CFA Level 1 · Module 04 Financial Statement Analysis · Chapter 11
A set of financial statements is a pile of raw numbers. On its own a revenue figure of ten million or a debt balance of three million says almost nothing, because size, industry, and the passage of time all change what a number means. Financial analysis is the craft of turning those raw figures into comparisons that carry meaning, and its central tools are ratios, common-size statements, and a small number of graphical and statistical techniques. This reading is the toolkit chapter of the whole module: it does not introduce a new accounting rule so much as teach how to interrogate the numbers the earlier readings produced.
The plan is straightforward. First it lays out the tools themselves, ratio analysis and common-size analysis, and is honest about what they cannot do. Then it works through the four families of ratios in turn, activity, liquidity, solvency, and profitability, computing and interpreting each one on a single invented company so that the numbers connect. Next it shows how those families interlock, because no ratio is read alone. Then it builds the flagship technique of the reading, the DuPont decomposition of return on equity, in both its three-part and five-part forms. Finally it covers valuation and industry-specific ratios and shows how the whole toolkit feeds credit analysis, equity analysis, and forecasting. Every company and every number below is invented by MidhaFin to teach the mechanics; none is taken from the source curriculum or any prep provider. Concepts, definitions, and formulas are shared knowledge and are used freely.
Financial analysis works by comparison. A number in isolation carries no verdict; it acquires meaning only when it is set against something else, a prior period, a competitor, an industry norm, or a related figure in the same statements. The techniques in this reading are all devices for making those comparisons cleanly, and the two that matter most are ratio analysis and common-size analysis.
Ratio analysis expresses one figure as a multiple or fraction of another, so that scale drops out. Saying a company holds inventory worth 1,200,000 tells you little; saying it turns its inventory over five times a year tells you how fast product moves regardless of whether the firm is large or small. A ratio converts an absolute amount into a rate, a margin, or a coverage that can be compared across companies and across time.
Common-size analysis restates a whole statement in percentage terms. In vertical common-size analysis, every line of the income statement is divided by revenue, and every line of the balance sheet is divided by total assets, so the statement becomes a set of proportions. This exposes structure: what share of every sales rupee is eaten by cost of goods sold, or what fraction of the asset base is tied up in inventory. In horizontal common-size analysis, also called trend analysis, each line is indexed to its value in a base year, set to 100, so the reader sees how each item has grown or shrunk over several years relative to a common starting point.
where each income-statement line is expressed as a percentage of revenue. For the balance sheet, the base is total assets instead of revenue. Vertical analysis reveals the internal structure of a single statement.
where the base year is set to 100 and every later year is shown relative to it. A trend index of 160 means the item is 60% larger than in the base year. Horizontal analysis reveals the direction and speed of change over time.
Setup. Cobalt Devices, an invented company, reports revenue of 8,000,000, cost of goods sold of 4,800,000, and selling, general, and administrative expense of 1,600,000 in the current year. Its revenue over the four years ending this year was 5,000,000, 6,000,000, 6,500,000, and 8,000,000. Build the vertical common-size income statement down to operating income, and build the revenue trend index against the first year as base.
Answer: the vertical statement shows cost of goods sold at 60.0% of revenue and an operating margin of 20.0%, and the revenue trend runs 100, 120, 130, 160. So what do these numbers mean? The vertical view says that of every sales rupee, sixty paise become cost of product and twenty paise survive as operating profit, a structure that can be compared directly with a much larger or smaller rival. The trend view says revenue is 60% above its starting level after three years of growth, with the largest jump in the final year. One technique reads the anatomy of a single year, the other reads the motion across years, and an analyst wants both.
| Line | Amount | % of revenue |
|---|---|---|
| Revenue | 8,000,000 | 100.0% |
| Cost of goods sold | 4,800,000 | 60.0% |
| Gross profit | 3,200,000 | 40.0% |
| SG&A | 1,600,000 | 20.0% |
| Operating income | 1,600,000 | 20.0% |
Two supporting techniques round out the toolkit. Graphs turn a table of ratios into a picture, and they are most useful for showing a trend over time or the relative size of components, such as a stacked bar of the asset mix or a line of margins across several years; the eye catches a turning point in a chart that a column of numbers can hide. Regression analysis goes further and quantifies a statistical relationship, for example estimating how a company’s sales move with a driver such as gross domestic product or a commodity price. Regression is the bridge from description to forecasting, because a fitted relationship can be projected forward, but it assumes the past relationship holds in the future, which is exactly what a structural change in the business would break.
