# Ratio Analysis Concept Card: [Your course or company]

> A concept card for financial ratio analysis as it is taught in an MBA financial accounting and corporate finance core:
> profitability and returns with the three-step and five-step DuPont decomposition, liquidity, solvency, efficiency and
> the cash conversion cycle, and the quality-of-earnings red flags that tell you when the ratios cannot be trusted. It is
> for MBA students, candidates preparing for consulting, banking and credit interviews, and managers who read peer
> benchmarks. It shows every ratio with its formula, an Excel formula on a fixed statement layout, and fully computed
> examples, and it explains how IFRS 16, US GAAP ASC 842 and the IFRS 18 subtotals (from 2027) change the numbers.
> Source basis: the DuPont system (developed at DuPont in the 1910s), Richards and Laughlin (1980), Sloan (1996),
> Beneish (1999), Nissim and Penman (2001) and the IFRS and FASB standards named in the text, written up in original
> words with fictional companies. Replace every [bracketed] value and every row marked *Example*. This is a learning
> aid, not investment or credit advice.

<!--
Guidance: How to use this template
- Start with "The idea in plain language" and the diagnostic diagram, then rebuild Worked example A in a spreadsheet.
  The statements are the same as in mba/mba-three-statements-card (sheets IS, BS and CF; FY2024 in column B, FY2025 in
  column C, FY2026 in column D; row numbers shown in the exhibits). Every Excel formula below refers to that layout.
- Decide your definitions before you compute (average or closing balances, leases in debt or not, which profit for
  "EBIT"), write them in the definitions table, and keep them fixed across years and peers.
- Complete Worked example B and Exercise C before you look at the answer key.
- Northfield Outdoor Co. (outdoor-gear retailer, stores plus online) and Corvane Robotics (growth-stage
  warehouse-robotics company) are fictional; every number was computed in Python and is re-runnable.
- Related templates: mba/mba-financial-accounting-guide, mba/mba-three-statements-card,
  mba/mba-cash-flow-statement-card, mba/mba-capm-wacc-card, mba/mba-dcf-valuation-card, mba/mba-formula-sheet,
  mba/mba-case-prep-sheet, finance/working-capital-review, finance/quality-of-earnings-scope,
  finance/comparable-companies-analysis, finance/credit-memo, finance/covenant-compliance-certificate,
  finance/bond-credit-analysis, finance/equity-research-report, finance/formula-sheet, finance/ifrs-18-transition-plan.
-->

## Document control

<!-- Guidance: Record the definitions you used. Two analysts with the same statements can get different ROE, net debt or DSO purely from definitions. -->

| Field | Value |
|---|---|
| Course or purpose | [Financial accounting core / credit analysis / case interview preparation] |
| Learner or analyst | [Your name] |
| Company and peers | Northfield Outdoor Co. (fictional) / [your company and 3 to 5 peers] |
| Framework of the statements | [IFRS (IAS 1 or IFRS 18 form) / US GAAP] |
| Balance sheet basis for ratios | [Average of opening and closing / closing] |
| Leases in debt | [Yes, IFRS 16 lease liabilities included / no, with reason] |
| Standards checked on | 2026-10-28 (ifrs.org, fasb.org) |
| Reviewed by | [Study partner, tutor or mentor] |
| Version | [0.1] |
| Last updated | YYYY-MM-DD |

## Contents

1. [When to use it](#when-to-use-it)
2. [The idea in plain language](#the-idea-in-plain-language)
3. [Formulas and notation](#formulas-and-notation)
4. [Assumptions and limits](#assumptions-and-limits)
5. [How managers use it](#how-managers-use-it)
6. [Worked example A (fully solved)](#worked-example-a-fully-solved)
7. [Quality of earnings red flags](#quality-of-earnings-red-flags)
8. [Worked example B (half solved)](#worked-example-b-half-solved)
9. [Exercise C (unsolved)](#exercise-c-unsolved)
10. [Connections to other cards](#connections-to-other-cards)
11. [Common mistakes and misconceptions](#common-mistakes-and-misconceptions)
12. [Self-test questions](#self-test-questions)
13. [My notes and next steps](#my-notes-and-next-steps)
14. [Sources and further reading](#sources-and-further-reading)
15. [Answer key](#answer-key)

## When to use it

<!-- Guidance: Ratios answer comparative questions. If you cannot name the comparison (last year, a peer, a covenant, a target), you are not ready to compute. -->

Use ratio analysis when you need to:

- **Explain performance**: why return on equity moved, and whether the cause is margin, asset use or leverage.
- **Compare** a company with its own history, with peers (finance/comparable-companies-analysis) or with a plan.
- **Assess credit risk**: liquidity, leverage and coverage for a loan, a bond or a supplier decision
  (finance/credit-memo, finance/bond-credit-analysis).
- **Diagnose working capital**: how many days of cash are tied up in inventory and receivables
  (finance/working-capital-review).
- **Screen earnings quality** before you trust any of the above (finance/quality-of-earnings-scope).

Do not use ratios to value a company on their own (use mba/mba-dcf-valuation-card), and do not compare ratios across
companies that use different accounting (IFRS 16 against ASC 842 operating leases, for example) without adjusting.

