CFA Reading 28 Financial Analysis Techniques

What does the P/E ratio measure? a. The "multiple" that the stock market places on a company's EPS. b. The relationship between dividends and market prices. c. 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.

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

A creditor most likely would consider a decrease in which of the following ratios to be positive news? a. interest coverage (times interest earned). b. Debt-to-total assets. c. 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: a. develop possibilities relying exclusively on the results of financial analysis. b. use the results of financial analysis, analysis of other information, and judgment. c. 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.

Comparison of a company's financial results to other peer companies for the same time period is called: a. technical analysis. b. time-series analysis. c. 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: a. activity ratios. b. liquidity ratios. c, 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.

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

describe tools and techniques used in financial analysis, including their uses and limitations:Ratio Analysis

Ratio Analysis: Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas. The ratios are categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios. Ratios express one quantity in relation to another (usually as a quotient). Short-term Solvency Ratios attempt to measure the ability of a firm to meet its short-term financial obligations. In other words, these ratios seek to determine the ability of a firm to avoid financial distress in the short-run. The two most important Short-term Solvency Ratios are the Current Ratio and the Quick Ratio. (Note: the Quick Ratio is also known as the Acid-Test Ratio.)The Current Ratio is calculated by dividing Current Assets by Current Liabilities. Current Assets are the assets that the firm expects to convert into cash in the coming year and Current Liabilities represent the liabilities which have to be paid in cash in the coming year. This ratio attempts to measure the ability of the firm to meet its obligations relying solely on its more liquid Current Asset accounts such as Cash and Accounts Receivable. This ratio is calculated by dividing Current Assets less Inventories by Current Liabilities. Debt Management Ratios attempt to measure the firm's use of Financial Leverage and ability to avoid financial distress in the long run. These ratios are also known as Long-Term Solvency Ratios.The Debt Ratio, Debt-Equity Ratio, and Equity Multiplier are essentially three ways of looking at the same thing: the firm's use of debt to finance its assets. The Debt Ratio is calculated by dividing Total Debt by Total Assets. The Debt-Equity Ratio is calculated by dividing Total Debt by Total Owners' Equity. The Equity Multiplier is calculated by dividing Total Assets by Total Owners' Equity. Asset Management Ratios attempt to measure the firm's success in managing its assets to generate sales. For example, these ratios can provide insight into the success of the firm's credit policy and inventory management. These ratios are also known as Activity or Turnover Ratios. The Receivables Turnover and Days' Receivables Ratios assess the firm's management of its Accounts Receivables and, thus, its credit policy. In general, the higher the Receivables Turnover Ratio the better since this implies that the firm is collecting on its accounts receivables sooner. However, if the ratio is too high then the firm may be offering too large of a discount for early payment or may have too restrictive credit terms. The Receivables Turnover Ratio is calculated by dividing Sales by Accounts Receivables. (Note: since Accounts Receivables arise from Credit Sales it is more meaningful to use Credit Sales in the numerator if the data is available.) The Days' Receivables Ratio is calculated by dividing the number of days in a year, 365, by the Receivables Turnover Ratio. Therefore, the Days' Receivables indicates how long, on average, it takes for the firm to collect on its sales to customers on credit. This ratio is also known as the Days' Sales Outstanding (DSO) or Average Collection Period (ACP). The Inventory Turnover and Days' Inventory Ratios measure the firm's management of its Inventory. In general, a higher Inventory Turnover Ratio is indicative of better performance since this indicates that the firm's inventories are being sold more quickly. However, if the ratio is too high then the firm may be losing sales to competitors due to inventory shortages. The Inventory Turnover Ratio is calculated by dividing Cost of Goods Sold by Inventory. When comparing one firms's Inventory Turnover ratio with that of another firm it is important to consider the inventory valuation methid used by the firms. Some firms use a FIFO (first-in-first-out) method, others use a LIFO (last-in-first-out) method, while still others use a weighted average method. The Days' Inventory Ratio is calculated by dividing the number of days in a year, 365, by the Inventory Turnover Ratio. Therefore, the