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CHAPTER 7 FINANCIAL ANALYSIS TECHNIQUES Presenters name Presenters title dd Month yyyy

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FINANCIAL ANALYSIS TOOLS: DESCRIPTION Graphics Regression Common-Size Analysis Financial Ratio Analysis Copyright © 2013 CFA Institute 2

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GRAPHICS: EXAMPLE Copyright © 2013 CFA Institute 3

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GRAPHICS: EXAMPLE Copyright © 2013 CFA Institute 4 $ millions

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GRAPHICS: EXAMPLE Copyright © 2013 CFA Institute 5

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REGRESSION: EXAMPLE Copyright © 2013 CFA Institute 6

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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 whats 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. Copyright © 2013 CFA Institute 7

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COMMON-SIZE BALANCE SHEET EXAMPLE: SINGLE COMPANY, TWO PERIODS Copyright © 2013 CFA Institute Partial common-size balance sheet 8

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COMMON-SIZE BALANCE SHEET EXAMPLE: CROSS-SECTIONAL, TWO COMPANIES, SAME TIME AssetsCompany 1 % of Total Assets Company 2 % of Total Assets Cash3812 Receivables3355 Inventory2724 Fixed assets net of depreciation12 Investments17 Total Assets100 Copyright © 2013 CFA Institute Partial common-size balance sheet 9

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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? Copyright © 2013 CFA Institute 10

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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 comparisonstrends and across companies. Ratios are interrelated Copyright © 2013 CFA Institute 11

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RATIO ANALYSIS Copyright © 2013 CFA Institute 12 A ratio is NOT the answer (except sometimes on an exam). A ratio is an indicatorfor example, an indicator of relative activity, profitability, liquidity, solvency. How profitable was Company X?

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RATIO ANALYSIS Copyright © 2013 CFA Institute 13 A ratio is NOT the answer (except sometimes on an exam). A ratio is an indicatorfor example, an indicator of relative activity, profitability, liquidity, solvency. Interpretation generally involves comparison. Furthermore, analysis will address the question of why. How profitable was company X?

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RATIO ANALYSIS Copyright © 2013 CFA Institute 14 A ratio is NOT the answer (except sometimes on an exam). A ratio is an indicatorfor example, an indicator of relative activity, profitability, liquidity, solvency. Interpretation generally involves comparison. Furthermore, analysis will address the question of why. How profitable was Company X?

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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 companys 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 companys strategy? Copyright © 2013 CFA Institute 15

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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. Copyright © 2013 CFA Institute 16

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CATEGORIES OF FINANCIAL RATIOS CategoryDescription ActivityActivity ratios. How efficient are the firms operations and the firms management of assets? LiquidityLiquidity ratios. How well is the firm positioned to meet short-term obligations? SolvencySolvency ratios. How well is the firm positioned to meet long-term obligations? ProfitabilityProfitability ratios. How and how much is the firm achieving returns on its investments? ValuationValuation ratios. How does the firms performance or financial position relate to its market value? Copyright © 2013 CFA Institute 17

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PROFITABILITY AND OVERVIEW Copyright © 2013 CFA Institute 18 CategoryDescription ActivityActivity ratios. How efficient are the firms operations and the firms management of assets? LiquidityLiquidity ratios. How well is the firm positioned to meet short-term obligations? SolvencySolvency ratios. How well is the firm positioned to meet long-term obligations? ProfitabilityProfitability ratios. How much and how is the firm achieving returns on its investments? ValuationValuation ratios. How does the firms 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: Applied to shareholders equity: Rate of return = Amount of return Amount invested ROE = Net income Average equity Copyright © 2013 CFA Institute 19

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DECOMPOSE ROE = Net income × Average assets Average equity ROE = Net income Average equity =ROA×Leverage Copyright © 2013 CFA Institute 20

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DECOMPOSE ROE 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. ROE =ROA×Leverage Copyright © 2013 CFA Institute 21

