Reading 27 Financial Analysis Techniques

Defensive Interval Ratio

(Cash + Short-term marketable investments + Receivables) / Daily cash expenditures a Ratio of 50 shows the company can pay its operating expenses for 50 days before running out of quick assets, assuming no additional cash inflow

Quick Ratio

(Current Assets - Inventory) / Current Liabilities or (Cash + short term marketable investments + receivables) / current liabilities reflects that inventory may not be easily sold

Return on total capital (ROTC):

(EBIT or Operating Income)/average short and long term debt and equity

operating segment definition

(a) that engages in activities that may generate revenue and create expenses, including a start-up segment that has yet to earn revenues, b) whose results are regularly reviewed by the company's senior management, and c) for which discrete financial information is available

Retention Rate (b)

(earnings per share - div per share) / earnings per share self explanatory

Fixed Cover Charge

(ebit + lease payments) / (interest payments and lease payments) shows greater solvency - apparently used to evaluate preferred dividend

DuPont Analysis: Decomposition of ROE

Also known as ROE = ROA * Leverage so ROE is a function of the firms ROA and use of leveraging so if no leverage then ROE = ROA if leverage increases and returns increase (ROE) (making more money than interest payments) then ROA (net income) is going up as assets/equity is going up If leverage increases and ROE goes down then ROA is also going down

DuPont Analysis: Decomposition of ROE with a tax perspective

Also known as ROE = Tax burden [% left after taxes] × Interest burden [% left after interest] × EBIT margin [% left after Operating expenses] × Total asset turnover [Revenue per Asset or efficiency] × Leverage

Working Capital

Assets - minus current liabilities

Free Operating Cash flow to debt

CFO (adjusted) minus capital expenditures / total debt

Discretionary Cash Flow to debt

CFO minus capital expenditures minus dividends paid / Total Debt

CFO

Cash flow from operations

Cashflow per share

Cashflow from operations / average number of outstanding shares

Inventory Turnover and DOH (Days of Inventory on Hand)

Cost of sales or cost of goods sold / average inventory entities. It indicates the resources tied up in inventory (i.e., the carrying costs) and can, therefore, be used to indicate inventory management effectiveness. A higher inventory turnover ratio implies a shorter period that inventory is held, and thus a lower DOH. In general, inventory turnover and DOH should be benchmarked against industry norms. High inventory could mean very efficient, or doesn't have enough on hand to meet demand so never has inventory

Current Ratio

Current assets divided by current liabilities; measures the availability of current assets to pay current liabilities

Cash Conversion Cycle (net operating cycle)

DOH + DSO - Number of days of payables This metric indicates the amount of time that elapses from the point when a companyinvests in working capital until the point at which the company collects cash.

Dividend payout ratio

Dividends per share / Earnings per share

Return on Capital

EBIT / Average Capital (where capital = equity + non-current deferred taxes + debt)

EBIT Interest Coverage

EBIT / Gross interest (prior to deductions for capitalized interest or interest income)

Interest Coverage

EBIT / interest payments Higher the ratio more solvent a firm is as they can meet their immediate needs

EBITDA Interest Coverage

EBITDA / Gross interest (prior to deductions for capitalized interest or interest income)

Pretax Margin

EBT (Earnings Before Tax [so operating profit - interest]) /Revenue need to know if this is changing due to main sources of income or other sources outside of the main source

FFO Interest Coverage

FFO / Gross interest (prior to deductions for capitalized interest or interest income)

FFO to Debt

FFO / Total Debt

Net Cash Flow to Capital

FFO minus dividends / Capital Expenditures

FFO

Funds from Operations

Gross Profit Margin

Gross Profit/Revenue

Return on Common Equity (ROE)

Net Income - preferred div / Average common equity

Return on Equity (ROE)

Net Income / Average Total Equity

Net Profit Margin

Net Income / Revenue used as guidance for future potential revenue

Activity Ratio Averages Denominator how are they determined

Often ratios are calculated using the average (start of period end of period) Can also do quarterly (average of all 4 in a year, 4 points) or '5 points' (start of year and all the 4 quarters) can also get ratios from periods up to current by multiplying (so quarters by 4) and from there

Operating Profit Margin

Operating profit / revenue

Payables Turnover and the Number of Days of Payables

Purchases / Average trade payables A payables turnover ratio that is high (low days payable) relative to the industry could indicate that the company is not making full use of available credit facilities; alternatively, it could result from a company taking advantage of early payment discounts. An excessively low turnover ratio (high days payable) could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms. This is another example where it is useful to look simultaneously at other ratios. If liquidity ratios indicate that the company has sufficient cash and other short-term assets to pay obligations and yet the days payable ratio is relatively high, the analyst would favor the lenient supplier credit and collection policies as an explanation.

