Reading 24 - Financial Analysis Techniques

Valuation Ratios

Have long been used in investment decision making. See Pg. 285 (PINK TAB) for ratios and related quantities

EPS - further interpretation

It is simply the amount of earnings attributable to each share of common stock. In isolation, EPS does not provide adequate information for comparison of one company with another.

If a company has an increase in a number of days payable but has enough cash to pay suppliers, why might the company not be paying suppliers?

Company might be taking advantage of favorable credit terms granted by its suppliers.

Quantative Factors reflected in a credit rating

Profitability, leverage, cash flow adequacy, and liquidity.

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)

Defensive Interval Ratio

Measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in.

Defensive Interval Ratio

Measures how long the company can continue to pay its expenses from its existing liquid assets without receiving any additional cash inflow. A defensive interval of 50 would indicate that the company can continue to pay its operating expenses for 50 days before running out of quick assets, assuming no addition cash inflows. A higher defensive interval indicates greater liquidity.

DSO (Days Sales Outstanding)

Receivables/(Annual Sales/365) Represents the elapsed time between a sale and cash collection, reflecting how fast the company collects cash from customers to whom it offer credit.

What are stacked column charts used for?

When the composition and amounts, as well as their change over time, are all important

What are line graphs useful for?

When the focus is on the change in amount for a limited number of items over a relatively longer time period.

A low inventory turnover ratio (and commensurately high DOH) relative to the rest of the industry could be an indicator of....

slow-moving inventory. Perhaps due to technological obsolence or a change in fashion.

A relatively high receivables turnover (and commensurately low DSO) might indicate...

highly efficient credit and collection. Also, could indicate that the company's credit or collection policies is too stringent, suggesting the possibilities of sales being lost to competitors offering more lenient terms.

An excessively low turnover ratio (high days payable) could indicate...

trouble making payments on time, or alternatively, exploitation of lenient supplier terms.

Typically, higher debt/financial risk means higher...

weaker solvency (ability to pay long term debt)

Liquidity Ratios

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

Return on Equity (ROE)

Net income divided by average shareholders' equity.

Financial Statement Analysis Framework (6) See pg. 238 for deets

1. Articulate the purpose and context of the analysis 2. Collect input data 3. Process data 4. Analyze/interpret the processed data 5. Develop and communicate conclusions and recommendations (e.g. with an analysis report) 6. Follow up

Valuation Process Steps

1. Understanding the business and the existing financial profile 2. Forecasting company performance 3. Selecting the appropriate valuation model 4. Converting forecasts to a valuation 5. Making the investment decision

Vertical analysis

A common size analysis using only one reporting period or one base financial statement

Industry norms (cross-sectional analysis)

A company can be compared with others in its industry by relating its financial ratios to industry norms or to a subset of the companies in an industry. When industry norms are used to make judgements, care must be taken because: - Many ratios are industry specific, and not all ratios are important to all industries - Companies may have several different lines of business. This will cause aggregate financial ratios to be distorted. It is better to examine industry-specific ratios by lines of business - Differences in accounting methods used by companies can distort financial ratios - Differences in corporate strategies can affect certain financial ratios

Cash Conversion Cycle

A financial metric not in ratio form, that measures the length of time required for a company to convert cash invested in its operations to cash received as a result of its operations; AKA the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash during this period the company needs to finance its investment in operations through other sources (i.e. through debt or equity). Sometimes expressed as the length of time funds are tied up in working capital. A shorter CCC means greater liquidity and that the company only needs to finance its inventory and accounts receivable for a short period of time. A longer CCC means lower liquidity and longer time required to finance its inventory and accounts receivable .

What is a good general rule when determine a dominator when calculating the returns on assets?

A good general rule if that when an income statement or cash flow statement number is in the numerator of a ratio and a balance sheet number is in the dominator, then an average should be used for the dominator.

Return on Assets (ROA)

A profitability ratio calculated as net income divided by average total assets; indicates a company's net profit generated per dollar invested in total assets.