## The idea in plain language

<!-- Guidance: Be able to explain DuPont on a whiteboard in two minutes: it is the most common ratio question in MBA exams and finance interviews. -->

A ratio divides one number by another so that companies of different sizes, or one company over time, can be
compared. The numbers mean something only against a benchmark and only after you know how they were defined.

**DuPont analysis** answers the owner's question: "how much profit do I earn on my equity, and why?" It splits return
on equity (ROE) into pieces that managers control in different ways:

- **Three steps:** ROE = how much of each sale is profit (net margin) x how many sales each unit of assets produces
  (asset turnover) x how many assets each unit of equity supports (equity multiplier, a leverage measure).
- **Five steps:** the margin is split further into how much of pre-tax profit survives tax (tax burden), how much of
  operating-level profit survives financing costs (interest burden), and the operating-level margin.

Two companies with the same 13% ROE can be completely different businesses: a high-margin, low-turnover luxury brand
and a thin-margin, high-turnover discounter, or a company that earns it with leverage rather than operations.

The other families answer narrower questions: **liquidity** (can it pay what falls due within a year?), **solvency**
(can it carry its debt over time?), **efficiency** (how hard do the assets work, and how long is cash tied up in the
operating cycle?) and **quality of earnings** (do accounting profits turn into cash, and are the estimates behind them
reasonable?).

```mermaid
flowchart TD
  ROE["ROE = profit / average equity"] --> NM["Net margin = profit / revenue"]
  ROE --> AT["Asset turnover = revenue / average assets"]
  ROE --> EM["Equity multiplier = average assets / average equity"]
  NM --> TB["Tax burden = profit / profit before income taxes"]
  NM --> IB["Interest burden = profit before income taxes / EBIT"]
  NM --> OPM["EBIT margin = EBIT / revenue"]
  AT --> WC["Working capital days: DIO, DSO, DPO"]
  AT --> FA["Fixed asset and right-of-use asset turnover"]
  EM --> SOLV["Solvency: debt to equity, net debt to EBITDA, interest cover"]
  WC --> QOE{"Earnings quality checks pass?"}
  OPM --> QOE
  QOE -->|"yes"| USE["Use the ratios for comparison and decisions"]
  QOE -->|"no"| ADJ["Adjust the statements or investigate before concluding"]
```

## Formulas and notation

<!-- Guidance: Copy these definitions into your Document control choices. Use average balances for any ratio that mixes a flow (income statement) with a stock (balance sheet). -->

Three-step DuPont (with average balances $\bar{A}$ and $\bar{E}$):

$$ROE = \frac{NI}{\bar{E}} = \frac{NI}{S} \times \frac{S}{\bar{A}} \times \frac{\bar{A}}{\bar{E}}$$

Five-step DuPont, with EBIT defined as profit before financing and income taxes (the IFRS 18 subtotal):

$$ROE = \frac{NI}{PBT} \times \frac{PBT}{EBIT} \times \frac{EBIT}{S} \times \frac{S}{\bar{A}} \times \frac{\bar{A}}{\bar{E}}$$

Return on invested capital, consistent numerator and denominator:

$$ROIC = \frac{OP \times (1 - t)}{\overline{IC}}, \qquad IC = E + D + LL - Cash - Inv_{assoc}$$

Cash conversion cycle (Richards and Laughlin 1980):

$$CCC = DIO + DSO - DPO = \frac{\overline{Inv}}{COGS}\times 365 + \frac{\overline{AR}}{S}\times 365 - \frac{\overline{AP}}{COGS}\times 365$$

Accrual ratio (balance of profit not backed by operating cash, after Sloan 1996):

$$Accruals = \frac{NI - CFO}{\bar{A}}$$

| Symbol | Meaning | Northfield FY2026 (USD m) |
|---|---|---|
| $NI$ | Profit for the year | 19.5 |
| $S$ | Revenue | 512.0 |
| $PBT$ | Profit before income taxes | 25.3 |
| $EBIT$ | Profit before financing and income taxes (IFRS 18) | 40.2 |
| $OP$ | Operating profit (IFRS 18) | 37.4 |
| $t$ | Tax rate | 25% |
| $\bar{A}$, $\bar{E}$ | Average total assets, average equity | 490.60, 147.85 |
| $D$, $LL$ | Bank loan, lease liabilities (closing) | 70.0, 185.0 |
| $IC$ | Invested capital (average) | 350.60 |
| $COGS$ | Cost of sales | 284.2 |
| $\overline{Inv}$, $\overline{AR}$, $\overline{AP}$ | Average inventories, trade receivables, trade payables | 111.0, 16.3, 55.75 |
| $CFO$ | Net cash from operating activities | 70.4 (IFRS 18 basis), 56.3 (IAS 7 policy before the amendment) |

