Corporate Finance Fundamentals
Module 2: Financial Statement Analysis
Module Overview
Welcome to Module 2! Now that you understand the foundations of corporate finance, it's time to develop a critical skill: reading and analyzing financial statements. Think of financial statements as the language that companies use to tell their story. Learning to read them fluently will give you insights that most people miss.
Learning Objectives:
By the end of this module, you will be able to:
- Read and interpret balance sheets, income statements, and cash flow statements in detail
- Calculate key financial ratios across different categories
- Assess a company's liquidity, profitability, leverage, and efficiency
- Compare companies within the same industry
- Identify warning signs and strengths in financial statements
- Understand the limitations of financial statement analysis
Estimated Time: 5-6 hours
2.1 Deep Dive: The Balance Sheet
Understanding the Balance Sheet
The balance sheet is a snapshot of what a company owns (assets), what it owes (liabilities), and what belongs to the owners (equity) at a specific moment in time.
The Fundamental Equation:
ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY
This equation must always balance—hence the name "balance sheet."
Think of it like your personal financial situation:
- Assets: Your house, car, savings, investments
- Liabilities: Your mortgage, car loan, credit card debt
- Equity: What's left over—your net worth
Assets: What the Company Owns
Assets are listed in order of liquidity (how quickly they can be converted to cash).
Current Assets (Converted to cash within one year)
1. Cash and Cash Equivalents
- Physical cash
- Bank accounts
- Short-term investments (less than 3 months)
- Why it matters: The most liquid asset; shows ability to meet immediate obligations
2. Marketable Securities
- Stocks and bonds that can be sold quickly
- Short-term investments (3-12 months)
- Why it matters: Near-cash that can be liquidated if needed
3. Accounts Receivable
- Money owed by customers for goods/services already delivered
- "We delivered, they haven't paid yet"
- Often shown "net of allowances" (accounting for likely non-payments)
- Why it matters: Indicates how much cash should be coming in soon
4. Inventory
- Raw materials
- Work-in-process
- Finished goods ready for sale
- Why it matters: Must be sold to generate cash; excess inventory can be a warning sign
5. Prepaid Expenses
- Insurance paid in advance
- Rent paid for future months
- Why it matters: Already paid for, but not yet "used up"
6. Other Current Assets
- Any other assets convertible to cash within a year
Non-Current Assets (Long-term assets)
1. Property, Plant & Equipment (PP&E)
- Land
- Buildings
- Machinery
- Equipment
- Shown at historical cost minus accumulated depreciation
- Why it matters: Represents productive capacity; depreciation affects income
2. Intangible Assets
- Patents
- Trademarks
- Copyrights
- Brand value (when acquired)
- Goodwill (excess paid in acquisitions)
- Why it matters: Can be very valuable but harder to value objectively
3. Long-term Investments
- Stocks or bonds held for more than one year
- Investments in other companies
- Why it matters: Shows strategic investments and diversification
4. Other Long-term Assets
- Deferred tax assets
- Long-term receivables
- Any other assets not convertible within one year
Liabilities: What the Company Owes
Liabilities are also ordered by when they must be paid.
Current Liabilities (Due within one year)
1. Accounts Payable
- Money owed to suppliers
- "They delivered, we haven't paid yet"
- Why it matters: Shows short-term obligations to vendors
2. Short-term Debt
- Loans due within one year
- Current portion of long-term debt
- Lines of credit
- Why it matters: Must be repaid soon; puts pressure on cash flow
3. Accrued Expenses
- Wages owed to employees
- Utilities used but not yet billed
- Interest accumulated but not yet paid
- Why it matters: Obligations already incurred
4. Unearned Revenue (Deferred Revenue)
- Customer payments received for goods/services not yet delivered
- "They paid, we haven't delivered yet"
- Why it matters: A liability until the company delivers
5. Other Current Liabilities
- Taxes payable
- Any other obligations due within one year
Non-Current Liabilities (Long-term obligations)
1. Long-term Debt
- Bonds payable
- Long-term bank loans
- Mortgages
- Why it matters: Shows long-term financial obligations; interest affects profitability
2. Deferred Tax Liabilities
- Taxes owed in the future due to timing differences
- Why it matters: Future cash outflow
3. Pension Obligations
- Retirement benefits promised to employees
- Why it matters: Can be very large for older companies
4. Other Long-term Liabilities
- Long-term lease obligations
- Environmental cleanup obligations
- Legal settlements
Shareholders' Equity: What Belongs to Owners
Also called "stockholders' equity" or "owners' equity."
