In-Depth Financial Analysis Notes

Diagnostic Tools for Financial Analysis

  • Common-Size Analysis (Vertical)

    • Financial statement items are presented as a percentage of a base figure to allow for easier comparison.
    • Balance Sheet: Items displayed as a % of total assets.
    • Income Statement: Items displayed as a % of sales.

  • Trend Analysis (Time-Series)

    • Analyzes growth rates over time to assess performance.

  • Financial Ratios

    • Evaluate relationships among elements of financial statements.
    • Significance depends on the firm's financial state (e.g., P/E ratio more meaningful for profitable firms).

  • Benchmarking

    • Comparing financial metrics against industry norms.

Cross-Sectional Analysis

  • Comparison with similar companies in the same industry to benchmark performance.
    • Example Metrics: Gross margin, Income as % of sales, Growth in sales.

Common-Size and Trend Analysis: Income Statement

  • Common-Size Vertical Analysis

    • All line items expressed as a proportion of total revenue.
    • Helps in understanding changes in cost structure.

  • Trend (Horizontal) Analysis

    • Presents historical percentage change for key metrics to identify growth patterns.
    • Example of Inventory & Sales from Home Depot over years showing trends in cost structure and price evolution.

Common-Size and Trend Analysis: Balance Sheet

  • Common-Size Balance Sheet

    • Each account expressed as a percentage of total assets to analyze asset and liability structure.

  • Horizontal Analysis

    • Presents year-over-year changes in asset composition, liabilities, and equity to assess performance.

Financial Ratio Analysis

  • Purpose: Understand inter-relationships between financial ratios and the broader strategic context of the firm.
    • Key Areas of Focus:
    • Profitability Ratios: ROE, ROA, Net Profit Margin
    • Efficiency Ratios: Asset Turnover, Working Capital Turnover
    • Liquidity Ratios: Current Ratio, Quick Ratio
    • Solvency Ratios: Debt ratios, Interest Coverage Ratio
Profitability Ratios
  • Return on Assets (ROA): Measures the efficiency of asset usage.
  • Return on Equity (ROE): Reflects the profitability relative to equity.
Efficiency Metrics
  • Days Sales Outstanding: Average number of days to collect receivables.
  • Inventory Turnover: Efficiency in selling inventory is measured.

Leverage Analysis

  • Importance of measuring the extent of debt usage in capital structure.
  • Optimal leverage improves ROE but increases risk.

Liquidity Management

  • Current Ratio (CR): Current Assets / Current Liabilities
    • Indicates short-term financial health.
  • Quick Ratio (QR): (Cash + Marketable Securities + Receivables) / Current Liabilities
    • A stricter test of liquidity.

Cash Flow Statement Analysis

  • Cash Flows from Operating Activities (CFO): Key indicators of financial health and sustainability.
  • Cash Flows from Investing Activities (CFI): Insight into capital investments and growth potential.
  • Cash Flows from Financing Activities (CFF): Financing strategies and capital structure analysis.

Market Tests

  • Price to Earnings (P/E) Ratio: Compares the value of a firm’s stock to its earnings to gauge valuation.
  • Price to Book (P/B) Ratio: Compares a firm's market value to its book value.
  • Dividend Yield: Measures dividend income as a percentage of share price.