CHAPTER 9 FINANCIAL STATEMENT ANALYSIS Presenters name Presenters

CHAPTER 9 FINANCIAL STATEMENT ANALYSIS Presenter’s name Presenter’s title dd Month yyyy

1. INTRODUCTION Financial analysis is a process of selecting, evaluating, and interpreting financial data, along with other pertinent information, in order to formulate an assessment of a company’s present and future financial condition and performance. Market Data Financial Disclosures Economic Data Financial Analysis Copyright © 2013 CFA Institute 2

2. COMMON-SIZE ANALYSIS Common-size analysis is the restatement of financial statement information in a standardized form. - Horizontal common-size analysis uses the amounts in accounts in a specified year as the base, and subsequent years’ amounts are stated as a percentage of the base value. - Useful when comparing growth of different accounts over time. - Vertical common-size analysis uses the aggregate value in a financial statement for a given year as the base, and each account’s amount is restated as a percentage of the aggregate. - Balance sheet: Aggregate amount is total assets. - Income statement: Aggregate amount is revenues or sales. Copyright © 2013 CFA Institute 3

EXAMPLE: COMMON-SIZE ANALYSIS Consider the CS Company, which reports the following financial information: Year Cash Inventory Accounts receivable Net plant and equipment Intangibles Total assets 2008 $400. 00 1, 580. 00 1, 120. 00 3, 500. 00 400. 00 $6, 500. 00 2009 $404. 00 1, 627. 40 1, 142. 40 3, 640. 00 402. 00 $6, 713. 30 2010 $408. 04 1, 676. 22 1, 165. 25 3, 785. 60 404. 01 $6, 934. 12 2011 $412. 12 1, 726. 51 1, 188. 55 3, 937. 02 406. 03 $7, 162. 74 2012 $416. 24 1, 778. 30 1, 212. 32 4, 094. 50 408. 06 $7, 399. 45 2013 $420. 40 1, 831. 65 1, 236. 57 4, 258. 29 410. 10 $7, 644. 54 1. Create the vertical common-size analysis for the CS Company’s assets. 2. Create the horizontal common-size analysis for CS Company’s assets, using 2008 as the base year. Copyright © 2013 CFA Institute 4

EXAMPLE: COMMON-SIZE ANALYSIS Vertical Common-Size Analysis: Year Cash Inventory Accounts receivable Net plant and equipment Intangibles Total assets 2008 2009 2010 2011 2012 2013 6% 6% 5% 5% 23% 23% 22% 16% 16% 15% 15% 50% 51% 52% 6% 6% 5% 5% 100% 100% Graphically: 100% 80% Proportion 60% of Assets 40% 20% 0% 2008 Cash Inventory Copyright © 2013 CFA Institute 2009 Accounts receivable 2010 2011 Fiscal Year 2012 Net plant and equipment 2013 Intangibles 5

EXAMPLE: COMMON-SIZE ANALYSIS Horizontal Common-Size Analysis (base year is 2008): Year Cash Inventory Accounts receivable Net plant and equipment Intangibles Total assets 2008 100. 00% 2009 101. 00% 103. 00% 102. 00% 104. 00% 100. 50% 103. 08% 2010 102. 01% 106. 09% 104. 04% 108. 16% 101. 00% 106. 27% 2011 103. 03% 109. 27% 106. 12% 112. 49% 101. 51% 109. 57% 2012 104. 06% 112. 55% 108. 24% 116. 99% 102. 02% 112. 99% 2013 105. 10% 115. 93% 110. 41% 121. 67% 102. 53% 116. 53% Graphically: 140% Percentage 130% of Base 120% Year 110% Amount 100% 90% 2008 Cash Inventory Copyright © 2013 CFA Institute 2009 Accounts receivable 2010 2011 Fiscal Year Net plant and equipment 2012 Intangibles 2013 Total assets 6

