How to analyse financial statements and make sense of a company’s numbers

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03 October 2023

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Important: This article was originally written by Finimize. Any opinions offered are those of Finimize and not of CMC Invest.

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So, you’re a rocket scientist? Well, we’re impressed, even if Shania Twain’t. When it comes to analysing a company’s financials, however, making sense of all those numbers unassisted is beyond even the best of us – which is why your trusty friends at Finimize are here to help 😌

Knowing your way around a firm’s past and present financial statements allows an investor to really understand that company: its hopes, its fears, and its dirty little secrets. There are three main documents to deal with: the income statement, the cash flow statement, and the balance sheet.

The income statement details revenues, expenses, and resulting income relevant to a given period – usually a quarter, a half year, or a whole 12 months. The cash flow statement outlines a firm’s sources and uses of cash across operating, investing, and financing activities. The balance sheet, meanwhile, summarises all assets owned, their value, and how they’ve been financed – crystallising the company’s financial position at a single point in time 💎

A financial analyst examines trends in key financial metrics, calculates and interprets ratios, compares those to the firm’s competitors’ – and much more besides. It’s not rocket science, but it’s worth getting right. So, without further ado, let’s blast off.

Analysing income statements

Before you analyse any financial statement, you first need to understand what you’re looking at. Here’s an example of a simple income statement:

Finimize article image 1 - 2 October, 2023

Let’s break that down. Revenue is the amount of money generated from selling products and services, and when you subtract the direct costs of making those products and services available – collectively called the cost of sales – you get gross profit (note that parentheses always indicate a negative amount, so (200) is the same as saying -200). If Apple retails iPhones for £800 which cost the company £500 to manufacture and sell in stores or online, it’ll make a £300 gross profit on each iPhone sold 👌

Operating expenses capture all the indirect costs associated with sales: marketing and advertising spends, for example, as well as the everyday costs of running the company. Subtract this from gross profit, and you arrive at operating income – which is basically the amount of profit realised before fiddly deductions like interest and tax expenses. Once we subtract these, we’ve got the final figure in the income statement: net income.

Investors often consider a company’s net income as a percentage of its revenue. This profit margin indicates how much profit the firm makes for each pound of sales – the higher the better. It’s even more informative if we compare that profit margin to the company’s peers’; consistently higher profit margins suggest a superior operation 🧐

Another common ratio – in this case used to assess a company’s financial health – is interest coverage, which is calculated by dividing operating income by interest expense. This ratio measures a company’s ability to “service”, or pay interest on, its outstanding debt – and once again, the higher the better.

To put all this analysis into practice, let’s try looking at the income statements of two hypothetical companies in the same industry: GoodCo and BadCo.

Finimize article image 2 - 2 October, 2023

GoodCo has a lot here that you’d want to see as an investor. First, the company shows consistent revenue growth from year to year. Second, the firm has strong profit margins that are also expanding. That’s because GoodCo’s keeping its costs under control as it grows sales, meaning net income is rising faster than revenue. Third, the company has a healthy interest coverage ratio of over 6. That means it can pay its way six times over; existing debts aren’t an issue 😚

Now let’s look at BadCo’s income statement:

Finimize article image 3 - 2 October, 2023

Uh oh: this is quite a contrast to GoodCo, and definitely not what you’d want to see as an investor. BadCo’s revenue growth is volatile from year to year and is trending negative over time. The company’s also working on razor-thin margins that are steadily shrinking – which is never a good sign. Lastly, its interest coverage ratio is significantly lower than GoodCo’s; if revenue takes a hit or costs rise, it may struggle to handle its outstanding debt 🙈

Analysing cash flow statements

Now that income’s been and gone, let’s go with the flow. The cash flow statement explains a company’s sources and uses of cash across three main activities. Here’s a simple example:

Finimize article image 4 - 2 October, 2023

As the presence of net income suggests, cash flow from operations (CFO) is the crucial amount of money generated from core business activities like making and selling products. It’s calculated by adding back any non-cash expenses that were previously deducted from net income (such as depreciation and amortisation, which involve accounting for the declining value of assets over time) and factoring in any changes in working capital such as an increase in inventory (which represents a cash outflow).

Cash flow from investing (CFI), meanwhile, includes capital expenditures – the amount spent on building new factories and stores, purchasing equipment, and so on – as well as any money made (or lost) via other investing-type activities: acquisitions, asset sales, and so on. Finally, cash flow from financing (CFF) shows the amount of cash generated and jettisoned from dividend payments, share issues or repurchases, and taking out or paying off debt, i.e., bonds and loans 🔁

One of the first things to figure out when analysing a cash flow statement is the firm’s cash conversion rate. Cash, as they say, is king – and this metric measures a firm’s ability to convert accounting profit (as shown on the income statement) into actual money in the bank. It’s calculated as CFO divided by net income, and – you guessed it – the higher the ratio the better. Once again, it’s even more informative if we compare the company’s cash conversion rate to its peers’.

Another very important thing investors like to look at is how much free cash flow (FCF) the company generates – and what it does with it. FCF represents the amount of cash generated after all necessary reinvestments back into the business; it’s calculated as CFO minus capital expenditures. What investors ideally want to see is positive and growing FCF which the company is using to pay down debt – and dishing out to shareholders through dividends and share buybacks, natch 😉

Negative FCF is common among young companies spending heavily to grow – and that’s fine, so long as you think the company’s growth strategy will eventually lead to positive FCF. But persistently negative FCF – especially at a more mature company with lots of competition – is never a good sign. Making matters worse, a company in this position will have to constantly finance itself by issuing new debt or shares – and the latter dilutes the value of existing shares.

