CFA L1V4-FSA Financial Analysis Techniques PDF

LEARNING MODULE 11 Financial Analysis Techniques by Elaine Henry, PhD, CFA, Thomas R. Robinson, Phd, CAIA, CFA, and J. Hennie van Greuning, DCom, CFA. Elaine Henry, PhD, CFA, is at Stevens Institute of Technology (USA). Thomas R. Robinson, Phd, C AIA, CFA, is at Robinson Global Investme...

LEARNING MODULE 11 Financial Analysis Techniques by Elaine Henry, PhD, CFA, Thomas R. Robinson, Phd, CAIA, CFA, and J. Hennie van Greuning, DCom, CFA. Elaine Henry, PhD, CFA, is at Stevens Institute of Technology (USA). Thomas R. Robinson, Phd, C AIA, CFA, is at Robinson Global Investment Management LLC, (USA). J. Hennie van Greuning, DCom, CFA, is at BIBD (Brunei). LEARNING OUTCOMES Mastery The candidate should be able to: describe tools and techniques used in financial analysis, including their uses and limitations calculate and interpret activity, liquidity, solvency, and profitability ratios describe relationships among ratios and evaluate a company using ratio analysis demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components describe the uses of industry-specific ratios used in financial analysis describe how ratio analysis and other techniques can be used to model and forecast earnings The two major accounting standard setters are as follows: 1) the International Accounting Standards Board (IASB) who establishes International Financial Reporting Standards (IFRS) and 2) the Financial Accounting Standards Board (FASB) who establishes US GAAP. Throughout this learning module both standards are referred to and many, but not all, of these two sets of accounting rules are identified. Note: changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of this learning module may cause some of the information to become dated. 388 Learning Module 11 Financial Analysis Techniques 1 INTRODUCTION 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 competi- tors? 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 financial 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. LEARNING MODULE OVERVIEW 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 com- municate 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 financial 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. The Financial Analysis Process 389 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 turn- over, 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 financial leverage ratio) and coverage ratios (including interest cover- age 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 posi- tion and performance of a company. DuPont analysis breaks ROE into components that are indicators of different aspects of company performance. Many levels of decomposi- tion are possible. The five-component DuPont decomposition expresses a company’s ROE as a function of its tax rate, interest burden, operating profitabil- ity, 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 simula- tion are used to forecast future financial performance. THE FINANCIAL ANALYSIS PROCESS 2 describe tools and techniques used in financial analysis, including their uses and limitations 390 Learning Module 11 Financial Analysis Techniques In financial analysis, it is essential to clearly identify and understand the final objective and the steps required to reach that objective. In addition, the analyst needs to know where to find relevant data, how to process and analyze the data (in other words, know the typical questions to address when interpreting data), and how to communicate the analysis and conclusions. The Objectives of the Financial Analysis Process Because of the variety of reasons for performing financial analysis, the numerous available techniques, and the often substantial amount of data, it is important that the analytical approach be tailored to the specific situation. 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 potentially impair the analysis? Having clarified the purpose and context of the analysis, the analyst can select the set of techniques (e.g., ratios) that will best assist in making a decision. Although there is no single approach to structuring the analysis process, a general framework is set forth in Exhibit 1. The steps in this process were discussed in more detail in an earlier module; the primary focus of this module is on Phases 3 and 4, processing and analyzing data. Exhibit 1: A Financial Statement Analysis Framework Phase Sources of Information Output 1. Articulate the purpose and con- The nature of the analyst’s function, Statement of the purpose or objective text of the analysis. such as evaluating an equity or debt of analysis. investment or issuing a credit rating. A list (written or unwritten) of specific Communication with client or super- questions to be answered by the visor on needs and concerns. analysis. Institutional guidelines related to Nature and content of report to be developing specific work product. provided. Timetable and budgeted resources for completion. 2. Collect input data. Financial statements, other financial Organized financial statements. data, questionnaires, and industry/ Financial data tables. economic data. Completed questionnaires, if Discussions with management, suppli- applicable. ers, customers, and competitors. Company site visits (e.g., to produc- tion facilities or retail stores). The Financial Analysis Process 391 Phase Sources of Information Output 3. Process data. Data from the previous phase. Adjusted financial statements. Common-size statements. Ratios and graphs. Forecasts. 4. Analyze/interpret the processed Input data as well as processed data. Analytical results. data. 5. Develop and communicate con- Analytical results and previous Analytical report answering questions clusions and recommendations reports. posed in Phase 1. (e.g., with an analysis report). Institutional guidelines for published Recommendation regarding the pur- reports. pose of the analysis, such as whether to make an investment or grant credit. 6. Follow-up. Information gathered by periodically Updated reports and repeating above steps as necessary recommendations. to determine whether changes to holdings or recommendations are necessary. Distinguishing between Computations and Analysis An effective analysis encompasses both computations and interpretations. A well-reasoned analysis differs from a mere compilation of various pieces of infor- mation, computations, tables, and graphs by integrating the data collected into a cohesive whole. Analysis of past performance, for example, should address not only what happened but also why it happened and whether it created value. Some of the key questions to address include the following: What aspects of performance are critical for this company to successfully compete in this industry? How well did the company’s performance meet these critical aspects? (Established through computation and comparison with appropriate bench- marks, such as the company’s own historical performance or competitors’ performance.) What were the key causes of this performance, and how does this perfor- mance reflect the company’s strategy? (Established through analysis.) If the analysis is forward looking, additional questions include the following: What is the likely impact of an event or trend? (Established through inter- pretation of analysis.) What is the likely response of management to this trend? (Established through evaluation of quality of management and corporate governance.) What is the likely impact of trends in the company, industry, and economy on future cash flows? (Established through assessment of corporate strategy and through forecasts.) What are the recommendations of the analyst? (Established through inter- pretation and forecasting of results of analysis.) What risks should be highlighted? (Established by an evaluation of major uncertainties in the forecast and in the environment within which the com- pany operates.) 