Components:
1. Common Stock (at par value)
- Nominal value of shares issued
- Usually a very small number
- Why it matters: Shows the base capital contributed
2. Additional Paid-in Capital
- Amount paid above par value when stock was issued
- The "premium" investors paid
- Why it matters: Shows total capital raised from stock sales
3. Retained Earnings
- Cumulative profits kept in the business (not paid as dividends)
- Can be negative (accumulated losses)
- Why it matters: Shows how much value the company has created and retained
4. Treasury Stock
- Company's own stock that it has repurchased
- Shown as a negative (reduces equity)
- Why it matters: Shows capital returned to shareholders
5. Other Comprehensive Income
- Unrealized gains/losses on certain investments
- Foreign currency translation adjustments
- Why it matters: Items that affect equity but don't go through income statement
Key Insight: Equity is the residual claim—what's left after paying all liabilities. If assets decline or liabilities increase, equity takes the hit first.
Example Balance Sheet
Let's look at a realistic example:
TechStart Corporation
Balance Sheet as of December 31, 2024
ASSETS
Current Assets:
Cash and Cash Equivalents $ 450,000
Marketable Securities 200,000
Accounts Receivable (net) 850,000
Inventory 600,000
Prepaid Expenses 50,000
----------------------------------------
Total Current Assets 2,150,000
Non-Current Assets:
Property, Plant & Equipment 3,500,000
Less: Accumulated Depreciation (1,200,000)
Net PP&E 2,300,000
Intangible Assets 500,000
Long-term Investments 300,000
----------------------------------------
Total Non-Current Assets 3,100,000
TOTAL ASSETS $ 5,250,000
LIABILITIES
Current Liabilities:
Accounts Payable $ 400,000
Short-term Debt 250,000
Accrued Expenses 200,000
Unearned Revenue 150,000
----------------------------------------
Total Current Liabilities 1,000,000
Non-Current Liabilities:
Long-term Debt 1,500,000
Deferred Tax Liabilities 200,000
----------------------------------------
Total Non-Current Liabilities 1,700,000
TOTAL LIABILITIES 2,700,000
SHAREHOLDERS' EQUITY
Common Stock (par value) 5,000
Additional Paid-in Capital 1,500,000
Retained Earnings 1,045,000
----------------------------------------
Total Shareholders' Equity 2,550,000
TOTAL LIABILITIES + EQUITY $ 5,250,000
Key Observations:
- Total assets ($5.25M) equals liabilities + equity ($2.7M + $2.55M)
- Company has healthy cash position ($450K)
- Debt is split between short-term ($250K) and long-term ($1.5M)
- Retained earnings are positive, showing cumulative profitability
- Current assets ($2.15M) exceed current liabilities ($1M)—good liquidity
2.2 Deep Dive: The Income Statement
Understanding the Income Statement
The income statement (also called profit & loss statement or P&L) shows a company's revenues, expenses, and profit over a period of time (quarter or year).
The Basic Flow:
REVENUE
- Cost of Goods Sold
= GROSS PROFIT
- Operating Expenses
= OPERATING INCOME
- Interest and Taxes
= NET INCOME
Revenue (The Top Line)
What it represents: Money earned from customers for goods or services
Types of Revenue:
- Product sales
- Service fees
- Licensing income
- Subscription revenue
- Interest income (for financial companies)
Revenue Recognition: Companies can only record revenue when:
- The product/service has been delivered
- Payment is reasonably assured
Why it matters: Revenue growth indicates market demand and business expansion
Cost of Goods Sold (COGS)
What it represents: Direct costs of producing goods or delivering services
Includes:
- Raw materials
- Direct labor
- Manufacturing overhead
- Shipping costs (sometimes)
Does NOT include:
- Sales and marketing
- Administrative costs
- Research and development
Why it matters: Shows the direct cost of each dollar of revenue
Gross Profit
Gross Profit = Revenue - Cost of Goods Sold
Gross Profit Margin = (Gross Profit / Revenue) × 100%
Why it matters:
- Shows profitability before overhead costs
- Higher gross margin = more cushion for other expenses
- Varies widely by industry
Examples:
- Software companies: 70-90% (low COGS)
- Grocery stores: 20-30% (low margins, high volume)
- Manufacturing: 30-50% (moderate margins)
Operating Expenses
What it represents: Costs of running the business (not directly tied to production)
Categories:
1. Selling, General & Administrative (SG&A)
- Sales force salaries and commissions
- Marketing and advertising
- Executive salaries
- Office rent
- Legal and accounting fees
- Administrative staff
- Why it matters: Shows the cost of business infrastructure
2. Research & Development (R&D)
- Product development
- Innovation and engineering
- Testing and prototyping
- Why it matters: Investment in future products; high for tech companies
3. Depreciation & Amortization
- Depreciation: Allocating cost of physical assets over time
