Chapter 9 Financial Statement Analysis

Chapter 9 Financial Statement Analysis
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Financial Disclosures
1. Introduction Financial analysis is a process of selecting, evaluating, and interpreting financial data, along with other pertinent information, in order to formulate an assessment of a company’s present and future financial condition and performance. Financial Analysis Economic Data Market Data Financial Disclosures Pages 347–348 Introduction Financial analysis is a process of selecting, evaluating, and interpreting financial data, along with other pertinent information, in order to formulate an assessment of a company’s present and future financial condition and performance. Information needed: Financial disclosures (e.g., 10-K, annual report, 10-Q, 8-K) Market data (e.g., market price of stock, volume traded, value of bonds) Economic data (e.g., GDP, consumer spending) Copyright © 2013 CFA Institute

2. Common-Size Analysis Common-size analysis is the restatement of financial statement information in a standardized form. Horizontal common-size analysis uses the amounts in accounts in a specified year as the base, and subsequent years’ amounts are stated as a percentage of the base value. Useful when comparing growth of different accounts over time. Vertical common-size analysis uses the aggregate value in a financial statement for a given year as the base, and each account’s amount is restated as a percentage of the aggregate. Balance sheet: Aggregate amount is total assets. Income statement: Aggregate amount is revenues or sales. LOS: Interpret common-size balance sheets and common-size income statements and demonstrate their use by applying either vertical analysis or horizontal analysis. Pages 348–356 2. Common-Size Analysis Common-size analysis is the restatement of financial statement information in a standardized form. Horizontal common-size analysis uses the amounts in accounts in a specified year as the base, and subsequent years’ amounts are stated as a percentage of the base value. Useful when comparing growth of different accounts over time. When viewed graphically, reveals different growth patterns among accounts. Vertical common-size analysis uses the aggregate value in a financial statement for a given year as the base, and each account’s amount is restated as a percentage of the aggregate. Balance sheet: Aggregate amount is total assets. Reveals proportion of asset investment among accounts. Reveals capital structure (proportions of capital). Income statement: Aggregate amount is revenues or sales. Reveals profit margins. Copyright © 2013 CFA Institute

Example: Common-size analysis
Consider the CS Company, which reports the following financial information: Create the vertical common-size analysis for the CS Company’s assets. Create the horizontal common-size analysis for CS Company’s assets, using as the base year. Year 2008 2009 2010 2011 2012 2013 Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40 Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65 Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57 Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29 Intangibles 400.00 402.00 404.01 406.03 408.06 410.10 Total assets $6,500.00 $6,713.30 $6,934.12 $7,162.74 $7,399.45 $7,644.54 LOS: Interpret common-size balance sheets and common-size income statements and demonstrate their use by applying either vertical analysis or horizontal analysis. Pages 348–356 Example: Common-Size Analysis Vertical common-size analysis: Take each account in a given year, and divide it by the total assets. Horizontal common-size analysis: Take each account, and compare a given year’s value with the base year’s value (2008 in this case). Copyright © 2013 CFA Institute

Example: Common-size analysis
Vertical Common-Size Analysis: Graphically: Year 2008 2009 2010 2011 2012 2013 Cash 6% 5% Inventory 23% 22% Accounts receivable 16% 15% Net plant and equipment 50% 51% 52% Intangibles Total assets 100% LOS: Interpret common-size balance sheets and common-size income statements and demonstrate their use by applying either vertical analysis or horizontal analysis. Pages 348–356 Example: Common-Size Analysis Interpretation: The relative investment in fixed assets (currently around 52% of assets), when compared with current assets, has increased since 2008. The proportion of assets that are current assets have decreased slightly over time. Copyright © 2013 CFA Institute

Example: Common-Size Analysis
Horizontal Common-Size Analysis (base year is 2008): Graphically: Year 2008 2009 2010 2011 2012 2013 Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10% Inventory 103.00% 106.09% 109.27% 112.55% 115.93% Accounts receivable 102.00% 104.04% 106.12% 108.24% 110.41% Net plant and equipment 104.00% 108.16% 112.49% 116.99% 121.67% Intangibles 100.50% 101.51% 102.02% 102.53% Total assets 103.08% 106.27% 109.57% 112.99% 116.53% LOS: Interpret common-size balance sheets and common-size income statements and demonstrate their use by applying either vertical analysis or horizontal analysis. Pages 348–356 Example: Common-Size Analysis Interpretation: Net plant and equipment has increased more than other assets since 2008 (annual rate of 4%). Intangibles have increased the least over time. Copyright © 2013 CFA Institute

3. Financial Ratio Analysis
Financial ratio analysis is the use of relationships among financial statement accounts to gauge the financial condition and performance of a company. We can classify ratios based on the type of information the ratio provides: Activity Ratios Effectiveness in putting its asset investment to use. Liquidity Ratios Ability to meet short-term, immediate obligations. Solvency Ratios Ability to satisfy debt obligations. Profitability Ratios Ability to manage expenses to produce profits from sales. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 356–357 3. Financial Ratio Analysis Classifying ratios: Activity ratios Effectiveness in putting asset investment to use. Liquidity ratios Ability to meet short-term, immediate obligations. Solvency ratios Ability to satisfy debt obligations. Profitability ratios Ability to manage expenses to produce profits from sales. Copyright © 2013 CFA Institute

Activity Ratios Turnover ratios reflect the number of times assets flow into and out of the company during the period. A turnover is a gauge of the efficiency of putting assets to work. Ratios: How many times inventory is created and sold during the period. How many times accounts receivable are created and collected during the period. The extent to which total assets create revenues during the period. The efficiency of putting working capital to work LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 358–360 Activity Ratios Turnover ratios reflect the number of times assets flow into and out of the company during the period. A turnover is a gauge of the efficiency of putting assets to work. Inventory turnover: How many times inventory is created and sold during the period. Receivables turnover: How many times accounts receivable are created and collected during the period. Total asset turnover: The extent to which total assets create revenues during the period. Working capital turnover: The efficiency of putting working capital to work. Note: A way of looking at turnover ratios is to consider that the denominator is the investment that is being put to work and the numerator is the result of that effort. Copyright © 2013 CFA Institute

Operating cycle components
The operating cycle is the length of time from when a company makes an investment in goods and services to the time it collects cash from its accounts receivable. The net operating cycle is the length of time from when a company makes an investment in goods and services, considering the company makes some of its purchases on credit, to the time it collects cash from its accounts receivable. The length of the operating cycle and net operating cycle provides information on the company’s need for liquidity: The longer the operating cycle, the greater the need for liquidity. Number of Days of Inventory Number of Days of Receivables | Buy Inventory on Credit Pay Accounts Payable Sell Inventory on Credit Collect Accounts Receivable Number of Days of Payables Net Operating Cycle Operating Cycle LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 360–362 Operating Cycle Components The operating cycle is the length of time from when a company makes an investment in goods and services to the time it collects cash from its accounts receivable. The net operating cycle is the length of time from when a company makes an investment in goods and services, considering the company makes some of its purchases on credit, to the time it collects cash from its accounts receivable. The length of the operating cycle and net operating cycle provides information on the company’s need for liquidity: The longer the operating cycle, the greater the need for liquidity. Note: The operating cycle is also covered in Chapter 8, along with the formulas. Discussion question: Why do we say that a company with a long operating cycle has a greater need for liquidity? Copyright © 2013 CFA Institute

Operating Cycle Formulas
Average time it takes to create and sell inventory. Average time it takes to collect on accounts receivable. Average time it takes to pay suppliers. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 360–362 Operating Cycle Formulas Number of days of inventory: Average time it takes to create and sell inventory. Number of days of receivables: Average time it takes to collect on accounts receivable. By using average day’s revenues, we are assuming that all sales are on credit. If not, this would be modified to reflect only credit sales. Number of days of payables: Average time it takes to pay suppliers. Key: The numerator is the “stock” of the denominator’s “flow.” Copyright © 2013 CFA Institute

Operating Cycle Formulas
Time from investment in inventory to collection of accounts. Time from investment in inventory to collection of accounts, considering the use of trade credit in purchases. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 360–362 Operating Cycle Formulas Operating cycle: Time from investment in inventory to collection of accounts. "Operating cycle = " ■8("Number of days inventory " )" + " ■8("Number of days receivables" ) Net operating cycle: Time from investment in inventory to collection of accounts, considering the use of trade credit in purchases. ■8("Net )" = " ■8("Number of days inventory " )" + " ■8("Number of days receivables" )" − " ■8("Number of payables" ) Copyright © 2013 CFA Institute

