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Financial Analysis

Techniques
2014 Level I Financial Reporting and Analysis

IFT Notes for the CFA exam

Financial Analysis Techniques

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Contents
1. Introduction ....................................................................................................................................... 3
2. The Financial Analysis Process ....................................................................................................... 3
3. Analytical Tools and Techniques .................................................................................................... 5
4. Common Ratios Used in Financial Analysis .................................................................................. 8
5. Equity Analysis ............................................................................................................................... 18
6. Credit Analysis ............................................................................................................................... 21
7. Business and Geographic Segments .............................................................................................. 21
8. Model building and forecasting ..................................................................................................... 22
Summary ............................................................................................................................................. 22
Next Steps ........................................................................................................................................... 23

This document should be read in conjunction with the corresponding reading in the 2014 Level I
CFA Program curriculum.

Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality
of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and
Chartered Financial Analyst are trademarks owned by CFA Institute.

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1. Introduction
Financial analysis is a useful tool in evaluating a companys performance and trends. The primary
source of data is a companys annual report, financial statements, and MD&A. Although the
financial statements contain data about a companys past performance and current financial
condition, they do not contain all the information required to forecast future performance.
An analyst must be capable of using a companys financial statements along with other information
such as economy/industry trends to make projections and reach valid conclusions. An analyst
converts data into financial metrics like ratios that help in decision making.

2. The Financial Analysis Process


Objective: Before beginning any financial analysis, an analyst must clarify the purpose and context
of why it is needed. The following questions help in defining the purpose:

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 affect the analysis?

Once the purpose is defined, the analyst can choose the right techniques for the analysis. For
example, the level of detail required for a substantial long term investment in equities will be
higher than one needed for a short term investment in fixed income.

2.1 Financial Analysis Framework


This reading focuses on steps 3 and 4 of the financial analysis framework in detail: how to adjust
financial statements, compute ratios, and produce graphs and forecasts. The processed data is then
analyzed to arrive at a conclusion.

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Financial Analysis Framework


Phase

Output of the analysis

1. Define purpose and context based on


analysts function, client input and organizational
guidelines.

Objective
Questions to be answered
Nature and content of report to be provided
Timetable and budget

2. Collect data: financial statements, other


financial data, industry/economic data,
discussions with management, suppliers,
customers, and competitors.

Organized financial statements


Financial tables
Completed questionnaires

3. Process data

Adjusted financial statements


Common-size statements
Ratios and graphs
Forecasts

4. Analyze and interpret processed data

Analytical results

5. Develop and communicate conclusions and


recommendations

Report answering questions from phase 1


Recommendation regarding the purpose of the
analysis

6. Follow-up

Updated recommendations

2.2 Distinguishing between Computation and Analysis


An effective analysis comprises both calculations and interpretations. A good analysis is not just
a compilation of various pieces of information put together. It should address how the company
performed and the reasons behind its good/bad performance.
Some of the key questions to address for past performance include:

What aspects of performance are critical to success?

Did the company fare well on these critical aspects?

What were the key factors for this performance?

Questions to include for a forward looking analysis include:

What is the likely impact of a trend/events in the company, industry and the economy on
the companys future cash flows?

How will the management respond to this trend?

What are the risks involved?

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3. Analytical Tools and Techniques


Various tools and techniques such as ratios, common size analysis, graphs and regression analysis
help in evaluating a companys data. Evaluations require comparisons, but to make a meaningful
comparison of a companys performance, the data needs to be adjusted first. An analyst can then
compare a companys performance to other companies at any point in time (cross-section analysis)
or its own performance over time (time-series analysis).

3.1 Ratios
A ratio is an indicator of some aspect of a companys performance like profitability or inventory
management. Ratio analysis helps in analyzing the current financial health of a company, evaluate
its past performance, and provide insights for future projections.

Note: Although there are some widely accepted ratios like net profit margin, there is no
standardized set of ratios. Furthermore, names and formulas for computing ratios often differ from
analyst to analyst.

Uses and Limitations of Ratio Analysis


Uses of ratio analysis

Limitations of ratio analysis

Ratios allows analysts to:

An analyst must exercise judgment when


interpreting ratios. For example, a current ratio
of 1.1 may not necessarily be good/bad unless
viewed in perspective of company/industry.

