Financial Statement Analysis: Reading a Company Properly

The three statements as one system

The income statement records performance over a period on an accruals basis. The balance sheet records position at an instant. The cash flow statement reconciles the two by stripping the accruals back out.

The relationships are worth stating precisely, because interviewers test them and because analysis depends on them. Net income flows to retained earnings and starts the cash flow statement. Depreciation reduces income, does not move cash, and reduces the carrying value of assets. Working capital changes move cash without touching income. Capital expenditure moves cash and the balance sheet without touching income until it depreciates. Debt movements affect the balance sheet and the financing section, and only the interest touches income.

Start with the cash flow statement

Most people read top to bottom and start with revenue. Start at the back instead. The cash flow statement is the hardest of the three to manage and the quickest route to understanding what kind of business this is.

Three questions answer themselves in two minutes. Does operating cash flow track net income over several years, or diverge? Is capital expenditure at, above or below depreciation, and is that a growing, steady or shrinking asset base? And what is the business doing with the cash: reinvesting, acquiring, paying down debt or returning it?

The ratios that earn their place

Return on invested capital, and why it is the one to learn

If you calculate a single ratio, calculate this one. Net operating profit after tax over invested capital tells you whether the business creates value, and comparing it against the weighted average cost of capital tells you whether growth is worth having. A company growing fast at returns below its cost of capital is destroying value faster the better it sells.

The definitional care matters: invested capital is usually total debt plus equity less cash, or equivalently net working capital plus net fixed assets. Be consistent across the peer group, say which definition you used, and adjust for leases and goodwill where a comparison would otherwise be meaningless.

Quality of earnings: separating the number from the reality

Reported profit is an opinion expressed in numbers. Analysis means asking how much of it is cash, how much is repeatable, and how much reflects judgement the company made in its own favour.

• Compare cumulative operating cash flow to cumulative net income over three to five years. Persistent divergence is the single most informative signal available in a public filing.
• Read the adjustments in the company own non-GAAP reconciliation. Restructuring costs that recur every year are operating costs with a better name.
• Check whether receivables or inventory are growing faster than revenue. Either can mean demand is being pulled forward or product is not moving.
• Look at capitalisation policy. Development costs, software and contract acquisition costs moved to the balance sheet flatter current margins and defer the charge.
• Watch depreciation against capital expenditure over time. Sustained underinvestment produces good margins now and a problem later.
• Note changes in accounting estimates: useful lives, provisioning, revenue recognition timing. A change in estimate is disclosed and rarely read.

Red flags in order of seriousness

None of these proves anything on its own. Two or three together in the same filing are worth taking seriously.

• Operating cash flow below net income for three consecutive years with no structural explanation.
• Receivable days rising materially while revenue growth slows.
• Repeated one-off charges, particularly restructuring in consecutive years.
• An auditor change, a resignation, or a chief financial officer departure without a named successor.
• Growth driven by acquisitions with rising goodwill and no disclosed organic figure.
• Covenant headroom narrowing while management commentary becomes noticeably more optimistic.
• Related party transactions that are material rather than incidental.

How to use this in an interview or a case

Given a set of accounts and twenty minutes, work in this order: read the cash flow statement, calculate margins and returns for three years, check leverage and cover, then find the two or three numbers that explain the business. Say those out loud first when you present.

A strong answer sounds like a thesis rather than a recital. "Revenue is up eleven per cent but receivable days have gone from 45 to 62, so cash conversion has fallen and I would want to know whether terms were loosened to make the year" beats any number of correctly calculated ratios delivered in sequence.