fin st analysis midterm part 2

what is the first thing to do as a financial analyst?

look at the MD&A and non GAAP financial metrics

what is a time-series analysis?

helps identify trends for a company or business unit. look for errors and opportunities

what is a cross-sectional analysis?

helps identify similarities and differences across companies or business units.

what is benchmark comparison?

uses industry norms or predetermined standards. sort of an innovation killers (who cares what other firms are doing when we should be doing what’s best for our own firm/people)

how does the financial accounting “filter” work?

what is earnings quality?

how closely earnings from operations matches cash flows

what is conflict of interest?

interest of managers doesn’t match interest of shareholders. an AGENCY problem, management will always manipulate financial statements to their favor

what are buying sales?

higher sales from lowering prices. doesn’t really help us

why is growth trajector important?

because growth is essential in a capitalistic society

what is operating profit?

sales * operating margin

if i say our operating margin is 2%…what does that mean?

it means we made 2 cents on every dollar before taxes

what is a cause-of-change analysi?

a way to quantify the components of change. shows the effects of individual changes on the change in some performance metric of interest.

what is a common size income statement?

recasts each line item as a percentage of sales. shows how much of each sales dollar the company spent on operating expenses and other businesses costs and how much of each sales dollar hit the bottom line as profit.

helps spot changes in company’s cost structure and profit performance

what is noncontrolling interest?

own less than 50% of another company.

in a common size balance sheet, what is the denominator used?

total assets

what does the common size balance sheet tell us and asset and financing structure?

asset structure → what the company has invested its recourses in

financing structure → how the company’s assets are finances

what is the difference between an analytical technique vs source of information (like MD&A)?

analytical technique → method you use to analyze financial information (common size analysis, ratio analysis, trend analysis, etc)

source of information → where you obtain information (MD&A, SEC filings, annual report, financial statements, etc)

what is ROA?

EBI / average assets

what is operating profit margin?

EBI / sales

what is NOPAT?

net operating profit after taxes

used to find return on sales and assets

defined as EBIT * (1 - tax rate)

why do we exclude interest from EBIT?

because its a financing activity and it doesn’t affect operations

how do we use ROA?

it’s a percentage of what they make on each dollar (as a lender). if im internal, compare to PY rate and competitors

how do we calculate profit margin?

NOPAT / sales

good or bad? look at how competitors are doing

how do we calculate asset turnover?

EBI / average assets

what does asset turnover tell us?

higher turnover means higher profitability because we are moving assets (like inventory)

before computing ROA, an analysist may adjust the company’s reported earnings and asset figures for certain situations, like?

• adjustments aimed at isolating a company’s sustainable profits by removing nonrecurring items from reported income

• adjustments for distortions related to accounting quality concerns

how can a company increase or decrease ROA?

1. increase or decrease profit margin

2. increase or decrease the intensity of asset utilization (turnover rate)

how to calculate inventory turnover?

COGS / avg inventory

what are two basic ways for competitive advantage?

1. low cost

2. product differentiation

what is competitive advantage?

ability to create customer value in a way that allows the company to sustainably earn returns above the competitive floor

ROA is comprised of what two components?

profit margin (net income / sales) & asset turnover (sales / average total assets)

why do we decompose ROA into profit margin and asset turnover?

because two companies can have the same ROA for completely different reasons

how is competition and ROA related?

competition works to drive down ROA toward the competitive floor, so if the ROA is above the floor there is a competitive advantage. but a high ROA stimulates more competition which can lead to erosion of profitability and advantage

describe product and service differentation

unique products/services to gain brand loyalty and attractive margins, people are willing to pay premium prices for things they value and cant get elsewhere, can take several forms

describe low cost leadership

focuses on operating efficiencies, which allow company to underprice competition, achieve high sales volume, and make a profit on each sale

how is return on total capital calculated (ROTC)?

EBI / average level of all capital

what does ROTC measure?

profitability

how is return on common equity (ROCE) calculated?

(net income - pref dividends) / average common shareholders equity

what does return on common equity measure?

a company’s performance in using capital provided by common shareholders

what is ROCE affected by?