Liquidity Liquidity is the ability to satisfy the company’s short-term obligations using assets that can be most readily converted into cash. Liquidity ratios: Ability to satisfy current liabilities using current assets. Ability to satisfy current liabilities using the most liquid of current assets. Ability to satisfy current liabilities using only cash and cash equivalents. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 363–365 Liquidity Liquidity is the ability to satisfy the company’s short-term obligations using assets that can be most readily converted into cash. Liquidity ratios: Current ratio: Ability to satisfy current liabilities using current assets. Quick ratio: Ability to satisfy current liabilities using the most liquid of current assets. Cash ratio: Ability to satisfy current liabilities using only cash and cash equivalents. Copyright © 2013 CFA Institute

Solvency Analysis Risk Business Risk Sales Risk Operating Risk
A company’s business risk is determined, in large part, from the company’s line of business. Financial risk is the risk resulting from a company’s choice of how to finance the business using debt or equity. We use solvency ratios to assess a company’s financial risk. There are two types of solvency ratios: component percentages and coverage ratios. Component percentages involve comparing the elements in the capital structure. Coverage ratios measure the ability to meet interest and other fixed financing costs. Risk Business Risk Sales Risk Operating Risk Financial Risk LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 365–369 Solvency Analysis A company’s business risk is determined, in large part, from the company’s line of business. Financial risk is the risk resulting from a company’s choice of how to finance the business using debt or equity. We use solvency ratios to assess a company’s financial risk. There are two types of solvency ratios: component percentages and coverage ratios. Component percentages involve comparing the elements in the capital structure. Coverage ratios measure the ability to meet interest and other fixed financing costs. Copyright © 2013 CFA Institute

Solvency ratios Component-Percentage Solvency Ratios Coverage Ratios
Proportion of assets financed with debt. Proportion of assets financed with long-term debt. Debt financing relative to equity financing. Reliance on debt financing. Coverage Ratios Ability to satisfy interest obligations. Ability to satisfy interest and lease obligations. Ability to satisfy interest obligations with cash flows. Length of time needed to pay off debt with cash flows. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 366–368 Solvency Ratios Component-Percentage Solvency Ratios Debt-to-assets ratio "Debt−to−assets ratio = " "Total debt" /"Total assets" Proportion of assets financed with debt. Long-term debt-to-assets ratio "Long−term debt−to−assets ratio = " "Long−term debt" /"Total assets" Proportion of assets financed with long-term debt. Debt-to-equity ratio "Debt−to−equity ratio = " "Total debt" /"Total shareholders′ equity" Debt financing relative to equity financing. Financial leverage (also referred to as the equity multiplier) "Financial leverage = " "Total assets" /"Total shareholders′ equity" Reliance on debt financing. Coverage ratios Interest coverage ratio "Interest coverage ratio = " "EBIT" /"Interest payments" Ability to satisfy interest obligations. Fixed charge coverage ratio ■8("Fixed ratio" )" = " "EBIT + Lease payments" /"Interest payments + Lease payments" Ability to satisfy interest and lease obligations. Cash flow coverage ratio ■8("Cash ratio" )" = " "CFO + Interest payments + Tax payments" /"Interest payments" Ability to satisfy interest obligations with cash flows. Cash-flow-to-debt ratio ■8("Cash−flow−to−" @"debt ratio" )"= " "CFO" /"Total debt" Length of time needed to pay off debt with cash flows. Discussion question: Is it possible for a company to have solvency ratios, such as the debt-to-assets and debt-to-equity ratios, that are increasing over time, yet the coverage ratios are not increasing? Copyright © 2013 CFA Institute

Profitability Margins and return ratios provide information on the profitability of a company and the efficiency of the company. A margin is a portion of revenues that is a profit. A return is a comparison of a profit with the investment necessary to generate the profit. LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 369–372 Profitability Margins and return ratios provide information on the profitability of a company and the efficiency of the company. A margin is a portion of revenues that is a profit. A return is a comparison of a profit with the investment necessary to generate the profit. Copyright © 2013 CFA Institute

Profitability ratios: Margins
LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 369–370 Profitability Ratios: Margins Each margin ratio compares a measure income with total revenues: "Gross profit margin = " "Gross profit" /"Total revenue" "Operating profit margin = " "Operating profit" /"Total revenue" "Net profit margin = " "Net profit" /"Total revenue" "Pretax profit margin = " "Earnings before taxes" /"Total revenue" Copyright © 2013 CFA Institute

Profitability Ratios: Returns
LOS: Calculate and interpret measures of a company’s operating efficiency, internal liquidity (liquidity ratios), solvency, and profitability, and demonstrate the use of these measures in company analysis. Pages 371–372 Profitability Ratios: Returns Each margin ratio compares a measure income with total revenues: "Operating return on assets = " "Operating income" /"Average total assets" "Return on assets = " "Net income" /"Average total assets" "Return on total capital = " "Net income" /"Average interest−bearing debt + Average total equity" "Return on equity = " "Net income" /"Average shareholders′ equity" Copyright © 2013 CFA Institute

The DuPont Formulas Return on Equity Net Profit Margin Operating Profit Margin Effect of Nonoperating Items Tax Effect Total Asset Turnover Financial Leverage The DuPont formula uses the relationship among financial statement accounts to decompose a return into components. Three-factor DuPont for the return on equity: Total asset turnover Financial leverage Net profit margin Five-factor DuPont for the return on equity: Operating profit margin Effect of nonoperating items Tax effect LOS: Calculate and interpret variations of the DuPont expression and demonstrate use of the DuPont approach in corporate analysis. Pages 372–382 The DuPont Formulas Return on equity Net profit margin Operating profit margin Effect of nonoperating items Tax effect Total asset turnover Financial leverage Copyright © 2013 CFA Institute

Five-Component DuPont Model
LOS: Calculate and interpret variations of the DuPont expression and demonstrate use of the DuPont approach in corporate analysis. Pages 378–379 Five-Component DuPont Model The DuPont formulas involve the income statement and balance sheet relationships. Starting with the return on equity, we can break the return on assets component into its own components to get a better idea of what drives the return. Copyright © 2013 CFA Institute

Example: The DuPont Formula
Suppose that an analyst has noticed that the return on equity of the D Company has declined from FY2012 to FY2013. Using the DuPont formula, explain the source of this decline. (millions) 2013 2012 Revenues $1,000 $900 Earnings before interest and taxes $400 $380 Interest expense $30 Taxes $100 $90 Total assets $2,000 Shareholders’ equity $1,250 LOS: Calculate and interpret variations of the DuPont expression and demonstrate use of the DuPont approach in corporate analysis. Pages 372–382 Example: The DuPont Formula Suppose that an analyst has noticed that the return on equity of the D Company has declined from FY2012 to FY2013. Using the DuPont formula, explain the source of this decline. (millions) Revenues $1,000 $900 Earnings before interest and taxes Interest expense Taxes Total assets $2,000 $2,000 Shareholders’ equity $1,250 $1,000 Copyright © 2013 CFA Institute

Example: the DuPont Formula
2013 2012 Return on equity 0.20 0.22 Return on assets 0.13 0.11 Financial leverage 1.60 2.00 Total asset turnover 0.50 0.45 Net profit margin 0.25 0.24 Operating profit margin 0.40 0.42 Effect of nonoperating items 0.83 0.82 Tax effect 0.76 0.71 LOS: Calculate and interpret variations of the DuPont expression and demonstrate use of the DuPont approach in corporate analysis. Pages 372–382 Example: The DuPont Formula Return on equity Return on assets Financial leverage Total asset turnover Net profit margin Operating profit margin Effect of nonoperating items Tax effect Notes for discussion: Return on equity fell from 22% to 20%. This change is a result of the drop in the financial leverage (from 2 to 1.6); the return on assets increased. The return on assets increased from 11% to 13%. The net profit margin improved (24% to 25%). The asset turnover improved (0.45 times to 0.50 times). The change in the net profit margin improved because of taxes taking a smaller portion of income (although operating profit margin declined from 42% to 40%). Copyright © 2013 CFA Institute

Other Ratios LOS: Calculate and interpret basic earnings per share and diluted earnings per share. LOS: Calculate and interpret book value of equity per share, price-to-earnings ratio, dividends per share, dividend payout ratio, and plowback ratio. Pages 383–385 Other Ratios Earnings per share is net income, restated on a per share basis: "Earnings per share = " "Net income available to common shareholders" /"Number of common shares outstanding" Basic earnings per share is net income after preferred dividends, divided by the average number of common shares outstanding. Diluted earnings per share is net income minus preferred dividends, divided by the number of shares outstanding considering all dilutive securities. Book value per share is book value of equity divided by number of shares. Price-to-earnings ratio (PE or P/E) is the ratio of the price per share of equity to the earnings per share. If earnings are the last four quarters, it is the trailing P/E. Copyright © 2013 CFA Institute

