Financial Analysis Techniques - Financial Statement Analysis | CFA® Level 1 Guide

The Financial Analysis Process

Learning Outcome Statement:

describe tools and techniques used in financial analysis, including their uses and limitations

Summary:

The financial analysis process involves a series of steps to understand and evaluate a company's financial health and performance. This process includes identifying the purpose of the analysis, collecting and processing data, analyzing and interpreting the data, and communicating conclusions and recommendations. Various financial ratios and analytical tools such as graphs, regression analysis, and DuPont analysis are used to measure different aspects of a company's performance, including liquidity, solvency, profitability, and operational efficiency. The process also emphasizes the importance of considering industry-specific factors and using appropriate analytical techniques tailored to the specific context.

Key Concepts:

Financial Ratios

Financial ratios are quantitative measures used to assess various aspects of a company's performance, including liquidity, solvency, profitability, and operational efficiency. These ratios help analysts compare financial data over time or against industry benchmarks.

DuPont Analysis

DuPont analysis is a technique used to decompose the different drivers of return on equity (ROE). It helps in understanding how operating efficiency, asset use efficiency, and financial leverage impact the overall profitability of a company.

Graphs and Regression Analysis

Graphs are used to visualize financial data, trends, and performance over time, facilitating easier comparison and interpretation. Regression analysis helps in identifying relationships or correlations between different financial variables.

Sensitivity, Scenario, and Simulation Analysis

These techniques are used to forecast future financial performance by analyzing the potential impacts of varying conditions and assumptions on a company's financial outcomes.

Formulas:

Current Ratio

\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

Measures a company's ability to pay off its short-term liabilities with its short-term assets.

Variables:

$Current Assets$ :: Total assets that can be converted into cash within one year
$Current Liabilities$ :: Obligations due within one year

Units: ratio

Return on Equity (ROE)

\text{ROE} = \frac{\text{Net Income}}{\text{Shareholder's Equity}}

Indicates how effectively a company uses the money invested by its shareholders to generate profits.

Variables:

$Net Income$ :: Profit after all expenses and taxes
$Shareholder's Equity$ :: Total equity held by shareholders

Units: percentage

Analytical Tools and Techniques

Learning Outcome Statement:

describe tools and techniques used in financial analysis, including their uses and limitations

Summary:

The LOS focuses on describing various tools and techniques essential for financial analysis. It emphasizes the importance of context, such as economic, legal, and regulatory environments, and the need for a robust evaluation of corporate governance and management strategies. The content also highlights the use of comparative analyses, such as cross-sectional and time-series analyses, to assess financial performance and make informed decisions. Additionally, it discusses the role of financial ratios and common-size financial statements in achieving comparability among companies that differ in size or report in different currencies.

Key Concepts:

Comparative Analysis

Comparative analysis involves assessing a company's performance relative to others or over time. It includes cross-sectional analysis (comparing different companies at the same point in time) and time-series analysis (examining a company's performance over time).

Financial Ratios

Financial ratios are tools that express one financial metric relative to another, providing insights into aspects like profitability, efficiency, and liquidity. They are crucial for normalizing data across companies of different sizes or financial reporting standards.

Common-size Financial Statements

These statements restate financial data as a percentage of a common base figure (like total revenue or assets), which helps in comparing companies of different sizes by removing the scale factor.

Currency Translation for Comparability

To compare companies that report in different currencies, financial data can be converted into a common currency using average or period-end exchange rates, or by focusing on ratios that inherently adjust for currency differences.

Limitations of Financial Analysis

Limitations include differences in fiscal year ends, accounting standards, and external economic factors, which can affect the comparability and reliability of financial analysis.

Formulas:

Revenue Conversion

USD_{revenue} = \frac{TWD_{revenue}}{ExchangeRate}

This formula is used to convert revenue from Taiwan dollars to US dollars using the given exchange rate, facilitating comparison between companies reporting in different currencies.

Variables:

$USD_{revenue}$ :: Revenue in US dollars
$TWD_{revenue}$ :: Revenue in Taiwan dollars
$ExchangeRate$ :: Exchange rate from TWD to USD

Units: USD

Growth Rate Calculation

GrowthRate = \left(\frac{CurrentYearRevenue - PreviousYearRevenue}{PreviousYearRevenue}\right) \times 100\%

This formula calculates the percentage growth in revenue from one year to the next, providing a measure of financial performance over time.