DuPont Analysis on ROE

A useful technique to decompose ROE that involves expressing basic ratio (net income/ avg shareholder's equity) as a product of component ratios. This analysis shows the relationship between the various categories of ratios discussed in this reading and how they all influence the return on investment of owners.

Price to cash flow

A valuation ratio calculated as price per share divided by book value per share. Would be used as an alternative measure to P/E since P/E is sensitive to non-recurring earnings or one time earnings events.

Price to sales

A valuation ratio calculated as price per share divided by sales per share. Sometimes used as a comparative price metric when a company does not have positive net income.

Sensitivity Analysis

AKA "What if" analysis, shows range of possible outcomes as specific assumptions are changes; this could, in turn, influence financing needs or investment in fixed assets

Company goals and strategy

Actual ratios can be compared with company objectives to determine whether objectives are being attained and whether the results are consistent with the company's strategy

Credit Rating

Assess and communicate the probability of default by an issuer on its debt obligations and can be either long term or short term. Is an indication of the rating agency's opinion of the creditworthiness of a debt issuer with respect to a specific debt security or other obligation.

Current Ratio

Assumes that inventories and accounts receivables are indeed liquid (which is presumably not when related turnover ratios are low) This ratio expresses current assets in relation to current liabilities. A HIGHER ratio indicates a higher level of liquidity (i.e. a greater ability to meet short term obligations). A current ratio of 1.0 would indicate that the book value of its current assets exactly equals the book value of its current liabilities. A LOWER ratio indicates less liquidity, implying a greater reliance on operating cash flow and outside financing to meet short-term obligations.

How can a company improve on its ROE?

By improving on ROA or making more efficient use of leverage. Since leverage is measured as average total assets divided by average shareholders equity, if a company had no leverage (no liabilities) its leverage ratio would be equal to 1.0 and ROE would = ROA. As a company takes on liabilities, its leverage increases. As long as a company is able to borrow at a rate lower than the marginal rate it can earn investing the borrowed money in the business, the company is making an effective use of leverage and ROE would increase as leverage is increases.

Fixed Costs

Costs that stay the same within some range of activity - and can take two forms: operating leverage and financial leverage

What are pie graphs useful for?

Communicating the composition of a total value (e.g. assets over a limited amount of time, say one or two periods)

What are some criteria that analysts should consider when evaluating financial ratios? (3)

Company goals and strategy, industry norms (cross sectional analysis), economic conditions

Cross Sectional Analysis/Relative Analysis

Compares a specific metric for one company with the same metric for another company or group of companies, allowing comparisons even though the companies might be of significantly different sizes and/or operate in different currencies

Simulation

Computer generated or scenario analysis based on the 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.

An increase of receivables over 30 days indicates...

Customers are indeed taking longer to pay.

Solvency Ratios are primarily of two types:

Debt Ratios and Coverage Ratios. These ratios are useful in assessing a company's solvency and therefore, in evaluating the quality of a company's bonds and other debt obligations.

Abarbanell and Bushee (1997) - found some of the variables useful from Lev and Thiagarajan (1993) in predicting future accounting earnings. What strategy did they devise?

Devised an investment strategy using these same variables and found that they can generate excess returns under this strategy.

How is a vertical common-size balance sheet prepared?

Dividing each item on the balance sheet by the same period's total assets and expressing the results as percentages, highlights the composition of the balance sheet

Credit analysis

Evaluation of the credit risk. Approaches vary and depend on the purpose of the analysis and context in which it is being done. For some types of debt, requires projections of period-by-period cash flows similar to projections made by equity analysts. `

Both ____ and ____ analysis assess the entity's ability to generate and grow earnings, and cash flow, as well as any associated risks.

Equity (growth) and credit (risks)

Debt-to-EBITDA Ratio

Estimates how many years it would take to repay total debt based on earnings before income taxes, depreciation and amortization (an approx. of operating cash flow)

Lev and Thiagarajan (1993) - how did they demonstrate the usefulness of ratios in evaluation of equity investments and valuation?

