Financial Statement Analysis
Master the art of reading financial statements to evaluate company health, profitability, and growth prospects through comprehensive analysis techniques.
The Foundation of Fundamental Analysis
Mastering financial statements is crucial for gauging a company's health, profitability, and growth prospects. You'll dive into the three core statements—Income Statement, Balance Sheet, and Cash Flow Statement—and learn how to extract actionable insights.
The Three Pillars of Financial Analysis
Income Statement
Performance over time
Balance Sheet
Financial position snapshot
Cash Flow Statement
Actual cash movements
Income Statement Analysis
The Income Statement (or Profit & Loss) shows performance over a period by detailing revenue, expenses, and profit.
Key Components
Revenue (Sales)
Total income from goods or services
Cost of Goods Sold (COGS)
Direct costs to produce those goods
Operating Expenses
SG&A, R&D, depreciation costs
Net Income
Bottom-line profit after all expenses
Key Calculations
Gross Profit
Operating Income (EBIT)
Profitability Metrics
| Metric | Calculation | What It Shows |
|---|---|---|
| Gross Margin | Gross Profit ÷ Revenue | Efficiency of production |
| Operating Margin | EBIT ÷ Revenue | Core profitability |
| Net Margin | Net Income ÷ Revenue | Overall profitability |
| YoY Growth | (Current - Prior) ÷ Prior | Trend in sales or earnings |
Analysis Tip: Examine trends over multiple quarters/years to spot cyclicality or emerging pressures.
Balance Sheet Analysis
The Balance Sheet provides a snapshot of what the company owns (assets) and owes (liabilities) at a specific date, with the difference representing shareholder equity.
Balance Sheet Structure
| Section | Key Line Items |
|---|---|
| Assets | Current Assets (Cash, AR, Inventory); Non-Current Assets (PPE, Intangibles) |
| Liabilities | Current Liabilities (AP, Short-term Debt); Long-term Liabilities (Bonds, Leases) |
| Equity | Common Stock; Retained Earnings; Treasury Stock |
Key Balance Sheet Ratios
Current Ratio
Measures short-term liquidity
Quick Ratio
Conservative liquidity measure
Debt-to-Equity
Financial leverage assessment
Balance Sheet Insight: A strong balance sheet combines ample liquidity with manageable leverage.
Cash Flow Statement Analysis
The Cash Flow Statement translates accounting profits into actual cash movements, segmented into three key areas.
Cash Flow Components
| Section | Focus |
|---|---|
| Operating Cash Flow (CFO) | Cash from core business activities |
| Investing Cash Flow (CFI) | Cash used for capital expenditures, M&A |
| Financing Cash Flow (CFF) | Cash from debt/equity issuance or repurchase |
Free Cash Flow Analysis
Free Cash Flow Formula
Cash Flow Warning: Persistent divergence between net income and CFO can signal aggressive revenue recognition or working-capital issues.
Analytical Techniques
Horizontal Analysis
Compare line items over multiple periods to identify growth or contraction trends.
Vertical Analysis
Express each line as a percentage of a base figure for cross-company comparison.
Ratio Analysis
Evaluate liquidity, profitability, leverage, and efficiency using standard ratios.
Ratio Categories
| Ratio Category | Examples | Purpose |
|---|---|---|
| Liquidity | Current Ratio; Quick Ratio | Ability to meet short-term obligations |
| Profitability | ROA; ROE; Net Margin | Efficiency in generating profits |
| Leverage | Debt/Equity; Interest Coverage | Financial risk from debt |
| Efficiency | Inventory Turnover; Receivables Turnover | Asset utilization efficiency |
Red Flags & Quality Checks
Critical warning signs that require deeper investigation when analyzing financial statements.
Warning Signs
One-Time Items
Large gains/losses that distort recurring earnings
Working Capital Swings
Rapid AR or inventory build-ups can mask cash constraints
Debt Maturity Walls
Concentrated near-term debt increases refinancing risk
Impaired Assets
Write-downs indicating past over-investment or obsolete assets
Quality Assessment
Essential Review Areas
- •Footnote Review: Off-balance-sheet obligations
- •Lease Commitments: Future payment obligations
- •Pension Deficits: Unfunded retirement liabilities
- •Management Discussion & Analysis (MD&A)
Critical Reminder: Always read management discussion & analysis (MD&A) and footnotes for context. The devil is often in the details that don't appear in the main financial statement numbers.