3. FINANCIAL RATIO ANALYSIS • Financial ratio analysis is the use of relationships among financial statement accounts to gauge the financial condition and performance of a company. • We can classify ratios based on the type of information the ratio provides: Activity Ratios Liquidity Ratios Effectiveness in putting its asset investment to use. Ability to meet short-term, immediate obligations. Copyright © 2013 CFA Institute Solvency Ratios Profitability Ratios Ability to satisfy debt obligations. Ability to manage expenses to produce profits from sales. 7

ACTIVITY RATIOS • Turnover ratios reflect the number of times assets flow into and out of the company during the period. • A turnover is a gauge of the efficiency of putting assets to work. • Ratios: How many times inventory is created and sold during the period. How many times accounts receivable are created and collected during the period. The extent to which total assets create revenues during the period. The efficiency of putting working capital to work Copyright © 2013 CFA Institute 8

OPERATING CYCLE COMPONENTS • The operating cycle is the length of time from when a company makes an investment in goods and services to the time it collects cash from its accounts receivable. • The net operating cycle is the length of time from when a company makes an investment in goods and services, considering the company makes some of its purchases on credit, to the time it collects cash from its accounts receivable. • The length of the operating cycle and net operating cycle provides information on the company’s need for liquidity: The longer the operating cycle, the greater the need for liquidity. Number of Days of Inventory Number of Days of Receivables | | Buy Inventory on Credit Pay Accounts Payable Sell Inventory on Credit Collect Accounts Receivable Number of Days of Payables Net Operating Cycle Copyright © 2013 CFA Institute 9

OPERATING CYCLE FORMULAS Average time it takes to create and sell inventory. Average time it takes to collect on accounts receivable. Average time it takes to pay suppliers. Copyright © 2013 CFA Institute 10

OPERATING CYCLE FORMULAS Time from investment in inventory to collection of accounts, considering the use of trade credit in purchases. Copyright © 2013 CFA Institute 11

LIQUIDITY • Liquidity is the ability to satisfy the company’s short-term obligations using assets that can be most readily converted into cash. • Liquidity ratios: Ability to satisfy current liabilities using current assets. Ability to satisfy current liabilities using the most liquid of current assets. Ability to satisfy current liabilities using only cash and cash equivalents. Copyright © 2013 CFA Institute 12

SOLVENCY ANALYSIS • A company’s business risk is determined, in large part, from the company’s line of business. • Financial risk is the risk resulting from a company’s choice of how to finance the business using debt or equity. • We use solvency ratios to assess a company’s financial risk. • There are two types of solvency ratios: component percentages and coverage ratios. - Component percentages involve comparing the elements in the capital structure. - Coverage ratios measure the ability to meet interest and other fixed financing costs. Copyright © 2013 CFA Institute Risk Business Risk Financial Risk Sales Risk Operating Risk 13

Component-Percentage Solvency Ratios SOLVENCY RATIOS Proportion of assets financed with debt. Proportion of assets financed with longterm debt. Debt financing relative to equity financing. Reliance on debt financing. Coverage Ratios Ability to satisfy interest obligations. Copyright © 2013 CFA Institute Ability to satisfy interest and lease obligations. Ability to satisfy interest obligations with cash flows. Length of time needed to pay off debt with cash flows. 14

PROFITABILITY • Margins and return ratios provide information on the profitability of a company and the efficiency of the company. • A margin is a portion of revenues that is a profit. • A return is a comparison of a profit with the investment necessary to generate the profit. Copyright © 2013 CFA Institute 15

PROFITABILITY RATIOS: MARGINS • Copyright © 2013 CFA Institute 16

PROFITABILITY RATIOS: RETURNS • Copyright © 2013 CFA Institute 17

THE DUPONT FORMULAS Return on Equity • The Du. Pont formula uses the relationship among financial statement accounts to decompose a return into Total Asset Net Profit components. Margin Turnover • Three-factor Du. Pont for the return on equity: - Total asset turnover Operating Profit - Financial leverage Margin - Net profit margin • Five-factor Du. Pont for the return on equity: Effect of - Total asset turnover Nonoperating - Financial leverage Items - Operating profit margin - Effect of nonoperating items - Tax effect Tax Financial Leverage Effect Copyright © 2013 CFA Institute 18