Every one of these tools is a comparison device, and that is also the source of their limitations. A ratio, a common-size line, or a regression coefficient is only as informative as the benchmark it is judged against, and there are four traps worth naming explicitly.
Do not read a ratio as a verdict on its own. Four limitations bite constantly. First, no single ratio is sufficient; a high current ratio can hide slow-moving inventory, so ratios must be read in groups. Second, ratios need a benchmark; a net margin of 12% is neither good nor bad until it is set against the company’s history, a peer, or the industry. Third, accounting-method differences distort comparisons; a firm on FIFO and a firm on the weighted-average method, or firms with different depreciation policies, are not strictly comparable without adjustment. Fourth, seasonality can mislead any ratio built from a single balance-sheet date; a retailer measured the day after its peak season looks nothing like the same retailer measured mid-year, which is why turnover ratios often use an average of the beginning and ending balance rather than the year-end figure alone.
Throughout this reading the flow ratios (turnover, margins, returns) put an income-statement figure over a balance-sheet figure. The income statement covers a whole period while the balance sheet is a single instant, so the theoretically correct denominator is the average of the beginning and ending balance. In the worked examples that follow we use year-end balances to keep the arithmetic clean, but in practice, and especially where a balance grew sharply or the business is seasonal, use the average. This one habit removes a large share of spurious ratio movements.
Activity ratios, also called efficiency or asset-utilization ratios, measure how well a company turns its assets into sales and cash. Each pairs a flow from the income statement with the related balance-sheet stock, and most come in two equivalent forms: a turnover, which counts how many times the stock cycled during the year, and a days measure, which converts that turnover into an average number of days. The two are linked by the length of the year.
and Days of inventory on hand (DOH) = 365 ÷ Inventory turnover. Turnover counts how many times inventory was sold and replaced; DOH is the average number of days a unit sits in stock before it is sold.
and Days sales outstanding (DSO) = 365 ÷ Receivables turnover. DSO is the average number of days between making a sale on credit and collecting the cash.
and Number of days of payables = 365 ÷ Payables turnover. Where purchases are not disclosed, cost of goods sold is used as a practical proxy. Days of payables is the average number of days the company takes to pay its suppliers.
the cash conversion cycle (also called the net operating cycle) is the number of days between paying cash for inventory and collecting cash from customers. A shorter cycle ties up less cash in working capital.
with Fixed asset turnover = Revenue ÷ Average net fixed assets, and Working capital turnover = Revenue ÷ Average working capital, where working capital is current assets minus current liabilities. Each measures the sales generated per unit of the asset base named.
The company used for the rest of this reading is Marigold Manufacturing, an invented firm whose figures are designed so that the ratios connect cleanly. Its income statement shows revenue of 10,000,000, cost of goods sold of 6,000,000, operating expenses of 2,000,000 (including depreciation of 500,000), interest expense of 400,000, tax at 25%, and net income of 1,200,000. Its balance sheet is set out in Exhibit 3 later; the activity figures it needs are inventory of 1,200,000, receivables of 1,000,000, and accounts payable of 750,000, with net fixed assets of 4,500,000 and total assets of 8,000,000.
Setup. Using Marigold Manufacturing, compute inventory turnover and DOH, receivables turnover and DSO, payables turnover and days of payables, the cash conversion cycle, and the total, fixed, and working capital turnover ratios. Current assets are 3,000,000 and current liabilities are 1,500,000.
Answer: inventory turns 5.0 times (73.0 days), receivables turn 10.0 times (36.5 days), payables turn 8.0 times (45.6 days), and the cash conversion cycle is 63.9 days; total, fixed, and working capital turnover are 1.25, 2.22, and 6.67 times. So what do these numbers mean? Marigold ties up cash in a product for about 73 days and waits another 36 or so to collect from customers, but it holds off paying suppliers for about 46 days, so its own cash is committed for roughly 64 days per operating cycle. That 64-day gap is the working capital it must finance out of its own pocket; shortening it, by moving inventory faster, collecting sooner, or paying later, would free cash without any change in sales.
