Financial Statements and Ratios

The three statements, in one sentence each

• Balance sheet: a snapshot at one moment of what the firm owns (assets), what it owes (liabilities), and the residual that belongs to shareholders (equity).
• Income statement: a movie over a period showing revenue minus expenses, ending in net income.
• Cash flow statement: a reconciliation over the same period showing how net income, working-capital changes, investment, and financing decisions add up to the actual change in cash.

The fundamental identity that anchors the balance sheet:

$$\text{Assets} \;=\; \text{Liabilities} \;+\; \text{Stockholders' Equity}.$$

It must hold by construction. If your model breaks this, you have a modeling mistake.

Why net income is not cash flow

Net income is not cash flow. A firm can show a profit and run out of cash; a firm can post a loss and generate plenty of cash. Three big reconciling items:

1. Depreciation and amortization: non-cash expense on the income statement; added back in the cash flow statement.
2. Changes in working capital: accounts receivable up = sale booked but cash not yet received; inventory up = cash spent that hasn’t hit the income statement as COGS yet.
3. Capital expenditures: cash spent on equipment that will be depreciated over years; the full cash hit happens now, the income- statement hit is spread over time.

Why does this matter? Because shareholders ultimately get cash, not accrual earnings. Most corporate-finance decisions value cash flows, not net income.

Ratios: four families

Once you have the statements, you compress them into a handful of ratios that make firms comparable across time and across peers.

Profitability ratios:

• Gross margin = (Revenue − COGS) / Revenue. How much of each sales dollar survives the cost of producing the good.
• Operating margin = EBIT / Revenue.
• Net margin = Net Income / Revenue.
• Return on Assets (ROA) = Net Income / Total Assets.
• Return on Equity (ROE) = Net Income / Shareholders’ Equity.

Liquidity ratios (can it pay current bills?):

• Current ratio = Current Assets / Current Liabilities.
• Quick ratio = (Cash + Receivables) / Current Liabilities.

Leverage ratios (how much debt?):

• Debt-to-equity = Total Debt / Equity.
• Interest coverage = EBIT / Interest Expense.

Valuation ratios (how is the market pricing this?):

• P/E = Price per share / Earnings per share.
• EV/EBITDA = Enterprise Value / EBITDA.
• Price-to-book = Price per share / Book value per share.

Ratios are not answers; they are starting points. A high ROE could be a great business or a highly leveraged one. The DuPont identity tells you which.

DuPont: decomposing ROE

$$\text{ROE} \;=\; \underbrace{\frac{\text{Net Income}}{\text{Revenue}}}_{\text{Net margin}} \;\times\; \underbrace{\frac{\text{Revenue}}{\text{Assets}}}_{\text{Asset turnover}} \;\times\; \underbrace{\frac{\text{Assets}}{\text{Equity}}}_{\text{Equity multiplier}}.$$

Three different sources of ROE:

1. Operating profitability: how much profit per dollar of sales.
2. Asset efficiency: how many dollars of sales per dollar of assets.
3. Leverage: how many dollars of assets per dollar of equity.

Walmart and Tiffany have similar ROEs but very different decompositions. Walmart: thin margins, fast turnover, modest leverage. Tiffany: fat margins, slow turnover, modest leverage. A bank: ordinary margins, very high leverage. The same headline number is masking very different businesses.

A worked example

A firm reports:

• Revenue $1,000M
• Net income $80M
• Total assets $800M
• Equity $200M

Then ROE = 80 / 200 = 40%. Decomposing:

• Net margin = 80 / 1000 = 8%
• Asset turnover = 1000 / 800 = 1.25
• Equity multiplier = 800 / 200 = 4

Check: 0.08 × 1.25 × 4 = 0.40 ✓

This firm’s 40% ROE comes mostly from leverage (equity multiplier of 4 means 75% of assets are debt-financed). If interest rates rise or business slows, the leverage that boosted ROE in good times will amplify losses in bad times. Same ROE, very different risk profile from a firm with the same return at zero leverage.

Net margin: 8.0%Asset turnover: 1.25×Equity multiplier: 4.0×Reset

Load archetype:Discount retailerLuxury brandBank

Your firm: ROE = 8.0% × 1.25 × 4.0 = 40.0%

The three archetype bars are the same height: each reaches roughly the same ROE by a different route. Thin margin and fast turnover for the retailer, fat margin and slow turnover for the luxury brand, a thin revenue base carried by heavy leverage for the bank. Click each to load its mix into the sliders and watch the red "your firm" line drop onto the bars. Push the equity multiplier alone and the line rises with no improvement in the underlying business: that is leverage flattering ROE. Archetype figures are illustrative, not reported.

The three archetype bars sit at the same height: each reaches about 18% ROE through a different mix of margin, turnover, and leverage. Your firm starts at the worked example’s 40% (the red line), which is almost all leverage, an equity multiplier of 4. Push the equity multiplier slider alone and the line rises with no change in the business; load an archetype and it drops onto the bars. Archetype figures are illustrative.

Limitations to keep in mind

Accounting is conservative and historical. The book value of equity reflects what was paid in plus retained earnings; market value of equity reflects what investors will pay tomorrow. The two diverge significantly for firms with intangible assets (brand, software, R&D) or temporary distress. When you reach valuation in Unit 3, that gap is most of the story.