1. Chapter 7 Financial Analysis Techniques
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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 the relationships among ratios and evaluate a company using ratio analysis.
Demonstrate the application of DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components.
Calculate and interpret ratios used in equity analysis, credit analysis, and segment analysis.
Describe how ratio analysis and other techniques can be used to model and forecast earnings.

2. 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.
Pages 297–298
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.
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3. Graphics: example
LOS. Describe tools and techniques used in financial analysis, including their uses and limitations.
Pages 317–318
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

4. Graphics: example $ millions
LOS. Describe tools and techniques used in financial analysis, including their uses and limitations.
Pages 317–318
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

5. Graphics: example
LOS. Describe tools and techniques used in financial analysis, including their uses and limitations.
Pages 317–318
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.
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6. 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.
Pages 319, 360
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.)
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7. 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.
Pages 311–313
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.
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8. 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 the relationships among ratios and evaluate a company using ratio analysis.
Pages 311–313
This example follows Exhibit 7-3 in the text.
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.
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9. 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 the relationships among ratios and evaluate a company using ratio analysis.
Pages 311–313
This example follows Exhibit 7-5 in the text.
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.
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10. 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 the relationships among ratios and evaluate a company using ratio analysis.
Pages 316–317
This example follows Example 7-5 in the text.
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.
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11. 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.
Pages 306–307
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.
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12. 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.
Pages 306–307
The number is not “the answer.”
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13. 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.
Pages 307–308
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

14. 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.
Pages 307–308
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

15. 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.
Pages 307–318
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.)
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16. 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.
Pages 307–311, 321, 333, 352, 355
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
Industry ratio examples are listed in Exhibit 7-19 of the text.
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. For example, a couple of credit ratios in Exhibit 7-20 are not included in the basic list in Exhibit 7-14, such as funds from operations (FFO) to debt and debt to EBITDA.
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.
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17. 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.
Pages 319–320
Copyright © 2013 CFA Institute

18. 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.
Pages 319–320
Copyright © 2013 CFA Institute

19. 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.
Pages 342–347
ROE measures the return a company generates on its equity capital.
ROE =
Net income
Average equity
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20. 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.
Pages 342–347
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
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21. 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.
Pages 342–347
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

22. 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.
Pages 337–338
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
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23. 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.
Pages 342–347
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)
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24. 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.
Pages 342–347
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

25. 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.
Pages 342–347
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

26. 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.
Pages 342–347
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

27. 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.
Pages 342–347
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

28. 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.
Pages 342–347
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

29. 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.
Pages 342–347
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

30. 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.
Pages 335–338
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

31. 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.
Pages 319–320
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

32. 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.
Pages 320–326
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

33. 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.
Pages 320–326
Copyright © 2013 CFA Institute

34. 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.
Pages 320–326
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

35. 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.
Pages 320–326, 328–329
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

36. 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.
Pages 326–331
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

37. 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.
Pages 319–320
Copyright © 2013 CFA Institute

38. 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.
Pages 332–335
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

39. 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.
Pages 332–335
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

40. 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.
Pages 319–320
Copyright © 2013 CFA Institute
Copyright © 2013 CFA Institute

41. 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.
Pages 348–353
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 inThe 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

42. 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.
Pages 348–351
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

43. 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.
Pages 348–351
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

44. 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, credit analysis, and segment analysis.
Pages 353–356
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

45. 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, credit analysis, and segment analysis.
Pages 353–356
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

46. Segment analysis example: L’ORÉAL
LOS. Calculate and interpret ratios used in equity analysis, credit analysis, and segment analysis.
Pages 356–360
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

47. 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.
Page 360
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.
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48. 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.
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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

49. 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
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