- Amortization: Allocating cost of intangible assets over time
- Why it matters: Non-cash expense that reduces taxable income
Operating Income (EBIT)
Operating Income = Gross Profit - Operating Expenses
Also called: Earnings Before Interest and Taxes (EBIT)
Why it matters:
- Shows profitability from core operations
- Excludes financing decisions and tax effects
- Good for comparing companies with different capital structures
Interest Expense and Taxes
Interest Expense:
- Cost of borrowing money
- Why it matters: Higher debt = higher interest costs; reduces profit
Taxes:
- Federal, state, and local income taxes
- Usually shown as a rate (effective tax rate)
- Why it matters: Reduces profit available to shareholders
Net Income (The Bottom Line)
Net Income = Operating Income - Interest - Taxes
Also called: Earnings, profit, or "the bottom line"
Why it matters:
- What's left for shareholders after all expenses
- Used to calculate earnings per share (EPS)
- Retained earnings increase by this amount (minus dividends)
Can be divided into:
- Dividends (paid to shareholders)
- Retained earnings (reinvested in business)
Earnings Per Share (EPS)
EPS = Net Income / Number of Shares Outstanding
Why it matters:
- Shows profit per share
- Key metric for investors
- Used in P/E ratio (Price/Earnings)
Example Income Statement
TechStart Corporation
Income Statement for Year Ended December 31, 2024
Revenue $ 5,000,000
Cost of Goods Sold 2,000,000
-----------
Gross Profit 3,000,000
Gross Profit Margin: 60%
Operating Expenses:
Selling, General & Administrative 1,200,000
Research & Development 500,000
Depreciation & Amortization 300,000
-----------
Total Operating Expenses 2,000,000
Operating Income (EBIT) 1,000,000
Operating Margin: 20%
Interest Expense (100,000)
-----------
Income Before Tax 900,000
Income Tax (30%) (270,000)
-----------
NET INCOME $ 630,000
Shares Outstanding: 100,000
Earnings Per Share (EPS): $6.30
Key Observations:
- Healthy 60% gross margin
- Operating margin of 20% (good for many industries)
- Debt creates $100K interest expense
- Effective tax rate of 30%
- Company earned $6.30 per share
2.3 Deep Dive: The Cash Flow Statement
Why Cash Flow Matters
Critical Truth: Profit ≠ Cash
A company can be:
- Profitable but cash-poor: Growing fast, collecting slowly, inventory building up
- Unprofitable but cash-rich: Collecting cash upfront, delaying payments
Many bankruptcies happen not from lack of profit, but from running out of cash.
The Three Sections
The cash flow statement has three sections, each showing where cash came from or went to:
1. Operating Activities (Cash from the Business)
What it shows: Cash generated (or used) by running the core business
Starting Point: Net Income (from income statement)
Adjustments:
Add back non-cash expenses:
- Depreciation & Amortization (expense on income statement, but no cash paid)
- Stock-based compensation
Adjust for changes in working capital:
If Current Assets Increase: Uses cash (you have more tied up)
- Accounts Receivable ↑ = Cash ↓ (you've sold but haven't collected)
- Inventory ↑ = Cash ↓ (you've bought more inventory)
If Current Assets Decrease: Generates cash
- Accounts Receivable ↓ = Cash ↑ (collected from customers)
- Inventory ↓ = Cash ↑ (sold off inventory)
If Current Liabilities Increase: Generates cash
- Accounts Payable ↑ = Cash ↑ (delayed payment to suppliers)
If Current Liabilities Decrease: Uses cash
- Accounts Payable ↓ = Cash ↓ (paid suppliers)
Why it matters: This is the cash the business naturally generates. Positive and growing = healthy. Negative = trouble.
2. Investing Activities (Cash from Assets)
What it shows: Cash spent on (or received from) long-term assets
Typical Items:
Cash Outflows (Uses):
- Purchase of property, plant & equipment (capital expenditures/"capex")
- Acquisitions of other companies
- Purchase of long-term investments
Cash Inflows (Sources):
- Sale of equipment or property
- Sale of investments
- Sale of business units
Why it matters:
- Usually negative for growing companies (they're investing)
- Compare capital expenditures to depreciation
- Heavy investing = betting on future growth
3. Financing Activities (Cash from Investors/Creditors)
What it shows: Cash from borrowing, repaying debt, issuing stock, or paying dividends
Typical Items:
Cash Inflows (Sources):
- Borrowing money (new loans or bonds)
- Issuing new stock
Cash Outflows (Uses):
- Repaying debt
- Paying dividends
- Buying back stock (treasury stock)
Why it matters:
- Shows how the company funds itself
- Positive = raising capital; Negative = returning capital to investors
- High debt issuance might indicate growth or problems
The Bottom Line
Change in Cash = Operating CF + Investing CF + Financing CF
This should equal the change in cash on the balance sheet between periods.