Variables:

$GrowthRate$ :: Percentage growth rate
$CurrentYearRevenue$ :: Revenue for the current year
$PreviousYearRevenue$ :: Revenue for the previous year

Units: Percentage (%)

Financial Ratio Analysis

Learning Outcome Statement:

describe tools and techniques used in financial analysis, including their uses and limitations

Summary:

Financial ratio analysis is a crucial tool in financial analysis, providing insights into company performance, financial flexibility, and comparative metrics across industries or peers. Ratios express financial relationships and are used to assess profitability, operational efficiency, and other key financial metrics. However, they have limitations such as sensitivity to accounting policies and the need for contextual interpretation.

Key Concepts:

Financial Ratios

Financial ratios are quantitative measures derived from financial statement data used to assess various aspects of a company's performance such as profitability, efficiency, and liquidity.

Net Profit Margin

This ratio measures how much of each dollar of revenues is translated into profits, indicating the efficiency of a company in managing its expenses.

Operating Income to Average Total Assets

This ratio, a form of return on assets, measures how effectively a company uses its assets to generate operating income.

Combined Ratio

Used primarily in the insurance industry, this ratio assesses profitability by comparing losses and expenses to earned premiums. A ratio below 100% indicates profitability.

Common Size Analysis

This involves expressing each line item on a financial statement as a percentage of a base figure, facilitating comparisons across companies and time periods.

Limitations of Ratio Analysis

While useful, financial ratios must be interpreted with caution as they can be affected by accounting policies, company size, and the economic environment.

Formulas:

Net Profit Margin

\text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}}

This formula calculates the percentage of revenue that results in net income, indicating profitability.

Variables:

$Net Income$ :: The income remaining after all expenses have been deducted from revenues
$Revenue$ :: The total income generated from normal business operations

Units: Percentage (%)

Operating Income to Average Total Assets

\text{Operating Income to Average Total Assets} = \frac{\text{Operating Income}}{\text{Average Total Assets}}

This ratio measures the efficiency of a company's use of its assets to generate operating income.

Variables:

$Operating Income$ :: Income generated from the primary operations of the business, excluding expenses such as taxes and interest costs
$Average Total Assets$ :: The average value of all assets owned by a company over a given time period

Units: Percentage (%)

Common Size Balance Sheets and Income Statements

Learning Outcome Statement:

describe tools and techniques used in financial analysis, including their uses and limitations

Summary:

Common-size analysis is a financial analysis technique that involves expressing each item in a financial statement as a percentage of a single base item, such as total assets or revenue. This method allows for easier comparison across different periods or companies by standardizing the data. The analysis can be applied to balance sheets and income statements to understand changes in financial structure or performance over time.

Key Concepts:

Common-Size Balance Sheet

A common-size balance sheet expresses each item on the balance sheet as a percentage of total assets. This vertical analysis helps in understanding the composition and financing of the company's assets and how it changes over time or compares with peers.

Common-Size Income Statement

In a common-size income statement, each item is expressed as a percentage of total revenue. This method highlights changes in revenue composition, cost structure, and profitability, facilitating trend analysis and comparison among different companies or periods.

XBRL (eXtensible Business Reporting Language)

XBRL is a digital reporting language that allows for the tagging of financial information, enabling automated data collection and analysis. This technology supports the efficient handling of data in financial reporting and analysis.

Cross-Sectional and Trend Analysis

These analytical techniques involve comparing financial metrics across different companies at the same point in time (cross-sectional) or tracking changes within a company over different periods (trend analysis). They are useful for assessing relative performance and identifying trends.

Formulas:

Common-Size Percentage

\text{Common-Size Percentage} = \left(\frac{\text{Financial Statement Item}}{\text{Base Item}}\right) \times 100

This formula is used to convert financial statement items into percentages of a base item, facilitating comparison by standardizing values.