Use of alternate accounting methods may


require adjustments before the ratios are
comparable. For example Company A might
use the LIFO method while a comparable
company might use the FIFO method.

Companies may have divisions operating in


many different industries. This can make it
difficult to find comparable ratios.

Evaluate operational efficiency.


Evaluate financial flexibility to obtain cash
required for growth.
Compare company performance relative to
industry.
Compare across companies irrespective of
size and currency.
Compare with peer companies.

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3.2 Common-Size Analysis


Common size financial statements are used to compare the performance of different companies
within an industry or a companys performance over time. Common size statements are prepared
by expressing every item in a financial statement as a percentage of a base item.

Common-Size Analysis of the Balance Sheet


There are two types of common-size balance sheets: vertical and horizontal. In a vertical
common-size balance sheet, each item on the balance sheet is divided by the total assets for a
period and expressed as a percentage. This highlights the composition of the balance sheet.

simple common-size vertical balance sheet is shown below:

2011

2012

% of total assets

% of total assets

Cash

Marketable Securities

Accounts Receivables

Inventory

10

PP&E

80

80

Total Assets

100

100

In terms of time series analysis (also called trend analysis), the vertical common-size balance
sheet indicates how a particular item is changing relative to total assets. For the data given
above, we can observe that inventory is increasing as a percentage of total assets while accounts
receivable is decreasing as a percentage of total assets.

The vertical common-size balance sheet can be used in cross-sectional analysis (also called relative
analysis) to compare a specific metric of one company with another for a single time period. As
illustrated in the table below, this method allows comparison across companies which might be of
significantly different sizes and/or operate in different currencies.

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Cross Sectional Analysis


Company A

Company B

Cash

0.3%

$10

0.3%

120

Marketable Securities

2.6%

$90

2.8%

950

Accounts Receivables, net

5.8%

$200

7.3%

2,500

Inventory

8.7%

$300

10.2%

3,500

Non-Current Assets

82.6%

$2,580

79.4%

27,400

Total Assets

100%

$3,450

100%

34,470

This presentation makes it easy to see that Company A has lower receivables as a percentage of
total assets relative to Company B. Company A also has lower inventory as a percentage of total
assets relative to Company B.

In a horizontal common-size balance sheet, each balance sheet item is shown in relation to the
same item in a base year. Consider the following balance sheet excerpt:
2011 (base year)

2012

Cash

10

12

Marketable Securities

90

99

Inventory

600

900

The corresponding horizontal common size balance sheet will look like this:
2011 (base year)

2012

Cash

1.0

1.2

Marketable Securities

1.0

1.1

Inventory

1.0

1.5

Notice that the base-year value for all balance sheet items is set to 1. This makes it easy to see the
percentage change in each item relative to the base year. For the data given above, cash increased
by 20%, marketable securities increased by 10% and inventory increased by 50%. An analysis of

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horizontal common-size balance sheets highlights structural changes that have occurred in a
business.

Relationships among Financial Statements


Comparing the trend data of a horizontal common-size analysis across financial statements will
give some insight into a companys financial standing. Consider the following percentage changes
for a company to identify some potential issues:
Revenue: +15%, Operating income: +15%, Operating cash flow: -10%, Inventory: +60%,
Receivables: +40%, Total assets: +30%
The assets are growing at a faster rate than revenue which implies the company is spending more
than the sales it is able to generate. Operating cash flow is negative whereas operating income is
+15% indicating a problem that the company is booking sales (accrual accounting) but has not
realized the cash yet. Similarly, when inventory and receivables grow at a much faster pace than
sales, it shows signs of poor inventory and receivables management.

3.3 Graphs
Graphs can be considered an extension of the financial analysis. It is a pictorial representation of
the analysis done, be it ratio analysis or trend analysis. Analysts use appropriate graphs such as
line charts, bar graphs based on the type of data to be shown. It helps in quick comparison of
financial performance and structure over time.

3.4 Regression analysis


Regression analysis, described in detail in Level II, is a statistical method of analyzing
relationships (correlations) between variables.

4. Common Ratios Used in Financial Analysis


Note: This is the most important part of this reading.

