Ratios as a connected financial diagnosis

Learning goals

• Calculate activity, liquidity, solvency and profitability measures consistently.
• Connect DuPont, industry metrics and forecasts with limitations.

Draft · approximately 80 minutes, excluding further revision.

Choose consistent numerators, periods and balances

Use time series, peer comparisons, common-size statements and sensitivity analysis together. Ratio definitions can differ: state whether debt includes leases, whether profit is continuing operations and whether assets or equity are averaged. Match a flow measured over a year with an average balance where appropriate; year-end snapshots can be seasonal. Negative denominators can make conventional interpretations fail.

Activity ratios describe resource use: receivables turnover=credit sales/average receivables; inventory turnover=COGS/average inventory. DSO=days/receivables turnover and DIO=days/inventory turnover. Payables days should ideally use purchases rather than COGS. Cash-conversion cycle=DSO+DIO−DPO under compatible definitions. A shorter cycle is not automatically better if supplier relationships or customers are harmed.

Connect liquidity, leverage and return

Liquidity ratios test near-term resources; solvency ratios test financing structure and long-term capacity. Current ratio, quick ratio, debt/assets and interest coverage each answer a different question. High ROE can reflect strong margin, efficient asset use or heavy leverage. Compare the balance-sheet risk accompanying return rather than ranking companies on ROE alone.

Three-part DuPont: ROE=net margin×asset turnover×equity multiplier, using compatible average assets and equity. Five-part decomposition adds tax burden NI/EBT, interest burden EBT/EBIT and operating margin EBIT/revenue. Cancellation works algebraically only with consistent scope and nonzero denominators. It does not establish causality.

Adapt to industry and forecast drivers

A bank’s capital and credit metrics, a retailer’s same-store sales and inventory measures, and a property company’s occupancy and recurring rental cash have different economic meanings. Use an industry metric only after understanding its definition and reconciliation. A financial institution’s balance sheet cannot be interpreted as if all funding were ordinary industrial debt.

Forecast ratios from operational drivers rather than extend them blindly. Revenue times target margin yields a conditional earnings estimate; revenue/turnover yields asset needs. Rising sales with slower collections requires more financing even if net margin holds. Scenario-test price, volume, cost and working-capital assumptions and compare the implied capacity with real constraints.

Five-part DuPont identifies different levers

A second synthetic issuer has NI 96, EBT 120, EBIT 160, revenue 1,200, average assets 800 and average equity 400. Tax burden=.8, interest burden=.75, operating margin=.133333, asset turnover 1.5 and equity multiplier 2. Their product=.24=ROE.The factors share definitions and scope; changing only one while holding all others fixed is a sensitivity, not a claim about real-world causal independence.

If interest expense is 40, EBIT interest coverage=160/40=4 times. Liabilities equal 400 in the simple balance sheet, so liabilities/assets=.5 and liabilities/equity=1. These ratios do not prove the debt is all interest-bearing; distinguish total liabilities from financial debt before interpreting leverage or covenant compliance.

DuPont analysis distinguishes margin, efficiency and leverage

A fictional firm has net income 60, revenue 600, average assets 400 and average equity 200. Net margin=10%; asset turnover=1.5; equity multiplier=2. Product ROE=0.10 × 1.5 × 2=30%, matching 60/200. Use average assets and equity from comparable dates; mixing closing equity with average assets breaks the clean bridge. The decomposition explains arithmetic sources, not whether any source is sustainable.

A share buyback financed by debt can raise ROE through a smaller equity denominator even without operating improvement. Compare ROA, interest coverage, debt maturities and cash generation alongside ROE. When equity is very small or negative, the decomposition can become economically unhelpful; state that limit instead of ranking the largest computed percentage as best.

Formula and assumptions

ROE=NI/average equity=NI/sales×sales/average assets×average assets/average equity; CCC=DSO+DIO−DPO

A DuPont and operating-cycle dashboard

1. Revenue 1,200, net income 96, average assets 800, average equity 400 imply margin 8%, turnover 1.5 and equity multiplier 2. ROE=24%.
2. Credit sales 1,200 and receivables 120 give turnover 10 and DSO 36.5 days on 365 days. COGS 720 and inventory 90 give turnover 8 and DIO 45.625 days.
3. If DPO is 30, CCC=52.125 days. A projected revenue 1,320 with the same 8% net margin implies earnings 105.6, conditional on financing and operating assumptions.

Calculation lab

Errors to catch

• Comparing flow totals with mismatched balance periods.
• Treating leverage-driven ROE as free improvement.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.sec.gov
• Reference · www.ifrs.org