**Ratio map.** One line per ratio you will meet in a core course.

| Family | Ratio | Formula | Reads as |
|---|---|---|---|
| Profitability | Gross margin | Gross profit / revenue | Pricing power and sourcing cost |
| Profitability | Operating margin | Operating profit / revenue | Operating efficiency after all operating costs |
| Profitability | EBITDA margin | (Operating profit + D&A + impairment) / revenue | Cash-like operating margin; inflated by IFRS 16 |
| Profitability | Net margin | Profit / revenue | All-in profitability |
| Returns | ROA | Profit / average total assets | Return on all resources (mixes financing into the numerator) |
| Returns | ROE | Profit / average equity | Return to owners |
| Returns | ROIC | NOPAT / average invested capital | Operating return on the capital that funds operations |
| Liquidity | Current ratio | Current assets / current liabilities | Short-term coverage |
| Liquidity | Quick ratio | (Cash + receivables) / current liabilities | Coverage without selling inventory |
| Liquidity | Cash ratio | Cash / current liabilities | Strictest test |
| Solvency | Debt to equity | Borrowings (and leases) / equity | Balance sheet leverage |
| Solvency | Net debt to EBITDA | (Borrowings + leases - cash) / EBITDA | Years of EBITDA to repay; typical covenant |
| Solvency | Interest cover | EBIT / financing expense | Cushion over interest |
| Efficiency | Asset turnover | Revenue / average total assets | Sales per unit of assets |
| Efficiency | DIO, DSO, DPO | See formula above | Days of inventory, receivables, payables |
| Efficiency | Cash conversion cycle | DIO + DSO - DPO | Days of operating cash tied up |
| Quality | CFO / profit | Net cash from operating activities / profit | Cash backing of profit |
| Quality | Accrual ratio | (Profit - CFO) / average total assets | High positive values flag weak earnings quality |

## Assumptions and limits

<!-- Guidance: Every ratio inherits the accounting behind it. Write down the one or two limits that most affect your comparison. -->

- **Benchmarks are everything.** There is no "good" current ratio in general. A grocer runs below 1.0 because it is
  paid before it pays suppliers; a machine builder needs far more.
- **Definitions vary.** Average or closing balances, which "EBIT", leases in or out of debt, gross or net of cash. Fix
  the definitions and apply them to every year and every peer.
- **Leases change everything.** Under IFRS 16 store leases sit in debt and the lease cost is split into depreciation and
  interest, so EBITDA, operating profit, debt and CFO are all higher than under ASC 842 operating lease accounting.
  Compare IFRS and US GAAP retailers only after adjusting one to the other.
- **IFRS 18 changes the subtotals.** From annual periods beginning on or after 1 January 2027, IFRS reporters present
  operating profit and profit before financing and income taxes as defined subtotals. Ratios built on a company's old
  IAS 1 "operating profit" will not match the restated comparatives. Use the IFRS 18 subtotals for new work, and use
  management-defined performance measures (MPMs) only through their reconciliation note.
- **Year-end balances can be managed.** Retailers choose a year end after the peak season; any company can pay
  suppliers late or collect early around the reporting date. Averages of quarterly balances are better when available.
- **Ratios describe; they do not explain.** A falling margin can come from price, mix, cost or accounting. Use the
  ratio to find the question, then read the notes and talk to management.

## How managers use it

<!-- Guidance: Name the ratio your own manager, lender or board actually watches, and the decision it drives. -->

- **Boards and investors** track ROE and ROIC against the cost of capital (mba/mba-capm-wacc-card): growth that earns
  below the cost of capital destroys value even when profit rises.
- **Lenders** set covenants such as maximum net debt to EBITDA and minimum liquidity, and test them each quarter
  (finance/covenant-compliance-certificate). Treasurers forecast the covenant ratios before every major decision.
- **Operations and merchandising** manage DIO and the cash conversion cycle: each day of inventory at Northfield's
  FY2026 cost of sales ties up about USD 0.78m (284.2 / 365).
- **Finance teams** explain variances (finance/variance-analysis) by decomposing margin and turnover, and investor
  relations teams prepare the MPM reconciliations that analysts will use from 2027.

## Worked example A (fully solved)

<!-- Guidance: Rebuild Exhibit A1 in a spreadsheet, then type each formula and compare your answer to the table. Differences in the third decimal usually mean you used closing instead of average balances. -->

**Exhibit A1. Northfield Outdoor Co. inputs (USD m, fictional; full statements in mba/mba-three-statements-card).**

| Item | Sheet and row | FY2024 | FY2025 | FY2026 |
|---|---|---|---|---|
| Revenue | IS row 5 | | 468.0 | 512.0 |
| Cost of sales | IS row 6 | | 262.1 | 284.2 |
| Gross profit | IS row 7 | | 205.9 | 227.8 |
| Operating profit (IFRS 18) | IS row 11 | | 37.9 | 37.4 |
| Profit before financing and income taxes | IS row 14 | | 40.2 | 40.2 |
| Financing expenses (loan 5.6, leases 9.0 / 9.3) | IS rows 15 to 16 | | 14.6 | 14.9 |
| Profit before income taxes | IS row 17 | | 25.6 | 25.3 |
| Profit for the year | IS row 19 | | 19.6 | 19.5 |
| EBITDA (operating profit + D&A + impairment) | IS row 21 | | 87.9 | 95.7 |
| Adjusted operating profit (MPM) | IS row 22 | | 37.9 | 44.0 |
| Cash | BS row 5 | 45.0 | 50.5 | 22.0 |
| Trade receivables | BS row 6 | 14.0 | 15.0 | 17.6 |
| Inventories | BS row 7 | 96.0 | 101.0 | 121.0 |
| Total current assets | BS row 9 | 161.0 | 172.9 | 167.6 |
| Investment in associate | BS row 13 | 12.0 | 12.6 | 13.4 |
| Total assets | BS row 14 | 461.0 | 481.5 | 499.7 |
| Trade payables | BS row 15 | 52.0 | 55.0 | 56.5 |
| Lease liabilities, current / non-current | BS rows 20, 22 | 25.0 / 139.0 | 28.0 / 141.0 | 30.0 / 155.0 |
| Total current liabilities | BS row 21 | 108.0 | 116.9 | 122.6 |
| Bank loan | BS row 23 | 80.0 | 80.0 | 70.0 |
| Total equity | BS row 27 | 134.0 | 143.6 | 152.1 |
| Net cash from operating activities (IFRS 18 basis) | CF row 16 | | 81.4 | 70.4 |