FIVE-COMPONENT DUPONT MODEL • Copyright © 2013 CFA Institute 19

EXAMPLE: THE DUPONT FORMULA Suppose that an analyst has noticed that the return on equity of the D Company has declined from FY 2012 to FY 2013. Using the Du. Pont formula, explain the source of this decline. (millions) Revenues 2013 2012 $1, 000 $900 $400 $380 $30 $100 $90 Total assets $2, 000 Shareholders’ equity $1, 250 $1, 000 Earnings before interest and taxes Interest expense Taxes Copyright © 2013 CFA Institute 20

EXAMPLE: THE DUPONT FORMULA 2013 2012 Return on equity Return on assets 0. 20 0. 13 0. 22 0. 11 Financial leverage Total asset turnover Net profit margin Operating profit margin 1. 60 0. 50 0. 25 0. 40 2. 00 0. 45 0. 24 0. 42 Effect of nonoperating items Tax effect 0. 83 0. 76 0. 82 0. 71 Copyright © 2013 CFA Institute 21

OTHER RATIOS • Copyright © 2013 CFA Institute 22

OTHER RATIOS • Copyright © 2013 CFA Institute 23

EXAMPLE: SHAREHOLDER RATIOS Calculate the book value per share, P/E, dividends per share, dividend payout, and plowback ratio based on the following financial information: Book value of equity $100 million Market value of equity $500 million Net income $30 million Dividends $12 million Number of shares 100 million Copyright © 2013 CFA Institute 24

EXAMPLE: SHAREHOLDER RATIOS Book value per share $1. 00 There is $1 of equity, per the books, for every share of stock. P/E 16. 67 The market price of the stock is 16. 67 times earnings per share. Dividends per share $0. 12 The dividends paid per share of stock. Dividend payout ratio 40% The proportion of earnings paid out in the form of dividends. Plowback ratio 60% The proportion of earnings retained by the company. Copyright © 2013 CFA Institute 25

EFFECTIVE USE OF RATIO ANALYSIS • In addition to ratios, an analyst should describe the company (e. g. , line of business, major products, major suppliers), industry information, and major factors or influences. • Effective use of ratios requires looking at ratios - Over time. - Compared with other companies in the same line of business. - In the context of major events in the company (for example, mergers or divestitures), accounting changes, and changes in the company’s product mix. Copyright © 2013 CFA Institute 26

4. PRO FORMA ANALYSIS Estimate typical relation between revenues and salesdriven accounts. Estimate fixed burdens, such as interest and taxes. Copyright © 2013 CFA Institute Forecast revenues. Estimate sales-driven accounts based on forecasted revenues. Estimate fixed burdens. Construct future period income statement and balance sheet. 27

PRO FORMA INCOME STATEMENT Imaginaire Company Income Statement (in millions) One Year 0 Ahead Sales revenues € 1, 000. 0 € 1, 050. 0 Growth at 5% Cost of goods sold 600. 0 630. 0 60% of revenues Gross profit € 400. 0 € 420. 0 Revenues less COGS SG&A 100. 0 105. 0 10% of revenues Operating income € 300. 0 € 315. 0 Gross profit less operating exp. Interest expense Earnings before taxes Taxes Net income Dividends Copyright © 2013 CFA Institute 32. 0 € 268. 0 93. 8 € 174. 2 € 87. 1 33. 6 € 281. 4 98. 5 € 182. 9 € 91. 5 8% of long-term debt Operating income less interest exp. 35% of earnings before taxes Earnings before taxes less taxes Dividend payout ratio of 50% 28

PRO FORMA BALANCE SHEET Imaginaire Company Balance Sheet, End of Year (in millions) One Year 0 Ahead Current assets € 600. 0 € 630. 0 60% of revenues Net plant and equipment 1, 000. 0 1, 050. 0 100% of revenues Total assets € 1, 600. 0 € 1, 680. 0 Current liabilities € 250. 0 € 262. 5 25% of revenues Long-term debt 400. 0 420. 0 Debt increased by € 20 million to maintain the same capital structure Common stock and paid-in capital 25. 0 Assume no change Treasury stock (44. 0) Repurchased shares Retained earnings 925. 0 1, 016. 5 Retained earnings in Year 0, plus net income, less dividends Total liabilities and equity € 1, 600. 0 € 1, 680. 0 Copyright © 2013 CFA Institute 29

