Financial Analysis Techniques. This is one of the
most important readings in FRA, and in this reading,
we will talk briefly about the financial analysis
process. The analytical tools and techniques which
are used in financial analysis. Common ratios using
financial analysis. I would say this is perhaps
the most important segment within the reading,
and then we have a few short sections on equity analysis,
credit analysis, business and geographic segments.
Model building and forecasting. Just need to get
a high-level sense for what these sections are saying.
Most of your questions are likely to come from section
4. Financial analysis is a useful tool in assessing
a company's performance and trends. The primary
source of data is company's annual reports, financial
statements, and management discussion and analysis.
An analyst must be capable of using financial statements
in conjunction with other information to make projections
and reach valid conclusions. The financial analysis
process. Prior to beginning any financial analysis,
the analyst should clarify the purpose and context
and clearly understand the following: What is the
purpose of the analysis? What questions will this
analysis answer? What level of detail will be needed
to accomplish this purpose? What data are available
for the analysis? What are the factors of relationships
that will influence the analysis? What are the analytical
limitations, and will these limitations impair
the analysis? Once you have defined the purpose
and context based on the questions shown over
here, that will define the techniques that you use.
For example, if your purpose is to make a long-term
equity investment, and this is a substantial investment,
then obviously the level of detail required will
be more, relative to another analysis where you are
making a short-term fixed-income investment. Also,
your purpose and context will define the sorts of
techniques that you will use, and in this reading
we will talk about several techniques. The financial
analysis framework is shown over here. We saw
this in earlier reading, but just to highlight the
fact that in this particular reading, we are going
to focus on step 3 and step 4. In Step 3, we process data
and that means that we need to adjust the financial
statements that we are looking for. If you are comparing
two companies one follows U.S. GAAP, the other follows
IFRS, you need to make adjustments before you can
make comparisons. In the process data phase, you come up
with common size statements, you come up with appropriate
ratios, graphs and forecasts. Once you have this information,
you then need to analyze and process the information,
and the output would be an analysis statement or an
analysis document. Distinguishing Between Computation
and Analysis. If you think about what we just talked
about in step 3, we are coming up with tables, charts,
ratios, etc. You can think of that as computation,
and then in step 4, we come up with a analysis. So
we interpret the information that we have gathered.
The questions related to analysis of past performance
are as follows. What aspects of performance are critical
to success? How did a company perform on these aspects?
Simply looking at ratios will not answer these questions.
These questions are answered in the analysis phase,
and then you might also look at some forward-looking
items, such as what is the likely impact of trends
or events in the company industry and economy. What
are the risks that a company is facing? and it is an
analysis that addresses these questions, that will
help you decide whether or not to make an investment.
Coming now to section 3, Analytical Tools and
Techniques. Here, we are introduced to full tools
and techniques, ratios, common-size analysis, graphs, and
regression analysis. Ratios. We'll talk about briefly here,
but then this item is covered in detail in section
4. Common-Size Analysis. We have seen before, but
there is a little more detail that we will discuss
over here, and then graph, and regression analysis
mentioned very briefly. Techniques facilitate
the evaluation of company data. Evaluations generally
require comparison, and to make a comparison we have
to adjust data where necessary. In order to make the
data comparable the example I just talked about
where you are making a decision between two companies.
Company A follows U.S. GAAP, Company B follows IFRS, you need
to make adjustments so that the data is comparable
before you can do your analysis. We can perform cross-sectional
analysis, which means comparing two companies,
two or more companies, during the same time, or time-
series analysis, which essentially involves looking
at trends over time. A few high-level remarks related
to ratios--a ratio is an indicator of some aspect of
a company's performance. Ratios can help predict
investment returns. There is a substantial amount
of evidence that proper ratio analysis and making
decisions based on ratio analysis can help you pick
stocks, and investments that will do well. Some widely
accepted ratios, but no authoritative body which
provides exact formulas. This is a very important
point, you will notice that there is a very wide range
of ratios, and if you look a different finance textbooks
you will also see that sometimes the formulae vary
from textbook to textbook, and as we go through this
reading and other readings, I might give you some
examples, the reason is that there is no single body
that defines that here are the set of formulas you must
use, or there is no body which defines that. Here are
the exact formulas. So, there will be subtle differences
between formulas. You, as an analyst, need to know exactly
what formula you are using, and what is the exact
interpretation of that formula. Also, it is extremely
important that when you are making a comparison
between companies, or the same company overtime,
then you need to be consistent in the use of your formulas.