392 Learning Module 11 Financial Analysis Techniques Example 1 demonstrates how a company’s financial data can be analyzed in the context of its business strategy and changes in that strategy. An analyst must be able to understand the “why” behind the numbers and ratios, not just what the numbers and ratios are. EXAMPLE 1 Strategy Reflected in Financial Performance Apple Inc. engages in the design, manufacture, and sale of computer hardware, mobile devices, operating systems and related products, and services. It also operates retail and online stores. Microsoft develops, licenses, and supports software products, services, and technology devices through a variety of channels including retail stores in recent years. Selected financial data for 2015 through 2017 for these two companies are given in Exhibit 2 and Exhibit 3. Apple’s fiscal year (FY) ends on the final Saturday in September (for example, FY2017 ended on 30 September 2017). Microsoft’s fiscal year ends on 30 June (for example, FY2017 ended on 30 June 2017). ​ Exhibit 2: Selected Financial Data for Apple (US dollar millions) ​ ​ Fiscal year 2017 2016 2015 Net sales (or 229,234 215,639 233,715 Revenue) Gross margin 88,186 84,263 93,626 Operating income 61,344 60,024 71,230 ​ ​ Exhibit 3: Selected Financial Data for Microsoft (US dollar millions)* ​ ​ Fiscal year 2017 2016 2015 Net sales (or 89,950 85,320 93,580 revenue) Gross margin 55,689 52,540 60,542 Operating income 22,326 20,182 18,161 ​ * Microsoft revenue for 2017 and 2016 were subsequently revised in the company’s 2018 10-K report due to changes in revenue recognition and lease accounting standards. Source: 10-K reports for Apple and Microsoft. Apple reported a 7.7 percent decrease in net sales from FY2015 to FY2016 and an increase of 6.3 percent from FY2016 to FY2017 for an overall slight decline over the three-year period. Gross margin decreased 10.0 percent from FY2015 to FY2016 and increased 4.7 percent from FY2016 to FY2017. This also represented an overall decline in gross margin over the three-year period. The company’s operating income exhibited similar trends. Microsoft reported an 8.8 percent decrease in net sales from FY2015 to FY2016 and an increase of 5.4 percent from FY2016 to FY2017 for an overall slight decline over the three-year period. Gross margin decreased 13.2 percent from FY2015 to FY2016 and increased 6.0 percent from FY2016 to FY2017. Similar to Apple, this represented an overall decline in gross margin over the Analytical Tools and Techniques 393 three-year period. Microsoft’s operating income, in contrast, exhibited growth each year and for the three-year period. Overall growth in operating income was 23 percent. What caused Microsoft’s growth in operating income while Apple and Microsoft had similar negative trends in sales and gross margin? Apple’s decline in sales, gross margin, and operating income from FY2015 to FY2016 was caused by declines in iPhone sales and weakness in foreign currencies relative to the US dollar. FY2017 saw a rebound in sales of iPhones, Mac computers, and services offset somewhat by continued weaknesses in foreign currencies. Microsoft similarly had declines in revenue and gross margin from sales of its devices and Windows software in FY2016, as well as negative impacts from foreign currency weakness. Microsoft’s increase in revenue and gross margin in FY2017 was driven by the acquisition of LinkedIn, higher sales of Microsoft Office software, and higher sales of cloud services. The driver in the continuous increase in operating income for Microsoft was a large decline over the three- year period in impairment, integration, and restructuring charges. Microsoft recorded a USD10 billion charge in FY2015 related to its phone business, and there were further charges of USD1.1 billion in FY2016 and USD306 million in FY2017. Absent these large write-offs, Microsoft would have had a trend similar to Apple’s in operating income over the three-year period. Analysts often need to communicate the findings of their analysis in a written report. Their reports should communicate how conclusions were reached and why recommendations were made. For example, a report might present the following: the purpose of the report, unless it is readily apparent; relevant aspects of the business context, including: economic environment (country/region, macro economy, sector), financial and other infrastructure (accounting, auditing, rating agencies), and legal and regulatory environment (and any other material limitations on the company being analyzed); evaluation of corporate governance and assessment of management strategy, including the company’s competitive advantage(s); assessment of financial and operational data, including key assumptions in the analysis; and conclusions and recommendations, including limitations of the analysis and risks. An effective narrative and well supported conclusions and recommendations are normally enhanced by using 3–10 years of data as well as by analytic techniques appropriate to the purpose of the report. ANALYTICAL TOOLS AND TECHNIQUES 3 describe tools and techniques used in financial analysis, including their uses and limitations 394 Learning Module 11 Financial Analysis Techniques The tools and techniques presented in this lesson facilitate evaluations of company data. Evaluations require comparisons. It is difficult to say that a company’s financial performance was “good” or “bad” without clarifying the basis for comparison. In assessing a company’s ability to generate and grow earnings and cash flow, and the risks related to those earnings and cash flows, the analyst draws comparisons to other companies at the same point in time or over the same range of time (cross-sectional analysis) and over time (trend or time-series analysis). For example, an analyst may wish to compare the profitability of companies competing in a global industry. If the companies differ significantly in size or report their financial data in different currencies, comparing net income as reported is not useful. Ratios (which express one number in relation to another) and common-size financial statements can remove size as a factor and enable a more relevant compar- ison. To achieve comparability across companies reporting in different currencies, one approach is to translate all reported numbers into a common currency using average or period-end exchange rates. Alternatively, if the focus is primarily on ratios, comparability can be achieved without translating the currencies. The analyst may also want to examine comparable performance over time. Again, the nominal currency amounts of sales or net income may not highlight significant changes. To address this challenge, horizontal financial statements (whereby quan- tities are stated in terms of a selected base year value) can make such changes more apparent. Another obstacle to comparison is differences in fiscal year end. To achieve comparability, one approach is to develop trailing 12 months of data. Finally, it should be noted that differences in accounting standards can limit comparability. EXAMPLE 2 Ratio Analysis An analyst is examining the profitability of two international companies with large shares of the global personal computer market: Acer Inc. and Lenovo Group Limited. Acer has pursued a strategy of selling its products at affordable prices. In contrast, Lenovo aims to achieve higher selling prices by stressing the high engineering quality of its personal computers for business use. Acer reports in New Taiwan dollars (TWD) and Lenovo reports in US dollars (USD). For Acer, fiscal year end is 31 December. For Lenovo, fiscal year end is 31 March; thus, FY2017 ended 31 March 2018. The analyst collects the data shown in Exhibit 4. Use this information to answer the following questions: Analytical Tools and Techniques 395 ​ Exhibit 4: Acer versus Lenova Profitability ​ ​ Acer TWD Millions FY2013 FY2014 FY2015 FY2016 FY2017 Revenue 360,132 329,684 263,775 232,724 237,275 Gross profit 22,550 28,942 24,884 23,212 25,361 Net income (20,519) 1,791 604 (4,901) 2,797 ​ ​ Lenovo USD Millions FY2013 FY2014 FY2015 FY2016 FY2017 Revenue 38,707 46,296 44,912 43,035 45,350 Gross profit 5,064 6,682 6,624 6,105 6,272 Net income (Loss) 817 837 (145) 530 (127) ​ Note: Fiscal years for Lenovo end 31 March. Thus, FY2017 represents the fiscal year ended 31 March 2018; the same applies respectively for prior years. 