Days' Inventory indicates how long, on average, an inventory item sits on the shelf until it is sold. The Fixed Assets Turnover Ratio measures how productively the firm is managing its Fixed Assets to generate Sales. This ratio is calculated by dividing Sales by Net Fixed Assets. When comparing Fixed Assets Turnover Ratios of different firms it is important to keep in mind that the values for Net Fixed Assets reported on the firms' Balance Sheets are book values which can be very different from market values. The Total Assets Turnover Ratio measures how productively the firm is managing all of its assets to generate Sales. This ratio is calculated by dividing Sales by Total Assets. Profitability Ratios attempt to measure the firm's success in generating income. These ratios reflect the combined effects of the firm's asset and debt management. The Profit Margin indicates the dollars in income that the firm earns on each dollar of sales. This ratio is calculated by dividing Net Income by Sales. The Return on Assets Ratio indicates the dollars in income earned by the firm on its assets and the Return on Equity Ratio indicates the dollars of income earned by the firm on its shareholders' equity. It is important to remember that these ratios are based on Accounting book values and not on market values. Thus, it is not appropriate to compare these ratios with market rates of return such as the interest rate on Treasury bonds or the return earned on an investment in a stock. Market Value Ratios relate an observable market value, the stock price, to book values obtained from the firm's financial statements.Price-Earnings Ratio (P/E Ratio) The Price-Earnings Ratio is calculated by dividing the current market price per share of the stock by earnings per share (EPS). (Earnings per share are calculated by dividing net income by the number of shares outstanding.) The P/E Ratio indicates how much investors are willing to pay per dollar of current earnings. As such, high P/E Ratios are associated with growth stocks. (Investors who are willing to pay a high price for a dollar of current earnings obviously expect high earnings in the future.) In this manner, the P/E Ratio also indicates how expensive a particular stock is. This ratio is not meaningful, however, if the firm has very little or negative earnings. Earnings per share is net income divided by number of shares outstanding. Price earnings ratio is price per share divided by earnings per share. Market-to-Book Ratio relates the firm's market value per share to its book value per share. Since a firm's book value reflects historical cost accounting, this ratio indicates management's success in creating value for its stockholders. This ratio is used by "value-based investors" to help to identify undervalued stocks. Book Value per share is total owners equity divided by share outstanding. Market to book ratio is Price per share divided by book value per share. The value of ratio analysis is that 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. the ratio itself is not "the answer" but is an indicator of some aspect of a company's performance. Financial ratios provide insights into: microeconomic relationships within a company that help analysts project earnings and free cash flow; a company's financial flexibility, or ability to obtain the cash required to grow and meet its obligations, even if unexpected circumstances develop; management's ability; changes in the company and/or industry over time; and comparability with peer companies or the relevant industry(ies). There are also limitations to ratio analysis. Factors to consider include: The heterogeneity or homogeneity of a company's operating activities. Companies may have divisions operating in many different industries. This can make it difficult to find comparable industry ratios to use for comparison purposes. The need to determine whether the results of the ratio analysis are consistent. One set of ratios may indicate a problem, whereas another set may indicate that the potential problem is only short term in nature. The need to use judgment. A key issue is whether a ratio for a company is within a reasonable range. Although financial ratios are used to help assess the growth potential and risk of a company, they cannot be used alone to directly value a company or its securities, or to determine its creditworthiness. The entire operation of the company must be examined, and the external economic and industry setting in which it is operating must be considered when interpreting financial ratios. The use of alternative accounting methods. Companies frequently have latitude when choosing certain accounting methods. Ratios taken from financial statements that employ different accounting choices may not be comparable unless adjustments are made. Some important accounting considerations include the following: FIFO (first in, first out), LIFO (last in, first out), or average cost inventory valuation methods (IFRS does not allow LIFO); Cost or equity methods of accounting for unconsolidated affiliates; Straight line or accelerated methods of depreciation; and Capital or operating lease treatment.