Example Cash Flow Statement
TechStart Corporation
Cash Flow Statement for Year Ended December 31, 2024
OPERATING ACTIVITIES
Net Income $ 630,000
Adjustments:
Depreciation & Amortization 300,000
Changes in Working Capital:
(Increase) in Accounts Receivable (150,000)
(Increase) in Inventory (100,000)
Increase in Accounts Payable 80,000
Increase in Accrued Expenses 40,000
-----------
Cash from Operating Activities 800,000
INVESTING ACTIVITIES
Purchase of Equipment (400,000)
Purchase of Investments (50,000)
-----------
Cash from Investing Activities (450,000)
FINANCING ACTIVITIES
Proceeds from Long-term Debt 200,000
Repayment of Short-term Debt (100,000)
Dividends Paid (200,000)
-----------
Cash from Financing Activities (100,000)
NET CHANGE IN CASH 250,000
Cash at Beginning of Year 200,000
Cash at End of Year $ 450,000
Key Observations:
- Operating cash flow ($800K) exceeds net income ($630K)—excellent sign
- Company invested heavily ($450K) in growth
- Company is both borrowing and paying dividends
- Cash increased by $250K, matching balance sheet change
Interpreting Cash Flow Patterns
Healthy Growing Company:
- Operating CF: Strongly positive and growing
- Investing CF: Negative (investing in growth)
- Financing CF: Variable (might raise capital for expansion)
Mature Company:
- Operating CF: Positive and steady
- Investing CF: Modest negative (maintenance capex)
- Financing CF: Negative (paying dividends, buying back stock)
Struggling Company:
- Operating CF: Weak or negative
- Investing CF: Positive (selling assets to raise cash)
- Financing CF: Positive (desperately raising capital)
Warning Signs:
- Negative operating cash flow for multiple years
- Operating CF consistently less than net income
- Heavy reliance on financing activities to fund operations
2.4 Financial Ratios: Measuring Performance
Financial ratios turn raw numbers into meaningful insights. They allow you to:
- Track trends over time
- Compare companies of different sizes
- Benchmark against industry averages
- Identify strengths and weaknesses
We'll organize ratios into four categories:
Liquidity Ratios (Can the company pay short-term obligations?)
1. Current Ratio
Current Ratio = Current Assets / Current Liabilities
What it measures: Ability to pay short-term obligations with short-term assets
Interpretation:
- > 1.0: Can cover short-term liabilities
- 1.5-3.0: Generally healthy range
- < 1.0: May struggle to meet obligations
- Too high (>3): Inefficient use of assets
Example:
Current Assets: $2,150,000
Current Liabilities: $1,000,000
Current Ratio = 2,150,000 / 1,000,000 = 2.15
Interpretation: Company has $2.15 in current assets for every $1 of current liabilities—healthy liquidity.
2. Quick Ratio (Acid Test)
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
What it measures: Ability to pay short-term obligations with only the most liquid assets
Why exclude inventory?
- Inventory takes time to sell
- Might sell at a discount in a rush
- Some inventory might be obsolete
Interpretation:
- > 1.0: Can cover liabilities without selling inventory
- 0.5-1.0: Acceptable for many businesses
- < 0.5: Potential liquidity concerns
Example:
Current Assets: $2,150,000
Inventory: $600,000
Current Liabilities: $1,000,000
Quick Ratio = (2,150,000 - 600,000) / 1,000,000 = 1.55
Interpretation: Even without selling inventory, the company can easily cover short-term obligations.
3. Cash Ratio
Cash Ratio = Cash & Marketable Securities / Current Liabilities
What it measures: Most conservative liquidity measure—can pay with cash only
Interpretation:
- > 0.5: Strong liquidity position
- 0.2-0.5: Acceptable
- < 0.2: May need to rely on other current assets
Example:
Cash & Marketable Securities: $650,000
Current Liabilities: $1,000,000
Cash Ratio = 650,000 / 1,000,000 = 0.65
Interpretation: Company has 65 cents of cash for every dollar of short-term obligations—strong position.
Profitability Ratios (How profitable is the company?)
