Home
Part 2 · Section A

Financial Statement Analysis

Reading financial statements the way an analyst does: comparing periods and companies, computing and interpreting ratios, decomposing ROE, and adjusting for the accounting and economic issues that distort reported numbers. This section is 20% of Part 2.

Begin topic 1 Ratio analyzer

About 20 of the 100 multiple-choice questions. Estimated study time: 28 hours.

0%Section readiness
0 / 4Topics complete
—MCQ accuracy
28 hEstimated study time

Your learning path

Four topics. Topic 2 (ratios) is the core; the rest build on it.

0% of topics complete
Topic 1 of 4

Basic analytics

Comparing a company with itself over time (horizontal) and putting every line on a common scale (vertical).

Horizontal (trend) analysisChanges across periods
Horizontal analysis
$$\%\Delta = \frac{\text{Current} - \text{Base}}{\text{Base}}$$
Trend index
$$\text{Index}_t = \frac{\text{Amount}_t}{\text{Amount}_{\text{base year}}} \times 100$$
Exam trapA percentage change cannot be computed meaningfully when the base is zero or negative (e.g. a loss turning into a profit). Report the dollar change instead.
Vertical (common-size) analysisEvery line as a percentage of a base

Income-statement items are expressed as a percentage of sales; balance-sheet items as a percentage of total assets. Common-size statements allow comparison of companies of different size and reveal shifts in cost structure or asset mix.

Common-size
$$\text{Common-size \%} = \frac{\text{Line item}}{\text{Sales (IS) or total assets (BS)}}$$
Exam trapComparisons across companies are distorted by different accounting methods (FIFO vs LIFO, depreciation, leases), fiscal year ends and business mixes. Ratios are only as comparable as the underlying accounting.
Exam trapA common-size balance sheet uses total assets as the base, not sales. And a falling percentage can hide a rising dollar amount when the base grows faster.
Instructor noteUse three benchmarks together: the company's own trend, competitors or industry averages, and management's targets. A ratio in isolation tells you almost nothing.

Finished Basic analytics?

Mark it complete when you can prepare horizontal and common-size analyses and explain their limits.

Topic 2 of 4

Financial ratios

The five ratio families and how each answers one question: can the company pay, how risky is its financing, how efficient, how profitable, and how the market values it.

Data used in this topic ($000): Cash 120; receivables 380 (prior 340); inventory 500 (prior 460); prepaid 50; current assets 1,050; total assets 2,500 (prior 2,300); current liabilities 600 (payables 300, prior 280); long-term debt 700; equity 1,200 (prior 1,100). Sales (all on credit) 4,000; COGS 2,600; purchases 2,640; EBIT 500; interest 60; tax 25%; net income 330; 100 shares; price $39.60; dividends 132.

Liquidity and solvencyShort-term and long-term ability to pay
Liquidity
$$\text{Current} = \frac{CA}{CL} \qquad \text{Quick} = \frac{\text{Cash} + \text{MS} + AR}{CL}$$

Quick excludes inventory and prepaid expenses. Cash ratio = (cash + marketable securities) ÷ CL.

Solvency
$$\frac{D}{E} = \frac{\text{Total liabilities}}{\text{Equity}} \qquad TIE = \frac{EBIT}{\text{Interest}}$$

Debt ratio = total liabilities ÷ total assets. Fixed-charge coverage adds lease payments to EBIT and to interest.

Exam trapPaying a current liability with cash raises the current ratio when it is above 1 (e.g. 1,050/600 = 1.75 → 950/500 = 1.90) and lowers it when it is below 1. Both numerator and denominator fall by the same amount.
Activity ratios and the cash conversion cycleHow fast assets turn into cash
Turnover and days
$$\text{AR turnover} = \frac{\text{Credit sales}}{\text{Avg AR}} \qquad \text{Inv. turnover} = \frac{COGS}{\text{Avg inventory}}$$ $$\text{Days} = \frac{365}{\text{Turnover}}$$

AP turnover = purchases ÷ average payables. Use 360 days if the question says so.

Cash conversion cycle
$$CCC = DIO + DSO - DPO$$

Operating cycle = DIO + DSO. Total asset turnover = sales ÷ average total assets.

