Financial Statement Analysis and Interpretation
Ratio families
Candidates must compute and interpret profitability ratios (gross profit margin, net profit margin, return on assets, return on equity), liquidity ratios (current, quick, cash), efficiency ratios (inventory turnover, receivables collection, payables payment, asset turnover) and gearing ratios (debt-to-equity, interest cover). Know the DuPont decomposition linking margin, turnover and leverage to return on equity.
Interpretation, not calculation
Marks are usually earned for explanation. State the ratio result, compare it to a benchmark, prior year or industry, then explain the operational cause and consequence. Identify limitations: historical cost, differing accounting policies, seasonal averages, window dressing and the absence of non-financial indicators.
Traps to watch
Use average balances for turnover ratios when opening and closing figures are available but be consistent. Do not confuse return on equity with return on assets; the difference is financial leverage. Remember that a high current ratio may hide illiquid inventory, and that a improving gross margin with falling net margin signals rising operating expenses. Do not describe a ratio as good or bad without a comparison.
Worked example
Net profit $60,000, sales $600,000, average total assets $400,000, average equity $250,000. Net margin is 10%, asset turnover 1.5 times, so return on assets is 15%. Return on equity is $60,000 divided by $250,000, or 24%, higher than ROA because of favourable leverage. Rule of thumb: ROE equals ROA multiplied by the equity multiplier.