4. Gross Profit Margin
Gross Profit Margin = (Gross Profit / Revenue) × 100%
What it measures: Percentage of revenue remaining after direct costs
Interpretation:
- Higher is better
- Varies widely by industry
- Software: 70-90%
- Retail: 20-40%
- Manufacturing: 30-50%
Example:
Gross Profit: $3,000,000
Revenue: $5,000,000
Gross Profit Margin = (3,000,000 / 5,000,000) × 100% = 60%
Interpretation: Company keeps 60 cents of every revenue dollar after direct costs—healthy margin.
5. Operating Profit Margin
Operating Profit Margin = (Operating Income / Revenue) × 100%
What it measures: Profitability from core operations before interest and taxes
Interpretation:
- Shows efficiency of operations
- Higher is better
- Compare to competitors
Example:
Operating Income: $1,000,000
Revenue: $5,000,000
Operating Profit Margin = (1,000,000 / 5,000,000) × 100% = 20%
Interpretation: 20% operating margin is solid for many industries.
6. Net Profit Margin
Net Profit Margin = (Net Income / Revenue) × 100%
What it measures: What percentage of revenue becomes profit
Interpretation:
- The "bottom line" profitability
- Varies widely by industry
- Tech: 15-30%
- Grocery: 1-3%
- Banking: 20-30%
Example:
Net Income: $630,000
Revenue: $5,000,000
Net Profit Margin = (630,000 / 5,000,000) × 100% = 12.6%
Interpretation: Company converts 12.6% of revenue to profit—respectable.
7. Return on Assets (ROA)
ROA = (Net Income / Total Assets) × 100%
What it measures: How efficiently the company uses its assets to generate profit
Interpretation:
- Higher is better
- Shows asset efficiency
- Compare to industry averages
Example:
Net Income: $630,000
Total Assets: $5,250,000
ROA = (630,000 / 5,250,000) × 100% = 12%
Interpretation: Company generates 12 cents of profit for every dollar of assets.
8. Return on Equity (ROE)
ROE = (Net Income / Shareholders' Equity) × 100%
What it measures: Return generated for shareholders on their investment
Interpretation:
- Key metric for investors
- Higher is better
- 15-20%+ is generally excellent
- Compare to cost of equity
Example:
Net Income: $630,000
Shareholders' Equity: $2,550,000
ROE = (630,000 / 2,550,000) × 100% = 24.7%
Interpretation: Shareholders earn a 24.7% return—excellent performance.
Leverage Ratios (How much debt does the company use?)
9. Debt-to-Equity Ratio
Debt-to-Equity = Total Debt / Shareholders' Equity
What it measures: Relative proportion of debt versus equity financing
Interpretation:
- < 0.5: Conservative (low debt)
- 0.5-1.0: Moderate leverage
- > 1.0: High leverage (risky)
- > 2.0: Very high leverage
Varies by industry:
- Utilities: 1.0-2.0 (stable cash flows support debt)
- Tech: 0.0-0.5 (volatile, prefer equity)
- Banks: Different metrics apply
Example:
Total Debt: $1,750,000 ($250K short-term + $1,500K long-term)
Shareholders' Equity: $2,550,000
Debt-to-Equity = 1,750,000 / 2,550,000 = 0.69
Interpretation: Moderate leverage—for every dollar of equity, there's 69 cents of debt.
10. Debt-to-Assets Ratio
Debt-to-Assets = Total Debt / Total Assets
What it measures: What percentage of assets are financed by debt
Interpretation:
- < 0.3: Conservative
- 0.3-0.6: Moderate
- > 0.6: High leverage
Example:
Total Debt: $1,750,000
Total Assets: $5,250,000
Debt-to-Assets = 1,750,000 / 5,250,000 = 33.3%
Interpretation: One-third of assets are debt-financed—reasonable.
11. Interest Coverage Ratio
Interest Coverage = Operating Income / Interest Expense
What it measures: How many times the company can cover interest payments with operating income
Interpretation:
- > 3.0: Comfortable
- 1.5-3.0: Adequate
- < 1.5: Risky (may struggle to pay interest)
- < 1.0: Very risky (operating income doesn't cover interest)
Example:
Operating Income: $1,000,000
Interest Expense: $100,000
Interest Coverage = 1,000,000 / 100,000 = 10.0
Interpretation: Company can cover interest payments 10 times over—very safe.
Efficiency Ratios (How effectively does the company use assets?)
12. Asset Turnover Ratio
Asset Turnover = Revenue / Total Assets
What it measures: How efficiently the company uses assets to generate revenue
Interpretation:
- Higher is better
- Varies by industry
- Retail: 2-3× (low margins, high volume)
- Utilities: 0.3-0.5× (asset-intensive)
Example:
Revenue: $5,000,000
Total Assets: $5,250,000
Asset Turnover = 5,000,000 / 5,250,000 = 0.95
Interpretation: Company generates 95 cents of revenue for each dollar of assets.
