Chapter 6

FINANCIAL ANALYSIS TECHNIQUES

Presenter’s name
Presenter’s title
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CONTENTS
1. Introduction
2. The Financial Analysis Process
3. Analytical Tools and Techniques
4. Common Ratios Used in Financial Analysis
5. Equity Analysis
6. Credit Analysis
7. Business and Geographic Segments
8. Model Building and Forecasting
9. Summary

2
 FINANCIAL ANALYSIS TOOLS:
DESCRIPTION
• Graphics
• Regression
• Common-Size Analysis
• Financial Ratio Analysis

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 EXAMPLE 1: OPERATING PROFIT
BY GEOGRAPHIC SEGMENT
2018 Share of Operating Profit

5%
North America
21% 29%
Latin America
Europe
Asia Pacific
18% Africa/Eurasia
28%

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 EXAMPLE 2: OPERATING PROFIT
BY GEOGRAPHIC SEGMENT, 2016–2018

Africa/Eurasia

Asia Pacific

Europe

Latin America

North America

0 200 400 600 800 1000 1200 1400

2016 2017 20182

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 EXAMPLE 3: QUARTERLY GROSS PROFITS
4500

4000

3500

3000

2500

2000

1500

1000

500

0
2017/Q1 2017/Q2 2017/Q3 2017/Q4 2018/Q1 2018/Q2 2018/Q3 2018/Q4

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 EXAMPLE 4: REGRESSION

14.0

12.0

10.0
f(x) = 0.117565973870053 x + 5.81768507372527
GDP Change

R² = 0.268720817275207
8.0

6.0

4.0

2.0

0.0
-40.0 -30.0 -20.0 -10.0 0.0 10.0 20.0 30.0 40.0

-2.0

-4.0

Sales Growth

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 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.

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 COMMON-SIZE BALANCE SHEET EXAMPLE:
SINGLE COMPANY, TWO PERIODS
Partial common-size balance sheet

Period 1 Period 2
% of Total % of Total
Assets Assets
Cash 25 15
Receivables 35 57
Inventory 35 20
Fixed assets, net of 5 8
depreciation
Total assets 100 100

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 COMMON-SIZE BALANCE SHEET EXAMPLE:
CROSS-SECTIONAL, TWO COMPANIES, SAME TIME

Partial common-size balance sheet

Assets Company 1 Company 2
% of Total % of Total
Assets Assets
Cash 38 12
Receivables 33 55
Inventory 27 24
Fixed assets net of depreciation 1 2
Investments 1 7
Total Assets 100 100

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 USE OF COMPARATIVE GROWTH
INFORMATION: EXAMPLE

Company A, Inc. 2018 vs. 2017

Revenue +19%
Receivables +38%
Inventory +58%

Why are receivables growing so much faster than revenue?

Why is inventory growing so much faster than revenue?

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 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.

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 RATIO ANALYSIS

How profitable was Company X?

15.26%
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.

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 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.
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.
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 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.

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 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:
o What aspects of performance are critical to successfully competing
in the industry?
o How well did the company perform (relative to own history and
relative to competitors)?
o Why? What caused the performance?
o Does the performance reflect the company’s strategy?

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 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.

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 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?

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 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?

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 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:

Amount of return
Rate of return =
Amount invested

• Applied to shareholders’ equity:

Net income
ROE =
Average equity

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 DECOMPOSE ROE

Net income
ROE =
Average equity

Net income Average assets

= ×
Average assets Average equity

= ROA × Leverage

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 DECOMPOSE ROE

ROE = ROA × Leverage

A company can increase its ROE

1. With a business strategy, by increasing its ROA

and/or

2. With a financial strategy, by increasing its use of

leverage as long as returns on the incremental
investment exceed the cost of borrowing.

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 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:

Amount of return
Rate of Return =
Amount invested

Two variants of ROA computation:

Net income
(1) ROA =
Average assets

Net income adjusted for interest

(2) ROA =
Average assets

Net income + [Interest expense × (1 – Tax rate)]

=
Average assets

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 PROFITABILITY, COMPETITION,
AND BUSINESS STRATEGY

Net income
ROA =
Average assets

Net income Revenue

ROA = ×
Revenue Average assets

In other words,
ROA can
be thought
of as:

Profit margin × Turnover (efficiency)

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 DECOMPOSING
RETURN ON EQUITY

ROE = Profit margin × Turnover × Leverage

Net income Revenue Average assets

ROE = × ×
Revenue Average assets Average equity

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 DECOMPOSING
RETURN ON EQUITY
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)

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 DECOMPOSING RETURN ON EQUITY:
STYLIZED COMPARATIVE ANALYSIS MINI-CASE

