Financial Statement and Security Analysis
Ratio families you must command
Questions test whether you can select the right ratio and interpret it. Group them: liquidity (current ratio, quick ratio, cash ratio); profitability (gross margin, net margin, ROA, ROE); leverage (debt-to-equity, gearing, interest cover); efficiency (inventory turnover, receivables collection period, asset turnover); and valuation (EPS, P/E, dividend yield, price-to-book, dividend cover).
Decomposing performance
Use the DuPont identity: ROE = net profit margin × asset turnover × equity multiplier. It tells you whether returns come from profitability, operating efficiency or leverage - a firm can lift ROE purely by borrowing, which raises risk without improving operations. For security analysis, link fundamentals to value: earnings quality (cash conversion, accruals, one-off items), growth sustainability, and the difference between intrinsic value and market price. A top-down approach starts with the economy and industry; bottom-up starts with the company.
Traps
The examiner's favourite errors are: mixing ROA (profit/assets) with ROE (profit/equity); using year-end balances when an average is intended; quoting dividend yield on par value instead of market price; ignoring dilution when convertible instruments or options exist; comparing P/E ratios across industries of different growth; and treating accounting profit as cash flow.
Worked example
Net profit 120, sales 1,200, total assets 800, equity 400. Net margin = 10%, asset turnover = 1.5, equity multiplier = 2. ROE = 10% × 1.5 × 2 = 30%. If the firm repaid debt so that assets fell to 600 with equity unchanged, the multiplier falls to 1.5 and ROE drops to 22.5% - proof that leverage was contributing one-third of the return.