Financial Analysis Techniques

Learning Outcomes
• Describe tools and techniques used in financial analysis, including their uses and
limitations
• Classify, calculate, and interpret activity, liquidity, solvency, profitability, and
valuation ratios
• Describe relationships among ratios and evaluate a company using ratio analysis
• Demonstrate the application of DuPont analysis of return on equity and calculate
and interpret effects of changes in its components
• Calculate and interpret ratios used in equity analysis and credit analysis
• Explain the requirements for segment reporting and calculate and interpret
segment ratios
• Describe how ratio analysis and other techniques can be used to model and
forecast earnings
The Financial Analysis Process
• Why are financial analysis tools useful?
• What is the financial analysis process?
• What questions are analysts seek to answer?
• What is the primary source of data for financial analysis?
• Is it sufficient?
• What can be the purpose of performing financial analysis of a
company?
• What is the focus of analysis of equity vs credit analysis?
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
potentially impair the analysis?
Caselet1
 Analyst Report
Analysts often need to communicate the findings of their analysis in a written report. Their reports
should communicate how conclusions were reached and why recommendations were made. For
example, a report might present the following:

• the purpose of the report, unless it is readily apparent;

• relevant aspects of the business context:
• economic environment (country/region, macro economy, sector);
• financial and other infrastructure (accounting, auditing, rating agencies);
• legal and regulatory environment (and any other material limitations on the company being
analyzed);
• evaluation of corporate governance and assessment of management strategy, including the
company’s competitive advantage(s);
• assessment of financial and operational data, including key assumptions in the analysis; and
• conclusions and recommendations, including limitations of the analysis and risks.
• An effective narrative and well supported conclusions and recommendations are normally enhanced
by using 3–10 years of data, as well as analytic techniques appropriate to the purpose of the report.
Analytical Tools and Techniques
• Evaluations require comparisons
• The analyst draws comparisons to other companies (cross-sectional analysis) and over
time (trend or time-series analysis).
• For example, an analyst may wish to compare the profitability of companies competing
in a global industry. If the companies differ significantly in size and/or report their
financial data in different currencies, is comparing net income as reported useful?
• How to compare companies performance with significant size difference?
• How to compare companies performance who report financial data in different
currencies ?
• To examine comparable performance over time which analysis is more useful?
• How to compare if there are differences in fiscal year end?
• Finally, it should be noted that differences in accounting standards can limit
comparability.
Caselet 2
Example: Trailing Twelve Months

• On 15 July, an analyst is examining a company with a fiscal year ending on

31 December. Use the following data to calculate the company’s trailing 12
month earnings (for the period ended 30 June 2023):

• Earnings for the year ended 31 December, 2022: $1,200;

• Earnings for the six months ended 30 June 2022: $550; and
• Earnings for the six months ended 30 June 2023: $750.
• Solution:
• The company’s trailing 12 months earnings is $1,400, calculated as $1,200
– $550 + $750.
Ratios
• What does a financial ratio tells us?
• The ratio is an indicator of some aspect of a company’s performance, telling what
happened but not why it happened.
• Ratios control for the effect of size, which enhances comparisons between
companies and over time.
• An important aspect of ratio analysis is that differences in accounting policies
(across companies and across time) can distort ratios, and a meaningful
comparison may, therefore, involve adjustments to the financial data.
• Not all ratios are necessarily relevant to a particular analysis. The ability to select
a relevant ratio or ratios to answer the research question is an analytical skill.
• Ratio analysis does not stop with computation; interpretation of the result is
essential. In practice, differences in ratios across time and across companies can
be subtle, and interpretation is situation specific.
The Universe of Ratios
Interpreting a Financial Ratio
A US insurance company reports that its “combined ratio” is
determined by dividing losses and expenses incurred by net premiums
earned. It reports the following combined ratios:
Fiscal Year 5 4 3 2 1
Combined ratio 90.1% 104.0% 98.5% 104.1% 101.1%

