Ratio Analysis =

Better for identifying questions than answering them.

Limitations:

- not useful in isolation
- comparison between firms is difficult given different accounting practices
- difficult to find comparable industry ratios for companies that operate across different indices
- determining a target or comparison range is difficult

Common size analysis =

vertical CS BS: accounts are a % of total assets

vertical CS IS: accounts are a % of sales. useful for studying trends in cost and profit margins.

Good for ratios: balance sheet accounts are already % and can be slotted into a ratio.

NB: there are also horizontal CS FS: figures for one account are ratios of the first year (rather than as a % of another account)

Graphical Analysis =

stacked column graph

line graph

Regression Analysis =

can be used to identify relationships between variables.

Results are often used for forecasting

Activity Ratios =

measure how efficiently a firm is managing its assets (eg asset utilization/turnover)

A Ratios: receivables turnover =

NB. most times when a BS and IS/CFS item are compared the average of the account will be used:

(Beg + End)/2

"IT IS DESIRABLE TO HAVE A RECEIVABLES TURNOVER CLOSE TO THE INDUSTRY NORM"

A Ratios: days of sales outstanding =

Average number of days it takes for a company's customers to pay bills

"IT IS DESIRABLE TO HAVE A DOSO CLOSE TO THE INDUSTRY NORM"

Too low might mean credit policy is too tight, restricting sales.

Too high means it takes too long to receive payment and firm capital is being tied up in assets (not quite sure what this last bit means...)

A Ratios: Inventory turnover =

firm's efficiency or processing and inventory management

Make sure to use COGS, not sales

A Ratios: Inventory days =

aka average inventory processing period

industry norm is good.

Too high = too much capital is tied up in inventory/some inventory is obselete

Too low = firm has inadequate stock on hand, hurting sales

A Ratios: payables turnover =

purchases = end inventory - beg inventory + COGS

A Ratios: Days Payable =

average amount it takes the company to pay its bills.

Assumption for all the 'days' ratios - turnover ratios are ANNUAL, if quarterly use ~90 instead of 365

A Ratios: Total Asset Turnover =

effectiveness of use of total assets to create revenue.

May vary largely across industries.

Norm is good. Low = too much capital tied up in asset base. High = not enough assets for potential sales, or asset base is outdated.

A Ratios: Fixed Asset Turnover Ratio =

Similar to total asset turnover ratio.

Too low = too much capital tied up in asset base, or inefficient use.

Too high = may have obselete equipment or have to incur capital expenditures in the near future to increase capacity to support growing revenues.

Net = net of depreciation, firms with newer fixed assets will have lower ratios

A Ratios: Working capital turnover ratio =

Low working capital may be from outstanding payables equalling/exceeding inventory and receivables

This means a HIGH ratio - may vary a lot between periods, and is LESS INFORMATIVE about changes in operating efficiency.

L Ratios: Current Ratio =

high = higher likelihood of paying ST liabilities.

CURRENT RATIO < 1 = NEGATIVE WORKING CAPITAL, and potential liquidity crisis

WC = CURRENT ASSETS - CURRENT LIABILITIES

L Ratios: Quick Ratio =

Current ratio minus inventory and other less liquid assets = MORE STRINGENT RATIO

NB. marketable securities are short term debt instruments, normally LIQUID and of GOOD CREDIT

L Ratios: Cash Ratio =

most conservative ratio out of CURRENT, QUICK AND CASH.

Excludes receivables

L Ratios: Defensive Interval Ratio =

shows number of days of average cash expenditures could be paid with current assets.

avg daily exp = COGS, SGA,R&D

If depreciation was taken out in the income statement, it needs to be added back in.

L Ratios: Cash Conversion Cycle FUCK YEA =

time for cash investment in inventory to go back to cash

high CCC = BAD, too much capital investment tied up in the sales process

Solvency Ratios: debt and coverage =

measure leverage and ability to meet LT obligations.

Debt Ratios : based on the BS

Coverage Ratio: based on the IS

S Ratios: debt-to-equity =

measures use of fixed-cost financing sources.

increase: more reliance on debt

decrease: more reliance on equity

for CFA: total debt = LT debt + interest bearing ST debt

S Ratios: debt-to-capital =

where capital = ST+LT debt + Pref stock + eq

S Ratios: debt-to-assets =

S Ratios: (financial) leverage ratio =

average = average of beginning and end of period

S Ratios: Interest Coverage Ratio =

lower = more likely firm will struggle to meet obligations

S Ratios: Fixed charge coverage ratio =

ability to meet obligations (including non debt obligations ie taxes, leases)

better than interest coverage ratio for firms that lease a large portion of their assets

P Ratios: net profit margin =

Net income based on continuing operations as we are concerned with FUTURE EXPECTATIONS.

