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Financial Statement Analysis |
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-involves transforming accounting data into information useful for analysis, forecasting and decision-making |
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Tools and Techniques used in financial analysis |
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Ratio analysis; Common size analysis; cross sectional analysis; trend analysis; charts |
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-mathematical relationship between two quantities in terms of a percentage or a proportion -computation or a ratio is simple but its interpretation may not be as simple -must refer to an economically important relation |
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provide insights into: -microeconomic relationship within the company that are used by analysts to project the company's earnings and cash flows -a company's financial flexibility -a managements ability -changes in the company and industry over time -how the company compares to peer companies and the industry overall |
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-allows analysts to compare a company's performance w that of other firms and to evaluate its performance over time -common size IS are very useful in identifying trends in costs and profit margins --> express each item as a percentage of revenue -common size BS highlight changes in the mix of assets, liabilities and equity -does not tell us the entire story behind co. financials, but it leads us in the right direction and prompts us to ask relevant questions in assessing the company's operating performance over the period and evaluating its prospects going forward --> express each item as percentage of Total assets |
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-compares a specific metric for one co. w the same metric for another co. or group of co. over a period of time -allows comparisons even though co.'s might be of significantly different sizes and/or operate in different countries |
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-provides information about a company's historical performance -can offer assistance in forecasting the financial performance of a company -horizontal common-size financial statements are used when looking for trends over time --> dollar values of accounts are divided by their base-year values to determine their common size values -can help identify structural changes in the business |
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Uses of Charts in Financial Analysis |
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Graphs; pie charts; line graphs; stacked common graph; regression analysis |
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facilitate comparisons of firm performance and financial structures over time, highlighting changes in significant aspects of business operations |
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-most useful in illustrating the composition of a total value |
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-helps identify trends and detect changes in direction or magnitude |
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-illustrates the changes in various items over the period in graph form |
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-can help identify relationships between variables over time and assist analysts in making forecasts |
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Limitations of ration analysis |
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-companies may have divisions that operate in different industries, hard to find relevant industry ratios to use for comparisons -one set of ratios may suggest that there is a problem, but another set may indicate that the potential problem is only ST -no set ranges within which particular ratios for a co. must lie; analyst must own JUDGEMENT to evaluate implications --> examine operations of a company, external industry and economic scenario before interpreting results -enjoy significant latitude in the choice of accounting methods that are acceptable -comparing ratios of firms across international borders is difficult bc of differences in IFRS and US GAAP accounting standards |
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Activity, Liquidity, Solvency, Profitability, Valuation |
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measures how productive a co. is in using its assets and how efficiently it performs its everyday operations |
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measure the company's ability to meet its ST obligations |
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measures a co. ability to meet LT debt obligations. subsets of these ratios are aka "leverage" and "long term debt" ratios |
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measures the company's ability to generate an adequate return on invested capital |
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measure the quantity of an asset or flow (e.g. earnings) associated w ownership of a specific claim (e.g. stock) |
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-goal of ratio analysis" understand the causes of material differences in ratios of a company compared to its peers evaluate ratios based on: -ratios should be compared to company's stated objectives -compared w those of others in the industry -ratios should be studied in light of the current phase of business cycle |
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inventory turnover; days of inventory in hand; receivables turnover;days of sales outstanding; payables turnover; number of days of payables; working capital turnover; fixed asset turnover; total asset turnover |
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COGS / Average inventory -high ratio indicates highly effective mgmt. or it could indicate that the co does not hold adequate inventory levels, which can hurt sales incase shortages arise -low inventory TO suggests that co. has too many resources tied up in inventory, slow moving inventory |
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Days of Inventory on hand (DOH) |
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365 / Inventory Turnover -higher the inventory TO ratio, the shorter the length of the period that inventory is held on average -low number is good |
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Revenue / Avg Receivables -may indicate company's credit collection procedures are highly efficient. can also result from overly stringent credit policies which can hurt sales too -low ratio will raise questions regarding efficiency of a co. credit procedure -comparing co. sales growth w industry sales growth can help determine whether the reason behind a high receivables to RATIO IS STRICT CREDIT TERMS OR EFFICIENT MGMT -can also compare current estimates of bad debts w co's past estimates and peer companies' estimates -high number is good |
