Financial statement and ratio analysis

What BAR asks you to do

Area I, Group A, Topic 1 of the BAR blueprint is about analysing what already happened. The representative tasks are to decide what data an analysis needs, compare the current period with prior periods or the budget and explain the differences, interpret fluctuations and ratios, use the output of data analytics to explain results, and work out how a transaction changes the statements and notes (BAR blueprint, Area I, Group A). Most of these are analysis tasks: the Exam gives you the numbers and asks what they mean.

Getting the data right first

An analysis is only as good as its data. Before calculating anything, a CPA settles three things.

Question	What it means	Example
Attributes and structure	Which fields each record needs, at what level of detail	Invoice date, customer ID, product line, quantity, net amount, region
Format	How each field is stored	Dates as dates (not text), amounts as numbers in one currency, consistent product codes
Source	Where the data comes from and how reliable it is	General ledger and subledgers, ERP sales tables, bank data, industry statistics

Then verify completeness and accuracy before relying on the extract:

• Completeness: the record count and the control total agree with the source; the extract covers the whole period (watch the first and last days); no entity, location or currency was dropped.
• Accuracy: totals reconcile to the trial balance or subledger; there are no duplicates, blanks or obviously wrong values (negative quantities, dates in the wrong year); signs and units are consistent.

Example. A sales extract totals $4,362,500, but the general ledger shows net sales of $4,380,000. The $17,500 gap must be explained (perhaps credit memos posted in a separate table, or a missing day) before any ratio built on the extract is trusted.

Comparing periods and the budget

Three comparisons do most of the work:

• Horizontal analysis: the change in each line, in dollars and percent, from one period to the next.
• Vertical (common-size) analysis: each line as a percentage of a base (net sales for the income statement, total assets for the balance sheet), which makes companies of different sizes comparable.
• Budget-to-actual: each line against plan. A variance is favorable if it increases income (revenue above budget, cost below budget) and unfavorable otherwise.

Explaining a fluctuation means linking it to a cause you can support: volume, price, mix, a new contract, a one-time event, an accounting change, or an error. A good explanation is consistent with the other numbers. If sales rose 12% but receivables rose 19%, "more sales" explains only part of the receivables increase; slower collection or a change in credit terms must explain the rest.

Ratios the Exam uses

The AICPA publishes the definitions it uses for common ratios. Learn them as stated, because several ratios can be computed more than one way, and the Exam's version decides the answer unless a question gives another (AICPA, CPA Exam analytics definitions and valuation metrics). Two habits matter: turnover ratios and return ratios use average balances, while "days" ratios use ending balances with 365 days.

Family	Ratio	How the Exam computes it
Liquidity	Current ratio	Current assets ÷ current liabilities
Liquidity	Quick ratio	(Cash and cash equivalents + short-term marketable securities + net receivables) ÷ current liabilities
Liquidity	Operating cash flow ratio	Cash flow from operations ÷ ending current liabilities
Activity	Accounts receivable turnover	Net sales ÷ average net receivables
Activity	Days sales in receivables	Ending net receivables ÷ (net sales ÷ 365)
Activity	Inventory turnover	Cost of goods sold ÷ average inventory
Activity	Days in inventory	Ending inventory ÷ (cost of goods sold ÷ 365)
Activity	Days of payables outstanding	Ending accounts payable ÷ (cost of goods sold ÷ 365)
Activity	Cash conversion cycle	Days sales in receivables + days in inventory − days of payables outstanding
Activity	Asset turnover	Net sales ÷ average total assets
Solvency	Debt to equity	Total liabilities ÷ total equity
Solvency	Total debt ratio	Total liabilities ÷ total assets
Solvency	Equity multiplier	Total assets ÷ total equity
Solvency	Times interest earned	Earnings before interest and taxes ÷ interest expense
Profitability	Gross margin	(Net sales − cost of goods sold) ÷ net sales
Profitability	Profit margin	Net income ÷ net sales
Profitability	Return on sales	Income before interest income, interest expense and taxes ÷ net sales
Profitability	Return on assets	Net income ÷ average total assets
Profitability	Return on equity	Net income ÷ average total equity
Market	Basic EPS	Income available to common shareholders ÷ weighted-average common shares
Market	Price-earnings ratio	Price per share ÷ basic EPS
Market	Dividend payout	Cash dividends ÷ net income

The DuPont view splits return on equity into profit margin × asset turnover × equity multiplier: how much of each sales dollar is kept, how hard the assets work, and how much of the asset base is financed by others. The identity is exact when the equity multiplier uses the same average balances as the other two terms.

Worked example: Harbor Lane Supply

Harbor Lane Supply, Inc. reports the following (in thousands of dollars). Prior-year net sales were $3,900.

Balance sheet, December 31	20X2	20X1
Cash	120	150
Short-term marketable securities	60	40
Accounts receivable, net	380	320
Inventory	540	460
Prepaid expenses	30	30
Property and equipment, net	1,870	1,600
Total assets	3,000	2,600
Accounts payable	310	270
Accrued liabilities	140	130
Current portion of long-term debt	100	100
Long-term debt	950	800
Total liabilities	1,500	1,300
Total equity	1,500	1,300

Income statement, 20X2	Amount
Net sales	4,380
Cost of goods sold	2,920
Gross profit	1,460
Operating expenses	985
Earnings before interest and taxes	475
Interest expense	75
Income before taxes	400
Income tax expense	100
Net income	300

Cash flow from operations was $420 and cash dividends were $100. Current assets are $1,130 and current liabilities $550 at the end of 20X2.

