FINANCIAL ANALYSIS TOOLS: DESCRIPTION CHAPTER 7 FINANCIAL ANALYSIS TECHNIQUES GRAPHICS: EXAMPLE GRAPHICS: EXAMPLE

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1 Presenter s name Presenter s title dd Month yyyy CHAPTER 7 FINANCIAL ANALYSIS TECHNIQUES FINANCIAL ANALYSIS TOOLS: DESCRIPTION Graphics Regression Common-Size Analysis Financial Ratio Analysis Copyright 2013 CFA Institute 2 GRAPHICS: EXAMPLE GRAPHICS: EXAMPLE Operating Profit by Geographic Segment 22% 21% 19% Greater Asia/Africa Europe/South Pacific Latin America 38% North America North America Europe/South Pacific Latin America Greater Asia/Africa $ millions Copyright 2013 CFA Institute 3 Copyright 2013 CFA Institute 4

2 GRAPHICS: EXAMPLE REGRESSION: EXAMPLE 30.0% 25.0% Operating profit margin y = x R² = % 15.0% 10.0% GDP Change % % -4.0 Sales Growth Copyright 2013 CFA Institute 5 Copyright 2013 CFA Institute 6 COMMON-SIZE ANALYSIS Common-size analysis: Express financial data, including entire financial statements, in relation to a single financial statement item or base. Vertical common-size - Balance sheet: Each item as a percent of total assets. - Income statement: Each item as a percent of total net revenues. - Cash flow: Each line as a percent of sales, assets, or total in and out. - Highlights composition and identifies what s important. Horizontal common-size - Percentage increase or decrease of each item from the prior year or showing each year relative to a base year. - Highlights items that have changed unexpectedly or have unexpectedly remained unchanged. COMMON-SIZE BALANCE SHEET EXAMPLE: SINGLE COMPANY, TWO PERIODS Partial common-size balance sheet Period 1 % of Total Assets Period 2 % of Total Assets Cash Receivables Inventory Fixed assets, net of 5 8 depreciation Total assets Copyright 2013 CFA Institute 7 Copyright 2013 CFA Institute 8

3 COMMON-SIZE BALANCE SHEET EXAMPLE: CROSS-SECTIONAL, TWO COMPANIES, SAME TIME Partial common-size balance sheet Assets Company 1 % of Total Assets Company 2 % of Total Assets Cash Receivables Inventory Fixed assets net of depreciation 1 2 Investments 1 7 Total Assets USE OF COMPARATIVE GROWTH INFORMATION: EXAMPLE Sunbeam, Inc vs.1996 Revenue +19% Receivables +38% Inventory +58% Why are receivables growing so much faster than revenue? Why is inventory growing so much faster than revenue? Copyright 2013 CFA Institute 9 Copyright 2013 CFA Institute 10 FINANCIAL RATIOS RATIO ANALYSIS Ratios - Express one number in relation to another. - Standardize financial data in terms of mathematical relationships expressed as percentages, times, or days. - Facilitate comparisons trends and across companies. Ratios are interrelated How profitable was Company X? A ratio is NOT the answer (except sometimes on an exam). A ratio is an indicator for example, an indicator of relative activity, profitability, liquidity, solvency. Copyright 2013 CFA Institute 11 Copyright 2013 CFA Institute 12

4 RATIO ANALYSIS How profitable was company X? RATIO ANALYSIS How profitable was Company X? A ratio is NOT the answer (except sometimes on an exam). A ratio is an indicator for example, an indicator of relative activity, profitability, liquidity, solvency. Interpretation generally involves comparison. Furthermore, analysis will address the question of why. A ratio is NOT the answer (except sometimes on an exam). A ratio is an indicator for example, an indicator of relative activity, profitability, liquidity, solvency. Interpretation generally involves comparison. Furthermore, analysis will address the question of why. Copyright 2013 CFA Institute 13 Copyright 2013 CFA Institute 14 USING FINANCIAL ANALYSIS TOOLS Computation Analysis Analysis goes beyond collecting data and computing numbers. Analysis encompasses computations and interpretations. Where practical, directly experience the company s business. Analysis of past performance: What aspects of performance are critical to successfully competing in the industry? How well did the company perform (relative to own history and relative to competitors)? Why? What caused the performance? Does the performance reflect the company s strategy? USING FINANCIAL ANALYSIS TOOLS Not every ratio is relevant in every situation. - Some ratios are irrelevant for certain companies. - Some ratios are redundant. - Industry-specific ratios can be as important as general financial ratios. - Different users and questions (e.g., creditors, investors) focus on different ratios. Different sources categorize some ratios differently and include different ratios. Differences in accounting standards can limit comparability. Copyright 2013 CFA Institute 15 Copyright 2013 CFA Institute 16