Other Ratios LOS: Calculate and interpret book value of equity per share, price-to-earnings ratio, dividends per share, dividend payout ratio, and plowback ratio. Pages 383–385 Other Ratios Measures of Dividend Payment: ■8("Dividends (DPS)" )"= " "Dividends paid to shareholders" /"Weighted average number of ordinary shares outstanding" "Dividend payout ratio= " "Dividends paid to common shareholders" /"Net income attributable to common shares" Plowback ratio = 1 – Dividend payout ratio The proportion of earnings retained by the company. Copyright © 2013 CFA Institute

Example: Shareholder ratios
Calculate the book value per share, P/E, dividends per share, dividend payout, and plowback ratio based on the following financial information: Book value of equity $100 million Market value of equity $500 million Net income $30 million Dividends $12 million Number of shares 100 million LOS: Calculate and interpret book value of equity per share, price-to-earnings ratio, dividends per share, dividend payout ratio, and plowback ratio. Pages 383–385 Example: Shareholder Ratios Calculate the book value per share, P/E, dividends per share, dividend payout, and plowback ratio based on the following financial information: Book value of equity $100 million Market value of equity $500 million Net income $30 million Dividends $12 million Number of shares 100 million Copyright © 2013 CFA Institute

Example: Shareholder Ratios
Book value per share $1.00 There is $1 of equity, per the books, for every share of stock. P/E 16.67 The market price of the stock is times earnings per share. Dividends per share $0.12 The dividends paid per share of stock. Dividend payout ratio 40% The proportion of earnings paid out in the form of dividends. Plowback ratio 60% The proportion of earnings retained by the company. LOS: Calculate and interpret book value of equity per share, price-to-earnings ratio, dividends per share, dividend payout ratio, and plowback ratio. Pages 383–385 Example: Shareholder Ratios Book value per share = $1.00 There is $1 of equity, per the books, for every share of stock. P/E = 16.67 The market price of the stock is times earnings per share. Dividends per share = $0.12 The dividends paid per share of stock. Dividend payout ratio = 40% The proportion of earnings paid out in the form of dividends. Plowback ratio = 60% The proportion of earnings retained by the company. Copyright © 2013 CFA Institute

Effective Use of Ratio Analysis
In addition to ratios, an analyst should describe the company (e.g., line of business, major products, major suppliers), industry information, and major factors or influences. Effective use of ratios requires looking at ratios Over time. Compared with other companies in the same line of business. In the context of major events in the company (for example, mergers or divestitures), accounting changes, and changes in the company’s product mix. LOS: Calculate and interpret book value of equity per share, price-to-earnings ratio, dividends per share, dividend payout ratio, and plowback ratio. Page 386 Effective Use of Ratio Analysis In addition to ratios, an analyst should describe the company (e.g., line of business, major products, major suppliers), industry information, and major factors or influences. Effective use of ratios requires looking at ratios Over time. Compared with other companies in the same line of business. In the context of major events in the company (for example, restructuring, mergers, or divestitures), accounting changes, and changes in the company’s product mix. Copyright © 2013 CFA Institute

4. Pro Forma Analysis Estimate typical relation between revenues and sales-driven accounts. Estimate fixed burdens, such as interest and taxes. Forecast revenues. Estimate sales-driven accounts based on forecasted revenues. Estimate fixed burdens. Construct future period income statement and balance sheet. LOS: Demonstrate the use of pro forma income and balance sheet statements. Pages 392–394 4. Pro Forma Analysis (Information from Exhibit 9-20, p. 394) Estimate typical relation between revenues and sales-driven accounts. Estimate fixed burdens, such as interest and taxes. Forecast revenues. Estimate sales-driven accounts based on forecasted revenues. Estimate fixed burdens. Construct future period income statement and balance sheet. Copyright © 2013 CFA Institute

Pro Forma Income Statement
Imaginaire Company Income Statement (in millions) Year 0 One Year Ahead Sales revenues €1,000.0 €1,050.0  Growth at 5% Cost of goods sold 600.0 630.0  60% of revenues Gross profit €400.0 €420.0  Revenues less COGS SG&A 100.0 105.0  10% of revenues Operating income €300.0 €315.0  Gross profit less operating exp. Interest expense 32.0 33.6  8% of long-term debt Earnings before taxes €268.0 €281.4  Operating income less interest exp. Taxes 93.8 98.5  35% of earnings before taxes Net income €174.2 €182.9  Earnings before taxes less taxes Dividends €87.1 €91.5  Dividend payout ratio of 50% LOS: Demonstrate the use of pro forma income and balance sheet statements. Pages 398–400 Pro Forma Income Statement (Example from pages 398–400) Accounts that vary directly with sales: Cost of goods sold (COGS) Selling, general, and administrative expenses (SG&A) Calculated: Gross profit Operating income Earnings before taxes Taxes Net income Accounts that depend on other accounts: Interest expense (depends on long-term debt) Copyright © 2013 CFA Institute

Pro Forma Balance Sheet
Imaginaire Company Balance Sheet, End of Year (in millions) Year 0 One Year Ahead Current assets €600.0 €630.0  60% of revenues Net plant and equipment 1,000.0 1,050.0  100% of revenues Total assets €1,600.0 €1,680.0 Current liabilities €250.0 €262.5  25% of revenues Long-term debt 400.0 420.0  Debt increased by €20 million to maintain the same capital structure Common stock and paid-in capital 25.0  Assume no change Treasury stock (44.0)  Repurchased shares Retained earnings 925.0 1,016.5  Retained earnings in Year 0, plus net income, less dividends Total liabilities and equity LOS: Demonstrate the use of pro forma income and balance sheet statements. Pages 398–400 Pro Forma Balance Sheet Accounts that are a percentage of revenues: Current assets Current liabilities Net plant and equipment (can be based on a specific fixed asset turnover relationship) Accounts that are assumed not to change Common stock and paid-in capital Accounts that are determined by other accounts: Retained earnings Accounts that are the direct result of decisions: Treasury stock Long-term debt (capital structure decision) Copyright © 2013 CFA Institute

5. Summary Financial ratio analysis and common-size analysis help gauge the financial performance and condition of a company through an examination of relationships among these many financial items. A thorough financial analysis of a company requires examining its efficiency in putting its assets to work, its liquidity position, its solvency, and its profitability. We can use the tools of common-size analysis and financial ratio analysis, including the DuPont model, to help understand where a company has been. We then use relationships among financial statement accounts in pro forma analysis, forecasting the company’s income statements and balance sheets for future periods, to see how the company’s performance is likely to evolve. 5. Summary Copyright © 2013 CFA Institute

Chapter 7 Financial Analysis Techniques
Presenter’s name Presenter’s title dd Month yyyy LEARNING OUTCOMES Describe tools and techniques used in financial analysis, including their uses and limitations. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. Describe relationships among ratios and evaluate a company using ratio analysis. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret effects of changes in its components. Calculate and interpret ratios used in equity analysis and credit analysis. Explain the requirements for segment reporting, and calculate and interpret segment ratios. Describe how ratio analysis and other techniques can be used to model and forecast earnings.

Financial analysis tools: description
Graphics Regression Common-Size Analysis Financial Ratio Analysis LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. This chapter covers four common financial analysis tools. The emphasis is on financial ratio analysis and common-size analysis. Before turning to financial ratio analysis and common-size analysis, let’s look briefly at graphics and regression as tools. Copyright © 2013 CFA Institute

Graphics: example LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. Charts facilitate comparisons and communication. This slide, created using an Excel pie chart, shows the geographic composition of the 2011 operating profit margin for Colgate-Palmolive’s oral, personal, and home care segment. The pie chart allows an analyst to communicate about the geographical composition of the segment’s operating profit. Most of the operating profit margin for Colgate-Palmolive’s oral, personal, and home care segment comes from Latin America. Copyright © 2013 CFA Institute

Graphics: example $ millions
LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. This slide, created using an Excel bar chart, shows the geographic composition of the operating profit margin for Colgate-Palmolive’s oral, personal, and home care segment from 2007 to 2011. The bar chart allows an analyst to communicate about the geographical composition of the segment’s operating profit over time. Most of the operating profit margin for Colgate-Palmolive’s oral, personal, and home care segment has come from Latin America in each of the past five years. The biggest change in operating profit has also been in Latin America (from around $1 billion in 2007 to more than $1.4 billion in 2011). Optional discussion points: What are other ways to communicate these data graphically? (No single correct answer. Other possibilities include a series of pie charts, a series of stacked bars, etc.) In 2011, Colgate acquired Sanex (a skin care company with 2011 sales of $140 million, primarily in Western Europe) from Unilever and, in connection with the Sanex acquisition, sold its laundry detergent business in Colombia to Unilever. $ millions Copyright © 2013 CFA Institute