Ratio	Computation	Result
Current ratio	1,130 ÷ 550	2.05
Quick ratio	(120 + 60 + 380) ÷ 550	1.02
Operating cash flow ratio	420 ÷ 550	0.76
Receivables turnover	4,380 ÷ [(380 + 320) ÷ 2 = 350]	12.5 times
Days sales in receivables	380 ÷ (4,380 ÷ 365 = 12)	31.7 days
Inventory turnover	2,920 ÷ [(540 + 460) ÷ 2 = 500]	5.84 times
Days in inventory	540 ÷ (2,920 ÷ 365 = 8)	67.5 days
Days of payables outstanding	310 ÷ 8	38.75 days
Cash conversion cycle	31.7 + 67.5 − 38.75	60.4 days
Gross margin	1,460 ÷ 4,380	33.3%
Profit margin	300 ÷ 4,380	6.85%
Return on sales	475 ÷ 4,380	10.8%
Asset turnover	4,380 ÷ [(3,000 + 2,600) ÷ 2 = 2,800]	1.56 times
Return on assets	300 ÷ 2,800	10.7%
Return on equity	300 ÷ [(1,500 + 1,300) ÷ 2 = 1,400]	21.4%
Debt to equity	1,500 ÷ 1,500	1.00
Total debt ratio	1,500 ÷ 3,000	0.50
Times interest earned	475 ÷ 75	6.3 times
Dividend payout	100 ÷ 300	33.3%

DuPont check: 6.85% × 1.564 × (2,800 ÷ 1,400 = 2.0) = 21.4%, the same return on equity.

Interpreting it. Sales grew 12.3% (480 ÷ 3,900), but inventory grew 17.4% (80 ÷ 460) and receivables 18.8% (60 ÷ 320). Both working capital accounts outgrew sales, so the cash conversion cycle is lengthening, which is consistent with cash falling despite $300 of net income. The quick ratio of 1.02 is far below the current ratio of 2.05 because inventory is a large part of current assets. A good written explanation would ask whether the inventory build reflects planned growth or slow-moving stock, and whether credit terms were loosened to win sales.

Reading analytics output

Data analytics outputs such as dashboards, trend lines, scatter plots and exception reports point you to where to look; they rarely tell you why.

• Trends: a line chart of monthly gross margin that steps down in one month suggests a pricing change, a cost increase, a mix shift or a cut-off error in that month.
• Correlation: a scatter plot showing that store sales rise with local foot traffic (a correlation near +1) supports using traffic as a forecasting driver, but correlation alone does not prove that traffic causes sales; both might follow a third factor such as the season.
• Outliers: one customer with a gross margin far above all others may be a pricing error, a misposted credit memo or a genuinely different contract; investigate before excluding it.

How transactions move the ratios

The Exam often asks for the direction of a change. Work it out with the numerator and denominator separately.

Transaction	Current ratio (starting above 1)	Debt to equity	Return on assets
Pay an account payable in cash	Increases (both fall by the same amount)	Decreases	No change in income; average assets fall slightly, so it rises slightly
Buy inventory on account	Decreases	Increases	No immediate income effect
Borrow long-term cash	Increases	Increases	Assets rise, so it falls
Write inventory down	Decreases	Increases (equity falls)	Falls (loss reduces income)
Repurchase shares for cash	Decreases	Increases	Assets fall, so it rises

The current-ratio trap. Paying a current liability with cash raises a ratio above 1 but lowers a ratio below 1. With current assets of 1,130 and current liabilities of 550, paying $100 of payables gives 1,030 ÷ 450 = 2.29 (up from 2.05). With current assets of 400 and current liabilities of 500 (0.80), the same payment gives 300 ÷ 400 = 0.75.

Transactions also reach the notes. Refinancing short-term debt, signing a lease or a purchase commitment, pledging receivables or breaching a loan covenant may leave the face of the statements unchanged yet require disclosure, and a covenant breach can force reclassification of long-term debt to current, which changes liquidity ratios immediately.

Common traps

• Using ending balances for a turnover ratio, or averages for a days ratio, when the AICPA definitions say otherwise.
• Using net sales for inventory turnover or days in inventory; those use cost of goods sold.
• Putting inventory or prepaid expenses in the quick ratio.
• Treating a better ratio as automatically good: a very high current ratio can mean idle cash or slow-moving inventory.
• Comparing ratios across companies that use different accounting methods (for example LIFO versus FIFO inventory) without adjusting.
• Explaining a variance with a cause the other numbers contradict.

Check yourself

• Which ratios in the AICPA definitions use average balances, and which use ending balances?
• Compute the cash conversion cycle when days sales in receivables is 40, days in inventory 55 and days of payables 35.
• Why can the current ratio rise while the quick ratio falls?
• A company with a current ratio of 0.9 pays a supplier in cash. What happens to the ratio?
• A scatter plot shows a strong positive correlation between advertising spend and sales. What can and cannot be concluded?
• Before relying on a sales extract, what two totals would you reconcile it to?