🏦Financial Services Reporting Unit 13 – Financial Analysis for Financial Services

Key Concepts and Terminology

• 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