CFA 6: Financial Analysis Techniques

An analyst observes the following data for two companies: Company A ($) Company B ($) Revenue 4,500 6,000 Net income 50 1,000 Current assets 40,000 60,000 Total assets 100,000 700,000 Current liabilities 10,000 50,000 Total debt 60,000 150,000 Shareholders' equity 30,000 500,000 Which of the following choices best describes reasonable conclusions that the analyst might make about the two companies' ability to pay their current and long-term obligations? Company A's current ratio of 4.0 indicates it is more liquid than Company B, whose current ratio is only 1.2, but Company B is more solvent, as indicated by its lower debt-to-equity ratio. Company A's current ratio of 0.25 indicates it is less liquid than Company B, whose current ratio is 0.83, and Company A is also less solvent, as indicated by a debt-to-equity ratio of 200 percent compared with Company B's debt-to-equity ratio of only 30 percent. Company A's current ratio of 4.0 indicates it is more liquid than Company B, whose current ratio is only 1.2, and Company A is also more solvent, as indicated by a debt-to-equity ratio of 200 percent compared with Company B's debt-to-equity ratio of only 30 percent.

A is correct. Company A's current ratio of 4.0 (= $40,000/$10,000) indicates it is more liquid than Company B, whose current ratio is only 1.2 (= $60,000/$50,000). Company B is more solvent, as indicated by its lower debt-to-equity ratio of 30 percent (= $150,000/$500,000) compared with Company A's debt-to-equity ratio of 200 percent (= $60,000/$30,000).

What does the P/E ratio measure? The "multiple" that the stock market places on a company's EPS. The relationship between dividends and market prices. The earnings for one common share of stock.

A is correct. The P/E ratio measures the "multiple" that the stock market places on a company's EPS.

Brown Corporation had average days of sales outstanding of 19 days in the most recent fiscal year. Brown wants to improve its credit policies and collection practices and decrease its collection period in the next fiscal year to match the industry average of 15 days. Credit sales in the most recent fiscal year were $300 million, and Brown expects credit sales to increase to $390 million in the next fiscal year. To achieve Brown's goal of decreasing the collection period, the change in the average accounts receivable balance that must occur is closest to: +$0.41 million. -$0.41 million. -$1.22 million.

A is correct. The average accounts receivable balances (actual and desired) must be calculated to determine the desired change. The average accounts receivable balance can be calculated as an average day's credit sales times the DSO. For the most recent fiscal year, the average accounts receivable balance is $15.62 million [= ($300,000,000/365) × 19]. The desired average accounts receivable balance for the next fiscal year is $16.03 million (= ($390,000,000/365) × 15). This is an increase of $0.41 million (= 16.03 million - 15.62 million). An alternative approach is to calculate the turnover and divide sales by turnover to determine the average accounts receivable balance. Turnover equals 365 divided by DSO. Turnover is 19.21 (= 365/19) for the most recent fiscal year and is targeted to be 24.33 (= 365/15) for the next fiscal year. The average accounts receivable balances are $15.62 million (= $300,000,000/19.21), and $16.03 million (= $390,000,000/24.33). The change is an increase in receivables of $0.41 million

An analyst is evaluating the solvency and liquidity of Apex Manufacturing and has collected the following data (in millions of euro): FY5 (€) FY4 (€) FY3 (€) Total debt 2,000 1,900 1,750 Total equity 4,000 4,500 5,000 Which of the following would be the analyst's most likely conclusion? The company is becoming increasingly less solvent, as evidenced by the increase in its debt-to-equity ratio from 0.35 to 0.50 from FY3 to FY5. The company is becoming less liquid, as evidenced by the increase in its debt-to-equity ratio from 0.35 to 0.50 from FY3 to FY5. The company is becoming increasingly more liquid, as evidenced by the increase in its debt-to-equity ratio from 0.35 to 0.50 from FY3 to FY5.

A is correct. The company is becoming increasingly less solvent, as evidenced by its debt-to-equity ratio increasing from 0.35 to 0.50 from FY3 to FY5. The amount of a company's debt and equity do not provide direct information about the company's liquidity position. Debt to equity: FY5: 2,000/4,000 = 0.5000 FY4: 1,900/4,500 = 0.4222 FY3: 1,750/5,000 = 0.3500

Which ratio would a company most likely use to measure its ability to meet short-term obligations? Current ratio. Payables turnover. Gross profit margin.

A is correct. The current ratio is a liquidity ratio. It compares the net amount of current assets expected to be converted into cash within the year with liabilities falling due in the same period. A current ratio of 1.0 would indicate that the company would have just enough current assets to pay current liabilities.

