Financial Statement Drivers and Key Ratios for Business Analysis

Q1. What drives inventory?

Inventory is driven by COGS

Q2. What drives accounts receivable?

Sales

Q3. What drives something? (variation)

Same master driver list as Q1. Likely variants: Selling expense within SG&A

Q4. Question with COGS

COGS = labor + raw materials; variable cost driven by quantity. Normally grows ~1:1 with sales. If COGS spikes relative to sales -> suspect impairment/obsolescence (inventory written down, hit expensed to COGS). If COGS falls relative to sales -> suspect LIFO layer liquidation or cheaper inputs. Depreciation can sometimes be bundled into COGS.

Q5. EBIT question

EBIT (Earnings Before Interest & Taxes) = Sales - expenses tied to generating sales; measures overall operating performance; called 'the line' - everything above it must tie to operations (red flag: hiding an operating expense below the line to inflate EBIT). Times Interest Earned = EBIT / Interest Expense (common bank covenant). Build order: Net Sales - COGS = Gross Profit; -SG&A = EBITDA; -D&A = EBIT; -Interest +/- other income = EBT; -Taxes = Net Income.

Q6. Volatility in assets (something measured)

The most volatile asset on the balance sheet is perishable inventory - you know its value is heading to zero, just not exactly when. Inventory Turnover (COGS / Inventory) measures/offsets this risk; a higher turnover rate can negate the risk of a subpar perishable date.

Q7. What drives accrued liabilities?

Labor, COGS

Q8. House question (leverage / rate of return example)

Scenario 1 (day 1): House=$400K, 100% bank debt=$400K, Equity=$0. Scenario 2 (1 yr later): House=$425K, debt paid to $375K, Equity=$425K-$375K=$50K. Lesson: debt makes good times better and bad times worse (lottery-ticket effect); equity is a buffer against tough times (e.g., losing your job). With 90% debt/10% equity on a $100K asset, a given % move in the asset produces a much bigger % move in the small equity slice.

Q9. What drives prepaid expenses?

COGS, because you’ve paid for something you haven’t consumed yet

Q10. What drives accounts payable?

Purchases!

Q11. Gross and net sales

Gross sales = total value of invoices sent out (what you billed). Net sales = gross sales - sales returns (cancelled sales) - sales allowances (price reductions after sale); no chargebacks/rebates. We only care about net sales - it's the income statement's top line and what everything else is measured against.

Q12. Elasticity question

Elastic demand: a price change causes a big change in quantity demanded (easy substitution). Inelastic demand: little/no change - the goal for every business. Competitive advantage means no one can steal your customers (the dream = a monopoly); maintained via barriers to entry/exit, a differentiated product, strong selling relationships, brand loyalty, or blurring the price-value relationship. A contestable market (no barriers to entry) is bad - invites price cutting, ad wars, promotions, litigation.

Q13. Operating expenses (SG&A)

SG&A = Selling, General & Administrative expense, aka overhead (US) / functional costs (Europe) - costs needed to earn gross profit. Selling = commissions (variable, ~1:1 with quantity). General = rent, office supplies, utilities. Administrative = salaries, insurance. R&D and brand marketing spend are often buried in SG&A but must be broken out separately. Salespeople are the most liquid human capital (can walk to a competitor anytime).

Q14. Income statement

The P&L: Revenues - Expenses = Earnings. Full build: Net Sales - COGS = Gross Profit; - SG&A = EBITDA; - D&A = EBIT; +/- other income - Interest = Pre-tax Income (EBT); - Taxes = Net Income; Net Income - Dividends - Buybacks = addition to Retained Earnings. Profit (accrual-based) is NOT the same as cash flow.

Q15. Balance sheet

A = L + E (must always balance; E = A - L). Snapshot of the firm's financial condition at one point in time (like a photograph) - the DATE is the most important thing on it. Does NOT show the firm's future or true condition. Items listed top to bottom in order of decreasing liquidity. Anything reducing an asset without an offsetting liability reduction erodes equity. Common sizing = divide every line by Total Assets, for comparability.

Q16. What is the most important lesson in the class?

Cash is king! You must have ACCESS to cash - profit is not cash flow. A firm with only one principal source of funds is at risk. The statement of cash flows tells you how much cash you'll need.