Examined fundamental financial variables used by analysts to assess whether they are useful in security valuation. They found that fundamental variables add about 70 percent to the explanatory power of earnings alone in predicting excess returns. The fundamental variables they found useful included percentage changes in inventory and receivables relative to sales, gross margin, sales per employee, and the change in bad debts relative to the change in accounts receivable.

Return on Sales (ROS) Profitability Ratio

Express various subtotals on the income statement (e.g. gross profit, operating profit, net profit) as a percentage of revenue.

Debt Ratios

Focus on balance sheet and measure the amount of debt

Coverage Ratios

Focus on the income statement and measure the ability of a company to cover its debt payments.

Economic Conditions

For cyclical companies, financial ratios tend to improve when the economy is strong and weaken during recessions. Therefore, financial ratios should be examined in light of the current phase of the business cycle

Ou and Penman (1989) found what about ratios and common size metrics?

Found that ratios and common size metrics generated from accounting data were useful in forecasting earnings and stock returns.

Calculation of commonly used activity ratios: see pg 258

Generally combine information from the income statement in the numerator with balance sheet items in the denominator. Because the income statement measures what happened during a period whereas the balance sheet shows the condition only at the end of the period, average balance sheet data are normally used for consistency.

A higher Total Asset Turnover 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.

A higher value for the tax burden implies that the company can keep a HIGHER/LOWER percentage of its pretax profits, indicating HIGHER/LOWER tax rate.

HIGHER, LOWER. A decrease in tax burden implies the opposite (a higher tax rate leaving the company with less of its pretax profit)

The greater a company's operating leverage, the LOWER/HIGHER risk of the operating income stream available to cover debt payments?

HIGHER; operating leverage can thus limit a company's capacity to use financial leverage

Beaver (1967) - What does this person say about individual ratios to assess a company's ability to predict failure up to five years in advance?

He found 6 ratios (total debt, ROA, total debt to total assets, working capital to total assets, the current ratio, and the no-credit interval ratio) that could correctly predict company failure one year in advance 90 percent of the time and 5 years in advance at least 65 percent of the time

What are some limitations to ratio analysis?

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 judgement, the use of alternative accounting methods

Net Profit Margin/Net Profit/Net Income

IF net profit is calculated as revenue - all expenses and includes both recurring and non-recurring components. Generally, the net income used in calculating net profit margin is adjusted for non-recurring items to offer a better view of a company's potential future profitability.

What is regression analysis useful for?

Identifying relationships or correlation between variables. For example, a regression analysis could relate a company's sales to GDP over time, providing insight into whether the company is cyclical. In addition the statistical relationship between sales and GDP could be used as a basis for forecasting sales.

A higher turnover ratio implies a SHORTER/LONGER the period of time an inventory is held and thus, a LOWER/HIGHER DOH?

Implies a SHORTER period that inventory is held and thus LOWER DOH.

Diluted EPS

Includes the effect of all the company's securities whose conversion or exercise would result in a reduction of basic EPS; dilutive securities include convertible dent, convertible preferred, warrants, and options). To calculate diluted EPS, earnings are adjusted for the after tax effects assuming conversion, and the following adjustments are made to the weighted number of shares.

Equity Analysis

Incorporates an owner's perspective, either for valuation or performance evaluation.

Credit Analysis

Incorporates creditor's (such as bankers or bondholders) perspectives.

Gross Profit Margin

Indicates percentage of revenue available to cover operating and other expenses and to generate profit. Higher gross profit margin indicates some combination of higher product pricing and lower product costs. The ability to charge higher price is constrained by competition, so gross profits are affected by competition. If company has competitive advantage, can charge more.

Qualitative Factors reflected in a credit rating

Industry's growth prospects, volatility, technological change, and competitive environment. At the individual company level, may include operational effectiveness, strategy, governance, financial policies, risk management practices, and risk tolerance.

A low Total Asset Turnover ratio indicates...