Operating Profitability ratios and terms =

Gross profits

operating profits

net income

total capital (x2)

how good is management at turning EFFORTS into PROFITS?

to simplify, these ratios compare the top line to the bottom line - sales to profits.

Gross profits = net sales - COGS

operating profits = EBIT

net income = earnings (before dividends)

Total capital = LT + ST debt and comm + pref eq

= total assets

nb. the difference is working capital liabilities such as accounts payable

P Ratios: gross profit margin =

Gross profit can only be increased by raising prices or reducing costs - ability to raise prices may be limited by competition.

P Ratios: Operating profit margin =

EBIT may contain some non operating items - such as gains on investment.

Depr and Amor can be added back in to get EBITDA,

P Ratios: Pretax Margin =

calculated from EBT

P Ratios: ROA (return on assets) =

= net income/assets

However net income excludes interest, but assets includes debt. We have to add back in the tax adjusted interest expense, so that the numerator reflects the **complete return **earned on the assets in the denominator.

P Ratios: Operating Return on Assets =

includes both interest and taxes (where ROA adds back in interest but excludes taxes/taxes paid).

P Ratios: ROTC (Return on Total Capital) =

total capital includes ST + LT debt, pref + comm equity.

There is also an alternative method....

P Ratios: ROE =

sometimes called return on total equity

P Ratios: Return on Common Equity =

often more thoroughly analyzed using DuPont decomposition.

DuPont Analysis =

SIDENOTE: debt/assets + equity/assets = 1

or

(debt+equity)/assets = 1, ie they are equal

used to analyse ROE

ROE = Net Income/Eq

x Rev/Rev

x Ass/Ass

= Net Profit Margin x Asset Turnover x Leverage Ratio

note: Lev Ratio = Ass/Eq

If ROE is low, at least one of the three parts is too low

NOTE FOR EXAM: remember that ROA = (netincome/sales)x(sales/assets)

DuPont - 5 step =

Breakdown net profit margin further.

Increases in the interest/tax burden means lower interest/tax burden ratios, means lower ROE.

If we replace EBIT with operating earnings we have operating margin instead of EBIT margin.

Note that increasing leverage will also increase the interest burden - so does not always increase ROE.

Retention Rate and Sustainable Growth Rate =

RR = proportion of earnings reinvested (retained earnings/net income available to common stock)

g = RR x ROE

Net income/sales per employess, growth in same store sales, sales per square foot =

net income/sales per employee is used in evaluating service businesses.

growth in same store sales shows how well stores are doing at attracting new customers and maintaining existing ones - which locations are doing well

sales per square foot - retail ratio

Business Risk: co-efficient of variation =

co-efficient of variation (std dev/mean) is used to measure the volatility of certain figures - eg variation/uncertaintly of sales or net income for example

Business Risk: Financial Institutions - capital adequacy, reserve reqs, net interest margin =

**capital adequacy** is a measure of risk in relation to the firms equity capital (or other measure of capital). **VAR** is a measure of capital risk - potential dollar size loss over a period of time, a certain percent of the time.

**Reserve requirements**: ratio of various liabilities to their central bank reserves must be above a minumum. (ALSO liquid assets to certain liabilities may have to meet a minimum *liquid asset requirement*)

For a company that lends funds, performance can be measured as **net interest margin**, net interest/interest earning assets.

Credit Analysis (and Altman's Z-score) =

a low score is a predictor of high likelihood of a default.

Based on working capital to assets, retained earnings to assets, EBIT to assets, market to book value of a share of stock, revenues to assets.

Segment Analysis =

a segment is a portion of a larger company that is at least 10% of revenue or assets and is distinguishable from the rest of the company.

Analysts can break down segments to get a more detailed analysis of the company.

Sensitivity and scenario analysis, and simulation =

sensitivity and scenario analysis will yield a range of values for financial statement items.

Sensitivity analysis is based on 'what ifs' - what will be the effect on net income if sales increase 3% rather than the predicted 5%?

Scenario analysis is based on specific scenarios (specific set of outomes for key variables).

Simulation - probability distribution of key variables is used and a computer is used to generate a distribution of outcomes based on random variable selection.