Two companies report identical net income. One trades at twice the price-to-book of the other. Ratio analysis tells you why, and tells you which one is sustainable.
describe tools and techniques used in financial analysis, including their uses and limitations calculate and interpret activity, liquidity, solvency, and profitability ratios describe relationships among ratios and evaluate a company using ratio analysis demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components describe the uses of industry-specific ratios used in financial analysis describe how ratio analysis and other techniques can be used to model and forecast earnings
Five tools dominate financial analysis. Ratio analysis scales line items against each other to standardize comparison. Common-size analysis expresses every income statement line as a percent of revenue (vertical) or every balance sheet line as a percent of total assets, then tracks percent change over time (horizontal). Cross-sectional analysis compares one company to peers at a single point in time. Trend analysis tracks one company across multiple periods.
Common mistakes
- Treating a higher current ratio as automatically better. A 3.0 current ratio may signal idle cash or obsolete inventory. Trap: ranking firms by current ratio alone.
- Mixing up turnover and days. Inventory turnover of 6 means DOH = 365/6 = 61 days, not 6 days. Trap: a question gives turnover and asks for days, or vice versa.
- Confusing DuPont 3-step components. The middle term is asset turnover, not asset growth. The right term is leverage (assets/equity), not debt-to-equity. Trap: substituting D/E for assets/equity.
Bottom line
- Four ratio families: activity (efficiency), liquidity (short-term coverage), solvency (long-term debt capacity), profitability (return generation)
- DuPont 3-step: ROE = Net Margin × Asset Turnover × Leverage. 5-step adds Tax Burden (NI/EBT) and Interest Burden (EBT/EBIT)
- Cash Conversion Cycle = DOH + DSO − DPO. Lower is better; a negative value means suppliers finance operations
- Liquidity ladder: quick ratio strips inventory, cash ratio strips receivables too (the most stringent test)
Exam shortcut
For DuPont memorization: "Margin × Turnover × Leverage" reads left to right as income statement, bridge, balance sheet. For ratio family identification: if it has "turnover" or "days" in the name, it is activity; if the denominator is current liabilities, it is liquidity; if it concerns total debt or equity, it is solvency; if it is a margin or return, it is profitability.
The full lesson (about 2,255 words, 15 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- financial analysis techniques
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