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Financial Statement Analysis

The analyst's daily work: turning a set of statements into a defensible verdict on financial health.

When to use

Reviewing a target's audited statements for M&A or investment screening
Assessing borrower health for credit risk (Al Adabiya MRCC FP review pattern)
Producing the financial-health section of a CPS feasibility study (Bunyan, GSB)
Preparing a CFO-ready board pack with ratio commentary
Benchmarking a client against listed peers

The three statements — what each tells you

Statement	Reading question	Time frame
Income Statement (P&L)	Did the business make money this period?	Period (month, quarter, year)
Balance Sheet	What does the business own and owe right now?	Point in time (snapshot)
Cash Flow Statement	Where did cash come from and go?	Period

The three are linked:

Net Income (P&L) → Retained Earnings (BS) and Operating CF (CFS)
CapEx (CFS investing) → PP&E (BS)
Debt issued/repaid (CFS financing) → Debt (BS)
Ending Cash (CFS) = Cash on BS

Income Statement structure (CPS standard)

Revenue
(–) Cost of Goods Sold (COGS)
    = Gross Profit
(–) Operating Expenses (SG&A, R&D)
    = EBITDA
(–) Depreciation & Amortization
    = EBIT (Operating Income)
(–) Interest Expense
(+) Interest Income
    = Earnings Before Tax (EBT)
(–) Tax Expense
    = Net Income

Balance Sheet structure

ASSETS                              LIABILITIES + EQUITY
─ Current Assets                    ─ Current Liabilities
  • Cash & equivalents                • Accounts Payable
  • Accounts Receivable               • Accrued Expenses
  • Inventory                         • Short-term Debt
  • Prepaid Expenses                  • Deferred Revenue
─ Non-current Assets                ─ Non-current Liabilities
  • PP&E (net)                        • Long-term Debt
  • Intangibles                       • Lease Liabilities
  • Goodwill                          • Deferred Tax
  • Long-term Investments           ─ Equity
                                      • Share Capital
                                      • Retained Earnings
                                      • Reserves

TOTAL ASSETS                  =     TOTAL LIABILITIES + EQUITY

Cash Flow Statement structure (indirect method)

Net Income
(+) Depreciation & Amortization
(±) Changes in working capital
    = Cash from Operations (CFO)

(–) CapEx
(±) Acquisitions / disposals
    = Cash from Investing (CFI)

(+) Debt issued / (–) Debt repaid
(+) Equity raised / (–) Buybacks
(–) Dividends paid
    = Cash from Financing (CFF)

CFO + CFI + CFF = Net Change in Cash
                + Opening Cash
                = Closing Cash    (ties to Balance Sheet)

The four ratio families

A. Liquidity — can it pay near-term obligations?

Ratio	Formula	Healthy range
Current Ratio	Current Assets / Current Liabilities	1.5x – 2.5x
Quick Ratio (Acid Test)	(CA − Inventory − Prepaids) / CL	> 1.0x
Cash Ratio	(Cash + Marketable Securities) / CL	> 0.5x
Working Capital	CA − CL (absolute, not ratio)	Positive

B. Solvency — can it survive long-term?

Ratio	Formula	Healthy range
Debt-to-Equity	Total Debt / Total Equity	< 1.5x (sector-dependent)
Debt-to-Assets	Total Debt / Total Assets	< 0.6x
Interest Coverage (TIE)	EBIT / Interest Expense	> 3.0x
Debt Service Coverage (DSCR)	CFADS / (Interest + Principal)	> 1.20x (banking)
Equity Multiplier	Total Assets / Total Equity	2.0x – 3.0x

C. Profitability — how efficiently does it earn?

Ratio	Formula	Healthy range
Gross Margin	Gross Profit / Revenue	Sector-dependent (10 % – 70 %)
EBITDA Margin	EBITDA / Revenue	> 15 % (services), > 8 % (industrial)
Operating Margin	EBIT / Revenue	> 10 %
Net Margin	Net Income / Revenue	> 5 %
ROA	Net Income / Avg Total Assets	> 5 %
ROE	Net Income / Avg Equity	> 12 %
ROIC	NOPAT / Invested Capital	> WACC by 2-4 ppts

D. Growth & efficiency — is it scaling?

Ratio	Formula	Healthy signal
Revenue Growth (YoY)	(Rev_t − Rev_{t-1}) / Rev_{t-1}	> sector average
EBITDA Growth (YoY)	(EBITDA_t − EBITDA_{t-1}) / EBITDA_{t-1}	≥ Revenue Growth
Asset Turnover	Revenue / Avg Total Assets	Sector-dependent
Inventory Days	(Avg Inventory / COGS) × 365	Lower is better
Receivable Days (DSO)	(Avg AR / Revenue) × 365	Lower is better
Payable Days (DPO)	(Avg AP / COGS) × 365	Sector norm
Cash Conversion Cycle	DSO + DIO − DPO	Lower / negative ideal

See references/ratio-formulas.md for the full formula sheet and worked examples.

Common-size analysis

Express every P&L line as % of Revenue, every BS line as % of Total Assets. Enables cross-company and cross-period comparison.

P&L common-size example:

Revenue                         100.0 %
COGS                             62.5 %
Gross Profit                     37.5 %
SG&A                             18.0 %
EBITDA                           19.5 %
D&A                               4.5 %
EBIT                             15.0 %
Interest                          2.0 %
Tax                               3.5 %
Net Income                        9.5 %

If COGS grew from 60 % to 65 % of revenue, that's a 5-point margin compression — far more meaningful than the absolute COGS number.

Trend analysis (horizontal analysis)

Compare each line over 3-5 years. Index Year 1 = 100, show subsequent years as % of base. Reveals patterns that single-period analysis misses.

Five-step analyst review process (CPS standard)

Read the auditor's opinion first — qualified / adverse / disclaimer is a red flag before any numbers
Read the notes before the statements — accounting policies, related parties, contingencies, subsequent events
Compute and trend the four ratio families over 3+ years
Reconcile the three statements (Net Income → Retained Earnings → Cash)
Form a one-line verdict with three supporting ratio observations

Red flags checklist

Revenue growth without CFO growth (earnings quality issue)
AR growing faster than revenue (collection problem)
Inventory growing faster than COGS (obsolescence / sales slowdown)
Goodwill > 30 % of total assets (impairment risk)
Interest coverage < 2.0x (solvency stress)
Current ratio < 1.0x with negative working capital (liquidity stress)
Frequent restatements or change of auditor
Related-party transactions > 10 % of revenue
Discontinued operations or extraordinary items recurring

CPS deliverable quality gate

All three statements presented and reconciled
Minimum 3 years of historical data
All four ratio families computed (≥ 12 ratios total)
Common-size P&L included
Trend analysis with base year = 100
Peer benchmark or sector medians where available
One-line verdict with confidence level
Red flags explicitly addressed

See also

references/ratio-formulas.md — full formula sheet with worked examples
references/common-size-and-trend.md — template structure
plugins/finance/skills/accounting-fundamentals/SKILL.md — bookkeeping foundation
plugins/finance/scripts/ratio_analysis.py — automation
/cps-fin:ratios — slash command