Report

CHAPTER 7 FINANCIAL ANALYSIS TECHNIQUES Presenter’s name Presenter’s title dd Month yyyy FINANCIAL ANALYSIS TOOLS: DESCRIPTION • Graphics • Regression • Common-Size Analysis • Financial Ratio Analysis Copyright © 2013 CFA Institute 2 GRAPHICS: EXAMPLE Operating Profit by Geographic Segment 22% 21% 19% 38% North America Europe/South Pacific Copyright © 2013 CFA Institute Latin America Greater Asia/Africa 3 GRAPHICS: EXAMPLE 2007 2008 2009 2010 2011 Greater Asia/Africa Europe/South Pacific Latin America North America 0 200 400 600 800 1000 1200 1400 1600 $ millions Copyright © 2013 CFA Institute 4 GRAPHICS: EXAMPLE Operating profit margin 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Copyright © 2013 CFA Institute 5 REGRESSION: EXAMPLE 14.0 y = 0.1176x + 5.8177 R² = 0.2687 12.0 GDP Change 10.0 8.0 6.0 4.0 2.0 0.0 -40.0 -30.0 -20.0 -10.0 0.0 10.0 20.0 30.0 40.0 -2.0 -4.0 Sales Growth Copyright © 2013 CFA Institute 6 COMMON-SIZE ANALYSIS • Common-size analysis: Express financial data, including entire financial statements, in relation to a single financial statement item or base. • Vertical common-size - Balance sheet: Each item as a percent of total assets. - Income statement: Each item as a percent of total net revenues. - Cash flow: Each line as a percent of sales, assets, or total in and out. - Highlights composition and identifies what’s important. • Horizontal common-size - Percentage increase or decrease of each item from the prior year or showing each year relative to a base year. - Highlights items that have changed unexpectedly or have unexpectedly remained unchanged. Copyright © 2013 CFA Institute 7 COMMON-SIZE BALANCE SHEET EXAMPLE: SINGLE COMPANY, TWO PERIODS Partial common-size balance sheet Cash Receivables Inventory Fixed assets, net of depreciation Total assets Copyright © 2013 CFA Institute Period 1 Period 2 % of Total % of Total Assets Assets 25 15 35 57 35 20 5 8 100 100 8 COMMON-SIZE BALANCE SHEET EXAMPLE: CROSS-SECTIONAL, TWO COMPANIES, SAME TIME Partial common-size balance sheet Assets Cash Receivables Inventory Fixed assets net of depreciation Investments Total Assets Copyright © 2013 CFA Institute Company 1 Company 2 % of Total % of Total Assets Assets 38 12 33 55 27 24 1 2 1 7 100 100 9 USE OF COMPARATIVE GROWTH INFORMATION: EXAMPLE Sunbeam, Inc. 1997 vs.1996 Revenue +19% Receivables +38% Inventory +58% Why are receivables growing so much faster than revenue? Why is inventory growing so much faster than revenue? Copyright © 2013 CFA Institute 10 FINANCIAL RATIOS • Ratios - Express one number in relation to another. - Standardize financial data in terms of mathematical relationships expressed as percentages, times, or days. - Facilitate comparisons—trends and across companies. • Ratios are interrelated Copyright © 2013 CFA Institute 11 RATIO ANALYSIS How profitable was Company X? • A ratio is NOT the answer (except sometimes on an exam). • A ratio is an indicator—for example, an indicator of relative activity, profitability, liquidity, solvency. Copyright © 2013 CFA Institute 12 RATIO ANALYSIS How profitable was company X? • A ratio is NOT the answer (except sometimes on an exam). • A ratio is an indicator—for example, an indicator of relative activity, profitability, liquidity, solvency. • Interpretation generally involves comparison. Furthermore, analysis will address the question of why. Copyright © 2013 CFA Institute 13 RATIO ANALYSIS How profitable was Company X? • A ratio is NOT the answer (except sometimes on an exam). • A ratio is an indicator—for example, an indicator of relative activity, profitability, liquidity, solvency. • Interpretation generally involves comparison. Furthermore, analysis will address the question of why. Copyright © 2013 CFA Institute 14 USING FINANCIAL ANALYSIS TOOLS Computation ≠ Analysis • Analysis goes beyond collecting data and computing numbers. • Analysis encompasses computations and interpretations. • Where practical, directly experience the company’s business. • Analysis of past performance: What aspects of performance are critical to successfully competing in the industry? How well did the company perform (relative to own history and relative to competitors)? Why? What caused the