Reading 28 in the CFA curriculum combines the financial statements with key ratios and analysis
This is the fifth week of our Level I CFA Program review of the financial statement material. Reading 28 is your first look into the financial statement analysis and techniques that will make up a big portion of your CFA level 2 exam. In all, financial reporting and analysis accounts for 20% of your level 1 points and up to 20% of the second exam.
Check out the introduction to Level I CFA Program Financial Statements
Check out the Level I CFA Program Income Statement Review
Check out the Level I CFA Program Balance Sheet Review
Check out the Level I CFA Program Statement of Cash Flows Review
Some of the ratios and financial analysis techniques you’ll see in reading 28 have already been discussed in the separate readings on each financial statement. Besides specific techniques used in analysis, pay attention to assumptions used in different techniques and the limitations of each method.
Ratios and Common-Size Financial Statement Analysis
Ratios in financial statement analysis offer a way to standardize information and compare results across companies. It can be used to compare current results with past performance as well. Ratio analysis is limited across companies because each might operate in a slightly different product category or market. Differences in accounting practices can distort ratios and there’s no definite set of ratios that will tell you all you need about a company.
Activity ratios measure management efficiency in day-to-day operations. I’ve included some of the most common ratios used below. Activity ratios are also called asset utilization ratios. Notice that when you use Balance Sheet data in a ratio with another financial statement, you need to take the average of the beginning and ending number reported on the Balance Sheet.
Solvency ratios measure the firm’s ability to meet long-term obligations. Liquidity ratios measure the firm’s ability to meet short-term obligations. Pay attention to the Cash Conversion Cycle which reflects the number of days a company’s cash is tied up in the operating cycle. The conversion cycle equals the number of days inventory plus days receivable outstanding minus the number of days accounts payable outstanding.
Understand the difference between operating leverage and financial leverage. Operating leverage comes from using fixed costs in the company’s business and magnifies the effect of sales growth on operating income. Financial leverage comes from the use of debt and magnifies the effect of changes in EBIT on net income.
Profitability ratios measure overall performance and margins. Gross, operating and net margin are used often to show different ideas of profitability.
It may seem like a lot of ratios to memorize but they are fairly easy to remember after some repetition. Write the ratios and a brief explanation on some flash cards and review them each day until you’ve mastered the concept.
Common-size financial statement analysis is helpful in spotting trends within a company’s results as well as comparing accounting line items across firms. A horizontal common-size statement compares an accounting item like sales or operating expenses against itself from another year. It’s helpful in finding growth across time in each line item. A vertical common-size statement compares an accounting item against another line in the same year, usually against sales or total assets. It’s helpful in comparing the proportion of a line item in one company against another.
For common-size analysis on the balance sheet, you’ll use total assets as the common item. For analysis on the income statement, sales are used as the common item for comparison.
There’s quite a bit more in reading 28 including DuPont Analysis and some important ratios for equity analysis. All the ratios in the reading could easily show up on the CFA exam since they’re pretty easy to test in a quick question. The best way to approach the material is to understand the concept of the ratio. Instead of just rote memorization of the equation, understand what the components are and how they relate to each other. You’ll find it much easier to remember the mountain of ratios and equations for the exam.
‘til next time, happy studying
Joseph Hogue, CFA