Variables:

$Financial Statement Item$ :: The specific item from the financial statement being analyzed.
$Base Item$ :: The total assets or total revenue, against which other items are compared.

Units: percentage

Cross-Sectional, Trend Analysis, and Relationships in Financial Statements

Learning Outcome Statement:

describe tools and techniques used in financial analysis, including their uses and limitations

Summary:

This LOS covers the use of cross-sectional and trend analysis in financial statements to identify relationships and changes over time. It includes the examination of vertical and horizontal common-size statements, the comparison of financial metrics across different companies, and the analysis of year-over-year changes in financial data. The content emphasizes the importance of understanding the context and implications of financial data changes, such as shifts in asset composition or profitability, and highlights the potential for these analyses to reveal underlying operational or accounting issues.

Key Concepts:

Cross-Sectional Analysis

Compares specific financial metrics across different companies at the same point in time or over the same time range, facilitating comparisons despite differences in company size or operational currency.

Trend Analysis

Examines financial statements and ratios over time to assess whether they are improving or deteriorating, providing insights into historical performance and potential future trends.

Vertical Common-Size Statements

Expresses each line item on a financial statement as a percentage of a base figure (total revenue for income statements or total assets for balance sheets), allowing for comparisons across different periods or companies.

Horizontal Common-Size Statements

Presents financial data relative to a base year, showing how each item has changed over time in relation to its value in the base year. This method highlights structural changes in a business's assets, liabilities, or equity.

Year-over-Year Changes

Analyzes the percentage change of financial items from one year to the next, providing a quick view of growth or contraction in specific areas.

Formulas:

Vertical Common-Size Percentage

\text{Vertical Common-Size Percentage} = \left(\frac{\text{Item Value}}{\text{Total Value}}\right) \times 100

This formula calculates each line item as a percentage of total revenue or total assets, facilitating comparison across different entities or periods.

Variables:

$Item Value$ :: The financial statement line item value.
$Total Value$ :: The total revenue (for income statement) or total assets (for balance sheet).

Units: percentage

Year-over-Year Percentage Change

\text{Year-over-Year Percentage Change} = \left(\frac{\text{Current Year Value} - \text{Previous Year Value}}{\text{Previous Year Value}}\right) \times 100

This formula measures the percentage change of a financial item from one year to the next, highlighting growth or contraction.

Variables:

$Current Year Value$ :: The value of the item in the current year.
$Previous Year Value$ :: The value of the item in the previous year.

Units: percentage

The Use of Graphs and Regression Analysis

Learning Outcome Statement:

describe tools and techniques used in financial analysis, including their uses and limitations

Summary:

The learning outcome focuses on describing various tools and techniques used in financial analysis, particularly emphasizing the use of graphs and regression analysis. Graphs are highlighted as effective tools for visualizing financial trends and communicating financial conditions, while regression analysis is noted for its ability to identify relationships between variables and assist in forecasting.

Key Concepts:

Graphs in Financial Analysis

Graphs such as line graphs, pie charts, and stacked column graphs are utilized to visually represent financial data, making it easier to observe trends, compare performance, and communicate significant financial conclusions. Different types of graphs are suited for different analytical needs.

Regression Analysis

Regression analysis is a statistical tool used to identify the relationship between variables, which can help in forecasting and analyzing trends. It is particularly useful in complex situations where simple visual evaluations are insufficient.

Common Ratio Categories, Interpretation, and Context

Learning Outcome Statement:

calculate and interpret activity, liquidity, solvency, and profitability ratios

Summary:

This LOS focuses on understanding and applying various financial ratios within the categories of activity, liquidity, solvency, and profitability. These ratios are essential for evaluating a company's operational efficiency, financial stability, and profitability. The content also emphasizes the importance of interpreting these ratios within the appropriate context, considering factors like industry norms, economic conditions, and company strategies.

Key Concepts:

Regression Analysis

Regression analysis is used to identify relationships between variables, which can provide insights into business cycles and help in forecasting future performance based on historical data.

Financial Ratio Categories

Financial ratios are categorized into activity, liquidity, solvency, and profitability, each measuring different aspects of a company's performance and financial health.