5. SUMMARY • Financial ratio analysis and common-size analysis help gauge the financial performance and condition of a company through an examination of relationships among these many financial items. • A thorough financial analysis of a company requires examining its efficiency in putting its assets to work, its liquidity position, its solvency, and its profitability. • We can use the tools of common-size analysis and financial ratio analysis, including the Du. Pont model, to help understand where a company has been. • We then use relationships among financial statement accounts in pro forma analysis, forecasting the company’s income statements and balance sheets for future periods, to see how the company’s performance is likely to evolve. Copyright © 2013 CFA Institute 30

CHAPTER 7 FINANCIAL ANALYSIS TECHNIQUES Presenter’s name Presenter’s title dd Month yyyy

FINANCIAL ANALYSIS TOOLS: DESCRIPTION • Graphics • Regression • Common-Size Analysis • Financial Ratio Analysis Copyright © 2013 CFA Institute 32

GRAPHICS: EXAMPLE Operating Profit by Geographic Segment 22% 21% 19% 38% Copyright © 2013 CFA Institute North America Latin America Europe/South Pacific Greater Asia/Africa 33

GRAPHICS: EXAMPLE Greater Asia/Africa 2007 2008 2009 2010 2011 Europe/South Pacific Latin America North America 0 200 400 600 800 1000 1200 1400 1600 $ millions Copyright © 2013 CFA Institute 34

06 3 20 06 4 20 07 1 20 07 2 20 07 3 20 07 4 20 08 1 20 08 2 20 08 3 20 08 4 20 09 1 20 09 2 20 09 3 20 09 4 20 10 1 20 10 2 20 10 3 20 10 4 20 11 1 20 11 2 20 11 3 20 11 4 20 06 2 20 06 1 20 GRAPHICS: EXAMPLE Operating profit margin 30. 0% 25. 0% 20. 0% 15. 0% 10. 0% 5. 0% 0. 0% Copyright © 2013 CFA Institute 35

REGRESSION: EXAMPLE 14. 0 R 2 = 0. 2687 12. 0 GDP Change 10. 0 8. 0 6. 0 4. 0 2. 0 0. 0 -40. 0 -30. 0 -20. 0 -10. 0 20. 0 30. 0 40. 0 -2. 0 -4. 0 Sales Growth Copyright © 2013 CFA Institute 36

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. Copyright © 2013 CFA Institute 37

COMMON-SIZE BALANCE SHEET EXAMPLE: SINGLE COMPANY, TWO PERIODS Partial common-size balance sheet Copyright © 2013 CFA Institute 38

COMMON-SIZE BALANCE SHEET EXAMPLE: CROSS-SECTIONAL, TWO COMPANIES, SAME TIME Partial common-size balance sheet Assets Cash Receivables Inventory Fixed assets net of depreciation Investments Total Assets Copyright © 2013 CFA Institute Company 1 Company 2 % of Total Assets 38 12 33 55 27 24 1 2 1 7 100 39

USE OF COMPARATIVE GROWTH INFORMATION: EXAMPLE Sunbeam, Inc. 1997 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 40

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 Copyright © 2013 CFA Institute 41

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. Copyright © 2013 CFA Institute 42

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. • Interpretation generally involves comparison. Furthermore, analysis will address the question of why. Copyright © 2013 CFA Institute 43

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. • Interpretation generally involves comparison. Furthermore, analysis will address the question of why. Copyright © 2013 CFA Institute 44

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: ØWhat aspects of performance are critical to successfully competing in the industry? ØHow well did the company perform (relative to own history and relative to competitors)? ØWhy? What caused the performance? ØDoes the performance reflect the company’s strategy? Copyright © 2013 CFA Institute 45