1. Which company is larger based on the amount of revenue, in US dollars, reported in fiscal year 2017? For FY2017, assume the relevant, average ex- change rate was 30.95 TWD/USD. Solution: Lenovo is much larger than Acer based on FY2017 revenues in US dollar terms. Lenovo’s FY2017 revenues of USD45.35 billion are considerably high- er than Acer’s USD7.67 billion (= TWD237.275 million/30.95). Acer: At the assumed average exchange rate of 30.95 TWD/USD, Acer’s FY2017 revenues are equivalent to USD7.67 billion (= TWD237.275 million ÷ 30.95 TWD/USD). Lenovo: Lenovo’s FY2017 revenues totaled USD45.35 billion. Note: Comparing the size of companies reporting in different currencies requires translating reported numbers into a common currency using exchange rates at some point in time. This solution converts the revenues of Acer to billions of US dollars using the average exchange rate of the fiscal period. It would be equally informative (and would yield the same conclu- sion) to convert the revenues of Lenovo to New Taiwan dollars. 2. Which company had the higher revenue growth from FY2016 to FY2017? FY2013 to FY2017? Solution: The growth in Lenovo’s revenue was much higher than Acer’s in the most recent fiscal year and for the five-year period. ​ Change in Revenue FY2016 Change in Revenue FY2013 versus FY2017 (%) to FY2017 (%) Acer 1.96 (34.11) Lenovo 5.38 17.16 ​ The table shows two growth metrics. Calculations are illustrated using the revenue data for Acer: 396 Learning Module 11 Financial Analysis Techniques The change in Acer’s revenue for FY2016 versus FY2017 is 1.96 percent cal- culated as (237,275 – 232,724) ÷ 232,724 or equivalently (237,275 ÷ 232,724) – 1. The change in Acer’s revenue from FY2013 to FY2017 is a decline of 34.11 percent. 3. How do the companies compare, based on profitability? Solution: Profitability can be assessed by comparing the amount of gross profit to rev- enue and the amount of net income to revenue. The following table presents these two profitability ratios—gross profit margin (gross profit divided by revenue) and net profit margin (net income divided by revenue)—for each year. ​ FY2013 FY2014 FY2015 FY2016 Acer (%) (%) (%) (%) FY2017 (%) Gross profit 6.26 8.78 9.43 9.97 10.69 margin Net profit (5.70) 0.54 0.23 (2.11) 1.18 margin ​ ​ FY2013 FY2014 FY2015 FY2016 Lenovo (%) (%) (%) (%) FY2017 (%) Gross profit 13.08 14.43 14.75 14.19 13.83 margin Net profit 2.11 1.81 (0.32) 1.23 (0.28) margin ​ The net profit margins indicate that both companies’ profitability is relative- ly low. Acer’s net profit margin is lower than Lenovo’s in three out of the five years. Acer’s gross profit margin increased each year but remains signifi- cantly below that of Lenovo. Lenovo’s gross profit margin grew from FY2013 to FY2015 and then declined in FY2016 and FY2017. Overall, Lenovo is the more profitable company, likely attributable to its larger size and commen- surate economies of scale. (Lenovo has the largest share of the personal computer market relative to other personal computer companies.) 4 FINANCIAL RATIO ANALYSIS describe tools and techniques used in financial analysis, including their uses and limitations There are many relationships among financial accounts and various expected relation- ships from one point in time to another. Ratios are a useful way of expressing these relationships. Ratios express one quantity in relation to another, usually as a quotient. Extensive academic research has examined the importance of ratios in predicting stock returns (Ou and Penman, 1989; Abarbanell and Bushee, 1998) or credit failure (Altman, 1968; Ohlson, 1980; Hopwood et al., 1994). This research has found that Financial Ratio Analysis 397 financial statement ratios are effective in selecting investments and in predicting financial distress. Practitioners routinely use ratios to derive and communicate the value of companies and securities. Several aspects of ratio analysis are important to understand. First, the computed ratio is not “the answer.” The ratio is an indicator of some aspect of a company’s per- formance, telling what happened but not why it happened. For example, an analyst might want to answer the question: Which of two companies was more profitable? As demonstrated in the previous example, the net profit margin, which expresses profit relative to revenue, can provide insight into this question. Net profit margin is calculated by dividing net income by revenue: _ Net income ​​ Revenue ​.​ Assume Company A has EUR100,000 of net income and Company B has EUR200,000 of net income. Company B generated twice as much income as Company A, but was it more profitable? Assume further that Company A has EUR2,000,000 of revenue, and thus a net profit margin of 5 percent, and Company B has EUR6,000,000 of revenue, and thus a net profit margin of 3.33 percent. Expressing net income as a percentage of revenue clarifies the relationship: For each EUR100 of revenue, Company A earns EUR5 in net income, whereas Company B earns only EUR3.33 for each EUR100 of revenue. So, we can now answer the question of which company was more profitable in percentage terms: Company A was more profitable, as indicated by its higher net profit margin of 5 percent. Note that Company A was more profitable despite the fact that Company B reported higher absolute amounts of net income and revenue. However, this ratio by itself does not tell us why Company A has a higher profit mar- gin. Further analysis is required to determine the reason (perhaps higher relative sales prices or better cost control or lower effective tax rates). Company size sometimes confers economies of scale, so the absolute amounts of net income and revenue are useful in financial analysis. However, ratios control for the effect of size, which enhances comparisons between companies and over time. A second important aspect of ratio analysis is that differences in accounting policies (across companies and across time) can distort ratios, and a meaningful comparison, therefore, may involve adjustments to the financial data. Third, not all ratios are nec- essarily relevant to a particular analysis. The ability to select a relevant ratio or ratios to answer the research question is an analytical skill. Finally, as with financial analysis in general, ratio analysis does not stop with computation; interpretation of the result is essential. In practice, differences in ratios across time and across companies can be subtle, and interpretation is situation specific. The Universe of Ratios No authoritative bodies specify the exact formulas for computing ratios or provide a standard, comprehensive list of ratios. Formulas and even names of ratios often differ from analyst to analyst or from database to database. The number of different ratios that can be created is practically limitless. Several widely accepted ratios, however, have been found to be useful, which are the focus of this module. The analyst should be aware that different ratios may be used in practice and that certain industries have unique ratios tailored to the characteristics of that industry. When faced with an unfamiliar ratio, the analyst can examine the underlying formula to gain insight into what the ratio is measuring. For example, consider the following ratio formula: Operating income ______________ ​​Average       total assets ​​. 