Q17. Liquidity question - TWO DIMENSIONS

The two dimensions of liquidity: (1) speed - how quickly an asset converts to cash, and (2) transaction cost - how much value/cost is lost converting it. The current ratio (CA/CL) is a bad measure - it ignores timing mismatches between when assets actually monetize and liabilities come due. Quick ratio ((CA-Inventory)/CL) is used when inventory quality is doubtful but is also flawed. Better: bucket assets/liabilities by actual monetization timing (3/6/9/12 months) and compare like-for-like. Credit-analyst question: can the firm survive a sudden, catastrophic revenue disruption?

Q18. EBITDA, ROE, DuPont, ROCE

EBITDA = Net Sales - Cash COGS - Cash SG&A (= EBIT + D&A); not on the financials and NOT a cash-flow measure (ignores CAPEX and working-capital changes); born in 1980s LBOs to gauge debt-service ability (EBITDA >= 4x interest expense). ROE = NI/Shareholders' Equity = PM x TATA x EM (DuPont: Profit Margin x Total Asset Turnover x Equity Multiplier) - 3 levers to raise it: profitability, asset efficiency, leverage. ROCE (Europe) = EBIT / Capital, where Capital = Total Assets - AP - Accrued Liabilities.

Q19. True/False questions

Always TRUE: balance sheet always balances (A=L+E); credit=source of funds, debit=use of funds; markup > gross margin always. Always FALSE: 'Assets can be greater than Liabilities + Equity' (violates the accounting identity); '100% gross profit margin is achievable' (would need zero cost - but 100% markup IS possible); 'land depreciates'; 'the balance sheet shows the firm's future.' Profit != cash flow; EBITDA != cash flow.

Q20. COGS (second pass)

Same as Q4: COGS = labor + raw materials, variable, driven by quantity, normally ~1:1 with sales. Relative spikes = impairment/obsolescence; relative declines = LIFO layer liquidation or cheaper inputs.

Q21. CAPEX question

Two kinds: Maintenance CAPEX (grows ~1:1 with quantity/COGS, roughly = depreciation, smooth/predictable) and Expansion CAPEX (driven by capacity utilization, not COGS - none needed with excess capacity, a lump when near 100%; good analysts anticipate it). CAPEX flows into PP&E and depreciates over its useful life; it's a negative (use) under investing activities on the cash flow statement.

Q22. Depreciation

Depreciation = allocation of a tangible asset's cost over its useful life (wear and tear). Land never depreciates (no tax break for owning it). PP&E book value declines toward zero over time. Non-cash charge - added back to net income when building operating cash flow. Amortization = the same concept for leases, leasehold improvements, and intangibles (patents, copyrights, trademarks, franchises). Depletion = the equivalent for natural resources. Maintenance CAPEX ~= depreciation.

Q23. A liabilities question

AP

Q24. Pre-tax income

Pre-tax income (EBT) = EBIT - Interest Expense (+/- other non-operating income/expense); the firm then pays taxes on it. Effective Tax Rate = Taxes / Pre-tax Income. Firms can deduct all interest expense before taxes (an interest tax shield) - the present value of that shield can be large.

Q25. Markups and margins

Markup = (Sales-Cost)/Cost. Gross Profit Margin = (Sales-Cost)/Sales. Example: Cost=$100, Price=$120 -> Markup=20%, Margin=16.7%. Markup is always greater than gross margin; 100% markup is possible, 100% gross margin is not (needs zero cost). Conversion table: 15%->13.0%, 20%->16.7%, 25%->20.0%, 33.3%->25.0%, 40%->28.6%, 50%->33.0%, 100%->50.0% markup->margin. Gross profit measures brand power (bigger markup = more blurred price-value relationship); explained via Porter's Five Forces.

Q26. What drives what? (variation)

Same master driver list as Q1 (see Q1).

Q27. Fundamental analysis - know the ratios

Four pillars: Profitability, Efficiency, Leverage, Liquidity. ROE=NI/Shareholders' Equity. Profit Margin=NI/Sales. Total Asset Turnover=Sales/Total Assets. Days Payable Outstanding=AP/Daily COGS (dragging=bad). Days Sales Outstanding=AR/Daily Sales (ballooning=bad). Inventory Turnover=COGS/Inventory (JIT~365x/yr). Days of Inventory=Inventory/COGS. Leverage ratio=Total(or First-Lien) Debt/EBITDA. Current Ratio=CA/CL (flawed). Quick Ratio=(CA-Inventory)/CL (flawed). ROCE(Europe)=EBIT/(TA-AP-Accrued Liabilities).