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 46

CATEGORIES OF FINANCIAL RATIOS Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability ratios. How and how much is the firm achieving returns on its investments? Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 47

PROFITABILITY AND OVERVIEW Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 48

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: Rate of return = • Amount of return Amount invested Applied to shareholders’ equity: ROE = Copyright © 2013 CFA Institute Net income Average equity 49

DECOMPOSE ROE = Net income Average equity = Net income Average assets × Average assets Average equity = ROA × Leverage Copyright © 2013 CFA Institute 50

DECOMPOSE ROE = ROA × Leverage A company can increase its ROE 1. With a business strategy, by increasing its ROA and/or 2. With a financial strategy, by increasing its use of leverage as long as returns on the incremental investment exceed the cost of borrowing. Copyright © 2013 CFA Institute 51

RETURN ON ASSETS What rate of return has the firm earned on the assets it had available to use during the year? The general form of this computation is the same: Amount of return Rate of Return = Amount invested Two variants of ROA computation: Net income (1) ROA = Average assets (2) ROA = = Copyright © 2013 CFA Institute Net income adjusted for interest Average assets Net income + [Interest expense × (1 – Tax rate)] Average assets 52

PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY ROA = Net income Average assets ROA = Net income Revenue × Revenue Average assets In other words, ROA can be thought Profit margin × Turnover (efficiency) of as: Copyright © 2013 CFA Institute 53

DECOMPOSING RETURN ON EQUITY ROE = Profit margin Net income Revenue Copyright © 2013 CFA Institute × × Turnover Revenue Average assets × × Leverage Average assets Average equity 54

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) Copyright © 2013 CFA Institute 55

DECOMPOSING RETURN ON EQUITY: STYLIZED COMPARATIVE ANALYSIS MINI-CASE Co. A Co. B 2, 000 4, 000 6, 675 4, 225 Net income (NI) ($) 200 200 Average assets ($) 1, 000 2, 000 1, 500 Average equity ($) 1, 000 0 1, 000 500 Sales ($) Average liabilities ($) Co. C Averag e ROE (NI/Equity) Net profit margin (NI/Sales) Turnover (Sales/Assets) Leverage (Assets/Equity) Copyright © 2013 CFA Institute 56

DECOMPOSING RETURN ON EQUITY: STYLIZED COMPARATIVE ANALYSIS MINI-CASE Co. A Co. B 2, 000 4, 000 6, 675 4, 225 200 200 Average assets ($) 1, 000 2, 000 1, 500 Average equity ($) 1, 000 0 1, 000 500 ROE (NI/Equity) 20. 0% Net profit margin (NI/Sales) 10. 0% 5. 0% 3. 0% 4. 7% Turnover (Sales/Assets) 2 2 4. 45 2. 82 Leverage (Assets/Equity) 1 2 1. 50 Sales ($) NI ($) Average liabilities ($) Copyright © 2013 CFA Institute Co. C Average 57

DECOMPOSING RETURN ON EQUITY: COMPARATIVE AAPL ROE Net income/Sales/Average assets/ Average equity Copyright © 2013 CFA Institute HPQ 27. 19% 21. 50% Net profit margin Asset turnover Financial leverage DELL 61. 19% 14. 88% 7. 04% 4. 06% 1. 00 1. 17 2. 26 1. 83 2. 61 6. 67 58

DUPONT ANALYSIS : FURTHER DECOMPOSITION • ROE = Net income/Average equity • Decompose ROE into five factors ROE = Net income EBT Copyright © 2013 CFA Institute × EBT EBIT × Revenue Average assets × EBIT Revenue × Average assets Average equity 59

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 60

DISCUSSION BY CATEGORY Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Solvency Profitability Valuation Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 61

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 62

ACTIVITY RATIOS Also known as asset utilization or operating efficiency ratios Working capital turnover Fixed asset turnover Total asset turnover Copyright © 2013 CFA Institute Numerator Revenue Denominator Average working capital Average net fixed assets Average total assets 63

