Level 1 CFA® Exam:
Elements of Company Analysis
Factors affecting the development of an industry can be divided into macroeconomic, technological, demographic, governmental, and social influences.
Macroeconomic Influences
As you probably already know, many industries are affected by the economic situation or trends in economic activity. We can distinguish between cyclical and structural trends. Cyclical trends depend on the business cycle, while structural trends depend on changes in economic activity. When analyzing an industry, we should consider macroeconomic factors such as gross domestic product, interest rates, availability of credit, or inflation.
Technological Influences
One of the most important factors affecting the development of industries is new technologies. Their introduction can significantly weaken the demand for older products and services in an industry. Thanks to technological development, new products are launched, which may change the market shares of individual companies. As a result, an entirely new industry may be created, as it was the case with the computer market. With the invention of the microchip, the computer hardware industry was separated completely from the new personal computing industry.
Demographic Influences
Another group of factors affecting an industry is demographic factors. These factors include changes in population size or distributions of age and gender. An example of such a factor can be the demographic baby boom that occurred after World War II. The post-war increase in births contributed to a significant increase in demand for manufactured goods, and consequently to the development of many industries. Other demographic factors that had an impact on economic growth include the pop culture of the 1950s and ‘60s or the popularity of retirement-oriented investment products.
Governmental Influences
Also, governments influence the performance of particular industries. With legislation, governments affect the revenues and expenditures of both individuals and businesses. In addition, they determine the level of taxation, which strongly affects the performance of businesses. Government spending also affects the economic situation of the industry as governments are one of the largest corporate clients in many industries.
In some cases, the influence of the government on a variety of industries is indirect. Through their actions, governments may affect organizations associating participants of one industry, like, for example, stock exchanges or medical associations. These entities affect the entire industry by introducing rules such as good market practices.
Social Influences
Social influences also play their role when speaking of industry performance. Social changes take place in such aspects of life like work, leisure activities, hobbies, family life, or money spending. All of these factors are determinants of the profitability of particular industries.
Tobacco consumption is a good example showing how lifestyle may influence a business sector. For some time we have been observing campaigns designed to discourage smoking. It turned out that the most effective method was to show that smoking is no longer socially correct. This was a typical social change.
Company analysis is an analysis of the entirety of a company’s operations and their effects, which can be assessed based on the analysis of the company’s financial position, its products and services, as well as its competitive strategy.
Steps in Company Analysis
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The company analysis should provide us with information on:
- corporate profile, corporate governance, strengths and weaknesses, and the characteristics of the industry,
- characteristics of products and services, analysis of demand, supply and costs of production,
- pricing environment and financial ratios,
- forecasts regarding the company’s cash flows, profits, and cost of capital used in the discounted cash flow method to value the company.
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| Activity ratios | Liquidity ratios | Solvency ratios | Profitability ratios | Other measures of interest |
|---|---|---|---|---|
| days of sales outstanding, days of inventory on hand, days of payables outstanding | current ratio, quick ratio, cash ratio | net debt to EBITDA, net debt to capital, debt to assets | gross profit margin, operating profit margin, net profit margin | growth rate of net sales, growth rate of gross profit, EBITDA, net income |
Return on equity (ROE) is one of the most important profitability ratios on which analysis should be based.
An analyst wants to calculate a company’s ROE. He knows that the net profit margin (return on sales aka. ROS) is 3.1%, the asset turnover is 1.2, and the total value of assets is USD 30,000. If the equity of the company amounts to USD 20,000, ROE is equal to?
\(ROE=ROS\times{\text{asset turnover}}\times{\text{leverage}}=\\=3.1\%\times1.2\times\frac{30,000}{20,000}=5.58\%\)
- Factors affecting the development of an industry can be divided into macroeconomic, technological, demographic, governmental, and social influences.
- Company analysis is an analysis of the entirety of a company’s operations and their effects, which can be assessed based on the analysis of the company’s financial position, its products and services, as well as its competitive strategy.
- The first step in a company analysis is to find out about its external environment, whereas the second step is to look closely at the company’s strategy and method of its implementation.
- In a low-cost strategy companies try to be low-cost producers.
- A company implementing the product or service differentiation strategy tries to distinguish its products and services from other products and services available in the market.
- The company analysis should provide us with information on the corporate profile, corporate governance, strengths and weaknesses, the characteristics of the industry, characteristics of products and services, analysis of demand, supply and costs of production, pricing environment, financial ratios, forecasts regarding the company’s cash flows, profits, and cost of capital used in the discounted cash flow method to value the company.
- Among the ratios used in the analysis there are activity, liquidity, solvency, and profitability ratios, as well as some other financial measures.