# Financial Statement Analysis

Business I · Accounting I · https://tryals.app/learn/business-i/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: $\text{Margin} \times \text{Turnover} \times \text{Leverage}$.

| Family | Question | Flagship |
| --- | --- | --- |
| Liquidity | Pay this year's bills? | Current ratio |
| Solvency | Survive debt load? | Debt-to-equity |
| Profit | Earn its keep? | ROE |

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

## Practice questions

7 of this lesson's 13 practice questions, with answers. The full set is in the app.

### 1. EBIT 450, interest expense 90. **Estimate the interest cover ratio.**

**Answer:** 5 (within ±0.3)

**Why:** $450 / 90 = 5.0$. The firm earns five times its interest bill, comfortably above the danger zone (below 1.5). Lenders sleep well.

Page: https://tryals.app/practice/business-i/financial-statement-analysis/ebit-450-interest-expense-90-estimate-the-interest-cover-ratio

### 2. Liquidity, solvency, or profitability ratio?

**Answer:**

- Liquidity: Quick ratio, Current ratio
- Solvency: Debt-to-equity, Interest cover
- Profitability: Return on equity, Return on assets

**Why:** Three families: can we pay today (liquidity), can we survive long-term (solvency), are we earning enough (profitability).

Page: https://tryals.app/practice/business-i/financial-statement-analysis/liquidity-solvency-or-profitability-ratio

### 3. Match each DuPont component to its formula.

**Answer:**

- Margin → Net profit / Revenue
- Turnover → Revenue / Assets
- Leverage multiplier → Assets / Equity
- ROE → Margin x Turnover x Leverage

**Why:** DuPont's genius: one number (ROE) breaks into three levers, each diagnosable independently.

Page: https://tryals.app/practice/business-i/financial-statement-analysis/match-each-dupont-component-to-its-formula

### 4. A firm's ROE rises from 12% to 20% while its ROA is unchanged. What has management actually done?

A. Improved operating efficiency, which raises returns to shareholders
B. Increased leverage: the DuPont multiplier rose
C. Increased profit margins on the same asset base
D. Reduced its asset base while holding profit constant

**Answer:** B. Increased leverage: the DuPont multiplier rose

**Why:** ROA unchanged rules out margin and turnover, so the multiplier is the only factor left, and leverage amplifies returns in both directions. The DuPont decomposition exists precisely to make this visible, since 'ROE improved' reads as performance and can be nothing but a bigger loan.

Page: https://tryals.app/practice/business-i/financial-statement-analysis/a-firms-roe-rises-from-12-to-20-while-its-roa-is-unchanged-what

### 5. A firm's ROE is 18% but its ROA is only 6%. The DuPont leverage multiplier must be:

A. 12, the difference between ROE and ROA
B. 3.0, heavy leverage
C. Impossible to determine
D. 0.33, the firm has very little debt

**Answer:** B. 3.0, heavy leverage

**Why:** $18\% / 6\% = 3.0$. The firm's assets earn 6 cents on the euro, but leverage triples it to 18 cents for owners, as long as the borrowed money costs less than 6%.

Page: https://tryals.app/practice/business-i/financial-statement-analysis/a-firms-roe-is-18-but-its-roa-is-only-6-the-dupont-leverage

### 6. Which benchmarks make a ratio meaningful?

A. The same firm over several years (trend analysis)
B. Competitors in the same industry
C. Covenant targets set by lenders
D. A random firm in an unrelated industry

**Answer:** A. The same firm over several years (trend analysis); B. Competitors in the same industry; C. Covenant targets set by lenders

**Why:** Ratios need context: time trends, peer comparison, or contractual thresholds. A random firm in an unrelated industry provides no useful benchmark.

Page: https://tryals.app/practice/business-i/financial-statement-analysis/which-benchmarks-make-a-ratio-meaningful

### 7. A firm reports rising profit and an interest cover falling toward 1. What does that combination indicate?

A. That the firm is close to insolvency regardless of the profit figure
B. That interest cover is unrelated to the ability to service debt
C. That the profit figure must be misstated, since the two cannot both be true
D. That debt-service obligations grow faster than operating profit

**Answer:** D. That debt-service obligations grow faster than operating profit

**Why:** Cover below 1 means operating profit no longer pays the interest. Profitable firms fail on liquidity and solvency all the time, which is why the ratios are read together rather than separately.

Page: https://tryals.app/practice/business-i/financial-statement-analysis/a-firm-reports-rising-profit-and-an-interest-cover-falling-toward-1