| Ratio | Formula | Value |
|---|---|---|
| Inventory turnover | COGS ÷ inventory | 5.0× |
| Days of inventory on hand | 365 ÷ inventory turnover | 73.0 |
| Receivables turnover | Revenue ÷ receivables | 10.0× |
| Days sales outstanding | 365 ÷ receivables turnover | 36.5 |
| Payables turnover | COGS ÷ payables | 8.0× |
| Days of payables | 365 ÷ payables turnover | 45.6 |
| Cash conversion cycle | DOH + DSO − days of payables | 63.9 |
| Total asset turnover | Revenue ÷ total assets | 1.25× |
| Fixed asset turnover | Revenue ÷ net fixed assets | 2.22× |
| Working capital turnover | Revenue ÷ working capital | 6.67× |
A turnover ratio and its days ratio are the same fact stated two ways, so never read them as independent. High inventory turnover and low days of inventory on hand are the identical signal of fast-moving stock; low turnover and high days are the identical signal of slow stock. The direction of virtue depends on the ratio: for inventory and receivables, faster (higher turnover, fewer days) is usually better, but pushing days of payables too high can strain supplier relationships, and stretching collection too tight can cost sales. Efficiency ratios reward balance, not extremes.
Liquidity ratios ask a narrower question than solvency: can the company meet its short-term obligations as they fall due? They compare current assets, or progressively stricter subsets of them, with current liabilities. The three main ratios differ only in how demanding they are about what counts as a liquid asset, tightening the numerator at each step.
the broadest liquidity measure, counting all current assets including inventory. A ratio above 1.0 means current assets exceed current liabilities.
also called the acid-test ratio. It excludes inventory and prepaid items, which are the least liquid current assets, leaving only assets that can be converted to cash quickly.
the strictest measure, counting only cash and near-cash. It shows the fraction of current liabilities that could be paid immediately from cash on hand.
where daily cash operating expenditures is the cash operating costs for the year divided by 365. The result is expressed in days: how long the company could pay its cash operating costs from its liquid assets alone, with no new revenue.
Setup. For Marigold Manufacturing, current assets of 3,000,000 comprise cash of 500,000, marketable securities of 300,000, receivables of 1,000,000, and inventory of 1,200,000; current liabilities are 1,500,000. Its cash operating costs for the year are cost of goods sold of 6,000,000 plus cash operating expenses of 1,500,000 (operating expenses of 2,000,000 less non-cash depreciation of 500,000). Compute the current, quick, and cash ratios and the defensive interval.
Answer: the current ratio is 2.0, the quick ratio is 1.2, the cash ratio is 0.53, and the defensive interval is 87.6 days. So what do these numbers mean? Marigold holds two rupees of current assets for every rupee of current liabilities, and even after stripping out inventory it still has 1.2 rupees of quick assets per rupee of short-term debt, which is comfortable. The gap between the current ratio of 2.0 and the quick ratio of 1.2 is entirely the inventory sitting in current assets, so a reader who trusted only the current ratio would overstate how fast Marigold could pay. The defensive interval says that if sales stopped tomorrow, its liquid assets could fund about 88 days of cash operating costs.
The three liquidity ratios are a set of concentric filters, not competitors. Read them together and the gap between them is itself the message: a wide gap between the current ratio and the quick ratio means a lot of the liquidity is locked in inventory, and a wide gap between the quick and cash ratios means much of it sits in receivables that still have to be collected. A company can post a healthy current ratio and still be short of cash if its inventory is slow, which is exactly why liquidity analysis links back to the activity ratios and the cash conversion cycle: the faster the operating cycle, the less the company depends on a large liquidity cushion.
Solvency ratios take the long view of the same balance sheet: they measure the extent to which the company is financed with debt and whether its earnings can service that debt. They split into two groups. Debt ratios size the leverage on the balance sheet, and coverage ratios test the income statement’s ability to meet the fixed financing charges. Throughout, total debt means interest-bearing debt, short-term plus long-term.
both express leverage as a proportion. Debt-to-assets is the share of assets financed by debt; debt-to-capital is the share of the total capital structure that is debt.
debt-to-equity compares debt directly with the equity cushion beneath it. The financial leverage ratio (the equity multiplier) shows how many rupees of assets are carried on each rupee of equity, and it is the leverage term in DuPont analysis.
coverage ratios count how many times earnings cover the fixed charges. Interest coverage uses interest alone; fixed charge coverage adds lease payments to both the numerator and the denominator to capture lease-financed firms. Higher is safer.
Setup. Marigold Manufacturing has total assets of 8,000,000, total equity of 4,000,000, short-term debt of 500,000, and long-term debt of 2,500,000. Its EBIT (operating income) is 2,000,000 and its interest expense is 400,000, and it makes annual lease payments of 200,000. Compute the debt-to-assets, debt-to-capital, and debt-to-equity ratios, the financial leverage ratio, interest coverage, and fixed charge coverage.
