25400 · Financial Literacy
Financial Statement Analysis
Week 7 reads and links the three financial statements — the income statement, balance sheet (Assets = Liabilities + Equity) and cash-flow statement — then removes size differences with ratio analysis across five families: profitability, liquidity, efficiency (asset management), solvency (leverage) and market value. You compute and interpret ratios such as net profit margin, ROA, ROE, current and quick ratios, total asset turnover and the debt ratio, understand the DuPont decomposition of ROE, and weigh the limitations of statement-based analysis. Ratios are prime Quiz 2 material and underpin the group financial model.
What this chapter covers
- 01The three linked statements: income statement, balance sheet (Assets = Liabilities + Equity), cash-flow statement
- 02Why ratios: they divide out firm size so different-sized firms are comparable (intra-company, inter-company, industry-average)
- 03Profitability: Net Profit Margin = NI/Sales; ROA = NI/Total Assets; ROE = NI/Equity
- 04Liquidity: Current Ratio = CA/CL; Quick Ratio = (CA − Inventory)/CL
- 05Efficiency: Total Asset Turnover = Sales/Total Assets; inventory and receivables turnover
- 06Solvency/leverage: Debt Ratio = Total Debt/Total Assets; Debt-to-Equity; Interest Coverage = EBIT/Interest
- 07Market value: EPS, P/E, market capitalisation
- 08DuPont: ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier; and the limitations of ratios
A five-ratio scan with a DuPont cross-check
- +1Net Profit Margin = Net Income / Sales = 64,000 / 800,000 = 8.0% — eight cents of profit per sales dollar.
- +1ROA = Net Income / Total Assets = 64,000 / 500,000 = 12.8%; ROE = Net Income / Shareholders' Equity = 64,000 / 200,000 = 32.0%. ROE exceeds ROA because the firm uses leverage.
- +1Current Ratio = Current Assets / Current Liabilities = 180,000 / 120,000 = 1.5 — $1.50 of current assets per $1 of current liabilities.
- +1Total Asset Turnover = Sales / Total Assets = 800,000 / 500,000 = 1.6× — each asset dollar generates $1.60 of sales.
- +1DuPont check: ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier = 0.08 × 1.6 × (500,000/200,000 = 2.5) = 0.08 × 1.6 × 2.5 = 0.32 = 32.0% ✓, matching the direct ROE.
Key terms
- Ratio analysis
- Expressing statement figures as ratios (percentages, multiples or time periods) so firms of different sizes and a firm across time can be compared. Analysis can be intra-company, inter-company or against an industry average.
- Profitability ratios
- Measures of earnings relative to sales, assets or equity: net profit margin (NI/Sales), return on assets (NI/Total Assets) and return on equity (NI/Equity).
- Liquidity ratios
- Measures of the ability to meet short-term obligations: the current ratio (Current Assets/Current Liabilities) and the stricter quick or acid-test ratio ((Current Assets − Inventory)/Current Liabilities).
- Efficiency (asset-management) ratios
- Measures of how well assets generate sales, led by total asset turnover (Sales/Total Assets); also inventory and receivables turnover. Higher generally means more efficient use of assets.
- Solvency (leverage) ratios
- Measures of long-term debt burden and the ability to service it: the debt ratio (Total Debt/Total Assets), debt-to-equity, and interest coverage (EBIT/Interest Expense).
- DuPont identity
- A decomposition of return on equity into three drivers: ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier. It reveals whether ROE is driven by profitability, asset efficiency or financial leverage.
Financial Statement Analysis FAQ
Why use ratios instead of the raw statement numbers?
Because size distorts direct comparison — a large firm will have bigger revenues and profits than a small rival regardless of performance. Ratios divide out size, leaving percentages, multiples and turnover figures that let you compare firms of different scale, a firm over time, or a firm against its industry.
What is the difference between the current ratio and the quick ratio?
Both measure short-term liquidity, but the quick (acid-test) ratio strips inventory out of current assets because inventory can be slow to convert to cash. A firm can have a comfortable current ratio yet a weak quick ratio if it holds a lot of stock, so the two together give a fuller liquidity picture.
What does the DuPont decomposition add?
It explains why ROE is high or low by splitting it into profitability (net profit margin), efficiency (total asset turnover) and leverage (equity multiplier). Two firms with the same ROE can get there very differently — one on fat margins, another on heavy leverage — and DuPont makes that visible.
What are the limitations of ratio analysis?
Statements are historical and can use different accounting policies, and are affected by seasonality and one-off items, so a ratio needs industry and time context to be meaningful. Ratios flag questions rather than answer them; always interpret them critically and alongside other information.
Assessment move
Learn the five ratio families as a checklist (profitability, liquidity, efficiency, solvency, market value) so you can classify any ratio a question throws at you, and memorise the numerator/denominator of the core members rather than a long list. Use DuPont both to cross-check ROE and to explain what drives it. Practise reading the three statements together — the links between them are examinable — and always pair a computed ratio with an interpretation and, where possible, a benchmark or trend. These ratios also feed the group financial model, so rehearse them in a spreadsheet. Ask Sia to build a fresh statement set and check your ratios and DuPont reconciliation.
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