Explain what this ratio is measuring and compare the results reported
for each of the years shown in the chart.
What other information might an analyst want to review before making
any conclusions on this information?
Value, Purposes, and Limitations of Ratio
Analysis
Financial ratios provide insights into:
• economic 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).
Value, Purposes, and Limitations of Ratio
Analysis
There are also limitations to ratio analysis. Factors to consider include:
• The heterogeneity or homogeneity of a company’s operating activities.
• The need to determine whether the results of the ratio analysis are
consistent.
• The need to use judgment.
• The use of alternative accounting methods
• e.g. 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
Ratio Analysis
• What is the difference between a vertical common-size balance
sheet/income statement with a horizontal common-size balance
sheet/income statement?
• What is cross-sectional analysis?
Vertical Common-Size (Partial) Balance Sheet for Two Hypothetical Companies

Example
Vertical Common-Size (Partial) Balance Sheet for Two Hypothetical Companies

Company 1 Company 2
Assets Percent of Total Assets Percent of Total Assets
Cash 38 12
Receivables 33 55
Inventory 27 24
Fixed assets net of depreciation 1 2
Investments 1 7
Total Assets 100 100

What all can you interpret about the two companies?

Trend Analysis
• Trend analysis provides important information regarding historical
performance and growth and, given a sufficiently long history of
accurate seasonal information, can be of great assistance as a
planning and forecasting tool for management and analysts.
Partial Balance Sheet for a Hypothetical Company over Five Periods

Example
Partial Balance Sheet for a Hypothetical Company over Five Periods

Period

Change Change
4 to 5 4 to 5
Assets ($ Millions) 1 2 3 4 5 ($ Million) (Percent)
Cash 39 29 27 19 16 –3 –15.8

Investments 1 7 7 6 4 –2 –33.3

Receivables 44 41 37 67 79 12 17.9

Inventory 15 25 36 25 27 2 8.0

Fixed assets net of

depreciation 1 2 6 9 8 –1 –11.1

Total assets 100 104 113 126 134 8 6.3

Here what is the most significant change?

Horizontal Common-Size (Partial) Balance Sheet for a Hypothetical Company over Five Periods, with Each Item Expressed Relative to the Same Item in Perio

Example – Trend Analysis

Period The table presents the information from the
Assets 1 2 3 4 5 same partial balance sheet as in previous
Cash 1.00 0.74 0.69 0.49 0.41 example, but indexes each item relative to
the same item in Period 1. For example, in
Investme 1.00 7.00 7.00 6.00 4.00
Period 2, the company had $29 million
nts
cash, which is 74 percent or 0.74 of the
Receivabl 1.00 0.93 0.84 1.52 1.80 amount of cash it had in Period 1.
es Expressed as an index relative to Period 1,
Inventory 1.00 1.67 2.40 1.67 1.80 where each item in Period 1 is given a value
Fixed 1.00 2.00 6.00 9.00 8.00 of 1.00, the value in Period 2 would be 0.74
assets net ($29/$39 = 0.74). In Period 3, the company
of had $27 million cash, which is 69 percent of
depreciati the amount of cash it had in Period 1
on ($27/$39 = 0.69).
Total 1.00 1.04 1.13 1.26 1.34
assets
Horizontal common-size analysis
An analysis of horizontal common-size balance sheets highlights
• structural changes that have occurred in a business
• Past trends are obviously not necessarily an accurate predictor of the
future, especially when the economic or competitive environment changes.
• An examination of past trends is more valuable when the macroeconomic
and competitive environments are relatively stable and when the analyst is
reviewing a stable or mature business.
• However, even in less stable contexts, historical analysis can serve as a
basis for developing expectations.
• Understanding of past trends is helpful in assessing whether these trends
are likely to continue or if the trend is likely to change direction.
Question
• What is one measure of success for a company?
Example
• Consider the following year-over-year percentage changes for a
hypothetical company

