v2 24 Jan 2021

Chapter 2
Financial Analysis
Techniques

Masood Aijazi
CFA
28 January 2021
 Contents
Introduction

The Financial Analysis Process

Analysis tools and Techniques

 Financial Statements and Supplementary Information
 Other Sources of Information

Common Ratio

Equity Analysis

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 Introduction
Finacial Analysis:
– Assessing Co’s performance and trends
– Performance? Relative to own past, relative to competition
– How Co. likely to perform in future
– Co. value

Sources
– Financial statements
– Other; economy, industry, comparable

Analysis objectives
– Equity Analysis
– Credit Analysis

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4
5
The Objectives of Financial Analysis Process

The objectives, the purpose

Level of details needed
How to find and analyze data
Factors or relationships influencing the analysis
Analytical limitations
How to communicate analysis
Conclusion

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 The Financial Statement Analysis Framework

1. Articulate the Purpose and context

2. Collect Data
3. Process Data
4. Analyze / Interpret
5. Conclusion
6. Follow up

Purpose & Collect Process Analyze

context Data Data Conclusion Follow up
/ Interpret

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The Financial Statement Analysis Framework

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Distinguishing between Computation and Analysis

What?
Why?
Did it advance the strategy?
What may happen in future?

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 Distinguishing between Computation and Analysis

• What aspects of performance are critical for this company to

successfully compete in this industry?
• How well did the company’s performance meet these critical aspects?
(Established through computation and comparison with appropriate
benchmarks, such as the company’s own historical performance or
competitors’ performance.)
• What were the key causes of this performance, and how does this
performance reflect the company’s strategy? (Established through
analysis.)

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 Distinguishing between Computation and Analysis

If the analysis is forward looking, additional questions include:

• What is the likely impact of an event or trend? (Established through interpretation
of analysis.)
• What is the likely response of management to this trend? (Established through
evaluation of quality of management and corporate governance.)
• What is the likely impact of trends in the company, industry, and economy on
future cash flows? (Established through assessment of corporate strategy and
through forecasts.)
• What are the recommendations of the analyst? (Established through
interpretation and forecasting of results of analysis.)
• What risks should be highlighted? (Established by an evaluation of major
uncertainties in the forecast and in the environment within which the company
operates.)
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 Financial Statements Analysis

• Industry economic characteristics

• Company strategies (differentiators,
competitive advantage, business model )

• Quality of the financial

statements.
• Current profitability and risk.
• Prepare forecasted financial
statements.
• Value the firm (multiple techniques)

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 Ratio Analysis
• Value, purpose and limitations The computed
ratio is not “the
• Sources of Ratios
answer.” The ratio is
• Common Size Analysis an indicator of some
• Cross Sectional analysis aspect of a
company’s
• Trend analysis
performance,
• Use of graphs as an analytical tool telling what
happened but not
• Regression Analysis why it happened.

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 Financial Analysis Techniques

Limitations of Financial Ratios

Not useful in isolation – only valid when compared to other firms or the
company’s historical performance
Different accounting treatments – particularly when analyzing non-U.S.
firms
Finding comparable industry ratios for companies that operate in multiple
industries
All ratios must be viewed relative to one another
Determining the target or comparison value requires some range of
acceptable values

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 Financial Analysis Techniques
Ratio Analysis
Some general rules:
For ratios that use only income statement items, use the values
from the current income statement
For ratios using only balance sheet items, use the values from
the current balance sheet.
For ratios using both income statement and balance sheet
items, use the value from the current income statement and
the average value for the balance sheet item.

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 Financial Analysis Techniques

Interpreting Ratios
1. Cross-sectional analysis:
Comparison to industry norm or average
2. Time-series analysis (trend analysis):
Comparison to a company’s past ratios

Ratios help the analyst identify the questions that require further
analysis.

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Vertical
Common
Size
Analysis

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Cross Sectional analysis

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 Limitations of Financial Ratios

• The heterogeneity or homogeneity of a company’s

operating activities.

• The need to determine whether the results of the ratio

analysis are consistent.

• The need to use judgment.

• The use of alternative accounting methods.

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 Financial Analysis Techniques
Ratio Analysis Context
1. Company goals and strategy
2. Industry norms
– Ratios may be industry specific
– Multiple lines of business distort aggregate ratios
– Differences in accounting methods
3. Economic conditions
Cyclical businesses and the stage of the business
cycle

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 Key Financial Ratios
• Current Ratio
• Quick Ratio.
Liquidity Solvency
• Price-Earnings (P/E) Ratio.
• Debt-Equity Ratio.
• Return on Equity (ROE)
Profitabilit Operating • Gross Margin
y Efficiency
• Net Profit Margin
• Assets, Inventory or Rec. Turnover

How have key ratios changed and why?

