financial-statement-analysis

# Financial statement analysis

The statements tell you what happened. Analysis tells you why, and whether it continues.

## Read the three statements against each other

A single statement is almost never enough. The income statement reports profit, the cash flow
statement reports cash, and the gap between them is usually the story.

- **Net income rising while operating cash flow falls** is the signal worth chasing first. It means
  working capital is absorbing the growth, or revenue is being recognized ahead of collection.
- **The balance sheet is a point in time**; the other two cover a period. Comparing a period figure
  to a point-in-time balance without averaging the balance overstates efficiency ratios.
- **Read the notes.** Concentration of customers, debt maturities, commitments, related parties,
  and subsequent events routinely matter more than anything on the face of the statements.

## Do fluctuation analysis before you compute a single ratio

Compare against the prior period **and** against budget. They answer different questions: prior
period tells you what changed, budget tells you whether you understood your own business.

- **Set a threshold in both currency and percent.** Percent alone sends you chasing large swings on
  small accounts; currency alone hides a small account that doubled.
- **Explain with a driver, not a restatement.** "Revenue up 12%" is the observation, not the
  explanation. Volume, price, mix, timing, and one-off items are explanations.
- **Track how many variances you cannot explain.** A close where three material movements have no
  owner is telling you something about the underlying records, not about performance.

## Compute ratios against the question you actually have

- **Profitability** — gross margin, operating margin, net margin, return on invested capital.
- **Liquidity** — current and quick ratio, and the one that usually matters more in practice, days
  of cash on hand.
- **Leverage and solvency** — debt to EBITDA, interest coverage, debt to equity.
- **Efficiency** — days sales outstanding, days payable outstanding, days inventory outstanding,
  and the cash conversion cycle they combine into.

Ratios are comparative instruments. One ratio at one date means close to nothing; the trend across
periods and the comparison to peers are where the information is.

## Benchmark within industry and roughly within scale

Gross margin compared across industries is noise. So is comparing a company at $5M to one at $500M
on cost structure — the second has fixed costs the first cannot carry and buying power the first
cannot access.

Internal benchmarking across segments, regions, or product lines is often more useful than external
comparison, because the accounting policies are already consistent.

## Test non-GAAP measures before you repeat them

EBITDA, adjusted EBITDA, free cash flow, core earnings, adjusted net income, annual recurring
revenue. These exist for a real reason — statutory profit includes items that obscure operating
performance — and also because management chooses the adjustments.

- **Ask what was added back, and whether it recurs.** A restructuring charge that appears every year
  is an operating expense wearing a different label.
- **Ask whether the adjustment would survive good results.** Adjustments that only appear in bad
  quarters are presentation, not measurement.
- **Reconcile to the nearest statutory measure and show the reconciliation.** A number that cannot
  be tied back is not a measure, it is an assertion.

## Diagnosing a deteriorating trend

Work from the top down and stop at the first level that explains it. Revenue, then gross margin,
then operating expense, then working capital, then financing cost. Most deterioration that looks
like a demand problem is a margin or working capital problem, and the two call for different
responses.

## Never

- Present a ratio with no trend and no comparison. A number standing alone is decoration.
- Explain a variance by restating it in different words.
- Repeat an adjusted measure without seeing what was added back.
- Annualize a partial period without saying you did, or apply a seasonal quarter as a run rate.