Financial Management Ch 7 and 3

Ratio Analysis

• analyze a firm’s relative riskiness, profit potential, and general performance

• Analyze a firm’s weak and strong points and how it compares to other firms in the same industry

• Used to help predict the firm’s future earnings and dividends

External Analysis

People from the outside looking in, stock analyst, bond analyst, commercial loan officer, anyone one the outside looking at the companies giving views on how the company will do

Internal Analysis

Executive management team, CFO, the board of governors, trustees, directors, inside the company examining the finances within the company heading in the right directions and meeting their goals 

Ratio Analysis is used to

• compare difference companies in the same industry

• compare different industries aka cross-sectional analysis

• time-series comparison

time-series comparison

compare performance in different time periods which can be used to indicate future success or failure. That is, to spot future trends or problems.

High liquidity

high amount of money

Current Ratio

idea that does the company have enough to pay off their debt and still have a lot of money left over

Problems with financial statement analysis

• overdiversified firm since it hard to compare and keep track

• inflation can distort balance sheets

• seasonal factors since there many seasonal firms

• firms’ use of window dressing to make their numbers look better to credit analysts and investors

• there are various operating and accounting procedures that can distort a firm’s bottom line

The Capital Asset Pricing Model (CAPM)

shows the relationship between risk and return: given a particular risk for an investment, and the market return of a portfolio consisting of all stocks, and an alternative risk-free investment, such as T-bills, what is the return you could expect for a common stock as an investment

• the greater the risk, the greater the potential return

Diversifiable Risk/Unsystematic Risk

the risk specific to an individual company or industry that can be reduced or eliminated by spreading investments across different assets

Non-diversifiable/Systematic Risk

the risk that affects an entire market or a broad segment of it and cannot be eliminated through diversification

The higher the Measure of risk (Beta)

The higher the expected return

Security Market Line

shows the relationship between risk as measured by Beta (a stock’s risk volatility) and the required rate of return for individual securities

Key Points about Beta

• used to measure how far the returns on a given stock move with the market

• looks at a stock’s volatility relative to an average stock

• is needed to see how risky a stock is

• SML shows the relationship between

• risk measured by Beta and the required rate of return for individual securities

• tells how much systematic risk a particular asset has relative to an average asset

average risk for a stock

has a Beta of 1.0

Beta higher than average in a stock portfolio

then more risk involved in the portfolio

The CAPM states that the expected return of an investment is a function of:

The time value of money (the reward for waiting), A reward for taking on risk, the amount of risk

CAPM Limits

• Cannot predict what the market will do in the future or for one particular stock

• It is difficult to determine an asset’s future Beta

• It is not clear what time period is being used 

Beta above 1.0

stock is considered risk and will rise or fall more than the market

Beta below 1.0

the stock is considered less risky and will tend to rise or fall less than the market

If beta 1.0

then its return tends to track the market portfolio

Arbitrage Pricing Theory

• It is a model based on a market that is in equilibrium and free of arbitrage opportunities

• represents an alternative approach to securities valuation within the same framework

• relates asset returns within a multivariate framework in which the return relationships are linear

• asserts than an asset’s expected return depends on a linear combination of some set of factors, which can be identified empirically

factor analysis

a statistical method has been used to attempt to identify relevant factors