Sustainable Growth

Retention rate (b) * ROE

Total Asset Turnover

Revenue / Average Total Assets the company's overall ability to generate revenues with a given level of assets higher ratio indicates greater efficiency. Because this ratio includes both fixed and current assets, inefficient working capital management can distort overall interpretations. It is therefore helpful to analyze working capital and fixed asset turnover ratios separately

Fixed Asset Turnover

Revenue / average net fixed costs measures how efficiently the company generates revenues from its investments in fixed assets. Generally, a higher fixed asset turnover ratio indicates more efficient use of fixed assets in generating revenue. A low ratio can indicate inefficiency, a capital-intensive business environment, or a new business not yet operating at full capacity—in which case the analyst will not be able to link the ratio directly to efficiency. In addition, asset turnover can be affected by factors other than a company's efficiency. The fixed asset turnover ratio would be lower for a company whose assets are newer (and, therefore, less depreciated and so reflected in the financial statements at a higher carrying value) than the ratio for a company with older assets (that are thus more depreciated and so reflected at a lower carrying value). The fixed asset ratio can be erratic because, although revenue may have a steady growth rate, increases in fixed assets may not follow a smooth pattern; so, every year-to-year change in the ratio does not necessarily indicate important changes in the company's efficiency

Receivables Turnover and DSO (Days of Sales Outstanding)

Revenue / average receivables (DSO) The number of DSO represents the elapsed time between a sale and cash collection, reflecting how fast the company collects cash from customers to whom it offers credit A relatively high receivables turnover ratio (and commensurately low DSO) might indicate highly efficient credit and collection. Alternatively, a high receivables turnover ratio could indicate that the company's credit or collection policies are too stringent, suggesting the possibility of sales being lost to competitors offering more lenient terms

Working Capital Turnover

Revenue / average working capital indicates how efficiently the company generates revenue with its working capital. For example, a working capital turnover ratio of 4.0 indicates that the company generates €4 of revenue for every €1 of working capital. A high working capital turnover ratio indicates greater efficiency (i.e., the company is generating a high level of revenues relative to working capital). For some companies, working capital can be near zero or negative, rendering this ratio incapable of being interpreted.

Credit Risk

Risk a debtor will fail on a promised payment

Debt to EBITDA

Total / EBITDA

Financial Leverage Ratio

Total Assets/Total Equity so basically how much assets are supported by equity, which in turn tells you debt so a 3 means $3 for each $1 of equity or $2 of debt

Debt-to-Capital Ratio

Total Debt/(Total Debt + Total Shareholders Equity) how much debt represents the firm's capital

DuPont Analysis: Decomposition of ROE with a further ROA decomposition

also known as ROE = Net Profit Margin [I read this as effect of expenses] * Total Asset Turnover [efficiency] * Leverage

Scenario Analysis

analysis shows the changes in key financial quantities that result from given (economic) events, such as the loss of customers, the loss of a supply source, or a catastrophic event. If the list of events is mutually exclusive and exhaustive and the events can be assigned probabilities, the analyst can evaluate not only the range of outcomes but also standard statistical measures such as the mean and median value for various quantities of interest.

Cash Ratio

cash + marketable securities / current liabilities more of a crisis ratio....not that marketable securities may also lose value in a crisis...so not reliable

Simulation Analysis

computer-generated sensitivity or scenario analysis based on probability models for the factors that drive outcomes. Each event or possible outcome is assigned a probability. Multiple scenarios are then run using the probability factors assigned to the possible values of a variable.

Price to book value interpretation

consider book value the market's take on a company's assets. So at 1 price is = required return, above 1 expectation is that future return higher is than the internal rate of return

EBITDA

earnings before interest, taxes, depreciation and amortization

Sensitivity Analysis

known as "what if" analysis, sensitivity analysis shows the range of possible outcomes as specific assumptions are changed; this could, in turn, influence financing needs or investment in fixed assets.

Solvency Ratios

measure a company's ability to meet long-term obligations. Subsets of these ratios are also known as "leverage" and "long-term debt" ratios.

Activity Ratios

measure how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory.

Profitability Ratios

measure the company's ability to generate profits from its resources (assets)

Liquidity Ratios

measure the company's ability to meet its short-term obligations.

Valuation Ratios

measure the quantity of an asset or flow (e.g., earnings) associated with ownership of a specified claim (e.g., a share or ownership of the enterprise).

Return on Assets (ROA)

net income/average total assets: The basic Net Income + Interest Payment (1-tax) / average assets: gives you more the return based off equity and creditor holders Operating Income or EBIT / Average Assets: Gives you return on all assets (liabilities, debt, equity)

Disclosure requirement for a single customer (segment) is required when

they represent 10% or more of a company's revenue

debt to equity

total debt/stockholders equity 1 represents total equal debt and equity, so really 50%

debt to total assets ratio

total liabilities/total assets .4 or 40% indicates a companies assets are financed through debt

Credit Analysis

uses financial projections and expectations of assets sales and refinancing to determine likelihood of meeting payments and use other sources like credit rating,

When to disclose an operating segement

when it represents 10% or more of Revenue, Assets, Profit / Loss Profit and loss : so the absolute value of the segment P&L vs the greater of the combined profit segments or losses segments If the segments under the above are only 75% of company revenue, then you add smaller segments that are combined under similarities (type of business, geographic area) everything else goes into a "All other segments" category