R28 Inventories

CFA® Level I - Financial Reporting and Analysis
Financial Analysis Techniques
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Contents
1. Introduction
2. The Financial Analysis Process
3. Analytical Tools and Techniques
4. Common Ratios Used in Financial Analysis
5. Equity Analysis
6. Credit Analysis
7. Business and Geographic Segments
8. Model Building and Forecasting
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1. Introduction
• Financial analysis is a useful tool in assessing a company’s performance and

trends.
• The primary source of data is company’s annual reports, financial statements

and MD&A.
• An analyst must be capable of using financial statements in conjunction with

other information to make projections and reach valid conclusions.
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2. The Financial Analysis Process
Prior to beginning any financial analysis, the analyst should clarify the purpose and
context, and clearly understand the following:
 What is the purpose of the analysis? What questions will this analysis answer?
 What level of detail will be needed to accomplish this purpose?
 What data are available for the analysis?
 What are the factors or relationships that will influence the analysis?
 What are the analytical limitations, and will these limitations impair the analysis?
Purpose and
Techniques
Context
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Financial Analysis Framework
Objective 2. Collect data: financial
Organized financial
1. Articulate purpose and Questions to be statements, other financial statements; financial
context based on your answered data, industry/economic data; tables, completed
function, client input and Content to be provided discussions with management, questionnaires
organizational guidelines Timetable and budget
suppliers, customers and
competitors
4. Analyze and
3. Process data Adjusted financial statements; common- Analytical results
size statements, ratios, graphs, forecasts interpret processed
data
Report answering questions Updated

5. Develop and communicate from Phase 1, conclusions and 6. Follow up recommendations
conclusions and recommendations recommendations
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Distinguishing Between Computation and Analysis
Effective analysis encompasses computations and interpretations
4. Analyze and
3. Process data Adjusted financial statements; common- Analytical results
size statements, ratios, graphs, forecasts interpret processed
data
Questions related to analysis of past performance:

What aspects of performance are critical to success?
How did company perform on these aspects?
Forward looking analysis:
What is the likely impact of trends/events in the company, industry and economy?
What are the risks?
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3. Analytical Tools and Techniques
• Tools and techniques facilitate evaluation of
• Ratios
company data
• Evaluations require comparison
• Common Size Analysis • Need to make adjustments so data is
comparable
• Can perform cross-sectional and time-series
• Graphs
analysis
• Regression Analysis
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Ratios
• Ratio is an indictor of some aspect of a company’s performance
• Ratios can help predict investment returns
• Some widely accepted ratios but no authoritative body which provides exact
formulas
• Ratios help us 1) evaluate past performance, 2) assess current financial position of
the company, and 3) gain insights useful for projecting future results
Specifically ratios allow us to evaluate Factors to consider when using ratios

1. Operational efficiency 1. Need to use judgment
2. Financial flexibility 2. Use of alternate accounting methods
3. Changes in company/industry over time 3. Heterogeneity of a company's operating
4. Company performance relative to industry activities
4. Consistency of results
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Common Size Analysis
• Balance Sheet
 Vertical
 Horizontal
• Income Statement
• Cash Flow Statement
• Relationship Among Financial Statements
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Time-Series (Trend) Analysis
Current Assets 2011 2012
Vertical Common-Size Balance
Cash 0.3% $ 10 0.3% $ 12 Sheet
Marketable Securities 2.6% $ 90 2.8% $ 95
Accounts Receivables 5.8% $ 200 7.3% $ 250 All assets shown as percentage
Inventory 8.7% $ 300 10.2% $ 350
of total assets
Prepaid Expenses 0.6% $ 20 0.3% $ 10
Total Current Assets 18.0% $ 620 20.8% $ 717 Highlights composition of the
balance sheet
Period
1 2
Cash 1.00 0.80 Horizontal Common-Size Balance Sheet
Marketable Securities 1.00 1.00
Accounts Receivables 1.00 1.30 Highlights structural changes in a business
Inventory 1.00 1.20
Net Fixed Assets 1.00 0.90
Total Assets 1.00 1.20
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Cross Sectional (Relative) Analysis
Current Assets Comp. A Comp. B Vertical Common-Size Balance
Cash 0.3% $ 10 0.3% $ 12 Sheet
Marketable Securities 2.6% $ 90 2.8% $ 95
Accounts Receivables, Net 5.8% $ 200 7.3% $ 250 All assets shown as percentage
Inventory 8.7% $ 300 10.2% $ 350
Prepaid Expenses 0.6% $ 20 0.3% $ 10
of total assets
Total Current Assets 18.0% $ 620 20.8% $ 717
Highlights composition of the
Fixed Assets balance sheet
Buildings and Equipment 29.0% $1,000 29.0% $1,000
Less Accumulated
Depreciation 5.8% $ 200 8.7% $ 300
Net Buildings and Equipment 23.2% $ 800 20.3% $ 700
Land 58.0% $2,000 58.0% $2,000
Total Fixed Assets 81.2% $2,800 78.3% $2,700
Goodwill 0.9% $ 30 0.9% $ 30
TOTAL ASSETS 100.0% $3,450 100.0% $3,447
Relationships among Financial Statements (Examples)
• Compare growth rate of assets with growth rate of sales
• Compare growth rate of operating income with growth rate of operating cash flow
• Compare growth rate of inventory and receivables with growth rate of revenue
 Say revenue is up by 20%, inventory by 60% and receivables by 40%. Should you be concerned?
Graphs and Regression Analysis
• The Use of Graphs as an Analytical Tool
 Comparison of performance and financial
structure over time
 Several types of graphs can be used
• Regression Analysis
 Help identify relationships (correlation) between
variables
4. Common Ratios Used in Financial Analysis
Category Measures Example
Activity ratios Efficiency Revenue / Assets
Liquidity ratios Ability to meet its short term obligations Current Assets / Current Liabilities
Solvency ratios Ability to meet long term debt obligations Assets / Equity
Profitability ratios Profitability Net Income / Assets
Valuation ratios Quantity of an asset or flow per share Earnings / Number of Shares
Single Statement Interpret ratios in the