5 CATEGORIES OF FINANCIAL RATIOS PROFITABILITY AND OVERVIEW Category Activity Description Activity ratios. How efficient are the firm s operations and the firm s management of assets? Category Activity Description Activity ratios. How efficient are the firm s operations and the firm s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency Solvency ratios. How well is the firm positioned to meet long-term obligations? Solvency Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability Profitability ratios. How and how much is the firm achieving returns on its investments? Profitability Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation Valuation ratios. How does the firm s performance or financial position relate to its market value? Valuation Valuation ratios. How does the firm s performance or financial position relate to its market value? Copyright 2013 CFA Institute 17 Copyright 2013 CFA Institute 18 MEASURE OF PROFITABILITY: RETURN ON EQUITY (ROE) DECOMPOSE ROE What rate of return has the firm earned on the shareholders equity it had available during the year? The general form of the rate of return computation: Rate of return = Amount of return Amount invested ROE = = Average equity Average equity Applied to shareholders equity: ROE = Average equity = ROA Leverage Copyright 2013 CFA Institute 19 Copyright 2013 CFA Institute 20

6 DECOMPOSE ROE ROE = ROA Leverage A company can increase its ROE 1. With a business strategy, by increasing its ROA and/or 2. With a financial strategy, by increasing its use of leverage as long as returns on the incremental investment exceed the cost of borrowing. RETURN ON ASSETS What rate of return has the firm earned on the assets it had available to use during the year? The general form of this computation is the same: Amount of return Rate of Return = Amount invested Two variants of ROA computation: (1) ROA = (2) ROA = = adjusted for interest + [Interest expense (1 Tax rate)] Copyright 2013 CFA Institute 21 Copyright 2013 CFA Institute 22 ROA = PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY DECOMPOSING RETURN ON EQUITY ROA = Revenue Revenue ROE = Profit margin Turnover Leverage In other words, ROA can be thought of as: Profit margin Turnover (efficiency) ROE = Revenue Revenue Average equity Copyright 2013 CFA Institute 23 Copyright 2013 CFA Institute 24

7 DECOMPOSING RETURN ON EQUITY Du Pont Analysis DECOMPOSING RETURN ON EQUITY: STYLIZED COMPARATIVE ANALYSIS MINI-CASE What was the source of the firm s return on equity? To what extent... was it derived from selling a high margin product or keeping expenses low deriving more profits from each $1 of sales? (return on sales, net profit margin)... was it derived from generating higher sales from a lower investment in assets? (efficient use of assets, also known as turnover or efficiency)... was it derived from investing a lower amount of equity by using more debt in its capital structure? (financial leverage) Co. A Co. B Co. C Average Sales ($) 2,000 4,000 6,675 4,225 (NI) ($) ($) 1,000 2,000 1,500 1,500 Average equity ($) 1,000 1,000 1,000 1,000 Average liabilities ($) 0 1, ROE (NI/Equity) Net profit margin (NI/Sales) Turnover (Sales/Assets) Leverage (Assets/Equity) Copyright 2013 CFA Institute 25 Copyright 2013 CFA Institute 26 DECOMPOSING RETURN ON EQUITY: STYLIZED COMPARATIVE ANALYSIS MINI-CASE DECOMPOSING RETURN ON EQUITY: COMPARATIVE Co. A Co. B Co. C Average Sales ($) 2,000 4,000 6,675 4,225 NI ($) ($) 1,000 2,000 1,500 1,500 Average equity ($) 1,000 1,000 1,000 1,000 Average liabilities ($) 0 1, ROE (NI/Equity) 20.0% 20.0% 20.0% 20.0% Net profit margin (NI/Sales) 10.0% 5.0% 3.0% 4.7% AAPL HPQ DELL ROE 27.19% 21.50% 61.19% /Sales Net profit margin 14.88% 7.04% 4.06% Sales/ Asset turnover / Average equity Financial leverage Turnover (Sales/Assets) Leverage (Assets/Equity) Copyright 2013 CFA Institute 27 Copyright 2013 CFA Institute 28

