Financial Analysis Techniques
Vertical Common Size Statements
- Balance sheet - everything as % of total assets
- Income statement - everything as % of sales
- Analysis of common size is good for spotting trends, but does not tell whole story
Horizontal Common Size Statements
- Base year = set everything to 1
Limitations of ratio analysis
- Not useful when viewed in isolation - need historical or peer context
- Different accounting treatments - especially in non-US firms
- Companies operating in multiple industries - difficult to find comparable ratios
- Determining a target is difficult - use a range of values
Liquidity Ratios
- current ratio = current assets / current liabilities
- 1 is the crucial number
- quick ratio = (cash + mktable securities + receivables) / current liabilities
- More conservative - excludes inventory
- Cash ratio - same as quick, but even excludes receivables - most conservative
Solvency Ratios - measure financial risk/leverage - higher=more risk
- long term D/E = total long term debt / total equity
- D/E = total debt / total equity
- Total Debt Ratio = total debt / total assets
- Financial Leverage = total assets / total equity
Common Size Income statement
- Effective tax rate is usually more meaningful than common size tax rate
- Profitability ratios
- Gross profit margin = gross profit / revenue
- Net profit margin = net income / revenue
Activity ratios
- receivables turnover = sales / average receivables
- collection period = days sales outstanding = 365 / receivables turnover
- Too high is bad for obv reasons
- Too low might mean tight credit policy is hampering sales
- inventory turnover = COGS / average inventory
- how many times you sell your stock in a year
- days inventory = 365 / inventory turnover
- payables turnover = purchases / average AP
- days payables = 365 / payables turnover
- Note: if quarterly, divide number of days in quarter by quarterly turnover ratio to get 'days' form of these numbers
- total asset turnover = revenue / avg total assets
- Too low, might have too much capital tied up in asset base
- Too high, might not have enough assets available for sale, or assets outdated
- fixed asset turnover = revenue / average net fixed assets
- Too low = using assets inefficiently
- Too high = equipment is obsolete
- working capital turnover = revenue / average working capital
- effectiveness of WC
- If you have very low working capital, might not be meaningful
Liquidity ratios
- Current, quick, and cash ratios (see above)
- Defensive Interval Ratio
- Number of days you can survive on current liquid assets
- DIR = (cash + marketable secs + receivables) / avg daily expenditures
- Take items from income statement - adjust for non-cash items
- Cash Conversion Cycle
- Length of time to turn inventory into cash
- CCC = days sales out + days of inventory - number of days payables
- Too high is bad
Solvency ratios
- Debt/capital, debt/assets, financial leverage (see above)
- Coverage ratios
- interest coverage = EBIT / interest payments
- fixed charge coverage = (EBIT + lease pmts) / (interest pmts + lease pmts)
- Important for airlines
Profitability ratios
- Net profit margin = net income / revenue
- Note: net income is before dividends, and total capital = debt + eq (both common and preferred)
- EBIT margin - be sure to consider gains/losses (nonoperating items in EBIT)
- Pretax Margin = EBT / revenue
- ROA = net income / avg total assets
- Misleading tho - interest excluded from net income but assets includes debt
- Alternative: ROA = (net income + interest exp * (1-t)) / average total assets
- Operating ROA = operating income / avg total assets
- Return on Total Capital = EBIT / average total capital
- ROE = net income / average total equity
- This includes both preferred and common stock
- Return on Common Equity = (net income - preferred dividends) / average common equity
- Start with ROE = net income / equity
- Multiply by revenue/revenue and rearrange to get:
- ROE = (net income / revenue) * (revenue / equity)
- Multiply by assets/assets and rearrange again to get:
- ROE = (net income / revenue) * (revenue / assets) * (assets / equity)
- that is ROE = net profit margin * asset turnover * leverage
Dupont Analysis - 5 part approach
- Breaks net profit margin down even further
- ROE = (net income/EBIT) * (EBT/EBIT) * (EBIT/Revenue) * (Rev / assets) * (assets / equity)
- That is, ROE = tax burden * interest burden * EBIT margin * asset turnover * leverage
- This shows that increasing leverage does not necessarily increase ROE
- Interest burden rises
- Higher taxes always decrease ROE
Equity analysis
- PE ratio, price to cash flow, price to sales, price to book - all covered later
- Per share - EPS
- Diluted EPS - what if analysis
- Cash Flow per Share, EBIT per share, EBITDA per share
- Per share prices cannot be compared across companies
Dividends
- Proportion of earnings reinvested is called retention rate = 1 - dividend payout ratio
- Sustainable Growth Rate
- g = retention rate * ROE
Net income or sales per employee often used in service/consulting companies
Growth in same store sales and sales / sq foot are common in retail industry
Business risk - coefficients of variation
- CV sales = standard deviation / mean
- CV op income = sdev / mean
- Same for net income
- Can compare across firms, or within a firm across time
- Capital Adequacy = risk / equity capital
- Value at risk = dollar size of loss a firm will exceed only some % of time, over a given time
- Minimum reserve requirements - liquid asset requirements = liquid assets / certain liabilities
- Net Interest Margin = interest income / interest earning assets
- Similar to those used before
- Altman Z-score - useful in predicting bankruptcies (low = high prob of failure)
- Segment accounts for 10% or more of revenue or assets
- Distinguishable from company's other lines of business in terms of risk/return characteristics
- Can be geographic too
- GAAP and IFRS both require segment reporting but standards for segments are lower
- Can be useful for forecasting
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