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A large number of ratios are used to measure various aspects of performance. Commonly used
financial ratios can be categorized as follows:
Category

What they measure

Example

Activity ratios

Efficiency of a company

Revenue / Assets

Liquidity ratios

Ability to meet its short term

Current assets / Current

obligations

liabilities

Ability to meet long term

Assets / Equity

Solvency ratios

obligations
Profitability ratios

Profitability

Net Income / Assets

Valuation ratios

Quantity of an asset or flow per

Earnings / Number of shares

share

Note that for some ratios, the numerator and denominator are from the same statement. Examples
of such ratios are net profit margin (net income/sales) and leverage (assets/equity). For other ratios
(called mixed ratios), the numerator is from one statement the denominator is from another
statement. An example is the asset turnover ratio (sales/assets).

4.1 Interpretation and Context


As standalone numbers, the financial ratios of a company dont make much sense. The ratios are
usually industry-specific. For instance, you cannot compare the ratios of Schlumberger with that
of Facebook. The financial ratios should be used to periodically evaluate a companys goals and
strategy, how it fares against its peers in the industry, and the effect of economic conditions on its
business.

4.2 Activity Ratios


Activity ratios measure how efficiently a company manages its assets. They are also known as
asset utilization ratios or operating efficiency ratios.
Note: In general, a high number for the turnover ratio relative to its industry means greater
efficiency.

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Activity Ratios Formulae


Activity Ratios

Numerator

Denominator

Inventory turnover

Cost of goods sold

Average inventory

Days of inventory on hand

Number of days in period

Inventory turnover

Receivables turnover

Revenue

Average receivables

Days of sales outstanding

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

In ratios above, average = (beginning period value + ending period value)/2. If beginning period value
is not available, then use ending period value.
Average inventory = (beginning inventory + ending inventory )/2
Average receivables = (beginning receivable + ending receivable)/2
Average payables = (beginning payable + ending payable)/2
Purchases = cost of goods sold + ending inventory beginning inventory

How to remember the ratios:


1. Name of the ratio indicates the balance sheet item. For example, in the receivables turnover ratio, the
average receivable is in the denominator.
2. The income statement item is in the numerator.
3. Average value of balance sheet in the denominator. Income statement measures an item over a period
but balance sheet indicates values of items only at the end of a period. So, always use the average value
for balance sheet items.
4. All turnover ratios except inventory turnover use revenue in the numerator. Inventory turnover uses
cost of goods sold.

Interpretation of Activity Ratios


Activity Ratios

Interpretation

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Inventory turnover

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How many times per period entire inventory was sold. Measures
the ability of a company to sell its inventory.
Higher number means greater efficiency because inventory is kept
for a shorter period. It could also mean insufficient inventory,
which in turn, might affect growth /revenue.

Days of inventory on hand

On an average, how many days of inventory kept on hand.

(DOH)
Receivables turnover

How quickly does a company collect cash.


More appropriate to use credit sales instead of revenue but it is not
readily available.
Higher number means greater efficiency in credit and collection. It
could also mean stringent cash collection policies are hurting
potential sales.

Days of sales outstanding (DSO)

Elapsed time between credit sale and cash collection.


Higher number means it takes a long time to collect receivables.

Payables turnover

Indicates how quickly a company pays suppliers. A high number


means the company is paying suppliers quickly and is possibly not
making use of credit facilities. Low number may mean the
company is facing trouble making payments on time and a sign of
liquidity issues.

Number of days of payables

On an average, how many days it takes to pay suppliers.

Working capital turnover

How efficiently does a company generate revenue from working


capital
Working capital = current assets (CA) current liabilities (CL)
Higher number means greater efficiency. If CA= CL, then working
capital would be zero making the ratio meaningless.

Fixed asset turnover

How efficiently does a company generate revenue from fixed assets


Higher number means efficient use of fixed assets. Lower number
may mean inefficiency, or newer business (higher carrying value on
B/S), or a capital intensive business.

Total asset turnover

How efficiently does a company generate revenue from total assets


(fixed + current assets)

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As with other turnover ratios, higher number means efficiency.


Higher number for turnover ratios = greater efficiency

4.3 Liquidity Ratios


Liquidity ratios measure a companys ability to meet short term obligations. It also indicates how
quickly it turns assets into cash.

Liquidity Ratios Formulae


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

Interpretation of Liquidity Ratios


Liquidity Ratios

Interpretation

Current ratio

Higher number implies greater liquidity

Quick ratio

Higher number implies greater liquidity


More conservative than current ratio as only more liquid current
assets are included.