13. Inventory Turnover
Inventory Turnover = Cost of Goods Sold / Average Inventory
What it measures: How many times inventory is sold and replaced during the period
Interpretation:
- Higher is generally better (inventory moves quickly)
- Too high: May be running out of stock
- Too low: Inventory sitting too long (spoilage, obsolescence)
- Varies widely by industry
Example:
Cost of Goods Sold: $2,000,000
Average Inventory: $600,000
Inventory Turnover = 2,000,000 / 600,000 = 3.33
Interpretation: Inventory turns over 3.33 times per year (every ~110 days).
14. Days Sales Outstanding (DSO)
DSO = (Accounts Receivable / Revenue) × 365
What it measures: Average number of days to collect payment from customers
Interpretation:
- Lower is better (faster collection)
- Compare to payment terms (if terms are "net 30," DSO should be ~30-40)
- Rising DSO may indicate collection problems
Example:
Accounts Receivable: $850,000
Revenue: $5,000,000
DSO = (850,000 / 5,000,000) × 365 = 62 days
Interpretation: Takes about 62 days to collect payment on average.
15. Days Payable Outstanding (DPO)
DPO = (Accounts Payable / Cost of Goods Sold) × 365
What it measures: Average number of days the company takes to pay suppliers
Interpretation:
- Higher might be better (conserving cash)
- But too high might damage supplier relationships
- Balance between cash management and relationships
Example:
Accounts Payable: $400,000
Cost of Goods Sold: $2,000,000
DPO = (400,000 / 2,000,000) × 365 = 73 days
Interpretation: Company takes about 73 days to pay suppliers.
16. Cash Conversion Cycle
Cash Conversion Cycle = DSO + Days Inventory Outstanding - DPO
What it measures: How long cash is tied up in operations
Interpretation:
- Lower is better (cash returns faster)
- Negative is ideal (collect before paying—like Amazon)
Example:
DSO: 62 days
Days Inventory Outstanding: 110 days
DPO: 73 days
Cash Conversion Cycle = 62 + 110 - 73 = 99 days
Interpretation: Cash is tied up for 99 days—reasonable but could improve.
Market Value Ratios (How does the market value the company?)
17. Price-to-Earnings (P/E) Ratio
P/E Ratio = Market Price per Share / Earnings per Share
What it measures: How much investors pay for each dollar of earnings
Interpretation:
- Higher P/E = investors expect more growth
- Compare to industry average
- Tech: 20-40+
- Utilities: 10-15
- Market average: ~15-20
Example:
Stock Price: $75 per share
EPS: $6.30
P/E Ratio = 75 / 6.30 = 11.9
Interpretation: Investors pay $11.90 for each dollar of earnings—relatively modest valuation.
18. Price-to-Book (P/B) Ratio
P/B Ratio = Market Price per Share / Book Value per Share
What it measures: How much investors pay relative to accounting value
Interpretation:
-
1.0: Market values company above book value
- < 1.0: Market values company below book value (possible value opportunity or troubled company)
Example:
Stock Price: $75 per share
Book Value per Share: $25.50 ($2,550,000 equity / 100,000 shares)
P/B Ratio = 75 / 25.50 = 2.94
Interpretation: Market values the company at almost 3× its book value—reflects intangible value.
2.5 Putting It All Together: Comprehensive Analysis
The DuPont Analysis
The DuPont framework breaks down ROE into components to understand what drives returns:
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
ROE = (Net Income/Revenue) × (Revenue/Assets) × (Assets/Equity)
What it reveals:
- Net Profit Margin: Operational efficiency
- Asset Turnover: Asset efficiency
- Equity Multiplier: Financial leverage
Example:
Net Profit Margin: 12.6%
Asset Turnover: 0.95
Equity Multiplier: 2.06 ($5,250K assets / $2,550K equity)
ROE = 12.6% × 0.95 × 2.06 = 24.7%
Insight: The 24.7% ROE comes from decent margins, moderate asset efficiency, and moderate leverage.
Two companies could have the same ROE with very different profiles:
- Company A: High margins, low turnover, low leverage (luxury goods)
- Company B: Low margins, high turnover, moderate leverage (retail)
Trend Analysis
One year's ratios tell you where a company stands. Multiple years show you where it's going.
Example Trend:
2022 2023 2024 Trend
Current Ratio 1.8 2.0 2.15 ↑ Improving
ROE 20% 22% 24.7% ↑ Improving
Debt/Equity 0.85 0.75 0.69 ↓ Reducing leverage
Gross Margin 55% 58% 60% ↑ Improving
Interpretation: Company is improving across all dimensions—stronger liquidity, higher profitability, better margins, and reducing debt.
