Financial Statement Analysis
Framework
Financial statement analysis converts reported numbers into decision-useful ratios and trends. Candidates should command the major families: liquidity (current, quick, cash ratios), solvency (debt-to-equity, interest coverage), profitability (gross, operating, net margins, ROA, ROE), and efficiency (inventory turnover, receivables turnover, asset turnover). Understand DuPont decomposition: ROE = net profit margin × asset turnover × equity multiplier, which separates profitability, efficiency, and leverage.
Quality of Earnings
Beyond ratios, assess accounting quality. Watch for aggressive revenue recognition, rising days sales outstanding relative to peers, growing inventory relative to sales, and accruals that persistently diverge from cash flow. Compare accrual-based net income to operating cash flow; a widening gap signals earnings quality concerns.
Common Traps
- Averaging versus ending balance sheets in ratio denominators (averages are preferred for flow-based ratios).
- Comparing ratios across firms with different accounting policies or fiscal years without adjustment.
- Treating a high current ratio as automatically healthy when it is driven by slow-moving inventory.
- Misreading a declining asset turnover as improved efficiency.
Worked Example
A firm has net income of 60, sales of 1,200, average assets of 800, and average equity of 400. Net margin = 5%, asset turnover = 1.5, equity multiplier = 2.0. ROE = 5% × 1.5 × 2.0 = 15%. If leverage rises while margin falls, ROE may look stable while underlying profitability deteriorates-decompose before concluding.