101 Concepts for the Level I Exam
Essential Concept 33: Integration of Financial Statement Analysis Techniques
- DuPont analysis decomposes ROE into its components:
- ROE = Return on assets × Leverage
- ROE = Net profit margin × Asset turnover × Leverage
- ROE = EBIT margin × Tax burden × Interest burden × Asset turnover × Leverage
- Evaluating the different components of ROE allows the analyst to identify a company’s potential strengths and weakness.
- DuPont analysis should be performed with and without the impact of ‘income from associates’. This is because the operations and resources of associate companies are not in the parent company’s control.
Asset base composition
Common size balance sheets are used to examine the change in asset base composition over time.
Capital structure analysis
- An analyst can use leverage ratios and liquidity ratios to evaluate changes in the capital structure of a company.
- However, simply looking at high-level leverage numbers is not enough. An analyst should dive deeper to evaluate whether the capital structure is becoming riskier.
Segment analysis and capital allocation
- For large companies with multiple business segments it is important to perform a segment analysis and understand how the company allocates funds to different segments.
- The segment EBIT margin should be compared with the ratio of total capital expenditure % to total assets.
- Ideally, segments with high margins should receive a relatively high capital allocation.
- However, high EBIT margins does not necessarily mean that a segment is doing well from a cash-flow perspective. Beyond EBIT margin we should also estimate the cash return on assets across different segments.
Accruals and earnings quality
- Earnings can be separated into cash flow and accruals. The accrual ratio can be estimated using a balance sheet approach or a cash flow approach.
Balance sheet accruals ratio for time t = (NOAt – NOAt -1) / [(NOAt + NOAt-1)/2]
Cash flow accruals ratio for time t = [NIt – (CFOt + CFIt)] / [(NOAt + NOAt-1)/2]
- In both cases if the accrual ratio is close to zero, this means that accruals play little or no role in the financial performance of a company and the earnings are of high quality.
Cash flow relationships
- Cash flow from operations should be compared with operating profit to determine if the earnings are of high quality.
- Other cash flow ratios such as the cash flow interest coverage ratio can also be used in the analysis.
Decomposition and analysis of the company’s valuation
When a company has significant investments in associates, the price-to-earnings multiple of the “pure company” should be calculated by removing the impact of associates and using adjusted market value and net income.