fsa 11: Financial Analysis Techniques

What is the value of ratio analysis

• Evaluate past performance

• Assess current financial position

• Project future earnings and cash flows

What is the purpose of ratio analysis?

• Convert financial statement data into useful indicators of performance

• Help understand relationships between financial variables

• Support analysis of:

  • Profitability

  • Liquidity

  • Efficiency

  • Risk

• Provide inputs for forecasting and decision-making

What are the limitations of ratio analysis?

• Industry differences: Firms may operate in multiple industries, making comparisons difficult

• Inconsistent signals: Different ratios may give conflicting conclusions

• Judgment required: Ratios must be interpreted within context; no absolute “correct” value

• Not a valuation tool alone: Cannot directly determine value or creditworthiness

• Accounting method differences reduce comparability

What is common-size analysis of the balance sheet and what does it show?

• Expresses each balance sheet item as a % of total assets

• Shows the composition of assets and financing structure

• Helps compare:

  • Asset mix over time

  • Capital structure

  • Differences vs peers

• Useful for identifying changes in liquidity, leverage, or risk profile

What is common-size analysis of the income statement and what does it show?

• Expresses each income statement item as a % of revenue

• Shows cost structure and profitability drivers

• Helps analyze:

  • Changes in margins (gross, operating, net)

  • Revenue mix (product/service breakdown)

  • Expense trends relative to sales

• Useful for identifying shifts in profitability or cost pressures

What is cross-sectional analysis?

• Compares financial metrics of different companies at the same point in time

• Allows comparison across:

  • Different sizes

  • Different currencies

  • Industry peers

• Helps assess:

  • Relative liquidity

  • Efficiency

  • Risk and asset structure

• Useful for benchmarking performance against competitors

What is trend analysis in financial statement analysis?

• Examines financial data over multiple periods over time

• Focuses on:

  • Direction (improving or worsening trends)

  • Growth rates (absolute and percentage changes)

• Can be presented as:

  • Year-over-year changes

  • Index/base-year comparisons

• Helps forecast future performance and detect structural changes

What are the key relationships between financial statements important?

• Revenue growth vs asset growth → efficiency changes

• Net income vs operating cash flow → earnings quality

• Divergences (e.g., rising income but falling cash flow) may signal:

  • Aggressive accounting

  • Weak earnings quality

when to use

1. Pie graphs

2. Line graphs

3. Stacked column graph

Pie: a communicate the composition of a total value

Line: focus is on the change in amount for a limited number of items over a relatively longer time period

Stacked column: When the composition and amounts, as well as their change over time, are all important,

What do activity ratios measure?

How efficiently a company uses its assets

What do liquidity ratios measure?

A company’s ability to meet short-term obligations.

What do solvency ratios measure?

A company’s ability to meet long-term obligations.

what do profitability ratios measure?

A company’s ability to generate profit from assets, equity, or sales.

What context to look at when analysing ratios?

1. Prior period results.

2. Expectations.

3. Industry peers and competitors (cross-sectional analysis).

4. Company goals and strategy.

5. Economic conditions.

Inventory turnover meaning and formula

$$\frac{\text{COS or COGS}}{\text{Average inventory}}$$

How efficiently a company manages inventory and how quickly it sells inventory.

high = good

Days of inventory on hand (DOH) meaning and formula

$$\frac{\text{Number of days in period}}{\text{Inventory turnover}}$$

The average number of days inventory is held before being sold.

Receivables turnover formula

$$\frac{\text{Revenue}}{\text{Average receivables}}$$

Days of sales outstanding (DSO) meaning and formula

$$\frac{\text{Number of days in period}}{\text{Receivables turnover}}$$

The average number of days it takes to collect cash from customers.

Payables turnover meaning and formula

$$\frac{\text{COS or COGS}}{\text{Average trade payables}}$$

how many times per year the company theoretically pays off all its creditors

high = not making full use of credit

Number of days of payables meaning and formula

$$\frac{\text{Number of days in period}}{\text{Payables turnover}}$$

How quickly a company pays its suppliers.

high = trouble paying on time

Working capital turnover meaning and formula

$$\frac{\text{Revenue}}{\text{Average working capital}}$$

how efficiently the company generates revenue with its working capital

high = efficient

Fixed asset turnover

$$\frac{\text{Revenue}}{\text{Average net fixed assets}}$$

how efficiently the company generates revenues from its investments in fixed assets

high = efficient

Total asset turnover

$$\frac{\text{Revenue}}{\text{Average total assets}}$$

company’s overall ability to generate revenues with a given level of assets

what is liquidity?

ability to meet short term liabilities

Current ratio

$$\frac{\text{Current asset}}{\text{Current Liabilities}}$$

ability to meet short term liabilities

higher = higher liquidity

Quick ratio

$$\frac{\text{Cash + marketable securities + receivables}}{\text{Current Liabilities}}$$

more conservative than the current ratio

higher = more liquid

cash ratio

$$\frac{\text{Cash + marketable securities }}{\text{Current Liabilities}}$$

measure of an entity’s liquidity in a crisis situation

Defensive interval ratio

$$\frac{\text{Cash + marketable securities + receivables}}{\text{Daily cash expenditures}}$$

how many days a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in

Cash conversion cycle

DOH + DSO – Number of days of payables

short: only need to finance inventory and accounts receivable for short time

long: may need higher level of capital

what is solvency?

