**Financial Reporting and Analysis II**

**Reading 24. Financial Analysis Techniques**

**Learning Outcome Statements**

b. classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios;

c. describe relationships among ratios and evaluate a company using ratio analysis;

*CFA Curriculum, 2020, Volume 3*

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### Subject 2. Common Ratios

**Activity Ratios**

A company's operating activities require investments in both short-term (inventory and accounts receivable) and long-term (property, plant, and equipment) assets. Activity ratios describe the relationship between the company's level of operations (usually defined as sales) and the assets needed to sustain operating activities. They measure how well a company manages its various assets.

**Receivables turnover**measures the liquidity of the receivables - that is, how quickly receivables are collected or turn over. The lower the turnover ratio, the more time it takes for a company to collect on a sale and the longer before a sale becomes cash.**Inventory turnover**measures how fast the company moves its inventory through the system. The lower the turnover ratio, the longer the time between when the good is produced or purchased and when it is sold.**Payable turnover**measures the length of time a company has to pay its current liabilities to suppliers. This ratio examines the use of trade credit. The longer the time, the better it is for the company, since it is an interest-free loan and offsets the lack of cash from receivables and inventory turnovers.**Working capital turnover**measures how efficiently a company generates revenue with its working capital. Working capital is defined as current assets minus current liabilities.**Total asset turnover**is a measure of how many dollars of sales are generated by a dollar of assets. This number is smaller in capital-intensive industries since they have a higher investment in property, plants and equipment. It is also affected by the amount of leasing that is done by a company. Therefore, the ratio is very industry specific.- An exceedingly high ratio might imply too few assets for the potential business (sales) or the use of outdated, fully depreciated assets.
- A low ratio might imply capital tied up in an excess of assets relative to the needs of the company.

**Fixed asset turnover**is a measure of a company's utilization of fixed assets.

**Liquidity Ratios**

Liquidity ratios measure the ability of a company to meet short-term obligations. Major liquidity ratios such as current ratio, quick ratio, and cash ratio are discussed in Reading 24 [Understanding Balance Sheets].

- The
**defensive interval ratio**measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in. It provides an intuitive "feel" for a company's liquidity, albeit a most conservative one. It compares currently available "quick" sources of cash with the estimated outflows needed to operate the company: projected expenditures. - The
**cash conversion cycle**is the time period that exists from when the company pays out money for the purchase of raw materials to when it gets the money back from the purchasers of the company's finished goods. In short, it measures the number of days the company's cash is tied up in the business. When the company buys raw materials, it commits capital to inventory. At the same time, suppliers provide interest-free loans to the company by carrying its payables, thus offsetting the company's capital commitment. After the products are sold, the capital is then tied up in receivables for the collection period. The cash conversion cycle is a measure of how fast a dollar spent returns to the company in payment for a sale. A very high cash conversion cycle indicates that too much capital is tied up in the sales process.Cash Conversion Cycle = DOH + DSO - Number of Days of Payables

Note: Analysts should be aware of the impact of accounting choices and accounting transactions on liquidity ratios. For example, payment of an accounts receivable has no effect since one current asset is increasing and another is decreasing. Capitalizing a lease decreases the current ratio, since capitalizing a lease puts a liability on the balance sheet and the portion due in the next year is classified as a current liability. An increase in the turnover ratio decreases the number of days for collection of a receivable or sale of inventory and hence shortens the cash conversion cycle. Use of LIFO versus FIFO in periods of rising prices results in a lower inventory balance and hence a lower current ratio.

**Solvency Ratios**

Solvency ratios measure the ability of a company to meet long-term obligations. Major solvency ratios such as

**debt ratios**are discussed in Reading 24 [Understanding Balance Sheets].

__Coverage Ratios__

**Interest coverage ratio**measures how many times over a company could pay its interest out of earnings. The higher the ratio, the less likely that the company cannot meet its interest payments, and consequently, the lower the financial risk.**Fixed charge coverage**measures a company's ability to meet all fixed payment obligations, including interest payment on debt, entire lease payments (not limited to the interest component), and dividends on preferred stock. Lease payments are fixed payments just like debt and interest payments. Preferred dividends are grossed-up (on the same basis as the other items in the formula), because preferred dividends are paid from after-tax dollars.

