The financial analysis enables portfolio managers to gauge the past and current performance of companies, in order to assess the value and potential future performance of companies and their securities.
Companies that make their securities available to the public are required to publish audited financial statements on an annual basis. Annual financial statements must be reviewed by an independent auditor or auditing firm to ensure that they comply with accounting standards (Canada has adopted International Financial Reporting Standards (IFRS)). Interim reports are usually published quarterly or semi-annually but are not required to be audited.
These statements are the primary source of information for a fundamental analyst. A company’s financial statements provide information about its past, current, and future business performance. Through the analysis of financial statements, portfolio managers can evaluate the value of a company and its securities.
The primary financial statements used to evaluate a company include the following:
- balance sheet
- income statement
- cash flow statement
- statement of retained earnings
The balance sheet is often defined as a snapshot of a company’s financial position at a specific point in time. Sometimes referred to as a
statement of financial position or statement of assets and liabilities, it provides valuable information about what a company owns and what it owes.
There are three components to a balance sheet displayed as follows:
The balance sheet derives its name from the fact that both sides of the statement must be equal.
NOTE: In most cases, the assets and liabilities are recorded on the balance sheet at their historical value rather than market value. (An exception is a mutual fund where the assets or investments are recorded at market value.)
The income statement shows how much revenue a company earned and the expenses it incurred during a specific period. If
revenues are greater than expenses, the company shows a profit. If revenues are less than expenses, the company shows a
There are six main sections on an income statement.
Cash Flow Statement
The cash flow statement shows where a company’s cash is coming from and how it is being spent. It helps creditors and investors assess whether the company:
- is able to generate cash when needed
- has the cash to meet its financial obligations
- has enough cash to pay dividends or to reinvest
The cash flow statement is separated into three sections.
|operating activities||Refers to cash inflows and outflows from the company’s daily activities, such as the net income from the sale of its products and services.|
|investing activities||Includes cash expenditures for the purchase of assets or cash receipts through the sale of assets as well as income from investments, such as interest or dividends.|
|financing activities||Includes cash raised by borrowing money or the issuance of shares and amounts repaid to shareholders and debt-holders.|
Statement of Retained Earnings and Notes
Retained earnings are the amount remaining after a company’s net income is distributed to shareholders in the form of dividends. The statement of retained earnings captures what is distributed to shareholders and what is retained by the company. It carries forward the previous retained earnings balance, adds the net profit from the income statement, and subtracts dividends distributed to shareholders to determine the retained earnings at the end of the period.
Companies may use retained earnings to pay off existing debt or reinvest in the company, such as pay for machinery or building a new factory.
Notes to Financial Statements
Notes to financial statements are often included to clarify financial statements or to provide additional information.
Because these notes contain information that may be important for accurate comprehension of financial statements, they should be carefully studied. Here is a partial list of what topics might appear in notes to financial statements:
- consolidation of financial statements between a parent company and its subsidiaries
- deferred income taxes
- lease obligations
- the method of converting transactions in foreign currencies to Canadian dollars
- investment holdings
- legal actions in progress against the company
Common Ratios Used in Financial Analysis
Financial ratios are used to evaluate a company’s financial statements. Portfolio managers use financial ratios to compare a company’s financial information to a benchmark or to other companies in the same industry. Since ratios are relative numbers, portfolio managers may directly compare two companies of very different sizes.
Ratios are calculated over several years to look for trends and opportunities. They also provide information about the direction of the security’s future prices, as well as warning signals about companies in financial distress.
There are four main types of financial ratios:
NOTE: Although you will not be tested on the formulas used to calculate the different ratios, you are expected to understand their significance.
Profitability and Liquidity Ratios
Profitability ratios measure a company’s ability to generate profits from its resources. The data used to calculate profitability ratios is found primarily on the income statement.
One of the profitability ratios is the gross profit margin, which shows the percentage of revenue left over after a company pays for the cost of goods sold.
A company’s liquidity ratios tell us whether it has sufficient resources to meet current financial obligations.
A commonly used liquidity ratio is the current ratio, which shows a company’s ability to pay its short-term debt. The higher the ratio, the greater the company’s ability to pay the short-term debt.
|Current Ratio = current assets ÷ current liabilities|
Debt-equity and Valuation Ratios
Debt-equity ratios gauge how heavily a company relies on borrowed money to conduct its business. Generally, a higher debt-equity ratio represents greater risk. A company with too much debt may have difficulty making interest payments, borrowing additional funds, or borrowing at a favorable interest rate. However, if used wisely, greater debt can increase productivity and profits.
|Debt-equity Ratio = (total outstanding short-term and long-term debt) ÷ shareholders’ equity at book value|
Valuation ratios assess the investment value of a security in comparison to its share price.
