Ratio and Trend Analysis
Core concepts
Ratio and trend analysis turns raw statements into comparable, time-series signals. Candidates must understand the major ratio families-liquidity, leverage, efficiency (turnover), profitability, and market value-and how to compute and interpret them. Trend analysis examines changes over multiple periods, including common-size statements (each line as a percentage of revenue or total assets) and index-number trends. The goal is to detect direction, volatility, and structural shifts.
Traps to watch
- DuPont decomposition: Return on equity = net margin × asset turnover × equity multiplier. A rising ROE driven by leverage is not the same as operational improvement.
- Turnover and days: Inventory turnover = cost of goods sold ÷ average inventory; days = 365 ÷ turnover. Mixing revenue with cost of goods sold is a frequent error.
- Base-year distortion: Index trends anchored to an unusual base year can mislead.
- Seasonality: Single-period comparisons may reflect timing rather than trend.
Rule of thumb
Always decompose a changing ratio into its drivers before concluding. Worked example: ROE rises from 12% to 15% while net margin and asset turnover are flat. The equity multiplier must have increased-leverage, not performance, drove the gain. This DuPont check is a reliable way to answer "why did the ratio change" questions.