Level I CFA: FRA Financial Analysis Techniques-Lecture 1

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 used in 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 companies 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 or 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 a earlier reading but just to highlight the fact that in this particular reading we are going to focus on step three and step four in step three 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 a analysis statement or analysis document distinguishing between computation and analysis if you think about what we just talked about in step three we are coming up with tables charts ratios etc you can think of that as computation and then in step four 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 three analytical tools and techniques here we are introduced to four 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 four common size analysis we have seen before but there is a little more detail that we will discuss over here and then graphs and regression analysis are mentioned very briefly tools and 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 us 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 or 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 at different finance textbooks you will also see that sometimes the formulas 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 over time 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 that 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 over time 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 a 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 whereas 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 the 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 versus 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 period one and we look at each item in that base period let's say that our 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 one so every item in the base period is shown as a one and then subsequently the item is shown relative to the base period 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 two if the marketable securities remain the same then we will see one and one similarly what we are looking at here with accounts receivable is that essentially accounts receivable went up by 30 percent so notice that 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 percent of total assets for company a whereas inventory represents 10.2 percent 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 sized balance sheet common sized cash flow statement common sized income statement and all of them simply looked at ratios relative to that particular statement often it is useful 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 percent 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 a analyst 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 rates should be approximately the same if our operating income is growing at a relatively high rate of 15 percent but the operating cash flow is flat that would be a concern because it would imply that potentially earnings are growing 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 twenty percent inventory by sixty percent and receivables by forty percent should you be concerned the answer again is yes because revenue is only going up by twenty percent but at the same time inventory is going up much faster and receivables is also going up at 40 percent if these numbers are much higher relative to the growth in revenue that might imply a problem with inventory management and receivables management graphs are used frequently in financial analysis they allow us to compare performance and financial structure over time 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 over time 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 one 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 two 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 you

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