Which of the following would best explain an increase in receivables turnover? The company adopted new credit policies last year and began offering credit to customers with weak credit histories. Due to problems with an error in its old credit scoring system, the company had accumulated a substantial amount of uncollectible accounts and wrote off a large amount of its receivables. To match the terms offered by its closest competitor, the company adopted new payment terms now requiring net payment within 30 days rather than 15 days, which had been its previous requirement.

B is correct. A write off of receivables would decrease the average amount of accounts receivable (the denominator of the receivables turnover ratio), thus increasing this ratio. Customers with weaker credit are more likely to make payments more slowly or to pose collection difficulties, which would likely increase the average amount of accounts receivable and thus decrease receivables turnover. Longer payment terms would likely increase the average amount of accounts receivable and thus decrease receivables turnover.

Exhibit 1 FY10 FY11 FY12 FY13 FY14 Financial statements GBP m GBP m GBP m GBP m GBP m Income statements Revenue 4,390 3,624 3,717 8,167 11,366 Profit before interest and taxation (EBIT) 844 700 704 933 1,579 Net interest payable -80 -54 -98 -163 -188 Taxation -186 -195 -208 -349 -579 Minorities -94 -99 -105 -125 -167 Profit for the year 484 352 293 296 645 Balance sheets Fixed assets 3,510 3,667 4,758 10,431 11,483 Current asset investments, cash at bank and in hand 316 218 290 561 682 Other current assets 558 514 643 1,258 1,634 Total assets 4,384 4,399 5,691 12,250 13,799 Interest bearing debt (long term) -602 -1,053 -1,535 -3,523 -3,707 Other creditors and provisions (current) -1,223 -1,054 -1,102 -2,377 -3,108 Total liabilities -1,825 -2,107 -2,637 -5,900 -6,815 Net assets 2,559 2,292 3,054 6,350 6,984 Shareholders' funds 2,161 2,006 2,309 5,572 6,165 Equity minority interests 398 286 745 778 819 Capital employed 2,559 2,292 3,054 6,350 6,984 Cash flow Working capital movements -53 5 71 85 107 Net cash inflow from operating activities 864 859 975 1,568 2,292 Which of the following choices best describes reasonable conclusions an analyst might make about the company's profitability? Comparing FY14 with FY10, the company's profitability improved, as indicated by an increase in its debt-to-assets ratio from 0.14 to 0.27. Comparing FY14 with FY10, the company's profitability deteriorated, as indicated by a decrease in its net profit margin from 11.0 percent to 5.7 percent. Comparing FY14 with FY10, the company's profitability improved, as indicated by the growth in its shareholders' equity to GBP 6,165 million.

B is correct. Comparing FY14 with FY10, the company's profitability deteriorated, as indicated by a decrease in its net profit margin from 11.0 percent (= 484/4,390) to 5.7 percent (= 645/11,366). Debt-to-assets ratio is a measure of solvency not an indicator of profitability. Growth in shareholders' equity, in isolation, does not provide enough information to assess profitability.

Exhibit 1 FY10 FY11 FY12 FY13 FY14 Financial statements GBP m GBP m GBP m GBP m GBP m Income statements Revenue 4,390 3,624 3,717 8,167 11,366 Profit before interest and taxation (EBIT) 844 700 704 933 1,579 Net interest payable -80 -54 -98 -163 -188 Taxation -186 -195 -208 -349 -579 Minorities -94 -99 -105 -125 -167 Profit for the year 484 352 293 296 645 Balance sheets Fixed assets 3,510 3,667 4,758 10,431 11,483 Current asset investments, cash at bank and in hand 316 218 290 561 682 Other current assets 558 514 643 1,258 1,634 Total assets 4,384 4,399 5,691 12,250 13,799 Interest bearing debt (long term) -602 -1,053 -1,535 -3,523 -3,707 Other creditors and provisions (current) -1,223 -1,054 -1,102 -2,377 -3,108 Total liabilities -1,825 -2,107 -2,637 -5,900 -6,815 Net assets 2,559 2,292 3,054 6,350 6,984 Shareholders' funds 2,161 2,006 2,309 5,572 6,165 Equity minority interests 398 286 745 778 819 Capital employed 2,559 2,292 3,054 6,350 6,984 Cash flow Working capital movements -53 5 71 85 107 Net cash inflow from operating activities 864 859 975 1,568 2,292 Which of the following choices best describes reasonable conclusions an analyst might make about the company's solvency? Comparing FY14 with FY10, the company's solvency improved, as indicated by an increase in its debt-to-assets ratio from 0.14 to 0.27. Comparing FY14 with FY10, the company's solvency deteriorated, as indicated by a decrease in interest coverage from 10.6 to 8.4. Comparing FY14 with FY10, the company's solvency improved, as indicated by the growth in its profits to GBP 645 million.