Analysts may be required to adjust these ratios for accounting choices as well. If interest is capitalized, it reduces the interest expense in the current year and the interest is added to the cost of the asset. As a result, interest coverage will look more positive, since some of the interest for the current year will not be included in the interest expense and, hence, the ratio will be higher.

**Profitability Ratios**

Profitability ratios measure the ability of a company to generate profits from revenue and assets.

__Return on Sales__

Net profit margin and gross profit margin are discussed in Reading 23 [Understanding Income Statements].

**Operating profit margin**relates a company's operating income to its net sales.**Pre-tax margin**:

Since profit margin is valuable as a predictor of future earnings, an analyst needs to decide whether to back out other items, such as restructuring charges, in determining what represents income from "continuing" operations. These non-recurring items are considered part of continuing operations but may not be the best predictor of future earnings. Given the current problems in financial reporting, analysts should consider whether certain income statement items should be added/deleted from net income to obtain a better indicator of future earnings. In addition, any "quality of earnings" items should be considered, as should their potential effect on these operating performance ratios. For example, if a company decreased its bad debt expense calculation, it would improve the current year's net income but this might result in a larger expense being recorded in subsequent years. Analysts should be prepared to answer numerous ratio questions based on quality of earnings issues and their effects on ratios.

__Return on Investment__

The following ratios measure the percentage returns on capital employed.

**Operating ROA**=**ROA**measures the return earned by a company on its assets.**Return on total capital**indicates a company's return on all the capital employed (debt, preferred stock, and common stock). It measures return on all sources of funding.**ROE (Return on equity)**measures return on total equity capital only. This includes both preferred and common equity owners.**Return on common equity**is also a useful indicator. This ratio is

**Integrated Financial Ratio Analysis**

Ratios can also be combined and evaluated as a group to better understand how they fit together and how efficiency and leverage are tied to profitability. The information from one ratio category can be helpful in answering questions raised by another category. The most accurate overall picture comes from integrating information from all sources. Please refer to the textbook for examples.

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**User Contributed Comments**
12

You need to log in first to add your comment. ###### sergashev

Another formula is:

Payables turnover = Purchases / Average trade payables

###### rocyang

I have never used some of these ratios btw. To me it would probably only be useful in the coming exam...

###### Raok

Too many to remember

###### thekobe

very important to remember, the cash conversion cycle and the operating cycle.

CCC = DAR + DI -DAP

OC = DAR + DI

###### moneyguy

I am VERY intimidated by the amount of info we have to ingest. I really don't expect to pass this exam. Great attitude -- i know!

###### johntan1979

thekobe: Where did you get the formula for

OC = DAR + DI?

From most textbooks and sources, CCC = OC

###### jonan203

moneyguy, memorize everything the same way you would memorize one of beethoven's later sonatas, repetition

###### gill15

No..dont memorize...use acronyms for everything...for eg. For activity ratios I use IP WTF R....IP man is an awesome movie...Sister name is Raji and she hates it(Exactly WTF)....so IP WTF R..Done...also worked out that IP out of all the ratios uses things other then Revenue in Numerator...all others use R..all denoms are easy...

so got Inventory TO, Paya TO, WorkinCApTO, TotaATO, FATO and receivable TO....Boom Done.

###### ldfrench

@Jonan203, why should I want to memorize a movie about a big, stupid dog? HUH?!

###### sshetty2

moneyguy... don't be a wuss

###### Haoran

We could do with a couple of examples of Integrated Financial Ratio Analysis. It seems to me it's not such a minor topic that you can afford to just refer to the textbook for examples.

###### pigletin

there aren't that many calculations in real CFA test just you know