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Reading 24: Financial Analysis Techniques (Earnings forecast (Ratio…
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
project earnings and future cashflows
Help identify the questions that need answering
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.
Common-size data
Vertical common-size
Present each items as % of sales or total assets
Horizontal common-size
Present each items as % of a base year (to measure growth)
Common-size income statement
Used to analyze changes in cost structure and profitability
Used for both cross-sectional and time-series analysis
Analysis Techniques
Cross-sectional analysis
Comparison to industry norm or average
Time-series analysis (trend analysis)
Comparison to a company's past ratios
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
Ratios
Classification
Activity Ratios
Efficiency of daily operation
Receivable Turnover= \( \frac{Sales}{Receivables_{Avg}}\)
How many times we collect cash from customer in a year
Days of Sales Outstanding=\( \frac{365}{ReceivablesTurnover}\)
Number of day from selling goods to receiving cash
Inventory Turnover=\(\frac{CoGS}{Inventory_{Avg}}\)
The number of time we run out of inventory and have to reorder
Days of Inventory in hand=\( \frac{365}{InventoryTurnover}\)
Number of days from receiving raw materials to selling finished goods
Payables Turnover=\(\frac{Purchases}{TradePayables_{Avg}}\)
Purchase = Cost of Good Sold - Beginning Inventory(average) + Ending Inventory (average)
How many times we play suppliers in a year
Payable Payment Period=\( \frac{365}{PayablesTurnover}\)
Number of day from receiving raw material to paying the supplier
Total Assets Turnover=\( \frac{Sales}{TotalAssets_{Avg}}\)
How efficiently the company uses total asset to generate sale
Fixed Asset Turnover=\( \frac{Sales}{NetFixedAssets_{Avg}}\)
Net of accumulated depreciation
How efficiently the company uses fixed asset to generate sale
Working Capital Turnover =\( \frac{Sales}{Working Capital_{Avg}}\)
Working Capital = Current Asset - Current Liabilities
How efficiently the company uses working capital to generate sale
Liquidity Ratios
Ability to meet short-term obligations
Current Ratio=\(\frac{Current Asset}{Current Liability}\)
If Current Ratio < 1, there maybe a problem with paying off short-term debts
Quick Ratio (Acid Test)= \(\frac{Cash + MarketableSecurities+Receivables}{Current Liability}\)
As inventory is quite illiquid, more conservative than current ratio
Cash Ratio= \(\frac{Cash + MarketableSecurities}{Current Liability}\)
If only use very liquid assets, more conservative than quick ratio
Defensive Interval= \(\frac{Cash + MarketableSecurities+Receivables}{Current Liability}\)
How long the company survive without new source of cash coming in
Cash Conversion Cycle = (Day Sales Outstanding) + (Days of Inventory on hand) - (Days of payables)
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
Solvency Ratio
Ability to meet long-term obligations
Debt-to-equity Ratio=\( \frac{Total Debt}{Total Equity}\)
Debt-to-capital Ratio=\( \frac{Total Debt}{Total Debt+Total Equity}\)
What % of capital structure that are financed by debts
Debt-to-assets Ratio=\( \frac{Total Debt}{Total Assets}\)
What % of assets are financed by using debts
Financial Leverage=\( \frac{Total Asset_{avg}}{Total Equity_{avg}}\)
If financing asset with retained earning, Financial Leverage would close to 1
Interest Coverage=\( \frac{EBIT}{Interest payment}\)
How comfortably we are making interest payments
Fixed Charge Coverage =\( \frac{EBIT+LeasePayment}{InterestPayment +LeasePayment}\)
context
Solvency
Earnings variability
Financial leverage
Capital structure
Business risk
Operating leverage:
fixed cost vs. variable cost
more fixed cost --> more volatility EBIT
Sales volatility
Total debt = all interest-bearing short-term and long-term debts
Debt to EBITDA\(=\frac{TotalDebt}{EBITDA} \)
Debt compared to Earnings to paydown the debt
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
=\( \frac{NetIncome}{TotalAssets}\)
alternatively =\( \frac{NetIncome+InterestExpense\times (1-t)}{TotalAssets}\)
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
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
Du Pont Analysis of ROE
Basic equation
ROE= \(\frac{Net Income}{Sale}\times \frac{Sales}{Assets}\times \frac{Assets}{Equity}\)
Or
ROE= \(NetProfitMargin \times AssetTurnover \times Leverage\)
ROE= \(\frac{Net Income}{Asset}\times \frac{Assets}{Equity}\)
Or
ROE= \(ROA \times Leverage\)
Extended Equation
ROE=\(\frac{Net Income}{EBT}\times \frac{EBT}{EBIT}\times \frac{EBIT}{Sale}\times \frac{Sales}{Assets}\times \frac{Assets}{Equity}\)
Or
ROE=\(OperatingProfitMargin \times InterestBurden \times TaxBurden \times AssetTurnover \times Leverage\)
To understand which factor causes the change in ROE
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
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
= \( \frac{Std.dev.NetIncome}{MeanNetIncome} \)
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
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
Segmental Reporting
Segment
:
a portion of a firm
Reportable business or geographic segment:
50% of its revenue from sales is external to the firm, AND
at least 10% of a firm's revenue, earnings, or assets
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.
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 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.
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