Mixed Ratios:
Ratios: context of:
Income Statement Goals and Strategy
Numerator from the Income Statement
Balance Sheet Industry Norms
Denominator from the Balance Sheet
Cash Flow Statement Economic Conditions
Activity Ratios
Activity Ratios Numerator / Dominator Interpretation
Inventory turnover Cost of good sold / Average inventory How many times per period entire
inventory was sold
Days of inventory on hand Number of days in period / Inventory On average how many days of inventory
turnover kept on hand
Receivables turnover Revenue / Average receivables How quickly does a company collect cash
Days of sales outstanding Number of days in period / Elapsed time between credit sale and
Receivables turnover cash collection
Payables turnover Purchases / Average trade payables Times/year company pays suppliers
Number of days of payables Number of days in period / Payables Average number of days to pay suppliers
turnover
Working capital turnover Revenue / Average working capital How efficiently does a company generate
revenue from working capital
Fixed asset turnover Revenue / Average net fixed assets How efficiently does a company generate
revenue from fixed assets
Inventory Turnover Ratio
Inventory turnover Cost of good sold / Average inventory How many times per period entire
inventory was sold
Income statement item in the numerator
Use of average inventory
Higher number shows greater efficiency
Days of inventory on hand
Receivables Turnover Ratio
Receivables turnover Revenue / Average receivables How quickly does a company collect cash
More appropriate to use credit sales but

this number is generally not available
Higher number shows greater efficiency
Days of sales outstanding
Payables Turnover Ratio
Payables turnover Purchases / Average trade payables Times/year company pays suppliers
If purchases not know we can use COGS +

change in inventory
Occasionally COGS is used as a proxy for

purchases
Relatively high number means company not

making use of credit facilities
Low ratio might indicate liquidity issues
Working Capital and Asset Turnover Ratios
Working capital turnover Revenue / Average working capital How efficiently does a company generate
revenue from working capital
Fixed asset turnover Revenue / Average net fixed assets How efficiently does a company generate
revenue from fixed assets
Total asset turnover Revenue / Average total assets How efficiently does a company generate
revenue from total assets
Remembering Ratios
1) Name tells you balance sheet item
2) Balance sheet item  income statement item
3) Income statement item in the numerator
4) Average value of balance sheet number in denominator
Liquidity Ratios
Liquidity Ratios Numerator Denominator
Current ratio Current assets Current liabilities
Quick ratio Cash + short term marketable investments + receivables Current liabilities
Cash ratio Cash + short term marketable investments Current liabilities
Defensive interval ratios Cash + short term marketable investments + receivables Daily cash expenditures
Additional Liquidity Ratios
Cash conversion cycle (net operating cycle) =
Days of inventory on hand + days of sales outstanding – number of days of payables
Solvency Ratios (Debt Ratios)
Solvency Ratios Numerator Denominator
Debt to assets ratio Total debt Total assets
Debt to capital ratio Total debt Total debt + Total shareholders equity
Debt to Equity ratios Total debt Total shareholders equity
Financial leverage ratios Average total assets Average total equity
Solvency Ratios (Coverage Ratios)
Solvency Ratios Numerator Denominator
Interest coverage EBIT Interest payments
Fixed charge coverage EBIT + lease payments Interest payments + lease payments
Profitability Ratios (Return on Sales)
Profitability Ratios Numerator Denominator
Gross profit margin Gross profit Revenue
Operating profit margin Operating income Revenue
Pretax margin EBT (earning before tax but after interest) Revenue
Net profit margin Net income Revenue
Profitability Ratios (Return on Sales)
Gross profit margin Gross profit Revenue
Operating profit margin Operating income Revenue
Pretax margin EBT (earning before tax but after interest) Revenue
Net profit margin Net income Revenue
Profitability Ratios (Return on Investment)
Operating ROA Operating income Average total assets
ROA Net income Average total assets
Return on total capital EBIT Short and long term debt and equity
ROE Net income Average total equity
Return on common equity Net income – preferred dividend Average common equity
DuPont Analysis
Return on
Equity
Return on Financial
Asset Leverage
Net Profit Total Asset

margin Turnover
Interest
Tax Burden EBIT Margin
Burden
Example
2010 2011 2012
ROE 19% 20.0% 22.0%
Return on total asset 8.1% 8.0% 7.9%
Total asset turnover 2.0 2.0 2.1
Based only on the information above, the most appropriate conclusion is that, over the period
2010 to 2012, the company’s
A. Net profit margin and financial leverage have decreased

