Question

1.) Explain how the credit analyst’s focus will differ from the investment analyst’s focus.

2.) What are the limitations of financial ratios?

3.) What do liquidity ratios measure? Activity ratios? Leverage ratios? Profitability ratios? Market ratios?

4.) How is the Du Pont System helpful to the analyst?

Answer 1

Part 1:

Credit analyst's focus:
They are concerned with the ability of a borrower to pay off the debt obligations on time.
If there is a risk of default, then the credit rating of the borrower will change irrespective of how it performed earlier.
They do not look for technicals analysis or signals like investment analysts and traders.

Investment analyst’s focus:
They are concerned about how attractive a company is for investment.
They focus on the rate of return that an investor will earn if he or she invests in a company.
They focus on capital appreciation and the dividend returns

Part 2:
Limitations of financial ratios are:
Information used in ratio analysis is derived from the historical results. The past results does not mean that a company will show the same results in future as well.
We cannot compare the ratio results for different companies that use different policies to record similar accounting transaction.
When two firms are pursuing different strategies, we cannot compare them using ratio analysis. If we do so, it will be completely incorrect.

Part 3:
Liquidity ratios:
Liquidity ratios are used to measure the ability of a firm to meet its short term debt obligations. Higher value of the ratio is preferred.
Activity ratios:
It measures how efficient a firm is in generating revenue by using its assets.
Leverage ratios:
It measures how leveraged a company is and the degree of leverage (which we also call as debt load).
Profitability ratio:
It measures the performance of a company in terms if profitability.
Market value ratio:
Analysts use the market value ratios to value share prices of publicly traded companies and also through these ratios investors determine whether the shares of a company is over valued or under valued.

Part 4:
Dupont analysis:
Return on equity=Net profit margin*Asset turnover*equity multiplier
Here,
Net profit margin = Net income / Revenue.
Asset turnover = Sales / Average total assets
Equity multiplier = Average total assets / Average shareholders’ equity

It helps analysts in identifying which component is contributing more or less towards the final return on equity value.
Net profit margin: Suppose this part is less then an analyst can look into management discussions and if the analyst finds that the company is going to reduce the cost or increase the selling price, then it will be good for the company and will also increase the return on equity.

Asset Turnover Ratio
If this part if high then the company is efficiently using its assets to generate sales revenue. If the value of low then the company is not efficient in generating revenue by using its assets.

Financial Leverage
If the return on equity value is high because of financial leverage then the analyst can look into debt ratios and other leverage ratios. This is an analysis of how a company is using debt to finance its assets.