**Step 1. Profitability and DuPont, FY2026 (FY2025 for comparison).**

| Ratio | FY2025 | FY2026 | Excel (FY2026) |
|---|---|---|---|
| Gross margin | 44.00% | 44.49% | `=IS!D7/IS!D5` |
| Operating margin (IFRS 18) | 8.10% | 7.30% | `=IS!D11/IS!D5` |
| Adjusted operating margin (MPM) | 8.10% | 8.59% | `=IS!D22/IS!D5` |
| EBITDA margin | 18.78% | 18.69% | `=IS!D21/IS!D5` |
| Net margin | 4.19% | 3.81% | `=IS!D19/IS!D5` |
| Asset turnover | 0.993 | 1.044 | `=IS!D5/AVERAGE(BS!C14,BS!D14)` |
| Equity multiplier | 3.395 | 3.318 | `=AVERAGE(BS!C14,BS!D14)/AVERAGE(BS!C27,BS!D27)` |
| **ROE (three-step product)** | **14.12%** | **13.19%** | `=IS!D19/AVERAGE(BS!C27,BS!D27)` |
| Tax burden | 0.766 | 0.771 | `=IS!D19/IS!D17` |
| Interest burden | 0.637 | 0.629 | `=IS!D17/IS!D14` |
| EBIT margin (PBFIT / revenue) | 8.59% | 7.85% | `=IS!D14/IS!D5` |
| **ROE (five-step product)** | **14.12%** | **13.19%** | `=(IS!D19/IS!D17)*(IS!D17/IS!D14)*(IS!D14/IS!D5)*(IS!D5/AVERAGE(BS!C14,BS!D14))*(AVERAGE(BS!C14,BS!D14)/AVERAGE(BS!C27,BS!D27))` |
| ROA | 4.16% | 3.97% | `=IS!D19/AVERAGE(BS!C14,BS!D14)` |
| NOPAT = operating profit x (1 - 25%) | 28.43 | 28.05 | `=IS!D11*(1-0.25)` |
| Average invested capital | 325.25 | 350.60 | `=AVERAGE(BS!C27+BS!C23+BS!C20+BS!C22-BS!C5-BS!C13, BS!D27+BS!D23+BS!D20+BS!D22-BS!D5-BS!D13)` |
| ROIC | 8.74% | 8.00% | `=IS!D11*(1-0.25)/E40` (E40 holds the average invested capital) |

Check: 0.0381 x 1.044 x 3.318 = 0.1319, and 0.771 x 0.629 x 0.0785 x 1.044 x 3.318 = 0.1319. Both products equal ROE
exactly because each numerator cancels the next denominator.

**Reading.** ROE fell by 0.93 percentage points. Turnover improved (more revenue per unit of assets, helped by online
growth from 33.3% to 37.1% of revenue), and leverage fell slightly as the loan was prepaid. The whole decline sits in
the EBIT margin (8.59% to 7.85%): restructuring and impairment of 6.6 cost 1.29 points of margin. On the adjusted
measure the operating margin rose, which is exactly why the MPM reconciliation matters: a reader must decide whether
store closures are a one-off or a recurring cost of running a store estate. ROIC of 8.0% should be compared with the
company's cost of capital (mba/mba-capm-wacc-card): at an illustrative cost of capital of 9%, the business would not
be covering it.

**Step 2. Liquidity and solvency, closing balances.**

| Ratio | FY2025 | FY2026 | Excel (FY2026) |
|---|---|---|---|
| Current ratio | 1.479 | 1.367 | `=BS!D9/BS!D21` |
| Quick ratio (cash + receivables) | 0.560 | 0.323 | `=(BS!D5+BS!D6)/BS!D21` |
| Cash ratio | 0.432 | 0.179 | `=BS!D5/BS!D21` |
| Bank debt to equity | 0.557 | 0.460 | `=BS!D23/BS!D27` |
| Debt including leases to equity | 1.734 | 1.677 | `=(BS!D23+BS!D20+BS!D22)/BS!D27` |
| Net debt including leases | 198.5 | 233.0 | `=BS!D23+BS!D20+BS!D22-BS!D5` |
| Net debt including leases / EBITDA | 2.26x | 2.43x | `=(BS!D23+BS!D20+BS!D22-BS!D5)/IS!D21` |
| Net bank debt (excluding leases) | 29.5 | 48.0 | `=BS!D23-BS!D5` |
| Interest cover (PBFIT / financing expense) | 2.75x | 2.70x | `=IS!D14/(IS!D15+IS!D16)` |
| Total liabilities / total assets | 70.2% | 69.6% | `=BS!D24/BS!D14` |

**Reading.** Leverage measured on the balance sheet improved, but liquidity weakened sharply: the quick ratio almost
halved because cash fell from 50.5 to 22.0 while inventory absorbed the difference. The current ratio hides this,
because inventory counts as a current asset. Net debt rose by 34.5 even though the loan fell by 10.0: lease
liabilities grew by 16.0 (new stores) and cash fell by 28.5.

