Financial Statements and Ratio Analysis - Study Guide
This domain tests reading the statement of profit and loss, balance sheet and cash-flow statement, and computing ratios for liquidity, solvency, efficiency, profitability and market valuation.
Core ideas
- Liquidity: current ratio = current assets/current liabilities; quick ratio = (current assets − inventory)/current liabilities.
- Solvency: debt–equity = debt/equity; interest coverage = EBIT/interest.
- Efficiency: inventory turnover = COGS/average inventory; receivables turnover = credit sales/average receivables.
- Profitability: net profit margin = net profit/sales; ROA = net profit/average total assets; ROE = net profit/average equity.
- Market ratios: EPS = profit available to equity shareholders/number of equity shares; P/E = market price/EPS.
- DuPont: ROE = net profit margin × asset turnover × equity multiplier.
Worked example
A firm has current assets ₹4,00,000, including inventory ₹1,20,000, and current liabilities ₹2,00,000. Current ratio = 4,00,000/2,00,000 = 2.0. Quick ratio = (4,00,000 − 1,20,000)/2,00,000 = 2,80,000/2,00,000 = 1.4. If the industry current ratio is 1.5, the firm looks more liquid, but 30% of current assets are inventory. The reasoning must check inventory quality and receivable collection before calling liquidity strong.
Traps
Use average balances for turnover ratios when both opening and closing figures are available. Do not mix sales with COGS in inventory turnover. Ratios are indicators, not proof; compare with industry and trends. Window dressing can inflate the current ratio just before year-end. Negative equity makes debt–equity and ROE misleading.