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CFA > 26. Financial Analysis Techniques > Flashcards

26. Financial Analysis Techniques Flashcards

1
Q

What are the tools and techniques to convert financial statement data into formats that facilitate analysis?

A

ratio analysis, common-size analysis, graphical analysis, and regression analysis

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2
Q

Ratio analysis

A

useful tools for expressing relationships among data that can be used for internal comparisons and comparisons across firms

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3
Q

Ratio analysis can be used to do the following:

A
  1. Project future earnings and cash flow. 2. Evaluate a firm’s flexibility (the ability to grow and meet obligations even when unexpected circumstances arise). 3. Assess management’s performance. 4. Evaluate changes in the firm and industry over time. 5. Compare the firm with industry competitors.
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4
Q

Limitations of ratios

A
  1. not useful when viewed by themselves, must be used to compare with other companies and industry 2. comparisons become harder because of different accounting treatments 3. hard to find comparable industry ratios when looking at companies that operate in multiple industries 4. cannot make conclusions by calculating a single ratio, conclusions are made by viewing all ratios relative to one another 5. can’t determine the target or comparison value for a ratio, there must bee some range of acceptable values
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5
Q

Common-size statements

A

normalize balance sheets and income statements and allow the analyst to more easily compare performance

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6
Q

A vertical common-size balance sheet

A

expresses all balance sheet accounts as a percentage of total assets

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7
Q

A vertical common-size income statement

A

expresses all income statement items as a percentage of sales.

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8
Q

vertical common-size income statement ratios

A

income statement account/ sales

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9
Q

vertical common-size balance-sheet ratios

A

balance sheet account/ total assets

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10
Q

How is net income shown on the common-size income statement?

A

net income/revenues - which is the net profit margin

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11
Q

net profit margin

A

tells the analyst the percentage of each dollar of sales that remains for shareholders after all expenses related to the generation of those sales are deducted

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12
Q

Graphical Analysis

A

visually present performance comparisons and composition of financial statement elements over time

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13
Q

stacked column graph

A

shows the changes in items from year to year in graphical form

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14
Q

line graph

A

presents the same data as Stacked Column Graph , but as a line graph

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15
Q

Regression Analysis

A

used to identify relationships between variables results used for forecasting

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16
Q

Two ways of interpreting ratios

A
  1. Cross sectional analysis - comparison to industry norm or average 2. Time series analysis - comparison to a company’s past ratios
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17
Q

Why do we produce common-size statements?

A

because statements are normally in monetary amounts making it hard to compare companies of different sizes and when companies are changing in sizes over time. So we want to convert monetary amounts into relative amounts

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18
Q

Net PP&E

A

gross cost + historic cost - accumulated depreciation

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19
Q

What does an increase of COGS as a percentage of sales mean?

A

either cost of good sold as a monetary value is increasing, or selling price is decreasing

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20
Q

What does a lower net profit margin mean?

A

net profit margin is net income as a percentage of sales. means there is a lower selling price or higher expenses

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21
Q

Different classifications of financial ratios

A
  1. Activity Ratios 2. Liquidity Ratios 3. Solvency Ratios 4. Profitability Ratios 5. Valuation Ratios
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22
Q

Activity Ratios

A

give indications of how well a firm utilizes various assets such as inventory and fixed assets

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23
Q

Activity Ratios are also known as

A

asset utilization or turnover ratios

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24
Q

Examples of Turnover Ratios

A

inventory turnover, receivables turnover, and total assets turnover

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25
Q

Liquidity Ratios

A

refers to the ability to pay short-term obligations as they come due

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26
Q

Solvency Ratios

A

give the analyst information on the firm’s financial leverage and ability to meet its longer-term obligations

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27
Q

Financial leverage

A

degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverag

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28
Q

Profitability Ratios

A

provide information on how well the company generates operating profits and net profits from its sales

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29
Q

Valuation ratios

A

ratios used in comparing the relative valuation of companies

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30
Q

Examples of valuation ratios

A

Sales per share, earnings per share, and price to cash flow per share

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31
Q

Sales per share, earning per share, and price to cash flow per share are examples of

A

valuation ratios

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32
Q

Asset utilisation ratios

A

also known as activity ratios or operating efficiency ratios, measure how efficiently the firm is managing its assets

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33
Q

Receivables Turnover Ratio

A

annual sales/average accounts receivables

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34
Q

What does the receivables turnover ratio measure?