performance? Does the performance reflect the company’s strategy? Copyright © 2013 CFA Institute 15 USING FINANCIAL ANALYSIS TOOLS • Not every ratio is relevant in every situation. - Some ratios are irrelevant for certain companies. - Some ratios are redundant. - Industry-specific ratios can be as important as general financial ratios. - Different users and questions (e.g., creditors, investors) focus on different ratios. • Different sources categorize some ratios differently and include different ratios. • Differences in accounting standards can limit comparability. Copyright © 2013 CFA Institute 16 CATEGORIES OF FINANCIAL RATIOS Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability Profitability ratios. How and how much is the firm achieving returns on its investments? Valuation Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 17 PROFITABILITY AND OVERVIEW Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency Solvency ratios. How well is the firm positioned to meet long-term obligations? Profitability Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 18 MEASURE OF PROFITABILITY: RETURN ON EQUITY (ROE) What rate of return has the firm earned on the shareholders’ equity it had available during the year? • The general form of the rate of return computation: Rate of return = • Amount of return Amount invested Applied to shareholders’ equity: ROE = Copyright © 2013 CFA Institute Net income Average equity 19 DECOMPOSE ROE ROE = Net income Average equity = Net income Average assets × Average assets Average equity = ROA × Leverage Copyright © 2013 CFA Institute 20 DECOMPOSE ROE ROE = ROA × Leverage A company can increase its ROE 1. With a business strategy, by increasing its ROA and/or 2. With a financial strategy, by increasing its use of leverage as long as returns on the incremental investment exceed the cost of borrowing. Copyright © 2013 CFA Institute 21 RETURN ON ASSETS What rate of return has the firm earned on the assets it had available to use during the year? The general form of this computation is the same: Amount of return Rate of Return = Amount invested Two variants of ROA computation: Net income (1) ROA = Average assets (2) ROA = = Copyright © 2013 CFA Institute Net income adjusted for interest Average assets Net income + [Interest expense × (1 – Tax rate)] Average assets 22 PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY ROA = Net income Average assets ROA = Net income Revenue × Revenue Average assets In other words, ROA can be thought Profit margin × Turnover (efficiency) of as: Copyright © 2013 CFA Institute 23 DECOMPOSING RETURN ON EQUITY ROE = ROE = Profit margin Net income Revenue Copyright © 2013 CFA Institute × × Turnover Revenue Average assets × × Leverage Average assets Average equity 24 DECOMPOSING RETURN ON EQUITY Du Pont Analysis What was the source of the firm’s return on equity? To what extent • . . . was it derived from selling a high margin product or keeping expenses low—deriving more profits from each $1 of sales? (return on sales, net profit margin) • . . . was it derived from generating higher sales from a lower investment in assets? (efficient use of assets, also known as turnover or efficiency) • . . . was it derived from investing a lower amount of equity—by using more debt in its capital structure? (financial leverage) Copyright © 2013 CFA Institute 25 DECOMPOSING RETURN ON EQUITY: STYLIZED COMPARATIVE ANALYSIS MINI-CASE Co. A Sales ($) Co. B Co. C Average 2,000 4,000 6,675 4,225 Net income (NI) ($) 200 200 200 200 Average assets ($) 1,000 2,000 1,500 1,500 Average equity ($) 1,000 1,000 1,000 1,000 0 1,000 500 500 Average liabilities ($) ROE (NI/Equity) Net profit margin (NI/Sales) Turnover (Sales/Assets) Leverage (Assets/Equity) Copyright © 2013 CFA Institute 26 DECOMPOSING RETURN ON EQUITY: STYLIZED COMPARATIVE ANALYSIS MINI-CASE Co. A Co. B 2,000 4,000 6,675 4,225 200 200 200 200 Average assets ($) 1,000 2,000 1,500 1,500 Average equity ($) 1,000 1,000 1,000 1,000 0 1,000 500 500 ROE (NI/Equity) 20.0% 20.0% 20.0% 20.0% Net profit margin (NI/Sales) 10.0% 5.0% 3.0% 4.7% Turnover (Sales/Assets) 2 2 4.45 2.82 Leverage (Assets/Equity) 1 2 1.5 1.50 Sales ($) NI ($) Average liabilities ($) Copyright © 2013 CFA