MODULE 11: FINANCIAL ANALYSIS TECHNIQUES

Introduction to Financial Ratios

1. Financial analysis starts with a problem: raw statements are too messy to compare, so you first adjust them for your purpose → that makes the numbers usable → but adjusted numbers still do not explain themselves → so the next step is to pass them through tools like ratios, common-size statements, graphs, and regression analysis (a method that estimates how one variable moves with another).

2. Ratios come first because they compress two numbers into one relationship → that helps you project earnings and cash flow, judge flexibility, assess management, track change, and compare firms → but a ratio by itself is weak because different accounting methods, mixed-industry firms, and shifting business conditions distort the comparison → so a ratio only tells you where to look next, not what the final answer is.

3. Once ratios tell you where the tension is, common-size statements show you exactly where it sits inside the accounts → a vertical balance sheet turns every item into a share of total assets, and a vertical income statement turns every item into a share of sales → but this still has a limit because percentages reveal pattern, not cause → so you use common-size analysis to separate “this changed” from “why it changed,” which pushes you into deeper investigation.

4. If you want the pattern to become even easier to see, you move from percentages to pictures and statistical links → graphs highlight composition shifts over time, and regression analysis (a method that links variables for forecasting) helps estimate outputs like sales from inputs like Gross Domestic Product (GDP) → but neither a graph nor a regression proves the business reason behind the movement → so they work best as early warning systems that tell you which line items deserve real analysis.

5. Put it together with the PDF’s example: net profit margin rose about 5% in 20X6, but cost of goods sold improved only 0.48% and Selling, General, and Administrative expense (SG&A) improved only about 0.5% → that pushes you to the next layer, where common-size analysis shows most of the jump came from lower amortization and lower interest and other debt expense → but lower amortization is non-cash and lower interest may not last → so the correct conclusion is not “profitability is permanently better,” but “you now know exactly which items must be tested before trusting future cash flow.”

Turnover and Liquidity Ratios

1. Turnover means how quickly something is replaced or replenished, inventory turnover ratio (ITR) would be COGS / Avg. Inventory, AR turnover (ART) would be Sales / Avg. AR, AP turnover would be COGS / Avg. AP. So think intuitively, for one unit of inventory, I have ITR units of COGS, so my inventory gets replenished ITR times.

1. Divide any turnover ratio by 365 and you get Days of that thing. For example, Days of Inventory (DIO) = 365 / ITR, Days of AP (DPO) = 365 / APR, Days Sales Outstanding (DSO) = 365 / ART
2. JIT maufacturing makes ITR go very high often unusable especially for software companies.
3. Current Ratio = Current Assets / Current Liabilities. In liquidity ratios, the denominator will usually be CL.

HOW TO GAME CURRENT RATIO?

• Have aggressive sales on credit (AR goes up, CA goes up)
• Do not pay creditors (AP goes down, CL goes down)
• Sell a fixed asset. (Cash goes up, CA goes up)
• Take a long term loan (Cash goes up, CA goes up; Long term debt goes up, CL does not change)

• Issue shares (Cash goes up, CA goes up; Equity goes up, CL does not change)

• Cash Ratio = (Cash + Marketable Securities) / Current Liabilities. Marketable Securities are anything that you can quickly sell and generate cash.

• Quick Ratio = (Cash + Marketable Securities + AR) / Current Liabilities.
• Cash Conversion Cycle (CCC) = DSO + DIO - DPO. Assets are plus (Inventory and AR), Liability (AP) is minus. It measures how quickly inventory turns into cash. You can crank this up by aggressively demanding payments, not paying your suppliers. If it is negative then you require short term financing to cover the period. If it is positive, then you are sitting on cash that can be used in other parts of business. You can afford (CA < CL).
• The quick ratio reflects the fact that certain current assets—such as prepaid expenses, some taxes, and employee-related prepayments—represent costs of the current period that have been paid in advance and cannot usually be converted back into cash.

Solvency and Profitability Ratios

1. Debt to Equity ratio = Total Debt / Total Shareholder Equity. All interest bearing instruments except leases are part of total debt. If question is silent, treat Preference shares as Total Shareholder Equity.
2. Debt to Capital Ratio = Total Debt / (Total Debt + Total Shareholder Equity)
3. Debt to Asset Ratio = Total Debt / Total Assets
4. Debt to EBITDA Ratio = Total Debt / EBITDA
5. Financial Leverage = Avg Total Assets / Avg Total Equity. How much of shareholder equity has been used to finance the assets
6. Interest Coverage = EBIT / Interest Payments (Always EBIT, not EBITDA, not PBT, and not PAT). Suppose I earn (EBIT) 100 and I have to pay 10 as interest, I can cover interest 10 times.