Exam trapInventory turnover uses cost of goods sold, not sales; receivables turnover uses credit sales. Using the wrong numerator is one of the commonest distractors.
Profitability and market ratiosReturns and how investors price them
Profitability
$$ROA = \frac{NI}{\text{Avg total assets}} \qquad ROE = \frac{NI}{\text{Avg equity}}$$

Gross, operating and net margins = gross profit, operating income and net income ÷ sales.

Market
$$EPS = \frac{NI - D_{pref}}{\text{Weighted shares}} \qquad P/E = \frac{\text{Price}}{EPS}$$

Dividend yield = DPS ÷ price; payout = DPS ÷ EPS; book value per share = common equity ÷ shares.

Exam trapWhen beginning and ending balances are given, turnover ratios use the average balance. Using only the ending balance distorts turnover whenever receivables, inventory or assets are growing or shrinking.
Instructor noteFor "effect of a transaction" questions, write the ratio as a fraction, change the numerator and denominator, and compare. Do not rely on intuition: the answer for a ratio above 1 is often the opposite of the answer below 1.

Finished Financial ratios?

Mark it complete when you can compute every ratio from a set of statements and predict how transactions move them.

Topic 3 of 4

Profitability analysis

Breaking ROE into its drivers, finding how fast a company can grow without new equity, and separating lasting income from one-offs.

DuPont analysisThree and five components of ROE
DuPont: three steps
$$ROE = \underbrace{\frac{NI}{S}}_{\text{margin}} \times \underbrace{\frac{S}{TA}}_{\text{turnover}} \times \underbrace{\frac{TA}{E}}_{\text{equity multiplier}}$$

ROA = margin × turnover. The equity multiplier measures financial leverage.

DuPont: five steps
$$ROE = \frac{NI}{EBT} \times \frac{EBT}{EBIT} \times \frac{EBIT}{S} \times \frac{S}{TA} \times \frac{TA}{E}$$

Tax burden × interest burden × operating (EBIT) margin × asset turnover × equity multiplier.

flowchart TD
  ROE[Return on equity] --> ROA[Return on assets]
  ROE --> EM[Equity multiplier: assets ÷ equity]
  ROA --> NPM[Net profit margin: NI ÷ sales]
  ROA --> TAT[Asset turnover: sales ÷ assets]
  NPM --> TB[Tax burden: NI ÷ EBT]
  NPM --> IB[Interest burden: EBT ÷ EBIT]
  NPM --> OM[Operating margin: EBIT ÷ sales]
Exam trapA rising ROE is not always good news: if it comes from a higher equity multiplier (more debt), risk has risen too. DuPont shows which lever moved.
Sustainable growthGrowth funded by retained earnings
Sustainable growth rate
$$g^{*} = ROE \times (1 - \text{payout ratio}) = ROE \times b$$

The growth the company can finance without issuing equity or changing its leverage, margin, turnover or payout.

Sources of incomeWhat will recur
  • Separate recurring operating income from gains on asset sales, restructuring charges, discontinued operations, litigation settlements and other one-offs.
  • Analyze revenue by segment, geography, product and customer to see where growth and margins come from (segment disclosures under ASC 280).
  • Decompose revenue growth into price, volume and mix; decompose margin changes into input costs, productivity and pricing.
  • Nonoperating income (interest, investment gains) and income from equity-method investees are less controllable and often less persistent.
Exam trapNet income boosted by a gain on the sale of a division is not sustainable. Valuation and trend analysis should use income from continuing operations, adjusted for unusual items.
Exam trapThe equity multiplier is total assets ÷ equity, not debt ÷ equity. It equals 1 + D/E: a debt-to-equity ratio of 1.08 means a multiplier of 2.08.
Instructor noteWhen a question asks which change "best explains" an ROE movement, compute each DuPont component for both years. Only one usually moves enough to matter.

Finished Profitability analysis?

Mark it complete when you can decompose ROE both ways and compute sustainable growth.

Topic 4 of 4

Special issues

Adjusting ratios for currency translation, inflation, items kept off the balance sheet, and accounting choices that flatter earnings.