Comparative Analysis
Compare ratios to:
1. Industry Averages
- Is the company better or worse than peers?
- Industry data available from financial databases
2. Direct Competitors
- Apple vs. Microsoft
- Coca-Cola vs. PepsiCo
- Similar size and business model
3. Historical Performance
- Is the company improving or declining?
- What's the trajectory?
Warning Signs in Financial Statements
Red Flags:
- Declining gross margins (losing pricing power)
- Negative or declining operating cash flow (trouble generating cash)
- Rising DSO (collection problems)
- Inventory building faster than sales (obsolete inventory)
- Consistently negative working capital changes (cash flow problems)
- Operating cash flow less than net income for several years (earnings quality issues)
- High and rising debt levels with declining interest coverage (financial distress)
- Declining current ratio approaching 1.0 (liquidity crisis)
- Unusual accounting changes or restatements (potential manipulation)
- Revenue growth without profit growth (unprofitable growth)
Green Flags (Positive Indicators)
Good Signs:
- Operating cash flow consistently exceeds net income
- Improving margins over time
- Stable or improving working capital efficiency
- Manageable debt with strong interest coverage
- Consistent revenue and profit growth
- Strong return on invested capital (ROE, ROA)
- Positive and growing free cash flow
- Conservative accounting policies
- Transparent and clear financial reporting
- Management that returns cash to shareholders when appropriate
2.6 Limitations of Financial Statement Analysis
Financial statements are powerful tools, but they have limitations:
1. Historical Data
Issue: Financial statements look backward, not forward Impact: Past performance doesn't guarantee future results Solution: Combine with forward-looking analysis and industry trends
2. Accounting Choices
Issue: Different accounting methods produce different results Examples:
- FIFO vs. LIFO inventory valuation
- Straight-line vs. accelerated depreciation
- Revenue recognition timing Impact: Makes comparisons difficult Solution: Adjust for known differences; read footnotes
3. Non-Financial Factors
Issue: Statements don't capture intangibles Missing:
- Employee morale and talent
- Brand strength and reputation
- Management quality
- Innovation pipeline
- Customer satisfaction
- Competitive positioning Solution: Supplement with qualitative analysis
4. Industry Differences
Issue: Ratios vary dramatically by industry Example:
- Tech company with 0.3 debt-to-equity: conservative
- Utility with 0.3 debt-to-equity: unusually low Solution: Always compare within industry
5. Size Differences
Issue: Ratios can't fully capture scale advantages Example:
- Small company with 15% ROE vs. large company with 15% ROE
- The large company may be more impressive given its scale Solution: Consider absolute size alongside ratios
6. Manipulation and "Earnings Management"
Issue: Companies can manipulate results within legal bounds Tactics:
- Aggressive revenue recognition
- Capitalizing vs. expensing costs
- Cookie jar reserves
- Channel stuffing Solution: Scrutinize cash flow; read auditor notes; look for consistency
7. One-Time Items
Issue: Unusual events distort normal performance Examples:
- Asset sales
- Restructuring charges
- Legal settlements
- Tax law changes Solution: Adjust for one-time items; focus on recurring operations
8. Missing Liabilities
Issue: Some obligations don't appear on balance sheet Examples:
- Operating leases (pre-2019)
- Contingent liabilities
- Pension underfunding
- Environmental cleanup obligations Solution: Read footnotes and MD&A section carefully
2.7 Best Practices for Financial Analysis
Step-by-Step Analysis Process
1. Read the Financial Statements
- Start with the income statement (performance)
- Then balance sheet (position)
- Finally cash flow statement (liquidity)
- Note anything unusual
2. Calculate Key Ratios
- Compute liquidity, profitability, leverage, and efficiency ratios
- Organize them in a spreadsheet
3. Analyze Trends
- Get 3-5 years of data
- Look for patterns and changes
- Identify improving or deteriorating metrics
4. Compare to Industry
- Find industry averages
- Identify outliers (good or bad)
- Understand why company differs
5. Read the Footnotes
- Accounting policies
- Contingencies and commitments
- Segment information
- Management discussion and analysis (MD&A)
6. Form a Conclusion
- Synthesize quantitative and qualitative factors
- Identify key strengths and weaknesses
- Assess overall financial health
- Consider investment implications
Where to Find Financial Information
For U.S. Public Companies:
- SEC EDGAR database (sec.gov/edgar)
- Company investor relations websites
- Yahoo Finance / Google Finance
- Bloomberg / Thomson Reuters (subscription)
Key Documents:
- 10-K: Annual report with full financials
- 10-Q: Quarterly report
- 8-K: Current events disclosure
- Proxy Statement (DEF 14A): Executive compensation, governance
For Private Companies:
- Limited information available
- May need to request financials directly
- Industry databases (e.g., BizMiner)
Module 2 Practice Problems
Problem Set 1: Balance Sheet Analysis
Using TechStart Corporation's balance sheet (from Section 2.1):
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Calculate the following for TechStart: a. Current ratio b. Quick ratio c. Debt-to-equity ratio d. Debt-to-assets ratio
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What percentage of TechStart's assets are current vs. non-current?
