Chapter 27 - Financial Analysis Techniques Flashcards
Define “ratio” as it relates to financial analysis.
A ratio expresses a mathematical relationship between two quantities in terms of a percentage or a proportion. Ratios may be computed using data directly from companies’ financial statements or from other available databases. Computation of a ratio is a simple arithmetic operation but its interpretation may not be that simple. To be meaningful, a ratio must refer to an economically important relation.
What do financial ratios provide insight into?
- Microeconomic relationships within the company that are used by analysts to project the company’s earnings and cash flows.
- A company’s financial flexibility.
- Management’s ability.
- Changes in the company and industry over time.
- How the company compares to peer companies and the industry overall.
What do common-size statements allow analysts to do?
Common‐size statements allow analysts to compare a company’s performance with that of other firms and to evaluate its performance over time.
What do common-size income statements express? Why are they useful?
A common‐size income statement expresses all income statement items as a percentage of revenues. Common‐size income statements are extremely useful in identifying trends in costs and profit margins. Further, certain financial ratios are explicitly stated on these statements (e.g., the gross profit margin and the net profit margin).
What is the equation for vertical common-size income statement percentage?
Vertical common-size income statement percentage = (Income statement account/Revenue) x 100
What do common-size balance sheets express? Why are they prepared?
Common‐size balance sheets express each item as a percentage of total assets. Common‐ size balance sheets are prepared to highlight changes in the mix of assets, liabilities, and equity.
What is the equation for vertical common-size balance sheet percentage?
Vertical common-size balance sheet percentage = (Balance sheet account/Total assets) x 100
What is cross-sectional analysis? Why is it useful?
Cross‐sectional analysis, also known as relative analysis, compares a specific metric for one company with the same metric for another company or group of companies over a period of time. This allows comparisons even though the companies might be of significantly different sizes and/or operate in different countries. Consider two companies from the same industry. If one of them has accounts receivable representing 20% of its total assets, while the other has 40% of its assets in the form of accounts receivable, we might conclude that the latter has a greater proportion of credit sales or that it uses aggressive accounting policies for revenue recognition.
What does trend analysis provide? What do you prepare to look for trends over time?
Trend analysis provides important information about a company’s historical performance. It can also offer assistance in forecasting the financial performance of a company. When looking for trends over time, horizontal common‐size financial statements are often prepared. Dollar values of accounts are divided by their base‐year values to determine their common‐size values. Horizontal common‐size statements can also help identify structural changes in the business.
We can use horizontal common‐size analysis to evaluate the financial performance of the company. The year‐on‐year percentage changes for various financial variables are calculated below: What do you see?
The percentage growth figures allow us to draw the following conclusions:
- Net income is growing faster than revenue. This indicates increasing profitability. However, the analyst should dig deeper and identify the source of this higher net income (i.e., whether it results from continuing operations, or from nonoperating, nonrecurring items).
- The company’s operating cash flow is decreasing. This is a cause for concern and requires further investigation. The fact that operating cash flow is declining in spite of the positive growth in revenues may indicate a problem with the company’s earnings quality (e.g., aggressive recognition of revenue).
- Total assets are growing faster than revenue. This suggests that the company’s efficiency levels are declining. The analyst should look to identify the reason for the high growth rate in assets and also examine the composition of the increase in assets.
Using charts in financial analysis, how do graphs help?
Graphs facilitate comparisons of firm performance and financial structure over time, highlighting changes in significant aspects of business operations. They may also be used to communicate important conclusions of financial analysis.
Using charts in financial analysis, how do pie charts help?
Pie charts are most useful in illustrating the composition of a total value. For example, a pie chart should be used when presenting the components of total expenses for the year (COGS, SG&A, depreciation).
Using charts in financial analysis, how do line graphs help?
Line graphs help identify trends and detect changes in direction or magnitude. For example, a line graph that illustrates a marked increase in accounts receivable while cash balances are falling indicates that the firm might have problems managing its working capital going forward.
Using charts in financial analysis, how do stacked common graph help?
A stacked common graph illustrates the changes in various items over the period in graphical form. Figure 1-1 illustrates the asset mix of Bilan Company. It is quite clear from this graph that while total assets are generally increasing over the 5‐year period, an increasing proportion of the company’s assets are composed of receivables.
Using charts in financial analysis, how does regression analysis help?
