analyzing-financial-ratios

name	analyzing-financial-ratios
description	Computes and interprets liquidity, profitability, leverage, and efficiency ratios with peer benchmarking. Use when analyzing financial statements, building comparable analyses, or evaluating company health metrics.
tags	["analysis","equity-research"]
metadata	{"author":"casemark","practice_areas":["Equity Research","Investment Management"],"document_types":["Analysis Report"],"skill_modes":["Analysis"]}

Analyzing Financial Ratios

Computes, normalizes, and interprets financial ratios across four categories — liquidity, profitability, leverage, and efficiency — with mandatory peer benchmarking and time-series context. Produces analyst-ready output suitable for equity research reports, credit assessments, and comparable company analyses.

When To Use

• Equity research initiation or update requiring comparable company analysis
• Credit review or loan underwriting where leverage and coverage ratios determine capacity
• M&A screening to identify valuation anomalies or operational gaps between target and acquirer
• Portfolio monitoring when financial statements are freshly filed and ratios need updating
• Board-level or investment committee reporting on company financial health
• Any scenario where a single ratio has been cited without peer or temporal context — this skill enforces the discipline of comparison

Do not use for pure valuation (DCF, multiples-based pricing) — this skill feeds into valuation but does not produce one.

Inputs To Gather

Before computing any ratio, confirm every item below. Pause and ask if any are missing.

Input	Details Required
Subject company	Legal name, ticker (if public), sector, sub-industry, fiscal year-end
Analysis period	Fiscal years (e.g., FY2022–FY2024), quarterly, and/or TTM; specify if calendar-year aligned
Peer group	4–8 comparable companies with rationale for inclusion (size, geography, business mix)
Data sources	SEC filings, Bloomberg, CapIQ, company IR — specify which; note any data gaps
Purpose	Equity initiation, credit review, M&A screening, portfolio monitoring, or other — this affects which ratio categories to emphasize
Accounting standards	US GAAP vs. IFRS; note any recent standard changes affecting comparability (ASC 842, IFRS 16) [VERIFY]
Known adjustments	One-time charges, discontinued operations, restatements, fiscal year changes in peer group

Anti-hallucination rule: Never fabricate financial data. If a data point is unavailable, insert [DATA NEEDED: source]. If a filing has not been released, state that explicitly.

Workflow

Step 1: Data Collection & Normalization

1A. Pull raw financial data for the subject and each peer from the three core statements:

• Income Statement: Revenue, COGS, gross profit, SGA, R&D, D&A, EBIT, interest expense, pre-tax income, tax provision, net income, diluted share count, SBC expense, restructuring charges
• Balance Sheet (period-end and average where needed): Cash & equivalents, short-term investments, AR, inventory, total current assets, total assets, AP, short-term debt, current portion of LTD, total current liabilities, long-term debt, total debt, total equity, goodwill & intangibles, operating lease liabilities (current + non-current)
• Cash Flow Statement: CFO, capex, FCF, dividends, share repurchases

1B. Normalize for comparability — apply these adjustments consistently across subject and all peers:

Adjustment	When to Apply	Method
Operating leases	Comparing pre/post ASC 842 periods or GAAP vs. IFRS peers [VERIFY]	Capitalize remaining lease payments at incremental borrowing rate; add to debt and assets
Goodwill & intangibles	ROA, ROIC, or asset-based ratios	Compute both with and without; flag if goodwill > 30% of total assets
Stock-based compensation	Profitability margins, ROIC	Show GAAP and adjusted (add back SBC); note dilution impact separately
One-time items	Any margin or return metric	Remove restructuring, litigation, asset impairments, gain/loss on sale; document each
Pension obligations	Leverage ratios for companies with DB plans	Add unfunded pension to debt for adjusted leverage
Minority interest	Net income, equity	Use income attributable to parent; adjust equity accordingly

Every adjustment must be documented with dollar amount and source filing reference.

1C. Align time periods:

• Fiscal year — when all companies share the same FYE or analysis is annual trend
• TTM — most recent performance snapshot (last annual + recent quarters − year-ago quarters)
• Calendar-year aligned — when peers have different FYEs; restate to CY using quarterly data
• Quarterly — seasonal analysis or recent inflection points

Flag any peer with a fiscal year change during the analysis period.

Step 2: Compute Ratios by Category

Compute all ratios below for the subject and each peer across all periods.

Liquidity:

Ratio	Flags
Current Ratio	< 1.0 potential liquidity stress; > 3.0 may indicate inefficient capital deployment
Quick Ratio	Strips inventory; critical for manufacturing, retail
Cash Ratio	Most conservative; relevant for distressed or early-stage companies

Profitability:

Ratio	Flags
Gross Margin	Declining trend = pricing pressure or input cost inflation; compare within sub-industry
Operating Margin (EBIT)	Show both GAAP and adjusted; SBC treatment matters significantly for tech
Net Margin	Influenced by capital structure and tax jurisdiction; less useful for cross-border comps
ROE	Decompose via DuPont (Step 3); high ROE from leverage ≠ high ROE from operations
ROA	Use average total assets; compare with and without goodwill
ROIC	The single most important return metric; must exceed WACC for value creation

Leverage:

Ratio	Flags
Debt / Equity	> 2.0x warrants deeper investigation; meaningless if equity is negative
Total Debt / EBITDA	Market-standard leverage metric; include operating leases for adjusted version
Net Debt / EBITDA	Adjusts for cash; negative net debt = net cash position
Interest Coverage (EBIT / Interest)	< 3.0x raises credit concern; < 1.5x is distress territory
Fixed Charge Coverage	Adds lease payments and mandatory debt repayment to denominator
DSCR	CFO / (principal repayment + interest); critical for project finance and credit

Efficiency:

