📊 Financial Statement Analysis

Financial Ratios — Liquidity, Profitability & Solvency Formulas

Complete guide to financial ratios: current ratio, ROE, debt-to-equity, profit margins, and more. Formulas, interpretation, and CFA Level 1 practice.

Key Concepts

Revenue Recognition

IFRS 15 / ASC 606: 5-step model. Recognize when performance obligation satisfied and control transfers to customer.

Expense Recognition (Matching)

Expenses matched to the revenues they help generate. Period costs expensed immediately; product costs match to sales.

Capitalization vs Expensing

Capitalizing: asset on BS, depreciated over time (higher initial income). Expensing: immediate IS charge (lower initial income).

Basic EPS

Net income attributable to common / Weighted average common shares outstanding. Measures profit per share for common shareholders.

Diluted EPS

Assumes all dilutive securities (options, convertibles) are converted. Always ≤ Basic EPS. Treasury stock method for options.

Common-Size Income Statement

Express each line as % of revenue. Enables comparison across companies of different sizes and over time.

Formulas

From this module

Basic EPS

Basic EPS = (Net Income - Preferred Dividends) / Weighted Avg Common Shares

Where: Only common shareholders' income

Diluted EPS (Convertible Bonds)

Diluted EPS = (NI - PD + Interest×(1-t)) / (WACS + New shares from conversion)

Where: If-converted method: add back interest, add converted shares

Diluted EPS (Options)

Treasury Stock Method: New shares = Options exercised - Shares repurchased with proceeds

Where: Net new shares = N - (N×Exercise Price / Market Price)

Gross Profit Margin

GPM = (Revenue - COGS) / Revenue

Where: Measures production efficiency

Operating Margin

Op Margin = Operating Income / Revenue

Where: Includes SG&A and other operating expenses

Net Profit Margin

Net Margin = Net Income / Revenue

Where: Bottom-line profitability

Master Formula Sheet -- Financial Statement Analysis

Basic EPS

EPS = (NI - Pref Div) / Wtd Avg Shares

Earnings per common share

Diluted EPS

Diluted EPS = (NI - Pref Div + Convertible Interest) / (Shares + Dilutive Securities)

Treasury stock method for options

Current Ratio

Current Ratio = Current Assets / Current Liabilities

>1 indicates short-term solvency

Quick Ratio

Quick = (Cash + Receivables + ST Investments) / Current Liabilities

Excludes inventory

ROE

ROE = Net Income / Average Equity

Return to shareholders

DuPont (3-way)

ROE = (NI/Rev) × (Rev/Assets) × (Assets/Equity)

Profit margin × Turnover × Leverage

DuPont (5-way)

ROE = Tax Burden × Interest Burden × EBIT Margin × Turnover × Leverage

Extended decomposition

Inventory Turnover

Inv Turnover = COGS / Avg Inventory

Days = 365 / Turnover

DSO

DSO = 365 / Receivables Turnover

Receivables Turnover = Revenue / Avg AR

Debt-to-Equity

D/E = Total Debt / Total Equity

Financial leverage measure

Interest Coverage

Interest Coverage = EBIT / Interest Expense

Ability to service debt

CFO (Indirect)

CFO = NI + Non-cash charges ± WC changes

Start from net income, adjust

Free Cash Flow to Firm

FCFF = NI + NCC + Int(1-t) - FCInv - WCInv

Cash available to all capital providers

Free Cash Flow to Equity

FCFE = FCFF - Int(1-t) + Net Borrowing

Cash available to equity holders

Decision Frameworks

Capitalize or Expense?

Use when:

  • Capitalize: future economic benefit expected (>1 year), cost reliably measurable
  • Expense: no future benefit, or benefit is uncertain

Avoid when:

  • Aggressive capitalization to inflate current profits — a red flag for earnings quality

Test Your Understanding

Capitalizing an expenditure rather than expensing it will initially:

Master this topic

Full cheat sheet, flashcards, mind map, and quiz for Analyzing Income Statements.

Master Formula Sheet

All 80+ CFA Level 1 formulas in one searchable reference page.

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