A

measures how efficiently the company collects on the credit that it issues to customers, the ending value of the ratio shows how many times a year the company collects receivables

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35
Q

Average accounts receivables calculated

A

adding beginning of year balance and ending year balance and dividing by 2

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36
Q

What should be the value of the receivables turnover ratio?

A

close to the industry norm

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37
Q

What does a high receivables turnover ratio mean

A

may suggest that a company operates on a cash basis collection of accounts receivable is efficient company has a high proportion of quality customers that pay off their debts quickly suggest that the company has a conservative policy regarding its extension of credit

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38
Q

What is the average collection period or days of sales outstanding?

A

its the inverse of receivables turnover times 365 its the average number of days it takes for the company’s customers to pay their bills

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39
Q

Days of sale outstanding/Average Collection Period

A

365 / receivables turnover

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40
Q

What should be the value of days of sale outstanding/average collection period?

A

industry norm

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41
Q

What does a high days of sale outstanding indicate?

A

collection period that is too high might mean that customers take too long to pay their bills

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42
Q

What does a too low days of sale outstanding indicate?

A

might indicate that the firm’s credit policy is too rigorous, which might be affecting sales

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43
Q

What is Inventory Turnover?

A

a ratio showing how many times a company has sold and replaced inventory during a given period

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44
Q

Inventory turnover

A

cost of goods sold/average inventory

45
Q

Days of inventory on hand/ Average inventory processing period

A

measures the number of days a company takes to sell its average balance of inventory inverse of inventory turnover times 365 365/inventory turnover

46
Q

What does a high days of inventory on hand indicate?

A

might mean that too much capital is invested in inventory and could mean that the inventory is obsolete

47
Q

What does a too low average inventory processing period indicate?

A

might mean that the company does not have enough inventory on hand, which could affect sales

48
Q

What is the Payables Turnover?

A

measures the rate at which a company pays off its suppliers

49
Q

Payables Turnover

A

purchases/average trade payables

50
Q

How to calculate purchases

A

Purchases = ending inventory - beginning inventory + cost of goods sold

51
Q

Payables payment period/ Number of days payable

A

365/payables turnover ratio

52
Q

What is the total asset turnover?

A

measures how effective the firm is in using its total assets to create revenue

53
Q

Total Asset Turnover Ratio

A

revenue/average total assets

54
Q

What does a too low total asset turnover ratio mean?

A

might mean that the company has too much capital tied up to its assets

55
Q

What does a very high total asset turnover mean?

A

might mean that the company has too few assets for potential sales, or that the assets are outdated

56
Q

What is the fixed asset turnover?

A

measures a company’s ability to generate net sales from fixed-asset investments, namely property, plant and equipment (PP&E), net of depreciation

57
Q

What does a higher fixed asset turnover mean?

A

indicates that a company has more effectively utilized investment in fixed assets to generate revenue

58
Q

What does a too low fixed asset turnover mean?

A

might mean that the company has too much capital tied up in its asset base or is using its assets inefficiently

59
Q

What does a too high fixed asset turnover mean?

A

might mean that the firm has obsolete equipment, or that the firm will probably have to incur capital expenditures in the near future to increase capacity to support growing revenues

60
Q

Net Fixed Assets

A

purchase price of fixed assets - accumulated depreciation

61
Q

What is the working capital turnover?

A

measures how efficiently a company is using its working capital to support a given level of sales

62
Q

Working Capital Turnover

A

revenue / average working capital

63
Q

Examples of Liquidity Ratios

A

current ratio, quick ratio, cash ratio, defensive interval, cash conversion cycle

64
Q

What is the current ratio?

A

measures the company’s ability to pay short-term obligations

65
Q

Current Ratio

A

current assets/current liabilities

66
Q

The higher the current ratio,

A

the more likely it is that the company will able to pay its short-term liabilities

67
Q

What does a current ratio less than 1 mean?

A

company has negative working capital and is facing liquidity problems

68
Q

Examples of current liabilities

A

accounts, wages, taxes payable, and the current portion of long-term debt

69
Q

Examples of current assets

A

cash, accounts receivable, inventory and other assets that are expected to be turned into cash in less than a year

70
Q

What is the quick ratio?