Interpretation and Context

Financial ratios must be interpreted in context, considering factors like past performance, industry norms, and economic conditions to accurately assess a company's financial status and strategy effectiveness.

Activity Ratios

Activity ratios (or asset utilization ratios) measure how effectively a company uses its assets to generate revenue. These include inventory turnover, receivables turnover, and payables turnover.

Formulas:

Inventory Turnover

\text{Inventory Turnover} = \frac{\text{Cost of Sales}}{\text{Average Inventory}}

This ratio measures how many times a company's inventory is sold and replaced over a period.

Variables:

$Cost of Sales$ :: Total cost of goods sold during the period
$Average Inventory$ :: Average value of inventory during the period

Units: times per period

Days of Inventory on Hand (DOH)

\text{Days of Inventory on Hand} = \frac{\text{Number of days in period}}{\text{Inventory Turnover}}

This ratio indicates the average number of days the company holds inventory before selling it.

Variables:

$Number of days in period$ :: Total days in the period being analyzed
$Inventory Turnover$ :: Inventory turnover ratio

Units: days

Receivables Turnover

\text{Receivables Turnover} = \frac{\text{Revenue}}{\text{Average Receivables}}

This ratio measures how efficiently a company collects revenue from its receivables.

Variables:

$Revenue$ :: Total revenue during the period
$Average Receivables$ :: Average amount of receivables during the period

Units: times per period

Days of Sales Outstanding (DSO)

\text{Days of Sales Outstanding} = \frac{\text{Number of days in period}}{\text{Receivables Turnover}}

This ratio shows the average number of days it takes for a company to collect payments from its credit sales.

Variables:

$Number of days in period$ :: Total days in the period being analyzed
$Receivables Turnover$ :: Receivables turnover ratio

Units: days

Payables Turnover

\text{Payables Turnover} = \frac{\text{Cost of Sales}}{\text{Average Trade Payables}}

This ratio measures how quickly a company pays off its suppliers.

Variables:

$Cost of Sales$ :: Total cost of goods sold during the period
$Average Trade Payables$ :: Average amount of trade payables during the period

Units: times per period

Number of Days of Payables

\text{Number of Days of Payables} = \frac{\text{Number of days in period}}{\text{Payables Turnover}}

This ratio indicates the average number of days a company takes to pay its payables.

Variables:

$Number of days in period$ :: Total days in the period being analyzed
$Payables Turnover$ :: Payables turnover ratio

Units: days

Activity Ratios

Learning Outcome Statement:

calculate and interpret activity, liquidity, solvency, and profitability ratios

Summary:

Activity ratios, also known as asset utilization ratios or operating efficiency ratios, measure how effectively a company uses its working capital and longer-term assets to generate revenue. These ratios are crucial for assessing operational performance and liquidity. The calculation involves using income statement figures in the numerator and average balance sheet figures in the denominator to ensure consistency. Interpretation of these ratios requires understanding the industry norms and the specific business cycle phase.

Key Concepts:

Inventory Turnover

This ratio measures how often a company's inventory is sold and replaced over a period. A higher inventory turnover indicates efficient management of inventory, whereas a lower turnover might suggest overstocking or obsolescence issues.

Days of Inventory on Hand (DOH)

DOH indicates the average number of days the company holds inventory before selling it. Lower DOH suggests efficient inventory management, while higher DOH could indicate slow-moving or excess inventory.

Receivables Turnover

This ratio shows how effectively a company collects its receivables. Higher receivables turnover indicates more efficient collection processes.

Days of Sales Outstanding (DSO)

DSO measures the average number of days it takes for a company to collect payments after a sale has been made. A lower DSO is preferable as it indicates quicker collection.

Payables Turnover

This ratio measures how quickly a company pays off its suppliers. A higher payables turnover indicates that the company is paying its suppliers at a faster rate.

Number of Days of Payables

This metric shows the average number of days a company takes to pay its bills and invoices. Higher days suggest better credit terms exploitation, while lower days might indicate liquidity issues.

Working Capital Turnover

Indicates how efficiently a company generates revenue from its working capital. Higher ratios suggest more efficient use of working capital.

Fixed Asset Turnover

This ratio measures a company's ability to generate revenue from its fixed assets. A higher ratio indicates better utilization of fixed assets.

