Financial Statement Analysis
Financial Statement Analysis tests your ability to convert statements into comparable ratios, decompose return on equity, and judge earnings quality. Expect common-size analysis, trend analysis, liquidity and solvency ratios, and the adjustments needed when accounting policies differ across peers.
Core framework
- Vertical analysis expresses each line as a percentage of revenue on the income statement or total assets on the balance sheet; horizontal analysis indexes each line to a base year.
- DuPont decomposition: ROE = net profit margin × asset turnover × financial leverage. The three-factor version uses net income/revenue, revenue/average total assets, and average total assets/average equity. The five-factor version splits tax burden and interest burden out of margin.
- Liquidity ratios such as current, quick, and cash ratios use short-term assets and liabilities; solvency ratios such as debt-to-equity, interest coverage, and net debt/EBITDA use longer horizons.
- The cash conversion cycle = days inventory outstanding + days sales outstanding - days payables outstanding. A shorter cycle frees cash but can signal weak bargaining power.
- Quality of earnings checks whether operating cash flow tracks net income; a rising accruals ratio warns that profit is not converting to cash.
Worked example
A firm reports revenue 1,000, net income 80, average assets 800, and average equity 400. Net margin is 8%, asset turnover is 1.25×, and leverage is 2.0×. ROE = 8% × 1.25 × 2.0 = 20%. If a peer earns the same 8% margin but turns assets 2.0× with leverage 1.5×, its ROE is 24%. The decomposition shows the peer wins on operating efficiency, not margin, so a margin-only comparison would miss the driver.
Traps
- Use average balances, not year-end balances, when the denominator is a flow item such as revenue or net income.
- Do not mix market values and book values in one ratio; P/E uses market price, while ROE uses book equity.
- A high current ratio can hide slow-moving inventory; check quick and cash ratios.
- Ratios are only comparable if accounting policies, fiscal years, and capitalization choices are aligned.