Title LM11 Financial Analysis Techniques IFT Notes.pdf ✅

LM11 Financial Analysis Techniques 2025 Level I Notes © IFT. All rights reserved 1 LM11 Financial Analysis Techniques 1. Introduction ........................................................................................................................................................... 2 2. The Financial Analysis Process ...................................................................................................................... 2 3. Analytical Tools and Techniques ................................................................................................................... 3 4. Financial Ratio Analysis .................................................................................................................................... 3 5. Common Size Balance Sheets and Income Statements ......................................................................... 4 6. Cross-Sectional, Trend Analysis, and Relationships in Financial Statements .............................. 6 7. The Use of Graphs and Regression Analysis ............................................................................................. 7 8. Common Ratio Categories, Interpretation, and Context ...................................................................... 7 9. Activity Ratios ....................................................................................................................................................... 8 10. Liquidity Ratios ...............................................................................................................................................10 11. Solvency Ratios ...............................................................................................................................................11 12. Profitability Ratios .........................................................................................................................................13 13. Integrated Financial Ratio Analysis ........................................................................................................14 14. Dupont Analysis—The Decomposition of ROE ..................................................................................14 15. Industry-Specific Financial Ratios ...........................................................................................................15 16. Model Building and Forecasting ...............................................................................................................15 Summary ...................................................................................................................................................................17 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM11 Financial Analysis Techniques 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction Financial analysis is a useful tool in evaluating a company’s performance and trends. The primary source of data is the company’s annual reports, financial statements, and MD&A. An analyst must be capable of using a company’s financial statements along with other information such as economy/industry trends to make projections and reach valid conclusions. 2. The Financial Analysis Process Before beginning any financial analysis, an analyst must clarify the purpose and context of why it is needed. Once the purpose is defined, an analyst can choose the right techniques for the analysis. For example, the level of detail required for a substantial long-term investment in equities will be higher than one needed for a short-term investment in fixed income securities. The Objectives of the Financial Analysis Process This learning module focuses on steps 3 and 4 of the financial analysis framework in detail: how to adjust financial statements, compute ratios, and produce graphs and forecasts. The processed data is then analyzed to arrive at a conclusion. Financial Analysis Framework Phase Output of the phase 1. Define purpose and context based on the analyst’s function, client input, and organizational guidelines. Objective Questions to be answered Nature and content of report to be provided Timetable and budget 2. Collect data: financial statements, other financial data, industry/economic data, discussions with management, suppliers, customers, and competitors. Organized financial statements Financial tables Completed questionnaires 3. Process data Adjusted financial statements Common-size statements Ratios and graphs Forecasts 4. Analyze and interpret processed data Analytical results 5. Develop and communicate conclusions and recommendations Report answering questions from phase 1 Recommendation regarding the purpose of the analysis 6. Follow-up Updated recommendations
LM11 Financial Analysis Techniques 2025 Level I Notes © IFT. All rights reserved 3 Distinguishing between Computations and Analysis An effective analysis is not just a compilation of various pieces of information, tables, and graphs. It includes both calculations and interpretations. For analyzing past performance, an analyst computes several ratios, compares them against benchmarks, evaluates how the company performed, and determines the reasons behind its good/bad performance. Similarly, for a forward-looking analysis, an analyst must forecast and make recommendations after analyzing trends, management quality, etc. Analysts often present the findings of their analysis through a written research report. For example, a report might present the following:  The purpose of the report  Relevant aspects of the business context, including economic environment, financial and other infrastructure, legal and regulatory environment  Evaluation of corporate governance and assessment of management strategy  Assessment of financial and operational data, including key assumptions in the analysis  Conclusions and recommendations, including limitations of the analysis and risks. 3. Analytical Tools and Techniques Various tools and techniques such as ratios, common size analysis, graphs, and regression analysis help in evaluating a company’s performance. Evaluations require comparisons, but to make a meaningful comparison of a company’s performance, the data needs to be adjusted first. An analyst can then compare a company’s performance to other companies at any point in time (cross-section analysis) or its own performance over time (time-series analysis). 4. Financial Ratio Analysis A ratio is an indicator of some aspect of a company’s performance like profitability or inventory management that tells us what happened, but not why it happened. Ratios help in analyzing the current financial health of a company, evaluate its past performance, and provide insights for future projections. Calculating ratios is straightforward, but interpreting them is subjective. Uses of ratio analysis Ratios allow us to evaluate:  operational efficiency.  financial flexibility.  Management’s ability.  changes in company/industry over time.
LM11 Financial Analysis Techniques 2025 Level I Notes © IFT. All rights reserved 4  company performance relative to industry. Limitations of ratio analysis Ratio analysis also has certain limitations. Some of the factors to consider include:  The heterogeneity or homogeneity of a company’s operating activities: Companies may have divisions that operate in a variety of industries. This can make it difficult to find comparable industry ratios.  Need to use judgment: An analyst must exercise judgment when interpreting ratios. All ratios must be viewed relative to one another. For example, a current ratio of 1.1 may not necessarily be good/bad unless viewed in perspective of other companies/industry.  Use of alternate accounting methods: Using alternate methods may require adjustments before the ratios are comparable. For example, Company A might use the LIFO method to measure inventory, while a comparable company might use the FIFO method. Similarly, one company may use the straight-line method of depreciation, while another may use an accelerated method.  Nature of a company’s business: Companies may have divisions operating in many different industries. This can make it difficult to find comparable ratios.  Consistency of results of ratio analysis: One set of ratios may indicate a problem, while the other may indicate the problem is short-term making the results inconsistent. Sources of Ratios Ratios can be computed using data obtained directly from companies’ financial statements or from a database such as Bloomberg, Thomson Reuters etc. Analysts should be aware that the underlying formulas used to calculate ratios may differ by vendor. Analysts should determine whether any adjustments are necessary. Similarly, data base providers may use judgement to classify items. For example, judgment may be used to classify income statement items as ‘operating’ or ‘non-operating’. Variation in such judgements would affect any computations involving operating income. A good practice is the use the same source of data when comparing different companies. 5. Common Size Balance Sheets and Income Statements Common-size financial statements are used to compare the performance of different companies within an industry or a company’s performance over time. Common size statements are prepared by expressing every item in a financial statement as a percentage of a base item. Common-Size Analysis of the Balance Sheet There are two types of common-size balance sheets: vertical and horizontal.