This topic review presents a “tool box” for an analyst. It would be nice if you could
calculate all these ratios, but it is imperative that you understand what firm
characteristic each one is measuring, and even more important, that you know
whether a higher or lower ratio is better in each instance. Different analysts calculate
some ratios differently. It would be helpful if analysts were always careful to
distinguish between total liabilities, total interest-bearing debt, long-term debt, and
creditor and trade debt, but they do not. Some analysts routinely add deferred tax
liabilities to debt or exclude goodwill when calculating assets and equity; others do
not. Statistical reporting services almost always disclose how each of the ratios they
present was calculated. So do not get too tied up in the details of each ratio, but
understand what each one represents and what factors would likely lead to significant
changes in a particular ratio. The DuPont formulas have been with us a long time and
were in the curriculum when I took the exams back in the 1980s. Decomposing ROE
into its components is an important analytic technique and it should definitely be in
your tool box.
LOS 27.a: Describe tools and techniques used in financial analysis, including their
uses and limitations.
CFA
Study Session 7
Program Curriculum, Volume 3, page 330
Various tools and techniques are used to convert financial statement data into formats
that facilitate analysis. These include ratio analysis, common-size analysis, graphical
analysis, and regression analysis.
Ratio Analysis
Ratios are useful tools for expressing relationships among data that can be used for
internal comparisons and comparisons across firms. They are often most useful in
identifying questions that need to be answered, rather than answering questions
directly. Specifically, ratios can be used to do the following:
Project future earnings and cash flow.
Evaluate a firm’s flexibility (the ability to grow and meet obligations even when
unexpected circumstances arise).
Assess management’s performance.
Evaluate changes in the firm and industry over time.
Compare the firm with industry competitors.
Analysts must also be aware of the limitations of ratios, including the following:
Financial ratios are not useful when viewed in isolation. They are only
informative when compared to those of other firms or to the company’s
historical performance.
Comparisons with other companies are made more difficult by different
accounting treatments. This is particularly important when comparing U.S. firms
to non-U.S. firms.
It is difficult to find comparable industry ratios when analyzing companies that
operate in multiple industries.
Conclusions cannot be made by calculating a single ratio. All ratios must be
viewed relative to one another.
Determining the target or comparison value for a ratio is difficult, requiring
some range of acceptable values.
It is important to understand that the definitions of ratios can vary widely among the
analytical community. For example, some analysts use all liabilities when measuring
leverage, while other analysts only use interest-bearing obligations. Consistency is
paramount. Analysts must also understand that reasonable values of ratios can differ
among industries.
Common-Size Analysis
Common-size statements normalize balance sheets and income statements and allow
the analyst to more easily compare performance across firms and for a single firm over
time.
A vertical common-size balance sheet expresses all balance sheet accounts as a
percentage of total assets.
A vertical common-size income statement expresses all income statement items
as a percentage of sales.
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