Financial Statement Analysis: A Primer

The financial statements and supporting disclosures required to be produced by public companies have the reputation for being dense, impenetrable documents. But when you reach the point wherein you can penetrate these documents, when you learn to “read” the story behind the numbers, you can understand a company’s strategy and its trajectory — not only where it has been, but, potentially, where it is headed. By scrutinizing financial disclosures and statements, journalists and financial analysts uncovered a wave of corporate accounting scandals in the early 2000s (e.g., Enron and off-balance sheet debt), continuing to this day (e.g., Under Armour and revenue recognition). Portfolio manager Harry Markopolos even analyzed Bernie Madoff’s financial disclosures, modeling out the returns and concluding — years before anyone else — that Bernard L. Madoff Investment Securities was a Ponzi scheme.

These, of course, are extreme examples. Most companies operate well within acceptable norms, but their financial disclosures can be complex, and the tendency for management to put a positive spin on results can obscure understanding a company’s true economic performance. Knowing what to look for can help inform investments, competitive insights, potential partnerships and even acquisitions.

So, imagine you’ve been handed an annual report or 10-K. Where to start?

Historical Ratio Analysis: Assessing the Past

How is a company faring now, compared to its recent past? Perform detailed “ratio analysis,” in which you look for patterns, levels and changes in the company’s balance sheets, income statements and statements of cash flow that either confirm or defy expectations. If the latter, additional research may be required through a review of the company’s other detailed narrative disclosures. Compare year-to-year performance across time to get a sense of whether the company is growing, by how much and whether that growth represents true expansion of the business. A business that begins heavily discounting its products, for example, might report robust sales that year, but the unusual promotional activity might foreshadow a sales or profit decline the following year.

Two tools are particularly useful because they simplify financial data into “apples-to-apples” comparisons: common-size statements, which analyze the portion of one account relative to another, and percentage change statements, which show the growth or decline in a specific account over time. View them for what they are — recasting dollar amounts contained in the original financial statements to an easy-to-interpret and more readily comparable set of financial relations. Both of these perspectives together help highlight key financial activity, particularly the often subtle but important shifts in asset, liability or expense mix. A percentage change income statement, for example, shows how the revenue and expense accounts have grown or shrunk from period to period. A common-size balance sheet, on the other hand, can easily highlight capital structure decisions, and the general mix of assets that comprise a company’s operations. The advantages of these basic tools are clear. Both statements would allow the analyst to readily compare the performance of companies of different size or to compare the performance of the same company as it grows or shrinks in size over time.

Using ratio analysis, also consider both the company’s solvency — a number of ratios can signal a company’s ability to meet its debt obligations — and liquidity — which considers not only how much cash, but also what can be converted to cash quickly. Both of these are critical should there be cause to handle a crisis (e.g., coronavirus) or seize an opportunity (e.g., a potential acquisition).

Finally, and critically, determine if the company is efficiently using capital to earn reasonable profits. Determine the appropriate benchmark (such as the industry average), and evaluate. A 10 percent profit margin, superlative in many industries, may reflect underperformance in the pharmaceutical industry, for instance, since the industry standard hovers in the 12 to 14 percent range. Conversely, a 4 percent profit margin for a food and drug retailer would be spectacular, since the industry standard is a lean 2.6 percent.

Forecasting Financial Statements: Peering Into the Future

Investing, acquiring or considering a joint venture? If so, you’ll need to weigh the business’ prospects by projecting its future performance. Always recommended is to forecast a complete set of financial statements (a balance sheet, income statement and statement of cash flow), as this forces the analyst to consider all critical aspects of the business. To understand how the company’s future performance might unfold, read the 10-K’s management discussion and analysis section (MD&A), and financial statement footnotes, and also do some independent research beyond that provided by the company to understand how the company’s strategy fits with the big picture for its industry. For a retailer, for instance, how many new stores can they reasonably expect to open? Will they have to remodel? Are any major cultural or economic trends affecting the business one way or another?

In the end, construct a complete forecast by performing a minimum series of projections:

1. Sales growth
2. Operating costs, and related working capital requirements
3. The complete balance sheet, including long-term assets and capital structure
4. Depreciation, amortization and interest
5. Cash flow, including capital expenditure needs and sources of financing

Valuation: The Final Frontier

What is this company worth? Does its stock price align with its value? To answer these questions, you might use the most popular valuation models: discounted cash flow or basic multiples approaches.

With discounted cash flow, this will require the following calculations:

1. Forecast the free cash flow over the immediate few future periods, usually a three to five year horizon: This is the amount of cash the firm can generate above what must be retained to keep it steadily operating.
2. Forecast an aggregate free cash flow for the indefinite set of years that remain: This “terminal value” approximates what the company can generate over its remaining operating life.
3. Discount all future free cash flows into current dollars: Determine the present value of projected future cash flows using an appropriate rate of return required by investors providing the capital to a company (e.g., WACC).
4. Add any non-operating assets and subtract any debt and non-operating liabilities: This can provide an approximation of total equity value, which, when divided by the number of shares outstanding, gives you share price — or a traded value for the company.

Of course, this is just a brief overview of some of the mechanics of financial analysis; mathematical modeling only answers the question of value in part. Assessment of financial figures only makes sense in the context of risks, trends and macroeconomic factors that affect a company. In fact, perhaps the greatest factor of all, one that cannot easily be quantified, is the long-term talent of the management team — do they have the ability to create a vision, attract others and operate ethically? A poorly managed firm will rarely profit over the long term.

The preceding is based on the technical note An Overview of Financial Statement Analysis: The Mechanics (Darden Business Publishing), by Paul J. Simko and Brandt R. Allen.