Institute Co. C Average 27 DECOMPOSING RETURN ON EQUITY: COMPARATIVE AAPL ROE Net income/Sales Sales/Average assets Average assets/ Average equity Copyright © 2013 CFA Institute HPQ 27.19% 21.50% Net profit margin Asset turnover Financial leverage DELL 61.19% 14.88% 7.04% 4.06% 1.00 1.17 2.26 1.83 2.61 6.67 28 DUPONT ANALYSIS : FURTHER DECOMPOSITION • ROE = Net income/Average equity • Decompose ROE into five factors ROE = Net income EBT Copyright © 2013 CFA Institute × EBT EBIT × EBIT Revenue × Revenue Average assets × Average assets Average equity 29 PROFITABILITY: RETURN ON SALES (FROM THE COMMON-SIZE INCOME STATEMENT) Gross profit margin = Gross profit/Revenue Measures the ability to translate sales into profit after consideration of cost of products sold. Operating profit margin = Operating profit/Revenue Measures the ability to translate sales into profit after consideration of operating expenses. Net profit margin = Net profit/Revenue Measures the ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes, and nonoperating items. Copyright © 2013 CFA Institute 30 DISCUSSION BY CATEGORY Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Solvency Profitability Valuation Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 31 ACTIVITY RATIOS • Also known as asset utilization or operating efficiency ratios. • How efficiently is the firm using its assets? How many dollars of sales was the firm able to generate from each dollar of assets? • Broadly Asset turnover = Revenue/Average total assets • Low or declining ratios could mean - Sales are sluggish, - A heavy investment in assets (inefficient? plant modernization to help in future? strategy shift?), and/or - Asset mix changed. • Specifically, for fixed assets: Fixed asset turnover = Revenue/Average net fixed assets • Can compute for any category of assets. Copyright © 2013 CFA Institute 32 ACTIVITY RATIOS Also known as asset utilization or operating efficiency ratios Working capital turnover Fixed asset turnover Total asset turnover Copyright © 2013 CFA Institute Numerator Revenue Revenue Revenue Denominator Average working capital Average net fixed assets Average total assets 33 OTHER COMMON ACTIVITY RATIOS Numerator Denominator Inventory turnover Cost of sales Average inventory Days of inventory on hand (DOH) Number of days in period Inventory turnover Receivables turnover Revenue Average receivables Days of sales outstanding (DSO) Number of days in period Receivables turnover Payables turnover Purchases Average trade payables Number of days of payables Number of days in period Payables turnover Copyright © 2013 CFA Institute 34 ACTIVITY RATIOS AND THE CASH CYCLE (CASH CONVERSION CYCLE, A LIQUIDITY RATIO) • Cash cycle: How long does it take for the firm to go from cash to cash? - Service company: sell service → receive cash. - Merchandising company: buy inventory → sell inventory → receive cash and pay for inventory. - Manufacturing company: buy raw materials → make product → sell product → receive cash and pay for materials and labor. • Cash conversion cycle (net operating cycle) = Days sales outstanding + Days inventory held – Number of days of payables • Close link to liquidity • Working capital (current assets minus current liabilities) reflects the investment required to support this cycle. Copyright © 2013 CFA Institute 35 LIQUIDITY • How well positioned is the firm to meet its near-term obligations? Current ratio = Current assets/Current liabilities Quick ratio = (Cash + Short-term marketable investments + Account receivables)/Current liabilities Cash ratio = (Cash + Short-term marketable investments)/ Current liabilities Copyright © 2013 CFA Institute 36 DISCUSSION BY CATEGORY Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Solvency Profitability Valuation Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 37 SOLVENCY: HOW WELL POSITIONED IS THE FIRM TO MEET ITS LONGER-TERM LIABILITIES? Debt ratios: How has the company financed itself? • Debt to total assets Lower ratio –> safer. • Debt to equity Higher cushion against • Debt to total capital } potential creditor losses Coverage ratios: Degree to which earnings or cash flow can decline without affecting firm’s ability to pay interest. • EBIT interest