Company Analysis and Financial Statement Interpretation
What is tested
Reading the three statements together, computing ratios correctly, and spotting accounting signals that change the earnings number you capitalise.
Statement linkage
- Profit and loss: revenue → EBITDA → EBIT → PBT → PAT → EPS.
- Balance sheet: assets = liabilities + equity; working capital ties the two statements together.
- Cash flow: CFO + CFI + CFF = net change in cash. CFO reconciles PAT for non-cash items and working-capital movement.
Ratio groups
- Liquidity: current ratio (CA/CL); quick ratio excludes inventory.
- Solvency: debt/equity; interest coverage (EBIT/interest).
- Efficiency: inventory days, receivable days, payable days, asset turnover.
- Profitability: gross, EBITDA and net margins; ROE (PAT/equity); ROCE (EBIT/capital employed).
- DuPont: ROE = net margin × asset turnover × equity multiplier.
Quality of earnings
Compare CFO with PAT over three to five years. Persistent CFO below PAT suggests receivables build-up or capitalised costs. Check auditor qualifications, related-party transactions, contingent liabilities, revenue-recognition changes, and dilution from options or convertibles (diluted EPS).
Worked example
Company A: net margin 8%, asset turnover 1.5x, equity multiplier 2.0x. ROE = 8% × 1.5 × 2.0 = 24%. Peer B: net margin 12%, turnover 1.5x, multiplier 1.0x, giving ROE = 18%. A's higher ROE comes entirely from leverage, not from operating performance. If A's interest coverage is 2.1x and B's is 9x, A's 24% is lower quality: a rate rise or demand dip compresses the margin, and leverage magnifies the fall. The analyst flags A as the higher-risk holding despite the headline ROE.
Traps
Using year-end equity where an average is appropriate for a fast-growing firm; comparing ratios across industries; ignoring dilution; equating PAT growth with cash generation; missing one-off gains that inflate margins.