Total Asset Turnover

Reflects the overall efficiency of a company in generating revenue from all its assets. Higher ratios indicate more efficient asset use.

Formulas:

Inventory Turnover

\text{Inventory Turnover} = \frac{\text{Cost of Sales}}{\text{Average Inventory}}

Measures how many times a company's inventory is sold and replaced over a period.

Variables:

$Cost of Sales$ :: Total cost of goods sold during the period
$Average Inventory$ :: Average value of inventory during the period

Units: times

Days of Inventory on Hand (DOH)

\text{DOH} = \frac{\text{Number of days in period}}{\text{Inventory Turnover}}

Calculates the average number of days the company holds inventory before selling it.

Variables:

$Number of days in period$ :: Total days in the accounting period
$Inventory Turnover$ :: Inventory turnover ratio

Units: days

Receivables Turnover

\text{Receivables Turnover} = \frac{\text{Revenue}}{\text{Average Receivables}}

Indicates how many times a company collects its average receivables.

Variables:

$Revenue$ :: Total revenue during the period
$Average Receivables$ :: Average accounts receivables during the period

Units: times

Days of Sales Outstanding (DSO)

\text{DSO} = \frac{\text{Number of days in period}}{\text{Receivables Turnover}}

Measures the average number of days it takes to collect payments after a sale.

Variables:

$Number of days in period$ :: Total days in the accounting period
$Receivables Turnover$ :: Receivables turnover ratio

Units: days

Liquidity Ratios

Learning Outcome Statement:

calculate and interpret activity, liquidity, solvency, and profitability ratios

Summary:

This LOS focuses on understanding and applying various financial ratios to assess a company's liquidity, solvency, and profitability. Liquidity ratios determine a company's ability to meet short-term obligations, solvency ratios assess long-term debt obligations, and profitability ratios evaluate the return on investment. The content includes detailed explanations and formulas for calculating these ratios, along with their interpretations to analyze a company's financial health.

Key Concepts:

Liquidity Ratios

Liquidity ratios measure a company's ability to cover its short-term obligations with its most liquid assets. Common liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio.

Solvency Ratios

Solvency ratios evaluate a company's capacity to meet its long-term debts and financial obligations. These ratios include debt-to-assets, debt-to-capital, debt-to-equity, financial leverage ratio, and coverage ratios like interest coverage and fixed charge coverage.

Profitability Ratios

Profitability ratios assess a company's ability to generate earnings relative to its revenue, assets, equity, or capital employed. These include gross profit margin, operating profit margin, net profit margin, return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC).

Formulas:

Current Ratio

\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

Measures the ability of a company to pay off its short-term liabilities with its short-term assets.

Variables:

$Current Assets$ :: Total assets that can be converted into cash within one year
$Current Liabilities$ :: Company's debts or obligations due within one year

Units: ratio

Quick Ratio

\text{Quick Ratio} = \frac{\text{Cash} + \text{Short-term Marketable Investments} + \text{Receivables}}{\text{Current Liabilities}}

Assesses the ability to meet short-term obligations with its most liquid assets, excluding inventories.

Variables:

$Cash$ :: Cash available
$Short-term Marketable Investments$ :: Investments that can be easily sold
$Receivables$ :: Money owed to the company
$Current Liabilities$ :: Short-term financial obligations

Units: ratio

Debt-to-Equity Ratio

\text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Shareholders' Equity}}

Indicates what proportion of equity and debt the company is using to finance its assets.

Variables:

$Total Debt$ :: Sum of the company's short-term and long-term debt
$Total Shareholders' Equity$ :: The amount of capital given by shareholders in exchange for stock

Units: ratio

Return on Equity (ROE)

\text{ROE} = \frac{\text{Net Income}}{\text{Average Total Equity}}

Measures the profitability of a company by revealing how much profit a company generates with the money shareholders have invested.

