6.1 Financial Statement Analysis

Financial statement analysis is a crucial tool for investors to evaluate a company's financial health and performance. By examining balance sheets, income statements, and cash flow statements, investors can gain insights into profitability, liquidity, and overall financial stability.

Key financial ratios and metrics help compare companies within an industry and identify potential red flags. Understanding these indicators allows investors to make informed decisions, spot trends, and assess a company's competitive position in the market.

Financial Statement Analysis

Primary Financial Statements

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• The three primary financial statements are the balance sheet, income statement, and cash flow statement
  • Each statement provides unique insights into a company's financial position (balance sheet), performance (income statement), and cash flows (cash flow statement)
• The balance sheet reports a company's assets, liabilities, and shareholders' equity at a specific point in time
  • It follows the fundamental accounting equation: $Assets = Liabilities + Shareholders' Equity$
  • Assets include items such as cash, inventory, and property, plant, and equipment (PP&E)
  • Liabilities include accounts payable, loans, and bonds
  • Shareholders' equity represents the residual interest in the assets after deducting liabilities
• The income statement, also known as the profit and loss (P&L) statement, presents a company's revenues, expenses, and net income over a specific period, typically a quarter or a year
  • It starts with revenue, subtracts various expenses (cost of goods sold, operating expenses, interest, and taxes), and arrives at net income
  • It provides information on a company's profitability and operating performance
  • Key metrics include gross profit, operating income, and net income
• The cash flow statement reports the inflows and outflows of cash during a specific period, categorized into operating, investing, and financing activities
  • Operating activities include cash generated from or used in the company's core business operations
  • Investing activities involve cash flows related to investments in long-term assets or other companies
  • Financing activities include cash flows from issuing or repaying debt, issuing equity, and paying dividends
  • It helps assess a company's ability to generate cash and meet its financial obligations

Financial Statement Analysis Techniques

• Horizontal analysis involves comparing financial statement items over time, typically using a base year as a reference point
  • It helps identify trends, growth rates, and changes in a company's financial performance
  • For example, comparing revenue growth year-over-year or analyzing the trend in gross profit margin over a five-year period
• Vertical analysis, also known as common-size analysis, expresses each financial statement item as a percentage of a base figure, such as total assets or total revenues
  • It allows for easier comparison of financial statements across different periods or companies of different sizes
  • For example, expressing each expense item as a percentage of revenue to see which expenses are consuming a larger portion of sales
  • Common-size balance sheets show each asset, liability, and equity item as a percentage of total assets, allowing for comparison of the composition of the balance sheet across companies or periods

Key Financial Ratios & Metrics

Profitability Ratios

• Profitability ratios measure a company's ability to generate profits relative to its revenue, assets, or equity
• Key profitability ratios include:
  • Gross profit margin: $(Revenue - Cost of Goods Sold) / Revenue$
    • Measures the percentage of revenue remaining after deducting the cost of goods sold
  • Operating profit margin: $Operating Income / Revenue$
    • Measures the percentage of revenue remaining after deducting operating expenses
  • Net profit margin: $Net Income / Revenue$
    • Measures the percentage of revenue remaining after deducting all expenses, interest, and taxes
  • Return on Assets (ROA): $Net Income / Average Total Assets$
    • Measures how efficiently a company generates profits from its assets
  • Return on Equity (ROE): $Net Income / Average Shareholders' Equity$
    • Measures the return generated on shareholders' invested capital

Liquidity and Solvency Ratios

• Liquidity ratios assess a company's ability to meet its short-term obligations using its current assets
• Important liquidity ratios include:
  • Current ratio: $Current Assets / Current Liabilities$
    • Measures the ability to cover short-term liabilities with short-term assets
  • Quick ratio (or Acid-test ratio): $(Cash + Marketable Securities + Accounts Receivable) / Current Liabilities$
    • A more conservative liquidity measure that excludes inventory and prepaid expenses
  • Cash ratio: $Cash and Cash Equivalents / Current Liabilities$
    • Measures the ability to cover short-term liabilities with the most liquid assets
• Solvency ratios evaluate a company's ability to meet its long-term financial obligations and its level of financial leverage
• Key solvency ratios include:
  • Debt-to-Equity ratio: $Total Liabilities / Total Shareholders' Equity$
    • Measures the proportion of debt financing relative to equity financing
  • Debt-to-Assets ratio: $Total Liabilities / Total Assets$
    • Measures the percentage of assets financed by debt
  • Interest Coverage ratio: $Earnings Before Interest and Taxes (EBIT) / Interest Expense$
    • Measures the ability to cover interest payments with operating income

