Chapter 6FINANCIAL ANALYSIS

TECHNIQUES

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CONTENTS
1. Introduction

2. The Financial Analysis Process

3. Analytical Tools and Techniques

4. Common Ratios Used in Financial Analysis

5. Equity Analysis

6. Credit Analysis

7. Business and Geographic Segments

8. Model Building and Forecasting

9. Summary
 FINANCIAL ANALYSIS TOOLS:DESCRIPTION

Graphics
Regression
Common-Size Analysis
Financial Ratio Analysis

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 EXAMPLE 1: OPERATING PROFITBY
GEOGRAPHIC SEGMENT

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 EXAMPLE 2: OPERATING PROFITBY
GEOGRAPHIC SEGMENT, 2016–2018

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 EXAMPLE 3: QUARTERLY GROSS PROFITS

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 EXAMPLE 4: REGRESSION

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 COMMON-SIZE ANALYSIS
Common-size analysis: Express financial data, including entire financial
statements, in relation to a single financial statement item or base.

Vertical common-size
Balance sheet: Each item as a percent of total assets.
Income statement: Each item as a percent of total net revenues.
Cash flow: Each line as a percent of sales, assets, or total in and out.
Highlights composition and identifies what’s important.

Horizontal common-size
Percentage increase or decrease of each item from the prior year or
showing each year relative to a base year.
Highlights items that have changed unexpectedly or have unexpectedly
remained unchanged.

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 COMMON-SIZE BALANCE SHEET EXAMPLE:
SINGLE COMPANY, TWO PERIODS
Partial common-size balance sheet

Period 1 Period 2
% of Total % of Total
Assets Assets
Cash 25 15
Receivables 35 57
Inventory 35 20
Fixed assets, net of 5 8
depreciation
Total assets 100 100

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 COMMON-SIZE BALANCE SHEET EXAMPLE:CROSS-
SECTIONAL, TWO COMPANIES, SAME TIME

Partial common-size balance sheet

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USE OF COMPARATIVE GROWTH INFORMATION:
EXAMPLE

Company A, Inc. 2018 vs. 2017

Revenue +19%
Receivables +38%
Inventory +58%

Why are receivables growing so much faster than revenue?

Why is inventory growing so much faster than revenue?

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 FINANCIAL RATIOS

Ratios
Express one number in relation to another.
Standardize financial data in terms of mathematical
relationships expressed as percentages, times, or days.
Facilitate comparisons—trends and across companies.
Ratios are interrelated.

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 RATIO ANALYSIS

How profitable was Company X?

15.26%
A ratio is NOT the answer (except sometimes on an exam).
A ratio is an indicator—for example, an indicator of relative
activity, profitability, liquidity, solvency.

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 RATIO ANALYSIS
How profitable was company X?

COMPANY X’S PROFITABILITY HAS

IMPROVED. ITS NET PROFIT MARGIN
WAS 15.3%, UP FROM 14.9% LAST
YEAR.
A ratio is NOT the answer (except sometimes on an exam).
A ratio is an indicator—for example, an indicator of
relative activity, profitability, liquidity, solvency.
Interpretation generally involves comparison. Furthermore,
analysis will address the question of why.

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 RATIO ANALYSIS
How profitable was Company X?
COMPANY X WAS MORE PROFITABLE THAN
COMPANY Y AS EVIDENCED BY ITS NET
PROFIT MARGIN. COMPANY X’S MARGIN OF
15.3% WAS HIGHER THAN COMPANY Y’S
MARGIN OF 12.0%.

A ratio is NOT the answer (except sometimes on an exam).

A ratio is an indicator—for example, an indicator of relative
activity, profitability, liquidity, solvency.
Interpretation generally involves comparison. Furthermore,
analysis will address the question of why.

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 USING FINANCIAL ANALYSIS TOOLS

Computation ≠ Analysis

Analysis goes beyond collecting data and computing numbers.

Analysis encompasses computations and interpretations.
Where practical, directly experience the company’s business.
Analysis of past performance:
What aspects of performance are critical to successfully competing in the
industry?
How well did the company perform (relative to own history and relative
to competitors)?
Why? What caused the performance?
Does the performance reflect the company’s strategy?

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 USING FINANCIAL ANALYSIS TOOLS
Not every ratio is relevant in every situation.
Some ratios are irrelevant for certain companies.
Some ratios are redundant.
Industry-specific ratios can be as important as general
financial ratios.
Different users and questions (e.g., creditors, investors) focus
on different ratios.

Different sources categorize some ratios differently and include

different ratios.
Differences in accounting standards can limit comparability.

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 CATEGORIES OF FINANCIAL RATIOS

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 PROFITABILITY AND OVERVIEW

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 MEASURE OF PROFITABILITY:RETURN ON
EQUITY (ROE)
What rate of return has the firm earned on the shareholders’ equity
it had available during the year?

The general form of the rate of return computation:

Applied to shareholders’ equity:

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 DECOMPOSE ROE

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 DECOMPOSE ROE

A company can increase its ROE

1. With a business strategy, by increasing its ROAand/or
2. With a financial strategy, by increasing its use of leverage as
long as returns on the incremental investment exceed the cost of
borrowing.

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 RETURN ON ASSETS

What rate of return has the firm earned on the assets it had available to use during
the year?

The general form of this computation is the same:

Two variants of ROA computation:

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 PROFITABILITY, COMPETITION, AND BUSINESS
STRATEGY

In other words,
ROA can
be thought
of as:

Profit margin × Turnover (efficiency)

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 DECOMPOSINGRETURN ON EQUITY

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 DECOMPOSINGRETURN ON EQUITY

What was the source of the firm’s return on equity?

