What financial statement analysis is for
Financial statement analysis for an MBA assignment answers a decision question: should we lend to this company, invest in it, buy from it or change how it is run? The ratios are tools for that decision, not the answer in themselves.
Graders reward interpretation. A table of 20 ratios with no explanation earns less than eight ratios that each lead to a clear conclusion about profitability, liquidity, efficiency or risk.
| Statement | What it shows | Key question |
|---|---|---|
| Income statement | Revenue, costs and profit over a period | Is the business profitable, and why? |
| Balance sheet | What the firm owns and owes, plus the owners' stake, on a single date | How is the business financed, and can it meet obligations? |
| Cash flow statement | Cash in and out from operations, investing and financing | Does profit turn into cash? |
The figures we will analyze
All figures are for a hypothetical manufacturer, in millions of dollars, for the current year (Year 2) with the prior year (Year 1) where needed.
| Income statement, Year 2 | $m |
|---|---|
| Revenue | 800 |
| Cost of goods sold | 480 |
| Gross profit | 320 |
| Selling, general and administrative | 200 |
| Depreciation | 30 |
| Operating profit (EBIT) | 90 |
| Interest expense | 10 |
| Profit before tax | 80 |
| Tax at 25 percent | 20 |
| Net income | 60 |
| Balance sheet | Year 2 | Year 1 |
|---|---|---|
| Cash | 40 | |
| Accounts receivable | 100 | 75 |
| Inventory | 120 | 90 |
| Total current assets | 260 | |
| Property, plant and equipment (net) | 340 | |
| Total assets | 600 | |
| Accounts payable | 80 | 75 |
| Short-term debt | 40 | |
| Total current liabilities | 120 | |
| Long-term debt | 160 | |
| Shareholders' equity | 320 | |
| Total liabilities and equity | 600 |
Check that the balance sheet balances before you start: 120 + 160 + 320 = 600. Year 1 revenue was $720 million.
Common-size and trend analysis
Common-size analysis expresses each line as a percentage of a base, revenue for the income statement and total assets for the balance sheet. It makes firms of different sizes comparable and shows the cost structure at a glance.
| Line | $m | Percent of revenue |
|---|---|---|
| Cost of goods sold | 480 | 60.0 percent |
| Gross profit | 320 | 40.0 percent |
| SG&A | 200 | 25.0 percent |
| Depreciation | 30 | 3.75 percent |
| Operating profit | 90 | 11.25 percent |
| Net income | 60 | 7.5 percent |
The balance sheet tells a similar story when each line is shown as a share of total assets of $600 million: receivables 100 / 600 = 16.7 percent, inventory 120 / 600 = 20.0 percent and net property, plant and equipment 340 / 600 = 56.7 percent. On the funding side, total debt is 200 / 600 = 33.3 percent and equity 320 / 600 = 53.3 percent, with payables making up the remaining 13.3 percent. This is a capital-intensive business funded mainly by equity.
Trend analysis compares growth rates across lines. Revenue grew (800 - 720) / 720 = 11.1 percent. Receivables grew (100 - 75) / 75 = 33.3 percent and inventory grew (120 - 90) / 90 = 33.3 percent. When working capital grows three times faster than sales, ask why: looser credit terms, slow-moving stock or weaker collection.
Ratio analysis, worked and interpreted
| Ratio | Formula | Calculation | Result |
|---|---|---|---|
| Gross margin | Gross profit / revenue | 320 / 800 | 40.0 percent |
| Operating margin | EBIT / revenue | 90 / 800 | 11.25 percent |
| Return on assets | Net income / total assets | 60 / 600 | 10.0 percent |
| Return on equity | Net income / equity | 60 / 320 | 18.75 percent |
| Current ratio | Current assets / current liabilities | 260 / 120 | 2.17 |
| Quick ratio | (Current assets - inventory) / current liabilities | 140 / 120 | 1.17 |
| Debt to equity | (Short-term + long-term debt) / equity | 200 / 320 | 0.63 |
| Interest coverage | EBIT / interest | 90 / 10 | 9.0 times |
| Asset turnover | Revenue / total assets | 800 / 600 | 1.33 times |
Read them as a story. Profitability is healthy and leverage is moderate, with interest covered nine times. Liquidity looks comfortable on the current ratio, but the quick ratio of 1.17 shows how much of that comfort depends on inventory. Many ratios here use year-end balances; if your course uses averages, say so and be consistent.