Efficiency Ratios

• Efficiency ratios measure how effectively a company manages its assets and liabilities
• Important efficiency ratios include:
  • Inventory Turnover: $Cost of Goods Sold / Average Inventory$
    • Measures how quickly inventory is sold and replaced
  • Receivables Turnover: $Net Credit Sales / Average Accounts Receivable$
    • Measures how quickly credit sales are collected from customers
  • Payables Turnover: $Cost of Goods Sold / Average Accounts Payable$
    • Measures how quickly the company pays its suppliers
  • Asset Turnover: $Net Sales / Average Total Assets$
    • Measures how efficiently a company generates sales from its assets

Red Flags in Financial Statements

Accounting and Reporting Issues

• Inconsistent or unexplained changes in accounting policies or estimates can be a red flag
  • May indicate attempts to manipulate financial results
  • Examples include changing inventory valuation methods or altering depreciation schedules without clear justification
• Significant off-balance sheet liabilities, such as operating leases or contingent liabilities, can understate a company's true financial obligations
  • These liabilities may not be immediately apparent on the balance sheet but can have a material impact on the company's financial position
• Frequent or significant related party transactions may suggest conflicts of interest or potential manipulation of financial results
  • Related party transactions involve dealings between the company and its owners, managers, or affiliates
  • These transactions should be scrutinized to ensure they are conducted at arm's length and properly disclosed

Operational and Financial Warning Signs

• Rapid growth in accounts receivable or inventory relative to sales growth may suggest issues with collection or inventory management
  • If receivables or inventory grow faster than sales, it may indicate difficulty collecting from customers or slow-moving/obsolete inventory
• Increasing days sales outstanding (DSO) or aging of accounts receivable can indicate problems with credit policies or customer financial health
  • DSO measures the average number of days it takes to collect payment from customers
  • An increasing trend in DSO may suggest deteriorating customer creditworthiness or ineffective collection processes
• Persistent negative cash flows from operations, despite reporting profits, can be a warning sign of unsustainable financial performance
  • If a company consistently reports profits but generates negative operating cash flows, it may be relying on non-operating sources of cash or aggressive accounting practices
• High employee turnover, particularly in key finance or accounting positions, may indicate underlying problems or financial irregularities
  • Frequent changes in CFOs, controllers, or other senior finance personnel can be a red flag
  • This may suggest disagreements over accounting practices, internal control issues, or other financial concerns

Company Performance vs Benchmarks

Industry Benchmarking

• Industry benchmarking involves comparing a company's financial ratios and metrics to those of its peers or industry averages to assess its relative performance
  • This helps identify whether a company is outperforming, underperforming, or in line with its industry
• Key metrics to compare include profitability ratios, liquidity ratios, solvency ratios, and efficiency ratios
  • Comparing gross margin, operating margin, and net margin to industry peers can indicate relative profitability
  • Liquidity and solvency ratios can be benchmarked to assess financial stability relative to peers
  • Efficiency ratios, such as inventory turnover and receivables turnover, can be compared to evaluate operational effectiveness
• Benchmarking should consider differences in company size, geographic focus, and business mix when selecting appropriate peers for comparison
  • Companies of similar size, operating in the same regions, and with comparable product/service offerings make the most suitable peers
  • Adjustments may be needed when comparing companies with different fiscal year-ends or reporting currencies

Growth and Valuation Analysis

• Comparing growth rates in revenue, earnings, and cash flows can provide insights into a company's competitive position and market share gains or losses
  • Higher growth rates relative to peers may indicate a competitive advantage or successful expansion strategies
  • Lower growth rates may suggest market share losses, industry headwinds, or company-specific challenges
• Analyzing market valuation multiples, such as price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, or enterprise value-to-EBITDA (EV/EBITDA), can help assess whether a company is over- or undervalued relative to its peers
  • Higher multiples may indicate investor optimism about growth prospects or a premium for superior performance
  • Lower multiples may suggest investor concerns about future prospects or a discount for underperformance
• Consistently outperforming or underperforming industry benchmarks can indicate competitive advantages or weaknesses that warrant further investigation
  • Sustained outperformance may be driven by factors such as strong brand loyalty, proprietary technology, or economies of scale
  • Persistent underperformance may stem from issues like weak market positioning, high cost structure, or management inefficiencies