Financial Statement Analysis
What you must know
Ratio analysis is the backbone of this domain. Learn the five families and what each reveals: liquidity (current, quick, cash ratios), activity (receivables turnover and days sales outstanding, inventory turnover and days, total asset turnover), solvency (debt-to-equity, debt-to-total-assets, times interest earned), profitability (gross, operating, and net margins; ROA; ROE), and market value (EPS, P/E, dividend payout, dividend yield, book value per share). Equally testable are common-size statements (each item as a percent of sales or of total assets), trend/horizontal analysis, and the DuPont decomposition of ROE.
Traps that show up
- Using ending balances where averages are expected. Turnover ratios should use average receivables, inventory, and assets when both beginning and ending figures are given.
- Assuming "higher is better." A very high current ratio may signal idle cash or obsolete inventory; a high P/E may reflect low earnings, not confidence.
- Comparing ratios across industries without adjustment for capital intensity and accounting policy.
- Mixing up return on assets (net income ÷ average total assets) with return on equity (net income ÷ average common equity).
- Ignoring earnings-quality red flags: rising revenue with falling operating cash flow, aggressive revenue recognition, capitalization of costs, or changes in estimates.
Worked example
Net income $120, sales $2,000, average total assets $1,000, average equity $500. Three-step DuPont: net profit margin = 120/2,000 = 6%; asset turnover = 2,000/1,000 = 2.0; equity multiplier = 1,000/500 = 2.0. ROE = 6% × 2.0 × 2.0 = 24%. If ROE falls, the decomposition tells you whether margin, efficiency, or leverage drove the change.
Rule of thumb
State the formula, use average balances for turnover and return measures, and always attach an interpretation to the number-CMA questions frequently ask what a ratio implies, not just what it equals.