🏦Financial Services Reporting Unit 13 – Financial Analysis for Financial Services
Financial analysis in financial services involves evaluating financial data to assess company performance and make informed decisions. Key concepts include liquidity, solvency, profitability, and efficiency ratios, as well as financial statement analysis and cash flow analysis.
Industry-specific metrics and risk assessment are crucial in financial services. Regulatory reporting requirements, such as Basel Accords and Dodd-Frank Act, play a significant role. Practical applications include investment decisions, M&A, lending decisions, and corporate finance.
Financial analysis evaluates financial data to assess a company's performance and make informed decisions
Financial statements include the balance sheet, income statement, and cash flow statement
Liquidity refers to a company's ability to meet short-term obligations and is measured by current ratio and quick ratio
Solvency assesses a company's ability to meet long-term debts and is evaluated using debt-to-equity ratio and interest coverage ratio
Profitability measures a company's ability to generate profits and is assessed using ratios like return on assets (ROA) and return on equity (ROE)
Efficiency ratios, such as asset turnover and inventory turnover, measure how effectively a company uses its resources
Valuation ratios, including price-to-earnings (P/E) and price-to-book (P/B), help determine if a company's stock is overvalued or undervalued
Trend analysis compares financial data over time to identify patterns and changes in performance
Financial Statement Analysis Basics
The balance sheet provides a snapshot of a company's financial position at a specific point in time
Assets are resources owned by the company (cash, inventory, property)
Liabilities represent the company's obligations (accounts payable, loans)
Equity is the residual interest in the assets after deducting liabilities
The income statement presents a company's revenues, expenses, and profits over a specific period
Revenue is the total amount earned from the sale of goods or services
Expenses are the costs incurred to generate revenue (salaries, rent, materials)
Net income is the bottom line, representing the company's profits after deducting expenses and taxes
The cash flow statement tracks the inflows and outflows of cash during a specific period
It is divided into three sections: operating activities, investing activities, and financing activities
The statement of changes in equity shows the changes in a company's equity over a specific period
Vertical analysis compares each line item to a base figure within the same financial statement (total assets, total revenue)
Horizontal analysis compares financial data across different periods to identify trends and growth rates
Ratio Analysis Techniques
Liquidity ratios assess a company's ability to meet short-term obligations
Current ratio = Current Assets / Current Liabilities
Quick ratio = (Current Assets - Inventory) / Current Liabilities
Solvency ratios evaluate a company's ability to meet long-term debts
Debt-to-equity ratio = Total Liabilities / Total Equity
Interest coverage ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
Profitability ratios measure a company's ability to generate profits
Return on assets (ROA) = Net Income / Total Assets
Return on equity (ROE) = Net Income / Total Equity
Profit margin = Net Income / Revenue
Efficiency ratios assess how effectively a company uses its resources
Asset turnover = Revenue / Total Assets
Inventory turnover = Cost of Goods Sold / Average Inventory
Valuation ratios help determine if a company's stock is overvalued or undervalued
Price-to-earnings (P/E) ratio = Market Price per Share / Earnings per Share (EPS)
Price-to-book (P/B) ratio = Market Price per Share / Book Value per Share
Cash Flow Analysis
Cash flow analysis assesses a company's ability to generate cash and meet its obligations
Operating cash flow represents cash generated from a company's core business activities
It is calculated by adjusting net income for non-cash items (depreciation, amortization) and changes in working capital
Free cash flow (FCF) is the cash available for distribution to investors after capital expenditures
FCF = Operating Cash Flow - Capital Expenditures
The cash conversion cycle (CCC) measures the time it takes for a company to convert investments in inventory to cash from sales
CCC = Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding
Cash flow ratios, such as the operating cash flow ratio and the cash flow coverage ratio, provide insights into a company's liquidity and solvency
Discounted cash flow (DCF) analysis estimates the intrinsic value of a company by projecting future cash flows and discounting them to the present value
Industry-Specific Metrics
Financial services companies have unique metrics to assess their performance and risk
Net interest margin (NIM) measures the difference between interest income and interest expense relative to interest-earning assets for banks
The efficiency ratio compares a bank's non-interest expenses to its revenue, indicating operational efficiency
The loan-to-deposit (LTD) ratio assesses a bank's liquidity by comparing total loans to total deposits
The non-performing loan (NPL) ratio measures the proportion of loans that are in default or close to default
Insurance companies use metrics like the combined ratio, which compares total expenses (claims and operating expenses) to premiums earned
The solvency ratio for insurance companies measures the ability to meet long-term obligations by comparing net assets to required capital
Asset management firms use metrics such as assets under management (AUM) and the net expense ratio to evaluate performance and costs
Risk Assessment in Financial Services
Credit risk is the risk of loss due to a borrower's failure to repay a loan or meet contractual obligations
It is assessed using credit ratings, credit scores, and the five C's of credit (character, capacity, capital, collateral, conditions)
Market risk is the risk of losses due to changes in market prices (interest rates, foreign exchange rates, commodity prices, equity prices)
Value at Risk (VaR) is a common measure of market risk, estimating the potential loss over a specific time horizon
Liquidity risk is the risk that a company will be unable to meet its short-term obligations due to insufficient liquid assets
Liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) are used to assess liquidity risk in banks
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events
It includes risks such as fraud, cybersecurity breaches, and compliance failures
Reputational risk is the risk of damage to a company's reputation, which can lead to loss of customers, revenue, and market value
Stress testing is a risk management tool that evaluates a company's financial resilience under adverse economic scenarios
Regulatory Reporting Requirements
Financial services companies are subject to extensive regulatory reporting requirements
Banks must comply with the Basel Accords, which set standards for capital adequacy, stress testing, and liquidity risk management
Pillar 3 disclosures provide transparency on a bank's risk management practices and capital adequacy
The Sarbanes-Oxley Act (SOX) requires public companies to maintain effective internal controls over financial reporting and disclose any material weaknesses
The Dodd-Frank Wall Street Reform and Consumer Protection Act introduced stricter regulations for the financial services industry, including stress testing and the Volcker Rule
The International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) set standards for financial reporting and disclosure
Regulatory reports, such as the Call Report for banks and the Annual Statement for insurance companies, provide detailed financial and risk information to supervisory authorities
The Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) set global standards for financial regulation and supervision
Practical Applications and Case Studies
Financial analysis is crucial for investment decisions, such as stock selection and portfolio management
Analysts use ratio analysis, cash flow analysis, and valuation techniques to identify undervalued or overvalued securities
Mergers and acquisitions (M&A) rely heavily on financial analysis to assess the potential synergies and risks of a transaction
Due diligence involves a thorough examination of the target company's financial statements, ratios, and industry-specific metrics
Lending decisions by banks and other financial institutions are based on a comprehensive analysis of the borrower's financial health and repayment capacity
Credit analysis includes the evaluation of financial statements, cash flow projections, and collateral
Financial analysis is essential for corporate finance decisions, such as capital budgeting and capital structure optimization
Discounted cash flow (DCF) analysis is used to evaluate the feasibility and profitability of investment projects
Case Study: Analyzing the financial statements of JPMorgan Chase & Co. (JPM) to assess its performance and risk profile
Key ratios: Return on equity (ROE), net interest margin (NIM), efficiency ratio, and non-performing loan (NPL) ratio
Case Study: Comparing the financial performance and valuation of two insurance companies, such as MetLife, Inc. (MET) and Prudential Financial, Inc. (PRU)
Key metrics: Combined ratio, solvency ratio, return on assets (ROA), and price-to-book (P/B) ratio