Financial Analysis Fundamentals

Financial analysis is critical to understanding company’s past performance and future prospects

There are many important steps in preparing a financial analysis, such as trends and ratio analysis.
The starting point is always the financial statements; income statement, balance sheet, cash flow
statement.

Vertical and Horizontal Income Statement Analysis

Objectives:

 Learn the key components of income statement

 Perform vertical analysis using ratios
 Perform horizontal analysis using percentage changes relative to the prior year
 Benchmark against other companies in an industry

Ratio Analysis

1. Performance ratios => How company is doing

a. Profitability ratios : evaluate the ability of a company to generate income relative to
revenue, balance sheet assets, operating costs and equity
b. Efficiency ratios : measure how well a company is utilizing its assets and resources
2. Financial leverage ratios => Financial condition of company; measures the amount of capital
that comes from debt
a. Liquidity ratios
b. Solvency ratios

As we analyze income statement, it is the profitability ratios that we pay attention to

Breakdown of the Income Statement

 Revenue
The most important part of a company and the major component of ratio analysis
 Direct Cost
Known as COGS / COS; include direct labor, raw materials and cost of generating the
revenue, may include depreciation and amortization of manufcaturing equipment in
generating the goods that being sold.
 Gross Profit
It tells us what the gross profit margin is before deducting indirect costs that are reuqired to
keep the business running. Gross profit margin is what remains after a company has paid for
the COGS to fund the rest of the business
 Indirect Expenses
This costs are required to keep the business going but not directly related to the cost of
generating revenue, such as SG&A, R&D, marketing, sallary, depreciation/amortization.
 Operating Income
Refer as EBIT, it is what remains to pay the creditors (interest), government (tax) and the
shareholders
 Net Income
The final line item of income statement which represent what is left for the shareholders
that can be paid as dividend or reinvested in the business
Vertical Analysis

Vertical analysis looks at only a single year on an income statement and calculates the contribution
each expense makes as a proportion of revenue.

We take each of the components under revenue and divided into revenue to calculate a percentage.
We calculate all the items in the income statement to understand how much contribution each costs
make as a proportion of revenue; for every one dollar of revenue that is earned how many cents of
epxenses that should be incurred.

While it is possible to calculate the ratio of every single line item of income statement, there are 3
most important profitability ratios:

a. Gross profit margin : for every one dollar of revenue that is generated how much is leftover
after paying the COGS, the higher the number is better

Gross Profit
Sales

b. O p e r a ti n g p r o fi
shareholders. This indicates the efficiency of the operation.

EBIT
Sales

c. Net profit margin : how much net income that is generating for one dollar of revenue

Net Income
Sales
Efficiency Ratio

 Tax ratio : demonstrates how well the company manages tax. By comparing the tax ratio to
the effective tax rate, we can identify if management is effectively using its asset to generate
operating income or if assets are sitting as idle investment. The higher tax ratio indicates the
later as investment income attracts a higher tax rate than operating income.

Tax Expense
EBT

Solvency Ratio

 Interest coverage ratio : indicates how easily a company can serve its interest expense, can
also be reffered as times interest earned or how many times over the company can cover its
interest expense.

EBIT ( DA )
Interest Expense
Horizontal Analysis

It is usualy performs after vertical analysis is complete. It also known as trend analysis, by comparing
the result across periods, ideally at least 5 years of analysis. The trend will inform forecasting and
future projection. By performing this type of analysis, we can see the growth pattern of a company,
whether it is a constant increase or decrease, exponential growth, or accelerating decline, etc. The
key is to look back over several years, identify a trend, then make an assessment about how that
trend would project in the future, this is the essence of trend or horizontal analysis.

Horizontal analysis is a powerful tool, it helps us to answer these question:

 Are margins rising or falling?
 Is performance improving or declining?
 What is causing margins to fall?
 Are margins impacted by indirect costs?

By understanding the trends of historical performace, we are able to predict future performance of
company.

Benchmarking

By using benchmarking, this will shine a light on how well a company is doing in context of an
industry or relative to other competitors. There 2 ways to compare a company to others:
a. Compare to direct competitors
b. Compare to industry average; consist of several companies that operate in the industry

A challenge on benchmarking is some of the competitors may categorize expenses differently with
the company that is being analyzed.

