Financial Statement Analysis

Turning Numbers into Judgments

Financial statements are data; analysis turns them into decisions. The tool is ratios — relationships between statement items that reveal what raw numbers hide.

Liquidity ratios — can the firm pay its short-term bills?

$$\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}} \qquad \text{Quick ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$$

The current ratio includes inventory; the quick ratio strips it out because inventory might not sell quickly. A current ratio of 2 says: for every euro owed within a year, the firm has two in short-term assets. A quick ratio below 1 warns that without selling inventory, the firm can't cover its obligations.

Solvency ratios — can the firm survive long-term?

$$\text{Debt-to-equity} = \frac{\text{Total liabilities}}{\text{Total equity}} \qquad \text{Interest cover} = \frac{EBIT}{\text{Interest expense}}$$

Debt-to-equity measures leverage; interest cover measures whether operating profit can service the debt. An interest cover of 3 means the firm earns three times what it owes in interest — comfortable. Below 1.5, lenders start worrying.

Profitability ratios — is the firm earning enough?

$$ROE = \frac{\text{Net profit}}{\text{Equity}} \qquad ROA = \frac{\text{Net profit}}{\text{Total assets}} \qquad \text{Net margin} = \frac{\text{Net profit}}{\text{Revenue}}$$

ROE (return on equity) tells owners what their capital earned. ROA (return on assets) tells managers what the asset base produced. The gap between ROE and ROA is the leverage effect: if the firm borrows at a rate below ROA, the extra debt amplifies ROE — until it amplifies losses instead.

DuPont decomposition breaks ROE into three drivers:

$$ROE = \underbrace{\frac{\text{Net profit}}{\text{Revenue}}}_{\text{margin}} \times \underbrace{\frac{\text{Revenue}}{\text{Assets}}}_{\text{turnover}} \times \underbrace{\frac{\text{Assets}}{\text{Equity}}}_{\text{leverage}}$$

A firm can raise ROE by earning fatter margins, generating more sales per euro of assets, or using more debt. DuPont tells you which lever is doing the work — or which one is dragging.

No ratio means anything alone. Ratios need benchmarks: the same firm over time (trend analysis), competitors in the same industry (cross-sectional analysis), or targets set by management or lenders (covenant analysis). A current ratio of 1.2 is excellent for a supermarket and dangerous for a shipbuilder.

The ratio families

Tip: A ratio alone is a number; a ratio against a benchmark is a judgment. Always compare against the firm's own history and its industry peers — a current ratio of 1.1 is alarming for a manufacturer and routine for a supermarket.

Common pitfall: Applauding a high ROE without opening the DuPont decomposition. Leverage inflates ROE mechanically — a mediocre business with heavy debt can out-ROE an excellent one, right up until the interest bill arrives in a bad year.