398 Learning Module 11 Financial Analysis Techniques Never having seen this ratio, an analyst might question whether a result of 12 percent is better than 8 percent. The answer can be found in the ratio itself. The numerator is operating income and the denominator is average total assets, so the ratio can be interpreted as the amount of operating income generated per unit of assets. For every EUR100 of average total assets, generating EUR12 of operating income is better than generating EUR8 of operating income. Furthermore, it is apparent that this particular ratio is an indicator of profitability (as well as efficiency in use of assets in generating operating profits). When encountering a ratio for the first time, the analyst should evaluate the numerator and denominator to assess what the ratio is attempting to measure and how it should be interpreted. This is demonstrated in Example 3. EXAMPLE 3 Interpreting a Financial Ratio A US insurance company reports that its “combined ratio” is determined by dividing losses and expenses incurred by net premiums earned. It reports the following combined ratios: ​ Exhibit 5: Combined Ratio ​ ​ Fiscal Year 5 4 3 2 1 Combined 90.1% 104.0% 98.5% 104.1% 101.1% ratio ​ 1. Explain what this ratio is measuring and compare the results reported for each of the years shown in the chart. What other information might an ana- lyst want to review before making any conclusions on this information? Solution: The combined ratio is a profitability measure. The ratio is explaining how much costs (losses and expenses) were incurred for every dollar of revenue (net premiums earned). The underlying formula indicates that a lower value for this ratio is better. The year 5 ratio of 90.1 percent means that for every dollar of net premiums earned, the costs were USD0.901, yielding a gross profit of $0.099. Ratios greater than 100 percent indicate an overall loss. A review of the data indicates that there does not seem to be a consistent trend in this ratio. Profits were achieved in years 5 and 3. The results for years 4 and 2 show the most significant costs at approximately 104 percent. The analyst would want to discuss this data further with management and understand the characteristics of the underlying business. He or she would want to understand why the results are so volatile. The analyst would also want to determine what should be used as a benchmark for this ratio. The Operating income/Average total assets ratio is one of many versions of the return on assets (ROA) ratio. Note that there are other ways of specifying this formula based on how assets are defined. Some financial ratio databases compute ROA using the ending value of assets rather than average assets. In limited cases, one may also see beginning assets in the denominator. Which one is right? It depends on what you are trying to measure and the underlying company trends. If the company has a stable level of assets, the answer will not differ greatly under the three measures of assets (beginning, average, and ending). However, if the assets are growing (or shrinking), the results will differ among the three measures. When assets are growing, operating Financial Ratio Analysis 399 income divided by ending assets may not make sense because some of the income would have been generated before some assets were purchased, and this would understate the company’s performance. Similarly, if beginning assets are used, some of the oper- ating income later in the year may have been generated only because of the addition of assets; therefore, the ratio would overstate the company’s performance. Because operating income occurs throughout the period, it generally makes sense to use some average measure of assets. A good general rule is that when an income statement or cash flow statement number is in the numerator of a ratio and a balance sheet num- ber is in the denominator, then an average should be used for the denominator. It is generally not necessary to use averages when only balance sheet numbers are used in both the numerator and denominator because both are determined as of the same date. However, in some instances, even ratios that only use balance sheet data may use averages. For example, return on equity (ROE), which is defined as net income divided by average shareholders’ equity, can be decomposed into other ratios, some of which only use balance sheet data. In decomposing ROE into component ratios, if an average is used in one of the component ratios, then it should be used in the other component ratios. The decomposition of ROE is discussed further in a later lesson. If an average is used, judgment is also required about what average should be used. For simplicity, most ratio databases use a simple average of the beginning and end-of-year balance sheet amounts. If the company’s business is seasonal so that levels of assets vary by interim period (semiannual or quarterly), then it may be beneficial to take an average over all interim periods, if available. (If the analyst is working within a company and has access to monthly data, this can also be used.) Value, Purposes, and Limitations of Ratio Analysis The value of ratio analysis is that it enables a financial analyst to evaluate past perfor- mance, assess the current financial position of the company, and gain insights useful for projecting future results. As noted previously, the ratio itself is not “the answer” but is an indicator of some aspect of a company’s performance. Financial ratios provide insights into the following: economic relationships within a company that help analysts project earnings and free cash flow; a company’s financial flexibility, or ability to obtain the cash required to grow and meet its obligations, even if unexpected circumstances develop; management’s ability; changes in the company or industry over time; and comparability with peer companies or the relevant industry(ies). Ratio analysis also has limitations. Factors to consider include the following: The heterogeneity or homogeneity of a company’s operating activities. Companies may have divisions operating in many different industries. This can make it difficult to find comparable industry ratios to use for compari- son purposes. The need to determine whether the results of the ratio analysis are consistent. One set of ratios may indicate a problem, whereas another set may indicate that the potential problem is only short term in nature. The need to use judgment. A key issue is whether a ratio for a company is within a reasonable range. Although financial ratios are used to help assess the growth potential and risk of a company, they cannot be used alone to directly value a company or its securities, or to determine its 400 Learning Module 11 Financial Analysis Techniques creditworthiness. The entire operation of the company must be examined, and the external economic and industry setting in which it is operating must be considered when interpreting financial ratios. The use of alternative accounting methods. Companies frequently have latitude when choosing certain accounting methods. Ratios taken from financial statements that employ different accounting choices may not be comparable unless adjustments are made. Some important accounting con- siderations include the following: FIFO (first in, first out), LIFO (last in, first out), or average cost inven- tory valuation methods (International Financial Reporting Standards [IFRS] does not allow LIFO); Cost or equity methods of accounting for unconsolidated affiliates; Straight-line or accelerated methods of depreciation; and Operating or finance lease treatment for lessors (under US GAAP, the type of lease affects classifications of expenses; under IFRS, operating lease treatment for lessors is not applicable). Convergence efforts between IFRS and US GAAP make the financial statements of different companies more comparable