Please summarize chapter 16 on your own words. "Accounting II"

Chapter 16: Financial Analysis and the Statement of Cash Flows

Financial analysis involves using financial data to assess a company's performance and make recommendations about how it can improve going forward. Financial Analysts primarily carry out their work in Excel, using a spreadsheet to analyze historical data and make projections of how they think the company will perform in the future. This guide will cover the most common types of financial analysis performed by professionals. The most common types of financial analysis are:

1. Vertical Analysis - This type of financial analysis involves looking at various components of the income statement and dividing them by revenue to express them as a percentage. For this exercise to be most effective, the results should be bench marked against other companies in the same industry to see how well the company is performing. This process is also sometimes called a common-sized income statement, as it allows an analyst to compare companies of different sizes by evaluating their margins instead of their dollars.
2. Horizontal Analysis - Horizontal analysis involves taking several years of financial data and comparing them to each other to determine a growth rate. This will help an analyst determine if a company is growing or declining, and identify important trends. When building financial models, there will typically be at least three years of historical financial information and five years of forecasted information. This provides 8+ years of data to perform a meaningful trend analysis, which can be bench marked against other companies in the same industry.
3. Leverage Analysis - Leverage ratios are one of the most common methods analysts use to evaluate company performance. A single financial metric, like total debt, may not be that insightful on its own, so it's helpful to compare it to a company's total equity to get a full picture of the capital structure. The result is the debt/equity ratio. Common examples of ratios include:

• Debt/equity
• Debt/EBITDA
• EBIT/interest (interest coverage)
• Dupont analysis - a combination of ratios, often referred to as the pyramid of ratios, including leverage and liquidity analysis

4. Growth Rates - Analyzing historical growth rates and projecting future ones are a big part of any financial analyst's job. Common examples of analyzing growth include:

• Year-over-year (YoY)
• Regression analysis
• Bottom-up analysis (starting with individual drivers of revenue in the business)
• Top-down analysis (starting with market size and market share)
• Other forecasting methods

5. Profitability Analysis - Profitability is a type of income statement analysis where an analyst assesses how attractive the economics of a business are. Common examples of profitability measures include:

• Gross margin
• EBITDA margin
• EBIT margin
• Net profit margin

6. Liquidity Analysis - This is a type of financial analysis that focuses on the balance sheet, particularly, a company's ability to meet short-term obligations (those due in less than a year). Common examples of liquidity analysis include:

• Current ratio
• Acid test
• Cash ratio
• Net working capital

7. Efficiency Analysis - Efficiency ratios are an essential part of any robust financial analysis. These ratios look at how well a company manages its assets and uses them to generate revenue and cash flow. Common efficiency ratios include:

Asset turnover ratio

Fixed asset turnover ratio

Cash conversion ratio

Inventory turnover ratio

8. Cash Flow - As they say in finance, cash is king, and, thus, a big emphasis is placed on a company's ability to generate cash flow. Analysts across a wide range of finance careers spend a great deal of time looking at companies' cash flow profiles.

The Statement of Cash Flows is a great place to get started, including looking at each of the three main sections: operating activities, investing activities, and financing activities. Common examples of cash flow analysis include:

• Operating Cash flow - operating Cash Flow (OCF) is the amount of cash generated by the regular operating activities of a business within a specific time period. OCF begins with net income (from the bottom of the income statement), adds back any non-cash items, and adjusts for changes in net working capital, to arrive at the total cash generated or consumed in the period. When performing financial analysis, operating cash flow should be used in conjunction with net income, free cash flow (FCF), and other metrics to properly assess a company's performance and financial health.
• Free Cash flow - Free cash flow (FCF) measures a company's financial performance. It shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from its operating cash flow. In other words, FCF measures a company's ability to produce what investors care most about: cash that's available to be distributed in a discretionary way.
• Free Cash Flow to the Firm - FCFF, or Free Cash Flow to Firm, is the cash flow available to all funding providers (debt holders, preferred stockholders, common stockholders, convertible bond investors, etc.). This can also be referred to as unlevered free cash flow, and it represents the surplus cash flow available to a business if it was debt-free. A common starting point for calculating it is Net Operating Profit After Tax (NOPAT), which can be obtained by multiplying Earnings Before Interest and Taxes (EBIT) by (1-Tax Rate). From that, we remove all non-cash expenses and remove the effect of CapEx and changes in Net Working Capital, as the core operations are the focus. To arrive at the FCFF figure, a Financial Analyst will have to undo the work that the accountants have done. The objective is to get the true cash inflows and outflows of the business.
• Free Cash Flow to Equity - Free cash flow to equity (FCFE) is the amount of cash a business generates that is available to be potentially distributed to shareholders. It is calculated as Cash from Operations less Capital Expenditures plus net debt issued

9. Rates of Return - At the end of the day, investors, lenders, and finance professionals, in general, are focused on what type of risk-adjusted rate of return they can earn on their money. As such, assessing rates of return on investment (ROI) is critical in the industry. Common examples of rates of return measures include:

• Return on Equity
• Return on Assets
• Return on Investment Capital
• Dividend Yield
• Capital Gain
• Accounting Rate of Return
• Internal Rate of Return

10. Valuation Analysis - The process of estimating what a business is worth is a major component of financial analysis, and professionals in the industry spend a great deal of time building financial models in Excel. The value of a business can be assessed in many different ways, and analysts need to use a combination of methods to arrive at a reasonable estimation.

Approaches to valuation include:

• Cost Approach
• Cost to build/replace
• Relative value (market approach)
• Comparable company analysis
• Precedent transactions
• Intrinsic value
• Discounted cash flow analysis

11. Scenario & Sensitivity Analysis - Another component of financial modeling and valuation is performing scenario and sensitivity analysis as a way of measuring risk. Since the task of building a model to value a company is an attempt to predict the future, it is inherently very uncertain. Building scenarios and performing sensitivity analysis can help determine what the worst-case or best-case future for a company could look like. Managers of businesses working in financial planning and analysis (FP&A) will often prepare these scenarios to help a company prepare its budgets and forecasts.

12. Variance Analysis - is the process of comparing actual results to a budget or forecast. It is a very important part of the internal planning and budgeting process at an operating company, particularly for professionals working in the accounting and finance departments. The process typically involves looking at whether a variance was favorable or unfavorable and then breaking it down to determine what the root cause of it was.

Financial Analysis Best Practices

All of the above methods are commonly performed in Excel using a wide range of formulas, functions, and keyboard shortcuts. Analysts need to be sure they are using best practices when performing their work, given the enormous value that's at stake and the propensity of large data sets to have errors.

Best practices include:

• Being extremely organized with data
• Keeping all formulas and calculations as simple as possible
• Making notes and comments in cells
• Auditing and stress testing spreadsheets
• Having several individuals review the work
• Building in redundancy checks
• Using data tables and charts/graphs to present data
• Making sound, data-based assumptions
• Extreme attention to detail, while keeping the big picture in mind