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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: Two variants of ROA computation: Rate of Return = Amount of return Amount invested (1)ROA = Net income Average assets (2)ROA = Net income adjusted for interest Average assets = Net income + [Interest expense × (1 – Tax rate)] Average assets Copyright © 2013 CFA Institute 22

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PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY In other words, ROA can be thought of as: ROA = Net income Average assets ROA = Net income × Revenue Average assets Copyright © 2013 CFA Institute 23 Profit margin × Turnover (efficiency)

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DECOMPOSING RETURN ON EQUITY ROE = Net income × Revenue × Average assets RevenueAverage assetsAverage equity ROE =Profit margin×Turnover×Leverage Copyright © 2013 CFA Institute 24

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DECOMPOSING RETURN ON EQUITY What was the source of the firms return on equity? To what extent... was it derived from selling a high margin product or keeping expenses lowderiving 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 equityby using more debt in its capital structure? (financial leverage) Du Pont Analysis Copyright © 2013 CFA Institute 25

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DECOMPOSING RETURN ON EQUITY: STYLIZED COMPARATIVE ANALYSIS MINI-CASE Co. A Co. B Co. C Average Sales ($)2,0004,0006,6754,225 Net income (NI) ($)200 Average assets ($)1,0002,0001,500 Average equity ($)1,000 Average liabilities ($)01, ROE (NI/Equity) Net profit margin (NI/Sales) Turnover (Sales/Assets) Leverage (Assets/Equity) Copyright © 2013 CFA Institute 26

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DECOMPOSING RETURN ON EQUITY: STYLIZED COMPARATIVE ANALYSIS MINI-CASE Co. A Co. B Co. C Average Sales ($)2,0004,0006,6754,225 NI ($)200 Average assets ($)1,0002,0001,500 Average equity ($)1,000 Average liabilities ($)01, ROE (NI/Equity)20.0% Net profit margin (NI/Sales)10.0%5.0%3.0%4.7% Turnover (Sales/Assets) Leverage (Assets/Equity) Copyright © 2013 CFA Institute

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DECOMPOSING RETURN ON EQUITY: COMPARATIVE AAPLHPQDELL ROE27.19%21.50%61.19% Net income/Sales Net profit margin14.88%7.04%4.06% Sales/Average assets Asset turnover Average assets/ Average equity Financial leverage Copyright © 2013 CFA Institute 28

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DUPONT ANALYSIS : FURTHER DECOMPOSITION ROE = Net income/Average equity Decompose ROE into five factors ROE = Net income × EBT × EBIT EBTEBITRevenue × × Average assets Average equity 29 Copyright © 2013 CFA Institute

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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 nonoperating items. Copyright © 2013 CFA Institute 30

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DISCUSSION BY CATEGORY CategoryDescription ActivityActivity ratios. How efficient are the firms operations and the firms management of assets? LiquidityLiquidity ratios. How well is the firm positioned to meet short-term obligations? SolvencySolvency ratios. How well is the firm positioned to meet long-term obligations? ProfitabilityProfitability ratios. How much and how is the firm achieving returns on its investments? ValuationValuation ratios. How does the firms performance or financial position relate to its market value? Copyright © 2013 CFA Institute 31

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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. Copyright © 2013 CFA Institute 32

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ACTIVITY RATIOS NumeratorDenominator Working capital turnoverRevenueAverage working capital Fixed asset turnoverRevenueAverage net fixed assets Total asset turnoverRevenueAverage total assets Copyright © 2013 CFA Institute 33 Also known as asset utilization or operating efficiency ratios

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OTHER COMMON ACTIVITY RATIOS NumeratorDenominator Inventory turnoverCost of salesAverage inventory Days of inventory on hand (DOH) Number of days in period Inventory turnover Receivables turnoverRevenueAverage receivables Days of sales outstanding (DSO) Number of days in period Receivables turnover Payables turnoverPurchases Average trade payables Number of days of payables Number of days in period Payables turnover Copyright © 2013 CFA Institute 34