**Step 3. Efficiency and the cash conversion cycle.**

| Ratio | FY2025 | FY2026 | Excel (FY2026) |
|---|---|---|---|
| Days inventory outstanding (DIO) | 137.2 | 142.6 | `=AVERAGE(BS!C7,BS!D7)/IS!D6*365` |
| Days sales outstanding (DSO) | 11.3 | 11.6 | `=AVERAGE(BS!C6,BS!D6)/IS!D5*365` |
| Days payables outstanding (DPO) | 74.5 | 71.6 | `=AVERAGE(BS!C15,BS!D15)/IS!D6*365` |
| **Cash conversion cycle** | **74.0** | **82.6** | `=DIO+DSO-DPO` |
| Inventory turnover | 2.66x | 2.56x | `=IS!D6/AVERAGE(BS!C7,BS!D7)` |
| PP&E turnover | 3.84x | 3.96x | `=IS!D5/AVERAGE(BS!C10,BS!D10)` |

DPO uses cost of sales because purchases are not disclosed; with purchases (cost of sales plus the increase in
inventory) the FY2026 DPO would be lower. The chart shows the cycle lengthening on both sides: more days of inventory
and fewer days of supplier credit.

```vega-lite
{
  "$schema": "https://vega.github.io/schema/vega-lite/v5.json",
  "description": "Northfield Outdoor Co. working capital days, FY2025 and FY2026 (fictional)",
  "width": 360,
  "height": 200,
  "data": {"values": [
    {"measure": "DIO", "year": "FY2025", "days": 137.2},
    {"measure": "DIO", "year": "FY2026", "days": 142.6},
    {"measure": "DSO", "year": "FY2025", "days": 11.3},
    {"measure": "DSO", "year": "FY2026", "days": 11.6},
    {"measure": "DPO", "year": "FY2025", "days": 74.5},
    {"measure": "DPO", "year": "FY2026", "days": 71.6},
    {"measure": "CCC", "year": "FY2025", "days": 74.0},
    {"measure": "CCC", "year": "FY2026", "days": 82.6}
  ]},
  "mark": "bar",
  "encoding": {
    "x": {"field": "measure", "type": "nominal", "sort": ["DIO", "DSO", "DPO", "CCC"], "title": null},
    "xOffset": {"field": "year"},
    "y": {"field": "days", "type": "quantitative", "title": "Days"},
    "color": {"field": "year", "type": "nominal", "title": "Year"}
  }
}
```

**Step 4. Quality of earnings.**

| Check | FY2025 | FY2026 | Excel (FY2026) | Signal |
|---|---|---|---|---|
| CFO / profit (IFRS 18 basis) | 4.15x | 3.61x | `=CF!D16/IS!D19` | Looks strong, but inflated by IFRS 16 |
| CFO / profit (IAS 7 policy with interest in operating) | 3.44x | 2.89x | `=56.3/IS!D19` | Still inflated by leases |
| CFO after lease principal / profit | 2.17x | 1.45x | `=(56.3-28.0)/IS!D19` | Falling fast: the real signal |
| Accrual ratio (IAS 7 policy CFO) | -10.2% | -7.5% | `=(IS!D19-56.3)/AVERAGE(BS!C14,BS!D14)` | Negative is normal for a business with large D&A |
| Closing inventory growth vs revenue growth | 5.2% vs n/a (FY2024 revenue not in the example) | 19.8% vs 9.4% | `=BS!D7/BS!C7-1` and `=IS!D5/IS!C5-1` | Red flag: inventory growing twice as fast as sales |
| Revenue growth vs receivables growth | | 9.4% vs 17.3% | `=BS!D6/BS!C6-1` | Watch: could be online payment settlement timing |
| Gross margin trend while inventory builds | 44.00% | 44.49% | `=IS!D7/IS!D5` | Margin up while stock piles up: check the inventory write-down |

The table shows why a single cash ratio can mislead under IFRS 16: lease principal sits in financing, so CFO looks
large relative to profit for any company with big leases. Subtracting lease principal gives a figure comparable to a
US GAAP company with operating leases (28.3 in FY2026, the same as the ASC 842 view computed in
mba/mba-cash-flow-statement-card).

**Conclusion.** Northfield's returns slipped modestly, but the more important story is cash: the cycle lengthened by
8.6 days, inventory rose 19.8% against 9.4% sales growth, and cash after leases fell to about 1.45 times profit. The
next questions are about the inventory (age profile, write-down policy under IAS 2, sell-through of seasonal lines)
and about whether the restructuring is really a one-off.