Inefficiency or of relative capital intensity of business. This ratio also reflects strategic decisions by management such as the decision whether to use a more labor intensive (and less capital intensive) approach to business or a more capital-intensive (and less labor-intensive) approach

Credit Rating Process

Involves both the analysis of a company's financial reports as well as a broad assessment of a company's operations. Rating agencies emphasize the importance of the relationship between a company's business risk profile and its financial risk

Common Size Analysis

Involves expressing financial data, including entire financial statements, in relation to a single financial statement, or base. Items most frequently used as the bases are total assets or revenue. In essence, common-size analysis creates a ratio between every financial statement item and base item.

Retention Rate/Earnings Retention Rate

Is the complement of the payout ratio or dividend payout ratio (1-payout ratio). Is the percentage of earnings that a company retains.

What is the value of a ratio analysis?

It enables a financial analyst to evaluate past performance, assess the current financial position of the company, and gain insights useful for projecting future results.

Contingent Liabilities and it's significance in the non banking and banking sector

Letters of credit or financial guarantees, can also be relevant when assessing liquidity Non banking sector - (usually disclosed in the footnotes to the company's financial statements) represent potential cash outflows, and when appropriate, should be included in an assessment of a company's liquidity. Banking Sector - Represent potentially significant cash outflows that are not dependent on the bank's financial condition.

Liquidity Ratios

Measure the ability to pay off short-term obligations. In day-to-day operations, liquidity management is typically achieved through efficient use of assets. Major liquidity ratios: current, quick, cash, and defensive interval ratio

Financial Analysis

May be performed for a variety of reasons, such as valuing equity securities, assessing credit risk, conducting due diligence related to an acquisition, or assessing a subsidiary's performance.

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 Major ratios: debt ratios (debt-to-assets ratio, debt-to-capital ratio, debt-to-equity ratio, and financial leverage ratio) and coverage ratios (including fixed charge coverage and interest coverage)

Debt-to-Equity Ratio

Measure amount of debt capital relative to equity capital. A ratio of 1.0 indicates equal amounts of debt and equity, which equil. to a debt-to-capital ratio of 50%

Activity Ratios

Measure how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory. Major activity ratios: inventory turnover, days of inventory on hand, receivables turnover, days of sales outstanding, payables turnover, number of days payables, working capital turnover, fixed asset turnover, and total asset turnover.

Return on Investment (ROI) Profitability Ratios

Measure income relative to assets, equity or total capital employed by the company.

ROA

Measures return earned by the company on its assets. The higher the ratio, the more income is generated by a given level of assets. Some analysts add back interest in calculation - see pg. 275 for details

Price to Earnings Ratio (P/E) - Valuation Ratio

Measures the "multiple" that the stock market places on a company's EPS Most widely cited indicator in discussing the value of equity securities - which relates share price to the earnings per share (EPS). Expresses the relationship between the price per share and the amount of earning attributable to a single share. In other words, the P/E ratio tells us how much an investor in common stock pays per dollar of earnings. Because they are calculated using net income, is sensitive to non-recurring earnings or one-time earnings events.

Financial Leverage Ratio

Measures the amount of total assets supported for each one money unit of equity. Ex) IF value = 3, means that each $1 of equity supports $3 of total assets. The higher the ratio, the more leveraged the company is in sense of using debt and other liabilities to finance assets.

Profitability Ratios

Measures the company's ability to generate profits from its resources (assets) Major ratios: include return on sales ratios (gross profit margin, operating profit margin, pretax margin, and net profit margin) and return on investment ratios (including operating ROA, ROA, return on total capital, ROE, and return on common equity)

Total Asset Turnover

Measures the company's overall ability to generate revenues with a given level of assets

Dividend Payout Ratio

Measures the percentage of earnings that the company pays out as dividends to shareholders. The amount of dividends per share tends to be relatively fixed because any reduction in dividends has been shown to result in a disproportionately large reduction in share price. Dividend payout ratios fluctuate with earnings therefore conclusions about a company's dividend payout policies should be based on examination of payout over a number of periods.

