Financial Analysis Techniques

Analysts convert financial statement and other data into metrics that assist in decision making and help answer questions such as the following: How successfully has a target company performed, relative to its own past performance and relative to its competitors? How is the company likely to perform in the future? Based on expectations about future performance, what is the value of this company or the securities it issues? This module describes various techniques used to answer these and other questions. These f inancial analysis techniques are crucial to a wide range of analytical tasks, including valuing equity securities, assessing credit risk, conducting due diligence related to an acquisition, and evaluating business performance.

• There is no single approach to structuring the financial analysis process, but a general framework entails the following phases: articulate the purpose of the analysis, collect input data, process the data, analyze and interpret the processed data, develop and communicate conclusions and recommendations, follow-up periodically to determine if any changes are necessary to recommendations or holdings.
• The purpose of analysis is not simply to compile information and do computations, but to integrate these into a cohesive result that addresses not just what happened, but why it happened and whether it created value. An analyst must be able to understand the “why” behind the numbers and ratios, not just what the numbers and ratios are.
• Evaluations require comparisons. It is difficult to say that a company’s f inancial performance was “good” or “bad” without clarifying the basis for comparison. Cross-sectional analysis compares multiple companies at the same point in time or over the same range of time, and trend or time-series analysis compares measures for a single company over a period of time.
• Ratios and common-size financial statements can remove size as a factor and enable more relevant comparisons. Financial statement ratios are helpful for valuing companies and securities, selecting investments, and predicting financial distress. The ratio is an indicator of some aspect of a company’s performance, telling what happened but not why it happened.
• Common-size analysis involves expressing financial data, including entire financial statements, in relation to a single financial statement item, or base. A vertical common-size balance sheet divides each balance sheet item by the same period’s total assets and expresses the results as percentages. A vertical common-size income statement divides each income statement item by revenue or by total assets. A horizontal common-size balance sheet divides the quantity of each item by a base year quantity of the same item to yield a percentage change in that item from the base year. Trend data generated by a horizontal common-size analysis can be compared across financial statements.Graphs facilitate comparison of performance and financial structure over time, provide a visual overview of changes and trends, and can be used to communicate the conclusions from financial analysis. Regression analysis can help identify relationships or correlation between variables.
• Activity ratios measure the efficiency of a company’s operations, such as a collection of receivables or management of inventory. Major activity ratios include inventory turnover, days of inventory on hand, receivables turnover, days of sales outstanding, payables turnover, number of days of payables, working capital turnover, fixed asset turnover, and total asset turnover.
• Liquidity ratios measure the ability of a company to meet short-term obligations. Major liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio. The cash conversion cycle is a measure of liquidity that is not a simple ratio.
• Solvency ratios measure the ability of a company to meet long-term obligations. Major solvency ratios include debt ratios (including the debt-to-assets ratio, debt-to-capital ratio, debt-to-equity ratio, and f inancial leverage ratio) and coverage ratios (including interest coverage and fixed charge coverage).
• Profitability ratios measure the ability of a company to generate profits from revenue and assets. Major profitability ratios include return on sales ratios (including gross profit margin, operating profit margin, pretax margin, and net profit margin) and return on investment ratios (including operating return on assets [ROA], ROA, return on total capital, return on equity [ROE], and return on common equity).
• It is important to examine a variety of financial ratios—not a single ratio or category of ratios in isolation—to ascertain the overall position and performance of a company.
• DuPont analysis breaks ROE into components that are indicators of different aspects of company performance. Many levels of decomposition are possible.
• The five-component DuPont decomposition expresses a company’s ROE as a function of its tax rate, interest burden, operating profitability, efficiency, and leverage.
• Because aspects of performance that are considered important in one industry may be irrelevant in another, industry-specific ratios are used that reflect these differences.
• Techniques such as sensitivity analysis, scenario analysis, and simulation are used to forecast future financial performance.