• Revenue +20%
• Net income +25%
• Operating cash flow –10%
• Total assets +30%
• What will be your interpretation of the above company’s
performance and what further analysis if required?
 Example- Use of Comparative Growth Information
• In July 1996, Sunbeam, a US company, brought in new management to turn the company
around. In the following year, 1997, using 1996 as the base, the following was observed
based on reported numbers:
• Revenue +19%
• Inventory +58%
• Receivables +38%
• It is generally more desirable to observe inventory and receivables growing at a slower (or
similar) rate compared to revenue growth. Receivables growing faster than revenue can
indicate operational issues, such as lower credit standards or aggressive accounting policies
for revenue recognition. Similarly, inventory growing faster than revenue can indicate an
operational problem with obsolescence or aggressive accounting policies, such as an
improper overstatement of inventory to increase profits.
• In this case, the explanation lay in aggressive accounting policies. Sunbeam was later
charged by the US Securities and Exchange Commission with improperly accelerating the
recognition of revenue and engaging in other practices, such as billing customers for
inventory prior to shipment.
Categories of Financial Ratios
Category Description
Activity Activity ratios measure how efficiently a company performs day-to-day tasks, such as the
collection of receivables and management of inventory.

Liquidity Liquidity ratios measure the company’s ability to meet its short-term obligations.

Solvency Solvency ratios measure a company’s ability to meet long-term obligations. Subsets of these
ratios are also known as “leverage” and “long-term debt” ratios.

Profitability Profitability ratios measure the company’s ability to generate profits from its resources (assets).

Valuation Valuation ratios measure the quantity of an asset or flow (e.g., earnings) associated with
ownership of a specified claim (e.g., a share or ownership of the enterprise).
Financial Ratios
An analyst should evaluate financial ratios based on the following:
• Company goals and strategy.
• Industry norms (cross-sectional analysis)
• Many ratios are industry specific, and not all ratios are important to all
industries.
• Companies may have several different lines of business. This will cause
aggregate financial ratios to be distorted. It is better to examine industry-
specific ratios by lines of business.
• Differences in accounting methods used by companies can distort financial
ratios.
• Differences in corporate strategies can affect certain financial ratios.
• Economic conditions
Activity Ratios
• What do activity ratios measure?
Activity Ratios Numerator Denominator
Inventory turnover Cost of sales or cost of goods sold Average inventory
Days of inventory on hand (DOH) Number of days in period Inventory turnover
Receivables turnover Revenue Average receivables
Days of sales outstanding (DSO) Number of days in period Receivables turnover
Payables turnover Purchases Average trade payables
Number of days of payables Number of days in period Payables turnover
Working capital turnover Revenue Average working capital
Fixed asset turnover Revenue Average net fixed assets
Total asset turnover Revenue Average total assets
 Example
• An analyst would like to evaluate Lenovo Group’s efficiency in
collecting its trade accounts receivable during the fiscal year ended 31
March 2018 (FY2017). The analyst gathers the following information
from Lenovo’s annual and interim reports:
US$ in Thousands

Trade receivables as of 31 March

4,468,392
2017
Trade receivables as of 31 March
4,972,722
2018
Revenue for year ended 31 March
45,349,943
2018
Calculate Lenovo’s receivables turnover and number of days of sales
outstanding (DSO) for the fiscal year ended 31 March 2018.
Activity Ratios-Interpretation of Activity Ratios

• What does a higher inventory turnover ratio implies?

• What should be the benchmark?
• What does the number of DSO represents?
Liquidity Ratios
• What do liquidity ratios measure?
Liquidity Ratios Numerator Denominator
Current ratio Current assets Current liabilities
Quick ratio Cash + Short-term marketable Current liabilities
investments + Receivables
Cash ratio Cash + Short-term marketable Current liabilities
investments
Defensive interval ratio Cash + Short-term marketable Daily cash expenditures
investments + Receivables
Additional Liquidity Measure
Cash conversion cycle DOH + DSO – Number of days of payables
(net operating cycle)
Example
• An analyst is evaluating the liquidity of Apple and calculates the
number of days of receivables, inventory, and accounts payable, as
well as the overall cash conversion cycle, as follows. What is your view
on company’s inventory and supplier management?
FY2017 FY2016 FY2015
DSO 27 28 27
DOH 9 6 6
Less: Number of days
of payables 112 101 86
Equals: Cash
conversion cycle (76) (67) (53)
Solvency Ratios
• What do solvency ratios measure?
• What is operating leverage? What is financial leverage?
Solvency Ratios Numerator Denominator
Debt Ratios
Debt-to-assets ratio Total debt Total assets
Debt-to-capital ratio Total debt Total debt + Total shareholders’
equity
Debt-to-equity ratio Total debt Total shareholders’ equity
Financial leverage ratio Average total assets Average total equity
Debt-to-EBITDA Total debt EBITDA