Answer: debt-to-assets is 37.5%, debt-to-capital is 42.9%, debt-to-equity is 0.75, financial leverage is 2.0, interest coverage is 5.0 times, and fixed charge coverage is 3.67 times. So what do these numbers mean? A little over a third of Marigold’s assets are financed with debt, and it carries 75 paise of debt for every rupee of equity, a moderate structure. On the earnings side, operating profit covers the interest bill five times over, so a large fall in profit would be needed before interest could not be paid; once leases are folded in, coverage is a thinner but still safe 3.67 times. The debt ratios say how heavy the load is; the coverage ratios say whether the engine is strong enough to carry it.
Watch the denominators, because they are the usual trap. Debt-to-assets divides by total assets; debt-to-capital divides by debt plus equity; debt-to-equity divides by equity alone. The three use the same numerator (total debt) but different bases, so they give different numbers for the same company, and a question will often give you one and ask for another. For coverage, remember that fixed charge coverage adds lease payments to both the top and the bottom, so it is not simply interest coverage with a bigger numerator. When a problem is silent on whether debt means interest-bearing debt or total liabilities, state your assumption; the CFA convention for these solvency ratios is interest-bearing debt.
Profitability ratios measure the reward the business earns. They come in two kinds. Margin ratios read profit at each stage of the income statement as a percentage of revenue, peeling the statement from the top down. Return ratios measure profit against the capital that produced it, whether that capital is total assets, total invested capital, or shareholders’ equity.
gross margin is what survives after the direct cost of the product; operating margin is what survives after all operating costs but before interest and tax. A widening gap between them points to rising overhead relative to gross profit.
pretax margin adds the effect of financing (interest) to the operating margin; net profit margin adds the effect of tax as well, giving the bottom-line profit per rupee of sales.
return on assets measures profit generated per rupee of assets. The net-income version is after financing and tax; the operating version uses EBIT to judge the assets independently of how they are financed.
return on total capital measures the operating return on all invested capital, debt and equity together. Return on equity measures the return earned for the shareholders alone, after debt has been served.
Setup. Marigold Manufacturing reports revenue of 10,000,000, gross profit of 4,000,000, operating income (EBIT) of 2,000,000, pretax income (EBT) of 1,600,000, and net income of 1,200,000. Total assets are 8,000,000, total invested capital (debt plus equity) is 7,000,000, and total equity is 4,000,000. Compute the four margins and the four return measures.
Answer: the gross, operating, pretax, and net margins are 40.0%, 20.0%, 16.0%, and 12.0%; ROA is 15.0%, operating ROA is 25.0%, return on total capital is 28.6%, and ROE is 30.0%. So what do these numbers mean? Reading the margins down the statement traces where profit is lost: 40 paise of gross profit per rupee of sales fall to 20 paise after operating costs, to 16 paise after interest, and to 12 paise after tax. On the return side, the assets earn 15% for shareholders after everything, but 25% before financing and tax, and the equity holders earn 30% because leverage lifts the asset return onto a smaller equity base. The fact that ROE of 30% sits well above ROA of 15% is the fingerprint of leverage, and that is precisely what DuPont analysis is built to disentangle.
Read the margins as a staircase and each step names a cause. Gross margin is set by pricing power and input costs. The drop from gross to operating margin is the weight of overhead and other operating costs. The drop from operating to pretax margin is the cost of debt (interest). The drop from pretax to net margin is tax. When a company’s net margin falls, do not stop at the bottom line: walk up the staircase to find which step widened, because a squeeze in gross margin (a competitive market) is a very different problem from a rise in interest (a financing choice) or a higher tax rate (often one-off).
No ratio is read alone, because the four families describe one business from four angles and they constrain each other. A firm that turns its assets quickly (strong activity) can earn a high return on assets even on a thin margin, because the asset base works harder. A firm that runs a short cash conversion cycle (strong activity) needs less liquidity, because its own cash is committed for fewer days. A firm that leans heavily on debt (high leverage in the solvency ratios) can magnify a modest return on assets into a large return on equity, but the same leverage makes its coverage ratios thinner and its earnings more fragile. Activity feeds profitability, profitability and leverage feed the return on equity, and the cash conversion cycle ties activity to liquidity.