How do key ratios and trends compare with competitors/industry?
What aspects of performance are critical for a competitive advantage?
How did the company perform in these areas?
What is the company’s business model and strategy - are they reflected in key
measures?
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Use of graphs as an analytical tool

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 Financial Analysis Techniques
Activity Ratios
Cost of goods sold
Inventory turnover =
Average inventory

Days of inventory 365

=
on hand (DOH) Inventory turnover

Receivables Revenue
=
turnover Average receivables

Days of sales 365

=
outstanding (DSO) Receivables turnover
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 Financial Analysis Techniques
Activity Ratios
Purchases
Payables turnover =
Average trade payables
Number of days of 365
=
payables Payables turnover
Revenue
Working capital =
turnover Average working capital

Current assets– Current

Working capital =
liabilities
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 Financial Analysis Techniques

Activity Ratios

Fixed asset Revenue

=
turnover Average net fixed assets

Net of accumulated
depreciation

Total asset turnover Revenue

=
Average total assets

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 Financial Analysis Techniques

Definitions: Liquidity Ratios

Cash + short-term
marketable investments +
receivables
Defensive interval =
ratio Daily cash expenditure
Days
DOH X
Cash DSO X
conversion =
cycle – # of days payables (X)
Cash conversion cycle X
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 Financial Analysis Techniques
Cash Conversion Cycle
Raw materials arrive
Number of
Production commences days of
payables
DOH
Production complete Pay supplier

Goods sold Cash

conversion
DSO
Cash collected from cycle
customer
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 Financial Analysis Techniques
Solvency Ratios
Total debt = interest bearing
Total debt ratio
short-term and long-term debt

Debt-to-assets Total debt

=
ratio Total assets

Debt-to-capital Total debt

=
ratio Total debt + total
shareholders’ equity
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 Financial Analysis Techniques
Solvency Ratios

Debt-to-equity Total debt

=
ratio Total shareholders’
equity

Financial leverage Average total assets

=
ratio Average total equity

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 Financial Analysis Techniques
Solvency Ratios

EBIT
Interest coverage =
Interest payments

Fixed charge EBIT + Iease payments

=
coverage Interest payments + lease
payments

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 Financial Analysis Techniques

Profitability Ratios

Net income
Return on assets =
(ROA) Average total assets

Net income + interest

Alternatively:
expense (1 – T)
Return on assets =
(ROA) Average total assets

Operating ROA Operating income

=
Average total assets

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 Financial Analysis Techniques

Profitability Ratios
EBIT
Return on total =
capital Short- + long-term debt +
equity
Net income
Return on equity =
(ROE) Average total equity

Return on Net income – pref. div.

=
common equity Average common equity

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 Financial Analysis Techniques

Integrated Financial Ratio Approach

Important to analyze all ratios collectively

Use information from one ratio category to answer

questions raised by another ratio

Classic example: DuPont analysis

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 Financial Analysis Techniques

DuPont System Analysis

ROE = Net income

Equity

Net income Total assets

×
Total assets Equity

ROA Financial leverage

ratio 34
 Financial Analysis Techniques
DuPont System: Original Equation
ROE = Net income
Equity
Net income Revenue
×
Revenue Equity

Net income Revenue Total assets

× ×
Revenue Total assets Equity

Net profit margin Asset turnover Leverage

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 Financial Analysis Techniques

DuPont System: Extended Equation

Net income Revenue Total assets

× ×
Revenue Total assets Equity

EBIT EBT Net income

× ×
Revenue EBIT EBT

EBIT margin Interest burden Tax burden

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 Financial Analysis Techniques

DuPont System: Extended Equation

Net income Revenue Total assets

× ×
Revenue Total assets Equity

EBIT EBT Net income

× ×
Revenue EBIT EBT

EBIT margin Interest burden Tax burden

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Equity Analysis Financial Analysis Techniques

Per-Share Ratios for Valuation

P Price per share
=
E Earnings per share

P Price per share

=
CF Cash flow per share

P Price per share

=
S Sales per share

P Price per Share

=
BV Book value per share
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 Financial Analysis Techniques

Per-Share Quantities
NI – Pref. div.
Basic EPS =
Weighted avg. # ordinary
shares
Income adjusted for dilutive
Diluted EPS = securities
Weighted avg. # shares
adjusted for dilution
Cash flow per CFO
=
share Weighted avg. # shares
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 Financial Analysis Techniques

Per-Share Quantities
EBITDA per EBITDA
=
share Avg. # ordinary shares

Dividends per Common dividend

=
share Weighted avg. #
common shares

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 Financial Analysis Techniques

Credit Ratings and Ratios

Assessing a company’s ability to service and repay its
debt:
Interest coverage ratio
Return on capital
Debt-to-assets ratio
Other ratios focus on various measures of cash
flow to total debt

Note: Adjustments are made for off-balance-sheet debt.

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 Financial Analysis Techniques

Segment Reporting
Reportable business or geographic segment:
50% of segment revenue from external sales, and at least 10%
of firm’s revenue, earnings, or assets
For each segment, firm reports limited financial statement
information.
For primary segments: internal and external revenue,
operating profit, capex, assets, depreciation, and
amortization are required.
IFRS also requires segment liabilities reporting.
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 Financial Analysis Techniques

Analysis has generated the following data:

Tax rate 35%
Equity multiplier 2.7
Net profit margin 4.6%
Equity turnover 5.2

ROE is closest to:

A. 13%. Net income / Sales × Sales / Equity =
B. 17%. Net income / Equity = 4.6% × 5.2 = 23.92%
C. 24%.

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Thank You

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