Graphics: example LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. This slide, created using an Excel bar chart, shows the quarterly operating profit margin for Colgate-Palmolive. It combines ratio analysis (operating profit margin, which is calculated as operating profit divided by sales) with graphics. The chart facilitates comparisons across time. An analyst can use such a chart to communicate the relative stability (volatility) of some aspect of a company’s performance over time. The dip in the first quarter of 2010 resulted from a one-time charge related to the transition to hyperinflationary accounting in Venezuela. Copyright © 2013 CFA Institute

Regression: example LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. LOS. Describe how ratio analysis and other techniques can be used to model and forecast earnings. Regressions quantify statistical relationships. This slide, created using Excel (scatterplot with trend line), shows the relationship between sales growth and GDP growth. The company is a cyclical company. An analyst might use regression analysis combined with a forecast for GDP growth as one input to forecast sales growth and earnings. The data used to create this chart include The years 1954–2011; Nominal U.S. GDP growth from the U.S. Department of Commerce Bureau of Economic Analysis ( and Total revenue for Ford Motor Company, from Compustat. Optional discussion points: What kinds of companies would this be most useful for? (cyclical rather than noncyclical) How common is the use of regression analysis in forecasting? (Anecdotal input indicates that although not extremely common, regression analysis is used by some analysts.) Copyright © 2013 CFA Institute

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. LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. Common-size analysis: Express financial data, including entire financial statements, in relation to a single financial statement item or base. Vertical common-size is in relation to a single financial statement item: For balance sheet, divide each item on the balance sheet by the same period’s total assets and express the results as percentages. For income statement, divide each item on the income statement by total net revenues and express the results as percentages. This analysis highlights composition and helps identify what items are important. Horizontal common-size is in relation to same item in prior period: Calculate percentage increase or decrease of each line item from the prior year. Alternative presentation is to calculate each item relative to its value in a base year. This analysis highlights items that have changed unexpectedly or have unexpectedly remained unchanged. Copyright © 2013 CFA Institute

Common-size Balance Sheet Example: Single company, Two periods
Partial common-size balance sheet LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. LOS. Describe relationships among ratios and evaluate a company using ratio analysis. A common-size balance sheet shows only the percentage of total assets represented by each line item. Judgment and interpretation are required to answer the following questions: What are the important components of the company’s balance sheet? Have any notable changes occurred? What caused the changes? What merits commentary in this example? In Period 2, receivables are 57% of total assets. We want to look at everything about receivables, including allowance for depreciation/amortization. What are possible reasons for the increase in receivables? The company is making more of its sales on a credit basis rather than a cash basis, perhaps in response to some action taken by a competitor. Alternatively, the increase in receivables as a percentage of assets may have occurred because of a change in another asset category—for example, a decrease in the level of inventory; the analyst would then need to investigate why that asset category had changed. Another possible reason for the increase in receivables as a percentage of assets is that the company has lowered its credit standards, relaxed its collection procedures, or adopted more aggressive revenue recognition policies. The analyst can turn to other comparisons and ratios (e.g., comparing the rate of growth in accounts receivable with the rate of growth in sales) to help determine which explanation is most likely. Copyright © 2013 CFA Institute

Fixed assets net of depreciation 1 2 Investments 7 Total Assets 100
Common-size Balance Sheet Example: Cross-sectional, Two companies, same time Partial common-size balance sheet Assets Company 1 % of Total Assets Company 2 Cash 38 12 Receivables 33 55 Inventory 27 24 Fixed assets net of depreciation 1 2 Investments 7 Total Assets 100 LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. LOS. Describe relationships among ratios and evaluate a company using ratio analysis. A common-size balance sheet shows only the percentage of total assets represented by each line item. Judgment and interpretation are required to answer the following questions: What merits commentary? What are the important components of each company’s balance sheet? What are the notable differences between the two? What explains the differences? This exhibit presents a vertical common-size (partial) balance sheet for two hypothetical companies at the same point in time. Company 1 is clearly more liquid (liquidity is a function of how quickly assets can be converted into cash) than Company 2, which has only 12% of assets available as cash, compared with the highly liquid Company 1, for which cash is 38% of assets. Given that cash is generally a relatively low-yielding asset and thus not a particularly efficient use of excess funds, why does Company 1 hold such a large percentage of total assets in cash? Perhaps the company is preparing for an acquisition or maintains a large cash position as insulation from a particularly volatile operating environment. Another issue highlighted by the comparison in this example is the relatively high percentage of receivables in Company 2’s assets, which may indicate a greater proportion of credit sales, overall changes in asset composition, lower credit or collection standards, or aggressive accounting policies. Copyright © 2013 CFA Institute

Use of Comparative Growth Information: example
Sunbeam, Inc vs.1996 Revenue +19% Receivables +38% Inventory +58% Why are receivables growing so much faster than revenue? Why is inventory growing so much faster than revenue? LOS. Describe relationships among ratios and evaluate a company using ratio analysis. In July 1996, Sunbeam, a U.S. company, brought in new management to turn the company around. In the following year, 1997, using 1996 as the base, the following was observed based on reported numbers: Revenue +19% Inventory +58% Receivables +38% It is generally more desirable to observe inventory and receivables growing at a slower (or similar) rate compared with revenue growth. Receivables growing so much faster than revenue could indicate Operational issues, such as lower credit standards, or Aggressive accounting policies for revenue recognition. Similarly, inventory growing faster than revenue can indicate An operational problem with obsolescence, or Aggressive accounting policies, such as an improper overstatement of inventory to increase profits. (An alternative, innocuous explanation could have been that the company was building inventory in anticipation of demand.) In the case of Sunbeam, the explanation lay in aggressive accounting policies. Sunbeam was later charged by the U.S. Securities and Exchange Commission with improperly accelerating the recognition of revenue and engaging in other practices, such as billing customers for inventory prior to shipment. Copyright © 2013 CFA Institute

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 LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. Ratios express one number in relation to another. Standardize financial data in terms of mathematical relationships expressed as percentages, times, or days. Ratios can facilitate comparisons—trends and cross-sectional. Ratios are interrelated. For example, an inefficient firm (with low asset turnover, low receivables turnover, low inventory turnover) is likely to have poor profitability (low return on sales, low return on assets, low return on equity), leading to low market valuation (low price earnings ratios, etc.), leading to difficulty in selling equity leading to high leverage (high debt-to-equity, etc.), leading to high cost and risky funding (high funding costs in terms of higher interest expense and stricter credit policies from trade creditors), leading to poor profitability, and so on. Copyright © 2013 CFA Institute

15.26% ratio analysis How profitable was Company X?
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. LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. The number is not “the answer.” Copyright © 2013 CFA Institute

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. LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. The number is not “the answer.” A ratio is an indicator. The net profit margin is an indicator of profitability. Interpretation and evaluation generally require comparison. Here, the comparison is between Company X’s profitability this year versus last year. Furthermore, it is generally not enough to state the interpretation/evaluation. Analysis addresses the question of why. Profitability changes because of changes in revenue, which in turn are driven by changes in volume, price, or exchange rates, and are related to a company’s business activities (products, markets), and/or changes in expenses, with the change in specific categories of expenses related to a company’s business activities. 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. Copyright © 2013 CFA Institute

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. LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. The number is not “the answer.” A ratio is an indicator. The net profit margin is an indicator of profitability. Interpretation and evaluation generally require comparison. Here the comparison is between Company X’s profitability and Company Y’s profitability. Furthermore, it is generally not enough to state the interpretation/evaluation. Analysis addresses the question of why. Copyright © 2013 CFA Institute

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? LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. In summary, whether using ratio analysis or any other tools of financial analysis, Effective analysis encompasses both computations and interpretations. A well-reasoned analysis differs from a mere compilation of various pieces of information by integrating the data collected into a cohesive whole. Analysis of past performance, for example, should address not only what happened but also why it happened and whether it advanced the company’s strategy. Some of the key questions to address include What aspects of performance are critical for this company to successfully compete in this industry? How well did the company’s performance meet these critical aspects? (Established through computation and comparison with appropriate benchmarks, such as the company’s own historical performance or competitors’ performance.) What were the key causes of this performance, and how does this performance reflect the company’s strategy? (Established through analysis.) Copyright © 2013 CFA Institute