and may overcome some of these difficulties. Nonetheless, there will remain accounting choices that the analyst must consider. Sources of Ratios Ratios may be computed using data obtained directly from companies’ financial state- ments or from a database such as Bloomberg, Compustat, FactSet, or Thomson Reuters. The information provided by the database may include information as reported in companies’ financial statements and ratios calculated based on the information. These databases are popular because they provide easy access to many years of historical data so that trends over time can be examined. They also allow for ratio calculations based on periods other than the company’s fiscal year, such as for the trailing 12 months (TTM) or most recent quarter (MRQ). EXAMPLE 4 Trailing 12 Months 1. On 15 July, an analyst is examining a company with a fiscal year ending on 31 December. Use the following data to calculate the company’s TTM earn- ings (for the period ended 30 June 2018): Earnings for the year ended 31 December 2017: USD1,200; Earnings for the six months ended 30 June 2017: USD550; and Earnings for the six months ended 30 June 2018: USD750. Solution: The company’s TTM earnings is USD1,400, calculated as USD1,200 – USD550 + USD750. Analysts should be aware that the underlying formulas for ratios may differ by vendor. The formula used should be obtained from the vendor, and the analyst should determine whether any adjustments are necessary. Furthermore, database providers often exercise judgment when classifying items. For example, operating income may Common Size Balance Sheets and Income Statements 401 not appear directly on a company’s income statement, and the vendor may use judg- ment to classify income statement items as “operating” or “non-operating.” Variation in such judgments would affect any computation involving operating income. It is therefore a good practice to use the same source for data when comparing different companies or when evaluating the historical record of a single company. Analysts should verify the consistency of formulas and data classifications by the data source. Analysts should also be mindful of the judgments made by a vendor in data classifi- cations and refer to the source financial statements until they are comfortable that the classifications are appropriate. Collection of financial data from regulatory filings and calculation of ratios can be automated. The eXtensible Business Reporting Language (XBRL) is a mechanism that attaches “smart tags” to financial information (e.g., total assets), so that software can automatically collect the data and perform desired computations. The organi- zation developing XBRL (www​.xbrl​.org) is an international nonprofit consortium of more than 600 members from companies, associations, and agencies, including the International Accounting Standards Board (IASB). Many stock exchanges and regu- latory agencies around the world now use XBRL for receiving and distributing public financial reports from listed companies. Analysts can compare a subject company to similar (peer) companies in vendor databases or use aggregate industry data. For non-public companies, aggregate industry data can be obtained from such sources as Annual Statement Studies by the Risk Management Association or Dun & Bradstreet. These publications typically provide industry data with companies sorted into quartiles. By definition, 25 percent of companies’ ratios fall within the lowest quartile, 25 percent have ratios between the lower quartile and median value, and so on. Analysts can then determine a company’s relative standing in the industry. COMMON SIZE BALANCE SHEETS AND INCOME STATEMENTS 5 describe tools and techniques used in financial analysis, including their uses and limitations Common-size analysis involves expressing financial data, including entire financial statements, in relation to a single financial statement item, or base. Items used most frequently as the bases are total assets or revenue. In essence, common-size analysis creates a ratio between every financial statement item and the base item. Common-size analysis was demonstrated in earlier modules for the income statement, balance sheet, and cash flow statement. In this lesson, we present common-size analysis of financial statements in greater detail and include further discussion of their interpretation. Common-Size Analysis of the Balance Sheet A vertical common-size balance sheet, prepared by dividing each item on the balance sheet by the same period’s total assets and expressing the results as percentages, highlights the composition of the balance sheet. What is the mix of assets being used? How is the company financing itself? How does one company’s balance sheet composition compare with that of peer companies, and what are the reasons for any differences? A horizontal common-size balance sheet, prepared by computing the increase or decrease in percentage terms of each balance sheet item from the prior year or prepared by dividing the quantity of each item by a base year quantity of the item, highlights changes in items. These changes can be compared to expectations. 402 Learning Module 11 Financial Analysis Techniques Exhibit 6 presents a vertical common-size (partial) balance sheet for a hypothetical company in two time periods. In this example, receivables have increased from 35 percent to 57 percent of total assets and the ratio has increased by 63 percent from Period 1 to Period 2. What are possible reasons for such an increase? The increase might indicate that the company is making more of its sales on a credit basis rather than a cash basis, perhaps in response to some action taken by a competitor. Alternatively, the increase in receivables as a percentage of assets may have occurred because of a change in another current asset category, for example, a decrease in the level of inven- tory; the analyst would then need to investigate why that asset category has changed. Another possible reason for the increase in receivables as a percentage of assets is that the company has lowered its credit standards, relaxed its collection procedures, or adopted more aggressive revenue recognition policies. The analyst can turn to other comparisons and ratios (e.g., comparing the rate of growth in accounts receivable with the rate of growth in sales) to help determine which explanation is most likely. Exhibit 6: Vertical Common-Size (Partial) Balance Sheet for a Hypothetical Company Period 1 Period 2 Percent of Total Assets Percent of Total Assets Cash 25 15 Receivables 35 57 Inventory 35 20 Fixed assets, net of depreciation 5 8 Total assets 100 100 Common-Size Analysis of the Income Statement A vertical common-size income statement divides each income statement item by revenue, or sometimes by total assets (especially in the case of financial institutions). If there are multiple revenue sources, a decomposition of revenue in percentage terms is useful. Exhibit 7 presents a hypothetical company’s vertical common-size income statement in two time periods. Revenue is separated into the company’s four services, each shown as a percentage of total revenue. In this example, revenues from Service A have become a far greater percentage of the company’s total revenue (30 percent in Period 1 and 45 percent in Period 2). What are possible reasons for and implications of this change in business mix? Did the company make a strategic decision to sell more of Service A, perhaps because it is more profitable? Apparently not, because the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) declined from 53 percent of sales to 45 percent, so other possible explanations should be examined. In addition, we note from the composition of operating expenses that the main reason for this decline in profitability is that salaries and employee benefits have increased from 15 percent to 25 percent