Financial Statement Analysis
What the domain tests
The financial statement analysis domain tests whether you can read the three statements as one integrated system, compute and interpret ratios, and spot accounting choices that distort comparability.
Core rules
- Balance sheet identity: Assets = Liabilities + Equity. The income statement links to retained earnings; the cash flow statement reconciles net income to cash.
- Accrual accounting recognizes revenue when earned and expenses when incurred, not when cash moves. CFO adjusts net income for non-cash items and working-capital changes.
- Ratio families: liquidity (current, quick), solvency (debt-to-equity, interest coverage), profitability (gross, operating, net margin), efficiency (inventory turnover, receivables days).
- DuPont: ROE = net margin × asset turnover × equity multiplier.
- Common-size statements divide income statement items by revenue and balance sheet items by total assets.
Worked example
A firm has net income 120, revenue 1,000, total assets 800, and equity 400. Net margin = 120/1,000 = 12%; asset turnover = 1,000/800 = 1.25; equity multiplier = 800/400 = 2.0. ROE = 12% × 1.25 × 2.0 = 30%. Check directly: 120/400 = 30%. If the analyst used only ending assets and ending equity, the ratio could be overstated when the firm grew during the year; average balances are preferred for flow-based ratios.
Traps
Using ending rather than average balances; treating operating leases as debt inconsistently; ignoring diluted shares; classifying non-recurring gains as operating; mixing book and market values.