Analyzing Financial Ratios

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.

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:

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:

Profitability:

Leverage:

Efficiency:

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)

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):

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:

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

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