CFA Level I - Financial Reporting and Analysis

Financial Analysis Techniques

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Contents
1.
2.
3.
4.
5.
6.
7.
8.

Introduction
The Financial Analysis Process
Analytical Tools and Techniques
Common Ratios Used in Financial Analysis
Equity Analysis
Credit Analysis
Business and Geographic Segments
Model Building and Forecasting
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1. Introduction
Financial analysis is a useful tool in assessing a companys performance and
trends.
The primary source of data is companys annual reports, financial statements
and MD&A.
An analyst must be capable of using financial statements in conjunction with
other information to make projections and reach valid conclusions.

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2. The Financial Analysis Process

Prior to beginning any financial analysis, the analyst should clarify the purpose and
context, and clearly understand the following:
What is the purpose of the analysis? What questions will this analysis answer?
What level of detail will be needed to accomplish this purpose?
What data are available for the analysis?
What are the factors or relationships that will influence the analysis?
What are the analytical limitations, and will these limitations impair the analysis?

Purpose and
Context

Techniques

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Financial Analysis Framework

1. Articulate purpose and
context based on your
function, client input and
organizational guidelines

3. Process data

2. Collect data: financial

statements, other financial
data, industry/economic data;
discussions with management,
suppliers, customers and
competitors

Objective
Questions to be
answered
Content to be provided
Timetable and budget

Adjusted financial statements; commonsize statements, ratios, graphs, forecasts

5. Develop and communicate

conclusions and recommendations

4. Analyze and
interpret processed
data

Report answering questions

from Phase 1, conclusions and
recommendations

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6. Follow up

Organized financial
statements; financial
tables, completed
questionnaires

Analytical results

Updated
recommendations

Distinguishing Between Computation and Analysis

Effective analysis encompasses computations and interpretations

3. Process data

Adjusted financial statements; commonsize statements, ratios, graphs, forecasts

4. Analyze and
interpret processed
data

Analytical results

Questions related to analysis of past performance:

What aspects of performance are critical to success?
How did company perform on these aspects?
Forward looking analysis:
What is the likely impact of trends/events in the company, industry and economy?
What are the risks?
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3. Analytical Tools and Techniques

Ratios
Common Size Analysis

Graphs

Tools and techniques facilitate evaluation of

company data
Evaluations require comparison
Need to make adjustments so data is
comparable
Can perform cross-sectional and time-series
analysis

Regression Analysis

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Ratios
Ratio is an indictor of some aspect of a companys performance
Ratios can help predict investment returns
Some widely accepted ratios but no authoritative body which provides exact
formulas
Ratios help us 1) evaluate past performance, 2) assess current financial position of
the company, and 3) gain insights useful for projecting future results
Specifically ratios allow us to evaluate

Factors to consider when using ratios

1.
2.
3.
4.

1.
2.
3.

Operational efficiency
Financial flexibility
Changes in company/industry over time
Company performance relative to industry

4.

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Need to use judgment

Use of alternate accounting methods
Heterogeneity of a company's operating
activities
Consistency of results

Common Size Analysis

Balance Sheet
Vertical
Horizontal

Income Statement
Cash Flow Statement
Relationship Among Financial Statements
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Time-Series (Trend) Analysis

Current Assets

2011

2012

Cash

0.3%

$ 10

0.3% $ 12

Marketable Securities
Accounts Receivables

2.6%
5.8%

$ 90
$ 200

2.8% $ 95
7.3% $ 250

Inventory

8.7%

$ 300

10.2% $ 350

Prepaid Expenses

0.6%

$ 20

0.3% $ 10

18.0%

$ 620

20.8% $ 717

Total Current Assets

Vertical Common-Size Balance

Sheet

All assets shown as percentage

of total assets
Highlights composition of the
balance sheet

Period
Cash
Marketable Securities
Accounts Receivables
Inventory
Net Fixed Assets
Total Assets

1
1.00
1.00
1.00
1.00
1.00
1.00

2
0.80
1.00
1.30
1.20
0.90
1.20
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Horizontal Common-Size Balance Sheet

Highlights structural changes in a business

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Cross Sectional (Relative) Analysis

Current Assets
Cash
Marketable Securities
Accounts Receivables, Net
Inventory
Prepaid Expenses
Total Current Assets
Fixed Assets
Buildings and Equipment
Less Accumulated
Depreciation
Net Buildings and Equipment
Land
Total Fixed Assets
Goodwill
TOTAL ASSETS

Comp. A

Comp. B

0.3%
2.6%
5.8%
8.7%
0.6%
18.0%

$
$
$
$
$
$

10
90
200
300
20
620

0.3%
2.8%
7.3%
10.2%
0.3%
20.8%

$
$
$
$
$
$

29.0%

$1,000

29.0%

$1,000

5.8%

$ 200

8.7%

$ 300

23.2%
58.0%
81.2%

$ 800
$2,000
$2,800

20.3%
58.0%
78.3%

$ 700
$2,000
$2,700

0.9%

$ 30

0.9%

$ 30

100.0%

$3,450

100.0%

$3,447

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95
250
350
10
717

Vertical Common-Size Balance

Sheet

All assets shown as percentage

of total assets
Highlights composition of the
balance sheet

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Relationships among Financial Statements (Examples)

Compare growth rate of assets with growth rate of sales

Compare growth rate of operating income with growth rate of operating cash flow

Compare growth rate of inventory and receivables with growth rate of revenue
Say revenue is up by 20%, inventory by 60% and receivables by 40%. Should you be concerned?

