Financial Statement Analysis for Equities
Financial Statement Analysis for Equities tests whether reported results reflect sustainable economics. The exam emphasizes earnings quality, cash conversion, ratio analysis, and adjustments that make companies comparable.
Core rules
- Read the income statement, balance sheet, and cash flow statement together. Profit is an accrual concept; cash flow tests whether profit is being collected.
- Revenue recognition can shift timing. Watch channel stuffing, bill-and-hold, percentage-of-completion, and changes in accounting policy.
- Separate operating from non-operating items. EBIT and EBITDA are not interchangeable; EBITDA ignores depreciation, interest, taxes, and working capital.
- DuPont analysis decomposes ROE into net profit margin × asset turnover × equity multiplier. Each driver has a different risk meaning.
- Diluted EPS includes options, convertibles, and other potential shares. Use diluted figures when evaluating per-share value.
Worked example
A company has net income of $48 million, sales of $600 million, assets of $400 million, and equity of $200 million. Net margin is 8.0%, asset turnover is 1.5×, and the equity multiplier is 2.0×. ROE is 8.0% × 1.5 × 2.0 = 24.0%. If a peer has the same ROE but a 4.0× equity multiplier, the peer relies more on leverage and carries greater financial risk.
Traps
Do not add back all non-cash charges as if they are free cash flow; stock-based compensation and capitalized costs still transfer value. Do not compare companies with different fiscal years without calendarization. Watch for one-off gains, lease accounting changes, and tax-rate distortions. A rising gross margin with falling cash conversion may signal aggressive revenue recognition.