The price-to-earnings (P/E) ratio is the most well-known valuation ratio. This ratio relates the current share price to its earnings per share and shows how much investors are willing to pay for $1 of earnings. Therefore, if a company’s shares are trading at a P/E of 20 that means investors are willing to pay $20 for $1 of current income. A higher P/E ratio means investors are expecting a higher income in the future. This ratio allows portfolio managers to compare the earning potential of different companies.
|P/E Ratio = (market price per share) ÷ (earnings per share)|
Mutual Fund Performance and Risk
Mutual fund performance, also called the return, is a measure of the income generated by the mutual fund combined with the fund’s capital appreciation over time. Mutual funds, like most investments, are affected by a variety of risks.
Sources of a Mutual Fund’s Return
How does a mutual fund investment grow in value? Quite simply, mutual funds make money in three ways:
- they earn income in the form of interest, dividends, or other income (e.g. foreign income)
- they realize capital gains (when securities are sold at a price higher than the initial purchase price)
- the price of the securities in the portfolio appreciates in value
How does a mutual fund lose money? They either:
- realize capital losses (when securities are sold at a price below the initial purchase price)
- the price of the securities in the portfolio declines in value
Each individual holding in the mutual fund has its own characteristics and makes a contribution to the portfolio according to those characteristics. The following illustrates how a bond or an equity holding makes a contribution to a mutual fund portfolio. For simplicity, assume the portfolio consists of only one investment.
Calculating Mutual Fund Standard Performance
Mutual fund investors are extremely interested in performance, both as a measure of their current investment values and as a yardstick in comparing potential new investments. A mutual fund’s performance over any time period is the result of a number of factors including:
• the performance of the financial markets in which the mutual fund invests
• the investment skill of the portfolio manager
• the flow of cash in and out of the mutual fund as a result of net sales and net redemptions
Standard Performance Data
The total return of a mutual fund incorporates the income generated from the fund, which includes interest, dividends, realized capital gains and other income, and the capital appreciation of the mutual fund over time.
There are many ways of calculating performance. Without a common methodology, comparing the performance of different funds can be very misleading. Standard performance data was developed so investors can make meaningful comparisons between funds.
For non-money market funds, standard performance data is calculated using the formula for the annual compounded rate of return. The calculation assumes that any distributions from the mutual fund are immediately reinvested back into the mutual fund.
For money market funds, current yield and effective yield are used to show performance.
It is important to understand that a fund’s past performance is no guarantee of future performance.
NOTE: You are not expected to calculate the returns for non-money market funds or money market funds. The formulas are provided to help you understand how mutual fund returns are calculated.
Non-money Market Mutual Funds Total Return
|This formula allows you to calculate the standard return for non-money market mutual funds, including reinvestment and compounding of distributions.|
|Total Return = [(redeemable value ÷ initial value)(1 ÷ n) – 1] x 100|
- n = the length of the performance measurement period in years, with a minimum value of 1
- initial value = the beginning net asset value of one unit or share of a mutual fund
- redeemable value = the end net asset value of one unit or share of a mutual fund, incorporating all distributions
Money Market Mutual Funds Total Return
|Money market returns are calculated using two different formulas: current yield and effective yield.|
The current Yield reflects the income earned on a money market fund for the most recent seven days expressed as a simple annualized percentage.
|Current Yield = [seven day return x 365 ÷ 7] x 100|
|Where: seven-day return = income generated divided by the beginning value of the money market fund|
Gargantuan Money Market Fund has assets of $10,000,000. In the last seven days, the fund earned $9,595 of interest. The current yield is 5.0031%, calculated as [($9,595 ÷ $10,000,000) x 365 ÷ 7] x 100.
Effective yield also calculates the return of a money market mutual fund, but this calculation includes the effect of compounding, the concept of interest added onto the principal, and then itself also earning interest.
Effective Yield = [(seven day return +1)(365 ÷ 7) – 1] x 100
Again looking at Gargantuan Money Market Fund, the effective yield is 5.1279%, calculated as
[(($9,595 ÷ $10,000,000) + 1)(365÷7) – 1] x 100.
Effect of Mutual Fund Distributions
In the course of a year, securities held in a mutual fund will generate income; this income increases the mutual fund’s net asset value which in turn raises the net asset value per unit (NAVPU). When this income is eventually distributed to unitholders it lowers the net asset value of the mutual fund, which results in a drop in the NAVPU.