Working capital and the cash conversion cycle
Days ratios (using a 365-day year)
Daily revenue = 800 / 365 = 2.192. Days sales outstanding = 100 / 2.192 = 45.6 days.
Daily cost of goods sold = 480 / 365 = 1.315. Days inventory outstanding = 120 / 1.315 = 91.3 days.
Days payables outstanding = 80 / 1.315 = 60.8 days.
Cash conversion cycle = 45.6 + 91.3 - 60.8 = about 76 days.
The company finances roughly 76 days of operations from its own funds. Inventory is the largest part. Cutting it to 70 days would release (91.3 - 70) x 1.315 = about $28 million of cash, which links the analysis directly to an action management could take.
Want your ratio analysis calculated and interpreted correctly?
Order your financial statement analysisDuPont analysis: what drives return on equity
DuPont analysis splits return on equity into three parts, so you can see whether it comes from margins, asset efficiency or borrowing.
Three-step DuPont
Net profit margin = 60 / 800 = 7.5 percent.
Asset turnover = 800 / 600 = 1.333.
Equity multiplier = total assets / equity = 600 / 320 = 1.875.
ROE = 0.075 x 1.333 x 1.875 = 18.75 percent, matching the direct calculation of 60 / 320.
The matching result is your check that the components are right. Now compare with a peer: if a competitor earns the same ROE with an equity multiplier of 2.8, its return depends far more on debt, which carries more risk. Two firms with identical ROE can have very different quality of returns.
Cash flow quality: does profit become cash?
Operating cash flow, indirect method
Net income 60, plus depreciation 30, less increase in receivables 25, less increase in inventory 30, plus increase in payables 5.
Operating cash flow = 60 + 30 - 25 - 30 + 5 = $40 million.
Operating cash flow to net income = 40 / 60 = 0.67.
With capital expenditure of $50 million, free cash flow = 40 - 50 = -$10 million.
This is the most important finding in the whole analysis. The company reports $60 million of profit but generates only $40 million of operating cash, and after investment it consumed cash. The cause is the build-up in receivables and inventory spotted in the trend analysis. A lender would want to know whether that build-up is temporary.
Other warning signs to look for
Revenue growing much faster than cash collections, repeated "one-off" charges, changes in accounting policies or estimates, large related-party transactions and an auditor change. None proves a problem; each is a reason to look closer.
Common mistakes in financial statement analysis
| Mistake | Why it matters | Better approach |
|---|---|---|
| Reporting ratios with no comparison | A current ratio of 2.17 means little alone | Compare with prior years and peers |
| Mixing periods | Using a full-year profit with a mid-year balance distorts results | Match periods; use averages where appropriate |
| Ignoring the cash flow statement | Profit can hide cash problems | Check operating cash flow against net income |
| Treating every change as bad | Inventory may rise ahead of a planned launch | Look for the business reason in the case |
| Copying formulas from different sources | Definitions vary (for example, debt with or without leases) | Define each ratio once and apply it consistently |
| Rounding too early | Small errors compound across ratios | Round only the final figure |
Check your arithmetic with a second route wherever one exists, as with the DuPont identity above. If two methods disagree, find the error before you interpret anything.
Writing up the analysis
Structure the report around conclusions, not ratio categories. Each paragraph should make a claim, give the evidence and spell out its consequence for the lender, investor or manager named in your brief.
- Start with the answer For example: profitable and moderately leveraged, but cash generation is weak because working capital is growing.
- Benchmark everything Against the prior year and at least one peer or an industry source you cite.
- Show formulas once In a table or appendix, then use the results in the text.
- Explain causes Link ratios to business events in the case: a new product line, price cuts, a customer loss.
- End with implications What a lender, investor or manager should do or watch.
If the assignment goes on to value the company, these ratios feed the forecasts; our valuation and DCF guide picks up from here. For cost behavior and internal decisions, see the managerial accounting guide.
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