Variables:

$Net Income$ :: Total earnings of the company after all expenses
$Average Total Equity$ :: Average equity over the period

Units: percentage

Profitability Ratios

Learning Outcome Statement:

calculate and interpret activity, liquidity, solvency, and profitability ratios

Summary:

Profitability ratios are crucial for assessing a company's ability to generate profit relative to its capital, assets, or equity. These ratios provide insights into the company's competitive position, management quality, and financial health. Key profitability ratios include gross profit margin, operating profit margin, pretax margin, net profit margin, ROA, ROE, and return on invested capital. Each ratio offers a different perspective on profitability, from revenue efficiency to asset and equity utilization.

Key Concepts:

Gross Profit Margin

Indicates the percentage of revenue that exceeds the cost of goods sold, reflecting the efficiency in production and pricing.

Operating Profit Margin

Shows the percentage of revenue remaining after all operating expenses are deducted, highlighting operational efficiency.

Pretax Margin

Represents the percentage of revenue remaining after all operating and non-operating expenses except taxes, indicating the effect of leverage and non-operating activities on profitability.

Net Profit Margin

Measures the percentage of revenue that remains as net income after all expenses, showing the overall profitability including non-recurring items.

Return on Assets (ROA)

Assesses how effectively a company uses its assets to generate net income, reflecting asset utilization efficiency.

Return on Equity (ROE)

Measures the return on shareholders' equity, indicating how effectively the management is using the equity capital invested by shareholders.

Return on Invested Capital

Evaluates the return on all capital employed, including debt and equity, reflecting the overall investment efficiency.

Formulas:

Gross Profit Margin

\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}}

Calculates the percentage of revenue that exceeds the cost of goods sold.

Variables:

$Gross Profit$ :: Total revenue minus cost of goods sold
$Revenue$ :: Total income from sales of goods or services

Units: Percentage (%)

Operating Profit Margin

\text{Operating Profit Margin} = \frac{\text{Operating Income}}{\text{Revenue}}

Shows the percentage of revenue remaining after deducting all operating expenses.

Variables:

$Operating Income$ :: Gross profit minus operating expenses
$Revenue$ :: Total income from sales of goods or services

Units: Percentage (%)

Net Profit Margin

\text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}}

Measures the percentage of revenue remaining as net income after all expenses.

Variables:

$Net Income$ :: Total revenue minus all expenses
$Revenue$ :: Total income from sales of goods or services

Units: Percentage (%)

ROA

\text{ROA} = \frac{\text{Net Income}}{\text{Average Total Assets}}

Assesses how effectively a company uses its assets to generate net income.

Variables:

$Net Income$ :: Income after all expenses, including taxes and interest
$Average Total Assets$ :: Average value of all assets over the period

Units: Percentage (%)

ROE

\text{ROE} = \frac{\text{Net Income}}{\text{Average Total Equity}}

Measures the return on shareholders' equity.

Variables:

$Net Income$ :: Income after all expenses, including taxes and interest
$Average Total Equity$ :: Average value of shareholders' equity over the period

Units: Percentage (%)

Integrated Financial Ratio Analysis

Learning Outcome Statement:

describe relationships among ratios and evaluate a company using ratio analysis

Summary:

This LOS focuses on the importance of using a variety of financial ratios to evaluate the overall position and performance of a company. It emphasizes that no single ratio or category should be analyzed in isolation. Instead, an integrated approach that considers multiple ratio categories provides a more accurate picture of a company's financial health. Examples are provided to illustrate how different ratios can be used together to analyze issues such as liquidity and compare the performance of different companies.

Key Concepts:

Integrated Financial Ratio Analysis

This concept involves using a combination of various financial ratios from different categories such as liquidity, solvency, profitability, and activity to gain a comprehensive understanding of a company's financial status. This approach helps in identifying issues that may not be apparent when analyzing ratios in isolation.

Liquidity Analysis

Liquidity ratios like the current ratio and quick ratio are used to assess a company's ability to meet its short-term obligations. The example provided shows how these ratios can sometimes present contradictory information, and how additional analysis, such as activity ratios, can provide clarity.

Activity Ratios

Activity ratios such as Days of Inventory on Hand (DOH) and Days Sales Outstanding (DSO) provide insights into a company's operational efficiency. These ratios help in understanding how quickly a company converts its inventory into sales and its receivables into cash.