Balance Sheet Analysis and Ratios

Objectives:

 Determine the financiall strength of a company by analyzing the balance sheet

 Determine how efficiently company is being run

Short Term Liquidity Ratios

This ratios are used to determined how easily a company can handle its short term obligation (due in
less than one year)

a. Current Ratio

Current Assets
Current Liabilities
Generic rule of thumb is 2 : 1
 b. Quick Ratio or Acid Test Ratio

Current Assets−Inventory
Current Liabilities

This ratio is a more conservative ratio for liquidity. This ratio is more cautious that in many
cases invetory is rarely can turn into cash. The generic rule of thumb is 1 : 1. This rule of thumb is
depends on the industry and the state of the company. Depending on how quickly a company can
turnover its invetory, financial analyst may determined that it is fine to have a lot of acurrent sset
tied up in inventory since it is liquid or financial analyst may determined it is risky and choose to use
quick ratio rather than current ratio.

Asset Turnover Ratio

Sales
Total ( ¿ net ) Assets

This metric is important for analyzing a company and requires both income statement and balance
sheet. This ratio will tell us the efficiency of a company on generating revenue from its asset, the
higher the ratio is, the more efficiently the company is run and the less capital is required to
generate the revenue.

All of these ratio analysis should be accompanied by trend analysis to determine:

 What are the ratios doing?

 Are they improving or deteriorating?

A benchmarking is also needed to compare the condition of the company to the industry

Working Capital

In the broadest sense, working capital is current asset – current liabilities. But, there is a narrower
definition of working capital that consist of:

Accounts Receivables+ Inventory −Accounts Pyabale

These 3 accounts denote the operating activity of a company, which means they represent the cash
outflow and inflow to fund its operation. The difference of cash in and cash out, which is
represented by the period outstanding of AR, Inventory and AP, generate a working capital funding
gap.
Manage working capital funding gap is a critical process for a company. Several ways to manage this
funding gap include:

o Renegotiating contracts with supplier to delay the payments

o Incentivize customers to pay faster
o Improve inventory management by using ‘just-in-time’, where inventory is ordered when
needed

Working Capital Efficiency Ratios

1. Inventory ratios
 Inventory turnover: indicates how quickly company sells its inventory, the higher the
better

Cost of sales
( Avg∨Ending ) Inventory
 Inventory days ratio: calculate the amount of time the inventory is on hand or
remain in the balance sheet, the lower the number is better.

Inventory ×365
Cost of sales

2. Account Receivables ratios

 Receivable turnover ratio: indicates how quickly company receive a payment from
its customer, the higher the ratio, the better.

Sales
( Avg∨Ending ) AR
 Receivable days ratio: calculates the number of days to take the AR to turnover, the
lower the number is better.
Receivables ×365
Sales

3. Account Payables ratios

 Payable turnover ratio: Indicates how many times in the period the payable turnover

Cost of sales
( Avg∨Ending ) AP
 Payable days ratio : How many days in average it takes for a company to pay its bills
Payables ×365
Cost of sales
 4. Funding Gap formula: Calculate the funding gap in days using the efficiency ratio above, the
smaller the number, the better

Days of Inventory+ Days of AR−Days of AP

PP&E Efficiency Ratios

PPE Turnover ratio:

Sales
Total PPE

This ratio indicates how much revenue a company is capable to generate for every dollar of PPE that
it has. If the ratio is lower than the average industry, it means that the sales is low or there is too
much PPE that is being invested. This ratio is also be easily impacted by the timing differences in
spending on PPE. If company invest a very large amount of capital in one quarter, it may takes
several more quarters for its revenue to goes up. So, it is important to look backward at the trend of
the ratio.

Cash Flow Statement Analysis and Ratios

Objectives:

 Understand the cash inflows and outflows throughout the year

 Calculate solvency and leverage ratios
 Examine funding options to operate and grow

Cash Flow Component

1. Operating CF
This is the connection of income statement by taking the bottom line of income statemet,
which is net income, as the starting point. Then, adding back all non-cash expenses and
adjust net changes of working capital. OCF demonstrates how much money that company
makae from operation in the period.

2. Investing CF
This section shows us how much a company is growing by looking at how much it’s investing
on its asset (Capex). From the net number of investing CF, we can see how much company is
investing back to the business, and if those assets are performing well then it will generate
more net income and growth for the company. If we take the OCF then deducted by capex,
we’ll get the free cash flow; which represents the amount of cash that is available to be
redistributed to the investors or put into other discretionary activities, this over time creates
the sharehodel value in a business.