The practical consequence is that an analyst evaluates a company with a combination of ratios and asks whether the story they tell is consistent. Exhibit 3 collects Marigold’s full ratio set on one page so the linkages are visible: the moderate leverage that lifts a 15% ROA to a 30% ROE, the comfortable liquidity that its fast operating cycle allows, and the healthy coverage that its moderate debt permits.
| Family | Ratio | Value |
|---|---|---|
| Activity | Total asset turnover | 1.25× |
| Activity | Cash conversion cycle | 63.9 days |
| Liquidity | Current ratio | 2.0 |
| Liquidity | Quick ratio | 1.2 |
| Solvency | Debt-to-equity | 0.75 |
| Solvency | Interest coverage | 5.0× |
| Profitability | Net profit margin | 12.0% |
| Profitability | Return on assets | 15.0% |
| Profitability | Return on equity | 30.0% |
The single number that pulls the most threads together is return on equity, because it is simultaneously a profitability ratio (it is a return) and the product of margin, activity, and leverage. That is why the reading treats its decomposition as a topic in its own right.
DuPont analysis breaks return on equity into the drivers that produce it, so that two companies with the same ROE can be told apart, and so that a change in ROE can be traced to its cause. It comes in two forms. The three-part decomposition splits ROE into a profitability driver, an efficiency driver, and a leverage driver. The five-part decomposition splits the profitability driver further, isolating the effects of tax and interest.
that is, ROE = (Net income ÷ Revenue) × (Revenue ÷ Average total assets) × (Average total assets ÷ Average total equity). Revenue and assets cancel, leaving Net income ÷ Average total equity, which is ROE. The three terms are profitability, efficiency, and leverage.
Setup. Using Marigold Manufacturing (net income 1,200,000, revenue 10,000,000, average total assets 8,000,000, average total equity 4,000,000), perform the three-part DuPont decomposition and confirm it equals ROE computed directly.
Answer: the three-part DuPont gives 0.12 × 1.25 × 2.0 = 30.0%, exactly the ROE of 1,200,000 ÷ 4,000,000. So what does this number mean? Marigold’s 30% return to shareholders is built from a 12% margin, assets that turn 1.25 times, and leverage of 2.0. None of the three is extreme, and the product is a strong ROE, which tells the analyst the return is broadly based rather than resting on a single aggressive lever. If the ROE were the same but leverage were doing most of the work, the quality of that ROE would be lower and its risk higher.
To isolate the effects of financing and tax, split the net profit margin into three of its own parts. Net income divided by revenue equals (net income ÷ EBT) times (EBT ÷ EBIT) times (EBIT ÷ revenue). The first factor is the tax burden (the fraction of pretax profit kept after tax), the second is the interest burden (the fraction of operating profit left after interest), and the third is the EBIT margin (operating profitability before financing and tax).
where Tax burden = Net income ÷ EBT, Interest burden = EBT ÷ EBIT, and EBIT margin = EBIT ÷ Revenue. The first three factors multiply to the net profit margin, so the five-part form is the three-part form with the margin expanded.
Setup. For Marigold Manufacturing (net income 1,200,000, EBT 1,600,000, EBIT 2,000,000, revenue 10,000,000, average total assets 8,000,000, average total equity 4,000,000), perform the five-part DuPont decomposition, confirm it equals the same 30.0% ROE, and then show what happens to ROE if the EBIT margin falls so that the net profit margin drops from 12% to 9% with all else unchanged.
Answer: the five-part DuPont gives 0.75 × 0.80 × 0.20 × 1.25 × 2.0 = 30.0%, the same ROE as the three-part form, and a fall in the net margin from 12% to 9% cuts ROE from 30.0% to 22.5%. So what do these numbers mean? Both decompositions must land on the identical ROE, and they do; the five-part form simply reveals that Marigold keeps 75% of pretax profit after tax and 80% of operating profit after interest. The margin experiment shows the leverage of the structure: because ROE is a product, a one-quarter cut in the margin (from 12% to 9%) produces a one-quarter cut in ROE (from 30.0% to 22.5%), all else equal. That is how DuPont pinpoints a cause, if ROE had fallen this way in reality, the tax burden, interest burden, turnover, and leverage would all be unchanged, so the analyst would know the damage was in operating profitability, not in financing or efficiency.