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. LOS. Describe tools and techniques used in financial analysis, including their uses and limitations. Not every ratio is relevant in every situation. Some ratios are irrelevant for certain companies. For example, inventory turnover and days of inventory on hand are irrelevant to a company with no inventory (e.g., financial services firms, or internet firms like Facebook for social networking or Zynga for games). Some ratios are redundant. Inventory turnover and days of inventory on hand tell you exactly the same thing. The two ratios are mechanically related, so if Firm A has higher inventory turnover than Firm B, it follows as a mathematical fact that Firm A will have lower days of inventory on hand than Firm B. You do not need to present or discuss both ratios. Industry-specific ratios can be as important as general financial ratios. For example, the hotel industry tracks Occupancy = Rooms sold divided by rooms available. Average daily rate = Total room revenue divided by number of rooms sold. “Revpar” (revenue per available room) = Total room revenue divided by number of rooms available. “Accordingly, management believes that a review of the historical performance of the operations of the Hotels, particularly with respect to occupancy, which is calculated as rooms sold divided by total rooms available, average daily rate (‘ADR’), calculated as total room revenue divided by number of rooms sold, and revenue per available room (‘REVPAR’), calculated as total room revenue divided by number of rooms available, is appropriate for understanding revenue from the Hotels.” InnSuites Hospitality Trust, 10-K Different users and questions will focus on different ratios: Creditors: Particular focus on solvency ratios (leverage and coverage). Investors: Focus on market ratios (P/E, P/B) combined with financial ratios. Different sources categorize some ratios differently and include different ratios. Sources include textbooks and commercially available databases (e.g., Thomson Reuters, ValueLine, Yahoo, Morningstar, Zachs Investment Research). For some ratios, there is little difference (e.g., the current ratio is probably universally defined as current assets divided by current liabilities and viewed as an indicator of liquidity). For other ratios, differences in categorization (e.g., cash conversion cycle [Days of inventory on hand + Days of sales outstanding – Days payable] is categorized as a measure of liquidity but is clearly closely related to measures categorized as measures of efficiency). Different sources include different ratios. Different accounting standards can result in different reported financials, which, in turn, can limit the comparability of ratios, so care should be taken with different accounting standards. Copyright © 2013 CFA Institute

Categories of Financial Ratios
Category Description Activity Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability Profitability ratios. How and how much is the firm achieving returns on its investments? Valuation Valuation ratios. How does the firm’s performance or financial position relate to its market value? LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Copyright © 2013 CFA Institute

profitability and overview
Category Description Activity Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation Valuation ratios. How does the firm’s performance or financial position relate to its market value? LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Copyright © 2013 CFA Institute

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: Rate of return = Amount of return Amount invested LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. ROE measures the return a company generates on its equity capital. ROE = Net income Average equity Copyright © 2013 CFA Institute

ROE = Net income/Average assets × Average assets/Average equity
Decompose ROE ROE = Net income Average equity = Net income × Average assets Average equity LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. LOS. Describe the relationships among ratios. Decomposing ROE into its component parts is useful for understanding what drives a company’s ROE; for determining the reasons for changes in ROE over time for a given company; for determining the reasons for differences in ROE for different companies; for suggesting areas to focus on to improve ROE; for showing why a company’s overall profitability, measured by ROE, is a function of its efficiency, operating profitability, taxes, and use of financial leverage; and/or for examining the relationship between the various categories of ratios discussed in this chapter and how they all influence the return on the investment of the owners. Decomposition of ROE is sometimes referred to as DuPont analysis because it was originally developed at that company. Decomposing ROE involves expressing the basic ratio (i.e., net income divided by average shareholders’ equity) as the product of component ratios. Each of these component ratios is an indicator of a distinct aspect of a company’s performance that affects ROE, so the decomposition allows us to evaluate how these different aspects of performance affected the company’s profitability as measured by ROE. Expressing ROE as a product of only two of its components, we can write ROE = Net income/Average assets × Average assets/Average equity (For purposes of analyzing ROE, this method usually uses average balance sheet factors; however, the math will work out if beginning or ending balances are used throughout.) The two components can be interpreted as return on assets and leverage (because it expresses how many dollars of assets are supported by each dollar of equity). In other words, ROE is a function of a company’s return on assets (ROA) and its use of financial leverage. = ROA × Leverage Copyright © 2013 CFA Institute

Decompose ROE ROE = ROA × Leverage A company can increase its ROE
With a business strategy, by increasing its ROA and/or With a financial strategy, by increasing its use of leverage as long as returns on the incremental investment exceed the cost of borrowing. ROE = ROA × Leverage LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. LOS. Describe the relationships among ratios. A company can improve its ROE by improving ROA or making more effective use of leverage. Consistent with the definition given earlier, leverage is measured as average total assets divided by average shareholders’ equity. If a company had no leverage (no liabilities), its leverage ratio would equal 1.0 and ROE would exactly equal ROA. As a company takes on liabilities, its leverage increases. As long as a company is able to borrow at a rate lower than the marginal rate it can earn investing the borrowed money in its business, the company is making an effective use of leverage and ROE would increase as leverage increases. If a company’s borrowing cost exceeds the marginal rate it can earn on investing in the business, ROE would decline as leverage increased because the effect of borrowing would be to depress ROA. Copyright © 2013 CFA Institute

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: Rate of Return = Amount of return Amount invested (1) ROA = Net income Average assets LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. ROA measures the return earned by a company on its assets. The higher the ratio, the more income is generated by a given level of assets. Most databases compute this ratio as net income/average assets (Equation 1). An alternative (Equation 2) is to use net income adjusted for interest as the numerator. This form of the ratio reflects that net income plus after-tax interest is the amount of earnings applicable to both equityholders and creditors, consistent with assets being financed by both equityholders and creditors. Net income (after the deduction of interest) is the return solely to equityholders. In general, whichever form of ROA is chosen, the analyst must use it consistently in comparison with other companies or time periods. For simplicity, the DuPont analysis will use the first variant (Equation 1). (2) ROA = Net income adjusted for interest Average assets = Net income + [Interest expense × (1 – Tax rate)] Average assets Copyright © 2013 CFA Institute

Profitability, Competition, and Business Strategy
ROA = Net income Average assets ROA = Net income × Revenue Average assets In other words, ROA can be thought of as: LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. A company can increase its ROA in two basic ways: By increasing operating profitability (operating profit margin). By increasing asset turnover—that is, better asset utilization (efficiency). In other words, ROA can be thought of as Profit margin × Turnover (efficiency). Profit margin × Turnover (efficiency) Copyright © 2013 CFA Institute

Decomposing Return on Equity
ROE = Profit margin × Turnover Leverage ROE = Net income × Revenue Average assets Average equity LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. By combining the decomposition of ROA with the previous step, we have three basic factors underlying profitability: First term on the right-hand side of this equation: Profit margin, an indicator of profitability. Shows how many dollars of income the company can generate for each dollar of revenue. Second term on the right: Turnover (i.e., the asset turnover ratio), an indicator of efficiency. Shows how many dollars of revenue the company can generate for each dollar of its assets. Third term on the right-hand: Leverage, an indicator of solvency. Shows how many dollars of assets are supported by each dollar of equity. Note that ROA is decomposed into the first two of these components: net profit margin and total asset turnover. A company’s ROA is a function of profitability (net profit margin) and efficiency (total asset turnover). This decomposition illustrates that a company’s ROE is a function of its net profit margin, its efficiency, and its leverage. Further decomposition can be used to examine the effects of tax and the costs of financing. First, we will look at an example using the three-way decomposition. Copyright © 2013 CFA Institute

Decomposing Return on Equity
Du Pont Analysis 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) LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. The decomposition illustrates that a company’s ROE is a function of its net profit margin, its efficiency, and its leverage. We can use the decomposition to assess what the source of the firm’s ROE was. Copyright © 2013 CFA Institute

Decomposing Return on Equity: Stylized comparative analysis Mini-case
Co. A Co. B Co. C Average Sales ($) 2,000 4,000 6,675 4,225 Net income (NI) ($) 200 Average assets ($) 1,000 1,500 Average equity ($) Average liabilities ($) 500 ROE (NI/Equity) Net profit margin (NI/Sales) Turnover (Sales/Assets) Leverage (Assets/Equity) LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Depending on the audience, the presenter may wish to provide this slide without “solutions,” which requires the audience to compute the ratios, or the following slide, which includes solutions. This mini-case asks the audience to assess what the source of each firm’s return on equity was. 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) All three companies have the same ROE. Company A’s ROE is driven by its net profit margin (10% versus 4.7% average for the three companies). Company B’s ROE is driven by its leverage (2× versus 1.5× average for the three companies). Its turnover is below average, and its profit margin is very slightly above average. Company C’s ROE is driven by its turnover (4.45× versus 2.82× average). Copyright © 2013 CFA Institute