Comparative Ratio Analysis

This involves comparing the same set of ratios across different companies to evaluate their relative performance. This type of analysis can highlight strengths and weaknesses in areas such as inventory management, receivables management, and overall operational efficiency.

Formulas:

Current Ratio

\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

This ratio measures a company's ability to pay off its short-term liabilities with its short-term assets.

Variables:

$Current Assets$ :: Total assets that can be converted into cash within one year
$Current Liabilities$ :: Obligations that are due within one year

Units: dimensionless

Quick Ratio

\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}}

This ratio, also known as the acid-test ratio, measures a company's ability to meet its short-term obligations with its most liquid assets.

Variables:

$Current Assets$ :: Total assets that can be converted into cash within one year
$Inventories$ :: Current assets that consist of stockpiled goods
$Current Liabilities$ :: Obligations that are due within one year

Units: dimensionless

Days of Inventory on Hand (DOH)

\text{DOH} = \frac{\text{Average Inventory}}{\text{Cost of Goods Sold}} \times 365

This ratio indicates the average number of days the company holds its inventory before selling it.

Variables:

$Average Inventory$ :: Average value of inventory over a period
$Cost of Goods Sold$ :: Total cost of goods sold during the period

Units: days

Days Sales Outstanding (DSO)

\text{DSO} = \frac{\text{Average Accounts Receivable}}{\text{Total Credit Sales}} \times 365

This ratio shows the average number of days it takes for a company to collect payments from its credit sales.

Variables:

$Average Accounts Receivable$ :: Average amount of money owed to the company by its customers
$Total Credit Sales$ :: Total sales made on credit

Units: days

DuPont Analysis-The Decomposition of ROE

Learning Outcome Statement:

demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components

Summary:

DuPont Analysis decomposes Return on Equity (ROE) into its component parts to understand the drivers behind a company's ROE. This analysis helps in evaluating the impact of different aspects of a company's performance on its profitability. The decomposition of ROE into ROA (Return on Assets) and leverage is a fundamental approach, further breaking down into net profit margin, total asset turnover, and leverage. This detailed breakdown allows analysts to pinpoint the specific factors contributing to changes in ROE over time or between different companies.

Key Concepts:

ROE

Return on Equity (ROE) measures the return a company generates on its equity capital. It is calculated as Net Income divided by Average Shareholders' Equity.

ROA

Return on Assets (ROA) indicates how efficiently a company uses its assets to generate earnings. It is calculated as Net Income divided by Average Total Assets.

Leverage

Leverage in this context refers to the ratio of Average Total Assets to Average Shareholders' Equity. It shows how much a company is financing its operations through debt versus equity.

Net Profit Margin

Net Profit Margin is a profitability ratio that shows how much net income a company makes from each dollar of revenue. It is calculated as Net Income divided by Revenue.

Total Asset Turnover

Total Asset Turnover is an efficiency ratio that measures the amount of revenue generated per dollar of assets. It is calculated as Revenue divided by Average Total Assets.

Formulas:

ROE Decomposition

ROE = \frac{\text{Net Income}}{\text{Average Shareholders' Equity}} = \left(\frac{\text{Net Income}}{\text{Revenue}}\right) \times \left(\frac{\text{Revenue}}{\text{Average Total Assets}}\right) \times \left(\frac{\text{Average Total Assets}}{\text{Average Shareholders' Equity}}\right)

This formula shows how ROE is influenced by the company's profitability (Net Profit Margin), efficiency (Total Asset Turnover), and leverage.

Variables:

$ROE$ :: Return on Equity
$Net Income$ :: Earnings after all expenses
$Revenue$ :: Total income from sales or services
$Average Shareholders' Equity$ :: Average equity capital held by shareholders
$Average Total Assets$ :: Average value of the company's assets

Units: Percentage (%)

Industry-Specific Financial Ratios

Learning Outcome Statement:

describe the uses of industry-specific ratios used in financial analysis

Summary:

Industry-specific financial ratios are crucial for analyzing the performance and value of companies within particular sectors, reflecting unique industry characteristics and regulatory requirements. These ratios vary significantly across industries such as retail, banking, service companies, and more, each tailored to highlight specific aspects of business performance and regulatory compliance.

