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CFA Level 1 > 3.6 Financial Analysis Techniques > Flashcards

3.6 Financial Analysis Techniques Flashcards

1
Q

Equity analysis focuses on?

A

Growth

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2
Q

Credit analysis focuses on?

A

risk

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3
Q

The following steps could be used for financial statement analysis:

A
  1. Articulate the purpose and context of the analysis.
  2. Collect input data.
  3. Process data.
  4. Analyze/interpret the processed data.
  5. Develop and communicate conclusions and recommendations.
  6. Follow up.
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4
Q

there are several important limitations to consider when using ratios:

A

Industry-specific ratios may not be applicable to companies with heterogeneous operations in multiple industries.

Different ratios can give inconsistent indications about a company.

Ratio analysis requires considerable judgment about, for example, macroeconomic and industry factors.

Comparing companies can be complicated by the use of different accounting standards or different choices that are allowed within the same set of accounting standards.

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5
Q

A vertical analysis of the balance sheet

A

is done with only one reporting period, dividing all items by the total assets

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6
Q

A horizontal analysis of the balance sheet

A

involves multiple time periods or companies.

It focuses on the percentage increase or decrease in each item.

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7
Q

A vertical analysis of the income statement

A

will divide everything by revenue, or, less commonly, by total assets (especially in the case of financial institutions).

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8
Q

Cross-sectional analysis

A

sometimes called relative analysis

compares a specific metric of one company to another

This is more easily done with a common-sized statement.

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9
Q

Trend Analysis

A

Trends are as important as the absolute or relative levels.

A horizontal common-size balance sheet will show everything in relation to the same base year.

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10
Q

The Use of Graphs as an Analytical Tool

A

Graphs can highlight changes in business operations.

They can also be used to effectively communicate the conclusions. Pie graphs are good at decomposing total value, while line graphs are more suited for analyzing changes over time.

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11
Q

Regression Analysis

A

Regression analysis can help identify and explain linear relationships between variables.

This technique is recommended for analysis that is more complex than, for example, observing changes in a particular ratio over time.

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12
Q

It is useful to categorize the large universe of financial ratios into manageable categories based on what they indicate about a company.

In this reading, we consider the following categories of ratios:

A

Activity ratios (operational efficiency)

Liquidity ratios (ability to meet short-term obligations)

Solvency ratios (ability to meet long-term obligations)

Profitability ratios (efficiency in using assets to generate profits)

Valuation ratios (relative price of ownership claims)

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13
Q

Activity Ratios

A

are also called asset utilization ratios or operating efficiency ratios.

They are indicators of ongoing operational efficiency.

They usually combine an income statement item in the numerator with a balance sheet item in the denominator

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14
Q

Inventory turnover

A

COGS / Average Inventory

A high ratio could indicate effective inventory management or inadequate inventory.

A high ratio combined with high revenue growth likely indicates good efficiency.

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15
Q

Days of inventory on hand (DOH)

A

Number of days in period / Inventory turnover

This (along with inventory turnover ratio) can be used to measure inventory effectiveness.

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16
Q

Receivables turnover

A

revenue / average receivables

A high ratio could indicate efficient credit and collection or that the company’s credit standards are too stringent.

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17
Q

Days of sales outstanding (DSO)

A

Number of days in period / receivables turnover

This represents the time between the sale and cash collection.

It would be better if the receivables turnover was only based on credit sales, but that data is not often available.

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18
Q

Payables turnover

A

Purchases / average trade payables

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19
Q

Number of days of payables

A

Number of days in period / Payables turnover

This reflects how many days it takes the company to pay suppliers.

A high ratio could indicate the company is taking advantage of credit opportunities, or perhaps missing out on early payment discounts.

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20
Q

Working capital turnover

A

revenue / average working capital

This ratio measures how effectively a company generates revenue from its working capital.

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21
Q

working capital

A

current assets minus current liabilities.

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22
Q

fixed asset turnover

A

revenue / average net fixed assets

This measures how effective a company is using its fixed assets.

A low ratio could indicate inefficiency or just that the company operates in a capital-intensive industry.

The ratio is normally greater for a company with older assets that have been marked down with depreciation.

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23
Q

total asset turnover

A

revenue / average total assets

This ratio measures the ability to generate revenue with total assets.

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24
Q

Liquidity Ratios

A

Liquidity analysis focuses on the ability to meet short-term obligations

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25
Q

Current ratio

A

current assets / current liabilities

A higher ratio indicates more liquidity, which means more capacity to take on debt.

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26
Q

quick ratio

A

(cash + short-term marketable securities + receivables) / current liabilities

This is more conservative than the current ratio, acknowledging some current assets like prepaid expenses cannot be converted back into cash.

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27
Q

defensive interval ratio

A

(cash + short-term marketable securities + receivables) / daily cash expenditures

measures how long a company can pay its daily cash expenditures with only existing liquid assets (i.e., no additional cash inflows).

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28
Q

cash ratio

A

(cash + short-term marketable securities) / current liabilities

This is the appropriate ratio during a crisis situation.

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29
Q

Solvency Ratios

A

relate to a company’s ability to meet its long-term debt.

The amount and type of debt will influence the future risk and return of the company.

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30
Q

Leverage results from?

A

fixed costs

can either come from operating leverage or financial leverage.

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31
Q

Operating leverage

A

comes from the use of fixed costs in the business operations

It will cause operating income to increase faster than revenues

32
Q

financial leverage

A

arises from fixed financing costs

It will magnify the earnings flowing to equity holders

The use of leverage could signal management’s confidence in future profitability.

