Reading 24: Financial Analysis Techniques

Tools and techniques

Ratio

Purpose

assess management's performance.

evaluate changes in firms and industry overtime.

compare the firm with competitors

Common-size data

Vertical common-size

Horizontal common-size

project earnings and future cashflows

Limitiations

Not useful when viewed in isolation

Requires adjustments when different companies use different accounting treatments

Hard to compare for companies working in multiple industries --> there can be segmental explanation in footnote

hard to determine the "acceptable" value range for a ratio.

Ratios

Classification

Activity Ratios
Efficiency of daily operation

Receivable Turnover= $\frac{Sales}{Receivables_{Avg}}$

Days of Sales Outstanding=$ \frac{365}{ReceivablesTurnover}$

Inventory Turnover=$\frac{CoGS}{Inventory_{Avg}}$

Days of Inventory in hand=$ \frac{365}{InventoryTurnover}$

Payables Turnover=$\frac{Purchases}{TradePayables_{Avg}}$

Payable Payment Period=$ \frac{365}{PayablesTurnover}$

Total Assets Turnover=$ \frac{Sales}{TotalAssets_{Avg}}$

Fixed Asset Turnover=$ \frac{Sales}{NetFixedAssets_{Avg}}$

Working Capital Turnover =$ \frac{Sales}{Working Capital_{Avg}}$

Liquidity Ratios
Ability to meet short-term obligations

Current Ratio=$\frac{Current Asset}{Current Liability}$

Quick Ratio (Acid Test)= $\frac{Cash + MarketableSecurities+Receivables}{Current Liability}$

Cash Ratio= $\frac{Cash + MarketableSecurities}{Current Liability}$

Defensive Interval= $\frac{Cash + MarketableSecurities+Receivables}{Current Liability}$

Cash Conversion Cycle = (Day Sales Outstanding) + (Days of Inventory on hand) - (Days of payables)

Solvency Ratio
Ability to meet long-term obligations

Debt-to-equity Ratio=$ \frac{Total Debt}{Total Equity}$

Debt-to-capital Ratio=$ \frac{Total Debt}{Total Debt+Total Equity}$

Debt-to-assets Ratio=$ \frac{Total Debt}{Total Assets}$

Financial Leverage=$ \frac{Total Asset_{avg}}{Total Equity_{avg}}$

Interest Coverage=$ \frac{EBIT}{Interest payment}$

Fixed Charge Coverage =$ \frac{EBIT+LeasePayment}{InterestPayment +LeasePayment}$

Profitability Ratios
Ability to generate profitable sales

Net Profit Margin=$ \frac{Net Income}{Sales}$

Gross Profit Margin=$ \frac{Gross Profit}{Sales}$

Operating Profit Margin=$ \frac{EBIT}{Sales} =\frac{GrossProfit - OperatingCost}{Sales} $

Pretax Margin=$ \frac{EBT}{Sales}$

Return on Asset

Operating Return on Assets=$ \frac{EBIT}{TotalAsset_(Avg)}$

Return on Total Capital=$ \frac{EBIT}{TotalCapital}=\frac{EBIT}{ShorttermDebt + LongtermDebt + Equity}$

Return on Total Equity=$ \frac{NetIncome}{TotalEquity}$

Return on Common Equity$ \frac{NetIncome-Dividends_{pref}}{CommonEquity}$

Valuation Ratios
Quantity of asset or flow associated with an ownership claim

Earnings per share

Price-to-earnings

Price-to-sales

Price-to-book-value

Price-to-cash-flow

Du Pont Analysis of ROE

Basic equation

Extended Equation

ROE= $\frac{Net Income}{Sale}\times \frac{Sales}{Assets}\times \frac{Assets}{Equity}$
Or
ROE= $NetProfitMargin \times AssetTurnover \times Leverage$

ROE=$\frac{Net Income}{EBT}\times \frac{EBT}{EBIT}\times \frac{EBIT}{Sale}\times \frac{Sales}{Assets}\times \frac{Assets}{Equity}$
Or
ROE=$OperatingProfitMargin \times InterestBurden \times TaxBurden \times AssetTurnover \times Leverage$

Specific Analyses

Equity Analysis

Price-to-Earnings per share

Price-to-Cash-flows per share

Price-to-Sale per share

Price-to-Book-value per share

Basic & Diluted EPS

Credit Analysis

Interest Coverage Ratios (higher is better)

Return on Capital (higher is better)

Debt-to-asset (Lower is better)

Cash-flow-to-Total-Debt

Segmental Reporting

Segment:
a portion of a firm

Earnings forecast

Ratio analysis can help construct pro-forma financial statement based on forecast of sales growth and assumption about relation of changes in key income statement and balance sheet items to growth of sales.