B. Net profit margin and financial leverage have increased
C. Net profit margin has decreased but its financial leverage has increased
Answer: C
ROA has been decreasing over 2010 to 2012 while total asset turnover has been increasing, it must be
case net profit margin has been declining. ROE has been increased despite the drop in ROA, financial
leverage must have increased.
5. Equity Analysis
Steps for equity valuation:
1. Understanding the business and existing financial profile
2. Forecasting company performance
3. Selecting the appropriate valuation model
4. Converting forecasts to a valuation
5. Making the investment decision
Research has shown that ratios are useful in forecasting earnings and
stock returns
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 (Per Share Quantities)
Numerator Denominator
Basic EPS Net income minus preferred Weighted average number of ordinary shares
dividends outstanding
Diluted EPS Adjusted income available Weighted average number of ordinary and
shares, reflecting conversion of potential ordinary shares outstanding
dilutive securities
Cash flow per share Cash flow from operations Weighted average number of shares outstanding
EBITDA per share EBITDA Weighted average number of shares outstanding
Dividends per share Common declared dividends Weighted average number of ordinary shares
outstanding
Industry-Specific Ratios
• No universally accepted definition and classification of ratios
• Ratios serve as indicators of performance and value
• Aspects of performance which are relevant in one industry might be
irrelevant in another; hence the need for industry specific ratios
• Examples shown in Exhibit 19
 Retail industry: same store sales changes
 Banks: capital adequacy ratios
6. Credit Analysis
• Credit analysis is the evaluation of credit risk
• Ratios are used extensively in credit analysis
Ratio Numerator Denominator

EBIT interest coverage EBIT Gross interest
EBITDA interest coverage EBITDA Gross interest
Debt to EBITDA Total debt EBITDA

Total debt to total debt plus Total debt Total debt plus equity
equity
7. Business and Geographic Segments
Often we need to evaluate the performance of underlying business segments.
Business segments: subsidiary companies, operating units, operations in different countries
Disclosure of segment information is required by IFRS and U.S. GAAP.
Ratio Numerator Denominator

Segment margin Segment profit Segment revenue
Segment turnover Segment revenue Segment assets
Segment ROA Segment profit Segment assets

Segment debt ratio Segment liabilities Segment assets
8. Model Building and Forecasting
Expected
Forecasts
Ratios
Models to Predict Future

Earnings and Cash Flow
Summary
Category Measures Example
Activity ratios Efficiency Revenue / Assets
Liquidity ratios Ability to meet its short term obligations Current Assets / Current Liabilities
Solvency ratios Ability to meet long term debt obligations Assets / Equity
Profitability ratios Profitability Net Income / Assets
Valuation ratios Quantity of an asset or flow per share Earnings / Number of Shares
Remembering Ratios
1) Name tells you balance sheet item
2) Balance sheet item  income statement item
3) Income statement item in the numerator
4) Average value of balance sheet number in denominator
Conclusion
• Read summary
• Review learning objectives
• Examples
• Practice problems: good but not enough
• Practice questions from other sources

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CFA® Level I - Financial Reporting and Analysis

Financial Analysis Techniques

• Financial analysis is a useful tool in assessing a company’s performance and

• The primary source of data is company’s annual reports, financial statements

• An analyst must be capable of using financial statements in conjunction with

Report answering questions Updated

Questions related to analysis of past performance:

Specifically ratios allow us to evaluate Factors to consider when using ratios

• Cash Flow Statement

• Relationship Among Financial Statements

TOTAL ASSETS 100.0% $3,450 100.0% $3,447

Single Statement Interpret ratios in the

Income statement item in the numerator

Use of average inventory

Higher number shows greater efficiency

Days of inventory on hand

More appropriate to use credit sales but

Higher number shows greater efficiency

Days of sales outstanding

If purchases not know we can use COGS +

Occasionally COGS is used as a proxy for

Relatively high number means company not

Low ratio might indicate liquidity issues

Cash conversion cycle (net operating cycle) =

Days of inventory on hand + days of sales outstanding – number of days of payables

Net Profit Total Asset

A. Net profit margin and financial leverage have decreased

EBITDA per share EBITDA Weighted average number of shares outstanding

Ratio Numerator Denominator

Debt to EBITDA Total debt EBITDA

Ratio Numerator Denominator

Segment ROA Segment profit Segment assets

Models to Predict Future

• Review learning objectives

• Practice problems: good but not enough

• Practice questions from other sources

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