Q28. NPV question - NPV is the extent to what?

NPV is the extent to which something is UNDERPRICED. With any investment, get the IRR - if you doubt you'll actually earn it, get out.

Q29. What's not equivalent?

Book Value != Market Value. Profit (Net Income) != Cash Flow. EBITDA != Cash Flow (ignores CAPEX/working capital). Gross Sales != Net Sales. Markup != Gross Profit Margin (markup always bigger). Cash-basis accounting != Accrual-basis accounting. Enterprise/Market Value of assets != Book Value of assets.

Q30. 4 ways to increase profit

Raise prices (depends on elasticity - dream is no competition), cut variable costs (needs volume/scale to matter - e.g., a penny saved per cup matters little at 1M cups, huge at 1B cups), cut fixed costs (no scale needed - e.g., cut $1,000/month off a lease and save it in perpetuity), or improve/minimize taxes (every dollar saved is a dollar of pure profit; only the government 'wins' from tax; PV of a tax shield is huge).

Q31. Commitments and contingencies (contingencies are a red flag)

Commitment = a non-cancelable contractual obligation to do something in the future (like a forward contract) that will substantially affect the firm; not yet a liability since delivery/performance hasn't happened (e.g., a commitment to buy foreign currency = FX risk). Contingency = a potential liability, almost always a pending lawsuit - if disclosed, it likely 'has legs.' Both appear in 10-K footnotes, often with no dollar amount (itself a warning sign), and both are red flags; a contingency can become a massive current liability that destroys value.

Q32. 5-company case (end of the deck) - match companies to financials

A=ACME grocery store (thin 1.8% margin, 3-day collection, 10.5x inventory turns, high PP&E). B=Zales jeweler (huge inventory 63.5% but only 1.3x turnover - jewelry sits a long time; low PP&E, leased mall space). C=Japanese shipping company/broker (huge receivables 63.1%, tiny inventory - no physical goods, ask why receivables are so high). D=PSE&G utility (PP&E-heavy 68.1%, highest margin 15.8% - regulated monopoly). E=Ford Motor Co. (155-day collection is the giveaway - captive dealer financing; WIP inventory, turns ~monthly, heavy R&D, ~155 days of dealer-lot inventory).

Q33. What is impairment, and how does it work?

Impairment = when an asset's value permanently drops below its historical cost. Mechanics: write down the asset's dollar value (credit the asset), reduce equity by the same amount (debit equity) so the balance sheet still balances, and expense the reduction into COGS (spiking it - see Q4). Firms delay recognizing impairments as long as possible because of the earnings/equity hit. The Inventory Obsolescence Reserve (a contra-asset, common in fashion retail) anticipates these write-downs at season-end.

Q34. Credit is a what? Debit is a what?

Credit is a source of funds. Debit is a use of funds.

Q35. Expensed vs. capitalized costs

Test: will the spending benefit the company for more than one year? No -> expense it (subtracted from revenue immediately to determine net profit - most COGS/SG&A, since there's no future benefit). Yes -> capitalize it (recorded as an asset on the balance sheet, then depreciated/amortized over its useful life - e.g., an equipment upgrade that increases the asset's value). Red flag/manipulation: capitalizing a cost that should be expensed overstates current profit and EBIT by keeping it off the income statement and spreading it into future years - the same trick as hiding an operating expense below the line (see Q5).

Return on equity is:

The rate of retrun on a $1 equity investment

Net income / total shareholders equity

DuPont Version:
(NI / Sales) x (Sales / Total Assets) x (Total Assets / Equity)

DuPont tells us there’s 3 ways to increase ROE: Increase profitability, increase asset efficiency, or raise leverage

ROCE

EBIT / Capital WHERE

Capital = Total Assets - Accounts Payable - Accrued Liabilities

There are:

Profitabilitym efficiency, leverage, and liquidity ratios

Days Payable Outstanding

AP / Daily Cogs

Days Sales Outstanding

AR / Daily Sales

Inventiry Turnover:

Cogs / inventory

Days of Inventory:

Inventory / COGS