Financial Analysis

Investment Policy Overview

  • Course Title: Investment Policy

  • Institution: Hong Kong University of Science & Technology

  • Instructor: Peter MacKay

Financial Analysis

  • Focus on understanding how firms make or lose money

  • Analysis of performance without revealing trade secrets

Key Topics Covered

  • Understanding the Business Model

  • Cracking Financial Statements

  • Conducting Ratio Analysis

  • DuPont Identity for relating financial ratios

  • Projections: analyzing past, present, and future financial performance

  • Importance of external financing and growth factors

Understanding How Firms Operate

  • Key Questions

    • How does a firm generate or lose profit?

    • What metrics indicate absolute and relative health of a firm?

    • How does comparison with benchmarks influence investment decisions?

  • Goals

    • Provide buy/sell/hold recommendations.

    • Offer managerial advisory based on financial analysis.

Income Statements

  • Reported Income Statement

    • Analysis based on normalizing values to compare across time and firms.

    • Key components include: Net Income (NI), Earnings Before Interest and Taxes (EBIT), and others.

  • Normalization Process

    • Adjust figures to real values (RV) for accurate comparisons.

Balance Sheet Insights

  • Reported Balance Sheet

    • Total Liabilities (TL) equates to Current Liabilities (CL) plus Long-term Liabilities (LL).

    • Watch for changes in components indicating financial health over time.

  • Comparison Strategies

    • Analyze a firm’s performance over time, against competitors within the same industry, and across industries.

Credit and Shareholder Insights

  • Stakeholder Focus

    • Creditors emphasize short-term liquidity.

    • Lenders focus on long-term solvency.

    • Managers assess efficiency and operational cycles.

    • Shareholders are concerned with profitability and returns.

Ratio Analysis Purpose

  • Understanding financial ratios and their relevance to performance evaluation.

  • The importance of different ratios in providing insight to various stakeholders.

Key Ratios Explained

  • Return on Equity (ROE)

  • Return on Assets (ROA)

  • Profit Margins

  • Asset Turnover

  • Equity Multiplier

  • Use the DuPont Identity to decompose ROE into contributing factors.

Pro-Forma Financial Statements

  • Project future financial performance by constructing pro-forma income statements and balance sheets based on growth assumptions.

  • Considerations for constructing these statements include:

    • Future revenue growth rates.

    • Account behaviors as a percentage of revenues or assets.

    • Assumptions should be robust and allow for stress-testing.

Financial Planning Insights

  • External Financing Needs & Sources

    • Calculation of External Financing Needed (EFN) to meet projected growth.

    • Strategies to manage growth sustainably without compromising financial structure.

  • Sustainable Growth Rate (SGR)

    • Understanding maximum revenue growth achievable without new equity financing.

    • Formulas for calculating Internal Growth Rate (IGR) and SGR based on profitability and retention of earnings.

Strategic Planning for Growth

  • Assessment of growth options

    • Balancing financing needs while maintaining optimal financial structure.

    • Review implications of external financing on the balance sheet and equity multiplier.