The real payoff of DuPont is that companies with the same ROE can be built very differently, and the decomposition exposes the difference. Exhibit 4 shows three invented firms that all earn a 30% ROE through completely different combinations of margin, turnover, and leverage.
| Company | Net margin | Asset turnover | Leverage | ROE |
|---|---|---|---|---|
| Marigold (balanced) | 12% | 1.25× | 2.0 | 30% |
| Thistle (thin margin, high leverage) | 6% | 1.25× | 4.0 | 30% |
| Amberline (fat margin, slow assets) | 20% | 0.75× | 2.0 | 30% |
All three earn 30%, but they are not equally attractive. Thistle reaches it by piling on leverage of 4.0, so its ROE is fragile: a downturn that dents the margin lands on a highly geared balance sheet with thin coverage. Amberline earns a fat 20% margin but works its assets slowly, a profile typical of a premium, capital-heavy business. Marigold sits in between. An investor who looked only at the headline 30% would miss all of this; the decomposition is what turns one number into a diagnosis.
Two habits score marks. First, always confirm that your DuPont product equals ROE computed directly as net income over equity; if they disagree, you have mixed up a factor (usually inverting leverage or asset turnover). Second, know that the three-part and five-part forms are the same identity, because tax burden times interest burden times EBIT margin equals the net profit margin. A common item gives you four of the five factors and one starting ROE and asks you to solve for the missing factor, so be ready to divide, not just multiply. Remember the direction of each lever: higher margin, higher turnover, and higher leverage all raise ROE, but higher leverage also raises risk and lowers the interest burden factor as interest grows.
Beyond the four families sit two more groups an analyst uses constantly. Industry-specific ratios capture the economics that generic ratios miss: a retailer is judged on revenue or profit per store and on same-store (comparable-store) sales growth, which strips out the effect of simply opening new outlets; a subscription business is judged on revenue per subscriber and on churn; an airline on revenue per available seat. These are not in the standard toolkit because they only make sense inside one industry, but within that industry they are often more revealing than any balance-sheet ratio.
Valuation ratios connect the financial statements to the market price. The most common are the price-to-earnings ratio (price per share divided by earnings per share), the price-to-book ratio (price per share divided by book value per share), and the per-share measures that feed them, earnings per share and book value per share. These ratios are where financial analysis meets equity valuation: they translate the profit and equity figures the statements report into the multiples at which the market prices them.
where Book value per share = Total equity ÷ Shares outstanding. The price-to-earnings ratio prices a rupee of earnings; the price-to-book ratio prices a rupee of net assets.
Setup. Zephyr Retail, an invented chain, operates 200 stores and reports total revenue of 1,000,000,000. Of its stores, 180 were open for both this year and last; those comparable stores generated 945,000,000 this year against 900,000,000 last year. The company reports net income of 150,000,000 on 50,000,000 shares, with total equity of 1,000,000,000, and its shares trade at 60.00. Compute revenue per store, same-store sales growth, EPS, book value per share, the price-to-earnings ratio, and the price-to-book ratio.
Answer: revenue per store is 5,000,000, same-store sales grew 5.0%, EPS is 3.00, book value per share is 20.00, the P/E is 20.0 times, and the P/B is 3.0 times. So what do these numbers mean? The same-store figure is the important one: total revenue could rise simply by opening stores, but 5.0% growth from stores open in both years shows the existing base is genuinely growing, not just the store count. The P/E of 20 says the market pays twenty rupees for each rupee of current earnings, and the P/B of 3 says it pays three times the accounting net worth, both signals that investors expect future growth, consistent with the positive same-store trend.
These techniques do not sit in a vacuum; they feed three concrete analytical tasks. In credit analysis, a lender leans on the solvency and coverage ratios and the cash conversion cycle to judge whether a borrower can service and repay debt, so interest coverage, debt-to-equity, and the stability of operating margins carry the most weight. In equity analysis, an investor combines profitability and the DuPont decomposition with the valuation ratios to judge both the quality of returns and the price being paid for them, asking not just whether ROE is high but whether it is durable and fairly valued. In forecasting, the analyst projects the future statements by holding or trending the common-size relationships and turnover ratios: if cost of goods sold has run near 60% of revenue and receivables near 36 days, those relationships, adjusted for expected change, become the assumptions that drive a forecast of next year’s earnings and cash flows.
Ratios are diagnostic, not prescriptive, so let them raise questions rather than deliver verdicts. A falling inventory turnover is not a conclusion; it is a prompt to ask whether demand has softened, whether the firm overstocked, or whether it changed its inventory accounting. The most valuable use of the whole toolkit is to build a consistent story: strong margins, efficient asset use, prudent leverage, and adequate liquidity should reinforce one another, and where one ratio contradicts the others (a high current ratio beside a slow cash conversion cycle, say) that tension is exactly where the real analysis begins.