1. Margins are basically common-size income statement items.
   CFA can ask this conceptually: return-on-sales ratios express income statement subtotals as a percentage of revenue. So gross margin, operating margin, pretax margin, and net margin are not random ratios; they are common-size income statement lines.  
2. Operating margin: be careful with EBIT.
   Some analysts use EBIT as a shortcut for operating income, but strictly EBIT may include non-operating items such as dividends received or gains/losses on investments. So consistency matters.  
3. Gross margin is competition-sensitive.
   Higher gross margin can mean pricing power, brand strength, quality, technology, or cost advantage. But competition limits pricing power, so gross margins are usually inversely related to competition.  
4. Pretax margin is where leverage enters profitability.
   Pretax margin reflects interest expense, so it captures the effect of financial leverage. A fall in pretax margin with stable operating margin may mean debt cost increased, not that operations worsened.  
5. Non-operating income can fake margin improvement.
   If pretax margin rises mainly because of non-operating income, ask whether the company deliberately changed its business focus and whether that income will continue.  
6. Net margin should often be adjusted.
   Net income includes recurring and non-recurring components. For future profitability, CFA expects adjusted net income, not blindly reported net income.
7. 1. ROE includes all equity unless specified.
      CFA says ROE measures return on equity capital including minority equity, preferred equity, and common equity. If they ask return on common equity, then subtract preferred dividends and divide by average common equity.

DUPONT ANALYSIS

1. Dupont Analysis breaks ROE into its drivers.

NET INCOME MARGIN = EAT / REVENUE Tax Burden = EBT / EAT Interest Burden = EBT / EBIT EBIT Margin = EBIT / Sales

INDUSTRY SPECIFIC RATIOS

1. Net income per employee and sales per employee are used in the analysis and valuation of service and consulting companies and software companies which usually have intangible assets such as employee skills. Steam has a $3.5 million to over $10 million in profit per employee.
2. For Walmart, average revenue per square foot is the metric.
3. For Spotify, average revenue per user is the metric.

DuPont Analysis

1. ROE alone tells you how much return equity holders earned → but it does not tell you why → DuPont splits ROE into component ratios so that each slice maps to a distinct driver (efficiency, profitability, taxes, interest, leverage) → but the decomposition is an algebraic identity, not causation → so DuPont tells you where the change came from, not whether it will persist.

2. Start from the definition and multiply by a clever "1":

1. Push one layer further by splitting ROA into margin × turnover:

1. Split net profit margin once more to separate the effect of taxes, interest, and operating profitability:

1. Leverage is a two-edged sword → increasing leverage multiplies ROE when ROA is positive and the firm borrows below its marginal return on invested funds → but if borrowing cost exceeds the return earned on the borrowed money, extra leverage depresses ROA and ROE falls as leverage rises → so leverage is not "free return," it is a magnifier of whatever ROA already exists.

Reliance Jio took on massive debt at launch, but its network assets earn more than its cost of debt, so leverage multiplied the equity return. Vodafone Idea carries over INR 2 lakh crore of net debt on a loss-making operation, so each extra rupee of leverage just magnifies the loss per rupee of equity. Same "company took on debt" headline, opposite effect — DuPont is where the difference shows up.

1. Tax burden and interest burden both sit between 0 and 1 → a fall in tax burden means the firm paid a higher average tax rate (kept less pretax profit) → a fall in interest burden means interest expense ate a bigger share of operating profit → both show up as a drop in net profit margin in the three-way form, but the five-way form tells you which of the two caused it.

Infosys historically earned tax-exempt profits inside Special Economic Zones — when those holidays expire, its tax burden (net income divided by earnings before tax) drops even though the operating business is unchanged. Tata Steel carries heavy debt from blast-furnace spending and the Corus acquisition, so a rate rise or a rating slip pushes its interest burden (earnings before tax divided by earnings before interest and tax) down instead. Same "margin fell" headline, but only the five-way DuPont tells you whether it was the tax authority or the bond market.

1. Use DuPont to compare firms or to trace a single firm's trend → if two firms have the same ROE but very different decompositions (one via margin, one via leverage), their risk profiles are not the same → leverage-driven ROE is more fragile because it depends on continued access to debt at a favourable rate.