Coverage Ratios
Interest coverage EBIT Interest payments
Fixed charge coverage EBIT + Lease payments Interest payments + Lease payments
Profitability Ratios
• What do profitability ratios measure?
Profitability Ratios Numerator Denominator
Return on Sales
Gross profit margin Gross profit Revenue
*
Operating profit margin Operating income Revenue
Pretax margin EBT (earnings before tax but after Revenue
interest)
Net profit margin Net income Revenue

Return on Investment
Operating ROA Operating income Average total assets
ROA Net Income+ I (1-T) Average total assets
Return on total capital EBIT Average short- and long-term debt
and equity
ROE Net income Average total equity
Return on common equity Net income – Preferred dividends Average common equity
 Example Dollars in
millions 2017 2016 2015 2014 2013
Sales 229,234 215,639 233,715 182,795 170,910
• Evaluation of Profitability Gross Profit 88,186 84,263 93,626 70,537 64,304
Ratios
• Recall from Example 1 that an
analysis found that Apple’s Operating 61,344 60,024 71,230 52,503 48,999
gross margin declined over the Income
three-year period FY2015 to Pre-tax 64,089 61,372 72,515 53,483 50,155
FY2017. An analyst would like
to further explore Apple’s Income
profitability using a five-year Net Income 48,351 45,687 53,394 39,510 37,037
period. He gathers the
following revenue data and
calculates the following Gross profit 38.47% 39.08% 40.06% 38.59% 37.62%
profitability ratios from margin
information in Apple’s annual
reports
• Evaluate the overall trend in Operating 26.76% 27.84% 30.48% 28.72% 28.67%
Apple’s profitability ratios for income
the five-year period. margin
Pre-tax 27.96% 28.46% 31.03% 29.26% 29.35%
income
Net profit 21.09% 21.19% 22.85% 21.61% 21.67%
margin
 Integrated Financial Ratio Analysis
• An analyst is evaluating the liquidity of a Canadian manufacturing company
and obtains the following liquidity and activity ratios:

Fiscal Year 10 9 8
Current ratio 2.1 1.9 1.6
Quick ratio 0.8 0.9 1.0
DOH 55 45 30

DSO 24 28 30

• What can be his interpretation?

Dupont Analysis

which can be interpreted as:

ROE = ROA × Leverage

which can be interpreted as:

ROE = Net profit margin × Total asset turnover × Leverage

Dupont Analysis

which can be interpreted as:

ROE = Tax burden × Interest burden × EBIT margin × Total asset turnover × Leverage
Caselet 3
Example
• An analyst examining ABC Ltd. (a hypothetical company) wishes to
understand the factors driving the trend in ROE over a four-year
period. The analyst obtains and calculates the following data from
ABC’s annual reports:
4 3 2 1
ROE 9.53% 20.78% 26.50% 24.72%
Tax burden 60.50% 52.10% 63.12% 58.96%
Interest burden 97.49% 97.73% 97.86% 97.49%
EBIT margin 7.56% 11.04% 13.98% 13.98%
Asset turnover 0.99 1.71 1.47 1.44
Leverage 2.15 2.17 2.10 2.14

What might the analyst conclude?

Dupont Analysis
• An analyst could further decompose individual components of a five-
way analysis.
• For example, EBIT margin (EBIT/Revenue) could be further
decomposed into a non-operating component (EBIT/Operating
income) and an operating component (Operating income/Revenue).
• The analyst can also examine which other factors contributed to these
five components. For example, an improvement in efficiency (total
asset turnover) may have resulted from better management of
inventory (DOH) or better collection of receivables (DSO).
Equity Analysis and Valuation Ratios
• What is equity analysis?
• What is the valuation process?
• understanding the business and the existing financial profile
• forecasting company performance
• selecting the appropriate valuation model
• converting forecasts to a valuation
• making the investment decision
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