How distributions lower NAVPU
The NAVPU is calculated by dividing the mutual fund’s net assets (total assets – total liabilities) by the number of units outstanding, in other words, the number of units held by all the mutual fund’s unitholders.
|NAVPU = (total assets – total liabilities) ÷ number of units outstanding|
Mutual Fund Distribution Options
When a mutual fund distributes income, unitholders can do one of two things with the distributions:
- receive a cash payment
- reinvest the distribution
If the investor chooses to receive a cash distribution, his or her number of units remains the same as before the distribution.
If on the other hand, an investor reinvests the distribution, he or she will receive additional units of the mutual fund. The number of units the investor will receive is calculated as follows:
|Number of new units = Income distribution ÷ NAVPU|
Mutual Fund Risks
Mutual fund returns like most investments are affected by a variety of risks that can be separated into three categories. We will discuss the three main categories and look at examples of those types of risks.
This is the risk that a single event, such as the failure of an institution, can trigger a domino effect and harm other interconnected financial institutions. Eventually, systemic risk can harm the whole economy. A prime example of systemic risk is the collapse of Lehman Brothers in 2008. The failure of this large investment bank reduced the stability of the entire U.S. financial system.
This type of risk is also referred to as market risk because it affects everyone and cannot be avoided. Systematic risk includes events such as interest rate changes, recessions, and wars. Systematic risk can be compared to the risk of bad weather. In the event of an earthquake, everyone is vulnerable.
Mutual Fund Unsystematic Risks
This is a risk specific to a given company or industry. This type of risk includes business risk and liquidity risk. For instance, poor management can lead to a decrease in a company’s security prices.
Diversification can reduce the amount of unsystematic risk in a portfolio.
Measures of Investment Risks
The various types of risk affect the value of the securities in a mutual fund. When looking at how to measure the impact of these risks, we refer to volatility. Volatility is a measure of changes of a security’s value over a period of time.
Highly volatile securities experience dramatic price fluctuations in a short time period, thereby forcing a higher risk that the actual performance of a mutual fund may differ from the expected performance.
Investments with lower volatility levels are those that experience a steady price change over time. As a result, these investments have a lower risk of failing to meet the expected return.
Knowing the types of risk to which securities are exposed is important in assessing the volatility level and therefore the total return of a fund.
Volatility measurements include:
- standard deviation
Standard deviation indicates how much a mutual fund’s performance fluctuates around its average historical return over a specified period of time. Returns closer to the average historical return, indicate a lower standard deviation. This means there is a lower risk that the fund will fail to meet its average return. A higher standard deviation, on the other hand, indicates that returns are farther away from the historical average return, and denotes a higher risk that the fund will not meet its average return.
A graphical representation of this measure is the familiar bell curve. The height and width of this curve reflects the amount of variation in an investment’s return.
Beta measures the systematic risk of an investment relative to a benchmark index. With beta, investors can compare the volatility level of an investment to its peer group.
As the basis of comparison, the benchmark index is assigned the value of one. The table below summarizes the relationship between the investment’s beta and volatility.
Duration is commonly used to measure the volatility of fixed-income investments such as bonds. Duration refers to the number of years, calculated as the weighted average time, it will take for the bondholder to receive the present value of the interest and principal payments.
The longer the duration, the longer bondholders will have to wait to get their interest and principal payment. As there is greater uncertainty in the future, for instance, the bond issuer can go bankrupt or interest rates may rise, longer durations mean higher risk. For instance, if two bonds have the same coupon rate, but different terms, the bond with the long term will have a longer duration and will be more volatile.
A bond’s coupon rate will also have an effect on duration. For example, if two bonds have the same term, but different coupon rates, the bond with the lower coupon rate will have a longer duration and will be more volatile.
|Since a zero-coupon bond only pays at maturity, its duration is equal to the bond’s time to maturity.|
The Relationship Between Risk and Return
Investments that experience higher volatility generally have the potential for higher returns due to the dramatic changes in the price of the investment. However, price volatility includes both upward and downward price movements. Therefore, while higher volatility provides the potential for larger returns, it also comes with the risk of steeper losses.
Another reason riskier investments provide a higher return is that issuers offer compensation to investors as an incentive for holding higher-risk investments. To compensate investors, issuers of higher-risk investments typically provide a risk premium.
Mutual Fund Risk Ratings
The simplified prospectus and the fund fact sheets list the types of risks that affect the mutual fund. The documents also classify the risk level of the mutual fund.
In addition, some fund fact sheets also indicate the mutual fund’s beta and standard deviation.
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