Level I · Financial Statement Analysis

Learning Module 11
Financial Analysis Techniques

Key Outcomes Summary & Practice Problems

Learning Outcomes

What you must be able to do

Curriculum Year: 2026

LOS 1

Describe tools and techniques used in financial analysis, including their uses and limitations.

LOS 2

Calculate and interpret activity, liquidity, solvency, and profitability ratios.

LOS 3

Describe relationships among ratios and evaluate a company using ratio analysis.

LOS 4

Demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components.

LOS 5

Describe the uses of industry-specific ratios used in financial analysis.

LOS 6

Describe how ratio analysis and other techniques can be used to model and forecast earnings.

1 · The Financial Analysis Process

    • Purpose & context — clarify the objective, audience, and specific questions the analysis must answer.

    • Collect & process data — gather financial statements, industry data, and management commentary; compute common-size statements, ratios, and graphs.

    • Analyze & interpret — move beyond computations to answer why performance occurred and whether it created value.

    • Communicate & follow up — present conclusions with supporting evidence; periodically update as new information arrives.

    A well-reasoned analysis integrates data into a cohesive whole, addressing not just what happened but why it happened and whether it created value.

2 · Common-Size Analysis

    • Vertical common-size balance sheet — each item expressed as a percentage of total assets; highlights asset composition and financing mix.

    • Vertical common-size income statement — each item expressed as a percentage of revenue; reveals cost structure and profit drivers.

    • Horizontal common-size — each item expressed relative to a base year or prior period; highlights growth trends and structural changes.

    • Cross-sectional comparison — compare a company's ratios to peers or industry averages to assess relative performance.

3 · Activity (Efficiency) Ratios

INVENTORY

Inventory turnover = Cost of sales / Average inventory
DOH = 365 / Inventory turnover

RECEIVABLES

Receivables turnover = Revenue / Average receivables
DSO = 365 / Receivables turnover

PAYABLES

Payables turnover = Cost of sales / Average trade payables
Days payable = 365 / Payables turnover

ASSET TURNS

Working capital turnover = Revenue / Average working capital
Fixed asset turnover = Revenue / Average net fixed assets
Total asset turnover = Revenue / Average total assets

    • Higher turnover generally indicates greater efficiency, but must be interpreted in context (e.g., low DOH may signal inventory shortages).

    • Activity ratios combine income statement and balance sheet data; use averages for consistency.

4 · Liquidity Ratios

CURRENT

Current ratio = Current assets / Current liabilities

QUICK

Quick ratio = (Cash + Marketable securities + Receivables) / Current liabilities

CASH

Cash ratio = (Cash + Marketable securities) / Current liabilities

DEFENSIVE

Defensive interval ratio = (Cash + Marketable securities + Receivables) / Daily cash expenditures

CCC

Cash conversion cycle = DOH + DSO − Days payable

    • Liquidity ratios measure ability to meet short-term obligations; a shorter cash conversion cycle indicates greater liquidity.

    • The quick and cash ratios are more conservative than the current ratio because they exclude less liquid assets.

5 · Solvency Ratios

DEBT RATIOS

Debt-to-assets = Total debt / Total assets
Debt-to-capital = Total debt / (Total debt + Total equity)
Debt-to-equity = Total debt / Total equity
Financial leverage = Average total assets / Average total equity

COVERAGE

Interest coverage = EBIT / Interest payments
Fixed charge coverage = (EBIT + Lease payments) / (Interest payments + Lease payments)
Debt-to-EBITDA = Total debt / EBITDA

    • Higher debt ratios indicate greater financial risk and weaker solvency.

    • Coverage ratios measure the ability to service debt from operating earnings; higher is better.

6 · Profitability Ratios

RETURN ON SALES

Gross profit margin = Gross profit / Revenue
Operating profit margin = Operating income / Revenue
Net profit margin = Net income / Revenue

RETURN ON INVESTMENT

Operating ROA = Operating income / Average total assets
ROA = Net income / Average total assets
ROIC = EBIT(1−t) / Average (debt + equity)
ROE = Net income / Average total equity

    • Higher margins and returns indicate greater profitability.

    • ROE is influenced by profitability (net margin), efficiency (asset turnover), and leverage.

7 · DuPont Analysis — Decomposition of ROE

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ROE Net income / Avg equity = NET PROFIT MARGIN Net income / Revenue × ASSET TURNOVER Revenue / Avg assets × LEVERAGE Avg assets / Avg equity
3‑WAY DUPONT DECOMPOSITION
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ROE Net income / Avg equity = TAX BURDEN Net income / EBT × INTEREST BURDEN EBT / EBIT × EBIT MARGIN EBIT / Revenue × ASSET TURNOVER Revenue / Avg assets × LEVERAGE Avg assets / Avg equity
5‑WAY DUPONT DECOMPOSITION (BLOOMBERG STANDARD)

    • DuPont analysis reveals whether ROE changes are driven by profitability, efficiency, or leverage.

    • Tax burden = 1 − effective tax rate; interest burden reflects the impact of borrowing costs.

8 · Industry-Specific Ratios & Forecasting

    • Industry-specific ratios — e.g., same-store sales (retail), average daily rate / occupancy (hotels), ARPU (subscription businesses), capital adequacy (banks).

    • Forecasting — use common-size and ratio analysis as inputs; apply sensitivity analysis, scenario analysis, and simulation to capture uncertainty.

    • Ratios are indicators, not answers; they require interpretation in the context of strategy, peers, and economic conditions.