A company has cost of goods sold of 9,000,000 and average inventory of 1,500,000. What are its inventory turnover and days of inventory on hand?
Inventory turnover = 9,000,000 ÷ 1,500,000 = 6.0 times. Days of inventory on hand = 365 ÷ 6.0 = 60.8 days. The company sells and replaces its entire inventory six times a year, holding a typical unit for about 61 days before it is sold.
A firm has days of inventory on hand of 50, days sales outstanding of 40, and days of payables of 30. What is its cash conversion cycle, and what would happen to it if the firm negotiated 45 days to pay suppliers?
Cash conversion cycle = DOH + DSO − days of payables = 50 + 40 − 30 = 60 days. If days of payables rose to 45, the cycle would fall to 50 + 40 − 45 = 45 days. Paying suppliers later means the firm finances its operating cycle with the suppliers’ money for longer, so less of its own cash is tied up, and the cash conversion cycle shortens.
Current assets are 2,400,000, of which inventory is 900,000, and current liabilities are 1,200,000. What are the current and quick ratios?
Current ratio = 2,400,000 ÷ 1,200,000 = 2.0. The quick ratio removes inventory from the numerator: (2,400,000 − 900,000) ÷ 1,200,000 = 1,500,000 ÷ 1,200,000 = 1.25. The gap between 2.0 and 1.25 is the inventory sitting in current assets, and it shows how much of the apparent liquidity depends on selling that stock.
A company has EBIT of 1,800,000 and interest expense of 300,000. What is its interest coverage, and roughly how far could EBIT fall before coverage dropped to 1.0?
Interest coverage = 1,800,000 ÷ 300,000 = 6.0 times. Coverage falls to 1.0 when EBIT equals interest of 300,000, so EBIT could fall by 1,500,000, or about 83% of its current level, before operating profit merely equalled the interest bill. A coverage of 6.0 therefore signals a wide safety margin on the interest obligation.
Revenue is 5,000,000, net income is 400,000, average total assets are 4,000,000, and average total equity is 2,000,000. Use the three-part DuPont to find ROE.
Net profit margin = 400,000 ÷ 5,000,000 = 0.08. Total asset turnover = 5,000,000 ÷ 4,000,000 = 1.25. Financial leverage = 4,000,000 ÷ 2,000,000 = 2.0. ROE = 0.08 × 1.25 × 2.0 = 0.20, or 20.0%. Check: net income ÷ equity = 400,000 ÷ 2,000,000 = 20.0%, which matches.
A company has a tax burden of 0.70, an interest burden of 0.90, an EBIT margin of 0.15, asset turnover of 1.6, and financial leverage of 2.5. What is its ROE, and what is its net profit margin?
ROE = 0.70 × 0.90 × 0.15 × 1.6 × 2.5. Working left to right: 0.70 × 0.90 = 0.63; 0.63 × 0.15 = 0.0945; 0.0945 × 1.6 = 0.1512; 0.1512 × 2.5 = 0.378, or 37.8%. The net profit margin is the first three factors: 0.70 × 0.90 × 0.15 = 0.0945, or 9.45%.
Two firms both report an ROE of 24%. Firm A has a net margin of 8%, asset turnover of 1.5, and leverage of 2.0; Firm B has a net margin of 4%, asset turnover of 1.5, and leverage of 4.0. Which ROE is riskier?
Both check out: A is 0.08 × 1.5 × 2.0 = 0.24, and B is 0.04 × 1.5 × 4.0 = 0.24. Firm B’s ROE is riskier because it is driven by leverage of 4.0 rather than profitability; the same 24% rests on a thin 4% margin and twice the gearing, so a fall in operating results would hit B’s shareholders far harder and its coverage ratios are thinner. DuPont shows that an identical ROE can carry very different risk.
A company reports net income of 200,000,000 on 40,000,000 shares, with total equity of 800,000,000, and its shares trade at 75.00. Compute EPS, book value per share, P/E, and P/B.
EPS = 200,000,000 ÷ 40,000,000 = 5.00. Book value per share = 800,000,000 ÷ 40,000,000 = 20.00. P/E = 75.00 ÷ 5.00 = 15.0 times. P/B = 75.00 ÷ 20.00 = 3.75 times. The market pays fifteen times current earnings and 3.75 times book value, a pricing that embeds an expectation of future growth above what the current book equity alone would justify.