Averag
Co. A Co. B Co. C e
Sales ($) 2,000 4,000 6,675 4,225
Net income (NI) ($) 200 200 200 200
Average assets ($) 1,000 2,000 1,500 1,500
Average equity ($) 1,000 1,000 1,000 1,000
Average liabilities ($) 0 1,000 500 500
ROE (NI/Equity)
Net profit margin
(NI/Sales)
Turnover
(Sales/Assets)
Leverage
(Assets/Equity)
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 DECOMPOSING RETURN ON EQUITY:
STYLIZED COMPARATIVE ANALYSIS MINI-CASE
Co. A Co. B Co. C Average
Sales ($) 2,000 4,000 6,675 4,225
NI ($) 200 200 200 200
Average assets ($) 1,000 2,000 1,500 1,500
Average equity ($) 1,000 1,000 1,000 1,000
Average liabilities ($) 0 1,000 500 500
ROE (NI/Equity) 20.0% 20.0% 20.0% 20.0%
Net profit margin
(NI/Sales) 10.0% 5.0% 3.0% 4.7%

Turnover (Sales/Assets) 2 2 4.45 2.82

Leverage (Assets/Equity) 1 2 1.5 1.50

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 DECOMPOSING RETURN ON EQUITY:
COMPARATIVE

Co 1 Co 2 Co 3
ROE 27.19% 21.50% 61.19%
Net profit
Net income/Sales margin 14.88% 7.04% 4.06%
Asset
Sales/Average assets turnover 1.00 1.17 2.26
Average assets/ Financial
Average equity leverage 1.83 2.61 6.67

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 DUPONT ANALYSIS :
FURTHER DECOMPOSITION

• ROE = Net income/Average equity

• Decompose ROE into five factors

Net income EBT EBIT

ROE = × ×
EBT EBIT Revenue
Revenue Average assets
× ×
Average assets Average equity

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 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 non-operating
items.

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 DISCUSSION BY CATEGORY

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?

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 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.

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 ACTIVITY RATIOS

Also known as asset utilization or operating efficiency ratios

Numerator Denominator
Working capital turnover Revenue Average working capital
Fixed asset turnover Revenue Average net fixed assets
Total asset turnover Revenue Average total assets

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 OTHER COMMON ACTIVITY RATIOS

Numerator Denominator

Inventory turnover Cost of sales Average inventory

Number of days in
Days of inventory on hand (DOH) Inventory turnover
period

Receivables turnover Revenue Average receivables

Number of days in Receivables

Days of sales outstanding (DSO)
period turnover
Average trade
Payables turnover Purchases
payables
Number of days in
Number of days of payables Payables turnover
period

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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.

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 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

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 DISCUSSION BY CATEGORY

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?

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 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
}
Lower ratio –> safer.
• Debt to equity
• Debt to total capital Higher cushion against
potential creditor losses

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)

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 COMMON SOLVENCY RATIOS

Solvency ratios Numerator Denominator

Debt ratios
Debt-to-assets ratio Total debt Total assets
Debt-to-capital ratio Total debt Total debt + Total
shareholders’ equity
Debt-to-equity ratio Total debt Total shareholders’ equity
Financial leverage Average total assets Average total equity
ratio
Debt-to-EBITDA ratio Total debt EBITDA
Coverage ratios
Interest coverage EBIT Interest payments
Fixed charge EBIT + Lease Interest payments + Lease
coverage payments payments

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 DISCUSSION BY CATEGORY
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?

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 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.

Price
P/E =
Earnings per share

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.

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 VALUATION RATIOS

Numerator Denominator
Valuation ratios
P/E Price per share Earnings per share
P/CF Price per share Cash flow per share
P/S Price per share Sales per share
P/BV Price per share Book value per share

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 DIVIDEND-RELATED QUANTITIES

Dividends per share

Dividend payout ratio =
Earnings per share

Dividends per share

Dividend yield =
Price

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 SELECTED CREDIT RATIOS USED BY
STANDARD & POOR’S AS PART OF CREDIT ANALYSIS

Ratio Numerator Denominator

Gross interest (prior to
EBIT and EBITDA
EBIT or EBITDA deductions for capitalized
interest coverage
interest or interest income)
FFO plus interest Gross interest (prior to
FFO interest coverage paid minus operating deductions for capitalized
lease adjustments interest or interest income)
FFO to debt FFO Total debt
CFO (adjusted)
Free operating cash
minus capital Total debt
flow to debt
expenditures
CFO minus capital
Discretionary cash flow
expenditures minus Total debt
to debt
dividends paid

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 SELECTED CREDIT RATIOS USED BY
STANDARD & POOR’S AS PART OF CREDIT ANALYSIS

Credit Ratio Numerator Denominator

Average capital, where capital is
Return on capital EBIT equity plus non-current deferred
taxes plus debt
Net cash flow to capital
FFO minus dividends Capital expenditures
expenditures

Total debt EBITDA

Debt to EBITDA

Total debt to total debt Total debt Total debt plus equity
plus equity

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 SEGMENT ANALYSIS EXAMPLE:
L’ORÉAL

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 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

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 RATIOS IN MODEL BUILDING

• Sales forecast
Forecast
Debt
• Expenses
• Gross Profit
• Operating Profit
Forecast
Forecast
Interest
Cash Flow • Assets
Expense
• Liabilities

Forecast
Income and • Cash Flow
Taxes

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 SUMMARY

• 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

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