Chapter 11: CFA Level 1 Financial Statement Analysis
Comprehensive ratio analysis and financial modeling techniques
Financial analysis is the process of interpreting a company's financial data to assess its performance, valuation, and risk. It forms the foundation of informed investment and credit decisions.
Purpose: Financial analysis helps investors, creditors, and other stakeholders make informed decisions by providing insights into a company's financial health, operational efficiency, and future prospects.
A thorough financial analysis follows a structured, multi-phase framework to ensure a comprehensive and objective outcome.
Define the goal of the analysis. Are you evaluating an equity investment, a credit extension, or something else? Establish objectives and communication lines.
Gather necessary information, including financial statements, industry data, economic forecasts, and discussions with company management.
Adjust raw financial data for accounting differences, create common-size statements, calculate financial ratios, and prepare graphs.
Analyze processed data to identify trends, strengths, and weaknesses. Use data to build forecasts and valuation models.
Formulate conclusions and recommendations based on the analysis and communicate them in an analytical report.
Periodically review the analysis by comparing actual results to forecasts, revising models and recommendations as needed.
Analysts use several core tools to dissect financial statements. These tools are designed to be "size-neutral" to allow for effective comparison between companies of different scales.
The calculation and interpretation of ratios that relate different financial statement items to each other. This is the cornerstone of financial analysis.
Expresses each line item as a percentage of a common base item. For income statements, the base is total revenue; for balance sheets, it's total assets.
Compares financial statement items across different time periods to identify patterns and growth trends.
When comparing companies, especially internationally, analysts must make adjustments for differences in:
Financial ratios are typically grouped into categories that measure different aspects of a company's performance and financial health.
Benefits:
Limitations:
These ratios measure how efficiently a company is managing its assets and operations.
| Ratio | Formula | What It Measures |
|---|---|---|
| Inventory Turnover |
COGS ÷ Average Inventory
|
How many times a company sells and replaces its inventory over a period. |
| Days of Inventory on Hand (DOH) |
365 ÷ Inventory Turnover
|
The average number of days inventory is held before being sold. |
| Receivables Turnover |
Revenue ÷ Average Accounts Receivable
|
How many times a company collects its average accounts receivable over a period. |
| Days of Sales Outstanding (DOS) |
365 ÷ Receivables Turnover
|
The average number of days it takes to collect payment after a sale. |
| Payables Turnover |
Purchases ÷ Average Trade Payables
|
How many times a company pays off its suppliers during a period. |
| Days of Payables |
365 ÷ Payables Turnover
|
The average number of days it takes for the company to pay its suppliers. |
| Working Capital Turnover |
Revenue ÷ Average Working Capital
|
How effectively working capital is used to generate revenue. |
| Fixed Asset Turnover |
Revenue ÷ Average Net Fixed Assets
|
How efficiently the company uses its fixed assets to generate sales. |
| Total Asset Turnover |
Revenue ÷ Average Total Assets
|
The overall efficiency in using all available assets to generate sales. |
These ratios measure a company's ability to meet its short-term obligations.
| Ratio | Formula | What It Measures |
|---|---|---|
| Current Ratio |
Current Assets ÷ Current Liabilities
|
The ability to cover short-term liabilities with short-term assets. |
| Quick Ratio (Acid-Test) |
(Cash + Mkt. Securities + Receivables) ÷ Current Liabilities
|
A more conservative liquidity measure that excludes less-liquid inventory. |
| Cash Ratio |
(Cash + Marketable Securities) ÷ Current Liabilities
|
The ability to cover current liabilities with only cash and cash equivalents. |
| Defensive Interval Ratio |
(Cash + Mkt. Securities + Receivables) ÷ Average Daily Expenditures
|
The number of days the company can operate without needing additional financing. |
| Cash Conversion Cycle |
DOH + DOS - Days of Payables
|
The length of time it takes to convert investments in inventory into cash from sales. A shorter cycle is better. |
These ratios assess a company's ability to meet its long-term debt obligations.