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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. Copyright © 2013 CFA Institute 35

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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 Copyright © 2013 CFA Institute 36

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DISCUSSION BY CATEGORY CategoryDescription ActivityActivity ratios. How efficient are the firms operations and the firms management of assets? LiquidityLiquidity ratios. How well is the firm positioned to meet short-term obligations? SolvencySolvency ratios. How well is the firm positioned to meet long-term obligations? ProfitabilityProfitability ratios. How much and how is the firm achieving returns on its investments? ValuationValuation ratios. How does the firms performance or financial position relate to its market value? Copyright © 2013 CFA Institute 37

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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 Debt to equity Debt to total capital Coverage ratios: Degree to which earnings or cash flow can decline without affecting firms 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 Copyright © 2013 CFA Institute 38

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COMMON SOLVENCY RATIOS Solvency ratiosNumeratorDenominator Debt ratios Debt-to-assets ratioTotal debtTotal assets Debt-to-capital ratioTotal debtTotal debt + Total shareholders equity Debt-to-equity ratioTotal debtTotal shareholders equity Financial leverage ratio Average total assetsAverage total equity Coverage ratios Interest coverageEBITInterest payments Fixed charge coverage EBIT + Lease payments Interest payments + Lease payments Copyright © 2013 CFA Institute 39

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DISCUSSION BY CATEGORY CategoryDescription ActivityActivity ratios. How efficient are the firms operations and the firms management of assets? LiquidityLiquidity ratios. How well is the firm positioned to meet short-term obligations? SolvencySolvency ratios. How well is the firm positioned to meet long-term obligations? ProfitabilityProfitability ratios. How much and how is the firm achieving returns on its investments? ValuationValuation ratios. How does the firms performance or financial position relate to its market value? Copyright © 2013 CFA Institute 40

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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 firms 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 Copyright © 2013 CFA Institute 41

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VALUATION RATIOS NumeratorDenominator Valuation ratios P/EPrice per shareEarnings per share P/CFPrice per shareCash flow per share P/SPrice per shareSales per share P/BVPrice per shareBook value per share Copyright © 2013 CFA Institute 42

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DIVIDEND-RELATED QUANTITIES Dividend payout ratio= Dividends per share Earnings per share Dividend yield= Dividends per share Price Copyright © 2013 CFA Institute 43

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SELECTED CREDIT RATIOS USED BY STANDARD & POORS AS PART OF CREDIT ANALYSIS RatioNumeratorDenominator 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 Gross interest (prior to deductions for capitalized interest or interest income) FFO to debtFFOTotal debt Free operating cash flow to debt CFO (adjusted) minus capital expenditures Total debt Discretionary cash flow to debt CFO minus capital expenditures minus dividends paid Total debt Copyright © 2013 CFA Institute 44

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SELECTED CREDIT RATIOS USED BY STANDARD & POORS AS PART OF CREDIT ANALYSIS Credit RatioNumeratorDenominator Return on capitalEBIT Average capital, where capital is equity plus noncurrent deferred taxes plus debt Net cash flow to capital expenditures FFO minus dividendsCapital expenditures Debt to EBITDA Total debtEBITDA Total debt to total debt plus equity Total debtTotal debt plus equity Copyright © 2013 CFA Institute 45

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SEGMENT ANALYSIS EXAMPLE: LORÉAL Copyright © 2013 CFA Institute 46

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MODEL BUILDING: EXAMPLES OF POSSIBLE USES OF RATIOS Copyright © 2013 CFA Institute 47 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 Copyright © 2013 CFA Institute 48 Forecast Debt Forecast Interest Expense Forecast Income and Taxes Forecast Cash Flow Sales forecast Expenses Gross Profit Operating Profit Assets Liabilities Cash Flow

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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 comparisonstrends and cross-sectional. A ratio is an indicator of -Activity -Profitability -Liquidity -Solvency Copyright © 2013 CFA Institute 49

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