


Quick Ratio =
Cash + short term marketable securities + receivables
Current liabilities

Cash Ratio =
Cash + short term marketable securities
Current liabilities

Measure financial risk & leverage as well as solvency.

the ratio
leverage & risk debt solvency ratio.

Debt to capital ratio = total debt/(total debt + total
shareholders equity)

Debt-to-equity ratio = total debt/ total equity.

Total debt ratio = total debt / total assets.

Financial leverage = total assets / total equity.

Income Statement Ratios

Profitability Ratios

How good management is at turning their efforts into
profits. Higher margin ratios are desirable.

Gross profit margin = gross profit/ revenue.

Net profit margin = net income/ revenue.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 8, Reading # 28

28.b

Financial Ratios

Activity Ratios

How well a firm utilizes

various assets.

Liquidity Ratios

Ability to meet
short-term
obligations.

Solvency Ratios

Profitability Ratios

Valuation Ratios

Financial leverage
& ability to meet
longer term
obligations.

How well a
company generate
profits on its
investment.

Sales per share.

EPS.

Price to cash
flow.

These categories are not mutually exclusive.

Activity Ratios

Receivable turnover = annual sales / average receivables, (desirable, close to industry norm).
Days of sales outstanding= 365 / receivable turnover.
Collection period too long, too much capital tied in assets, (too low, may hamper sale).
Inventory turnover = cost of goods sold / avg. inventory.
Days of inventory on hand = 365 / inventory turnover, (desirable close to industry norm).
Process period too high, too much capital tied up in inventory (obsolete inventory), if too low, inadequate stock.
Payable turnover = purchases / avg. trade payables.
Number of days of payables = 365 / payable turnover ratio
Total asset turnover = revenue / avg. total assets.
Fixed asset turnover = revenue / avg. net fixed assets.
Net refers to net of Acc. Depreciation.
Working capital turnover = revenue / avg. working capital.

Liquidity Ratios

Current, quick & cash ratio.

Defensive interval ratio = cash + marketable securities + receivable / avg. daily cash expenditures.
Daily expenditure include cash expenses for cost of goods, SG &A & R&D, add back dep. (if items taken from I.S).
Cash conversion cycle = [days sales outstanding] + [days of inventory on hand] [number of days of payables].
High conversion cycle is undesirable (excessive amount of capital in sales process).

Solvency Ratios

Total debt is calculated differently by different analysts.
Here (interest-bearing STD and LTD).

Debt-to-capital = total debt / (total debt + total equity).
Capital = short & LTD + preferred stock & equity.

Debt -to- assets = total debt / total assets.

Interest coverage = EBIT / interest payments,(firms ability to repay debts).

Fixed charge coverage = (EBIT + lease payments) / (interest payments + lease payments).
(Suitable for companies that lease a large portion of assets).

Profitability Ratios

Net profit margin should be based on net income from continuing operations.
See G.P & N.P margin.
Operating profit margin = EBIT / sales (EBIT = GP SG&A (analyst should be consistent in calculation method).
Pretax margin = EBT / revenue.
Return on assets = N.I / avg. total assets
misleading, because interest excluded from N.I but total assets include debt as well as equity. Alternative calculation is:
Return on assets = [net income + interest expense (1-tax rate)] / avg. total assets.
Operating return on assets = EBIT / avg. total assets.
Return on total capital = EBIT / avg. total capital
alternative way is to include PV of operating leases as asset & liability.
Return on equity = net income / avg. total equity.
Return on common equity = (N.I preferred dividends) / avg. common equity.
Analyst should be concerned if these ratios are low.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 8, Reading # 28

28.d

DuPont system of analysis can be used to analyze ROE (analyst can use impact of leverage, profit margins & turnover
on shareholders returns).

DuPont System

Original three-part approach

Extended five-part system

ROE = [net income / sales] [sales / assets] [assets / equity].

DuPont is a way to decompose ROE, to better see what
changes are driving in ROE.

ROE = [N.I / EBT] [EBT / EBIT] [EBIT / sales] [sales / T.A] [T.A
/ T.E].


in tax or interest burden will  ROE.

More leverage does not always lead to higher ROE (as
leverage rise, so does the interest burden).

28.e

Valuation ratios used in analysis for investments in common equity.

Valuation ratios are, P/E, P/CF, P/sales, P/BV.
Per share valuation measures include EPS (basic & diluted), dividends per share, CF per share & EBITDA per share.
Total dividends on firm wide-basis dividends declared.
N.I dividend declared = retained earnings (to grow corporation).
Sustainable growth rate = g = RR ROE.
Dividend payout ratio = dividends declared / N.I available to common shareholders.
R.R = 1 dividend payout.
N.I per employee & sales per employee is used for valuation of services & consulting companies.
Growth in same store sales restaurant & retail industries.
Sales per square foot retail industry.
Business risk S.D of revenue, EBIT & N.I are indicators of uncertainty of firms performance.
Coefficient of variation S.D divided by variables expected value.

CVsale =

SD of Sales
Mean Sales

CVEBIT =

SD of EBIT
Mean EBIT

SD of N.I

, CVN.I = Mean N.I

Capital adequacy ratio of banks capital to its total risk.

Business segment portion of a larger company that accounts for more than 10% of companys revenues, assets or profits.
Geographic segments business environment that is different from other segments.
U.S.GAAP & IFRS require companies to report segment data.

28.f

Ratio analysis can be used in preparing pro forma financial statements.

Methods of examining variability

Sensitivity Analysis

What if questions.

Scenario Analysis

Based on scenarios & yield

a range of values or
outcomes.

Simulation

Probability distributions for key

variables are selected & computer
is used for outcome.

Copyright FinQuiz.com. All rights reserved.