CFI: Financial Analysis Fundamentals

Profitability ratios

There are three profitability ratios:

1. Gross Profit Margin

2. Operating Profit Margin

3. Net Profit Margin

Efficiency Ratios

There are two efficiency ratios:

1. Tax ratio

2. Solvency ratio, also known as interest coverage ratio.

Tax Ratio

Tax expense/Pre-tax income

Solvency Ratio Equation

EBIT(DA)/ Interest Expense

How do you calculate profitability ratios?

By dividing the line item by sales, example gross profit/ sales

Vertical Analysis

It is the analysis of a company using profitability and efficiency ratios under a single time horizon.

Horizontal Analysis

Trend analysis over multiple time horizons (typically 5 or more years)

Benchmarking

It is a process where companies:

• Compare their company to two or more competing companies.

• Compare company ratios to industry averages.

Current Ratio

Current Assets/Current Liabilities, a liquidity ratio. Where 2:1 is a good rile of thumb.

Quick Ratio (Acid Test Ratio)

(Current Assets - Inventory) / Current Liabilities, it is a more conservative measure of liquidity which takes into account that inventory is not readily converted into cash. 1:1 is a good rule of thumb.

Working Capital

Inventory - Accounts Payable + Accounts Receivable

Working Capital Funding Gap

The period of time between when cash goes from a company and when the cash comes in.

What strategies can help the company reduce the time of the working capital funding gap?

1. Delay payments to supplierI

2. Incentivise customers to pay faster

3. Order inventory as needed instead of stockpiling.

Inventory Turnover Ratio

COGS/Inventory

Inventory Days

Inventory/ Cost of sales X 365

Receivables Turnover Ratio

Sales / Accounts Receivable

Receivable Days Ratio

(Accounts Receivable/ Sales) x 365

Payable Turnover Ratio

COGS/Accounts Payable

Payable Days Ratio

(Accounts Payable / COGS) x 365

PP&E Efficiency Ratio

Sales/ PP&E

Cash flow groups

Asset management, operational management, financial strategy

Asset Management

The management of investment in the company. It is indicative of whether or not a company is committed to growth.

How can we see if a company is committed to growth?

• Working capital: whether a company is investing or taking out.

• Capex > amortisation and depreciation means a company is growing asset base. Capex < amortisation and depreciation means that the company is shrinking its asset base.

• We can see whether the company is making acquisitions of other businesses.

• Generally, there will be a cash outflow in asset management when a company is investing in growth. If there is the latter, it is shrinking its asset base.

Operational Management

The operational strategy followed by an organisation.

1. Margin Management

2. Volume Management

3. Operating Profit

Financial Strategy

Determines the capital structure, prefers to optimise structure by keeping cost of capital as low as possible. Make decisions regarding:

• Debt / Equity funding

• Long- term or short-term

• Other instruments

• Interest/ Dividends

Net Assets

Total Assets - Total Liabilities

Typical forms of debt

• Overdraft

• Operating line of credit

• Term Loans

Overdraft

Occurs when an account lacks the funds to cover a withdrawal, but the bank allows the transaction to go through anyway. Typically used for working capital funding gap.

Operating Line of Credit

It is a preset borrowing limit that can be tapped into at any time. The borrower can take money out as needed until the limit is reached. As money is repaid, it can be borrowed again in the case of an open line of credit. Typically used for working capital funding gap.

Term Loan

A fixed repayment schedule. Could be amortising or not. Typically used for purchases of PP&E but can be used for working capital funding gap.

Bond

A debt instrument requiring the issuer to repay the borrowed amount to the lender or investor plus interest over time.

Fixed Rate Bond

Have constant coupon throughout life of bond.

Floating Rate Bond

Coupons linked to interest rate benchmark(for e.g. LIBOR). Coupons reset periodically (e.g. every 3 months).

Zero Coupon Bond

No interest, trade at a discount from their maturity value.

Inflation-linked Bond

Principal amount indexed to inflation, interest rate is fixed but principal and interest payments grow.

Callable Bond

A debt instrument in which the issuer reserves the right to return the investor's principal and stop interest payments before the bond's maturity.

Puttable bond

A debt instrument that allows the bondholder to force the issuer to repurchase the security at specified dates before maturity.

Convertible Bond

Converted into shares in the company.

Warrants

Financial assets giving the holder the right but not obligation to buy shares of common stock directly from the issuer at a fixed price for a given period of time.

What is the difference between warrants and convertible bonds?

Convertible bonds carry the option of conversion into common stock at a specified price during a particular period. Stock purchase warrants are given with bonds or preferred stock as an inducement to the investor, because they permit the purchase of the company's common stock at a stated price at any time.

Syndicated loans/lending

When two or more banks provide credit to one borrower in an agreement.

Types of syndicated loans

1. Term Loans

2. Revolving credit facilities

3. Standby Facilities

Revolving Credit Facilities

Offering the borrower the right but not obligation to draw a loan

Standby Facilities

Lines only expected to be used in extraordinary circumstances. (e.g. commercial paper backup).

Leasing

When an asset is leased, it remains the property of the lessor.

Capital or Finance Lease

Usually longer term; most of the risk and rewards of ownership transfer to the lessee. Recorded on the balance sheet.

Operating Lease

Usually shorter term; risks and rewards do not transfer to the lessee. Recorded on the income statement

Why capital leases?

It is a way to borrow funds for assets directly through the assets’ owners.

Why operating leases?

It is a way to obtain use of an asset until it is no longer required or useful.