company’s ability to fulfill its long-term debt obligations

Debt-to-assets ratio

$$\frac{\text{Total debt}}{\text{Total assets}}$$

percentage of total assets financed with debt

higher → higher financial risk → weaker solvency

Debt-to-capital ratio

$$\frac{\text{Total debt}}{\text{Total assets + total shareholder equity}}$$

measures the percentage of a company’s capital (debt plus equity) represented by debt

higher → higher financial risk → weaker solvency

Financial leverage ratio

$$\frac{\text{Average total assets}}{\text{Average total equity}}$$

amount of total assets supported for each one money unit of equity

higer = more leveraged = using debt/ other liabilities to fund assets

Debt-to-EBITDA

$$\frac{\text{Total or net debt}}{\text{EBITDA}}$$

how many years it would take to repay total debt based on earnings before income taxes, depreciation, and amortization

• used in debt convenant or with investors

Interest Coverage

$$\frac{\text{EBIT}}{\text{Interest payments }}$$

measures the number of times a company’s EBIT could cover its interest payments

higher = higher solvency

Fixed charge coverage

$$\frac{\text{EBIT + Lease payments}}{\text{Interest payments + Lease payments}}$$

the number of times a company’s earnings (before interest, taxes, and lease payments) can cover the company’s interest and lease payments

higher = better solvency

what do profitability ratios measure?

the return earned by the company during a period

Gross profit margin

$$\frac{\text{Gross profit}}{\text{revenue}}$$

percentage of revenue available to cover operating and other expenses and to generate profit

higher = higher product prices and lower costs

operating profit

$$\frac{\text{operating profit}}{\text{revenue}}$$

Operating profit = gross profit - operating costs

• operating profit margin increasing faster than the gross profit margin → improvements in controlling operating costs, such as administrative overheads.

• declining operating profit margin → deteriorating control over operating costs.

net profit

$$\frac{\text{net profit}}{\text{revenue}}$$

• Net profit, or net income = revenue - all expenses

• Net income includes both recurring and non-recurring components

• generally adjusted for non-recurring items to give better view of future profitability

Pretax Margin

$$\frac{\text{EBT}}{\text{revenue}}$$

• also called EBT

• pretax margin = operating profit - interest

• ratio of pretax income to revenue

• reflects the effects on profitability of leverage and other (non-operating) income and expenses.

• If non-operating income is increasing, analysts should assess whether it reflects a sustainable shift in business strategy or a temporary source of earnings.

Operating ROA

$$\frac{\text{Operating income}}{\text{Average total assets}}$$

• returns are measured prior to deducting interest on debt capital (i.e., as operating income or EBIT)

• reflects the return on all assets invested in the company, whether financed with liabilities, debt, or equity

ROA

$$\frac{\text{Net income}}{\text{Average total assets}}$$

• return earned by a company on its assets

• higher = more income generated by a given level of assets

issue:

• net income = return to equity holders (interest already deducted)

• but assets financed by both equity holders and creditors

• some cases: adjust for interest → ROIC

• some cases:pre-interest and pre-tax basis → operating ROA

Return on Invested Capital (ROIC)

$$\frac{\text{EBIT × (1 - Effective Tax Rate)}}{\text{Average total short and long-term debt and equity}}$$

• after-tax profitability a company earns on all of the capital that it employs (short-term debt, long-term debt, and equity)

• measured prior to deducting interest on debt capital (i.e., as operating income or EBIT).

ROE

$$\frac{\text{Net income}}{\text{Average total equity}}$$

• measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity.

• measured as net income (i.e., interest on debt capital is not included in the return on equity capital).

• variation of ROE is return on common equity, which measures the return earned by a company only on its common equity.

Return on common equity

$$\frac{\text{Net income-preferred dividends}}{\text{Average common equity}}$$

basic dupont decomposition (into 2)

ROA * Leverage

when leverage ratio = 1 then ROE = ROA

How can a company increase ROE in the two-step DuPont model?

• Increasing ROA (better profitability/efficiency)

• Increasing financial leverage when return earned on borrowed funds exceeds the borrowing cost

What is the three-step DuPont decomposition formula?

ROE = Net profit margin × Total asset turnover × Leverage.

In the three-step DuPont model, ROE is a function of what three factors?

1. Profitability

2. Efficiency

3. Financial leverage

What is the five-step DuPont decomposition formula?

ROE = Tax burden × Interest burden × EBIT margin × Total asset turnover × Leverage.

What is the interest burden ratio?

$$\frac{\text{Net income}}{\text{EBT}}$$

• Measures how much pretax profit remains after taxes.

• higher = lower effective tax rate and more pretax profit retained

what is interest burden ratio

$$\frac{\text{EBT}}{\text{EBIT}}$$

• Measures the impact of interest expense on profitability.

• higher = lower interest expense and borrowing costs

What is EBIT margin?

$$\frac{\text{EBIT}}{\text{revenue}}$$

measures operating profitability before interest and taxes

How are ratio analysis and common-size analysis used in forecasting?

They help identify historical relationships and trends that can be projected into the future.

What is a pro forma financial statement?

A forecasted financial statement used for planning and financial analysis

What is sensitivity analysis?

• what-if” analysis showing how outcomes change when assumptions change

• to assess how changes in assumptions affect outcomes like earnings, financing needs, or asset investment.

• examines one scenario

What is scenario analysis?

• Analysis of outcomes resulting from specific economic or business events.

  • e.g loss of customers

  • loss of a supply source

  • catastrophic event.

• If events are mutually exclusive and exhaustive and can be assigned probabilities

  • can evaluate range of outcomes and the mean and median value for various quantities of interest.

What is simulation analysis?

• Computer-generated analysis using probability distributions for input variables

• assigns probabilities to variables and runs many possible scenarios automatically.