Financial Analysis Techniques for CFA Level I

What this chapter covers

Financial Analysis Techniques: topics in the order to study them

1. 1Financial Analysis Process and ToolsIt sets out the steps of an analysis and the tools you will use, so the later topics have a frame.
2. 2Common-Size and Trend AnalysisThese are the simplest tools and need only division, so they build comfort with the statements before ratios.
3. 3Activity and Liquidity RatiosTurnover, days and liquidity measures use the statements directly and are easy to calculate, so they are a good first ratio family.
4. 4Solvency and Coverage RatiosLeverage and coverage build on balance sheet and income statement items you now know, and prepare you for DuPont.
5. 5Profitability Ratios and DuPont AnalysisDuPont combines margins, turnover and leverage, so you need the earlier ratio families first.
6. 6Valuation Ratios, Per-Share Data and Segment AnalysisValuation and per-share measures use profitability inputs, and segment data adds detail to the picture.
7. 7Credit Analysis and Limitations of Ratio AnalysisIt pulls everything together and teaches you where ratios mislead, which is best learned last.

How to prepare Financial Analysis Techniques

1. Follow the study order above. Do not skip to DuPont before the ratio families.
2. Make a one-page formula sheet as you go. Write each ratio with its numerator and denominator, and note whether it uses average or year-end balances.
3. Practise each ratio on a small set of statements. Calculate, then say in words what the result tells you.
4. Learn the links between ratios. For example, the cash conversion cycle uses days of inventory, receivables and payables, and DuPont links ROE to margin, turnover and leverage.
5. Practise your TI BA II Plus or HP 12C for division, percentages and chained calculations so arithmetic is fast and you avoid slips.
6. Do timed sets of standalone three-option questions at about 90 seconds each. For each miss, note whether the error was a formula, an input or interpretation.
7. In the last week, redo only the questions you missed and reread your formula sheet.

Common mistakes in Financial Analysis Techniques

• Mixing average and year-end balances

  Fix: Use the definition in the question. If none is given and data allows, use the average balance for flow-over-stock ratios, and note this on your formula sheet.

• Using the wrong numerator for turnover and days ratios

  Fix: Match the flow to the balance. Inventory goes with COGS, receivables with revenue, payables with purchases or COGS as the question specifies.

• Treating a ratio change as good or bad without a reason

  Fix: Ask what drove the change and compare against peers and history. Choose the answer that explains the cause.

• Forgetting DuPont components when ROE moves

  Fix: Split ROE into its parts. A rise in ROE from higher leverage is a different story from a rise driven by margin.

• Comparing companies without checking accounting differences

  Fix: Before you compare, look for different accounting choices, one-off items, and different industries or segments.

• Calculator slips on multi-step questions

  Fix: Keep full precision in the calculator, round only at the end, and check that your answer is a sensible size before choosing an option.

Last-day revision: Financial Analysis Techniques

• ✓Common-size statements divide income statement items by revenue and balance sheet items by total assets.
• ✓Trend analysis compares the same item across periods, often indexed to a base year.
• ✓Inventory turnover = cost of goods sold ÷ average inventory; days of inventory = 365 ÷ turnover.
• ✓Cash conversion cycle = days of inventory + days of sales outstanding − days of payables.
• ✓Current ratio = current assets ÷ current liabilities; quick ratio excludes inventory and other less liquid current assets.
• ✓Debt-to-equity and similar leverage ratios measure financial risk; interest coverage = EBIT ÷ interest expense.
• ✓Net profit margin = net income ÷ revenue; ROE = net income ÷ average equity.
• ✓Three-step DuPont: ROE = net profit margin × asset turnover × financial leverage.
• ✓Financial leverage = average total assets ÷ average equity.
• ✓P/E = price per share ÷ earnings per share; compare it only against similar companies or the company's own history.
• ✓Segment data shows which businesses drive profit, but segments may be defined differently from company to company.
• ✓Ratios depend on accounting choices, so check for different policies, one-off items and window dressing before comparing.

Financial Analysis Techniques practice questions

• A company reports total debt of 800, cash of 200, and EBITDA of 300. A covenant requires net debt to EBITDA of no more than 2.5. Cash of 120…
• A credit analyst is assessing a manufacturer. Which of the following ratios is most likely to be used to evaluate the company's ability to m…
• A company has days of inventory on hand of 60, days of sales outstanding of 45, and days payables outstanding of 30. Its cash conversion cyc…
• Company P has a five-step DuPont profile: tax burden 0.75, interest burden 0.80, EBIT margin 10%, total asset turnover 1.50 and equity multi…
• An analyst prepares a vertical common-size income statement for a company. Each line item is most likely expressed as a percentage of:
• A company reports net income of 300, interest expense of 100, and an effective tax rate of 25%. Depreciation is 150. The fixed charge covera…
• An analyst compares two retailers and finds that Retailer X has a higher price-to-earnings (P/E) ratio than Retailer Y. Holding everything e…
• An analyst compares two retailers. Retailer X has a gross profit margin of 35% and Retailer Y has a gross profit margin of 28%. Both report …

Financial Analysis Techniques in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• CMA IntermediateFinancial Ratio Analysis
• CS ExecutiveFinancial Statement Analysis
• NISM CertificationsCompany Analysis - Financial Analysis
• CA FinalAnalysis of Financial Statements