## Quality of earnings red flags

<!-- Guidance: Use this checklist on every company before you trust its ratios. One red flag is a question, not a verdict; three together deserve a closer look and perhaps a quality-of-earnings review (finance/quality-of-earnings-scope). -->

| ID | Red flag | Where to look | What it can mean | Northfield FY2026 |
|---|---|---|---|---|
| QE-01 *(Example)* | Profit grows but CFO (after leases) falls for two or more years | Cash flow statement, IFRS 16 lease note | Revenue or costs recognised before cash, working capital build | Yes, one year so far |
| QE-02 *(Example)* | Inventory grows much faster than cost of sales | Balance sheet, inventory note | Slow-moving stock, under-provided write-downs, over-buying | Yes: 19.8% vs 8.4% |
| QE-03 | Receivables grow faster than revenue (DSO rising) | Balance sheet, credit loss note (IFRS 9) | Aggressive revenue recognition, extended terms, collection problems | Watch: 17.3% vs 9.4% |
| QE-04 | Gross margin up while inventory builds | Income statement, inventory note | Costs held in inventory, low write-downs | Yes, needs explanation |
| QE-05 | Capitalised spending rising faster than depreciation (capex or capitalised software) | Cash flow statement, PP&E and intangibles notes | Expenses moved to the balance sheet | Capex and software 37.0 vs PP&E and software D&A 25.3: growth stores, plausible |
| QE-06 | Recurring "one-off" items in adjusted measures | MPM note (IFRS 18) or non-GAAP reconciliation | Normal costs presented as exceptional | First year: monitor |
| QE-07 | Allowances and provisions falling as a share of the balance | Notes | Earnings boosted by releasing reserves | Not disclosed in the example |
| QE-08 | Changes in estimates (useful lives, lease terms) or accounting policies | Accounting policies note | Profit boosted without economic change | None |
| QE-09 | Payables stretched or supplier finance arrangements | Liquidity note; IAS 7 and IFRS 7 supplier finance disclosures | CFO flattered by paying later | DPO fell, so no |
| QE-10 | Related-party transactions, auditor change, modified audit opinion, late filing | Audit report, related-party note | Governance risk | None in the example |

Two published screens are worth knowing by name: the accrual anomaly (Sloan 1996: high accruals predicted lower future
earnings and returns) and the Beneish (1999) M-score, a probit model built on eight ratios (including days receivables,
gross margin, asset quality and accruals) to flag likely earnings manipulators. Both were estimated on US companies and
are screens, not proof. Altman's (1968) Z-score is the classic solvency screen; it was estimated on US manufacturers and
does not transfer directly to retailers with large IFRS 16 lease liabilities.

## Worked example B (half solved)

<!-- Guidance: Fill each [ ] with a number to three decimals (or one decimal for days) before you open the answer key. Use FY2024 and FY2025 balances for the averages. -->

Compute Northfield's FY2025 five-step DuPont and cash conversion cycle. Inputs: profit 19.6, profit before income
taxes 25.6, profit before financing and income taxes 40.2, revenue 468.0, cost of sales 262.1, average total assets
471.25, average equity 138.8, average inventories 98.5, average receivables 14.5, average payables 53.5.

| Component | Formula | Value |
|---|---|---|
| Tax burden | 19.6 / 25.6 | 0.766 |
| Interest burden | 25.6 / 40.2 | [ ] |
| EBIT margin | 40.2 / 468.0 | [ ] |
| Asset turnover | 468.0 / 471.25 | 0.993 |
| Equity multiplier | [ ] | [ ] |
| ROE (product) | | [ ] |
| DIO | 98.5 / 262.1 x 365 | [ ] |
| DSO | [ ] | 11.3 |
| DPO | 53.5 / 262.1 x 365 | [ ] |
| Cash conversion cycle | [ ] | [ ] |

Then explain in two sentences which DuPont component moved most between FY2025 and FY2026 and why.

## Exercise C (unsolved)

<!-- Guidance: Compute first, then write the interpretation. The interpretation is what an exam marker grades; the numbers are only the entry ticket. -->

Corvane Robotics (fictional growth-stage warehouse-robotics company) reports for FY2026 (USD m): revenue 84.0, cost of
sales 50.4, operating loss 6.0, loss for the year 5.3, average total assets 120.0, average equity 78.0, trade
receivables 18.0 opening and 24.0 closing, inventories 16.0 opening and 21.0 closing, trade payables 8.0 opening and
10.4 closing, closing current assets 64.0, closing current liabilities 28.0, closing cash 30.0, and net cash used in
operating activities 4.1.

1. Compute gross margin, operating margin, net margin, asset turnover, equity multiplier and ROE, and check that the
   three-step product equals ROE.
2. Compute the current ratio and the quick ratio (cash plus closing receivables).
3. Compute DSO, DIO, DPO and the cash conversion cycle with average balances.
4. Compute CFO divided by the loss for the year. Why is a ratio of CFO to profit hard to read for a loss-making company?
5. In five sentences, compare Corvane's ratio profile with Northfield's. Which ratios would you not compare across the
   two companies at all, and why?

