Rate) Percentage Change

+ Non-cash Expenses
Formula 1: Change in Most Recent Value –Formula 3: Value
Base Period
FS+ Cash
ANALYSIS
Flow from Operating Current Assets & Base Period Value
Liab + Net Income
- Involves
+ Interest the assessment and
Expense evaluation of the firm’s past performance,+ Interest
its present condition, and future
Expense
Tax
business Shield on
potentials
CapEx
= Free Cash Flow Tax Shield on
Interest Expense Interest Expense
CapEx
Types of Information + Non-cash Expenses
= Free Cash Flow Change in
● Profitability Current Assets &
liab
● Ability to meet obligations (liquidity-short term & solvency-long term) CapEx
= Free Cash Flow
● Safety of the investment (stability)

● Effectiveness of management (turn-overs)

● Over-all company marketability

Vertical Analysis (common-size FS)

- process of comparing figures in the financial statements of a single period
- compare statement of two or more companies
- percentage based; total assets as 100%

Horizontal Analysis (trend percentages and index analysis)

- enables investors and analysts to see what has been driving a
company’s financial performance over time
- identify trends and growth patterns
- statements for two or more periods are used
- figures are presented as % of their base year

Cash Flow Analysis (free cash flow concept)

- cash a company generates after accounting for cash outflows
- measure of profitability that excludes non-cash expenses and includes spending on equipment as well as balance

sheet changes in working capital

- excludes interest payments
- cash flow available to repay creditors or pay dividends and interest to investors
- shrinking FCF is not necessarily a bad thing, particularly if increasing capex
Gross Profit Variance Analysis – determine the reasons why the gross profit margin changes
● Sales Price Variance (SPV)/Sales Factor = (SP/unit this year – SP/unit last year) x sales units this year

● Cost Price Variance (CPV)/Cost Factor = (Unit cost this year – Unit cost last year) x sales units this year

● Sales Quantity Variance = (Sales Qty this year – Sales Qty last year) x SP last year

● Cost Quantity Variance = (Sales Qty this year – Sales Qty last year) x Unit cost last year

● Sales Volume Variance/Quantity Factor = (Sales Qty this year – Sales Qty last year) x Gross profit/unit last year
o Sales Mix Variance
o Sales Yield Variance – market share variance & market size variance

Ratio Analysis
- Quantitative method for gaining insight into a company’s liquidity, operational efficiency, and profitability by
examining FS
- Fundamental component of fundamental equity analysis
- The higher the ratio, the better; the lower the period, the better
- Use average when comparing balance sheet item to income statement item
- There is direct relationship between nominator and the ratio, while inverse relationship between denominator
and ratio.

Potential Problems
● Benchmark to industry leaders’ ratios

● Distorted by inflation

● Just gives numbers, not causation factors

● Different divisions need comparison to different industry averages

● Different accounting practices

● Can use window dressing to manipulate FS

1. Tests of Liquidity

● Ideally greater than one

Current Ratio Current Assets / Current Liabilities
● Not yet an absolute test of
liquidity because it includes
receivables and inventories

Working Capital Current Assets – Current Liabilities

● Removed inventories and

prepaid expenses
● Still not an absolute test of
liquidity because of
Acid Test Ratio or Quick Ratio Quick Assets / Current Liabilities
receivables
 ● More sensitive than current
ratio

Cash Ratio Cash + Marketable Securities

● Absolute test of liquidity
Current Liabilities

Average Inventory

Average Age of Inventory Average Daily COGS

# of Working Days

Inventory Turnover

Average Receivables .

Average Age of Receivables Average Daily Credit Sales ● 365 days

# of Working Days in yr

Receivables Turnover

Average Accounts Payable

Average Age of Trade Payables Average Daily Credit Purchase

# of Working Days

Payables Turnover

● Cycle of buying and selling of

Operating Cycle Ave. Age of Receivables + Inventory goods
● Aka natural business year

Operating Cycle – Ave. Age of Trade

● Number of days payable is
Payables
Cash Conversion Cycle due but money is still tied up
● Need to be negative

2. Working Capital Activity

Receivable Turnover Net Credit Sales / Average

● The higher, the lesser
Receivables
average age of receivables
Inventory Turnover COGS or Credit Sales

Average Inventory

Trade Payables Turnover Net Credit Purchases

Average Trade Payables

Cost of Sales + Operating Expenses

● How well you utilized assets
(excluding dep. and amortization)
Current Assets Turnover for cash flows
Average Current Assets
Total Assets Turnover Total Sales / Total Assets
●

Operating Leverage % Net Income / % Sales

● If comparative years

CM / EBIT or Net Income

● If only 1 year

3. Tests of Solvency

Times Interest Earned EBIT / Interest Expense

● The higher, the better

Debt-Equity Ratio Liabilities / SHE

● Exception to the rule; should
Debt Ratio (always higher than debt be the lower, the better
to equity)
Liabilities / Assets ● If the company is using
leveraging, higher is good

● In starting operations, higher

Equity Ratio SHE / Assets is good
● If stable operations, lower is
good

● Leverage is measured
Equity Multiplier Assets / SHE
● When leveraging, focus on
long-term debt

Times Preferred Dividend

Requirements

Times Fixed Charges Earned Operating Profit + Lease

Lease + Interest Expense

Degree of Financial Leverage Operating Income / EBT

4. Test of Profitability

Return on Sales ! Earnings After Tax / Net Sales

Gross Profit or Gross Margin Ration Gross Profit / Sales

Return on Total Assets (ROA) !! Earnings Before Interest but After

Tax

Average Total Assets

Return on Equity (ROE) !!! Earnings After Tax

Average Owners Equity

Return on Common SHE or Earnings Earnings After Tax – Preferred Div

Per Share
Average Common SHE
 5. Market Tests

● For me to earn P1, how much

Price-Earnings Ratio Price per Share / Earnings per Share will I invest
● Lower, the better

Dividend Yield Ordinary Dividend per Share

● If I invest P1, how much is my
Price per Share dividends

● If I invest P1, how much will I

Earnings Yield Earnings per Share / Price per Share earn
● Higher, the better

Dividend Payout Ordinary Dividend per Share

● How generous the company
Earnings per Share in declaring dividends

Plow-back or Retention Ratio 1 – Payout Ratio

● Used to finance capital
investment projects

6. Du Pont Equation (expanded ROI) Net Income Margin x Asset Turnover

● Useful technique used to
x Equity Multiplier
decompose the different
drivers of return on equity

7. Growth Ratios

Sustainable Growth Rate Retention Ratio x Return on Equity

Financial Forecasting using Additional Funds Needed (AFN)

- AFN is a way of calculating how much new funding will be required
- Projected increase in Assets – Spontaneous increase in Liabilities – Any increase in Retained Earnings