Per-Share Quantities Numerator Denominator

Basic EPS Net income minus preferred Weighted average number of
dividends ordinary shares outstanding
Diluted EPS Adjusted income available for Weighted average number of
ordinary shares, reflecting ordinary and potential ordinary
conversion of dilutive securities 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 dividends declared Weighted average number of
ordinary shares outstanding
Equity Analysis and Valuation Ratios

Dividend-Related
Quantities Numerator Denominator
Dividend payout ratio Common share dividends Net income attributable to common shares
Retention rate (b) Net income attributable to Net income attributable to common shares
common shares –
Common share dividends
Sustainable growth rate b × ROE
Business Risk

Ratio Numerator Denominator

Business Risk

Coefficient of variation of operating Standard deviation of operating Average operating income

income income
Coefficient of variation of net Standard deviation of net income Average net income
income
Coefficient of variation of revenues Standard deviation of revenue Average revenue
Industry-Specific Financial Ratios
Retail Ratios Numerator Denominator
Same (or comparable) store sales Average revenue growth year over Not applicable
year for stores open in both periods
Sales per square meter (or square Revenue Total retail space in square meters
foot) (or square feet)

Service Companies Numerator Denominator

Revenue per employee Revenue Total number of employees
Net income per employee Net income Total number of employees

Hotel Numerator Denominator

Average daily rate Room revenue Number of rooms sold
Occupancy rate Number of rooms sold Number of rooms available
Industry-Specific Financial Ratios

Financial Sector Ratios Numerator Denominator

Capital adequacy—banks Various components of capital Various measures such as risk-
weighted assets, market risk
exposure, or level of operational risk
assumed
Monetary reserve requirement Reserves held at central bank Specified deposit liabilities
(Cash reserve ratio)
Liquid asset requirement Approved “readily marketable” Specified deposit liabilities
securities
Net interest margin Net interest income Total interest-earning assets
 Credit Analysis
• What is credit risk?
• What is credit rating process?
Credit Ratio Numerator Denominator
EBITDA interest coverage EBITDA Interest expense, including non-
cash interest on conventional debt
instruments
FFO (Funds from operations) to FFO (EBITDA minus net interest Total debt
debt expense minus current tax
expense)
Free operating cash flow to debt CFO minus capital expenditures Total debt

EBIT margin EBIT Total revenues

EBITDA margin EBITDA Total revenues
Debt to EBITDA Total debt EBITDA
Return on capital EBIT Average beginning-of-year and
end-of-year capital (Debt and
Equity)
Altman Z Score
• Altman (1968) and Altman, Haldeman, and Narayanan (1977) found that
financial ratios could be combined in an effective model for predicting
bankruptcy.
• Altman’s initial work involved creation of a Z-score that was able to
correctly predict financial distress. The Z-score was computed as
•Z = 1.2 × (Current assets – Current liabilities)/Total assets
+ 1.4 × (Retained earnings/Total assets)
+ 3.3 × (EBIT/Total assets)
+ 0.6 × (Market value of stock/Book value of liabilities)
+ 1.0 × (Sales/Total assets)
• a Z-score of lower than 1.81 predicted failure
Business and Geographic Segments
• Why analysis of business segment important?
• Analysts often need to evaluate the performance underlying business segments
(subsidiary companies, operating units, or simply operations in different geographic
areas) to understand in detail the company as a whole.
• Although companies are not required to provide full financial statements for segments,
they are required to provide segment information
• What is an operating segment?
• that engages in activities that may generate revenue and create expenses, including a start-up
segment that has yet to earn revenues,
• whose results are regularly reviewed by the company’s senior management, and
• for which discrete financial information is available
• How to identify a segment?
• A company must disclose separate information about any operating segment which
meets certain quantitative criteria—namely, the segment constitutes 10 percent or more
of the combined operating segments’ revenue, assets, or profit.
Segment Ratios

Segment Ratios Numerator Denominator

Segment margin Segment profit (loss) Segment revenue
Segment turnover Segment revenue Segment assets
Segment ROA Segment profit (loss) Segment assets
Segment debt ratio Segment liabilities Segment assets
Caselet 4