Regression analysis can help identify relationships between variables (e.g., between sales and inventory) over time and assist analysts in making forecasts (e.g., the relationship between GDP and sales can be used to make revenue forecasts).
For limitations of Ratio Analysis, how does industry comparison affect analysis?
Companies may have divisions that operate in different industries. This can make it difficult to find relevant industry ratios to use for comparisons.
For limitations of Ratio Analysis, how do conflicting ratios affect analysis?
One set of ratios may suggest that there is a problem, but another set may indicate that the potential problem is only short term.
For limitations of Ratio Analysis, how does ratios range affect analysis?
There are no set ranges within which particular ratios for a company must lie. An analyst must use her own judgment to evaluate the implications of a given value for a ratio. This usually involves examining the operations of a company, the external, industry and economic scenario before interpreting results and drawing conclusions.
For limitations of Ratio Analysis, how do accounting methods affect analysis?
Firms enjoy significant latitude in the choice of accounting methods that are acceptable given the jurisdiction in which they operate. For example, under U.S. GAAP, companies can:
- Use the FIFO, AVCO, or LIFO inventory cost flow assumption.
- Choose from a variety of depreciation methods.
For limitations of Ratio Analysis, how do regulatory bodies affect analysis?
Comparing ratios of firms across international borders is even more difficult in that most countries use IFRS. Despite the growing convergence between IFRS and U.S. GAAP, significant differences remain, which make it very difficult for analysts to compare ratios of firms that use different accounting standards.
Across the analyst community, what is important to understand about the differences in exact ratio definitions?
It is also important to understand that the exact definitions of certain ratios vary across the analyst community. For example, in measuring leverage, some analysts use total liabilities, while others using only interest‐bearing debt.
What has research shown about the usefulness of ratio analysis?
Research has shown that in addition to being useful in evaluating the past performance of a company, ratios can be useful in predicting future earnings and equity returns.
Ratios are typically classified into the following categories:
Activity
Liquidity
Solvency
Profitability
Valuation
Based on the categories that ratios are typically classified into, define the activity classification.
Activity ratios measure how productive a company is in using its assets and how efficiently it performs its everyday operations.
Based on the categories that ratios are typically classified into, define the liquidity classification.
Liquidity ratios measure the company’s ability to meet its short-term cash requirements.
Based on the categories that ratios are typically classified into, define the solvency classification.
Solvency ratios measure a company’s ability to meet long‐term debt obligations.
Based on the categories that ratios are typically classified into, define the profitability classification.
Profitability ratios measure a company’s ability to generate an adequate return on invested capital.
Based on the categories that ratios are typically classified into, define the valuation classification.
Valuation ratios measure the quantity of an asset or flow (e.g., earnings) associated with ownership of a specific claim (e.g., common stock).
Based on the categories that ratios are typically classified into, what is an important note about the categories not being mutually exclusive.
These categories are not mutually exclusive. Some ratios are useful in evaluating multiple aspects of the business. Certain profitability ratios, for example, also reflect the operating efficiency of the business.
How are financial ratios compared and analysed?
The financial ratios of a company are compared to those of its major competitors in cross-sectional analysis. A company’s ratios for a given year can also be compared to its own prior period ratios to identify trends. The goal of ratio analysis is to understand the causes of material differences in ratios of a company compared to its peers.
Why should an analyst evaluate ratios based on company’s objectives?
Actual ratios should be compared to the company’s stated objectives. This helps in determining whether the company’s operations are moving in line with its strategy.
If a company’s financial ratios are compared with those of the same industry, the analyst should be careful because:
- Not all ratios are important to every industry.
- Companies may have several lines of business, which can cause aggregate financial ratios to be distorted. In such a situation, analysts should evaluate ratios for each segment of the business in relation to relevant industry averages.
- Companies might be using different accounting standards.
- Companies could be at different stages of growth or may have different strategies. This can result in different values for various ratios for firms in the same industry.
Why should an analyst evaluate ratios based on company’s current phase?
Ratios should be studied in light of the current phase of the business cycle.
What are activity ratios and what do they measure?
Activity ratios are also known as asset utilization ratios or operating efficiency ratios. They measure how well a company manages its operations and particularly how efficiently it manages its assets—working capital and long‐lived assets.
What is the inventory turnover ratio equation and what is it used to evaluate?