B is correct. Comparing FY14 with FY10, the company's solvency deteriorated, as indicated by a decrease in interest coverage from 10.6 (= 844/80) in FY10 to 8.4 (= 1,579/188) in FY14. The debt-to-asset ratio increased from 0.14 (= 602/4,384) in FY10 to 0.27 (= 3,707/13,799) in FY14. This is also indicative of deteriorating solvency. In isolation, the amount of profits does not provide enough information to assess solvency.

A creditor most likely would consider a decrease in which of the following ratios to be positive news? Interest coverage (times interest earned). Debt-to-total assets. Return on assets.

B is correct. In general, a creditor would consider a decrease in debt to total assets as positive news. A higher level of debt in a company's capital structure increases the risk of default and will, in general, result in higher borrowing costs for the company to compensate lenders for assuming greater credit risk. A decrease in either interest coverage or return on assets is likely to be considered negative news.

When developing forecasts, analysts should most likely: develop possibilities relying exclusively on the results of financial analysis. use the results of financial analysis, analysis of other information, and judgment. aim to develop extremely precise forecasts using the results of financial analysis.

B is correct. The results of an analyst's financial analysis are integral to the process of developing forecasts, along with the analysis of other information and judgment of the analysts. Forecasts are not limited to a single point estimate but should involve a range of possibilities.

Assuming no changes in other variables, which of the following would decrease ROA? A decrease in the effective tax rate. A decrease in interest expense. An increase in average assets.

C is correct. Assuming no changes in other variables, an increase in average assets (an increase in the denominator) would decrease ROA. A decrease in either the effective tax rate or interest expense, assuming no changes in other variables, would increase ROA.

Exhibit 1 FY10 FY11 FY12 FY13 FY14 Financial statements GBP m GBP m GBP m GBP m GBP m Income statements Revenue 4,390 3,624 3,717 8,167 11,366 Profit before interest and taxation (EBIT) 844 700 704 933 1,579 Net interest payable -80 -54 -98 -163 -188 Taxation -186 -195 -208 -349 -579 Minorities -94 -99 -105 -125 -167 Profit for the year 484 352 293 296 645 Balance sheets Fixed assets 3,510 3,667 4,758 10,431 11,483 Current asset investments, cash at bank and in hand 316 218 290 561 682 Other current assets 558 514 643 1,258 1,634 Total assets 4,384 4,399 5,691 12,250 13,799 Interest bearing debt (long term) -602 -1,053 -1,535 -3,523 -3,707 Other creditors and provisions (current) -1,223 -1,054 -1,102 -2,377 -3,108 Total liabilities -1,825 -2,107 -2,637 -5,900 -6,815 Net assets 2,559 2,292 3,054 6,350 6,984 Shareholders' funds 2,161 2,006 2,309 5,572 6,165 Equity minority interests 398 286 745 778 819 Capital employed 2,559 2,292 3,054 6,350 6,984 Cash flow Working capital movements -53 5 71 85 107 Net cash inflow from operating activities 864 859 975 1,568 2,292 Which of the following choices best describes reasonable conclusions an analyst might make about the company's liquidity? Comparing FY14 with FY10, the company's liquidity improved, as indicated by an increase in its debt-to-assets ratio from 0.14 to 0.27. Comparing FY14 with FY10, the company's liquidity deteriorated, as indicated by a decrease in interest coverage from 10.6 to 8.4. Comparing FY14 with FY10, the company's liquidity improved, as indicated by an increase in its current ratio from 0.71 to 0.75.

C is correct. Comparing FY14 with FY10, the company's liquidity improved, as indicated by an increase in its current ratio from 0.71 [= (316 + 558)/1,223] in FY10 to 0.75 [= (682 + 1,634)/3,108] in FY14. Note, however, comparing only current investments with the level of current liabilities shows a decline in liquidity from 0.26 (= 316/1,223) in FY10 to 0.22 (= 682/3,108) in FY14. Debt-to-assets ratio and interest coverage are measures of solvency not liquidity.

Comparison of a company's financial results to other peer companies for the same time period is called: technical analysis. time-series analysis. cross-sectional analysis.

C is correct. Cross-sectional analysis involves the comparison of companies with each other for the same time period. Technical analysis uses price and volume data as the basis for investment decisions. Time-series or trend analysis is the comparison of financial data across different time periods.

In order to assess a company's ability to fulfill its long-term obligations, an analyst would most likely examine: activity ratios. liquidity ratios. solvency ratios.