Decomposing Return on Equity: Stylized comparative analysis Mini-case
Co. A Co. B Co. C Average Sales ($) 2,000 4,000 6,675 4,225 NI ($) 200 Average assets ($) 1,000 1,500 Average equity ($) Average liabilities ($) 500 ROE (NI/Equity) 20.0% Net profit margin (NI/Sales) 10.0% 5.0% 3.0% 4.7% Turnover (Sales/Assets) 2 4.45 2.82 Leverage (Assets/Equity) 1 1.5 1.50 LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Depending on the audience, the presenter may wish to provide this slide with “solutions” or the previous slide, which excludes solutions and requires the audience to compute the ratios. This mini-case asks the audience to assess what the source of each firm’s return on equity was. 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) All three companies have the same ROE. Company A’s ROE is driven by its net profit margin (10% versus 4.7% average for the three companies). Company B’s ROE is driven by its leverage (2× versus 1.5× average for the three companies). Its turnover is below average, and its profit margin is very slightly above average. Company C’s ROE is driven by its turnover (4.45× versus 2.82× average). Copyright © 2013 CFA Institute

Decomposing Return on Equity: comparative
AAPL HPQ DELL ROE 27.19% 21.50% 61.19% Net income/Sales Net profit margin 14.88% 7.04% 4.06% Sales/Average assets Asset turnover 1.00 1.17 2.26 Average assets/ Average equity Financial leverage 1.83 2.61 6.67 LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. This slide presents the ROE decomposition for three actual companies, using 2008 data: Apple (AAPL), Hewlitt-Packard (HPQ), and Dell (DELL). What was the source of each firm’s return on equity? For Dell, significantly higher financial leverage and asset turnover compensated for low net profit margin. For Apple, the net profit margin is much higher (reflects a strategy of competing on product features rather than price) and asset turnover is lower (reflects a strategy of having own retail stores). Also—not shown on slide—Apple’s lower turnover reflects its retail strategy, which requires increased investment in PPE; the significant amount of cash on its balance sheet, which generates nonoperating income does not generate “revenue”; and subscription accounting for iPhones creating deferred tax assets. Copyright © 2013 CFA Institute

DuPont Analysis : Further Decomposition
ROE = Net income/Average equity Decompose ROE into five factors ROE = Net income × EBT EBIT Revenue Average assets Average equity LOS. Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. To separate the effects of taxes and interest, we can further decompose the net profit margin. Net income/Average equity = NI/EBT × EBT/EBIT × EBIT/Revenue For ROE overall Net income/Average equity = NI/EBT × EBT/EBIT × EBIT/Revenue × Revenue/Average assets × Average assets/Average equity This can be interpreted as ROE = Tax burden × Interest burden × EBIT margin × Total asset turnover × Leverage Tax burden (Net income/EBT): Measures the effect of taxes on ROE. Essentially, it reflects the percentage of pretax profits the company “keeps” as net income after deducting the tax expense. It is equivalent to one minus the average tax rate (e.g., a 30% tax rate would yield a factor of 0.70, or 70%). A higher value for the tax burden implies that the company can keep a higher percentage of its pretax profits, indicating a lower tax rate. A lower value for the tax burden ratio implies the opposite (i.e., a higher tax rate leaving the company with less of its pretax profits). Interest burden (EBT/EBIT): Captures the effect of interest on ROE. Essentially, it reflects the percentage of pre-interest-and-tax profits the company “keeps” as pretax profit after deducting the interest expense. Lower borrowing costs increase ROE, and higher borrowing costs reduce ROE. Some analysts prefer to use operating income instead of EBIT for the second and third terms in this equation. In such a case, the second term would capture both the effect of interest expense and nonoperating income on ROE. EBIT margin (EBIT/Revenue) or operating margin (if operating income is used in the numerator): Captures the effect of EBIT margin (or operating margin if operating income is used) on ROE. In either case, this term primarily measures the effect of operating profitability on ROE. Total asset turnover ratio (Revenue/Average assets) is an indicator of the overall efficiency of the company (i.e., how much revenue it generates per unit of total assets). Financial leverage ratio (Average assets/Average equity) shows the total amount of a company’s assets relative to its equity capital. This decomposition expresses a company’s ROE as a function of its tax rate, interest burden, operating profitability, efficiency, and leverage. An analyst can use this framework to determine what factors are driving a company’s ROE. The decomposition of ROE can also be useful in forecasting ROE based upon expected efficiency, profitability, financing activities, and tax rates. Copyright © 2013 CFA Institute

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 nonoperating items. LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Before moving on to the other categories of ratios, this slide reviews several common profitability ratios that can be taken directly from the common-size income statement. Copyright © 2013 CFA Institute

Discussion by category
Description Activity Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation Valuation ratios. How does the firm’s performance or financial position relate to its market value? LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Having covered the decomposition of ROE, we turn to the various categories of ratios. Activity ratios and liquidity ratios are closely related. Copyright © 2013 CFA Institute

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. LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. 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, Maybe heavy investment in assets (inefficient? plant modernization which will 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. Copyright © 2013 CFA Institute

Activity ratios Also known as asset utilization or operating efficiency ratios Numerator Denominator Working capital turnover Revenue Average working capital Fixed asset turnover Average net fixed assets Total asset turnover Average total assets LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Copyright © 2013 CFA Institute

Other Common Activity Ratios
Numerator Denominator Inventory turnover Cost of sales Average inventory Days of inventory on hand (DOH) Number of days in period Receivables turnover Revenue Average receivables Days of sales outstanding (DSO) Payables turnover Purchases Average trade payables Number of days of payables LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Inventory and DOH Inventory turnover = Cost of goods sold/Average inventory Days inventory held = Days in period/Inventory turnover Days required to sell inventory. Average number of days held in storage. Typically, low and declining days held indicates better efficiency. Too high might indicate obsolete inventory or slowing sales; or a high inventory may result from a company’s preparing for an increase in sales. Too low could result in shortages and missed sales. Compare revenue growth with the industry. Receivables and DSO Receivables turnover = Revenue/Average receivables Days of sales outstanding = Days in period/Receivables turnover Days required to convert receivables to cash. Typically, low and declining days indicates better efficiency. Too high might indicate credit issues. But too low might indicate stringent credit policies that could hurt competitiveness. Compare credit period allowed by the company, sales growth relative to industry, and actual credit losses. Payables Payables turnover = Purchases/Average trade payables Days payable outstanding = Days in period/Receivables turnover Average number of days to pay suppliers. Days as high as possible (without harming supplier relations) indicates better efficiency. Too long and/or lengthening period could suggest impending liquidity issues. Or suppliers could be offering longer payment terms. Compare other liquidity and solvency indicators. Copyright © 2013 CFA Institute

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. LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Cash conversion cycle (net operating cycle) = Days sales outstanding + Days inventory held – Number of days of payables This illustrates the close link between activity and liquidity: The shorter the cash conversion cycle, the lower the need for external sources of liquidity. Copyright © 2013 CFA Institute

Current ratio = Current assets/Current liabilities
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 LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Liquidity refers to a company’s ability to meet its short-term obligations. The level of liquidity needed differs from one industry to another. A particular company’s liquidity position may vary according to the anticipated need for funds at any given time. Judging whether a company has adequate liquidity requires analysis of its historical funding requirements, current liquidity position, anticipated future funding needs, and options for reducing funding needs or attracting additional funds (including actual and potential sources of such funding). Liquidity ratios reflect a company’s position at a point in time and, therefore, typically use data from the ending balance sheet rather than averages. The current, quick, and cash ratios reflect three measures of a company’s ability to pay current liabilities. Each uses a progressively stricter definition of liquid assets. Copyright © 2013 CFA Institute

Description Activity Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation Valuation ratios. How does the firm’s performance or financial position relate to its market value? LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Copyright © 2013 CFA Institute

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 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) } Lower ratio –> safer. Higher cushion against potential creditor losses LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Generally, two types of solvency ratios: debt and coverage. Debt: How much debt does a company have in its capital structure? Coverage: By how much did earnings “cover” the interest costs? Copyright © 2013 CFA Institute