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Days of Sales Outstanding |
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365 / receivables turnover -tells us how long it takes to collect receivables -lower the better |
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Purchases / Average Trade Payables -measures how many times a year the company pays off all its creditors -high ratio could indicate that co is not making full use of available credit facilities and repaying creditors too soon, could also result from a co making payments early to avail early payment discounts -low ratio could mean that co is having trouble making pmts on time. could also result from a co. successfully exploting lenient supplier terms -if co has sufficient cash and ST investments, low payables TO ratio is not an indicator of liquidity crisis Purchases = Ending inventory + COGS - Opening inventory |
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Number of Days of Payables |
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365 / Payables Turnover -the higher the payables to, THE LOEWR THE NUMBER OF DAYS OF PAYABLES |
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Revenue / Average working capital -how efficiently the co. generates revenue from its working capitals -higher ratio indicates higher operating efficiency working capital = current assets - current liabilities |
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Revenue / average fixed assets -how efficiently a co. generates revenues from its investments in LLA -higher ratio indicates more efficient use -low ratio could be indicator of operating inefficiency OR the result of a capital intensive business environment |
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Revenue / Avg Total Assets -measures the company's overall ability to generate revenues w a given level of assets -high ratio indicates efficient while a low ratio can indicate inefficient or the level of capital inteisvness of the business -identifies strategic decisions by mgmt. business w highly capital intensive techniques of production will have lower total asset TO |
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Current Ratio; Quick Ratio; cash ratio; defensive interval ratio; cash conversion cycle |
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Current Assets / Current Liabilities -higher ratio is desirable bc it indicates a higher level of liquidity -low ratio implies greater reliance on operating cash flow and outside financing to meet ST obligations -assumes inventory and A/R can readably be converted into cash at close to their fair value |
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Cash + Short term marketable investments + receivables / current liabilities -high quick ratio indicates greater liquidity |
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cash + ST marketable investments / current liabilities -very reliable measure of an entity's liquidity position in the event of an unforeseen crisis. only includes cash and highly liquid ST investments in numerator |
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Cash + ST marketable investments + receivables / daily cash expenditures -measures how long the co. can continue to meet its daily expense recognition from its existing liquid assets without obtaining any additional financing |
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DSO + DOH - number of days of payables -measures the length of the period between the point that a company invests in working capital and the point that the company collects cash proceeds from sales -shorter cycle is desirable and implies greater liquidity |
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-measure the relative amount of debt in a company's capital structure, and the ability of earnings and CFs to meet debt servicing requirements Debt Ratios -Debt to assets ratio; debt to capital ratio; debt to equity ratios; financial leverage ratios Coverage ratios -interest coverage; fixed charge coverage |
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Total Debt / Total Assets -take total debt to be the sum of interest-bearing ST and LT debt -measures the proportion of the firm's total assets that have been financed by debt -higher D/A ratio implies higher financial risk and weaker solvency |
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Total Debt / Total Debt + Shareholders' equity
-measures the proportion of a company's total capital that is composed of debt -higher ratio indicates higher financial risk |
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Total debt / Shareholders' equity
-amount of debt capital relative to a firm's equity capital -higher ratio indicates greater financial risk |
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Average Total Assets / average total equity -measure the amount of total assets supported by each money unit of equity -the higher the ratio, the more leveraged (dependent on debt) the company |
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EBIT / Interest Payment
-number of times a company's operating earnings cover its annual interest payment obligations -gauge how comfortably a company can meet its debt servicing requirements from operating profits -higher ratio is better |
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Fixed Charge Coverage Ratio |
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EBIT + Lease Payments / Interest payments + Lease Payments -measures the number of times a company's operating earnings can cover its interest and lease payments |
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Gross Profit / Revenue
-percentage of a company's revenues that are available to meet operating and non-operating expenses |
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Operating profit / Revenue
-operating profit margin that is increasing at a higher rate than the gross profit margin indicates that the co. has successfully controlled operating costs |
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EBT (earnings before tax, but after interest) / Revenue
-EBT is operating income minus non operating expenses plus non operating income -if a company's pretax margin is rising primarily due to higher non-opaerating income, analyst should evaluate whether this source of income will continue to bring in significant earnings going forward |
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Net Profit / Revenue
-shows how much profit a company makes for every dollar it generates in revenue -low profit margin indicates a low margin of safety |
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net income / average total assets
-measures the return earned by the company on its assets -higher the ROA, the greater the income generated by the company given its total assets -uses only the return to equity holders in numerator |