Cash ratio

This is the most conservative liquidity ratio, and a good measure


of a companys ability to handle a crisis situation.

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Defensive interval ratio

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Measures the number of days a company can operate before it runs


out of cash.
Higher number implies greater liquidity

Cash conversion cycle

The time between cash paid (to suppliers) and cash collected (from
customers)
Lower the number, better for the company as it means high
liquidity
Long cash conversion cycle = low liquidity

The example below for ABC Corp. illustrates cash conversion cycle better. The timeline for
various events is illustrated below:

4.4 Solvency Ratios


Solvency ratios measure a companys ability to meet long term obligations. In simple terms, it
provides information on how much debt the company has taken and if it is profitable enough to
pay the interest on debt in the long term. It has to be analyzed within an industrys perspective.
Certain industries such as real estate use a higher level of leverage.

Solvency Ratios Formulae


Solvency Ratios

Numerator

Denominator

Total debt

Total assets

Debt ratios
Debt to assets ratio

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Debt to capital ratio

Total debt

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Total debt + total shareholders
equity

Debt to equity ratio

Total debt

Total shareholders equity

Financial leverage ratio

Average total assets

Average total equity

Interest coverage ratio

EBIT

Interest payments

Fixed charge coverage ratio

EBIT + lease payments

Interest payments + lease

Coverage Ratios

payments

Note that there are two categories of solvency ratios: debt (or leverage) ratios and coverage ratios.
In general, a high debt (or leverage) ratio implies a high level of debt, high risk and low solvency.
With coverage ratios, a high number is good because this indicates high income relative to interest
payments.

Interpretation of Solvency Ratios


Solvency Ratios

Interpretation

Debt to assets ratio

Measures the amount of debt in total assets.


Higher debt means low solvency and higher risk. A ratio of 0.5
implies 50% of assets are financed with debt.

Debt to capital ratio

Measures the amount of debt as a percentage of capital (debt +


shareholders equity).

Debt to equity ratio

Measures the amount of debt as a percentage of equity.

Financial leverage ratio

Measures the amount of assets per unit of equity.


Higher value means company is leveraged more.

Interest coverage ratio

Measures the companys ability to make interest payments (how


many times the company can make interest payments with its
EBIT).
Unlike the other solvency ratios, higher value for this ratio is
better as it means stronger solvency.

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Fixed charge coverage ratio

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Measures the ability of a company to pay interest on debt.


Here, lease payments are added to EBIT as they are an obligation
like interest payments. Like interest coverage ratio, higher value for
this ratio implies stronger solvency.

4.5 Profitability Ratios


Profitability Ratios Formulae
Profitability Ratios

Numerator

Denominator

Gross profit margin

Gross profit

Revenue

Operating profit margin

Operating income

Revenue

Pretax margin

EBT (earnings before tax but

Revenue

Return on Sales

after interest)
Net profit margin

Net profit

Revenue

Operating ROA

Operating income

Average total assets

Return on assets (ROA)

Net income

Average total assets

Return on total capital

EBIT

Short and long term debt and

Return on Investment

equity
Return on equity (ROE)

Net income

Average total equity

Return on common equity

Net income preferred dividend

Average common equity

How to remember the profitability ratios:


1. Return on sales ratios are single statement ratios i.e. both numerator and denominator are from income
statement. As the name margin implies, denominator is always the revenue.
2. Return on investment ratios are mixed statement ratios. The earlier rule discussed for activity ratios
apply here. From the name, you can predict the numerator. The numerator comes from the income
statement. For instance, in return on assets, return implies net income.
3. The denominator is from the balance sheet which is again present in the name itself but the average
value has to be used. So, in return on equity, average total equity becomes the denominator.

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Interpretation of Profitability Ratios


Profitability Ratios

Interpretation

Gross profit margin

Higher value means higher pricing and lower costs

Operating profit margin

Operating profit = gross profit - operating costs.


Good sign if operating profit margin grows at a faster rate than
gross profit margin.

Pretax margin

Pretax profit = operating profit - interest related expenses.


Needs further analysis if pretax income increases only because of
non-operating income.

Net profit margin

Net profit = revenue all expenses

Operating ROA/ Return on

For return, either net income or operating income (EBIT) can be

Assets (ROA)

used.

Return on total capital

Like operating ROA, EBIT is used. Measures return on capital


before deducting interest.