Vertical common-size analysis restates every line of a single statement as a percentage of a base within that same period: each income-statement line is divided by revenue, and each balance-sheet line is divided by total assets. It reveals the internal structure of one year, such as what share of revenue is consumed by cost of goods sold. Horizontal common-size analysis, also called trend analysis, indexes each line to its value in a base year set to 100 and tracks it across several years, so a value of 130 means the item is 30% larger than in the base year. Vertical analysis reads the anatomy of a single statement; horizontal analysis reads the motion across time. Analysts use both together.
Four limitations matter most. First, no single ratio is sufficient on its own; ratios must be read in groups, because a strong current ratio can hide slow inventory. Second, ratios need a benchmark: a number like a 12% margin is meaningless until compared with the company’s own history, a peer, or the industry. Third, differences in accounting methods distort cross-company comparisons; firms using different inventory or depreciation methods are not strictly comparable without adjustment. Fourth, seasonality can mislead any ratio built from a single balance-sheet date, which is why turnover ratios often use the average of the beginning and ending balances rather than the year-end figure alone. Ratios are diagnostic prompts, not verdicts.
The cash conversion cycle equals days of inventory on hand plus days sales outstanding minus the number of days of payables. Days of inventory on hand is 365 divided by inventory turnover (cost of goods sold over average inventory); days sales outstanding is 365 divided by receivables turnover (revenue over average receivables); and days of payables is 365 divided by payables turnover (purchases or cost of goods sold over average payables). The cycle measures the number of days between paying cash for inventory and collecting cash from customers. It matters because it is the working capital the firm must finance itself: a shorter cycle frees cash and reduces the need for a large liquidity cushion, while a lengthening cycle silently absorbs cash even when sales look healthy.
The three are concentric filters that tighten the definition of a liquid asset. The current ratio divides all current assets by current liabilities and is the broadest measure. The quick ratio, or acid-test, removes inventory and prepaid items from the numerator, leaving cash, short-term marketable securities, and receivables, because those are the assets that convert to cash quickly. The cash ratio is strictest of all, counting only cash and short-term marketable securities. Reading them together is informative: a wide gap between the current and quick ratios means much of the liquidity is tied up in inventory, and a wide gap between the quick and cash ratios means much of it depends on collecting receivables.
The three-part DuPont writes ROE as net profit margin times total asset turnover times financial leverage, that is, (net income over revenue) times (revenue over average total assets) times (average total assets over average total equity). Revenue cancels between the first two terms and total assets cancels between the last two, leaving net income over average total equity, which is ROE by definition. The three factors isolate the drivers of the return: profitability (how much profit per rupee of sales), efficiency (how much sales per rupee of assets), and leverage (how many rupees of assets per rupee of equity). Because ROE is a product of the three, a change in any one flows straight through to ROE, which lets an analyst pinpoint the cause of a rise or fall.
The five-part form expands the net profit margin of the three-part decomposition into three factors of its own: tax burden (net income over pretax income), interest burden (pretax income over EBIT), and EBIT margin (EBIT over revenue). The full expression is ROE equals tax burden times interest burden times EBIT margin times total asset turnover times financial leverage. Because tax burden times interest burden times EBIT margin equals the net profit margin, the five-part form must give the same ROE as the three-part form; it simply separates the effects of tax and financing from pure operating profitability. This is useful when a change in ROE could come from a higher tax rate, more expensive debt, or a genuine operating change, because the five-part form tells the three apart.
Because ROE is the product of margin, asset turnover, and leverage, the same ROE can be assembled from very different combinations. One firm might reach a 30% ROE with a healthy margin and modest leverage, while another reaches the same 30% with a thin margin and heavy borrowing, and a third with a fat margin but slowly turning assets. They are not equally attractive: the highly leveraged ROE is more fragile because a downturn lands on a geared balance sheet with thin coverage, while the fat-margin, slow-asset profile is typical of a premium, capital-intensive business. An analyst who reads only the headline ROE misses this entirely, which is exactly why the DuPont decomposition exists.
In credit analysis, a lender leans on solvency and coverage ratios (interest coverage, debt-to-equity) and the cash conversion cycle to judge whether a borrower can service and repay its debt, so the stability of operating margins and the size of the coverage cushion carry the most weight. In equity analysis, an investor combines profitability and the DuPont decomposition with valuation ratios such as P/E and P/B to judge both the quality and durability of returns and the price paid for them. In forecasting, the analyst projects future statements by holding or trending the common-size relationships and turnover ratios, so that assumptions like cost of goods sold near 60% of revenue or receivables near 36 days become the drivers of a forecast of earnings and cash flows.
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