A

measures a company’s ability to meet its short-term obligations with its most liquid assets, does not include inventories and other assets that might not be very liquid

71
Q

Quick Ratio

A

cash + marketable securities + receivables/ current liabilities

72
Q

Cash Ratio

A

most liquid measure cash + marketable securities / current liabilities

73
Q

The higher the cash ratio

A

the more likely it is that the company will be able to pay its short-term obligations

74
Q

What is the Defensive Interval Ratio?

A

measure of liquidity that indicates the number of days of average cash expenditures the firm could pay with its current assets

75
Q

Defensive Interval Ratio

A

cash + marketable securities + receivables / average daily expenditures

76
Q

What is the cash conversion cycle?

A

is the length of time it takes to turn the firm’s cash investment in inventory back into cash, in the form of collections from the sales of that inventory

77
Q

cash conversion cycle

A

days of sales outstanding + days of inventory on hand - number of days of payables

78
Q

High cash conversion cycles

A

are undesirable

79
Q

What does a very high cash conversion cycle mean?

A

implies that the company has an excessive amount of capital investment in the sales process

80
Q

What does the analyst do after he has computed the company’s ratios?

A

The analyst looks at the company’s goals and strategy in the MD&A, to check if the ratios that he has computed are consistent with what the company is trying to achieve

81
Q

Which type of companies have more volatile ratios?

A

Cyclical businesses, because when the economy is booming there is an improvement in their ratios but when the economy is not doing well the ratios are below the average

82
Q

Cyclical businesses are going to have more volatile ratios than

A

defensive businesses

83
Q

Defensive businesses

A

businesses that have stable earnings throughout the business cycle

84
Q

Pure ratio

A

both numerator and denominator come from b/s or both numerator and denominator come from the income statement

85
Q

Mixed ratio

A

part of the ratio is coming from the balance sheet and part of the ratio is coming from the income statement

86
Q

When do we take an average when computing ratios?

A

when its a mixed ratio

87
Q

Days of inventory on hand

A

365/inventory turnover - the length of time between receiving raw materials and selling finished goods

88
Q

What does it mean if the current ratio is below 1?

A

it means that current assets are insufficient to pay off current liabilities

89
Q

What is the defensive interval ratio?

A

this ratio is telling you that if the company were to make no more sales, it tells you how long the company could survive if there are no more sources of cash coming in

90
Q

What is the days of inventory on hand + days of sale outstanding?

A

operating cycle

91
Q

What type of companies have negative cash conversion cycles?

A

retail companies, like supermarkets, they collect cash from their customers way before they have to pay their suppliers

92
Q

Examples of solvency ratios

A

debt-to-equity, debt-to-capital, debt-to-assets, financial leverage, interest coverage and fixed charge coverage

93
Q

Solvency ratios

A

looking at ability to service long term obligations, principal payments on debt

94
Q

Earnings Variability

A

variability of your profit, net income

95
Q

What causes earnings variability

A
  1. Businesses Risks 2. Financial Leverage
96
Q

Two components of Business Risk

A
  1. Sales Volatility 2. Operating leverage
97
Q

Explain why sales volatility causes earnings variability?

A

sales volatility is the standard deviation of our sales, our sales going up and down causes earnings to change

98
Q

Fixed costs

A

costs that the company incurs that do not vary in line with its sales, ex: salary

99
Q

Operating profit margin

A

EBIT/sales

100
Q

How does fixed costs affect operating profit margin?

A

since fixed costs don’t vary with sales, you get a much less stable operating profit margin. Fixed costs in the income statement leads to volatility in the earnings

101
Q

Example of a fixed cost

A

interest, because it does not vary in line with your sales`

102
Q

Total debt

A

all interest bearing liabilities

103
Q

Debt-to-assets ratio

A

total debt/total assets

104
Q

What is the debt-to-assets ratio?

A

ratio that defines the total amount of debt relative to assets

105
Q

The higher the debt-to-asset ratio

A

the greater the reliance on debt as a source of financing, hence the larger the financial risk

106
Q

debt-to-capital

A
107
Q

What is the debt-to-capital ratio?

A

this ratio tells you the % of debt in your capital structure

108
Q

What is capital?

A

equals all short-term and long-term debt plus preferred stock and equity

109
Q
A

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