Financial Statement Analysis

Liquidity & Solvency Ratios

Financial statements are raw data; analysis turns them into decisions using ratios.

Liquidity ratios measure short-term bill-paying ability. The Current ratio is $\frac{\text{Current assets}}{\text{Current liabilities}}$, showing asset coverage per euro owed. The Quick ratio is $\frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$, stripping out inventory that might not sell fast.

Solvency ratios measure long-term survival. Debt-to-equity ($\frac{\text{Total liabilities}}{\text{Total equity}}$) measures leverage. Interest cover ($\frac{\text{EBIT}}{\text{Interest expense}}$) checks if operating profit services debt. Below 1.5, lenders worry.

Profitability & DuPont Analysis

Profitability ratios measure returns. ROE ($\frac{\text{Net profit}}{\text{Equity}}$) tells owners what capital earned. ROA ($\frac{\text{Net profit}}{\text{Total assets}}$) tells managers what assets produced. Net margin is $\frac{\text{Net profit}}{\text{Revenue}}$.

The leverage effect is the gap between ROE and ROA. DuPont decomposition splits ROE: $\text{Margin} \times \text{Turnover} \times \text{Leverage}$.

Pitfall: High ROE from heavy debt can mask a mediocre business until interest bills hit.