33
Q

Debt-to-assets ratio

A

total debt / total assets

This is the percentage of total assets financed with debt.

34
Q

debt-to-equity ratio

A

total debt / total shareholder’s equity

35
Q

financial leverage ratio

A

average total assets / average total equity

This represents the amount of total assets supported by each unit of equity.

36
Q

debt to EBITDA

A

Total debt / EBITDA

37
Q

Coverage Ratios

A

used to show the level of income that is available to meet a company’s fixed financial obligations

38
Q

interest coverage

A

EBIT / interest payments

Interest coverage is also called times interest earned because it represents how many times EBIT can cover the interest payments.

39
Q

Fixed charge coverage

A

(EBIT + Lease payments) / (Interest payments + Lease payments)

The fixed charge coverage is the number of times earnings can cover interest and lease payments.

40
Q

Profitability Ratios

A

indicate a company’s ability to use its assets to generate returns.

Analysts may be interested in returns relative to sales or returns on invested capital.

41
Q

Gross profit margin

A

Gross profit / revenue

The gross profit margin is the percentage of revenue available to cover expenses and generate profit. This ratio is affected by competition.

42
Q

Operating profit margin

A

operating profit / revenue

43
Q

pretax margin

A

EBT / revenue

EBT is operating profit minus interest.

44
Q

Net profit margin

A

net income / revenue

Often the net income is adjusted for non-recurring items.

45
Q

Operating return on assets

A

operating income / average total assets

46
Q

return on Assets (ROA)

A

net income / average total assets

Some analysts prefer to add back the after-tax interest expense in the numerator since the denominator represents assets financed by debt and equity.

47
Q

return on capital

A

EBIT / (Short Term and Long Term Debt and Equity)

48
Q

Return on equity (ROE)

A

Net Income / Average total equity

49
Q

Return on common equity

A

(Net Income - Preferred dividends) / average common equity

50
Q

DuPont analysis

A

examine the overall position and profitability of a company

decomposing the company’s return on equity (ROE)

Each component represents a different aspect of the company’s profitability.

51
Q

according to the Dupont analysis, how can you decompose ROE?

A

ROE = net Income / Average Shareholders’ equity

ROE = ROA * Leverage

ROE = Net Profit Margin * Total Asset Turnover * Leverage

ROE = Tax Burden * Interest Burden * Total Asset Turnover * Leverage

52
Q

The best-known valuation ratios are expressed as multiples of an equity’s market price.

They include:

A

P/E (price-to-earnings)

P/S (price-to-sales)

P/CF (price-to-cash flow)

P/B (price-to-book value)

53
Q

The most popular valuation ratio

A

P/E (price-to-earnings)

which indicates the price that investors are willing to pay for one unit of a company’s net income.

54
Q

P/S (price-to-sales)

A

can be used to analyze and compare entities that do not currently have positive net income.

55
Q

P/CF (price-to-cash flow)

A

is often used when there are concerns about the quality of a company’s reported earnings.

56
Q

P/B (price-to-book value)

A

provides an indication of the market’s assessment of the company’s expected future returns relative to the required rate of return.

57
Q

Basic earnings per share (EPS)

A

the amount of earnings (net income) for each share of common stock.

If the company has issued new common stock or repurchased shares during the earnings period, the time-weighted average number of shares outstanding is used as the denominator.

58
Q

diluted EPS

A

makes adjustments for the effect of dilutive securities (e.g., convertible debt, options).

59
Q

The dividend payout ratio

A

the percentage of earnings the company pays out as dividends

60
Q

The retention rate

A

the percentage of earnings that are retained by the company to be reinvested in new projects

A company with a 40% dividend payout ratio has a 60% retention rate.

61
Q

A company’s sustainable growth rate

A

a function of its profitability (return on equity) and its retention rate

g = b * ROE

b = retention rate

62
Q

Credit risk

A

measures the exposure to counterparties not making promised payments

63
Q

Credit analysis

A

the evaluation of credit risk.

It could relate to a specific transaction or a borrower’s overall credit risk.

The probability of default can be determined and communicated.

64
Q

EBITDA interest coverage ratio

A

EBITDA / interest expense (including non-cash interest)

65
Q

Free funds from operations (FFO) to debt

A

FFO / Total debt

66
Q

free operating cash flow (CFO)

A

CFO / total debt

67
Q

EBIT margin

A

EBIT / total revenues

68
Q

EBITDA margin

A

EBITDA / total revenues

69
Q

Debt to EBITDA

A

Total Debt / EBITDA

70
Q

return on capital

A

EBIT / average total capital

71
Q

Many studies have been conducted to determine which ratios help predict bankruptcies. One study found the best six ratios were:

A

cash flow to total debt

ROA

total debt to assets

working capital to total assets

current ratio

no-credit interval ratio.

72
Q

An operating segment

A

a unit of a company with its own distinct financial information

A start-up unit that has yet to begin generating revenue may be treated as a separate business unit.

73
Q

Sensitivity analysis

A

measures the impact of changes in specific assumptions by producing a range of outcomes.

This method is also known as “what if” analysis.

74
Q

Scenario analysis

A

models the impact of economic events, such as the loss of a key supplier.

If the possible events are mutually exclusive and collectively exhaustive, it is possible to assign probabilities and estimate expected values.

75
Q

Simulation

A

uses computer models to run sensitivity or scenario analysis and generates a forecast based on the probability assigned to each outcome.

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