Key Concepts:

Industry-Specific Importance

Different industries prioritize different aspects of performance, which is reflected in their specific financial ratios. For instance, retail industries focus on same-store sales to differentiate growth from new stores versus existing ones.

Regulatory Ratios

In regulated industries like banking, certain ratios are mandated to ensure liquidity and solvency, reflecting the industry's risk exposure and regulatory requirements.

Coefficient of Variation Ratios

These ratios, such as the coefficient of variation of operating income, net income, and revenues, measure the volatility of these metrics relative to their averages, providing insight into business risk.

Financial Sector Ratios

Specific ratios in the financial sector like capital adequacy and liquid asset requirements are used to assess the financial health and regulatory compliance of banks.

Retail and Service Company Ratios

Ratios such as sales per square meter and revenue per employee help in assessing operational efficiency in retail and service industries.

Hotel Industry Ratios

Ratios like average daily rate and occupancy rate are crucial for evaluating the performance of hotels.

Subscription-Based Business Ratios

Average revenue per user (ARPU) is a common ratio used to measure revenue efficiency per user or subscriber in industries like telecommunications.

Formulas:

Coefficient of Variation of Operating Income

\text{Coefficient of Variation} = \frac{\text{Standard Deviation of Operating Income}}{\text{Average Operating Income}}

This ratio measures the relative variability of operating income, indicating the level of operational risk.

Variables:

$Standard Deviation of Operating Income$ :: Measure of the spread of operating income data points
$Average Operating Income$ :: Mean value of operating income over a specified period

Units: dimensionless

Capital Adequacy Ratio

\text{Capital Adequacy Ratio} = \frac{\text{Various Components of Capital}}{\text{Risk-Weighted Assets}}

This ratio assesses a bank's financial strength and ability to handle potential losses, reflecting regulatory compliance.

Variables:

$Various Components of Capital$ :: Sum of different types of capital held by a bank
$Risk-Weighted Assets$ :: Total value of assets, weighted by their respective risk levels

Units: dimensionless

Model Building and Forecasting

Learning Outcome Statement:

describe how ratio analysis and other techniques can be used to model and forecast earnings

Summary:

The LOS focuses on using ratio analysis and other financial techniques to model and forecast earnings. It emphasizes the importance of understanding industry-specific ratios and how they can be applied to forecast a company's financial performance. Techniques such as sensitivity analysis, scenario analysis, and simulation are discussed as methods to handle forecasting with varying assumptions and probabilities.

Key Concepts:

Ratio Analysis

Ratio analysis involves using financial ratios derived from a company's financial statements to gauge its condition and performance. These ratios are crucial for comparing different aspects of a company's operations and can be used to forecast future performance.

Sensitivity Analysis

Sensitivity analysis, or 'what if' analysis, explores the potential outcomes of a decision given a certain range of variables. By adjusting one or more assumptions, analysts can see how these changes can affect the financial outcome.

Scenario Analysis

Scenario analysis examines the changes in financial outcomes under different hypothetical scenarios. This can include external economic events or internal company changes, helping in understanding potential risks and outcomes.

Simulation

Simulation involves using computer models to predict outcomes based on probability distributions of input variables. It combines elements of both sensitivity and scenario analyses to provide a statistical range of possible future outcomes.

Formulas:

Net Interest Margin

\text{Net Interest Margin} = \frac{\text{Net Interest Income}}{\text{Total Interest-Earning Assets}}

This ratio measures the difference between the interests earned on assets and the interest paid on liabilities, scaled to the total interest-earning assets.

Variables:

$Net Interest Income$ :: The total interest income minus interest expenses
$Total Interest-Earning Assets$ :: Assets that generate interest income

Units: Percentage (%)

Average Revenue Per User (ARPU)

\text{ARPU} = \frac{\text{Revenue}}{\text{Average Number of Subscribers}}

ARPU is a measure used primarily by consumer communications, digital media, and networking companies, indicating the average revenue generated per user or unit.

Variables:

$Revenue$ :: Total revenue generated
$Average Number of Subscribers$ :: Average number of subscribers or users during the period

Units: Currency (e.g., USD, EUR)