## Connections to other cards

<!-- Guidance: Pick the next card from the question your ratios raised. -->

| Next card | Use it when |
|---|---|
| mba/mba-three-statements-card | You need the full statements behind the ratios, or the IFRS 18 subtotals |
| mba/mba-cash-flow-statement-card | Your ratios point to cash: CFO, free cash flow, lease effects |
| mba/mba-capm-wacc-card | You compare ROIC with the cost of capital |
| mba/mba-dcf-valuation-card | You move from ratios to a valuation |
| mba/mba-inventory-card | DIO is the problem and you need ordering and safety-stock logic |
| mba/mba-financial-accounting-guide | You want the course map, the mini-case and the exam plan |
| finance/working-capital-review, finance/quality-of-earnings-scope, finance/credit-memo | You apply the analysis at work |

## Common mistakes and misconceptions

<!-- Guidance: Read before an exam and before you present any benchmark. Log every mistake in mba/mba-error-log. -->

- **Mixing stocks and flows on different dates.** Dividing a full-year flow by a closing balance biases ratios when the
  balance sheet is growing. Use averages and say so.
- **A DuPont product that does not equal ROE.** If your components use different profit or balance definitions, the
  product breaks. Each numerator must cancel the next denominator.
- **Comparing IFRS 16 and ASC 842 retailers directly.** IFRS 16 raises EBITDA, operating profit, CFO and debt. Adjust
  before comparing margins, leverage or cash conversion.
- **Calling the current ratio "liquidity".** Inventory is the least liquid current asset. Northfield's current ratio
  fell modestly while its quick ratio almost halved.
- **Using adjusted figures without the reconciliation.** An MPM or non-GAAP number is management's view. Start from
  the IFRS 18 subtotal and add back only what you agree is non-recurring.
- **Treating high ROE as good news.** ROE can rise because equity shrinks (buybacks, losses written against equity) or
  because leverage rises. Check the equity multiplier and ROIC.
- **Computing DPO on revenue.** Payables relate to purchases at cost; use cost of sales (or purchases) consistently.
- **Comparing ratios across business models.** A robotics company's inventory days, margins and asset turnover have
  little to do with a retailer's. Compare with peers in the same model.
- **Ignoring seasonality.** A retailer's year-end inventory and payables depend on where the season sits. Use
  quarterly averages when you can.

## Self-test questions

<!-- Guidance: Answer from memory, then check the key. Repeat after two days and a week. -->

1. Write the three-step and five-step DuPont identities and say why each product equals ROE exactly.
2. Northfield's ROE fell from 14.12% to 13.19%. Which component explains the fall?
3. Why did the quick ratio fall much more than the current ratio?
4. Net debt including leases rose by 34.5 although the loan fell by 10.0. Reconcile the movement.
5. Define the cash conversion cycle and compute Northfield's FY2026 value from DIO 142.6, DSO 11.6, DPO 71.6.
6. Give two reasons why CFO divided by profit is high for an IFRS 16 retailer even when earnings quality is ordinary.
7. Under IFRS 18, which subtotal would you use as EBIT in the five-step DuPont, and why?
8. A company's gross margin rises while inventory grows twice as fast as cost of sales. Name two explanations, one benign
   and one worrying.
9. What does the Sloan (1996) accrual anomaly say?
10. Why is ROIC more useful than ROE for judging operating performance?

## My notes and next steps

<!-- Guidance: Record your peer set and definitions so the next update is quick and consistent. -->

| Item | My entry |
|---|---|
| Confidence with DuPont (1 to 5) | [ ] |
| Confidence with working capital days (1 to 5) | [ ] |
| Peer set and data source | [ ] |
| Definitions chosen (averages, leases, EBIT) | [ ] |
| Mistakes logged in mba/mba-error-log | [Date and short description] |
| Next review date | YYYY-MM-DD |
| Next card | [mba/mba-cash-flow-statement-card / mba/mba-dcf-valuation-card] |

## Sources and further reading

<!-- Guidance: Primary works first, then the standards, then textbooks named for further reading only. -->

- DuPont system of financial control: developed inside the DuPont company in the 1910s and usually credited to
  F. Donaldson Brown; the five-step extension is the textbook form used in financial statement analysis.
- Richards, V. D., and Laughlin, E. J. (1980). A cash conversion cycle approach to liquidity analysis. *Financial
  Management*, 9(1), 32-38.
- Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. *The Journal
  of Finance*, 23(4), 589-609.
- Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings?
  *The Accounting Review*, 71(3), 289-315.
- Beneish, M. D. (1999). The detection of earnings manipulation. *Financial Analysts Journal*, 55(5), 24-36.
- Nissim, D., and Penman, S. H. (2001). Ratio analysis and equity valuation: from research to practice. *Review of
  Accounting Studies*, 6(1), 109-154.
- Dechow, P. M., and Dichev, I. D. (2002). The quality of accruals and earnings: the role of accrual estimation errors.
  *The Accounting Review*, 77(Supplement), 35-59.
- IFRS Foundation: IFRS 18 (annual periods beginning on or after 1 January 2027), IAS 7, IFRS 16, IAS 2.
  https://www.ifrs.org (checked 2026-10-28). FASB: ASC 842 (ASU 2016-02), ASC 230. https://www.fasb.org (checked
  2026-10-28).
- Textbooks (further reading by name only): Penman, S. H., *Financial Statement Analysis and Security Valuation*
  (McGraw Hill); Palepu, K. G., Healy, P. M. and Wright, S., *Business Analysis and Valuation: IFRS Edition* (Cengage);
  Koller, T., Goedhart, M. and Wessels, D., *Valuation: Measuring and Managing the Value of Companies* (Wiley).
- Open resource: OpenStax, *Principles of Accounting, Volume 1: Financial Accounting* (CC BY-NC-SA 4.0), openstax.org.

