Reading 28 LOS's

Question 1

LOS 28a: Describe the tools and techniques used in financial analysis, including their uses and limitations

Answer 1

Ratio Analysis

The value of ratio analysis lies in its ability to assist an equity or credit analysis in the evaluation of a company’s past performance, assessment of its current financial position, and forecasting its future cash flows and profitability trends

Uses of financial ratios are:

• Microeconomic relationships within the company that are used by analysts to project the company’s earnings and cash flows
• A company’s financial flexibility
• a management’s ability
• chages in the company and industry over time

Limitations of ratio analysis is:

• Companies may have divisions that operate in different industries, which can make it difficult to find relevant industry ratios to use for comparisons
• One set of ratois may suggest that there is a problem, but another set may indicate that tthe potential problem is only short term
• There are no set ranges within which particular ratios for a company must lie. An analyst must use her own judgement to evalutate the implications of a given value for a ratio
• Firms enjoy significant latitude in the choice of accounting methods that are acceptable given the jurisdication in which they operate

Common-Size Analysis

These allow analysts to compare a company’s performance with that of other firms and to evaluate its performance over time

• Common Size income statements are extremely useful in identifying trends in costs and profit margins

Vertical common-size inc statement % =(Income statement account/ revenue) x 100

• Common size balance sheets are prepared to highlight changes in the mix of assets,liabilities, and equity

Vertical common-sizebalance statement % =(balance sheet account/ total assets) , x 100

While common-size analysis does not tell us the entire story behind the company’s financials, it does lead us in the right direction and prompt us to ask relevant questions in assessing the company;s operationg performance over the period and evaluating its prespects going forward

Cross-Sectional Analysis

Is also known as relavtive analysis, compares a specific metric for one company with the same metric for another company or group of companies over a period of time

Trend analysis

Provides important information about a company’s historical performance. Horizontal common-size financial statements are often prepared. Dollar values of accounts are divided by their base-year values to determine their common-size values.

Uses of Charts in Financial analysis

• Graphs facilitate comparisons of firm performance and financial structure over time, highlighting changes in significant aspects of business operations
• Pie Charts are most useful in illustrating the comparison of total value
• Line graphs help identify trends and detect changes in direction or magnitude
• Stacked common graph illustrates the changes in varios items over the period in graphical form

Question 2

LOS 28b: Classify, calculate, and interpret activity ratios

Answer 2

Activity ratios measure how productive a company is in using its assets and how efficiently it performs its everday operations (aka asset utilization ratios or operating effeciency ratios)

Inventory Turnover = COGS / Average inventory

• Ratio is used to evaluate the effectiveness of a company’s inventory management. Generally benchmarked against the industry average
• A high inventory comparatively can mean either that they are highly effective in management of inventory, or that they are not holding adequate levels of inventory, which could hurt sales if shortages arise.
• A low inventory turnover can be an indicator of slow moving or obsolete inventory

Days of Inventory On Hand (DOH) = 365/ Inventory turnover

• Inveresely related to inventory turnover

Receivables turnover = Revenue/ Average receivables

• A high ratio can indicate that the company’s credit collection procedures are highly effecient. It can also mean there are overly stringent collection or credit policies that can hurt sales
• As with inventory turnover ratio, a simple comparison of the company’s sales growth within the industry can deteremine if sales are being hurt
• A low ratio will raise questions regarding the effeciency of a company’s collection procedures

Days of Sales Outstanding (DSO) = 365 / receivables turnover

• inversely related with Receivables Turnover

Payables Turnover= Purchases/ average trade payables

• The amount of purchases over the year is usually not stated on the income statement. We can calculate purchases by
  
  • Purchases = Ending inventory + COGS - Opening Inventory
• Payables turnover measures how many times a year the company theoretically pays off all its creditors
• A high ratio can indicate that the company is not making full use of available credit facilities and repaying too soon. However it could also result from a company making payments early to avail early prepayment discounts
• A low ratio could indicate that a company might be having trouble making payments on time. However it could also result from a company successfully exploiting lenient supplier terms. If the company has sufficient cash and short-term invesments, this would indicate a low turnover ratio is not a liquidity problem, just the company taking advantage of good credit

Number of Days Payable = 365 / Payables turnover

• Inversely related to payables turnover ratio

Working Capital Turnover = Revenue/Average working capital

• Indicates how effieciently the company generates revenue from its working capital. Working capital is current assets minus current liabilities
• A higher working capital turnover ratio indicates higher operating efficiency