of total revenue. Are more highly compensated employees required for Service A? Were higher training costs incurred to increase revenues from Service A? If the analyst wants to predict future performance, the causes of these changes must be understood. In addition, Exhibit 7 shows that the company’s income tax as a percentage of sales has declined dramatically (from 15 percent to 8 percent). Furthermore, taxes as a percentage of earnings before tax (EBT) (the effective tax rate, which is usually the Cross-Sectional, Trend Analysis, and Relationships in Financial Statements 403 more relevant comparison), have decreased from 36 percent (= 15/42) to 24 percent (= 8/34). Is Service A, which in Period 2 is a greater percentage of total revenue, provided in a jurisdiction with lower tax rates? If not, what is the explanation for the change in effective tax rate? The observations based on Exhibit 7 summarize the issues that can be raised through analysis of the vertical common-size income statement. Exhibit 7: Vertical Common-Size Income Statement for Hypothetical Company Period 1Percent of Period 2Percent of Total Revenue Total Revenue Revenue source: Service A 30 45 Revenue source: Service B 23 20 Revenue source: Service C 30 30 Revenue source: Service D 17 5 Total revenue 100 100 Operating expenses (excluding depreciation) Salaries and employee benefits 15 25 Administrative expenses 22 20 Rent expense 10 10 EBITDA 53 45 Depreciation and amortization 4 4 EBIT 49 41 Interest paid 7 7 EBT 42 34 Income tax provision 15 8 Net income 27 26 EBIT = earnings before interest and tax. CROSS-SECTIONAL, TREND ANALYSIS, AND RELATIONSHIPS IN FINANCIAL STATEMENTS 6 describe tools and techniques used in financial analysis, including their uses and limitations As noted previously, ratios and common-size statements derive their utility through comparison. Cross-sectional analysis (sometimes called “relative analysis”) compares a specific metric for one company with the same metric for another company or group of companies measured at the same point in time or over the same range of time, allowing comparisons even though the companies might be of significantly different sizes or operate in different currencies. This is illustrated in Exhibit 8. 404 Learning Module 11 Financial Analysis Techniques Exhibit 8: Vertical Common-Size (Partial) Balance Sheet for Two Hypothetical Companies Company 1 Company 2 Assets Percent of Total Assets Percent of Total Assets Cash 38 12 Receivables 33 55 Inventory 27 24 Fixed assets net of depreciation 1 2 Investments 1 7 Total Assets 100 100 Exhibit 8 presents a vertical common-size (partial) balance sheet for two hypothetical companies at the same point in time. Company 1 is clearly more liquid (liquidity is a function of how quickly assets can be converted into cash) than Company 2, which has only 12 percent of assets available as cash, compared with the highly liquid Company 1, which has 38 percent of assets available as cash. Given that cash is generally a relatively low-yielding asset and thus not a particularly efficient use of excess funds, why does Company 1 hold such a large percentage of total assets in cash? Perhaps the company is preparing for an acquisition, or maintains a large cash position as insulation from a particularly volatile operating environment. Another issue highlighted by the com- parison in this example is the relatively high percentage of receivables in Company 2’s assets, which may indicate a greater proportion of credit sales, overall changes in asset composition, lower credit or collection standards, or aggressive accounting policies. Trend Analysis When looking at financial statements and ratios, trends in the data, whether they are improving or deteriorating, are as important as the current absolute or relative levels. Trend analysis provides important information regarding historical performance and growth and, given a sufficiently long history of accurate seasonal information, can be of great assistance as a planning and forecasting tool for management and analysts. Exhibit 9 presents a partial balance sheet for a hypothetical company over five periods. The last two columns of the table show the changes for Period 5 compared with Period 4, expressed both in absolute currency (in this case, dollars) and in per- centages. A small percentage change could hide a significant currency change and vice versa, prompting the analyst to investigate the reasons despite one of the changes being relatively small. In this example, the largest percentage change was in investments, which decreased by 33.3 percent. However, an examination of the absolute currency amount of changes shows that investments changed by only USD2 million, and the more significant change was the USD12 million increase in receivables. Another way to present data covering a period of time is to show each item in relation to the same item in a base year (i.e., a horizontal common-size balance sheet). Exhibit 10 and Exhibit 11 illustrate alternative presentations of horizontal common-size balance sheets. Exhibit 10 presents the information from the same partial balance sheet as in Exhibit 9, but indexes each item relative to the same item in Period 1. For example, in Period 2, the company had USD29 million cash, which is 74 percent or 0.74 of the amount of cash it had in Period 1. Expressed as an index relative to Period 1, where each item in Period 1 is given a value of 1.00, the value in Period 2 would be 0.74 (USD29/USD39 = 0.74). In Period 3, the company had USD27 million cash, which is 69 percent of the amount of cash it had in Period 1 (USD27/USD39 = 0.69). Cross-Sectional, Trend Analysis, and Relationships in Financial Statements 405 Exhibit 11 presents the percentage change in each item, relative to the previous year. For example, the change in cash from Period 1 to Period 2 was –25.6 percent (USD29/ USD39 – 1 = –0.256), and the change in cash from Period 2 to Period 3 was –6.9 per- cent (USD27/USD29 – 1 = –0.069). An analyst will select the horizontal common-size balance that addresses the particular period of interest. Exhibit 10 clearly highlights that in Period 5 compared to Period 1, the company has less than half the amount of cash, four times the amount of investments, and eight times the amount of property, plant, and equipment. Exhibit 11 highlights year-to-year changes: For example, cash has declined in each period. Presenting data this way highlights significant changes. Again, note that a mathematically big change is not necessarily an important change. For example, fixed assets increased 100 percent (i.e., doubled between Period 1 and 2); however, as a proportion of total assets, fixed assets increased from 1 percent of total assets to 2 percent of total assets. The company’s working capital assets (receivables and inventory) are a far higher proportion of total assets and would likely warrant more attention from an analyst. An analysis of horizontal common-size balance sheets highlights structural changes that have occurred in a business. Past trends are obviously not necessarily an accurate predictor of the future, especially when the economic or competitive environment changes. An examination of past trends is more valuable when the macroeconomic and competitive environments are relatively stable and when the analyst is reviewing a stable or mature business. However, even in less stable contexts, historical analysis can serve as a basis for developing expectations. Understanding of past trends is helpful in assessing whether these trends are likely to continue or if the trend is likely to change direction. Exhibit 9: Partial Balance Sheet for a Hypothetical Company over Five Periods Period Change 4 to 5 Change Assets (US (US dollar 4 to 5 dollar millions) 1 2 3 4 5 millions) (%) Cash 39 29 27 19 16 –3 –15.8 Investments 1 7 7 6 4 –2 –33.3 Receivables 44 41 37 67 79 