Financial Analysis Techniques

Ratios turn three long financial statements into a handful of numbers that can be compared across years and companies, and they are the analyst's main screening and diagnostic tool. This module covers common-size analysis, activity, liquidity, solvency and profitability ratios, the DuPont decomposition of return on equity, and the valuation, industry-specific and segment measures used in equity and credit analysis, along with the limits of each.

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What you will learn

1. Describe the main tools of financial analysis, including ratios and common-size statements, and explain their uses and limitations.

Ratios remove size effects; they describe what happened, not why.
Vertical common-size: items as a percentage of revenue or total assets. Horizontal: changes relative to a base year.
Time-series compares a company with its past; cross-sectional compares it with peers.
Different accounting methods, diversification, seasonality, window dressing and inflation limit ratio comparisons.
Always check how a ratio is defined, especially when using third-party data.

2. Calculate and interpret activity and liquidity ratios, including the cash conversion cycle.

Turnover ratios divide flows by average balances; days = 365 / turnover.
Payables turnover uses purchases = cost of sales + change in inventory.
Cash conversion cycle = DOH + DSO - DPO; shorter is better for liquidity.
Quick ratio excludes inventory and prepaid items; cash ratio excludes receivables as well.
Interpret liquidity in the context of the business model and operating cycle.

3. Calculate and interpret solvency and profitability ratios.

Leverage: debt-to-assets, debt-to-capital, debt-to-equity, financial leverage (avg assets / avg equity), debt-to-EBITDA.
Coverage: EBIT / interest; fixed charge coverage adds lease payments to numerator and denominator.
Margins compare profit measures with revenue; ROA, operating ROA, return on total capital and ROE compare profit with investment.
Use average balance sheet figures for return ratios.
Negative equity makes debt-to-equity and ROE meaningless; rely on asset-based and coverage ratios.

4. Apply DuPont analysis to decompose return on equity and interpret how changes in its components affect ROE.

Three-step: ROE = net margin x asset turnover x financial leverage.
Five-step: tax burden x interest burden x EBIT margin x asset turnover x leverage.
More debt raises leverage but lowers the interest burden; the net effect depends on returns versus the cost of debt.
ROE driven by margins and turnover is higher quality than ROE driven by leverage.
Buybacks and accumulated losses shrink equity and can inflate ROE.

5. Describe valuation, industry-specific and segment ratios and explain how ratio analysis supports credit analysis, equity analysis and forecasting.

Valuation ratios: P/E, P/CF, P/S, P/B; per-share figures: EPS, BVPS, DPS.
Sustainable growth g = retention rate x ROE.
Industry ratios: bank capital and net interest margin, insurer combined ratio, retail same-store sales, airline load factor, hotel RevPAR.
Credit analysis relies on leverage, coverage and cash-flow-to-debt ratios.
Segment ratios reveal where value is created; sensitivity, scenario and simulation analysis quantify forecast uncertainty.

Module at a glance

Vertical common-size scales by revenue or total assets; horizontal analysis tracks change over time.
Days ratios = 365 / turnover; cash conversion cycle = DOH + DSO - DPO.
Quick ratio excludes inventory; cash ratio also excludes receivables.
Fixed charge coverage = (EBIT + lease payments) / (interest + lease payments).
DuPont: ROE = tax burden x interest burden x EBIT margin x asset turnover x leverage.
Sustainable growth = retention rate x ROE.
Adjust for accounting differences and use industry-specific ratios before comparing companies.

This free module has 5 lessons, 14 practice questions with full explanations.

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