IFT Notes for Level I CFA^® Program

LM06 Financial Analysis Techniques

Part 3

9. Liquidity Ratios

Liquidity ratios measure a company’s ability to meet short term obligations. It also indicates how quickly it turns assets into cash.

Liquidity Ratios
Current ratio	$\frac{Current Assets}{Current Liabilities}$	Higher number implies greater liquidity.
Quick ratio	$\frac{Cash + Marketable Securities + Receivables}{Current Liabilites}$	Higher number implies greater liquidity. More conservative than current ratio as only more liquid current assets are included.
Cash ratio	$\frac{Cash + Marketable Securities} {Current Liabilities}$	This is the most conservative liquidity ratio, and a good measure of a company’s ability to handle a crisis situation.
Defensive interval ratio	$\frac{Cash + Marketable Securities + Receivables} {Daily Cash Expenditure}$	Measures the number of days a company can operate before it runs out of cash. Higher number implies greater liquidity.
Cash conversion cycle (net operating cycle)	Days of inventory on hand (DOH) + Days of sales outstanding (DSO) – Number of days of payables	The time between cash paid (to suppliers) and cash collected (from customers). A low number is better for the company as it means high liquidity. Long cash conversion cycle implies low liquidity

The example below for ABC Corp. illustrates the cash conversion cycle. The timeline for various events is illustrated below:

10. Solvency Ratios

Solvency ratios measure a company’s ability to meet long term obligations. In simple terms, it provides information on how much debt the company has taken and if it is profitable enough to pay the interest on debt in the long term. It has to be analyzed within an industry’s perspective. Certain industries such as real estate use a higher level of leverage.

Solvency Ratios	Formula	Interpretation
Debt ratios
Debt to assets ratio	$\frac{Total Debt}{Total Assets}$	Measures the amount of debt in total assets. Higher debt means low solvency and higher risk. A ratio of 0.5 implies 50% of assets are financed with debt.
Debt to capital ratio	$\frac{Total Debt}{Total Debt + Total Shareholder's Equity}$	Measures the amount of debt as a percentage of capital (debt + shareholder’s equity).
Debt to equity ratio	$\frac{Total Debt} {Total Shareholder's Equity}$	Measures the amount of debt as a percentage of equity.
Financial leverage ratio	$\frac{Average Total Assets}{Average Total Equity}$	Measures the amount of assets per unit of equity. Higher value means company is more leveraged.
Coverage ratios
Interest coverage ratio (also called ‘times interest earned’	$\frac{EBIT} {Interest Payments}$	Measures the company’s ability to make interest payments (how many times the company can make interest payments with its EBIT). Unlike the other solvency ratios, higher value for this ratio is better as it means stronger solvency.
Fixed charge coverage ratio	$\frac{EBIT + Lease Payments} {Interest Payments + Lease Payments}$	Measures the ability of a company to pay interest on debt. Here, lease payments are added to EBIT as they are an obligation like interest payments. Like interest coverage ratio, higher value for this ratio implies stronger solvency.

Note that there are two categories of solvency ratios: debt (or leverage) ratios and coverage ratios.

In general, a high debt (or leverage) ratio implies a high level of debt, high risk and low solvency. With coverage ratios, a high number is good because this indicates high income relative to interest payments.

11. Profitability Ratios

Profitability ratio	Formula	Interpretation
Return on Sales
Gross profit margin	$\frac{Gross Profit}{Revenue}$	Higher value means higher pricing and lower costs.
Operating profit margin	$\frac{Operating Income}{Revenue}$	Operating profit = gross profit – operating costs. Good sign if operating profit margin grows at a faster rate than gross profit margin.
Pretax margin	$\frac{EBT}{Revenue}$	EBT = operating profit – interest related expenses. Needs further analysis if pretax income increases only because of non-operating income.
Net profit margin	$\frac{Net Profit}{Revenue}$	Net profit = revenue – all expenses.
Return on Investment
Operating ROA	$\frac{Operating Income} {Average Total Assets}$	For return, either net income or operating income (EBIT) can be used.
Return on assets (ROA)	$\frac{Net Income}{Average Total Assets}$	For return, either net income or operating income (EBIT) can be used.
Return on total capital	$\frac{EBIT}{Debt + Equity}$	Like operating ROA, EBIT is used. Measures return on capital before deducting interest.
Return on equity (ROE)	$\frac{Net Income}{Equity}$	A very important measure of return earned on equity capital. Unlike return on common equity, it includes minority and preferred equity.
Return on common equity	$\frac{Net Income - Prferred Dividends}{ Average Common Equity}$	Money available to common shareholders.

12 & 13. Integrated Financial Ratio Analysis

DuPont Analysis: The Decomposition of ROE

DuPont analysis decomposes a firm’s ROE to better analyze a firm’s performance.

Start with ROE

$ROE=\ \left(\frac{net\ income}{equity}\right)$

Traditional DuPont equation is

$ROE=\ \left(\frac{net\ income}{sales}\right)\left(\frac{sales}{assets}\right)\left(\frac{assets}{equity}\right)$

$ROE=\ \left(net\ profit\ margin\right)\left(asset\ turnover\right)\left(leverage\ ratio\right)$

Extended DuPont equation is

$ROE=\ \left(\frac{net\ income}{EBT}\right)\left(\frac{EBT}{EBIT}\right)\left(\frac{EBIT}{revenue}\right)\left(\frac{revenue}{total\ assets}\right)\left(\frac{total\ assets}{total\ equity}\right)$

$ROE=\ \left(tax\ burden\right)\left(interest\ burden\right)\left(EBIT\ margin\right)\left(asset\ turnover\right)\left(financial\ leverage\right)$

Example

The following data is available for a company:

	2010	2011	2012
ROE	19%	20%	22%
ROA	8.1%	8%	7.9%
Total asset turnover	2	2	2.1

Based only on the information above, the most appropriate conclusion is that over the period 2010 to 2012, the company’s:

Net profit margin and financial leverage have decreased.
Net profit margin and financial leverage have increased.
Net profit margin has decreased but its financial leverage has increased.

Solution:

A quick glance at the data says profitability is going up and asset turnover has slightly increased from 2010 to 2012. ROA is going down from the second year.

First, break down ROE into: $\frac{Net\ income}{Assets}\times \ \frac{Assets}{Equity}$ = $\ ROA\times \ Leverage$

ROE is going up (first row). Since ROA is going down, leverage must increase for ROE to increase. So A is incorrect.

Next, to determine if net profit margin increased or decreased, break down ROA into $\frac{Net\ income}{Sales}\times \ \left(\frac{Sales}{Assets}\right)$ . Since $\left(\frac{Sales}{Assets}\right)$ or asset turnover is increasing, net profit margin has to decrease for return on assets to decrease. So, the correct answer is C.