coverage = (EBT + Interest payments)/Interest payments • Fixed charge coverage = (EBIT + Lease payments)/(Interest payments + Lease payments) Copyright © 2013 CFA Institute 38 COMMON SOLVENCY RATIOS Solvency ratios Debt ratios Debt-to-assets ratio Debt-to-capital ratio Debt-to-equity ratio Financial leverage ratio Coverage ratios Interest coverage Fixed charge coverage Copyright © 2013 CFA Institute Numerator Denominator Total debt Total debt Total assets Total debt + Total shareholders’ equity Total debt Total shareholders’ equity Average total assets Average total equity EBIT EBIT + Lease payments Interest payments Interest payments + Lease payments 39 DISCUSSION BY CATEGORY Category Activity Description Activity ratios. How efficient are the firm’s operations and the firm’s management of assets? Liquidity Liquidity ratios. How well is the firm positioned to meet short-term obligations? Solvency ratios. How well is the firm positioned to meet long-term obligations? Solvency Profitability Valuation Profitability ratios. How much and how is the firm achieving returns on its investments? Valuation ratios. How does the firm’s performance or financial position relate to its market value? Copyright © 2013 CFA Institute 40 VALUATION RATIOS: PRICE-TO-EARNINGS RATIO P/E relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings. P/E = Price Earnings per share High P/E indicates - Firm is valued highly by market, possibly because of growth expectations, or - That a firm may have very low earnings per share. Copyright © 2013 CFA Institute 41 VALUATION RATIOS Numerator Denominator P/E Price per share Earnings per share P/CF Price per share Cash flow per share P/S Price per share Sales per share P/BV Price per share Book value per share Valuation ratios Copyright © 2013 CFA Institute 42 DIVIDEND-RELATED QUANTITIES Dividend payout ratio = Dividends per share Earnings per share Dividend yield = Dividends per share Price Copyright © 2013 CFA Institute 43 SELECTED CREDIT RATIOS USED BY STANDARD & POOR’S AS PART OF CREDIT ANALYSIS Ratio EBIT and EBITDA interest coverage FFO interest coverage FFO to debt Numerator Denominator Gross interest (prior to EBIT or EBITDA deductions for capitalized interest or interest income) FFO plus interest Gross interest (prior to paid minus operating deductions for capitalized lease adjustments interest or interest income) FFO CFO (adjusted) minus capital expenditures CFO minus capital Discretionary cash flow expenditures minus to debt dividends paid Free operating cash flow to debt Copyright © 2013 CFA Institute Total debt Total debt Total debt 44 SELECTED CREDIT RATIOS USED BY STANDARD & POOR’S AS PART OF CREDIT ANALYSIS Credit Ratio Numerator Denominator Return on capital EBIT Average capital, where capital is equity plus noncurrent deferred taxes plus debt Net cash flow to capital expenditures FFO minus dividends Capital expenditures Debt to EBITDA Total debt to total debt plus equity Copyright © 2013 CFA Institute Total debt EBITDA Total debt Total debt plus equity 45 SEGMENT ANALYSIS EXAMPLE: L’ORÉAL Copyright © 2013 CFA Institute 46 MODEL BUILDING: EXAMPLES OF POSSIBLE USES OF RATIOS • Sales forecast (percent change from horizontal common-size income statement) • Expenses (from common-size income statement) • Gross profit (gross profit margin) • Operating profit (operating profit margin) • Assets (days receivable, days payable, PP&E turnover) • Liabilities (leverage ratios) • Cash flow Copyright © 2013 CFA Institute 47 RATIOS IN MODEL BUILDING • Sales forecast Forecast Debt Forecast Interest Expense Forecast Cash Flow Forecast Income and Taxes Copyright © 2013 CFA Institute • Expenses • Gross Profit • Operating Profit • Assets • Liabilities • Cash Flow 48 SUMMARY: FINANCIAL ANALYSIS TOOLS • Graphics facilitate comparisons, and regressions quantify statistical relationships. • Common-size analysis expresses financial data, including entire financial statements, in relation to a single financial statement item or base. • Ratios, which express one number in relation to another, facilitate comparisons—trends and cross-sectional. • A ratio is an indicator of - Activity - Profitability - Liquidity - Solvency Copyright © 2013 CFA Institute 49