Finance: Financial Ratio Analysis Essay

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Fundamentals, Techniques & Theory

CASH FLOWS AND FINANCIAL RATIO ANALYSIS

CHAPTER TWO

ANALYSIS OF THE STATEMENT
OF CASH FLOW AND
FINANCIAL RATIO ANALYSIS
“Patience is the best remedy for every trouble.”
Plantus, Titus Maccius (c. 254- 184 B.C.)

“Be not afraid of going slowly; be only afraid of standing still.”
Chinese Proverb

Learning Objective
The Statement of Cash Flow provides valuation analysts with valuable information about an entity’s operating investment and financing cash flows. This Chapter provides readers with a review of how the same is derived. NACVA Instructors will only discuss the difference between the Cash from Operations
(CFO) and the Cash Flows used for Valuation Purposes.
An understanding of the different methods used to derive a Statement of Cash Flow is presumed in this course. IMPORTANT: The Cash Flows used for Valuation Purposes are Net Cash Flow to Invested Capital and
Net Cash Flow to Equity!
CFO is not the Cash Flow used for business valuation purposes! Nevertheless it is important to understand how the same is derived. Once that is understood, it is far easier to understand the differences between various types of Cash Flows and easier to understand the cash flows used for valuation purposes.
Neither CVA nor AVA Candidates will be tested on the Derivation of the Statement of Cash Flows!
In this Chapter, financial ratios are covered, too; many ratios are based on historical data, and other ratios rely on cash flow. The ratios presented are just some of the many used/ developed and should be understood. Candidates will be tested on the non-Cash Flow Financial Ratios, not on the ratios containing Cash Flow from Operations (CFO) or Free Cash Flow (FCF).
In Corporate Valuation Transactional Analysis (CVTA), NACVA’s Day 5 of the Training Center (TC), reference is made to various types of Cash Flows. Accordingly, at this stage familiarity with these concepts is highly recommended, those practicing will need to be proficient and at ease using these financial concepts.

© 1995–2005 National Association of Certified Valuation Analysts
August 2005

Chapter Two – 43

CASH FLOWS AND FINANCIAL RATIO ANALYSIS

I.

Fundamentals, Techniques & Theory

FINANCIAL RATIO (TREND) ANALYSIS SUMMARY
In general, a thorough financial analysis of any business would include a study of the following financial information:
a.
b.
c.
d.
e.

A summary of both the historical and the adjusted economic/ normalized balance sheets over the period being analyzed, detailing each balance sheet line item.
A summary of both the historical and the economic/normalized adjusted income statements over the period being analyzed, detailing each income statement line item.
A summary of both the historical and the economic/normalized adjusted income statements over the period being analyzed, where each income statement line item is reported as a percentage of net sales (often referred to as common size analysis).
A summary of both the historical and the economic/normalized adjusted cash flows from operating activities (on the basis of operations and adjusted for owner/manager discretionary items such as compensation) over the period being analyzed.
A summary of the five main categories of selected financial ratios over the period being analyzed: 1.
2.

Operating efficiency ratios

3.

Operating profitability ratio

4.

Business (operating) risk analysis ratios

5.
f.

Internal liquidity ratios

Financial risk (leverage) analysis ratios

The valuation analyst should then compare the aforementioned ratios for the subject company to those for other specific businesses or to an industry average.

II. COMMON-SIZE ANALYSIS
The conversion of balance sheet and income statement line items to percentages of a total is often referred to as placing the statements on a “common-size” basis. For purposes of commonsize statements, balance sheet line items are
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