To what extent
. . . was it derived from selling a high margin product or keeping expenses
low—deriving more profits from each $1 of sales? (return on sales, net profit
margin)
. . . was it derived from generating higher sales from a lower investment in
assets? (efficient use of assets, also known as turnover or efficiency)
. . . was it derived from investing a lower amount of equity—by using more
debt in its capital structure? (financial leverage)

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 DECOMPOSING RETURN ON EQUITY:STYLIZED
COMPARATIVE ANALYSIS MINI-CASE

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 DECOMPOSING RETURN ON EQUITY:STYLIZED
COMPARATIVE ANALYSIS MINI-CASE

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 DECOMPOSING RETURN ON EQUITY:
COMPARATIVE

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DUPONT ANALYSIS :FURTHER DECOMPOSITION

ROE = Net income/Average equity

Decompose ROE into five factors

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 PROFITABILITY: RETURN ON SALES (FROM THE
COMMON-SIZE INCOME STATEMENT)

Gross profit margin = Gross profit/Revenue

Measures the ability to translate sales into profit after consideration of cost of
products sold.

Operating profit margin = Operating profit/Revenue

Measures the ability to translate sales into profit after consideration of operating
expenses.

Net profit margin = Net profit/Revenue

Measures the ability to translate sales into profit after consideration of all
expenses and revenues, including interest, taxes, and non-operating items.

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 DISCUSSION BY CATEGORY

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 ACTIVITY RATIOS
Also known as asset utilization or operating efficiency ratios.
How efficiently is the firm using its assets? How many dollars of sales was the
firm able to generate from each dollar of assets?
Broadly:
Asset turnover = Revenue/Average total assets
Low or declining ratios could mean:
Sales are sluggish,
A heavy investment in assets (inefficient? plant modernization to help in
future? strategy shift?), and/or
Asset mix changed.
Specifically, for fixed assets:
Fixed asset turnover = Revenue/Average net fixed assets
Can compute for any category of assets.

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 ACTIVITY RATIOS

Also known as asset utilization or operating efficiency

ratios

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 OTHER COMMON ACTIVITY RATIOS

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ACTIVITY RATIOS AND THE CASH CYCLE
(CASH CONVERSION CYCLE, A LIQUIDITY RATIO)

Cash cycle: How long does it take for the firm to go from cash to cash?

Service company: sell service → receive cash.

Merchandising company: buy inventory → sell inventory → receive cash
and pay for inventory.
Manufacturing company: buy raw materials → make product → sell
product → receive cash and pay for materials and labor.

Cash conversion cycle (net operating cycle) = Days sales outstanding + Days
inventory held – Number of days of payables

Close link to liquidity

Working capital (current assets minus current liabilities) reflects the

investment required to support this cycle.

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 LIQUIDITY

How well positioned is the firm to meet its near-term

obligations?
Current ratio = Current assets/Current liabilities
Quick ratio = (Cash + Short-term marketable investments +
Account receivables)/Current liabilities
Cash ratio = (Cash + Short-term marketable investments)/ Current
liabilities

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 DISCUSSION BY CATEGORY

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 SOLVENCY: HOW WELL POSITIONED IS THE
FIRM TO MEET ITS LONGER-TERM LIABILITIES?
Debt ratios: How has the company financed itself?
Debt to total assets
Debt to equity
Debt to total capital
} Lower ratio –> safer.
Higher cushion against potential
creditor losses

Coverage ratios: Degree to which earnings or cash flow can decline

without affecting firm’s ability to pay interest.
EBIT interest coverage = (EBT + Interest payments)/Interest
payments
Fixed charge coverage = (EBIT + Lease payments)/(Interest payments
+ Lease payments)

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 COMMON SOLVENCY RATIOS

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 DISCUSSION BY CATEGORY

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VALUATION RATIOS: PRICE-TO-EARNINGS RATIO

P/E relates earnings per common share to the market price at which the
stock trades, expressing the “multiple” that the stock market places on
a firm’s earnings.

High P/E indicates

Firm is valued highly by market, possibly because of growth

expectations, or
That a firm may have very low earnings per share.

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 VALUATION RATIOS

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 DIVIDEND-RELATED QUANTITIES

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 SELECTED CREDIT RATIOS USED BY STANDARD &
POOR’S AS PART OF CREDIT ANALYSIS

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 SELECTED CREDIT RATIOS USED BY STANDARD &
POOR’S AS PART OF CREDIT ANALYSIS

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 SEGMENT ANALYSIS EXAMPLE:L’ORÉAL

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 MODEL BUILDING:EXAMPLES OF POSSIBLE
USES OF RATIOS

Sales forecast (percent change from horizontal common-size income

statement)

Expenses (from common-size income statement)

Gross profit (gross profit margin)
Operating profit (operating profit margin)

Assets (days receivable, days payable, PP&E turnover)

Liabilities (leverage ratios)

Cash flow

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 RATIOS IN MODEL BUILDING

Forecast Sales forecast

Debt

Expenses
Forecast Forecast Gross Profit
Cash Flow Interest Operating
Expense Profit
Assets
Liabilities
Forecast
Income and
Taxes Cash Flow

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 SUMMARY

Graphics facilitate comparisons, and regressions quantify statistical

relationships.
Common-size analysis expresses financial data, including entire financial
statements, in relation to a single financial statement item or base.
Ratios, which express one number in relation to another, facilitate
comparisons—trends and cross-sectional.
A ratio is an indicator of
Activity
Profitability
Liquidity
Solvency

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