Analysis and Interpretation of Financial Statements
Ratio families
Profitability (gross margin, net margin, ROCE, ROE), liquidity (current, quick), solvency (debt-equity, interest coverage), efficiency (inventory days, receivable days, payable days, cash conversion cycle) and market ratios (EPS, P/E). Interpretation matters more than computation: benchmark against prior years, peers and the business model.
DuPont and EVA
ROE = net profit margin × asset turnover × equity multiplier. This decomposes performance into operating efficiency, asset use and leverage. EVA = NOPAT − (WACC × invested capital); it charges for equity, which accounting profit does not.
Worked example
Net profit ₹80 lakh on revenue ₹1,000 lakh (8%); total assets ₹667 lakh (asset turnover 1.5); equity ₹333 lakh (equity multiplier 2.0). ROE = 8% × 1.5 × 2.0 = 24%. If a peer earns 24% with a 12% margin and turnover of 1.0, the company's return is leverage-supported, so a margin fall would be dangerous. EVA check: NOPAT ₹120 lakh, WACC 12%, invested capital ₹800 lakh, capital charge ₹96 lakh, EVA ₹24 lakh.
Cash and quality of earnings
Reconcile profit to operating cash flow. Growth in receivables and inventory, capitalised costs and non-recurring gains are the usual explanations for profit without cash.
Traps
- Mixing average and closing balances across compared ratios.
- Reading a high current ratio as liquidity when inventory is unsaleable.
- Treating a one-off asset sale as sustainable margin.