Level 1 CFA® Exam:
We will begin with a common-size analysis. The common-size analysis helps us compare data of different sizes. We distinguish between:
- vertical common-size analysis, and
- horizontal common-size analysis.
Of course, common-size analysis helps us not only analyze one company but also compare companies with each other. For example, if you know that long-term debt in one company is equal to USD 500,000 and in the other to USD 2 million, you won’t be able to state which of these companies is characterized by bigger leverage. However, if you know that for the first company long-term debt is equal to 40% of total assets and for the second one long-term debt amounts to 20% of total assets, you will be able to better evaluate the situation.
In this example, we’ve analyzed the cross-sectional data, namely the data for more than one entity in the same period. We can also analyze the so-called panel data, that is cross-sectional data for more than one period.
As we all know a ratio is computed as one value divided by another value. Ratios help us better evaluate what is going on in a given company or companies. Remember that often we are not much interested in ratio values in isolation but rather we as financial analysts prefer to compare ratios with each other.
For example, we compare the same ratio for different companies or compare one ratio with another ratio for one company, or compare the same ratio across different periods. There are a lot of possibilities here.
When you think about ratios, you should think about the comparison and interpretation. It doesn’t mean that absolute values of ratios are not used at all. It very often depends on the goal of the analysis. If for example credit analysis is conducted, then absolute values of ratios are important.
Creditors are very often required to maintain given ratios on a specific level or take care so that ratios do not increase or decrease above or below some specified thresholds.
Financial statement ratios can be divided into specific groups. We distinguish among:
- activity ratios,
- liquidity ratios,
- solvency ratios,
- profitability ratios,
- valuation ratios,
- industry-specific and task-specific ratios,
- ratios used in credit analysis,
- segment ratios.
- not all ratios should be used and are relevant for every company,
- when comparing ratios for different companies, remember that average ratios for companies operating in different industries may vary a lot,
- ratios for a given company should be coherent with its strategy,
- ratios for cyclical companies vary over time.
Activity ratios measure:
- how well a company manages various activities,
- how effectively assets are used by the company.
Liquidity ratios measure the company's ability to meet short-term obligations. They also help us assess how quickly the company can convert assets into cash.
Solvency ratios measure the company's ability to meet long-term debt obligations. In other words, they tell us how much of assets is financed by debt and to what extent earnings and cash flows can cover interest expenses, lease payments, rental payments, etc.
Valuation ratios are used in the valuation process to value the equity of the company.
Examples of valuation ratios:
In different industries, we may use different ratios to compare companies from the same industry. The role of industry-specific ratios & task-specific ratios is to cover issues and characteristics typical of a given industry.
Credit risk is the risk of incurring a loss as a result of the counterparty not being able to make full and timely payments.
Credit analysis is used for the evaluation of credit risk.
The same as for the company, we can compute ratios for segments. They will help analyze performance, efficiency, etc. for segments.
Note: The construction of segment ratios is the same as in the case of ratios for the whole company with the exception that we choose data for a segment, e.g. in the case of segment margin, we use segment profit in the numerator and segment revenue in the denominator.
- According to the vertical common-size analysis, we analyze the data from one financial statement, for example, a balance sheet, an income statement, or a cash flow statement, for a given period and divide all relevant items from this financial statement by one common item.
- Horizontal common-size analysis assumes that we compare a given item to the same item but from a different year.
- To check the sensitivity of the earnings forecasting on the inputs, we can use 3 techniques: sensitivity analysis (aka. ‘what if’ analysis), scenario analysis, and simulation.
- Financial statement ratios can be divided into specific groups. We distinguish among: activity ratios, liquidity ratios, solvency ratios, profitability ratios, valuation ratios, industry-specific and task-specific ratios, ratios used in credit analysis, and segment ratios.
- Activity ratios measure: how well a company manages various activities and how effectively assets are used by the company.
- Liquidity ratios measure the company's ability to meet short-term obligations. They also help us assess how quickly the company can convert assets into cash.
- Solvency ratios measure the company's ability to meet long-term debt obligations.
- Profitability ratios tell us what is the profitability of the company measured by different categories of profit and in relation to different measures like revenue, total assets, equity, etc.
- Valuation ratios are used in the valuation process to value the equity of the company.
- The role of industry-specific ratios & task-specific ratios is to cover issues and characteristics typical of a given industry.
- A company discloses separate information about the segment if it constitutes at least 10% of total revenue, assets, or profit.