Ratio	Flags
Asset Turnover	Higher = more efficient; compare only within same industry
Inventory Turnover	Low = potential obsolescence; very high = potential stockout risk
DSO	Growing faster than revenue = collection deterioration or channel stuffing
DPO	Increasing = supplier leverage or liquidity management; watch for coercive practices
Cash Conversion Cycle	DSO + DIO − DPO; negative = company funded by suppliers

Step 3: DuPont Decomposition

Decompose ROE into three drivers for the subject across all periods:

ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
    = (Net Income / Revenue) × (Revenue / Avg Assets) × (Avg Assets / Avg Equity)

Period	Net Margin	× Asset Turnover	× Equity Multiplier	= ROE
FY20XX	X.X%	X.Xx	X.Xx	X.X%

Interpretation:

• ROE rising from margin improvement → operational strength
• ROE rising from equity multiplier → leverage-driven, investigate sustainability
• ROE rising from asset turnover → efficiency gains, verify not from asset write-downs
• Declining margin offset by rising leverage → red flag for deteriorating quality of returns

Step 4: Peer Benchmarking

4A. Comparable table for the most recent period (TTM or latest FY):

Metric	Subject	Peer 1	Peer 2	…	Peer Median	Peer Mean
Revenue ($M)
Gross Margin
Operating Margin (adj.)
Net Margin
ROE
ROIC
Debt / EBITDA
Net Debt / EBITDA
Interest Coverage
DSO
Cash Conversion Cycle
Current Ratio

Use median as the primary benchmark (resistant to outliers). Flag any metric where the subject deviates > 1 standard deviation from peer median.

4B. Time-series trend for the subject across all analysis periods. Highlight:

• Improving vs. deteriorating trends
• Inflection points and potential causes
• Convergence toward or divergence from peer median

Step 5: Red Flag Identification

Systematically check for these warning signals:

Red Flag	Detection Method
Declining ROIC with increasing leverage	ROIC trend vs. Debt/EBITDA trend; value destruction signal
DSO growing faster than revenue	DSO % change vs. revenue % change; potential revenue quality issue
Negative working capital trend	Current ratio declining toward 1.0x with tightening quick ratio
Gross margin compression	Multi-period gross margin decline; pricing power erosion
Interest coverage deterioration	Coverage approaching 2.0x with upcoming maturities
EBITDA adjustments > 20% of reported EBITDA	Adjusted vs. GAAP gap; management credibility concern
Capex consistently below D&A	Under-investment; unsustainable margin improvement
Inventory build outpacing revenue growth	Demand weakness or obsolescence risk
Leverage through the cycle	Debt/EBITDA at cycle peak vs. trough; assess sustainability in downturn

Every red flag must cite the specific data points that triggered it and a severity assessment: watch / concern / critical.

Step 6: Synthesis & Narrative

Write a structured narrative covering:

1. Financial health summary — 2–3 sentence assessment citing the most significant ratios
2. Strengths — where the subject outperforms peers, with specific metrics
3. Weaknesses — where the subject underperforms, with specific metrics
4. Trend assessment — improving, stable, or deteriorating, with DuPont drivers
5. Key risks — red flags from Step 5, ranked by materiality
6. Credit perspective (if applicable) — leverage capacity, coverage adequacy, maturity profile
7. Conclusion — what the ratio analysis implies for the investment thesis or credit view

Output

# Financial Ratio Analysis: [COMPANY NAME] ([TICKER])
## Analysis Period: [PERIOD] | Peer Group: [LIST]
## Date: [DATE] | Analyst: [NAME]

### Executive Summary
[2–3 sentence overall assessment]

### Adjustments Applied
| Adjustment | Amount ($M) | Periods Affected | Source |
|---|---|---|---|

### Ratio Dashboard
[Comparable table from Step 4A]

### Time-Series Analysis
[Trend table from Step 4B]

### DuPont Decomposition
[Table and interpretation from Step 3]

### Red Flags & Watchlist Items
[Findings from Step 5, ranked by severity]

### Narrative Analysis
[Structured commentary from Step 6]

### Data Sources & Limitations
[List all sources; note any data gaps or estimation methods]

### Disclaimer
This analysis is based on publicly available financial data and is intended
for informational purposes. It does not constitute investment advice.
All financial data should be independently verified against primary sources.

Quality Checks

Criterion	Verification
Arithmetic accuracy	Every ratio is independently calculable from the stated inputs; no circular references
Adjustment consistency	Same adjustments applied identically across subject and all peers; documented in table
Period alignment	All companies compared on same time basis; FYE differences noted
Source traceability	Every data point traceable to a specific filing, page, or database field
Interpretation validity	No ratio interpreted without industry context; no standalone numbers presented as good/bad
Completeness	All four ratio categories covered; DuPont decomposition included; red flag scan completed
Anti-hallucination	No fabricated data; all gaps marked [DATA NEEDED]; no assumed filing data
GAAP vs. adjusted clarity	Clear labeling of which metrics are GAAP and which are adjusted; no mixing
Outlier treatment	Peer outliers flagged and explained, not silently excluded
Disclaimer present	Analysis includes appropriate disclaimer language

Escalate to human review when: subject company has negative equity, recent restatement, going concern opinion, or complex multi-segment structure requiring allocation judgments.

Standing rules:

• Ratios without peer or temporal context are prohibited — never present a ratio without comparison
• GAAP and adjusted figures must always be clearly distinguished
• Flag all one-time items explicitly, even if immaterial — let the analyst decide significance
• Non-GAAP adjustments must be sourced from management's own reconciliation or independently derived and labeled as such

Reference Files

File	Description
references/RATIO-DEFINITIONS.md	Complete ratio definitions, exact formulas, input definitions, and interpretation guidance for all ratio categories