Walmart runs on a net profit margin of only 2–3% but spins its inventory hard enough to hit a total asset turnover around 2.5×, with little financial leverage — its return on equity comes from operating efficiency. HDFC Bank runs on a thin interest margin with structural leverage of roughly 7–10× because deposits sit against a small sliver of equity — its return on equity comes from leverage by regulatory design. Two similar-looking return-on-equity numbers, but Walmart's survives a credit cycle and the bank's does not.

Industry-Specific Financial Ratios

1. Ratios are tools, not definitions → the same label can mean different things across analysts, so the point is to pick ratios that indicate something important about this industry → that is why aspects irrelevant to one business (same-store sales for a bank) become central in another (same-store sales for a retailer).
2. Business risk is measured by coefficient of variation (CV) — standard deviation scaled by the mean → it tells you how volatile the line is relative to its typical level, which lets you compare firms of different sizes. Three common forms: $$ \text{CV of Net Income} = \frac{\sigma(\text{Net Income})}{\text{Avg. Net Income}} $$ $$ \text{CV of Revenues} = \frac{\sigma(\text{Revenue})}{\text{Avg. Revenue}} $$

1. Financial sector ratios exist because banks are regulated on liquidity and solvency, not just profitability:
2. Capital adequacy = Components of capital ÷ risk-weighted assets (or market/operational risk exposure) → ties solvency to risk exposure.
3. Monetary reserve requirement (cash reserve ratio) = Reserves held at the central bank ÷ specified deposit liabilities → indicates banking liquidity under monetary rules.
4. Liquid asset requirement = Approved “readily marketable” securities ÷ specified deposit liabilities.
5. Net interest margin (NIM) = Net interest income ÷ total interest-earning assets → the spread earned on the asset base that actually generates interest.

1. Retail ratios focus on where retail growth actually comes from:
2. Same (or comparable) store sales = average revenue growth year over year for stores open in both periods → isolates organic growth from new-store growth. No denom
3. inator in the classical sense; it is a growth metric, not a stock metric.
   • Remember this: If Starbucks says total revenue grew 12% but same-store sales grew only 2%, it means the existing stores barely grew. The extra growth came from opening new stores. That is why analysts watch same-store sales — it tells you whether the business itself is getting stronger, or whether the company is only buying growth by opening new outlets.

4. Sales per square meter (or square foot) = Revenue ÷ total retail space → a productivity-of-space metric.

   • Remember this: An Apple Store earns about USD 5,500 of sales per square foot every year. A Walmart earns about USD 400. Both are called "retailers," but one square foot of floor space is doing completely different work in each. The ratio shows you how much money the shop squeezes out of every bit of floor it pays rent on.

5. Service companies are measured on human-capital productivity because their assets are skill-based:

6. Revenue per employee = Revenue ÷ total number of employees.

7. Net income per employee = Net income ÷ total number of employees.

   • Remember this: Valve, the company that runs the Steam gaming store, has only about 350 employees but serves more than 100 million gamers. It reportedly earns between USD 3.5 million and over USD 10 million of profit per employee. A normal consulting firm earns around USD 300,000 of revenue per employee. For service and software companies, the people are the factory, so this number tells you how much output each person produces.

8. Hotels are measured on room utilisation and pricing:

9. Average daily rate (ADR) = Room revenue ÷ number of rooms sold → pricing power per occupied room.

10. Occupancy rate = Number of rooms sold ÷ number of rooms available → how intensively capacity is used.

    • Remember this: The Taj in Mumbai might charge USD 400 per night and fill 70% of its rooms. A budget hotel like OYO might charge USD 30 and fill 95%. Both are hotels, but one makes its money from high prices and the other from filling rooms. Because of this, hotel analysts multiply the two ratios together to get Revenue per Available Room (the standard industry number): average price per room sold × fraction of rooms sold. This single number lets you compare a luxury hotel and a budget hotel fairly.

11. Subscription / relationship-based businesses are measured on the customer base:

12. Average revenue per user (ARPU) = Revenue ÷ average number of subscribers or users → the monetisation intensity of each relationship.
    • Remember this: Spotify earns roughly USD 5 per user per month. Netflix earns about USD 12. Both stream content, but each Netflix customer is worth more than twice a Spotify customer. When Reliance Jio launched in India, it deliberately kept this number near zero to pull in hundreds of millions of users, then slowly raised prices. Average revenue per user is the number subscription businesses live and die by — it tells you whether each customer relationship is actually worth something.

1. The scope limit: Exhibit 36 is illustrative, not exhaustive → many industries have their own ratios outside this module (for example, Standard and Poor’s Industry Surveys and industry bodies publish more) → so the exam-relevant point is the principle: the ratio must reflect what actually drives value in that industry.