To better illustrate these points, let’s once again compare two hypothetical companies in the same industry: GreatCo and AwfulCo.

Finimize article image 5 - 2 October, 2023

Whaddaya know: GreatCo’s CFO is growing every year, and it’s got a very high cash conversion rate. It’s not only generating positive FCF, but that figure is growing every year. That allows the company to distribute an increasing amount of cash back to GreatCo’s shareholders. Finally, note the net increase in cash every year other than 2017, when the firm paid back lots of debt. That’s not a bad use of cash; it should lower interest expenses and reduce overall riskiness 👍

Now let’s look at AwfulCo’s cash flow statement:

Finimize article image 6 - 2 October, 2023

Dear oh dear. AwfulCo’s CFO is shrinking every year – and its cash conversion rate, at less than 50%, is very poor. It’s also generating ever-more negative FCF. To make up for that shortfall, the firm has to constantly issue both new shares and debt – and despite that, its cash pile is still consistently decreasing… 🙀

Analysing balance sheets

The balance sheet sets out the assets owned by the company, their value, and how they’ve been financed – all at a single point in time. Here’s an example of a simple balance sheet:

Finimize article image 7 - 2 October, 2023

On the left is everything the firm owns – split into current assets (cash and other things, like client bills, expected to be converted into cash within a year), long-term assets it’s holding on to, and intangible assets – things that aren’t physical in nature, like intellectual property and goodwill. Goodwill, by the way, is the lingering result of past acquisitions: it’s the excess amount often paid for a company above and beyond its accounting value.

The right-hand side of the balance sheet shows how all these assets are financed. It’s usually split into current liabilities (those due within a year), long-term liabilities, and shareholders’ equity. Note how the total value of the firm’s assets is equal to liabilities plus equity (hence the term “balance” sheet).

Analysing a balance sheet mainly involves making an assessment of the company’s ability to satisfy both its short-term obligations and its long-term debt. For the former, investors typically look at the company’s current ratio: current assets divided by current liabilities. A ratio above 1 is considered good, while anything below is a potential red flag 🚩

To get a rough sense of how worrying a firm’s debt pile might be we can look at the firm’s debt-to-total-assets ratio, which is calculated as total debt (both short- and long-term) divided by total assets. But to properly assess a firm’s ability to meet its obligations, investors often compare net debt (total debt minus any cash on the balance sheet) to some measure of earnings – most often a measure of operating income known as EBITDA.

EBITDA refers to earnings before interest, tax, depreciation, and amortisation. It’s calculated by adding back the latter two (both of which are non-cash expenses) to the operating income we looked at earlier. A company’s net-debt-to-EBITDA ratio provides a proxy for how many years it would take for a company to pay back its debt – and this time it’s the lower the better. Anything above 5 is a potential red flag.

To better illustrate all of this, let’s once again compare two hypothetical companies in the same industry: StrongCo and WeakCo.

Finimize article image 8 - 2 October, 2023

A few things stand out. StrongCo has a nice cash pile, which helps give the firm a healthy current ratio of 2. The firm’s debt-to-total-assets is a modest 30% – and better yet, its net-debt-to-EBITDA ratio is 2 (you can’t see StrongCo’s income statement here, but it made £165 in EBITDA last year; 200 + 430 - 300 = 330, and 330 / 165 = 2). Taken together, we can conclude that StrongCo is a healthy company in a good position to meet satisfy its short-term obligations and its long-term debt 😋

Now let’s look at WeakCo’s balance sheet:

Finimize article image 9 - 2 October, 2023

This is not a company you want to invest in. WeakCo barely has any cash, and its current ratio of 0.5 is shaky. The firm has a high debt-to-total-assets ratio of 65% – and to make matters worse, its net-debt-to-EBITDA ratio is 6 (WeakCo made £260 in EBITDA last year; can you do the maths?). All of this should be cause for concern: WeakCo doesn’t seem set to keep its debt plates spinning in either the short or the long term 😰

Also, did you notice the large amount of goodwill on WeakCo’s balance sheet? That could be seen as a red flag too: it indicates WeakCo has made a lot of acquisitions in the past and potentially overpaid for them. A company that can grow organically is always preferable to one that can only do so by taking over others.

One last ratio afore ye go...

Investors in a company’s shares often look at an important measure of profitability called return on equity (ROE). ROE measures how well a company is using shareholders’ money (i.e., equity) to generate profit. It’s calculated as net income over a certain period (e.g., one year) divided by the average shareholder equity (from the balance sheet) over that period. Take, for example, a firm that made £200 in net income in a calendar year which saw total equity in January of £800 and December equity of £1,200. Its average equity over the year = (800 + 1,200) / 2 = 1000, and its ROE is therefore 200 / 1000 = 0.2, a.k.a., 20% 😌

Basically, the higher its ROE, the more attractive a firm is as an investment. A rising ROE is also a good sign because it means the company’s becoming more efficient in using its equity to generate more profit. Once again, it’s useful to compare a firm’s ROE to its peers’: a firm that has a higher ROE has some competitive advantage and is therefore considered a superior company.

And that’s it! You now have all the basic tools you need to effectively analyse company financials – whether income, cash flow, or balance sheet statement.