C is correct. Solvency ratios are used to evaluate the ability of a company to meet its long-term obligations. An analyst is more likely to use activity ratios to evaluate how efficiently a company uses its assets. An analyst is more likely to use liquidity ratios to evaluate the ability of a company to meet its short-term obligations.

An analyst is interested in assessing both the efficiency and liquidity of Spherion PLC. The analyst has collected the following data for Spherion: FY3 FY2 FY1 Days of inventory on hand 32 34 40 Days sales outstanding 28 25 23 Number of days of payables 40 35 35 Based on this data, what is the analyst least likely to conclude? Inventory management has contributed to improved liquidity. Management of payables has contributed to improved liquidity. Management of receivables has contributed to improved liquidity.

C is correct. The analyst is unlikely to reach the conclusion given in Statement C because days of sales outstanding increased from 23 days in FY1 to 25 days in FY2 to 28 days in FY3, indicating that the time required to collect receivables has increased over the period. This is a negative factor for Spherion's liquidity. By contrast, days of inventory on hand dropped over the period FY1 to FY3, a positive for liquidity. The company's increase in days payable, from 35 days to 40 days, shortened its cash conversion cycle, thus also contributing to improved liquidity.

Exhibit 1 FY10 FY11 FY12 FY13 FY14 Financial statements GBP m GBP m GBP m GBP m GBP m Income statements Revenue 4,390 3,624 3,717 8,167 11,366 Profit before interest and taxation (EBIT) 844 700 704 933 1,579 Net interest payable -80 -54 -98 -163 -188 Taxation -186 -195 -208 -349 -579 Minorities -94 -99 -105 -125 -167 Profit for the year 484 352 293 296 645 Balance sheets Fixed assets 3,510 3,667 4,758 10,431 11,483 Current asset investments, cash at bank and in hand 316 218 290 561 682 Other current assets 558 514 643 1,258 1,634 Total assets 4,384 4,399 5,691 12,250 13,799 Interest bearing debt (long term) -602 -1,053 -1,535 -3,523 -3,707 Other creditors and provisions (current) -1,223 -1,054 -1,102 -2,377 -3,108 Total liabilities -1,825 -2,107 -2,637 -5,900 -6,815 Net assets 2,559 2,292 3,054 6,350 6,984 Shareholders' funds 2,161 2,006 2,309 5,572 6,165 Equity minority interests 398 286 745 778 819 Capital employed 2,559 2,292 3,054 6,350 6,984 Cash flow Working capital movements -53 5 71 85 107 Net cash inflow from operating activities 864 859 975 1,568 2,292 The company's total assets at year-end FY9 were GBP 3,500 million. Which of the following choices best describes reasonable conclusions an analyst might make about the company's efficiency? Comparing FY14 with FY10, the company's efficiency improved, as indicated by a total asset turnover ratio of 0.86 compared with 0.64. Comparing FY14 with FY10, the company's efficiency deteriorated, as indicated by its current ratio. Comparing FY14 with FY10, the company's efficiency deteriorated due to asset growth faster than turnover revenue growth.

C is correct. The company's efficiency deteriorated, as indicated by the decline in its total asset turnover ratio from 1.11 {= 4,390/[(4,384 + 3,500)/2]} for FY10 to 0.87 {= 11,366/[(12,250 + 13,799)/2]} for FY14. The decline in the total asset turnover ratio resulted from an increase in average total assets from GBP3,942 [= (4,384 + 3,500)/2] for FY10 to GBP13,024.5 for FY14, an increase of 230 percent, compared with an increase in revenue from GBP4,390 in FY10 to GBP11,366 in FY14, an increase of only 159 percent. The current ratio is not an indicator of efficiency.

An analyst compiles the following data for a company: FY13 FY14 FY15 ROE 19.8% 20.0% 22.0% Return on total assets 8.1% 8.0% 7.9% Total asset turnover 2.0 2.0 2.1 Based only on the information above, the most appropriate conclusion is that, over the period FY13 to FY15, the company's: net profit margin and financial leverage have decreased. net profit margin and financial leverage have increased. net profit margin has decreased but its financial leverage has increased.

C is correct. The company's net profit margin has decreased and its financial leverage has increased. ROA = Net profit margin × Total asset turnover. ROA decreased over the period despite the increase in total asset turnover; therefore, the net profit margin must have decreased. ROE = Return on assets × Financial leverage. ROE increased over the period despite the drop in ROA; therefore, financial leverage must have increased.