Fixed Asset Turnover= Revenue/ Average Fixed assets

• This ratios measures how efficiently a company generates revenues from its investments in long-lived assets
• A higher ratio indicates more efficient use of fized assets in generating revnue
• A low ratio could be an indicator of operating inefficiency. Howver a low ratio could also be the result of a capital intensive business environment. Companies that have recently entered a new business that is not fully operational also report low fixed asset turnover

Total Asset Turnover = Revenue / Average Total Assets

• this ratio measures the company’s overall ability to generate revenues with a given level of assets
• A high ratio indicated efficiency while a low ratio can be an indicator of inefficiency or the level of capital intensity of the business

Question 3

LOS 28b: Classify, calculate, and interpret liquidity ratios

Answer 3

Liquidity Ratios aim to evaluate a company’s ability to meet its short-term obligations. They measure how quickly a company can convert its assets into cash at prices that are close to their fair values

Current Ratio = Current Assets/ Current Liabilities

• A higher ratio is desireable because it indicates the higher level of liquidity
• A low ratio indicates less liquidity and implies a greater reliance on operating cash flow and outside financing to meet short-term obligations

Quick Ratio = Cash+ Short-term marketable investments + Receivable /

Current Liablities

• The quick ratio recognizes that certain current assets (such as prepaid expense) represent costs that have been paid in advance in the current year and cannot ususally be converted into cash.
• The ratio also considers the fact that inventory cannot be immediately liquidated at its fair value
• A higher ratio indicates greater liquidity

Cash Ratio = Cash + Short-term marketable investments / current liablities

• This ratio is very reliable measure of an entity’s liquidity position in the event of unforseen crisis.

Defensive Interval ratio = Cash + Short-term marketable investments + Receivables

/ Daily cash expendituers

• This ratio measures how long the company can continue to meet its daily expense requirements from its exisiting liquid assets without obtaining any additional financing. An interval of 40 indicates the company can pay its operating expenses for 40 days by liquidating its quick assets
• A high ratio is desireable as it indicates greater liquidity
• If it is low, an analyst might want to determine whether significant cash inflows are expected in the near future to meet expense requirements

Cash Conversion Cycle = DSO + DOH - Number of days payables

• The cash conversion cycly (aka Net operating cycle) measures the length of the period between the point that a company invests in working capital and the point that the company collects cash proceeds from sales
• A shorter cycle is desireable as it indicates greater liquidity
• A longer cycle indicates lower liquidity. It implies that the company has to finance its inventory and accounts receivable for a longer period of time

Question 4

LOS 28b: Classify, calculate, and interpret solvency ratios

Answer 4

Solvency Ratios measure the relative amount of debt in a company’s capital structure and the ability of earnings and cash flows to meet debt-servicing requirements.

Debt-to-asset ratio = Total debt / total assets

• Important we take total debt in this context to be the sum of interest-bearing short-term and long-term debt
• A higher D/A ratio is undesirable because it implies higher financial risk and a weak solvency position

Debt-To- capital ratio= Total debt/ Total debt + Shareholders equity

• This ratio measures the proportion of a company’s total capital that is composed of debt
• A higher ratio indicates higher financial risk and is undesirable

Debt To equity Ratio = Total debt/ shareholders equity

• This ratio measures the amount of debt capital relative to a firms equity capital
• A higher ratio is undesirable and indicates higher financial risk

Financial Leverage Ratio = EBIT/ Interest payments

• this ratio measure the number of times a company’s operating earnings cover its annual interest payment obligations.
• This very important ratio is widely used to gauge how comfortably a company can meet its debt servicing requirements from operating profits
• A higher ratio provides assurance that the company can serive its debt from operating earnings

Fixed charge coverage ratio = EBIT + Lease payments/ Inerest Payments + lease payments

• This ratio relates the fixed charges or obligations of the company to its earnings.
• It measures the number of times a company’s operating earnings can cover its interest and lease payments
• A higher taio suggests that the company is comfortably placed to service its debt and make lease payments from the earnings it generates from operations
  *

Question 5

LOS 28b: Classify, calculate, and interpret profitability ratios

Answer 5

The ability of a company to generate profits is a key driver to the company’s overall value and the value of the securities it issues. Therefore many analysts consider profitability to be the focus of their analysis

Gross Profit Margin = Gross Profit / Revenue

• The gross profit margin tells us the percentage of a company’s revenues that are available to meet operating and nonoperating expenses
• A high margin can be a combination of high product price ( reflected in revenue) and low product costs (reflected in COGS)

Operating Profit Margin = Operating profit/ Revenue

• Operating profts are calculated as gross profits minus operating costs
• A margin that is increasing at a higher rate than gross profit margin indicates that the company has successfully controlled operating costs
• A decreasing margin compared to gross margin, indicates that they company is not efficiently controlling operating expenses