Return on Equity (ROE)

A very important measure of return earned on equity capital.


Unlike return on common equity, it includes minority and
preferred equity.

Return on common equity

Money available to common shareholders

4.6 DuPont Analysis


Note: This section is important from a testability perspective.

Why is DuPont analysis important?


Return on equity (ROE) measures the return a company generates from stockholders equity. Lets
say a companys ROE is 20%. It is important to understand what is driving this growth low
interest, low taxes, or high revenue? Some factors may be positive, some neutral and some
negative. DuPont analysis decomposes the return on equity into various components listed below.
This insight will help understand the companys performance better and focus on areas that need
improvement.
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Return on Equity

Return on assets

Financial Leverage

Net profit margin

Total asset turnover

EBIT margin

Interest burden

Tax burden

Note: From exam perspective the following two forms of return on equity are important.
Return on equity = Net income/ equity = (Net income/assets) * (assets/equity)
Return on equity = Net income/equity = (Net income/revenue) * (revenue/assets) *
(assets/equity)

The five point DuPont formula can be decomposed into:


Return on equity = (Net income/EBT) * (EBT/EBIT) * (EBIT/revenue) * (revenue/average
total assets) * (average total assets/equity)
which translates into
Return on equity = Tax burden * Interest burden * EBIT margin * total asset turnover *
leverage

Say you are given the follow data for a particular company:

2010

2011

2012

ROE

19%

20%

22%

ROA

8.1%

8%

7.9%

2.1

Total asset turnover

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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

Solution: A quick glance at the data says profitability is going up and asset turnover has
slightly increased from 2010 to 2012. ROA is going down from the second year.
Steps: 1. Break down ROE into: (return on assets) * (assets/equity) = (ROA) * financial
leverage. ROE is going up (first row). Since ROA is going down, leverage must increase for
ROE to increase. So A is incorrect.
2. To determine if net profit margin increased or decreased, break down ROA into (net
income/sales) * (sales/assets). Since (sales/assets) or asset turnover is increasing, net profit
margin has to decrease for return on assets to decrease. So, the correct answer is C.

5. Equity Analysis
One of the most common applications of financial analysis is that of selecting stocks. An equity
analyst uses various tools (such as valuation ratios) before recommending a security to be included
in an equity portfolio. The valuation process consists of the following steps:
(i)

Understanding the companys business and existing financial profile

(ii)

Forecasting company performance such as revenue projections

(iii)

Selecting the appropriate valuation model

(iv)

Converting forecasts to a valuation

(v)

Making the investment decision to buy or not to buy

This section, in particular, focuses on the ratios used to value equity. Research has shown that
ratios are useful in forecasting earnings and stock returns. Note that this material is covered in
more detail in the equity segment of the curriculum.

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5.1 Valuation Ratios


Valuation ratios aid in making investment decisions. They help us determine if a stock is
undervalued or overvalued.
Valuation Ratios Formulae
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


Basic EPS

Diluted EPS

Cash flow per share

Net income minus preferred

Weighted average number of

dividends

ordinary shares outstanding

Adjusted income available

Weighted average number of

shares, reflective conversion of

ordinary and potential ordinary

dilutive securities

shares outstanding

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


shares outstanding

Interpretation of Valuation Ratios


Profitability Ratios

Interpretation

P/E

Most often used valuation measure. Prone to earnings


manipulation. Non-recurring earnings may distort the ratio.

P/CF

Less manipulative than P/E

P/S

Used when net income is not positive

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P/BV

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An indicator of what the market perceives. A value greater than 1


means future rate of return is higher than required rate of return.

5.2 Dividend related ratios


Dividend-related formulae
Dividend Ratios

Numerator

Denominator

Dividend payout ratio

Dividend

Earnings

Retention rate = 1- payout rate


Sustainable growth rate = retention rate *ROE

Interpretation of Dividend-related Ratios


Dividend-related ratios

Interpretation

Dividend payout ratio

Measures the percentage of earnings a company pays out as


dividends to equity shareholders

Retention Rate

Measures the percentage of earnings a company retains

Sustainable growth rate

Measures how much growth a company is able to finance from its


internally generated funds. Higher retention rate and ROE result in
higher sustainable growth rate.