Return on Total Capital

Measures the profits a company earns on all of the capital that it employs (short term debt, long term debt, and equity). As with operating ROA, returns are measured prior to deducting interest on debt capital.

ROE

Measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity.

The eXtensible Business Reporting Language (XBRL)

Mechanism that attaches "smart tags" to financial information (e.g. total assets), so that software can automatically collect the data and perform desired computations.

A higher fixed asset turnover ratio indicates...

More efficient use of fixed assets in generating revenue.

Cash Ratio

Normally represents a reliable measure of an entity's liquidity in a crisis situation. Only highly marketable short term investments and cash are included.

What is the end product of equity analysis?

Often a valuation and investment recommendation. Theoretical valuation models are useful in selecting ratios that would be useful in this process. Another common valuation method involves forecasts of the future cash flows that are discounted back to present.

What does receivables growing faster than revenue usually indicate? Inventory?

Operational issues, such as lower credit standards or aggressive accounting policies for revenue recognition. Similarly, inventory growing faster than revenue can indicate an operational issue with obsolesce or aggressive accounting policies, such as an improper overstatement of inventory to increase profits.

What other factors can affect the asset turnover ratio?

Other than a company's efficiency, it would be lower for a company whose asset are newer (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).

Why might a company hold a large percentage of total assets in cash? Since cash is generally low-yielding asset and thus, not a particularly efficient use of excess funds

Perhaps preparing for an acquisition, or maintains large cash position as insulation from a particularly volatile operating environment

How is a horizontal common-size balance sheet prepared?

Prepared by computing the increase or decrease in percentage terms of each balance sheet item from the prior year or prepared by dividing the quantity of each item by a base year quantity of the item, highlights changes in items.

Basic EPS

Provides information regarding the earnings attributable to each share of common stock.

Interest Coverage (Times Interest Earned)

Ratio measures the number of times a company's EBIT could cover its interest payments. A higher interest coverage ratio means strong solvency, offering greater assurance that the company can service its debt from operating earnings

Price to book value

Ratio of price to book value per share. This ratio is often interpreted as an indicator of market judgement about the relationship between a company's required rate of return and its actual rate of return. Assuming that book values reflect the fair values of the assets, a price to book ratio one can be interpreted as an indicator that the company's future returns are expected to be exactly equal to the returns required by the market. A ratio greater than one would indicate that the future probability of the company is expected to exceed the required rate of return, and values of this ratio less than one indicate that the company is not expected to earn excess returns.

Solvency

Refers to a company's ability to fulfill its long-term debt obligations. Assessment of a company's ability pay its long-term obligations (i.e., to make interest and principal payments) generally includes in-depth analysis of its components of its financial structure. Solvency ratios show info about the relative amount of debt in the company's capital structure and the adequacy of earnings and cash flow to cover interest expenses and other fixed charges (rent) as they come due.

Horizontal Analysis

Refers to an analysis comparing a specific financial statement with prior or future time periods or to a cross sectional analysis of one company with another.

The number of days payables

Reflects the average number of days the company takes to pay its suppliers, and the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors.

Trend Analysis, what important information does it give?

Regarding historical performance and growth and, given sufficiently long history of accurate seasonal information, can be of great assistance as a planning and forecasting tool for management and analysts.

Fixed Charge Coverage

Relates to fix charges, or obligations, to the cash flow generated by the company. It measures the number of times a company's earnings (before interest, taxes, and lease payments) can cover the company's interest and lease payments. A higher fixed charge coverage ratio implies stronger solvency, offering greater assurance that the company can service its debt from normal earnings. Ratio is sometimes used as an indication of the quality of the preferred dividend, with a higher ratio indicating a more secure preferred dividend.

Operating Leverage

Results from the use of fixed costs in conducting the company's business. Magnifies the changes in sales on operating income. Profitable companies may use operating leverage because when revenues increase, with operating leverage, their operating income increases at a faster rate. Variable costs will rise proportionally with revenue, fixed costs will not.