Pretax Margin = EBT( Earnigns before tax, but after interest )/ Revenue

• EBT is calculated as operating income minus nonoperating expenses plus nonoperating income
• If a company’s pretax margin is rising primarily due to higher nonoperating income, the analyst should evaluate whether this source of income will continue to bring in significant earnings going forward

Net profit margin = Net profit / revenue

• This margin shows how much profit a company makes for every dollar it generates in revenue
• A low net profit margin indicates a low margin of saftey. It alerts analysts to the risk that a decline in the company’s sales revene will lower profits or even result in a net loss

Return On Assets (ROA) = Net Income/ Average Total assets

• ROA measures the return earned by the company on its assets
• The higher the ROA, the greater the income generated by the comany given its total assets

NOTE The problem with this calculation of ROA is that is uses on the return to equity holders in the numerator. Assets are financed by both equity holders and bond holders. Therefore some analysts prefer to add interest expense back to net income in the numerator. However the interest expense must be adjusted for the tax shield it provides

Adjusted ROA = Net income + Interest expense (1- tax rate)/ Average total assets

Operating ROA = Operating income or EBIT / Average total assets

• This ratio reflects the return on all assets used by the company, whether financed with debt or equity

Return on Total Capital = EBIT/ Short-term debt+ long-term debt + Equity

• This ratio measures the profits that a company earns on all sources of capital that is employs- short-term debt, long-term debt, and equity

Return on Equity = Net income/ Average total equity

• This ratio measures that rate of return earned by a company on its equity capital.
• It measures a firm’s efficiency in generating profits from every dollar or net assets, and shows how well a company uses its investment dollars to generate earnings
• ROE is commonly used to compare the profitability of a company to that of other firms in the industry

Return On common Equity = Net Income - Preferred Dividends / Average common equity

• This ratio measures the return earned by a company only on its common equity

Question 6

LOS 28d: Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret effects of changes in its components

Answer 6

ROE measures the return a company generate on its equity capital. Decomposing ROE into its components through DuPont analysis has the following uses:

• It facilitates a meaningful evaluation of the different aspects of the company’s performance that affect reported ROE
• It helps in determining the reasons for change in ROE over time for a given company. It also helps us understand the reasons for difference in ROE for different companies
• It can direct management to areas that it should focus on to improve ROE

Two-Way Dupont

ROE = (Net Income/ Average total assets) x

(average total assets/ Average shareholders equity)

• The two -way illustrates that ROE is a function of company’s return on assets (ROA) and financial leverage ratio.
• A company can improve ROE by improving its ROA or by using debt more extensively to finance its operations
• As long as a company is able to borrow at a rate lower than the marginal rate it can earn by investing the borrowed money in the business. taking on more debt will result in an increase in ROE

Three-Way Dupont

ROE = (Net Income/Revenue) x (Revenue/Average Total Assets) X

(Average Total assets / Average Shareholder’s equity)

• This illustrates that a company’s ROE is a function of its net profit margin, its asset turnover ratio, and financial leverage ratio
• Net profit is an indicator of profitability
• Asset turnover is an idicator of efficiency
• Financial leverage is an indicator of solvency

Five-Way DuPont

ROE = ( Net Income/ EBT) x (EBT/EBIT) x (EBIT/Revenue) x

(Revenue/ Average total assets) x (Avg Total Assets/ Avg Shareholders equity)

• This illustrate ROE as a function of the company’s tax burden, interest burden, operating profitability, efficiency, and leverage
• the tax burden measures the proportion of its pretax profits that a company gets to keep. A higher tax burden ratio implies that the company can keep a higher percentage of its pretx profits
• the interst burden captures the effects of interest expense on ROE. High borrowing costs reduce ROE

NOTE The calculated value for ROE will be the same under evey kind of DuPont. DuPont is simply a way of seeing more clearly the underlying changes in the company’s operations that drive changes in ROE

Question 7

LOS 28e: Calculate and interpret ratios used in equity analysis and credit analysis

Answer 7

Analysts use a variety of methods to value a company’s equity. One of the most common methods is to use valuation ratios

Valutaion Ratios

Price to Earnings (P/E) = Price per share/ earning per share

• The P/E ratio expresses the relationship between the price per share of common stock and the amount of earnings attributable to a single share
• It basically tells us how much a share of common stock is currently worth per dollar of earning in the company

