Introduction to

Business
Analytics
VEN3022

Prof. Sunyoung (Skylar) Lee

Financial Analytics

Chapter 9

2
Learning Objectives
9.1 9.5
Describe the types of finance
Define finance and its three primary questions addressed using diagnostic
branches: corporate finance, investments analytics.
and financial markets and institutions.
9.6
9.2 Describe the types of finance
Identify representative finance questions questions addressed by predictive
analytics.
addressable by business analytics.

9.3 9.7
Describe the basics of prescriptive
Enumerate the sources of financial data. financial analytics.

9.4 9.8
Describe and provide examples of Identify methods of reporting financial
analytics results.
descriptive analytics used in financial
analysis.
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The Role of Finance in Business and Its Three
Primary Branches
LO 9.1

4
What is Finance?
• Finance is the management of money, or financial capital,
by investing, borrowing, lending, budgeting, saving, and/or
forecasting.

• Financial capital (or simply capital) refers to the economic

resources that companies use to operate their business.

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Branches of Finance
• Corporate finance is the function in a business that manages funding
sources, capital structure and investment decisions with the goal of
increasing the value of the firm for shareholders (owners).
• Investments is a branch of finance that focuses on acquisition and
disposition of assets with the objective of generating profit (or income).
Examples of financial assets include equity investments (common stock),
US treasury bonds, corporate bonds and commodities (e.g., oil, wheat,
gold, pork bellies, etc.).

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Branches of Finance
• Financial markets and Institutions
Financial markets are the markets for selling various investments including stocks and
bonds, commodities, and derivatives markets selling various types of investments.
These include the New York Stock Exchange, NASDAQ and Chicago Board Options
Exchange (CBOE).
Financial institutions work in financial markets such as banks (e.g., Bank of America,
Wells Fargo), investment companies (e.g., pension investment firms like Cal PERS), and
brokerages (e.g., Goldman Sachs and Merrill Lynch).

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 Specifying the Finance Questions
LO 9.2

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Four Example Finance Questions – By Analytics
Type
• Descriptive Analytics: What is the return to investing in the stock market over the previous
five years?

• Diagnostic Analytics: How well did the corporation perform relative to its budget?

• Predictive Analytics: Will a potential borrower repay their loan (based on credit score,
payment history, existing debt, etc.)?

• Prescriptive Analytics: What happens to Bank of America profits if the interest rates on its
loans change in the future from 3% to 4% to 5% or more?

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Finance
Questions

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 Financial Data Sources
LO 9.3

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Primary Financial Data Sources
• Stock Return Data (Available on Yahoo! Finance, Marketwatch, Bloomberg,
Reuters, Factset, and Stock Exchange Web Sites)

• Summarized Financial Data (Bloomberg, Reuters, Damodaran (free))

• Financial Statement Data

Corporate websites
Securities and Exchange Commission filings (EDGAR:The Electronic Data Gathering,
Analysis, and Retrieval System)
XBRL (eXtensible Business Reporting Language)– financial statement data repository
with identifying tags

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 Descriptive Financial Analytics
LO 9.4

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Descriptive Analytics - characterizes, summarizes, and
organizes features and properties of the data
Statistical Technique to Use Example of Type of Finance Question It Addresses
Perform Descriptive Analytics

Counts Show how frequently an How many companies have gone public (had an initial
attempt occurs public offering) in the past six months?

Totals, sums, averages, Summarize measures of How many loans were extended by the bank in the
subtotals performance previous quarter?

Minimums, maximums, Summarize measures showing Which stock in the portfolio has the highest price
medians, standard deviations extreme values to help explain volatility?
what happened Which stock in the portfolio has the lowest price
volatility?

Graphs (bar charts), Shows performance graphically What are the levels of quarterly profits over the past
histograms three years shown in a bar graph?

Ratio analysis like price-to- Calculates important financial What is the relative market valuations of retail firms like
earnings, price-to-book and ratios for comparison between Amazon, Walmart, Target, or Kroger? Which company
price-to-sales ratios companies. has the highest price-to-earnings ratio?