5.3 Industry-Specific Ratios


Ratios serve as indicators of some aspect of a companys performance and value. Aspects of
performance that are important in one industry may be irrelevant in another. These differences are
reflected through industry-specific ratios. For example, companies in the retail industry may report
same-store sales changes because, in the retail industry, it is important to distinguish between
growth that results from opening new stores and growth that results from generating more sales at
existing stores.

Another example is the inventory turnover ratio which is useful in the

manufacturing industry but is not relevant for the financial services industry. Exhibit 15 in the
curriculum identifies some common industry and task specific ratios.

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6. Credit Analysis
Credit risk is the risk that the borrower will default on a payment when it is due. For example, if
you are a bondholder, credit risk is the risk that the bond issuer will not pay you the interest on
time. Credit analysis is the evaluation of this credit risk. Just as ratio analysis is useful in valuing
equity, it can also be applied to analyze the creditworthiness of a borrower. Some of the ratios
commonly used in credit analysis are listed below:

Credit Analysis Ratios Formulae


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 equity

Total debt

Total debt plus equity

High coverage ratios would imply good credit quality. Similarly low debt/EBITDA and low debt
/ (debt + equity) would imply good credit quality.

7. Business and Geographic Segments


To get a holistic understanding of a companys businesses, analysts often study the performance
of its underlying business segments. A business segment may be a subsidiary company, operating
units or operations in the same business at different locations across the world. For example,
General Electric is involved in various businesses ranging from electrical appliances to aircraft
engines across geographies. An analyst deciding whether or not to buy GE stock might want to
study each business segment separately. To facilitate this type of analysis both U.S. GAAP and
IFRS require companies to provide segment information.

Some of the key segment ratios are listed below:

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Segment related Ratios

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

8. Model building and forecasting


Analysts use several methods to forecast future performance. One commonly used method is to
project sales and to combine the forecasted sales numbers with expected values for key ratios. For
example, by using sales numbers and gross profit margin, one can determine cost of goods sold
and gross profit. A similar approach is followed for other financial statements as well to arrive at
a valuation for company under analysis.

Summary
Note: This summary has been adapted from the CFA Program curriculum.
Financial analysis techniques, including common-size and ratio analysis, are useful in
summarizing financial reporting data and evaluating the performance and financial position of a
company. The results of financial analysis techniques provide important inputs into security
valuation. Key facets of financial analysis include the following:

Common-size financial statements and financial ratios remove the effect of size, allowing
comparisons of a company with peer companies (cross-sectional analysis) and comparison of
a companys results over time (trend or time-series analysis).

Activity ratios measure the efficiency of a companys operations, such as collection of


receivables or management of inventory. Major activity ratios include inventory turnover, days
of inventory on hand, receivables turnover, days of sales outstanding, payables turnover,
number of days of payables, working capital turnover, fixed asset turnover, and total asset
turnover.

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Financial Analysis Techniques

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Liquidity ratios measure the ability of a company to meet short-term obligations. Major
liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio.

Solvency ratios measure the ability of a company to meet long-term obligations. Major
solvency ratios include debt ratios (including the debt-to-assets ratio, debt-to-capital ratio,
debt-to-equity ratio, and financial leverage ratio) and coverage ratios (including interest
coverage and fixed charge coverage).

Profitability ratios measure the ability of a company to generate profits from revenue and
assets. Major profitability ratios include return on sales ratios (including gross profit margin,
operating profit margin, pretax margin, and net profit margin) and return on investment ratios
(including operating ROA, ROA, return on total capital, ROE, and return on common equity).

Ratios can also be combined and evaluated as a group to better understand how they fit together
and how efficiency and leverage are tied to profitability.

ROE can be analyzed as the product of the net profit margin, asset turnover, and financial
leverage. This decomposition is sometimes referred to as DuPont analysis.

Valuation ratios express the relation between the market value of a company or its equity (for
example, price per share) and some fundamental financial metric (Ex: earnings per share).

Ratio analysis is useful in the selection and valuation of debt and equity securities and is a part
of the credit rating process.

Ratios can also be computed for business segments to evaluate how units within a business are
performing.

The results of financial analysis provide valuable inputs into forecasts of future earnings and
cash flow.

Next Steps

Work through the examples in the curriculum.

Solve the practice problems in the curriculum.

Solve the IFT Practice Questions associated with this reading.

Review the learning outcomes presented in the curriculum. Make sure that you can perform
the implied actions.

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