Diving into the complexities of a company’s financials can be a daunting task. Fear not, for we are here to guide you through the intricate world of financial statements, helping you unravel the hopes, fears, and even the dirty little secrets of the companies you wish to explore.
Understanding a firm’s past and present financial statements is akin to peering into its soul. It reveals the essence of the company at different points in time, encapsulating its journey through revenues, expenses, assets, and liabilities. There are three primary documents that constitute the financial anatomy of a company: the income statement, the cash flow statement, and the balance sheet.
The income statement, also known as the profit and loss statement, details a company’s revenues, expenses, and resulting income over a specific period: a quarter, a half-year, or an entire year. The cash flow statement guides you through a company’s sources and uses of cash across operating, investing, and financing activities. Lastly, the balance sheet, summarizes all assets owned, their value, and how they’ve been financed – crystallizing the company’s financial position at a single point in time.
Enter the financial analyst, the unsung hero of deciphering financial statements. Armed with an arsenal of tools, a financial analyst delves into trends, calculates ratios, and compares them to competitors. It’s not exactly rocket science, but getting it right is paramount. Now, let’s embark on our financial exploration.
Decoding the Income Statement
Here’s an example of a simple income statement:
Breaking it down, revenue represents the money generated from selling products and services. Subtracting the direct costs, known as the cost of sales, unveils the gross profit. For instance, if Apple sells iPhones for $800, which cost $500 to manufacture, the gross profit per iPhone is $300.
Operating expenses encompass all indirect costs associated with sales, including marketing and advertising spends, as well as everyday operational costs. Subtracting operating expenses from gross profit yields the operating income, the profit realized before deductions such as interest and tax expenses. The final figure on the income statement is the net income.
Investors often view a company’s net income as a percentage of its revenue, known as the profit margin. This metric signifies how many cents of profit a company makes for each dollar of sales. A higher profit margin is desirable, especially when compared to competitors, indicating superior operations. Another critical ratio is the interest coverage ratio, calculated by dividing operating income by interest expense. A higher ratio implies a company’s ability to service its outstanding debt effectively.
Let’s apply this analysis to two hypothetical companies in the same industry: GoodCo and BadCo.
GoodCo shows promising signs. It demonstrates consistent revenue growth, robust profit margins, and a healthy interest coverage ratio (an interest coverage ratio of 6 means the company can pay its way six times over). Now let’s look at BadCo’s income statement:
In contrast, BadCo’s income statement reveals volatile revenue growth (and trending negative), declining and thin profit margins, and a concerning interest coverage ratio: if revenue takes a hit or costs rise, it may struggle to handle its outstanding debt
Navigating cash flow statements
The cash flow statement explains a company’s sources and uses of cash across three main activities. Here’s a simple example:
Cash flow from operations (CFO) represents the money generated from core business activities, calculated by adding back any non-cash expenses that were previously deducted from net income (such as depreciation and amortization, 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) includes capital expenditures (the amount spent on building new factories and stores, purchasing equipment, etc.) and gains or losses from other investing activities.
Lastly, cash flow from financing (CFF) shows the cash generated or spent on dividend payments, share issuances or repurchases, and debt transactions.
A key metric in cash flow analysis is the cash conversion rate, measuring a firm’s ability to convert accounting profit into actual cash. Calculated as CFO divided by net income, a higher ratio is clearly preferable, especially when compared to peers. Another very important number is free cash flow (FCF), representing cash generated after necessary reinvestments. Positive and growing FCF, used to pay down debt or distribute to shareholders, is desirable. Negative FCF is common among early-stage companies spending heavily on growth – and that’s ok, so long as 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.
Let’s once again compare two hypothetical companies in the same industry: GreatCo and AwfulCo.
In our comparative analysis, GreatCo’s CFO is growing, boasting a high cash conversion rate, positive FCF, and consistent cash increase. Specifically, 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:
In contrast, AwfulCo’s cash flow statement reveals shrinking CFO, a poor cash conversion rate, and persistent negative FCF, necessitating constant share and debt issuance (and despite that, its cash pile is still consistently decreasing).
Interpreting Balance Sheets
The balance sheet provides a snapshot of a company’s assets, liabilities, and equity at a specific moment in time.
The left side details everything a company owns, categorized into current assets, long-term assets, and intangible assets. Goodwill, an intangible asset, represents the excess amount paid for a company above its accounting value, often resulting from past acquisitions. The right side illustrates how these assets are financed: it’s 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).
Analyzing a balance sheet involves assessing a company’s ability to meet short-term obligations and manage long-term debt. The current ratio, calculated as current assets divided by current liabilities, is a key indicator to evaluate the former. A ratio above 1 is favorable, while anything below raises a red flag.
To get a sense of how concerning a firm’s debt pile might be investors usually 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, net debt (total debt minus any cash on the balance sheet) is generally compare to some measure of earnings – most often a measure of operating income known as EBITDA.
EBITDA refers to earnings before interest, tax, depreciation, and amortization. It’s calculated by adding back the latter two (both of which are non-cash expenses) to the operating income. 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.
StrongCo displays a healthy balance sheet with a robust current ratio of 2, modest debt-to-total-assets ratio of 30%, and a favorable net-debt-to-EBITDA ratio of 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:
Conversely, WeakCo’s balance sheet signals trouble: there is almost no cash, current ratio is low (0.5), debt-to-total-assets ratio at 65% is high, and the net-debt-to-EBITDA ratio is alarming (WeakCo made $260 in EBITDA last year).
Also, the large amount of goodwill on WeakCo’s balance sheet 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 final ratio: return on equity (ROE)
Before concluding this post, let’s explore one last, important measure of profitability: return on equity (ROE). This metric measures how effectively a company utilizes shareholders’ money to generate profit. Calculated as net income over a specific period divided by average shareholder equity over the same period, a higher ROE indicates a relatively more attractive 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. Comparing a company’s ROE to peers can provide insights into its competitive advantage.