8 DUPONT ANALYSIS : FURTHER DECOMPOSITION ROE = /Average equity Decompose ROE into five factors ROE = EBT EBIT EBT EBIT Revenue Revenue Average equity PROFITABILITY: RETURN ON SALES (FROM THE COMMON-SIZE INCOME STATEMENT) Gross profit margin = Gross profit/revenue Measures the ability to translate sales into profit after consideration of cost of products sold. Operating profit margin = Operating profit/revenue Measures the ability to translate sales into profit after consideration of operating expenses. Net profit margin = Net profit/revenue Measures the ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes, and nonoperating items. Copyright 2013 CFA Institute 29 Copyright 2013 CFA Institute 30 DISCUSSION BY CATEGORY ACTIVITY RATIOS Category Activity Liquidity Solvency Profitability Valuation Description Activity ratios. How efficient are the firm s operations and the firm s management of assets? Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm s performance or financial position relate to its market value? Also known as asset utilization or operating efficiency ratios. How efficiently is the firm using its assets? How many dollars of sales was the firm able to generate from each dollar of assets? Broadly Asset turnover = Revenue/Average total assets Low or declining ratios could mean - Sales are sluggish, - A heavy investment in assets (inefficient? plant modernization to help in future? strategy shift?), and/or - Asset mix changed. Specifically, for fixed assets: Fixed asset turnover = Revenue/Average net fixed assets Can compute for any category of assets. Copyright 2013 CFA Institute 31 Copyright 2013 CFA Institute 32

9 ACTIVITY RATIOS OTHER COMMON ACTIVITY RATIOS Also known as asset utilization or operating efficiency ratios Numerator Denominator Numerator Denominator Working capital turnover Revenue Average working capital Fixed asset turnover Revenue Average net fixed assets Total asset turnover Revenue Average total assets Inventory turnover Cost of sales Average inventory Days of inventory on hand (DOH) Number of days in period Inventory turnover Receivables turnover Revenue Average receivables Days of sales outstanding (DSO) Payables turnover Number of days of payables Number of days in period Purchases Number of days in period Receivables turnover Average trade payables Payables turnover Copyright 2013 CFA Institute 33 Copyright 2013 CFA Institute 34 ACTIVITY RATIOS AND THE CASH CYCLE (CASH CONVERSION CYCLE, A LIQUIDITY RATIO) Cash cycle: How long does it take for the firm to go from cash to cash? - Service company: sell service receive cash. - Merchandising company: buy inventory sell inventory receive cash and pay for inventory. - Manufacturing company: buy raw materials make product sell product receive cash and pay for materials and labor. Cash conversion cycle (net operating cycle) = Days sales outstanding + Days inventory held Number of days of payables Close link to liquidity Working capital (current assets minus current liabilities) reflects the investment required to support this cycle. LIQUIDITY How well positioned is the firm to meet its near-term obligations? Current ratio = Current assets/current liabilities Quick ratio = (Cash + Short-term marketable investments + Account receivables)/current liabilities Cash ratio = (Cash + Short-term marketable investments)/ Current liabilities Copyright 2013 CFA Institute 35 Copyright 2013 CFA Institute 36