ROTCA and financial leverage (the degree to which the company finances its operations with debt vs equity)

for firms with more financial leverage, the ups and downs in ROTC are exaggerated…explain

when ROTC is low at a highly levered firm, ROCE will be very low (or negative)

when ROTC is high at a highly levered firm, ROCE will be very high

explain how financial leverage can affect ROCE

if a company can earn a higher return on borrowed money than the cost of borrowing it, leverage can increase the return earned by common shareholders. but debt doesnt automatically increase ROCE

good performance = leverage can magnify shareholder return

poor performance = leverage can magnify shareholder loss

double edge sword

explain debt vs equity financing

debt financing: company borrows money. interest can provide tax benefits, can increase ROCE through leverage, but int payments required, increases financial risk, too much debt can be bad

equity financing: company raises money from shareholders. no mandatory interest payments, no principal payment, but dilutes existing shareholders, lacks the interest tax benefit of debt

why isn’t debt always better than equity financing?

we need to look at companies cash flow and their ability to payback debt. more debt can potentially raise ROCE, but it also increases financial risk

what is credit risk?

the risk of nonpayment by a borrower

what is a borrowers ability to repay debt driven by?

its capacity to generate cash from operations, asset sales, or external financial markets

what are the main sources of cash?

operating (cash from core business operations), investing (cash from sale of fixed assets and securities), financing (cash from external financial markets like debt or equity)

where is cash needed?

to sustain existing operations (operating), to fund investments in fixed assets (investing), to buy back stock or pay dividends or debt principal (financing)

what are short-term liquidity ratios?

liquidity ratios (current ratio & quick ratio)

activity ratios (accounts receivable turnover, inventory turnover, accounts payable turnover)

what does liquidity mean?

ability to meet short-term financial obligations - can we pay our bills?

what is solvency?

ability to meet long-term financial obligations - can we sustain our debt over time?

what is financial flexibility?

ability to obtain financing or adjust cash needs when unexpected events occur - can we handle financial surprises?

what is the current ratio?

current assets / current liabilities

what does the current ratio tell us?

tells us how much money a firm has to pay their bills. healthy ratio is between 1.5 - 3.0

what is the quick ratio?

(cash + marketable securities + receivables) / current liabilities

what does the quick ratio tell us?

whether a company has enough mostly liquid assets to pay off short term liabilities. 1.0 or higher is good, below is bad. too high means business may have too much idle cash

what is accounts receivable turnover?

net credit sales / average accounts receivable

what does AR turnover tell us?

how many times a company collects its average accounts receivables

what does inventory turnover tell us?

how many times a company sells and replaces stock

for lending decisions, why is cash flow important?

because debt must be paid with cash and not accounting income

why is financial statement quality important for analyzing credit risk?

b/c lenders need to identify whether the company’s financial statements accurately represent it’s financial condition. a higher quality financial statement means its more reliable

why is future financial condition important for analyzing credit risk?

b/c the lender is concerned about whether the company will continue generating enough cash flows to repay its debt in the future. historical financial performance doesn’t guarantee future repayment ability.

why is reliance on key individuals or customers important when analyzing credit risk?

b/c if a company generates most of its revenue from one customer, then they may be vulnerable to events outside of its own control

what do we want the current ratio to be?

1:1 or better, 3:1

what is the prime rate?

the rate that banks charge their best customers

what are loan covenants?

all the terms of the loan imposed on the borrowers - tied to their financial ratios

if a loan covenant is violated, what happens?

bank has right to call loan payable immediately, which can bankrupt a borrower. risk of foreclosure.

what is the interest coverage ratio?

operating income (aka EBIT) / total interest amount

what does the interest coverage ratio tell us?

its another measure in telling banks whether they will be repaid. anything above 2 is good

what is aging days in AR?

360 / AR turnover

what is aging days in inventory?

360 / inventory turnover

what does aging days inventory or AR tell us?

how many days we keep inventory and how many days it takes to receive cash from credit sales

what is collateral?

an asset pledged to secure a loan

what is a secured loan?

a loan backed by a collateral (an asset)

what is an unsecured loan?

a loan not backed by a collateral (assets)

if a borrower defaults, what can the lender do?

its dependent on the contractual agreement. the lender remedies depends on the loan agreement and applicable law

what are long term solvency ratios?

debt ratios (long term debt to assets & long term debt to tangible assets)

coverage ratios (interest coverage, operating cash flow to total liabilities)

how do you calculate long term debt to assets?

long term debt / total assets

how do you calculate long term debt to tangible assets?

long term debt / total tangible assets

how do you calculate operating cash flow to total liabilities?

cash flow from continuing operations / (avg current liabilities + long term debt)

why is cash flow from operating activities important in analyzing credit risk?

b/c generating cash from operations is essential to any companys long term economic viability

why is cash flow from investing activities important in analyzing credit risk?

b/c changes in companys capital expenditures or fixed asset sales over time must be analyzed carefully b/c they have implications for the company’s future operating CF

why is cash flow from financing activities important in analyzing credit risk?

b/c determining the optimal debt level involves a trade-off between two competing economic forces - taxes and costs of financial distress