3. Financing CF
This part shows us how the company is funding the business. It can issue debt or shares to
raise money, which will be shown in the cash flow statement.
 Idealy, in the long run, a company will try optimize its capital structure and lower its cost of
capital, as well as plan carefully for investing activities that it needs money for, andfunding
any operating activities shortfall. The bottom line of cash flow statement is the ending cash
balance which is linking to the balance sheet. This is how all of those financial statement is
connected and create a robust financial statement.

Capital Employed

An analytical balance sheet look at the balance sheet by grouping in a different ways than traditional
balance sheet. In an analytical balance sheet, there are 2 categories; net asset and capital
employed.

 Net asset: total asset – current liabilities (exclude the current portion of LTD)
 Capital emploed: combination of debt and equity; noncurrent liabilities + shareholder’s
eqity + current portion of LTD + short term debt + interest bearing current liabilities.

Understanding Debt

 Short–term debt: Commonnly used for funding working capital. These two debt do not have
fix repayment schedule, they are simply drawn on and then repaid as soon as the company is
able to, or when the bank demands it to be.
 Overdraft
 Operating line of credit

 Term loans: A loan comes from a bank that has fix repayment schedule. This is more likely
used to purchased fixed asset, also can be used to fund working capital, such as purchasing
inventory.

 Bonds: Another way of raising debt; a company raise money by issuing securities of its own
debt. Bonds are a commong form of debt financing, with ‘coupon’ as its interest rate. This is
effective to fund long-term investment, as it may be more difficult to obtain a bank loan with
a reasonable repayment schedule.
 Fixed rate bonds : regardless of the interest rate in the market, coupon rate is fixed
 Floating rate : Coupon reset periodically using interest rate as its benchmark
 Zero coupon : Pay no interest, trade at a discount
 Inflation-linked : the amount that is received at maturity is linked to inflation; the
interest remain fixed; whereas the principal amount may grow
 Callable bonds : The issuer has rights to repay the bond before the maturity; the
opposite is putable bonds
 Convertible bonds : has an option to convert the debt into shares
 Bonds with warrants : tend to be more common in private placements; the warrant
can be excercised in the future by purchasing stock; which provide more fund to the
company

 Syndicated loans : two or more banks provide credit to one borrower in one agreement to
spread the risk across the participating lender, this is what banks do to manage its risk. It
tend to be medium-term with floating interest rate.

 Leasing : Obtaining asset without having to pay immediately.

  Finance lease: long term lease transfer risks and rewards of ownership, recorded on
balance sheet. It esentially a way for a company to finance an acquisition of asset
directly to the owner rather than through bank.
 Operating lease: short term lease, no transfer risks and rewards of ownership,
recorded in income statement as expense. The objeticve is to have access of an
asset for short term period and return it back to the owner when no longer useful or
required.

In order to raise debt financing, a company need to be able to show a history of profitability or be
able to have asset to be pledged as security against the loan.

Understanding Equity

 Common shares

 Preferred shares : similar to debt as there is a requirement to pay dividend. However,

dividend payment is not tax deductible like interest payment.
 Cumulative : fixed rate of dividend and will be accumulated for forward payment if
unpaid
 Participating : Entitles the holder to receive additional profits after all other
preffered dividends are paid
 Redeemable : Will be redeemed at a specified future date at the option of either the
company or the shareholders
 Convertible : Rights to convert the preferred stock to common stock at a specified
future date at specified rate of conversion
 Retractable : can be repaid at specified price at a maturity date

 Retained earnings : Generated by positive net income, ofsetted by dividend payment and
dedcuted by any losses

Leverage

The relationship between debt and equity is referred to leverage. The higher the proportion of debt
relative to equity the hihger the leverage is. Leverage ratio is used to assess a company’s ability to
meet its long term fixed expenses and to accpmmodate long term expansion and growth.

Benefits of leverage:

 Obtain a loan form a bank is often very quick and inexpensive, whereas equity takes a long
time to arrange and is much more expensive to issue
 The timing of the loan can be matched to the asset and the cash flow of the asset, whereas
equity is a permanent capital that not necessarily match to the life of asset
 Debt is not dilutive to equity investor, which means raising new capital does not decrease
the percentage own by shareholders
Leverage ratios:

1. Debt to equity / Debt to capital

Interest bearingliabilities
Total Equity(+interest bearingliabiities)

If the ratio is greater than 1 (or 50%), the company has more financing coming from debt than
equity

2. Debt to Tangible Net Worth (TNW)

Interest bearingliabilities
Total Equity−Intangible assets

This ratio is useful to understand how many physical asset that company has. Tangible net worth
represents the proceed that could be available if the company has to be quickly sold. It is
better to have ratio less than 1, if it is greater than 1, then some attention need to pay at what is
happening and how the company serve its debt.