Analysis Techniques

Cross-sectional analysis

Comparison to industry norm or average

Time-series analysis (trend analysis)

Comparison to a company's past ratios

Help identify the questions that need answering

Present each items as % of sales or total assets

Present each items as % of a base year (to measure growth)

Graphs

purposes

to facilitate comparison over time

To communicate analyst conclusions

types

Pie graph: composition of total value

Stacked column graph: composition of total value OVER TIME

Line graph: change over time

Common-size income statement

Used to analyze changes in cost structure and profitability

Used for both cross-sectional and time-series analysis

Context

Company goals and strategy (consistent with MD&A or not)

Industry norms

Ratios may be industry-specific

Multiple lines of business distort aggregate ratios

Difference in accounting methods

Economic conditions: Cyclical businesses and the stage of the business cycle

Average value

For ratios that use only Income Statement Items, use the value from current income statement.

For ratios using only Balance Sheet Items, use the values from current balance sheet

For ratios using both income statement and balance sheet items, use value from current income statement and AVERAGE VALUE for the balance sheet item

The number of time we run out of inventory and have to reorder

Number of days from receiving raw materials to selling finished goods

Number of day from selling goods to receiving cash

How many times we collect cash from customer in a year

Purchase = Cost of Good Sold - Beginning Inventory(average) + Ending Inventory (average)

How many times we play suppliers in a year

Number of day from receiving raw material to paying the supplier

Working Capital = Current Asset - Current Liabilities

How efficiently the company uses working capital to generate sale

Net of accumulated depreciation

How efficiently the company uses total asset to generate sale

How efficiently the company uses fixed asset to generate sale

If Current Ratio < 1, there maybe a problem with paying off short-term debts

As inventory is quite illiquid, more conservative than current ratio

If only use very liquid assets, more conservative than quick ratio

How long the company survive without new source of cash coming in

The time between paying supplier and receiving cash from customers

Retailers can have negative Cash Conversion Cycle

They can use CCC to finance other business

if CCC>0 and Current Ratio < 1, then there is a big trouble of liquidity

if CCC<0 you can support the situation where Current Ratio <1

context

Solvency

Earnings variability

Financial leverage

Business risk

Operating leverage:

fixed cost vs. variable cost

more fixed cost --> more volatility EBIT

Capital structure

Total debt = all interest-bearing short-term and long-term debts

Sales volatility

What % of assets are financed by using debts

What % of capital structure that are financed by debts

If financing asset with retained earning, Financial Leverage would close to 1

How comfortably we are making interest payments

Debt to EBITDA$=\frac{TotalDebt}{EBITDA} $

Debt compared to Earnings to paydown the debt

=$ \frac{NetIncome}{TotalAssets}$

alternatively =$ \frac{NetIncome+InterestExpense\times (1-t)}{TotalAssets}$

ROE= $\frac{Net Income}{Asset}\times \frac{Assets}{Equity}$
Or
ROE= $ROA \times Leverage$

To understand which factor causes the change in ROE

Cash flow per share

EBITDA per share

Dividend related quantities

Dividend per share

Dividend payout ratio $= \frac{CommonDividend}{NetIncome-PreferredDividend} $

Retention rate (b) $= \frac{EarningAvailableToCommonShares - CommonDividend}{EarningAvailableToCommonShares} $

Sustainable growth rate = $ b \times ROE $

This is the growth rate that firm can sustain without raising any new external EQUITY capital

Business Risk Ratios

CV of Operating Income = $ \frac{Std.dev.OperatingIncome}{MeanOperatingIncome} $

CV of Revenue = $ \frac{Std.dev.Revenue}{MeanRevenue} $

CV of Net Income = $ \frac{Std.dev.NetIncome}{MeanNetIncome} $

Altmans Z-Score = $ 1.2 \times \frac{CurrentAsset-CurrentLiabilities}{TotalAsset} + 1.4 \times\frac{RetainedEarnings}{TotalAsset} + 3.3 \times\frac{EBIT}{TotalAsset} + 0.6 \times\frac{MV_(Equity)}{BV_(Liabilities)}+ 1.0 \times\frac{Sales}{TotalAsset}$

if Z-score < 1.81 --> has bankruptcy risk

Reportable business or geographic segment:

For each segment, firm reports limited financial statement information

For primary segments, must report revenue (internal and external), operating profit, assets, liabilities (IFRS only), capex, depreciation, and amortization.

50% of its revenue from sales is external to the firm, AND

at least 10% of a firm's revenue, earnings, or assets

Segment Ratios

Segment Margin = $ \frac{SegmentProfit}{SegmentRevenue} $

Segment ROA = $ \frac{SegmentProfit}{SegmentAssets} $

Segment Asset Turnover =$ \frac{SegmentRevenue}{SegmentAssets} $

Segment Debt Ratio (IFRS only) = $ \frac{SegmentLiabilities}{SegmentAssets} $

Earnings model

Revenue-driven model

Sensitivity analysis: how sensitive the forecast to a single variable changes

Scenario analysis: how forecast changes if multiple variables change

Simulation: build scenarios based on probability