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Graphs and Regression Analysis

The Use of Graphs as an Analytical Tool
Comparison of performance and financial
structure over time
Several types of graphs can be used

Regression Analysis
Help identify relationships (correlation) between
variables

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4. Common Ratios Used in Financial Analysis

Category

Measures

Example

Activity ratios

Efficiency

Revenue / Assets

Liquidity ratios

Ability to meet its short term obligations

Current Assets / Current Liabilities

Solvency ratios

Ability to meet long term debt obligations

Assets / Equity

Profitability ratios

Profitability

Net Income / Assets

Valuation ratios

Quantity of an asset or flow per share

Earnings / Number of Shares

Single Statement
Ratios:
Income Statement
Balance Sheet
Cash Flow Statement

Mixed Ratios:
Numerator from the Income Statement
Denominator from the Balance Sheet

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Interpret ratios in the

context of:
Goals and Strategy
Industry Norms
Economic Conditions

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Activity Ratios
Activity Ratios

Numerator / Dominator

Interpretation

Inventory turnover

Cost of good sold / Average inventory

How many times per period entire

inventory was sold

Days of inventory on hand

Number of days in period / Inventory

turnover

On average how many days of inventory

kept on hand

Receivables turnover

Revenue / Average receivables

How quickly does a company collect cash

Days of sales outstanding

Number of days in period /

Receivables turnover

Elapsed time between credit sale and

cash collection

Payables turnover

Purchases / Average trade payables

Times/year company pays suppliers

Number of days of payables

Number of days in period / Payables

turnover

Average number of days to pay suppliers

Working capital turnover

Revenue / Average working capital

How efficiently does a company generate

revenue from working capital

Fixed asset turnover

Revenue / Average net fixed assets

How efficiently does a company generate

revenue from fixed assets

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Inventory Turnover Ratio

Activity Ratios

Numerator / Dominator

Interpretation

Inventory turnover

Cost of good sold / Average inventory

How many times per period entire

inventory was sold

Income statement item in the numerator

Use of average inventory

Higher number shows greater efficiency
Days of inventory on hand

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Receivables Turnover Ratio

Activity Ratios

Numerator / Dominator

Interpretation

Receivables turnover

Revenue / Average receivables

How quickly does a company collect cash

More appropriate to use credit sales but

this number is generally not available
Higher number shows greater efficiency
Days of sales outstanding

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Payables Turnover Ratio

Activity Ratios

Numerator / Dominator

Interpretation

Payables turnover

Purchases / Average trade payables

Times/year company pays suppliers

If purchases not know we can use COGS +

change in inventory

Occasionally COGS is used as a proxy for

purchases
Relatively high number means company not
making use of credit facilities
Low ratio might indicate liquidity issues

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Working Capital and Asset Turnover Ratios

Activity Ratios

Numerator / Dominator

Interpretation

Working capital turnover

Revenue / Average working capital

How efficiently does a company generate

revenue from working capital

Fixed asset turnover

Revenue / Average net fixed assets

How efficiently does a company generate

revenue from fixed assets

Total asset turnover

Revenue / Average total assets

How efficiently does a company generate

revenue from total assets

Remembering Ratios
1) Name tells you balance sheet item
2) Balance sheet item income statement item
3) Income statement item in the numerator
4) Average value of balance sheet number in denominator

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Liquidity Ratios
Liquidity Ratios

Numerator

Denominator

Current ratio

Current assets

Current liabilities

Quick ratio

Cash + short term marketable investments + receivables

Current liabilities

Cash ratio

Cash + short term marketable investments

Current liabilities

Defensive interval ratios

Cash + short term marketable investments + receivables

Daily cash expenditures

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Additional Liquidity Ratios

Cash conversion cycle (net operating cycle) =
Days of inventory on hand + days of sales outstanding number of days of payables

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Solvency Ratios (Debt Ratios)

Solvency Ratios

Numerator

Denominator

Debt to assets ratio

Total debt

Total assets

Debt to capital ratio

Total debt

Total debt + Total shareholders equity

Debt to Equity ratios

Total debt

Total shareholders equity

Financial leverage ratios

Average total assets

Average total equity

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Solvency Ratios (Coverage Ratios)