Foreign-currency translationCurrent-rate vs temporal method
Translation methods
Method When Rates Gain or loss goes to
Current-rate (translation) Functional currency is the local currency Assets and liabilities at the current rate; income at the average rate; equity at historical Cumulative translation adjustment in OCI
Temporal (remeasurement) Functional currency is the parent's (e.g. the dollar) Monetary items at current; nonmonetary items (inventory, PP&E) at historical Net income
Translation adjustment (current-rate, simplified)
$$CTA = \text{Net assets}_{FC} \times (\text{Rate}_{new} - \text{Rate}_{old})$$
InflationHow rising prices distort historical-cost ratios
  • Historical-cost assets are understated, so ROA and asset turnover look better than in real terms; depreciation is too low, overstating income.
  • Under FIFO, old cheap costs flow into COGS: higher profits ("inventory profits") and higher taxes. LIFO matches current costs with revenue but understates inventory on the balance sheet.
  • Nominal growth includes inflation; compare real growth.
Real rate
$$r_{real} = \frac{1 + r_{nominal}}{1 + \text{inflation}} - 1$$
Exam trapDuring inflation, a FIFO company reports a higher current ratio and higher net income than an otherwise identical LIFO company, but its cash flow is lower because it pays more tax.
Off-balance-sheet items and accounting changesWhat the balance sheet may not show
  • Off-balance-sheet risks: guarantees of others' debt, take-or-pay and purchase commitments, receivables sold with recourse, unconsolidated joint ventures, short-term leases (ASC 842 now puts most leases on the balance sheet), contingent liabilities that are reasonably possible but not probable.
  • Analysts adjust debt ratios by adding such obligations back, using the footnotes.
  • Accounting changes: change in principle (e.g. inventory method) and change in reporting entity → retrospective; change in estimate (useful life, bad-debt rate) → prospective; correction of an error → restate prior periods (prior-period adjustment).
Exam trapA change in depreciation method is treated as a change in estimate (prospective) under US GAAP, even though it looks like a change in principle.
Quality of earningsAre profits backed by cash?
Cash backing of earnings
$$\frac{CFO}{NI}$$

Persistently below 1 suggests income is running ahead of cash.

Accrual ratio
$$\frac{NI - CFO}{\text{Avg total assets}}$$

Higher = more of earnings come from accruals, which tend to reverse.

  • Warning signs: receivables growing faster than sales (channel stuffing, aggressive revenue recognition), shrinking reserves releasing income ("cookie jar"), a large write-off clearing the decks ("big bath"), capitalizing costs that should be expensed, frequent "one-time" charges.
Exam trapUnder the current-rate method, translation gains and losses bypass net income and go to OCI; under the temporal method (remeasurement), they go straight into net income. Know which method applies before predicting the effect on earnings.
Instructor noteFor any special-issue question, ask which direction the issue pushes reported income and assets, and therefore which ratios look better or worse than economic reality.

Finished Special issues?

Mark it complete when you can explain how translation, inflation, off-balance-sheet items and accounting choices distort ratios.

Calculators

Interactive tools

Each tool is pre-filled with an example from the lessons. Change any input; the results show the method, your numbers and what they mean.

Ratio analyzer with DuPont tree

Enter a mini balance sheet (this year and last) and income statement. The analyzer computes every ratio family, the cash conversion cycle and both DuPont decompositions, and draws the DuPont tree with your numbers.

Statements ($000)

flowchart TD
  ROE[Return on equity] --> ROA[Return on assets]
  ROE --> EM[Equity multiplier]
Print-ready

Formula sheet

Every ratio and formula in Financial Statement Analysis on one sheet. Print it from here: the sidebar is hidden and the sheet prints black on white.

Spaced repetition

Flashcards

Recall first, then flip. Your grade schedules the next review (SM-2-lite).

Exam-style questions

Practice MCQs

Practice mode gives instant feedback; timed mode allows 1.8 minutes per question, like the exam. Filter by topic, difficulty, or questions you missed.

Essay section

Written-response practice

Write your answer first (aim for about 30 minutes per case), then compare it with the model answer and score yourself against the rubric. Show your calculations: the exam awards marks for method.

Key terms

Glossary

Search the section's vocabulary. Underlined terms in the lessons show these definitions on hover or keyboard focus.