Price to Cash Flow = Price per share / Cash flow per share

• Cash flow per share = Cash flow from operations /

Average number of shares outstanding

Price to Sale = Price per share/ Sales per share

Price to Book = Price per share/ Book value per share

Basic EPS = (Net income - Preferred Dividends) /

Weighted Average number of ordinary shares outstanding

• Basic EPS are the earnings of a company attributable to each share of common stock. The weighted average number of shares consists of the number of ordinary shares outstanding in the begininng of the period, adjusted for those bought back or issued during the period, weighted by the length of time that they were outstanding during the relevant period

Diluted EPS = Adjusted income available for odrinary share relfecting conversion

of diluted securities/ Weighted average number of ordinary and

potential ordinary share outstaning

• Dilted EPS includes the effects of all outstanding securities whose conversion or exercise will result in a reduction of EPS

Dividend Payout Ratio = Common Share divided/

Net income attributable to common shares

• This ratio measures the percentage of earnings that a company pays out as dividends to shareholder
• The per share dividend paid by companies is typically fixed, so this ratio fluctuates as a percentage of earnings
• Therefore conclusions about a company’s dividend payout policy should be based on examination of the payout ratio over a number of periods

Retention Rate = Net Income attributable to common - Common shares dividends /

net income attributable to common

• This ratio measures the percentage of earnings that a company retains and reinvests in the business
• Retention Rate = (1- Dividend Payout Ratio)

Sustainable Growth Rate = Retention Ratio x ROE

• A company’s sustainable growth rate is a function of its profitability (ROE) and its ability to finance operations from inernally generate funds ( retention rate)

Industry-Specific Ratios

Aspects of performance that are deem relevant in one industry may be irrelevant in another. Industry-specific rations reflect these differences

• For companies in the retail industry, changes in same store sale sshould be tracked. This is because it is important to distinguish between sales growth generated from opening new stores and sales growth resulting from higher sales at existing stores
• Regulated industries are required to adhere to specific regulatory ratios. The banking sector has liquidity and cash reserve ratio requirements. Banking capital adequacy requirements relate banks’ solvency to their specific levels of risk exposure

Credit Analysis

Credit risk is the risk of loss that is cause by a debtor’s failureto make a promised payment. Credit analysis is the evaluation of credit risk

The Credit-Rating Process

The proces involves the analysis of a company’s financial reports and a broad assessment of a company’s operations. It includes the following procedures:

• Meetings with management
• tours of major facilities
• Meetings of rating committees where the analysts recommendations are voted on, after considering factors that include
  
  • Business risk, including the evaluation of
    
    • Operating environment
    • Industry characeristics
    • Success areas and areas of vulnerability
  • Financial risk
    
    • The evaluation of capital structure, interest coverage, and profitability using ratio analysis
    • The examination of debt covenants
  • Evaluation of management

These are some credit ratios used by S&P

EBIT Interest Coverage = EBIT/ Gross interest

EBITDA interest coverage = EBITDA / Gross interest

Return on Capital = EBIT/ Capital

Funds from operations to total debt = FFO/ Total Debt

Total Debt to total debt plus equity = Total Debt/ Total debt + total equity

Question 8

LOS 28f: Explain the requirements for segment reporting, and calculate and interpret segement ratios

Answer 8

Segment analysis

Analysts often need to analyze the performance of underlying business segments to understand the company as a whole. These segments may include subsidiary companies. operating units, or simply operations in different geographical ares

A business segment is a separtely identifiable component of a company that is engages in providing an individual product or service or a group of related products or servives.

A geographical segment is distinguishable component of a company that is engaged in providing an individual product or service within a particular region

Segement Ratios:

_Segment Margin =_Segment proft(loss)/ Segment Revnue

• measures operating profitability relative to sales

Segment Turnover = Segment Revenue / Segment assets

• measures overall efficiency- how much revenue is generated per dollar of assets

Segment ROA = Segment profit(loss)/ Segment assets

• measures operating profitability relative to assets

Segment Debt ratio = Segment liabilities/ Segment assets

• measure solvency of the segment

Question 9

LOS 28g: Describe how ratio analysis and other techniques can be used to model and forecast earnings

Answer 9

Analysts develop models and pro forma (standard document) financial statements to forecast future performance. They are constructed using past trends and relationships and also account for expected future events and changes. Pro Forma income statements are usually prepared by using the historical relationship between a company’s income statement items an sales to profect the nature of relationship going forward.

Some other techniques that are used in making a forecase are:

Sensitivity Analysis - which shows the range of possible outcomes as underlying assumptions are altered

Scenario Analysis shows the changes in key financial quantities that result from given events such as a loss of supply of raw materials or a reduction in demand for the firm’s produts

Simulations are computed-generated sensitivity or scenario analyses based on probability models for the factos that drive outcomes