An analyst observes a decrease in a company's inventory turnover. Which of the following would most likely explain this trend? The company installed a new inventory management system, allowing more efficient inventory management. Due to problems with obsolescent inventory last year, the company wrote off a large amount of its inventory at the beginning of the period. The company installed a new inventory management system but experienced some operational difficulties resulting in duplicate orders being placed with suppliers.

C is correct. The company's problems with its inventory management system causing duplicate orders would likely result in a higher amount of inventory and would, therefore, result in a decrease in inventory turnover. A more efficient inventory management system and a write off of inventory at the beginning of the period would both likely decrease the average inventory for the period (the denominator of the inventory turnover ratio), thus increasing the ratio rather than decreasing it.

An analyst is evaluating the solvency and liquidity of Apex Manufacturing and has collected the following data (in millions of euro): FY5 (€) FY4 (€) FY3 (€) Total debt 2,000 1,900 1,750 Total equity 4,000 4,500 5,000 With regard to the data in Problem 6, what would be the most reasonable explanation of the financial data? The decline in the company's equity results from a decline in the market value of this company's common shares. The €250 increase in the company's debt from FY3 to FY5 indicates that lenders are viewing the company as increasingly creditworthy. The decline in the company's equity indicates that the company may be incurring losses, paying dividends greater than income, and/or repurchasing shares.

C is correct. The decline in the company's equity indicates that the company may be incurring losses, paying dividends greater than income, or repurchasing shares. Recall that Beginning equity + New shares issuance - Shares repurchased + Comprehensive income - Dividends = Ending equity. The book value of a company's equity is not affected by changes in the market value of its common stock. An increased amount of lending does not necessarily indicate that lenders view a company as increasingly creditworthy. Creditworthiness is not evaluated based on how much a company has increased its debt but rather on its willingness and ability to pay its obligations. (Its financial strength is indicated by its solvency, liquidity, profitability, efficiency, and other aspects of credit analysis.)

A decomposition of ROE for Company A and Company B is as follows: Company A Company B FY15 FY14 FY15 FY14 ROE 26.46% 18.90% 26.33% 18.90% Tax burden 0.7 0.75 0.75 0.75 Interest burden 0.9 0.9 0.9 0.9 EBIT margin 7.00% 10.00% 13.00% 10.00% Asset turnover 1.5 1.4 1.5 1.4 Leverage 4 2 2 2 An analyst is most likely to conclude that: Company A's ROE is higher than Company B's in FY15, and one explanation consistent with the data is that Company A may have purchased new, more efficient equipment. Company A's ROE is higher than Company B's in FY15, and one explanation consistent with the data is that Company A has made a strategic shift to a product mix with higher profit margins. The difference between the two companies' ROE in FY15 is very small and Company A's ROE remains similar to Company B's ROE mainly due to Company A increasing its financial leverage.

C is correct. The difference between the two companies' ROE in 2010 is very small and is mainly the result of Company A's increase in its financial leverage, indicated by the increase in its Assets/Equity ratio from 2 to 4. The impact of efficiency on ROE is identical for the two companies, as indicated by both companies' asset turnover ratios of 1.5. Furthermore, if Company A had purchased newer equipment to replace older, depreciated equipment, then the company's asset turnover ratio (computed as sales/assets) would have declined, assuming constant sales. Company A has experienced a significant decline in its operating margin, from 10 percent to 7 percent which, all else equal, would not suggest that it is selling more products with higher profit margins.

Which of the following ratios would be most useful in determining a company's ability to cover its lease and interest payments? ROA. Total asset turnover. Fixed charge coverage.

C is correct. The fixed charge coverage ratio is a coverage ratio that relates known fixed charges or obligations to a measure of operating profit or cash flow generated by the company. Coverage ratios, a category of solvency ratios, measure the ability of a company to cover its payments related to debt and leases.

A decomposition of ROE for Integra SA is as follows: FY12 FY11 ROE 18.90% 18.90% Tax burden 0.70 0.75 Interest burden 0.90 0.90 EBIT margin 10.00% 10.00% Asset turnover 1.50 1.40 Leverage 2.00 2.00 Which of the following choices best describes reasonable conclusions an analyst might make based on this ROE decomposition? Profitability and the liquidity position both improved in FY12. The higher average tax rate in FY12 offset the improvement in profitability, leaving ROE unchanged. The higher average tax rate in FY12 offset the improvement in efficiency, leaving ROE unchanged.

C is correct. The increase in the average tax rate in FY12, as indicated by the decrease in the value of the tax burden (the tax burden equals one minus the average tax rate), offset the improvement in efficiency indicated by higher asset turnover) leaving ROE unchanged. The EBIT margin, measuring profitability, was unchanged in FY12 and no information is given on liquidity.