BU.210.620 Chap.4 Financial Statement Analysis and Ratios
Financial Statement Analysis and Ratios
Analysis starts with strategy
Module 4 treats statements as the end of a chain: business strategy shapes operating decisions, which create transactions, which the statements summarise. A product-differentiation strategy should show high margins; a cost-differentiation strategy should show thin margins and fast-turning assets.
Analysis is comparison, either time-series, following one company over years, or cross-sectional, comparing companies at one date.
Component percentages restate each income statement line as a share of net sales and each balance sheet line as a share of total assets, so companies of different sizes can be compared.
The ratio families
Profitability ratios relate income to what produced it: return on equity and return on assets on average balances, earnings per share, gross profit percentage, net profit margin and the quality-of-income ratio of operating cash flow to net income.
Efficiency ratios measure turnover: total and fixed asset turnover, receivable turnover on credit sales and inventory turnover on cost of goods sold, each convertible to days.
Liquidity ratios, current, quick and cash, test short-term obligations; solvency ratios, times interest earned, cash coverage and debt-to-equity on ending balances, test long-term ones.
Decomposing returns
The DuPont model writes return on assets as net profit margin times total asset turnover, and return on equity as those two times financial leverage.
The course's three-level breakdown moves from the headline returns, to their DuPont drivers, to specific expense percentages and turnover ratios.
Capacity constraints cap turnover, so margin becomes the lever; competitive constraints cap margin, so turnover becomes the lever.
Link to the team project
The final presentation asks for exactly this route over a chosen company's recent history, plus an account of how the firm financed its growth and a buy, hold or sell recommendation grounded in the evidence.
What this chapter covers
- 01
Strategy and the comparison frame
- 02
Component percentages
- 03
Profitability ratios
- 04
Turnover ratios and the cash conversion cycle
- 05
Liquidity and solvency ratios
- 06
DuPont and the three-level breakdown
Worked example · free
Locate why return on equity changed
- 2Old leverage: 15% = 5% × 2.0 × leverage, so leverage was 1.5.
- 2New leverage: 20% = 5% × 2.0 × leverage, so leverage is 2.0.
- 2Interpretation: returns on assets held at 10%; the higher ROE comes entirely from more debt financing.
Key terms
- Component percentages
- Component percentages express each income statement item as a percentage of net sales and each balance sheet item as a percentage of total assets.
- Quality of income
- Quality of income is operating cash flow divided by net income; a value above one means reported income is backed by cash.
- Cash conversion cycle
- The cash conversion cycle is days to sell inventory plus days to collect receivables minus days to pay suppliers.
- Financial leverage
- Financial leverage in the DuPont model is average total assets divided by average shareholders' equity.
- Sustainable growth
- Sustainable growth is the fastest growth a firm can fund without new equity or debt, measured as the plowback ratio times return on equity.
- Times interest earned
- Times interest earned divides net income plus interest expense plus income tax expense by interest expense, showing how many times profit before those items covers the interest bill.
Financial Statement Analysis and Ratios FAQ
Should ratios use average or ending balances?
Returns and turnover ratios in this course use the average of beginning and ending balances, since the income was earned over the whole year. Debt-to-equity and the liquidity ratios use ending balances. State your convention whenever you present a ratio.
Why does inventory turnover use cost of goods sold rather than sales?
Inventory is carried at cost, so dividing sales, which include the markup, by an inventory balance measured at cost would mix two measurement bases and overstate how quickly the goods actually move through the business.
Is a very high inventory turnover always good?
Usually a rising turnover is favourable, but an extremely high figure can mean stock-outs and lost sales, so compare it with the business model and with close competitors.
What does the cash conversion cycle tell an analyst?
It measures how many days a company's own cash is tied up between paying suppliers and collecting from customers. A shorter cycle frees cash, while a lengthening one can signal slower collections or piling-up stock.
Exam move
Pick one real company and one competitor, compute the full ratio set for two years on a single sheet, then write three sentences: what moved, which DuPont driver explains it, and which specific expense or turnover line explains that driver.
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