Inventory turnover = (Cost of goods sold/Average inventory)
This ratio is used to evaluate the effectiveness of a company’s inventory management. Generally, this ratio is benchmarked against the industry average.
What does a high inventory turnover ratio indicate?
A high inventory turnover ratio relative to industry norms might indicate highly effective management. Alternatively, it could also indicate that the company does not hold adequate inventory levels, which can hurt sales incase shortages arise. A simple comparison of the company’s sales growth to the industry’s growth in sales can indicate whether sales are suffering because too little stock is available for sale at any given point in time.
What does a low inventory turnover ratio indicate?
A low inventory turnover relative to the rest of the industry can be an indicator of slow moving or obsolete inventory. It suggests that the company has too many resources tied up in inventory.
What is the days of inventory on hand (DOH) ratio equation and what is it used to evaluate?
Days of inventory on hand (DOH) = (365/Inventory Turnover)
The ratio evaluates the length of the period the inventory is held on average.
This ratio is inversely related to inventory turnover.
What does a higher days of inventory on hand (DOH) ratio indicate?
The higher the inventory turnover ratio, the shorter the length of the period that inventory is held on average.
What is the receivable turnover ratio and what is it used to evaluate?
Receivable turnover = Revenue/Average receivables
It evaluates the efficiency of a company’s credit or collection policies.
What does a high receivable turnover ratio indicate?
A high receivables turnover ratio might indicate that the company’s credit collection procedures are highly efficient. However, a high ratio can also result from overly stringent credit or collection policies, which can hurt sales if competitors offer more lenient credit terms to customers.
What does a low receivable turnover ratio indicate?
A low ratio relative to industry averages will raise questions regarding the efficiency of a company’s credit or collection procedures.
How can we come to a conclusion about a high or low receivable turnover ratio value?
As with the inventory turnover ratio, a simple comparison of the company’s sales growth with industry sales growth can help determine whether the reason behind a high receivables turnover ratio is strict credit terms or efficient receivables management.
Analysts can also compare current estimates of the company’s bad debts and credit losses with its own past estimates and peer companies’ estimates to assess whether low receivables turnover is the result of credit management issues.
What is the days of sales outstanding (DSO) ratio equation and what does it indicate?
Days of sales outstanding (DSO) = 365/Receivables turnover
This ratio indicates the length of period receivables are cashed on average.
How are days of sales outstanding (DSO and receivables turnover ratio related?
The receivables turnover ratio and days of sales outstanding are inversely related.
The higher the receivables turnover ratio, the lower the DSO.
What is the payables turnover ratio equation? What does it measure? If the amount for purchases over the year is usually not explicitly stated on the income statement; it is typically only disclosed in the footnotes to the financial statement. If we have to calculate purchases, what is the formula?
Payables turnover = (Purchases/Average trade payables)
Payables turnover measures how many times a year the company theoretically pays off all its creditors.
Purchases = Ending inventory + COGS − Opening inventory
What does a high payables turnover ratio indicate?
A high ratio can indicate that the company is not making full use of available credit facilities and repaying creditors too soon. However, a high ratio could also result from a company making payments early to avail early payment discounts.
What does a low payables turnover ratio indicate?
A low ratio could indicate that a company might be having trouble making payments on time. However, a low ratio can also result from a company successfully exploiting lenient supplier terms. If the company has sufficient cash and short-term investments, the low payables turnover ratio is probably not an indication of a liquidity crisis. It is probably a result of lenient supplier credit and collection policies.
What is the number of days of payables ratio equation? What does it evaluate?
Number of days payables = 365/Payables turnover
Number of days payables indicates the average length of time it takes for a company to pay off its creditors.
What does a higher payables turnover ratio indicate? How is it related to the payables turnover ratio?
The number of days of payables is inversely related to the payables turnover ratio.
The higher the payables turnover, the lower the number of days of payables.
What is the working capital turnover ratio equation? What does it indicate?
Working capital turnover = Revenue/Average working capital
Working capital turnover indicates how efficiently the company generates revenue from its working capital. Working capital equals current assets minus current liabilities
What does a higher working capital turnover ratio indicate?
A higher working capital turnover ratio indicates higher operating efficiency.
What is the fixed asset turnover ratio equation? What does it indicate?
Fixed asset turnover = Revenue/Average fixed assets
This ratio measures how efficiently a company generates revenues from its investments in long‐lived assets.
What does a high fixed asset turnover ratio indicate?