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Descriptive Statistics (for three possible investments)

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 Diagnostic Financial Analytics
LO 9.5

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Define Diagnostic Analytics

• Diagnostic analytics is broken down into two broad categories

to help determine “Why Something Happened?”:
Identifying Anomalies and Outliers – something different than we
expected
Finding Previously Unknown Linkages, Patterns, or Relationships
between Variables
• Performing Drill-Down Detailed Analytics
• Performing Statistical Analyses

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Identifying Anomalies and Outliers: Comparing Actual
to Expectation (or Benchmarks)

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Assets Liabilities and Equity?
• Assets are measurable items, both tangible and intangible, that
increase your company's value.
• Liabilities represent what your company owes to external parties,
such as investors or lending institutions.
• Equity is the everything left that remains after deducting liabilities
from assets, reflecting the owners' stake in the company.
• To balance your books, the accounting equation says assets should
always equal liabilities plus equity.
DuPont ratio analysis
• Summarizes and disaggregates company performance into three ratio to hep explain the
return on stockholders’ equity and address the important question “What happened?”
Return on equity (ROE)
• A measure of profitability generated for each dollar of stockholders’ investment. Generally, it
is defined as net profit (income) divided by stockholders’ equity, or Net profit/Equity.

• In DuPont ration analysis, ROD is calculated as follows:

Drill-down
Techniques:
Disaggregating
Performance
(Return on Equity)
into its Component
Parts Using DuPont
Analysis

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DuPont ration analysis example
Drill-down Techniques: Disaggregating Performance
(Return on Equity) into its Component Parts Using DuPont
Analysis

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Return on Asset
• ROA is a measure of profitability for each dollar of resources (assets) available for
management to sue, computed as net profit (net income)/total assets.
The Higher the Risk, The Higher the Expected Return

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Sharpe Ratio
The Sharpe Ratio is a ratio of the average returned earned in excess of the risk-free rate to a
unit of volatility.

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 Regression Analysis: Investigating the Relationship
between Risk and Return
Regression:
• Dependent variable: Different measures of expected investment return [e.g., past stock
Dependent Variable:
prices (or returns), bond yields, or returns on real estate investments, etc.]
Investment Returns
• Independent variables: Different measures of risk [e.g., past stock price volatility, volatility of
earnings, beta, bankruptcy risk (also known as default risk), level of debt (leverage), etc.]
Independent Variable:
Different Measures of
Risk Capital Asset Pricing Model (CAPM): Model used to predict the relationship between systematic risk
and expected return for financial assets.

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 Progress Check 9.5
Q. Why is a disaggregation (such as that used in a
DuPont analysis) considered to be diagnostic
analytics?

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 Predictive Financial Analytics
LO 9.6

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Three Predictive Analytics Techniques

• Classification

• Regression

• Time Series Analysis

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What can a bank use to predict whether a borrower will pay
back their loan?
Credit History
Does the borrower have any delinquent accounts (where the payments are late or behind schedule)?
What is the borrower’s monthly credit card bill?
Does the borrower have any unpaid collections accounts? Medical bills, for example?
Has the borrower declared bankruptcy in the past 3–5 years?
How many recent applications have been made for credit?
How much total outstanding debt does the borrower have? What is the debt-to-annual income ratio?
What is the borrower’s credit score (a statistic that evaluates a customer’s creditworthiness and
ability to repay a loan)?
Do they rent or own their home (or condo)?

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What can a bank use to predict whether a borrower will pay
back their loan?
Income
What is the borrower’s annual income?
How long has the borrower been employed at his/her current job?
Is the income verified? Does it come from self-employment, or is it from salary?
What is the salary history?
Loan Specifics
For what purpose is the borrower intending to use the loan?
How big of a loan is the borrower requesting?

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Examples of Predictive Analytics Addressing
Financial Questions
Predictive Analytics Techniques Example of Type of Question It Type of Test
Addresses
Classification: A predictive Which potential borrowers will Run classification analysis to predict
analytics technique used to most likely pay back their loan (and which borrowers will pay back a
separate or classify a sample (or which will not)? And relatedly, loan and which will not.
population) into two or more which client should be granted a
groups of classes. bank loan (and which should not)?