Solvency Ratios

Numerator

Denominator

Interest coverage

EBIT

Interest payments

Fixed charge coverage

EBIT + lease payments

Interest payments + lease payments

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Profitability Ratios (Return on Sales)

Profitability Ratios

Numerator

Denominator

Gross profit margin

Gross profit

Revenue

Operating profit margin

Operating income

Revenue

Pretax margin

EBT (earning before tax but after interest)

Revenue

Net profit margin

Net income

Revenue

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Profitability Ratios (Return on Sales)

Profitability Ratios

Numerator

Denominator

Gross profit margin

Gross profit

Revenue

Operating profit margin

Operating income

Revenue

Pretax margin

EBT (earning before tax but after interest)

Revenue

Net profit margin

Net income

Revenue

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Profitability Ratios (Return on Investment)

Profitability Ratios

Numerator

Denominator

Operating ROA

Operating income

Average total assets

ROA

Net income

Average total assets

Return on total capital

EBIT

Short and long term debt and equity

ROE

Net income

Average total equity

Return on common equity

Net income preferred dividend

Average common equity

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DuPont Analysis
Return on
Equity

Return on
Asset

Tax Burden

Financial
Leverage

Net Profit
margin

Total Asset
Turnover

Interest
Burden

EBIT Margin

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Example
2010

2011

2012

ROE

19%

20.0%

22.0%

Return on total asset

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
2010 to 2012, the companys
A. Net profit margin and financial leverage have decreased
B. Net profit margin and financial leverage have increased
C. Net profit margin has decreased but its financial leverage has increased
Answer: C
ROA has been decreasing over 2010 to 2012 while total asset turnover has been increasing, it must be
case net profit margin has been declining. ROE has been increased despite the drop in ROA, financial
leverage must have increased.
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5. Equity Analysis
Steps for equity valuation:
1. Understanding the business and existing financial profile
2. Forecasting company performance
3. Selecting the appropriate valuation model
4. Converting forecasts to a valuation
5. Making the investment decision
Research has shown that ratios are useful in forecasting earnings and
stock returns

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Valuation Ratios
Numerator

Denominator

P/E

Price per share

Earnings per share

P/CF

Price per share

Cash flow per share

P/S

Price per share

Sales per share

P/BV

Price per share

Book value per share

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Valuation Ratios (Per Share Quantities)

Numerator

Denominator

Basic EPS

Net income minus preferred

dividends

Weighted average number of ordinary shares

outstanding

Diluted EPS

Adjusted income available

shares, reflecting conversion of
dilutive securities

Weighted average number of ordinary and

potential ordinary shares outstanding

Cash flow per share

Cash flow from operations

Weighted average number of shares outstanding

EBITDA per share

EBITDA

Weighted average number of shares outstanding

Dividends per share

Common declared dividends

Weighted average number of ordinary shares

outstanding

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Industry-Specific Ratios
No universally accepted definition and classification of ratios
Ratios serve as indicators of performance and value
Aspects of performance which are relevant in one industry might be
irrelevant in another; hence the need for industry specific ratios
Examples shown in Exhibit 19
Retail industry: same store sales changes
Banks: capital adequacy ratios

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6. Credit Analysis
Credit analysis is the evaluation of credit risk
Ratios are used extensively in credit analysis
Ratio

Numerator

Denominator

EBIT interest coverage

EBIT

Gross interest

EBITDA interest coverage

EBITDA

Gross interest

Debt to EBITDA

Total debt

EBITDA

Total debt to total debt plus Total debt

equity

Total debt plus equity

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7. Business and Geographic Segments

Often we need to evaluate the performance of underlying business segments.
Business segments: subsidiary companies, operating units, operations in different countries
Disclosure of segment information is required by IFRS and U.S. GAAP.
Ratio

Numerator

Denominator

Segment margin

Segment profit

Segment revenue

Segment turnover

Segment revenue

Segment assets

Segment ROA

Segment profit

Segment assets

Segment debt ratio

Segment liabilities

Segment assets

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8. Model Building and Forecasting

Expected
Ratios

Forecasts

Models to Predict Future

Earnings and Cash Flow
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Summary
Category

Measures

Example

Activity ratios

Efficiency

Revenue / Assets

Liquidity ratios

Ability to meet its short term obligations

Current Assets / Current Liabilities

Solvency ratios

Ability to meet long term debt obligations

Assets / Equity

Profitability ratios

Profitability

Net Income / Assets

Valuation ratios

Quantity of an asset or flow per share

Earnings / Number of Shares

Remembering Ratios
1) Name tells you balance sheet item
2) Balance sheet item income statement item
3) Income statement item in the numerator
4) Average value of balance sheet number in denominator

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Conclusion
Read summary

Review learning objectives

Examples
Practice problems: good but not enough
Practice questions from other sources
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