Financial Statement Analysis
The four ratio families
Liquidity: current ratio = current assets ÷ current liabilities; quick ratio = (cash + marketable securities + receivables) ÷ current liabilities. Leverage: debt-to-equity; debt-to-tangible net worth (exclude goodwill and other intangibles). Profitability: gross margin, operating margin, net margin, return on assets. Efficiency: AR turnover = credit sales ÷ average AR; DSO = 365 ÷ AR turnover; inventory turnover = cost of goods sold ÷ average inventory.
Quality of earnings and cash flow
Ratios are only as good as the statements. Read the notes for accounting policies, related-party transactions, off-balance-sheet obligations, and contingencies. Compare accrual net income with operating cash flow; persistent gaps signal aggressive revenue recognition or weak collection. Use common-size and trend analysis (three to five years) rather than one year in isolation.
Worked example
A customer reports current assets of $900,000 (including $300,000 inventory and $400,000 receivables), current liabilities of $600,000, total debt of $750,000, and tangible net worth of $300,000. Current ratio = 900 ÷ 600 = 1.50. Quick ratio = (900 − 300) ÷ 600 = 1.00. Debt-to-tangible net worth = 750 ÷ 300 = 2.50. The current ratio looks acceptable, but the quick ratio shows reliance on inventory, and leverage is high. Before extending terms, check inventory turnover and whether the debt is subordinated.
Traps
Comparing ratios across industries without benchmarks; using year-end AR in a seasonal business; treating intangibles as tangible net worth; ignoring subordinated debt or guarantees; and reading net income without operating cash flow.