A higher ratio indicates more efficient use of fixed assets in generating revenue.
What does a low fixed asset turnover ratio indicate?
A low ratio could be an indicator of operating inefficiency. However, a low fixed asset turnover can also be the result of a capital intensive business environment. Companies that have recently entered a new business that is not fully operational also report low fixed asset turnover ratios.
How does the age of assets affect the fixed asset turnover ratio?
The fixed asset turnover ratio will be lower for a firm whose assets are newer than for a firm whose assets are relatively older. The older‐asset firm will have depreciated its assets for a longer period so the book value of its fixed assets will be lower.
What is the total asset turnover ratio equation? What does it evaluate?
Total asset turnover = Revenue/Average total assets
Total asset turnover measures the company’s overall ability to generate revenues with a given level of assets.
What does high/low total asset turnover ratio indicate?
A high ratio indicates efficiency, while a low ratio can be an indicator of inefficiency or the level of capital intensity of the business.
How does the total asset turnover ratio relate to strategic decisions by management?
This ratio also identifies strategic decisions by management. For example, a business that uses highly capital-intensive techniques of production will have a lower total asset turnover compared to a business that uses labor-intensive production methods.
List the commonly used activity ratios and their equations.
Inventory turnover = Cost of goods sold/Average Inventory
Days of inventory on hand (DOH) = Number of days in period/Inventory Turnover
Receivables turnover = Revenue/Average Receivables
Days of sales outstanding (DSO) = 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 fixed net assets
Total asset turnover = Revenue/Average total assets
What is the purpose of liquidity ratios?
Analysis of a company’s liquidity ratios aims to evaluate a short-term obligations. Liquidity measures how quickly a company can convert its assets into cash at prices that are close to their fair values.
What is the current ratio equation? What does it evaluate?
Current ratio = Current assets/Current liabilities
Measures level of liquidity
What does a higher current ratio indicate?
A higher ratio is desirable because it indicates a higher level of liquidity.
What does a current ratio of 1.0 indicate?
A current ratio of 1.0 indicates that the book value of the company’s current assets equals the book value of its current liabilities.
What does a low current ratio indicate?
A low ratio indicates less liquidity and implies a greater reliance on operating cash flow and outside financing to meet short-term obligations.
What is the basic assumption of the current ratio?
The current ratio assumes that inventory and accounts receivable can readily be converted into cash at close to their fair values.
What is the quick ratio equation? What does it indicate?
Quick ratio = (Cash + Short-term marketable investments + Receivables) / Current liabilities
The quick ratio recognizes that certain current assets (such as prepaid expenses) represent costs that have been paid in advance in the current year and cannot usually be converted into cash. This ratio also considers the fact that inventory cannot be immediately liquidated at its fair value. Therefore, these current assets are excluded from the numerator in the calculation of the quick ratio. When inventory is illiquid, this ratio is a better indicator of liquidity than current ratio.
What does a high quick ratio indicate?
A high quick ratio indicates greater liquidity.
What is the cash ratio equation? What does it indicate?
Cash ratio = (Cash + Short-term marketable investments) / Current liabilities
The cash ratio is a very reliable measure of an entity’s liquidity position in the event of an unforeseen crisis. This is because it only includes cash and highly liquid short-term investments in the numerator.
What is the defensive interval ratio equation? What does it indicate?
The defensive interval ratio = (Cash + Short-term marketable investments + Receivables) / Daily cash expenditures
This ratio measures how long the company can continue to meet its daily expense requirements from its existing liquid assets without obtaining any additional financing. A defensive interval of 40 indicates that the company can pay its operating expenses for 40 days by liquidating its quick assets.
What does a high defensive ratio indicate?
A high defensive interval ratio is desirable as it indicates greater liquidity.
What does a low defensive ratio indicate?
If a company’s defensive interval ratio is very low compared to the industry average, the analyst might want to determine whether significant cash inflows are expected in the near future to meet expense requirements.
What is the cash conversion cycle ratio equation? What does it indicate?
The cash conversion cycle = DSO + DOH – Number of days of payables
The cash conversion cycle (also known as net operating cycle) 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. Specifically, it is the time between the outlay of cash (to pay off accounts payable for credit purchases) and the collection of cash (from accounts receivable for goods sold on credit).
In the income statement, detail the link between Net Sales to Income available to common shareholders.
