Financial Analysis An Introduction
Financial Analysis An Introduction
Financial Analysis An Introduction
Welcome to the Knowledge Check. If you have prior knowledge of Financial Analysis, try the Knowledge Check. A perfect score is no guarantee that you know everything covered in the tutorial, but a less than perfect score will help you identify any knowledge gaps. If the subject of this tutorial is new to you, the Knowledge Check will indicate the level of the information that you're about to encounter. You may think you don't know much about this area, but you might surprise yourself!
Question 1 of 3
If a company is reporting profits, then its cash flow will be sufficient to fund asset growth. Inventory turnover Quick ratio Price/earnings ratio
Question 2 of 3
Which of the following companies is likely to have the largest inventory as a percentage of total assets? Commercial bank Software developer Discount retailer Airline Correct. You will learn how to analyze various financial ratios across different industries in Topic 2, Performing a Financial Analysis.
Question 3 of 3
True or False? If a company is reporting profits, then its cash flow is sufficient to fund asset growth. True False Correct. You will learn about the basics of cash flow analysis in Topic 3, Trend Analysis & Cash Flow Analysis. On completion of this tutorial, you will be able to: describe the uses of financial analysis calculate and analyze various financial ratios for a range of different companies/industries understand the drawbacks of reviewing a company's performance in the form of 'elevator analysis', an uncomplimentary term to describe how some analysts discuss companies Prerequisite Knowledge Prior to studying this tutorial, you should have a fundamental understanding of credit analysis as outlined in the following tutorial: Credit Analysis An Introduction
compare a particular company against its peers, that is, against companies in the same or a similar industry. This helps to focus further analysis on areas where a company differs from its peers, in terms of operating performance and capital structure.
determine if a company is funding itself internally from operations, or if it needs to access external sources of cash. This is a primary means of assessing credit risk. evaluate if operating performance is real, that is, whether or not there is a chance of fraud in the accounts. Peer analysis is the way to achieve this. Historical financial performance is only the starting point for predicting future financial performance. A company's future performance is a function of many factors, including: its industry its competitive situation its past performance relative to its peers the competency of its management a comparison of its stated strategy and the analyst's view of the strategic opportunities As many sorry investors and lenders have learned, the past is not always a guide to the future. Judgments about future performance are clearly based on past performance, but must consider a number of factors that go beyond historic financial analysis. This will be the subject of a separate tutorial that examines cash flow forecasting in the context of credit analysis.
itself. When compared either with a previous period or with the company's peers, the ratio takes on a more meaningful value. Let's look at some frequently used financial ratios for evaluating: Liquidity
Efficiency
Leverage
Operating performance
Click each term to learn more about the financial ratios associated with it. When you have finished, click the Forward arrow to continue.
Leverage
Leverage ratios are a key indicator of financial risk. A basic measure of leverage is the ratio of total equity to total assets.
This describes the portion of total assets that are funded by equity rather than liabilities. Other typical metrics for leverage are:
Interest coverage is a metric that assesses the relationship between a company's gross cash flow and its periodic interest payments. This is a particularly important metric for highly leveraged companies. There are some arbitrary market standards for coverage, by debt rating, but it is important that all fixed obligations (interest, principal payments, taxes, and capital expenditure) are reviewed relative to a company's earnings. Gross earnings for this measurement are sometimes referred to as 'EBITDA' earnings before interest, taxes, depreciation, and amortization. EBITDA is a proxy for gross cash flow.
Current Ratio
What does a very low current ratio indicate for a company? Long-term debt is too high Inventory is too high Liquidity problems exist Correct. The current ratio is the ratio between a company's current assets and its current liabilities. The ratio determines the company's ability to pay its day-to-day debts as they fall due. A very low current ratio therefore indicates that a company may have liquidity problems.
All companies within an industry will tend to have common financial characteristics - in relation to both the balance sheet and the income statement. Competition will drive profit margins among competitors, and the operating risks of an industry will drive the composition of the balance sheet. Industry practices will determine how much funding is supplied by vendors, and how much by debt and equity. A peer analysis of companies within an industry will lead to the identification of 'outliers' - financial indicators that are different from peers - which require investigation to determine why performance is above or below average. Sometimes the answer is logical, due to the company's management or a particular situation. On other occasions, the answer is not clear, which should lead to a sense of scepticism about whether or not the situation is correctly portrayed by the financial statements and data.
Click each link to go through the details. When you have finished, click the Forward arrow to continue.
identify factors that imply outstanding performance, or factors that are warning signs.
Trend Analysis
Which of the following statements is true? If net margins are growing, operating expense margins must be improving. A falling accounts receivable collection period is generally an indication of poor financial control. A high and rising inventory turnover is generally a sign of good management. Correct. Generally speaking, a high inventory turnover is a sign of good management. Efficient companies turn over their inventory rapidly and do not keep too much capital tied up in raw materials and finished goods. Declining inventory turnover could highlight products that are not selling well, and could be a signal that mark-downs or inventory write-downs will have to be recognized at some point in the near future.