10 Category Activity Liquidity Solvency Profitability Valuation DISCUSSION BY CATEGORY Description Activity ratios. How efficient are the firm s operations and the firm s management of assets? Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm s performance or financial position relate to its market value? SOLVENCY: HOW WELL POSITIONED IS THE FIRM TO MEET ITS LONGER-TERM LIABILITIES? Debt ratios: How has the company financed itself? Debt to total assets Lower ratio > safer. Debt to equity } Debt to total capital Higher cushion against potential creditor losses Coverage ratios: Degree to which earnings or cash flow can decline without affecting firm s ability to pay interest. EBIT interest coverage = (EBT + Interest payments)/interest payments Fixed charge coverage = (EBIT + Lease payments)/(interest payments + Lease payments) Copyright 2013 CFA Institute 37 Copyright 2013 CFA Institute 38 COMMON SOLVENCY RATIOS Solvency ratios Numerator Denominator Debt ratios Debt-to-assets ratio Total debt Total assets Debt-to-capital ratio Total debt Total debt + Total shareholders equity Debt-to-equity ratio Total debt Total shareholders equity Financial leverage ratio Average total assets Average total equity Coverage ratios Interest coverage EBIT Interest payments Fixed charge coverage EBIT + Lease payments Interest payments + Lease payments Category Activity Liquidity Solvency Profitability Valuation DISCUSSION BY CATEGORY Description Activity ratios. How efficient are the firm s operations and the firm s management of assets? Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm s performance or financial position relate to its market value? Copyright 2013 CFA Institute 39 Copyright 2013 CFA Institute 40

11 VALUATION RATIOS: PRICE-TO-EARNINGS RATIO P/E relates earnings per common share to the market price at which the stock trades, expressing the multiple that the stock market places on a firm s earnings. P/E = Price Earnings per share High P/E indicates - Firm is valued highly by market, possibly because of growth expectations, or - That a firm may have very low earnings per share. VALUATION RATIOS Numerator Denominator Valuation ratios 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 Copyright 2013 CFA Institute 41 Copyright 2013 CFA Institute 42 DIVIDEND-RELATED QUANTITIES SELECTED CREDIT RATIOS USED BY STANDARD & POOR S AS PART OF CREDIT ANALYSIS Dividend payout ratio = Dividend yield = Dividends per share Earnings per share Dividends per share Price Ratio Numerator Denominator EBIT and EBITDA interest coverage FFO interest coverage EBIT or EBITDA FFO plus interest paid minus operating lease adjustments FFO to debt FFO Total debt Free operating cash flow to debt Discretionary cash flow to debt CFO (adjusted) minus capital expenditures CFO minus capital expenditures minus dividends paid Gross interest (prior to deductions for capitalized interest or interest income) Gross interest (prior to deductions for capitalized interest or interest income) Total debt Total debt Copyright 2013 CFA Institute 43 Copyright 2013 CFA Institute 44

12 SELECTED CREDIT RATIOS USED BY STANDARD & POOR S AS PART OF CREDIT ANALYSIS SEGMENT ANALYSIS EXAMPLE: L ORÉAL Credit Ratio Numerator Denominator Return on capital Net cash flow to capital expenditures EBIT FFO minus dividends Average capital, where capital is equity plus noncurrent deferred taxes plus debt Capital expenditures Debt to EBITDA Total debt EBITDA Total debt to total debt plus equity Total debt Total debt plus equity Copyright 2013 CFA Institute 45 Copyright 2013 CFA Institute 46 MODEL BUILDING: EXAMPLES OF POSSIBLE USES OF RATIOS RATIOS IN MODEL BUILDING Sales forecast (percent change from horizontal common-size income statement) Expenses (from common-size income statement) Gross profit (gross profit margin) Operating profit (operating profit margin) Assets (days receivable, days payable, PP&E turnover) Liabilities (leverage ratios) Forecast Cash Flow Forecast Debt Forecast Interest Expense Sales forecast Expenses Gross Profit Operating Profit Assets Liabilities Cash flow Forecast Income and Taxes Cash Flow Copyright 2013 CFA Institute 47 Copyright 2013 CFA Institute 48

13 SUMMARY: FINANCIAL ANALYSIS TOOLS Graphics facilitate comparisons, and regressions quantify statistical relationships. Common-size analysis expresses financial data, including entire financial statements, in relation to a single financial statement item or base. Ratios, which express one number in relation to another, facilitate comparisons trends and cross-sectional. A ratio is an indicator of - Activity - Profitability - Liquidity - Solvency Copyright 2013 CFA Institute 49