OTHER COMMON ACTIVITY RATIOS Numerator Denominator Inventory turnover Cost of sales Average inventory Days of inventory on hand (DOH) Number of days in period Inventory turnover Receivables turnover Revenue Average receivables Days of sales outstanding (DSO) Number of days in period Receivables turnover Payables turnover Purchases Average trade payables Number of days of payables Number of days in period Payables turnover Copyright © 2013 CFA Institute 64

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 65

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 66

DISCUSSION BY CATEGORY Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Solvency Profitability Valuation Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 67

SOLVENCY: HOW WELL POSITIONED IS THE FIRM TO MEET ITS LONGER-TERM LIABILITIES? Debt ratios: How has the company financed itself? • Debt to total assets Lower ratio –> safer. • Debt to equity Higher cushion against • Debt to total capital } potential creditor losses Coverage ratios: Degree to which earnings or cash flow can decline without affecting firm’s ability to pay interest. • EBIT interest coverage = (EBT + Interest payments)/Interest payments • Fixed charge coverage = (EBIT + Lease payments)/(Interest payments + Lease payments) Copyright © 2013 CFA Institute 68

COMMON SOLVENCY RATIOS Solvency ratios Debt-to-assets ratio Debt-to-capital ratio Debt-to-equity ratio Financial leverage ratio Numerator Total debt Denominator Total assets Total debt + Total shareholders’ equity Total debt Total shareholders’ equity Average total assets Average total equity Coverage ratios Interest coverage EBIT Fixed charge coverage EBIT + Lease payments Copyright © 2013 CFA Institute Interest payments + Lease payments 69

DISCUSSION BY CATEGORY Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Solvency Profitability Valuation Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 70

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. P/E = Price Earnings per share High P/E indicates - Firm is valued highly by market, possibly because of growth expectations, or - That a firm may have very low earnings per share. Copyright © 2013 CFA Institute 71

VALUATION RATIOS Numerator Denominator P/E Price per share Earnings per share P/CF Price per share Cash flow per share P/S Price per share Sales per share P/BV Price per share Book value per share Valuation ratios Copyright © 2013 CFA Institute 72

DIVIDEND-RELATED QUANTITIES Dividend payout ratio = Dividends per share Earnings per share Dividend yield = Dividends per share Price Copyright © 2013 CFA Institute 73

SELECTED CREDIT RATIOS USED BY STANDARD & POOR’S AS PART OF CREDIT ANALYSIS Ratio EBIT and EBITDA interest coverage FFO to debt Numerator Denominator Gross interest (prior to EBIT or EBITDA deductions for capitalized interest or interest income) FFO plus interest Gross interest (prior to paid minus operating deductions for capitalized lease adjustments interest or interest income) FFO Total debt CFO (adjusted) Free operating cash flow minus capital Total debt to debt expenditures CFO minus capital Discretionary cash flow expenditures minus Total debt to debt dividends paid Copyright © 2013 CFA Institute 74

SELECTED CREDIT RATIOS USED BY STANDARD & POOR’S AS PART OF CREDIT ANALYSIS Credit Ratio 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 to total debt plus equity Copyright © 2013 CFA Institute Total debt EBITDA Total debt plus equity 75

SEGMENT ANALYSIS EXAMPLE: L’ORÉAL Copyright © 2013 CFA Institute 76

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 Copyright © 2013 CFA Institute 77

RATIOS IN MODEL BUILDING • Sales forecast Forecast Debt Forecast Interest Expense Forecast Cash Flow Forecast Income and Taxes Copyright © 2013 CFA Institute • Expenses • Gross Profit • Operating Profit • Assets • Liabilities • Cash Flow 78

SUMMARY: FINANCIAL ANALYSIS TOOLS • Graphics facilitate comparisons, and regressions quantify statistical relationships. • Common-size analysis expresses financial data, including entire financial statements, in relation to a single financial statement item or base. • Ratios, which express one number in relation to another, facilitate comparisons—trends and cross-sectional. • A ratio is an indicator of - Activity - Profitability - Liquidity - Solvency Copyright © 2013 CFA Institute 79