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NI + Interest expense (1 - Tax Rate) / Avg total assets
- takes into account that assets are financed by both equity holders AND bond holders! |
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EBIT / Average Total Assets
-reflects the return on all assets used by the company, whether financed w debt or equity |
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EBIT / ST debt + LT debt + Equity
-the profits that a company earns on all sources of capital that it employs |
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NI / Average Total Equity
rate of return earned by a company on its equity capital -shows how well a company uses its investment dollars to generate earnings |
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Net Income - Preferred Dividends / Avg Common equity
-measures the return earned by a company only on its common equity |
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Relationships among ratios |
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EX) if current ratio is increasing and quick ratio is decreasing then the difference must be due to changes in certain current assets that are not included in the quick ratio (e.g. inventory) then we see that DOH is increasing and DSO is decreasing, so company is holding higher levels of inventory and is collecting on its receivables more quickly than before. can conclude that although the co. is collecting on its receivables more quickly than before, the proceeds form sales are being used to purchase inventory which is not being sold as quickly so the company's quick ratio is suffering but not its Current ratio |
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-way of decomposing rOE to see more clearly the underlying changes in the company's operations that dire changes in its ROE -higher leverage will not always lead to increase ROE bc as the co. takes on more debt, its interest costs rise, and the interest burden ratio falls -higher interest and tax expenses, the lower the interest and tax burden will be. so the higher the interest and tax burden the better |
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-methods to value a company's equity valuation ratios -Price to Earnings Ratio; Price to Cash Flow; Price to Sales; Price to Book Value Per share quantities -Basic EPS, Diluted EPS, CF per share, EBITDA per share, dividends per share dividend related quantities -dividend payout ratio, retention rate, sustainable growth rate Industry Specific Ratios |
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Price-to-Earnings Ratio (P/E) |
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price per share / earnings per share -how much a share of common stock is currently worth per dollar of earnings of the company |
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Price to Cash Flow (P/CF) |
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Price per share / Cash flow per share -how much a share of common stock is currently worth per dollar of cash flow of the company |
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Price per share / sales per share -how much a share of common stock is currently worth per dollar of sales of the company |
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Price to Book Value (P/BV) |
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Price per share / Book value per share |
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(NI - Preferred dividends) / Weighted avg. # of ordinary shares outstanding
-earnings of a company attributable to each share of common stock |
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Adjusted income available for ordinary shares reflecting conversion of dilutive securities / weighted avg # of ordinary and potential ordinary shares outstanding
-includes the effects of all outstanding securities whose conversion or exercise will result in a reduction in EPS |
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CF from operations / average # of shares outstanding
-CFO of a company attributable to each share of common stock |
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EBITDA / Average number of shares outstanding
-operating income of a company attributable to each share of common stock |
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common dividends declared/ weighted average number of ordinary shares
-dividends declared of a company attributable to each share of common stock |
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Common Share Dividends / Net income attributable to common shares
-percentage of earnings that a company pays out as dividends to shareholders |
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NI attributable to common shares - common share dividends / NI attributable to common shares
Retention Rate = (1-Dividend payout ratio) |
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Retention Rate * ROE
-co.s sustainable growth is a function of its profitability and its ability to finance its operations from internally generated funds |
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evaluation of credit risk -risk of loss that is caused by a debtor's failure to make a promised payment -credit rating process -EPIT interest coverage, EBITDA interest coverage, Funds from operations to total debt, CFO to tool debt, total debt to total equity |
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-meetings w mgmt -tours of major facilities -meetings of ratings committees where recommendations are voted on after considering factors of : --> business risk --> financial risk --> evaluation of mgmt -monitoring of publicly distributed ratings, including reconsideration of ratings due to changing conditions |
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analyze the performance of underlying business segments to understand the company as a whole -business segment is a separately identifiable component of a co. it is subject to risks and returns that are different from those of other business segments of the co. -geographical segment: distinguishable component of a company that is engaged in providing an individual product or service withn a particular region |
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segment margin, segment TO, segment ROA, segment debt ratio |
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forecasting future earnings |
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-analysts use data about the economy, industry and company itself -results of financial analysis (common size and ratio analysis) are integral to this proess -Sensitivity anaylsis: shows the range of possible outcomes as underlying assumptions are altered -scenario analysis: changes in key financial quantities that result from given events -simulations: computer generated senstivitiy or scenario analyses based on probability models for the factors that drive outcomes |
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