Regression: A predictive analysis Can we predict the interest rate Run regression analysis to predict
technique used to predict a given to prospective loan the interest rate given based on
specific dependent variable borrowers at a bank? prospective loan borrower’s
outcome value based on characteristics.
independent variable inputs.
Forecasting using time series Can we predict next year’s Use time series analysis
analytics: A predictive analytics dividends given past dividends? incorporating past values of
technique used to predict future dividends to predict the next few
values based on past values of the year’s dividends.
same variable.

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Altman’s Z can be used for bankruptcy
classification/bankruptcy prediction.
Altman’s Z found five factors that X3: Earnings before interest and taxes / Total
helps predict bankruptcy. assets

X1: Working capital / Total assets Measures recent, or short-term profitability of the
company.
Measures how liquid, cash-like
assets (or liquidity level in relation to X4: Market value of stockholders’ equity / Book
the size of the company). value of total debt owed

X2: Retained earnings / Total assets Measures long-term solvency of the company, or
whether the company will have sufficient funds to
Measures long-term profitability
pay its debt as it comes due.
over the life of the company.
X5: Sales / Total assets
Measures asset efficiency, or how well assets are
utilized.
Decisions rules determine which cases fit within each class.

Original Z-score formula:

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5.

Decision Rules:
If Z < 1.80 Classify as significant risk of
bankruptcy, or in the
“distress zone”
If Z > = 1.80 and Classify as at risk of
Z < 3.00 bankruptcy, or “gray zone”
If Z > = 3.00 Classify as not currently at
risk of bankruptcy, or “safe
zone”
The results of the classification appear in the base
analysis.

Results of base analysis of the retail industry

from 2009 to 2017 (see Lab 8-1):

Bankruptcy Zone Based on Number of

Altman’s Z Firm/Years
Classify as bankrupt, or
305
“distress zone”
Classify as at risk of bankruptcy,
516
or “gray zone”
Classify as nonbankrupt, or
1,508
“safe zone”
Total firms included in analysis 2,329
 Progress Check 9.6

Q. What could be used to predict future stock returns?

What could be used to predict whether a company would go
bankrupt?

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 Prescriptive Financial Analytics
LO 9.7

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Prescriptive Analytics Techniques
• Marginal (or incremental) analysis
Technique used in finance to determine the change in profit associated typically with the cost or
benefit of selling/buying/making the next (or the marginal) unit.
• Cash Flows Analysis
Evaluating future cash flows using various analytics techniques, including net present value (NPV)
and internal rate of return (IRR), for potential investments.
• Scenario analysis
Analysis of potential future events by considering potential outcomes.
• Goal-seek analysis
A form of what-if analysis that tells us what will need to be done (or assumed) in order to reach a
desired outcome, output or result.
• Sensitivity analysis
Evaluating the outcomes based on uncertainty regarding the inputs.

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Examples of Prescriptive Analytics Addressing Finance
Questions

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 Progress Check 9.7
Q. Why is sensitivity analysis considered to be
prescriptive analytics? What is trying to be
determined?

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Reporting the Results of Financial Analytics
LO 9.8

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Reporting the Results
We highlighted the following topics:

• Descriptive and Diagnostic Analytics: Graphs and Tables to Show Performance

• Predictive Analytics: Tables to Show Analyst Projections

• Prescriptive Analytics: A Graph to Show the Impact of Sensitivity Analysis

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Descriptive and Diagnostic Analytics: Graphs and Tables to
Show the Return on Investment

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Using Line Graphs to Emphasize Sensitivity Analysis –
Prescriptive Analytics

Exhibit 9.31 Sample Sensitivity Analysis Shown in a Line Graph 46

 Progress Check 9.8
Q. In the sensitivity analysis displayed in Exhibit 9.31, which change of
1% (or 0.01) in either sales growth or discount rate is associated with
the greatest change in the intrinsic value? How can you tell?
Do you think it easiest to figure this out using tables or graphs?

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© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.