3. Total liabilities to equity

Total Liabilities
Total Equity

This ratio assess company’s obligations including its short term working capital requirement
compare to its equity. By using this ratio in conjunction with debt to equity ratio, it is possible to
see the impact of operational activities on the business.

4. Total assets to equity

Total Assets
Total Equity

If the ratio is low, the company may be underleveraged. If the number is high, while taking the
advantage of debt, the comapny may be over-levered. This ratio can also be used in conjunction
with debt to equity to assess the leverage of company.

5. Debt to EBITDA

Interest bearingliabilities
EBITDA

This ratio is commonly used by lenders to referring how levered a company is, whether it is
levered at 2, 3 or 4 times EBITDA. EBITDA is oftenly used as proxy of cash flow, eventhough it is
still far from from true cash flow metric since it doesn’t use any capex and working capital
changes. This ratio reflects the cash available to pay back the debt.
Rates of Return and Profitability Analysis

Objectives:

 Use the pyramid of ratios to explain what drives a company’s financial performance

Return on Equity

Net Income
Shareholde r ' s Equity
This ratio is a strong measure of how the management of a company creates value. By analyzing the
trend of return on equity over time, we can assess management’s performance to see if it is
improving through climbing ROE or if it is deteriorating through lower ROE.

ROE holds the key of the story;

x x
Net Income Revenu Total Assets
Sales Total Assets Equity
Net Profit Margin Asset Turnover Financial Leverage

Component of ROE:

 Profitability : Profitability is the most obvious lever of ROE. By improving profitability a

company will improver its rate of return for shareholders.
 Efficiency : How well an asset is being used to generate sales
 Leverage : Increasing financial leverage has effect of reducing amount of equity. Having a
lower equity base make it easier for a company to have a higher ROE

Dupont Analysis

Dupont analysis breakdown the formula of ROE to see what impacts each drivers have on the overall
performance of a company

 Profitability Ratios
 o Tax impact
Understand the impact of tax in a company; how well they are bing managed and is
it operating in a high tax or low tac environements. As the tax rate increase, the net
income decreases as a percent of pretax profit. As a result, the better a company is
at managing its taxes or the lower of a tax rate it can operate it, the higher this ratio
will be, and the higher the ROE will be.
o Capital structure impact
Uncovers what the cost surrounding interest on debt is, therefore how levered a
company is. As a company takes on debt, the interest expense increase and the ratio
will decline. A low net income may be the result of operating margins, but it may be
also the result of interest expense relating to debt from capital structure of a
company.
o Margin Impact
This ratio is solely impacted by the operations of the company as it is not affected by
interests or taxes. This ratio gives a sense of the overall operating efficiency of the
business from the profitability point of view.

 Efficiency Ratios

The secondary efficiency ratios breakdown the total asset turnover by categorized the asset
type:

o PPE Turnover
Influenced by the investment behaviour of a company. A high number may indcates
that there is a low investment that being made, or may indicate an efficiency of its
assets. If the number is low, it indicates a poor efficiency of the assets or there may
be an overinvestment on its asset. PPE turnover is time sensitive, since company
need takes time to generate sales after making a capital expenditure. Therefore, it is
important to analyze what drives the ratio and the trend of the ratio.
o Working capital
This ratio depends on how well the company managing its working capital
  Leverage Ratios

The secondary leverage ratios are those that indicates how levered a company is and an
assessment of overall solvency.

o Debt to Equity
This ratio give a sense on how levered the company is just on an interest bearing
debt perspective. How much debt a company has and is it in the sweet spot from a
cost of capital persepective.
o Liabilities to Equity
This ratio analyzes the amount of equity held relative to all liabilities, not just the
interest bearing debt. Has the company over levered or overextended itself.

These ratios is not normally used in the pyramid ratios of ROE. Instead, we use total asset to
equity.

Pyramid of Ratios

Pyramid ratios are breaking down the drivers of ROE by analyzing each components