12 17.9 Inventory 15 25 36 25 27 2 8.0 Fixed assets net of depreciation 1 2 6 9 8 –1 –11.1 Total assets 100 104 113 126 134 8 6.3 Exhibit 10: Horizontal Common-Size (Partial) Balance Sheet for a Hypothetical Company over Five Periods, with Each Item Expressed Relative to the Same Item in Period One Period Assets 1 2 3 4 5 Cash 1.00 0.74 0.69 0.49 0.41 Investments 1.00 7.00 7.00 6.00 4.00 406 Learning Module 11 Financial Analysis Techniques Period Assets 1 2 3 4 5 Receivables 1.00 0.93 0.84 1.52 1.80 Inventory 1.00 1.67 2.40 1.67 1.80 Fixed assets net of 1.00 2.00 6.00 9.00 8.00 depreciation Total assets 1.00 1.04 1.13 1.26 1.34 Exhibit 11: Horizontal Common-Size (Partial) Balance Sheet for a Hypothetical Company over Five Periods, with Percent Change in Each Item Relative to the Prior Period Period Assets 2 (%) 3 (%) 4 (%) 5 (%) Cash –25.6 –6.9 –29.6 –15.8 Investments 600.0 0.0 –14.3 –33.3 Receivables –6.8 –9.8 81.1 17.9 Inventory 66.7 44.0 –30.6 8.0 Fixed assets net of depreciation 100.0 200.0 50.0 –11.1 Total assets 4.0 8.7 11.5 6.3 One measure of success is for a company to grow at a rate greater than the rate of the overall market in which it operates. Companies that grow slowly may find themselves unable to attract equity capital. Conversely, companies that grow too quickly may find that their administrative and management information systems cannot keep up with the rate of expansion. Relationships Among Financial Statements Trend data generated by a horizontal common-size analysis can be compared across financial statements. For example, the growth rate of assets for the hypothetical company in Exhibit 12 can be compared with the company’s growth in revenue over the same period of time. If revenue is growing more quickly than assets, the com- pany may be increasing its efficiency (i.e., generating more revenue for every dollar invested in assets). As another example, consider the following year-over-year percentage changes for a hypothetical company: Exhibit 12: Year-over-Year Percentage Changes Revenue +20% Net income +25% Operating cash flow –10% Total assets +30% The Use of Graphs and Regression Analysis 407 Net income is growing faster than revenue, which indicates increasing profitability. However, the analyst would need to determine whether the faster growth in net income resulted from continuing operations or from non-operating, non-recurring items. In addition, the 10 percent decline in operating cash flow despite increasing revenue and net income clearly warrants further investigation because it could indicate a problem with earnings quality (perhaps aggressive reporting of revenue). Lastly, the fact that assets have grown faster than revenue indicates the company’s efficiency may be declining. The analyst should examine the composition of the increase in assets and the reasons for the changes. Example 5 illustrates a historical example of a company for which comparisons of trend data from different financial statements were actually indicative of aggressive accounting policies. EXAMPLE 5 Use of Comparative Growth Information1 In July 1996, Sunbeam, a US company, brought in new management to turn the company around. In the following year, 1997, using 1996 as the base, the following was observed based on reported numbers: ​ Exhibit 13: Sunbeam Revenue ​ ​ Revenue +19 percent Inventory +58 percent Receivables +38 percent ​ It is generally more desirable to observe inventory and receivables growing at a slower (or similar) rate than revenue growth. Receivables growing faster than revenue can indicate operational issues, such as lower credit standards or aggressive accounting policies for revenue recognition. Similarly, inventory growing faster than revenue can indicate an operational problem with obsoles- cence or aggressive accounting policies, such as an improper overstatement of inventory to increase profits. In this case, the explanation lay in aggressive accounting policies. Sunbeam was later charged by the US Securities and Exchange Commission with improperly accelerating the recognition of revenue and engaging in other practices, such as billing customers for inventory prior to shipment. THE USE OF GRAPHS AND REGRESSION ANALYSIS 7 describe tools and techniques used in financial analysis, including their uses and limitations 1 Adapted from Robinson and Munter (2004, p. 2–15). 408 Learning Module 11 Financial Analysis Techniques Graphs facilitate comparison of performance and financial structure over time, high- lighting changes in significant aspects of business operations. In addition, graphs provide the analyst (and management) with a visual overview of risk trends in a busi- ness. Graphs may also be used effectively to communicate the analyst’s conclusions regarding financial condition and risk management aspects. Exhibit 14 presents the information from Exhibit 9 in a stacked column format. The graph makes the significant decline in cash and growth in receivables (both in absolute terms and as a percentage of assets) readily apparent. In Exhibit 14, the vertical axis shows US dollar millions and the horizontal axis denotes the period. Choosing the appropriate graph to communicate the most significant conclusions of a financial analysis is a skill. In general, pie graphs are most useful to communicate the composition of a total value (e.g., assets over a limited amount of time, say one or two periods). Line graphs are useful when the focus is on the change in amount for a limited number of items over a relatively longer time period. When the composition and amounts, as well as their change over time, are all important, a stacked column graph can be useful. Exhibit 14: Stacked Column Graph of Asset Composition of Hypothetical Company over Five Periods 160 140 120 100 80 60 40 20 0 1 2 3 4 5 Cash Investments Receivables Fixed assets Inventory When comparing Period 5 with Period 4, the growth in receivables appears to be within normal bounds; but when comparing Period 5 with earlier periods, the dramatic growth becomes apparent. In the same manner, a simple line graph will also illustrate the growth trends in key financial variables. Exhibit 15 presents the information from Exhibit 9A as a line graph, illustrating the growth of assets of a hypothetical company over five periods. The steady decline in cash, volatile movements of inventory, and dramatic growth of receivables is clearly illustrated. Again, the vertical axis is shown in US dollar millions and the horizontal axis denotes periods. Common Ratio Categories, Interpretation, and Context 409 Exhibit 15: Line Graph of Growth of Assets of Hypothetical Company over Five Periods 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 Cash Investments Receivables Fixed assets Inventory Regression Analysis When analyzing the trend in a specific line item or ratio, frequently it is possible simply to visually evaluate the changes. For more complex situations, regression analysis can help identify relationships (or correlation) between variables. For example, a regres- sion analysis could relate a company’s sales to GDP over time, providing insight into whether the company is cyclical. In addition, the statistical relationship between sales and GDP could be used as a basis for forecasting sales. Other examples in which regression analysis may be useful include the relation- ship between a company’s sales and inventory over time, or the relationship between hotel occupancy and a company’s hotel revenues. In addition to providing a basis for forecasting, regression analysis facilitates identification of items or ratios that are not behaving as expected, given historical statistical relationships. COMMON RATIO CATEGORIES, INTERPRETATION, AND CONTEXT 8 calculate and interpret activity, liquidity, solvency, and profitability ratios In the previous lesson, we focused on ratios resulting from common-size analysis. In this lesson, we