Common solvency ratios
Numerator Denominator Debt ratios Debt-to-assets ratio Total debt Total assets Debt-to-capital ratio Total debt + Total shareholders’ equity Debt-to-equity ratio Total shareholders’ equity Financial leverage ratio Average total assets Average total equity Coverage ratios Interest coverage EBIT Interest payments Fixed charge coverage EBIT + Lease payments Interest payments + Lease payments LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Debt-to-assets ratio: Measures the percentage of total assets financed with debt. For example, a debt-to-assets ratio of 0.40, or 40%, indicates that 40% of the company’s assets are financed with debt. Generally, higher debt means higher financial risk and thus weaker solvency. Debt-to-capital ratio: Measures the percentage of a company’s capital (debt plus equity) represented by debt. As with the previous ratio, a higher ratio generally means higher financial risk and thus indicates weaker solvency. Debt-to-equity ratio: Measures the amount of debt capital relative to equity capital. Interpretation is similar to the preceding two ratios (i.e., a higher ratio indicates weaker solvency). A ratio of 1.0 would indicate equal amounts of debt and equity, which is equivalent to a debt-to-capital ratio of 50%. Alternative definitions of this ratio use the market value of stockholders’ equity rather than its book value (or use the market values of both stockholders’ equity and debt). Financial leverage ratio: Often called simply the “leverage ratio.” Measures the amount of total assets supported for each one money unit of equity. For example, a value of 3 for this ratio means that each €1 of equity supports €3 of total assets. The higher the financial leverage ratio, the more leveraged the company is in the sense of using debt and other liabilities to finance assets. This ratio is often defined in terms of average total assets and average total equity and plays an important role in the DuPont decomposition of return on equity discussed earlier. Interest coverage: Measures the number of times a company’s EBIT could cover its interest payments. Thus, it is sometimes referred to as “times interest earned.” A higher interest coverage ratio indicates stronger solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds, notes) from operating earnings. Fixed charge coverage: Relates fixed charges, or obligations, to the cash flow generated by the company. It measures the number of times a company’s earnings (before interest, taxes, and lease payments) can cover the company’s interest and lease payments. Similar to the interest coverage ratio, a higher fixed charge coverage ratio implies stronger solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds, notes, and leases) from normal earnings. The ratio is sometimes used as an indication of the quality of the preferred dividend, with a higher ratio indicating a more secure preferred dividend. For computing this ratio, an assumption sometimes made is that one-third of the lease payment amount represents interest on the lease obligation and that the rest is a repayment of principal on the obligation. For this variant of the fixed charge coverage ratio, the numerator is EBIT plus one-third of lease payments and the denominator is interest payments plus one-third of lease payments. Copyright © 2013 CFA Institute

Description Activity Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation Valuation ratios. How does the firm’s performance or financial position relate to its market value? LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Copyright © 2013 CFA Institute Copyright © 2013 CFA Institute

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. P/E = Price Earnings per share LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. LOS. Calculate and interpret ratios used in equity analysis. The price-to-earnings ratio (P/E)—probably the most widely cited indicator in discussing the value of equity securities—relates share price to the earnings per share (EPS). The P/E expresses the relationship between the price per share and the amount of earnings attributable to a single share (i.e., how much an investor in common stock pays per dollar of earnings). In general, a high P/E indicates that the market places a high value on the earnings of a company. Higher P/E stocks are sometimes referred to as “glamour” stocks and lower P/E stocks as “value” stocks. A higher P/E may reflect expectations for higher growth. Note that sometimes a firm may have a high P/E because it has very low EPS. Interpreting EPS: EPS is simply the amount of earnings attributable to each share of common stock. In isolation, EPS does not provide adequate information for comparison of one company with another. For example, assume two companies (A and B) have the following characteristics: Both have only common stock outstanding and no dilutive securities outstanding. Both have identical net income of $10 million and identical book equity of $100 million. Thus, both have identical profitability (ROE = 10%, using ending equity in this case for simplicity). If Company A has 100 million weighted average common shares outstanding and Company B has 10 million weighted average common shares outstanding, Company A will report EPS of $0.10 per share and Company B will report EPS of $1 per share. The difference in EPS does not reflect a difference in profitability; the companies have identical profits and profitability. The difference reflects only a different number of common shares outstanding. The P/E and the other price-based ratios are used in equity analysis. Price-based ratios may effectively be used by equity investors in combination with financial ratios. For example, how can an equity investor looking at low P/E stocks (i.e., “value stocks”) figure out which of the following is more likely: Is the low P/E stock undervalued? Or alternatively, is the low P/E stock appropriately valued given its financial performance? As a specific example of this approach, Piotroski (2000) used financial ratios to supplement a value investing strategy. He showed that the approach can generate significant excess returns. The financial variables used by Piotroski include ROA, cash flow ROA, change in ROA, change in leverage, change in liquidity, change in gross margin, and change in inventory turnover. Another specific example of this approach, from Benjamin Graham’s stock selection criteria in The Intelligent Investor (1949), includes financial variables in addition to a P/E maximum criteria. The financial variables used by Graham included dividend payment history, size criteria, and a leverage ratio (minimum of equity as a percent of total capitalization). Copyright © 2013 CFA Institute

Valuation ratios Numerator Denominator Valuation ratios P/E
Price per share Earnings per share P/CF Cash flow per share P/S Sales per share P/BV Book value per share LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. P/E ratios are calculated using net income as the denominator, so It can be sensitive to nonrecurring earnings or one-time earnings events. Net income is generally considered to be more susceptible to manipulation than are cash flows. P/CF: Analysts may use price to cash flow as an alternative measure to EPS—particularly in situations where earnings quality may be an issue. P/S: Price to sales is calculated in a similar manner. Sometimes used as a comparative price metric, particularly when a company does not have positive net income. Note, although P/S is common, there is a theoretical mismatch in the numerator and denominator. The numerator “price” refers to the price of a share of common stock; however, “sales” relate to all providers of capital, not just common stockholders. Therefore, enterprise value to sales is considered a more theoretically correct metric. P/B: Price to book value is the ratio of price per share to book value per share. This ratio is often interpreted as an indicator of market judgment about the relationship between a company’s required rate of return and its actual rate of return. Assuming that book values reflect the fair values of the assets, a price-to-book ratio of 1 can be interpreted as an indicator that the company’s future returns are expected to be exactly equal to the returns required by the market. A ratio greater than 1 would indicate that the future profitability of the company is expected to exceed the required rate of return, and values of this ratio less than 1 indicate that the company is not expected to earn excess returns. Copyright © 2013 CFA Institute

Dividend-related quantities
Dividend payout ratio = Dividends per share Earnings per share Dividend yield = Dividends per share Price LOS. Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios. LOS. Describe the relationships among ratios and evaluate a company using ratio analysis. Dividend payout ratio: Percentage of earnings that the company pays out as dividends to shareholders. Reflects a company’s dividend policy. Optimal dividend policy is a function of many factors, but in general, a company balances current dividend payout with future growth. The amount of dividends per share tends to be relatively fixed because any reduction in dividends has been shown to result in a disproportionately large reduction in share price. Because dividend amounts are relatively fixed, the dividend payout ratio tends to fluctuate with earnings. Therefore, conclusions about a company’s dividend payout policies should be based on examination of payout over a number of periods. Dividend yield: Dividends as a percentage of share price. Another dividend-related quantity (shown in text but not on this slide) is the retention rate, which is simply the complement of the dividend payout ratio (i.e., 1 – Payout ratio). Whereas the payout ratio measures the percentage of earnings that a company pays out as dividends, the retention rate is the percentage of earnings that a company retains. Copyright © 2013 CFA Institute