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If TechStart needed to raise $500,000 quickly, what options does the balance sheet suggest?
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TechStart's accumulated depreciation is $1,200,000 on PP&E that cost $3,500,000. What does this tell you about the age of their assets?
Problem Set 2: Income Statement Analysis
Using TechStart Corporation's income statement (from Section 2.2):
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Calculate the following margins: a. Gross profit margin b. Operating profit margin c. Net profit margin
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If revenue grows by 20% next year and gross margin stays constant, what would gross profit be?
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Operating expenses are 40% of revenue. Is this high or low? What might explain it?
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Calculate TechStart's effective tax rate. Is this reasonable?
Problem Set 3: Cash Flow Analysis
Using TechStart's cash flow statement (from Section 2.3):
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Operating cash flow is $800,000 while net income is $630,000. Explain why they differ.
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Calculate free cash flow: Operating CF - Capital Expenditures
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Is TechStart generating enough cash from operations to fund its investments, or must it rely on external financing?
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The company paid $200,000 in dividends. What's the dividend payout ratio (Dividends / Net Income)?
Problem Set 4: Ratio Analysis
Using all three statements:
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Calculate the following ratios: a. Return on Assets (ROA) b. Return on Equity (ROE) c. Interest coverage ratio d. Asset turnover ratio
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Perform a DuPont analysis to break down ROE into its components.
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If TechStart's stock trades at $75 per share with 100,000 shares outstanding, calculate: a. Market capitalization b. P/E ratio c. P/B ratio
Problem Set 5: Real Company Analysis
Choose a publicly traded company that interests you:
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Download their most recent 10-K from SEC EDGAR
-
Calculate at least 2 ratios from each category:
- Liquidity
- Profitability
- Leverage
- Efficiency
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Get the same ratios for 2 years earlier. What trends do you see?
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Research industry averages (online or financial databases). How does your company compare?
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Write a one-page summary of the company's financial health based on your analysis.
Additional Resources
Excel Templates
Download templates for:
- Financial statement analysis
- Ratio calculations and trending
- Comparative company analysis
- DuPont analysis
Recommended Reading
Books:
- "Financial Statement Analysis" by Martin Fridson and Fernando Alvarez
- "The Interpretation of Financial Statements" by Benjamin Graham
Online Resources:
- SEC EDGAR Tutorial (sec.gov)
- Khan Academy: Finance and Capital Markets
- Corporate Finance Institute (CFI)
Practice Databases
- Yahoo Finance (finance.yahoo.com)
- FINRA Market Data
- Company investor relations websites
Looking Ahead to Module 3
You now have a powerful skillset: you can read financial statements and evaluate company performance through ratios. This quantitative analysis capability will serve you throughout your finance career.
In Module 3, we'll dive deep into the Time Value of Money—the mathematical foundation of finance. You'll learn to:
- Calculate present and future values
- Work with annuities and perpetuities
- Discount any stream of cash flows
- Apply these skills to real financial decisions
Master Module 3's concepts, and you'll have the tools to evaluate virtually any investment.
Prepare for Module 3 by:
- Ensuring you're comfortable with basic algebra
- Having a calculator or Excel ready
- Reviewing the time value of money introduction from Module 1
Summary
Congratulations on completing Module 2! You can now:
✓ Read and interpret balance sheets, income statements, and cash flow statements ✓ Calculate and interpret key financial ratios across all categories ✓ Assess company liquidity, profitability, leverage, and efficiency ✓ Identify trends and compare companies ✓ Recognize warning signs and strengths in financial statements ✓ Understand the limitations of financial analysis
These are professional-level skills. You can now pick up any financial statement and extract meaningful insights—a capability that sets you apart in business.
Ready for the next challenge? Proceed to Module 3: Time Value of Money to build the mathematical foundation of corporate finance.
"Accounting is the language of business." — Warren Buffett
"In God we trust; all others must bring data." — W. Edwards Deming
You now speak the language. Keep practicing, and it will become second nature.
See you in Module 3!