Segment Ratios

SEE ORANGE TAB - PG 294 The segment margin measure the operating profitability of the segment relative to revenues, whereas the segment ROA measure the operating profitability relative to assets. Segment turnover measures overall efficiency of the segment: how much revenue is generated per unit of assets. The segment debt ratio examines the level of liabilities (hence solvency) of the segment

Definitions of some common industry and task specific ratios

See pg. 288 - BLUE TAB

Selected Credit Ratios Table

See pg. 291 GREEN TAB

Model Building and Forecasting Techniques (3)

Sensitivity analysis, Scenario Analysis, Simulation

Scenario Analysis

Shows the change in key financial quantities that result from given (economic) events, such as the loss of customers, loss of a supply sources, or a catastrophic event

Pre Tax Margin/Earnings Before Tax

Since Pre Tax Income is calculated as operating profit minus interest, Pre Tax Margin is the ratio of pre tax income to revenue. Reflects the effect on profitability of leverage and other (non-operating) income and expenses. If a company's pre-tax margin is increasing primarily as a result of increasing amounts of non-operating income, the analyst should evaluate whether this increase reflects a deliberate change in a company's business focus and, therefore, the likelihood that the increase will continue.

Operating Profit Margin

Since operating profit is = Gross profit - operating costs. If increasing faster than gross profit can indicate improvements in controlling costs, such as administrative overheads. Declining operating profit margin can indicate deteriorating control over operating costs.

Financial Leverage

The extent to which a company can effect, through the use of debt, a proportional change in the return on common equity that is greater than a given proportional change in operating income; also, short for the financial leverage ratio.

Credit Risk

The risk of loss caused by a counterparty's or debtor's failure to make a promised payment. Also called default risk. For ex: credit risk with respect to a bond is the risk that the obligor (issuer of the bond) is not able to pay interest and principal according to the terms of the bond indenture (contract).

Quick Ratio

This ratio is more conservative than current ratio because it includes only the more liquid current assets in relation to current liabilities. Like the current, a higher ratio means greater liquidity. It also reflects that fact that certain current assets - prepaid expenses, some taxes, and employee-related prepayments - represent costs of the current period that have been paid in advance and cannot usually be converted back to cash. This ratio may be a better indicator of liquidity.

Fixed Asset Turnover

This ratio measures how efficiently the company generates revenues from its investments in fixed assets.

T or F: When financing a company (raising capital for it), the use of debt constitutes financial leverage because interest payments are essentially fixed financing costs.

True. Thus, financial leverage tends to magnify the effect of changes in EBIT on returns flowing to equity holders. Assuming that a company can earn more on funds than it pays in interest, the inclusion of some level of debt in a company's capital structure may lower a company's overall cost of capital and increase returns to equity holders.

Sustainable Growth Rate (SGR)

Viewed as a function of its profitability (measured as ROE) and its ability to finance itself from internally generated funds (measured as the retention rate). The sustainable growth rate is ROE times the retention rate. A higher ROE and higher retention rate result in a higher sustainable growth rate. This calculation is used to estimate a company's growth rate, a factor commonly used in equity valuation.

An operating segment is defined as

a component of a company 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 c) for which discrete financial information is available.

A high working capital turnover indicates..

greater efficiency (i.e. the company is generating high levels of revenues relative to working capital).

Working capital turnover

indicates how efficiently the company generates revenue with its working capital

A low fixed asset turnover ratio indicates...

inefficiency, a capital-intensive business environment, or a new business not yet operating at full capacity

Judging whether a company has adequate liquidity requires analysis of...

its historical funding requirements, current liquidity position, anticipated funding needs, and options for reducing funding needs or attracting additional funds (including actual and potential sources of such funding)

A high payables turnover ratio (low days payable) relative to the industry could indicate...

the company is not making full use of available credit facilities; alternatively, could result from a company taking advantage of early payment discounts.

A relatively low receivables turnover ratio would typically raise questions about...

the company's credit and collection procedures