## Answer key

<!-- Guidance: Check only after writing your own answers; for each miss, note why your first answer was wrong. -->

**Worked example B.** Interest burden 25.6 / 40.2 = 0.637. EBIT margin 40.2 / 468.0 = 0.0859 (8.59%). Equity multiplier
471.25 / 138.8 = 3.395. ROE = 0.766 x 0.637 x 0.0859 x 0.993 x 3.395 = 0.1412 (14.12%) at full precision (the rounded factors give 0.1413), equal to
19.6 / 138.8. DIO
= 98.5 / 262.1 x 365 = 137.2 days. DSO = 14.5 / 468.0 x 365 = 11.3 days. DPO = 53.5 / 262.1 x 365 = 74.5 days. CCC =
137.2 + 11.3 - 74.5 = 74.0 days. Between FY2025 and FY2026 the EBIT margin moved most (8.59% to 7.85%), because the
6.6 of restructuring and impairment fell within operating profit while revenue grew only 9.4%; turnover improved and
leverage fell slightly, so neither explains the lower ROE.

**Exercise C.**

| Ratio | Corvane FY2026 |
|---|---|
| Gross margin | 33.6 / 84.0 = 40.00% |
| Operating margin | -6.0 / 84.0 = -7.14% |
| Net margin | -5.3 / 84.0 = -6.31% |
| Asset turnover | 84.0 / 120.0 = 0.700 |
| Equity multiplier | 120.0 / 78.0 = 1.538 |
| ROE | -5.3 / 78.0 = -6.79% (product -0.0631 x 0.700 x 1.538 = -0.0679) |
| Current ratio | 64.0 / 28.0 = 2.29 |
| Quick ratio | (30.0 + 24.0) / 28.0 = 1.93 |
| DSO | 21.0 / 84.0 x 365 = 91.3 days |
| DIO | 18.5 / 50.4 x 365 = 134.0 days |
| DPO | 9.2 / 50.4 x 365 = 66.6 days |
| Cash conversion cycle | 91.25 + 133.98 - 66.63 = 158.6 days (unrounded inputs) |
| CFO / loss | -4.1 / -5.3 = 0.77 |

(4) With both numbers negative, the ratio is positive and a "better" (smaller) cash burn gives a smaller ratio, so the
usual reading reverses; compare cash burn with the loss directly instead (cash burn 4.1 is less than the 5.3 loss
because depreciation and share-based compensation are non-cash, partly offset by the working capital build). (5)
Corvane has low leverage (equity-funded), high liquidity from its latest equity raise, slow asset turnover, long
receivable days typical of enterprise equipment sales, and negative returns. Margins and returns are comparable in
concept but not in level; working capital days and asset turnover reflect different business models and should be
compared only with robotics peers.

**Self-test.**

1. ROE = (NI/S)(S/A)(A/E) and ROE = (NI/PBT)(PBT/EBIT)(EBIT/S)(S/A)(A/E); each numerator cancels the next denominator,
   leaving NI/E.
2. The EBIT margin (8.59% to 7.85%), driven by 6.6 of restructuring and impairment; turnover rose and the tax burden was
   stable.
3. Cash fell from 50.5 to 22.0 and inventory rose by 20.0; the current ratio counts inventory, the quick ratio does not.
4. Lease liabilities +16.0 (169.0 to 185.0), loan -10.0, cash -28.5 (which raises net debt by 28.5): 16.0 - 10.0 + 28.5 =
   34.5.
5. CCC = DIO + DSO - DPO = 142.6 + 11.6 - 71.6 = 82.6 days.
6. Lease principal is a financing outflow, so CFO excludes a large recurring cash cost; and depreciation of right-of-use
   assets is a large non-cash charge added back. (Under the amended IAS 7, interest paid is also outside CFO.)
7. Profit before financing and income taxes, because it is a defined IFRS subtotal that sits exactly above the financing
   category, so the interest burden captures all financing costs including lease interest.
8. Benign: a planned build of new-season stock or a product mix shift towards higher-margin own brands. Worrying:
   too few write-downs of slow-moving stock, or costs capitalised into inventory, both of which flatter the margin.
9. Firms with high accruals (profit well above operating cash flow) tended to have lower future earnings and stock
   returns; the market appeared to overweight the accrual component of earnings.
10. ROIC measures operating returns on all capital that funds operations, independent of how it is financed; ROE mixes
    operating performance with leverage.

## Revision history

<!-- Guidance: Add a row when you update the peer set, the definitions or the year. -->

| Version | Date | Author | Change summary |
|---|---|---|---|
| 0.1 | YYYY-MM-DD | [Your name] | First pass through Worked examples A and B |
| 0.2 | YYYY-MM-DD | [Your name] | *Example:* Added three listed retail peers, leases adjusted to one basis |

## Standard and licence note

Based on the published research named above (Richards and Laughlin 1980, Altman 1968, Sloan 1996, Beneish 1999,
Nissim and Penman 2001, Dechow and Dichev 2002), the DuPont decomposition as commonly taught, and the IFRS and FASB
standards named in the text, using standard numbers and effective dates only, checked on ifrs.org and fasb.org on
2026-10-28. The explanations, exhibits, red-flag checklist and questions are original; Northfield Outdoor Co. and
Corvane Robotics are fictional. The template is independent and not affiliated with or endorsed by the IFRS Foundation,
the FASB or any business school. Check the current official versions before you rely on any date or requirement.
Template licence: MIT.