Ratios help us evaluate past performance, ratios
help us assess the current financial position of
a company, and ratios help us gain insight which will
be useful in projecting future results. Specifically,
ratios allow us to evaluate the operational efficiency
of a company, and we are going to look at ratios which
are called activity ratios, that allow us to do this.
In other words, we can see how efficiently a company
is using its assets, how efficient is a company about
collecting receivables and so on. Financial flexibility.
This means a company that has low levels of debt, generally
tends to have more financial flexibility, versus
a company that has a high level of debt, and needs to
make substantial interest payments is likely to
have lower financial flexibility. A study of ratios
related to the balance sheet, for example, can allow
us ascertain this item. Changes in a company or industry
overtime, for example, we can look at how gross profit
margins are changing over time. We can look at how
profit margins are changing, or how activity ratios are
changing over time, and finally company performance
relative to the industry; all this can be done using
ratio analysis. Some factors to consider when using
ratios: we need to use judgment. If you have a current
ratio, current assets over current liabilities, which
is equal to 1.1. Is this good or bad? The answer is
that we need to use our judgment. We need to evaluate
the specific company, we need to look at this ratio
in the context of the industry. So, an important point
when using ratios is that there isn't always necessarily
a right answer, or the wrong answer, you have to use
your judgment. You need to recognize that different
companies might be using different accounting
policies or accounting methods, and hence you
need to make adjustments in order to compare ratios
across different companies. Very often a given
company will have a diverse set of operating units
or operating activities, so there is a high degree
of heterogeneity, you as an analyst need to recognize
that, and perhaps come up with ratios for each business
unit. A company, such as General Electric, which has
a financial services division, an aircraft division,
an appliances division, obviously has a very heterogeneous
business, and looking at a single ratio that captures
all of GE'S businesses might not make a lot of sense.
Consistency of results. What this means is that occasionally
when you are doing ratio analysis, one set of ratios,
such as profit margin ratios, might indicate that
there is a problem where there is another set of ratios.
For example, activity ratios might indicate that
there is no problem, you as an analyst need to dig in
deeper and try to understand exactly what is going
on. Coming now to Common Size Analysis. We have talked
about a common size balance sheet, common size income
statement, common size cash flow statement. What
we are going to do in this brief segment, is get into a little
more detail with a balance sheet and talk about the
vertical common size balance sheet versus the horizontal
common size balance sheet. Income statement, or the
common size income statement, we've already talked
about. Just as a quick refresher, every item on a common
size income statement is shown as a percentage of
revenue, or sales with the cash flow statement. We
talked about two possible strategies for the common
size cash flow statement, one is to show every item
on the cash flow statement as a percentage of revenue.
The other is to show every inflow as a percentage
of inflows, and every cash outflow as a percentage of outflows.
Coming now to the vertical vs. horizontal common
size balance sheet. This slide highlights the difference between
a vertical common size balance sheet and a horizontal
common size balance sheet. We have already seen
the vertical common size balance sheet in the reading
on balance sheets. Now, let us also look at a horizontal
common size balance sheet. With a horizontal common
size balance sheet, we essentially highlight structural
changes in a business. Let's look at what's going
on. We take a base period, such as 1 and we look at each
item in that base. Let's say that a cash in the base period
is 50, and then cash at the end of period 2 is 40. All numbers
after the base period are then shown relative to the base period.