Selected credit ratios used by standard & Poor’s as part of credit analysis
Numerator Denominator EBIT and EBITDA interest coverage EBIT or EBITDA Gross interest (prior to deductions for capitalized interest or interest income) FFO interest coverage FFO plus interest paid minus operating lease adjustments FFO to debt FFO Total debt Free operating cash flow to debt CFO (adjusted) minus capital expenditures Discretionary cash flow to debt CFO minus capital expenditures minus dividends paid LOS. Calculate and interpret ratios used in equity analysis and credit analysis. This slide and the next list selected credit ratios used by Standard & Poor’s (S&P) as part of credit analysis of industrial companies. The source is Standard & Poor’s Corporate Ratings Criteria (2008). Note that before calculating ratios, rating agencies make certain adjustments to reported financials, such as adjusting debt to include off-balance-sheet debt in a company’s total debt. FFO is funds from operations, defined as net income adjusted for noncash items; CFO is cash flow from operations. Ratios are only one part of credit analysis. Credit analysis is the evaluation of credit risk, which can be defined as the risk of loss caused by a counterparty’s or debtor’s failure to make a promised payment. Approaches to credit analysis vary and, as with all financial analysis, depend on the purpose of the analysis and the context in which it is done. For example: Credit analysis for acquisition financing and other highly leveraged financing often involves projections of period-by-period cash flows similar to projections made by equity analysts. Whereas the equity analyst may discount projected cash flows to determine the value of the company’s equity, a credit analyst would use the projected cash flows to assess the likelihood of a company complying with its financial covenants in each period and paying interest and principal as due. For credit analysis assessing overall creditworthiness (as opposed to risk of a specific transaction), one general approach is credit scoring, a statistical analysis of the determinants of credit default. The credit rating process used by credit rating agencies, such as S&P, to assess and communicate the probability of default by an issuer on its debt obligations (e.g., commercial paper, notes, and bonds) involves both the analysis of a company’s financial reports as well as a broad assessment of a company’s operations. Meeting with management to discuss, for example, industry outlook, overview of major business segments, financial policies and goals, distinctive accounting practices, capital spending plans, and financial contingency plans. Tours of major facilities. Ratings committee votes on analyst’s recommendations, after considering factors that include business risk (operating environment, cyclicality and capital intensity of industry); success factors and areas of vulnerability; company’s competitive position, including size and diversification; and financial risk, including the evaluation of capital structure, interest coverage, and profitability using ratio analysis. The examination of debt covenants. Evaluation of management. In assigning credit ratings, rating agencies emphasize the importance of the relationship between a company’s business risk profile and its financial risk. “The company’s business risk profile determines the level of financial risk appropriate for any rating category.” In other words, a company with lower business risk has the ability to take on more financial risk. The first ratios listed are variations of coverage ratios. The other ratios measure the percentage of debt that could be paid with one year of FFO, then cash flow after paying for capital expenditures (cap ex), then cash flow after paying for both cap ex and dividends. Copyright © 2013 CFA Institute

Selected credit ratios used by standard & Poor’s as part of credit analysis
Numerator Denominator Return on capital EBIT Average capital, where capital is equity plus noncurrent deferred taxes plus debt Net cash flow to capital expenditures FFO minus dividends Capital expenditures Debt to EBITDA Total debt EBITDA Total debt to total debt plus equity Total debt plus equity LOS. Calculate and interpret ratios used in equity analysis and credit analysis. This slide lists additional credit ratios used by S&P as part of credit analysis of industrial companies. The source is Standard & Poor’s Corporate Ratings Criteria (2008). Note that before calculating ratios, rating agencies make certain adjustments to reported financials, such as adjusting debt to include off-balance-sheet debt in a company’s total debt. FFO is funds from operations, defined as net income adjusted for noncash items; CFO is cash flow from operations. Copyright © 2013 CFA Institute

Segment analysis example: L’ORÉAL
LOS. Calculate and interpret ratios used in equity analysis and credit analysis. LOS. Explain the requirements for segment reporting, and calculate and interpret segment ratios. Slide shows an excerpt from Note 2 to the financial statements of L’Oreal. (The accompanying text is shown below for the presenter’s reference.) Segment profitability can be analyzed. Each segment’s operating return on sales (i.e., operating profit margin) can be calculated (operating profit divided by sales). This ratio measures the operating profitability of the segment relative to revenues. Each segment’s operating return on assets can be calculated (operating profit divided by operating assets). This ratio measures operating profitability relative to assets. Each segment’s operating asset turnover can be calculated (sales divided by operating assets). This ratio measures how much revenue is generated per unit of assets. An analyst can use these ratios to evaluate each segment over time to assess the contribution of one segment versus another to the company’s total profitability and/or to evaluate a segment of one company compared with a competing entity. Some ratios are not as relevant on a segment basis. For example, funding is typically done at the corporate level, so segment liquidity measures are not relevant. Note 2 to the financial statements of L’Oreal “The Cosmetics branch is organized into four sectors, each operating with specific distribution channels: Professional Products Division: products used and sold in hair salons; Consumer Products Division: products sold in mass-market retail channels; L’Oréal Luxury Division: products sold in selective retail outlets, i.e. department stores, perfumeries, travel retail, the Group’s own boutiques and certain online sites; Active Cosmetics Division: products for “borderline” complexions (i.e. neither healthy nor problematic), sold through all health channels such as pharmacies, parapharmacies, drugstores and medispas.” “The non-allocated item includes expenses incurred by the Functional Divisions, fundamental research and the costs of stock options not allocated to the Cosmetics Divisions. It also includes activities that are auxiliary to the Group’s core businesses, such as insurance, reinsurance and banking. ‘The Body Shop’ branch: The Body Shop offers a wide range of naturally inspired cosmetics and toiletry products. The brand, originally created in the United Kingdom, distributes its products and expresses its values through a large multi-channel network of exclusive retail shops (in more than 60 countries), as well as through home and online sales. The Body Shop net sales and operating profit are characterized by strong seasonal fluctuations due to a high level of activity during the last few months of the year.” “The Dermatology branch, consisting of Galderma, a joint venture between L’Oréal and Nestlé, meets the needs of dermatologists and their patients. Data by branch and by Division are prepared using the same accounting principles as those used for the preparation of the consolidated financial statements.” “The performance of each branch and Division is measured on the basis of operating profit.” Copyright © 2013 CFA Institute

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 LOS. Describe how ratio analysis and other techniques can be used to model and forecast earnings. Analysts often need to forecast future financial performance. For example, analysts’ EPS forecasts are widely followed by Wall Street. Analysts use data about the economy, industry, and company to arrive at a company’s forecast. The results of an analyst’s financial analysis, including common-size and ratio analyses, are integral to this process, along with the judgment of the analysts. Based on forecasts of growth and expected relationships among the financial statement data, the analyst can build a model (sometimes referred to as an “earnings model”) to forecast future performance. Of course, a forecast should not just be a mechanical exercise of extrapolating from historical performance and historical ratios; however, information gained from ratio analysis from prior years can provide useful input. Often, a forecast begins with a revenue forecast. Revenue forecasts would generally be based on numerous factors, but one input to sales forecast can be percent change from prior year as shown on the horizontal common-size income statement. Then, to forecast income, an analyst can use ratios expressing the relationship between revenues and various items on the income statement. An analyst may use historical common-size data as an input to developing expectations about specific expense line items. The gross profit margin could be used to forecast gross profit directly and/or to forecast cost of goods sold. (Recall that gross profit equals sales minus the cost of goods sold.) The operating profit margin could be used to forecast operating profit directly. As illustrated on the next slide, forecasts typically involve iterations (circularity) because the amount of borrowing is a function of cash flow requirements, which are a function of earnings and taxes, which depend on income net of interest expense, and interest expense is a function of the amount of borrowing. Forecasts of the balance sheet and cash flow statements can be derived from expected ratio data. To forecast the amount of receivables, an analyst can use the days receivable data from prior periods’ ratio analysis. To forecast the amount of inventory, an analyst can use the days inventory data from prior periods’ ratio analysis. To forecast the amount of property, plant, and equipment (PP&E), an analyst can use PP&E turnover data from prior periods’ ratio analysis. The amount of forecast liabilities would typically be a result of cash flow requirements. In other words, after projecting cash flow from operations minus cash needed for working capital and fixed capital (PP&E), an analyst can determine financing needs. It is then a modeling choice regarding the extent to which incremental financing is obtained from debt or equity. An analyst can use information from historical and targeted leverage ratios in making that choice. The reason that cash flow is listed here with no reference to ratios is that cash flow is often one of the most important outputs (if not the most important output) of models, particularly valuation models. The level of operating cash may be an input to forecasts, but change in cash is an output. As noted, cash flow (i.e., change in cash) can be an interim output in the case of models that incorporate iterations (circularity) because the amount of borrowing is determined by the amount of cash flow before incremental borrowing. Copyright © 2013 CFA Institute

Ratios in model building
Sales forecast Expenses Gross Profit Operating Profit Assets Liabilities Cash Flow Forecast Debt Forecast Interest Expense Forecast Income and Taxes Forecast Cash Flow LOS. Describe how ratio analysis and other techniques can be used to model and forecast earnings. Forecasts often involve iterations (circularity) because the amount of borrowing is a function of cash flow requirements, which are a function of earnings and taxes, which depend on income net of interest expense, and interest expense is a function of the amount of borrowing. One common solution is to forecast interest expense based on the balance of borrowings at the beginning of the period. This solution is generally acceptable in situations where decisions are not overly sensitive to the exact level of interest payments in each period. Copyright © 2013 CFA Institute

Summary: financial analysis tools
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 Copyright © 2013 CFA Institute

Chapter 9 Financial Statement Analysis

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Chapter 9 Financial Statement Analysis

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