expand the discussion to include other commonly used financial ratios and the broad classes into which they are categorized. There is some overlap 410 Learning Module 11 Financial Analysis Techniques with common-size financial statement ratios. For example, a common indicator of profitability is the net profit margin, which is calculated as net income divided by sales. This ratio appears on a vertical common-size income statement. Other ratios involve information from multiple financial statements or even data from outside the financial statements. Because of the large number of ratios, it is helpful to think about ratios in terms of broad categories based on what aspects of performance a ratio is intended to detect. Financial analysts and data vendors use a variety of categories to classify ratios. The category names and the ratios included in each category can differ. Common ratio categories include activity, liquidity, solvency, and profitability, which were introduced in earlier modules in Corporate Issuers. These categories are summarized in Exhibit 16. Each category measures a different aspect of the company’s business, but all are useful in evaluating a company’s overall ability to generate cash flows from operating its business and the associated risks. Exhibit 16: Categories of Financial Ratios Category Description Activity Activity ratios measure the efficiency of a company’s operations, such as the collection of receivables and management of inventory. Liquidity Liquidity ratios measure the company’s ability to meet its short-term obligations. Solvency Solvency ratios measure a company’s ability to meet long-term obligations. Subsets of these ratios are also known as “leverage” and “long-term debt” ratios. Profitability Profitability ratios measure the company’s ability to generate profits from its resources (assets) or sales. Interpretation and Context Financial ratios can be interpreted only in the context of other information. In general, the financial ratios of a company are compared with those of its major competitors (cross-sectional and trend analysis) and to the company’s prior periods (trend analysis). The goal is to understand the underlying causes of divergence between a company’s ratios and those of the industry. Even ratios that remain consistent require understand- ing because consistency can sometimes indicate accounting policies selected to smooth earnings. An analyst should evaluate financial ratios in the context of the following: 1. Prior period results. Trend analysis can reveal whether a company’s perfor- mance and position are weakening or strengthening. 2. Expectations. These are point or range estimates for key values, such as sales growth, profit margins, and leverage ratios, that are specified by the analyst or external analysts before results are published. Differences from expecta- tions should be scrutinized for setting expectations in subsequent periods. 3. Industry peers and competitors (cross-sectional analysis). A company can be compared with others in its industry by relating its financial ratios to indus- try norms or to a subset of the companies in an industry. When industry norms are used to make judgments, care must be taken for the following reasons: Activity Ratios 411 Companies may have several different lines of business. This will cause aggregate financial ratios to be distorted. It is better to examine indus- try-specific ratios by lines of business. Differences in business model and corporate strategies can affect certain financial ratios. Some ratios are industry specific, and not all ratios are important to all industries. Differences in accounting methods used by companies can distort finan- cial ratios. 4. Company goals and strategy. Actual ratios can be compared with company objectives to determine whether objectives are being attained and whether the results are consistent with the company’s strategy. 5. Economic conditions. For cyclical companies, financial ratios tend to improve when the economy is strong and weaken during recessions. Therefore, financial ratios should be examined in light of the current phase of the business cycle. The following lessons discuss the calculation and interpretation of activity, liquidity, solvency, and profitability ratios using a company’s financial statements. ACTIVITY RATIOS 9 calculate and interpret activity, liquidity, solvency, and profitability ratios Activity ratios, also known as asset utilization ratios or operating efficiency ratios, are measures of operational performance—how effectively the company is using working capital and longer term assets. Since working capital efficiency has a direct impact on liquidity, some activity ratios are also useful in assessing liquidity. Calculation of Activity Ratios Exhibit 17 presents commonly used activity ratios. Exhibit 17: Definitions of Commonly Used Activity Ratios Activity Ratios Numerator Denominator Inventory turnover Cost of sales or cost of Average inventory goods sold Days of inventory on hand Number of days in period Inventory turnover (DOH) Receivables turnover Revenue Average receivables Days of sales outstanding (DSO) Number of days in period Receivables turnover Payables turnover Cost of sales or cost of Average trade payables goods sold Number of days of payables Number of days in period Payables turnover 412 Learning Module 11 Financial Analysis Techniques Activity Ratios Numerator Denominator Working capital turnover Revenue Average working capital Fixed asset turnover Revenue Average net fixed assets Total asset turnover Revenue Average total assets Activity ratios generally combine information from the income statement in the numerator with balance sheet items in the denominator. Because the income state- ment measures what happened during a period, whereas the balance sheet shows the condition only at the end of the period, average balance sheet figures are normally used for consistency. Activity ratios can be computed for any annual or interim period, but care must be taken in the interpretation and comparison across periods. For example, if the same company had cost of goods sold for the first quarter (90 days) of the following year of EUR35,000 and average inventory of EUR11,000, the inventory turnover would be 3.18 times. However, this turnover rate is 3.18 times per quarter, which is not directly comparable to the 12 times per year in the preceding year. In this case, we can annualize the quarterly inventory turnover rate by multiplying the quarterly turnover by 4 (12 months/3 months; or by 4.06, using 365 days/90 days) for comparison to the annual turnover rate. So, the quarterly inventory turnover is equivalent to a 12.72 annual inventory turnover (or 12.90 if we annualize the ratio using a 90-day quarter and a 365-day year). To compute the DOH using quarterly data, we can use the quarterly turnover rate and the number of days in the quarter for the numerator—or, we can use the annualized turnover rate and 365 days; either results in DOH of around 28.3, with slight differences due to rounding (90/3.18 = 28.30 and 365/12.90 = 28.29). Another time-related computational detail is that for companies using a 52/53-week annual period and for leap years, the actual days in the year should be used rather than 365. In some cases, an analyst may want to know how many days of inventory are on hand at the end of the year rather than the average for the year. In this case, it would be appropriate to use the year-end inventory balance in the computation rather than the average. If the company is growing rapidly or if costs are increasing rapidly, analysts should consider using cost of goods sold just for the fourth quarter in this computation because the cost of goods sold of earlier quarters may not be relevant. Example 6 further demonstrates computation of activity ratios using Hong Kong Stock Exchange (HKEX)–listed Leno