So if cash went from 50 to 40, the 50 is represented as 1,
so every item in the base period is shown as a 1, and then
subsequently the items is shown relative to the base.
So, if cash went from 50 to 40, that means it went from 1
in the base period down to 0.8. If marketable securities were
100 million at the end of base period 1, then
at the end of period 2, if the marketable securities remain
the same, then we will see 1 and 1. Similarly what
we are looking at here with accounts receivable
is that essentially accounts receivable went up
by 30%. So, notice as with a vertical common size balance sheet, even
here we are doing a trend analysis over time, and
again this highlights the structural changes in
a business. Whereas, the vertical common size balance
sheet highlights the composition of the balance
sheet. The vertical common size balance sheet can
also be used for a cross-sectional analysis. Here,
we have two companies, company A and Company B,
and we are looking at every item on the balance sheet
relative to total assets. Inventory, for example, represents 8.7%
of total assets for company A whereas, inventory
represents 10.2% of total assets for Company B.
All else equal, this seems to imply that company A is
doing a better job of managing inventory. Let us
briefly talk about the relationships among financial
statements. What we've seen so far is a common size
balance sheet, common size cash flow statement, common
size income statement, and all of them simply looked
at ratios relative to that particular statement.
Often it is used to compare numbers across statements and look at the relationships
between those numbers. For example, it would be
useful to compare the growth rate of assets, and you
would get this from the balance sheet analysis with
the growth rate of sales, which would come through an analysis
of the income statement. Let's say that your total
assets are growing at 20%, but the sales are growing
at 15%. Would this be a concern? The answer is yes, because
our assets are growing at a relatively high rate,
that means our costs must be going up, approximately
by 20% whereas, sales are only going up by 15%, this
number is smaller than the 20% number which would
be a concern, and something that analysts would have
to look into. Comparing the growth rate of operating
income with the growth rate of operating cash flow.
Ideally, these growth rates should be similar even
though operating income from the income statement
and operating cash flow from the cash flow statement
are slightly different. They are measuring slightly
different items, but still the growth rate should be
approximately the same. If our operating income
is growing at a relatively high rate of 15%, but the
operating cash flow is flat, that would be a concern,
because it would imply that, potentially earnings
are going up because of accrual based
accounting, and the impact is not being seen with
the actual cash flow. Compare growth rate of inventory
and receivables with growth rate of sales revenue.
Here again, let's say you have a situation where
revenue is going up by 20%, inventory by 60%, and receivables
by 40%. Should you be concerned? The answer again is
yes, because revenue is only going up by 20%, but at
the same time inventory is going up much faster,
and receivables is also going up at 40%. If these numbers
are much higher relative to the growth in revenue,
that might imply a problem with inventory management
and receivables management. Graph are used frequently
in financial analysis. They allow us to compare
performance and financial structure overtime.
There are several types of graphs, such as line charts,
pie charts, bar charts, and so on, and the key is for a financial
analyst to use the right chart for the right purpose,
and that is partly a science, and partly an art. The curriculum
shows us two kinds of charts; one is a simple line chart,
where overtime we are looking at how the assets of
a company are changing. So, you might have a situation
where the cash situation is presented. You can show
the current assets, the long-term assets. If you
look up any annual report of a company, you will see
charts, that perhaps show how the net income is changing.
You might see, pie charts that show the financial structure
of a company. The curriculum also shares a bar chart,
which shows essentially how the asset composition is changing
over time. So, in period 1, we might have fixed assets that
are a certain amount, and current assets that are
depicted by the height of this bar, and then in period 2,
the fixed assets have increased by this amount the
current assets have also increased and so on. From
a testability perspective, I don't think this is
overly important, though in the real world, charts
and graphs are used frequently. Regression analysis
is something that you will see at level 2, but regression
analysis, essentially helps you identify relationships
or correlations between variables.