| Ratio | Formula | What It Measures |
|---|---|---|
| Debt-to-Assets Ratio |
Total Debt ÷ Total Assets
|
The proportion of assets financed through debt. |
| Debt-to-Capital Ratio |
Total Debt ÷ (Total Debt + Total Equity)
|
The proportion of a company's capital structure that is debt. |
| Debt-to-Equity Ratio |
Total Debt ÷ Total Equity
|
The amount of debt relative to shareholders' equity. |
| Financial Leverage Ratio |
Average Total Assets ÷ Average Total Equity
|
How much of the asset base is supported by equity. A higher ratio means more leverage and risk. |
| Interest Coverage Ratio |
EBIT ÷ Interest Payments
|
The ability to cover interest payments from earnings before interest and taxes. |
| Fixed-Charge Coverage Ratio |
(EBIT + Lease Payments) ÷ (Interest Payments + Lease Payments)
|
A broader coverage measure that includes lease payments, an often significant fixed obligation. |
These ratios measure a company's ability to generate profits from its sales and assets.
| Ratio | Formula | What It Measures |
|---|---|---|
| Gross Profit Margin |
Gross Profit ÷ Revenue
|
Profitability after accounting for the cost of goods sold. |
| Operating Profit Margin |
Operating Income ÷ Revenue
|
Profitability from core business operations before interest and taxes. |
| Net Profit Margin |
Net Income ÷ Revenue
|
The overall profitability, representing the percentage of revenue that becomes profit. |
| Return on Assets (ROA) |
Net Income ÷ Average Total Assets
|
How efficiently assets are used to generate net income. |
| Return on Equity (ROE) |
Net Income ÷ Average Total Equity
|
The return generated for the company's shareholders. This is a key measure of profitability. |
| Return on Common Equity |
(Net Income - Preferred Dividends) ÷ Average Common Equity
|
The return specifically available to common shareholders. |
DuPont analysis breaks down Return on Equity (ROE) into its key components, providing deeper insight into what drives a company's profitability.
Ratio analysis is a critical input for building pro-forma financial statements and forecasting future performance. Analysts use several techniques to handle uncertainty.
A "what-if" analysis that shows how changing one variable (e.g., sales growth) impacts a forecast. Helps identify key value drivers.
Explores different outcomes ("worst-case," "base-case," "best-case") by changing multiple variables at once to model different business environments.
A computer-based technique that runs thousands of scenarios based on probability distributions for key variables to model a range of possible outcomes.
Best Practice: Combine multiple forecasting techniques and always validate models against historical performance and industry benchmarks. Remember that financial analysis is as much art as science, requiring judgment and experience to interpret results correctly.
Financial analysis techniques are high-yield exam material. Master these areas:
DuPont Component Confusion: The 3-part model uses Net Profit Margin, Asset Turnover, and Financial Leverage. The 5-part model decomposes NPM further into Tax Burden, Interest Burden, and EBIT Margin while keeping Asset Turnover and Leverage. Don't mix up the components.
Turnover vs. Days Ratios: Turnover ratios (higher = better) measure how many times an asset cycles per period. Days ratios (lower = better, except DPO) measure the length of time assets are held. Days Payables is an exception—higher DPO can be good because it means the company delays payments and conserves cash longer.
Cash Conversion Cycle Formula: The formula is CCC = DOH + DSO Days Payables. Many candidates mistakenly add all three components. Remember to SUBTRACT payables because delaying supplier payments improves cash flow.
Average vs. Ending Balances: ROE, ROA, and all turnover ratios must use AVERAGE balance sheet values, calculated as (Beginning + Ending) / 2. Using only ending balances will produce incorrect results.
ROE and Financial Leverage: From DuPont, ROE = ROA ×Financial Leverage. If two companies have the same ROA but different ROEs, the difference is due to leverage. Higher leverage amplifies ROE but also increases financial risk.
Inventory vs. Receivables Turnover Bases: Inventory Turnover uses COGS in the numerator, while Receivables Turnover uses Revenue. Don't confuse the two—they measure different aspects of efficiency.