Financial analysis is a very useful tool to understand how a company is doing.
It’s a bit like one of these Russian dolls, a matryoshka.
You have a good look at it from all sides, and then you find out there’s a level below it.
You take a good look at that level,
notice all the details, and find out there’s a level below it.
And on and on and on.
Let’s apply that idea to financial analysis!
Financial analysis matryoshka-style!
Financial analysis starts with revenue: the goods or services that a company delivered
to its customers.
Does the company have any revenue, or is it still in its “pre-revenue” phase: in such
an early stage of its development that the company does not have any revenue yet.
In the “pre-revenue phase”, you can analyze the business plan projecting expected future
results, or analyze the “burn rate”: how quickly is the company burning through the
cash they raised before they run out (as they don’t generate any revenue).
If the company does have revenue, how much did they generate in actual revenue?
You find information about a company’s revenue in its income statement, it’s actually the
very first thing on there, the top line.
Start with the absolute amount, and then check whether the revenue is growing or shrinking
over the years.
That’s often called the V%, for Variance %.
How do you calculate the revenue growth versus prior year?
Take the current year number, deduct the prior year number, divide the outcome of that by
the prior year number, and deduct 1 from that outcome.
Here’s that calculation with the numbers filled in for our example.
In financial analysis, both the absolute amount and the direction are important.
A company with $1 million in revenue and 20% growth might be more interesting than a company
with $2 million in revenue and no growth.
Let’s go one level deeper into revenue growth.
Here’s an example: you read a financial news headline about ABC Corp’s double-digit
revenue growth of 10%.
The key financial analysis question to ask is:
what was the company’s underlying organic revenue growth?
Organic revenue growth is the revenue growth excluding the revenue impact of acquisitions
and divestitures, and excluding the revenue impact of foreign currency fluctuations.
For ABC Corp, total revenue growth is 10%, of which 1% was driven by favorable currency
impact, and 2% by acquisitions, so the organic revenue growth is 7%.
That’s the apples-to-apples revenue growth number you are looking for, most publicly
listed companies will provide it to you in the management discussion and analysis section
of the annual report.
Analyzing revenue and revenue growth.
Your financial analysis takes you from the absolute revenue number in dollars to the
revenue growth %, to the organic revenue growth %, and onwards to revenue and revenue growth
by business, an analysis of price versus volume, on and on and on.
With a matryoshka doll, there is a starting point and an ending point.
If only financial analysis was that easy!
From revenue analysis we move to profitability analysis.
We move down the line items of the income statement: revenue minus expenses equals profit.
There are various subtotals of profitability in the income statement: Gross Profit, Operating
Margin, Earnings Before Tax, and Net Income.
The most important one for financial analysis is Operating Margin.
This is the margin or profit that a company generates from its operations.
The starting question to ask in your financial analysis of profitability: is Operating Margin
a positive or negative number in dollars, and how has it been developing over the years?
Preferably, you would have Operating Margin growing faster than revenue, like in this
example: 25% Operating Margin growth on 20% revenue growth, which means profitability
is growing faster than revenues.
Here’s the income statement on its own.
Here’s the same income statement again, with each of the line items shown as a percentage
of revenue.
This helps to put profitability in perspective, and provide a starting point for further analysis.
Analyzing profitability.
How much Operating Margin does the company generate?
What is the Operating Margin as a percentage of revenue?
Is the margin growing (expanding) over the years, or shrinking (contracting)?
If you go one level deeper into Operating Margin: were there any “unusual items”
included in current year or prior year results?
Things like one-time acquisition-related, restructuring or litigation-related charges.
If so, it’s a good idea to compare Operating Margin excluding these items for both years.
Your financial analysis can then take you to the next level: which of the expense line
items is the largest one, how does the Gross Margin % look versus the Operating Margin
%, how does the Operating Margin % of this company compare to its competitors?
From profitability analysis we move to cash flow analysis.
Does the company’s profitability translate to cash flowing into its bank accounts?
Sometimes it does, sometimes it doesn’t.
The key financial analysis concept here is free cash flow generation: how much cash does
the company generate that it is free to spend?
And is that number higher or lower than last year?
Free cash flow is that part of the total cash flow that is not needed for either operations
or reinvestment into the company.
This number can be calculated from the cash flow statement.
The cash flow statement explains how much cash has come in and gone out during an accounting
period, and what the sources and uses of this cash flow were.
The cash flow statement has three sections: cash from operating activities, cash from
investing activities, cash from financing activities.
These sections are showing what their titles suggest.
Cash from operating activities details the net cash provided by or used in operating
activities: customers paying the company, the company paying suppliers and employees,
that sort of thing.
Cash from investing activities details the net cash used in investing activities: buying
property and equipment, paying for the acquisition of a business.
Cash from financing activities details the net cash provided by or used in financing
activities: transactions between a company and its lenders like raising cash by issuing
new debt, or paying dividends to shareholders.
To calculate Free Cash Flow, we need one and a half of these categories: cash from operating
activities, minus capital expenditures.
And now for something completely different!
So far our financial analysis has focused on the positive, the “upside potential”:
revenue growth, margin improvement, free cash flow generation.
If those are indicators of financial health, then their opposites must be indicators of
an unhealthy financial situation, right?
Revenue decline, margin deterioration, and free cash flow decline as indicators of an
unhealthy financial situation?
Well, that’s only part of the story!
The most important question in financial analysis might actually be: can the business survive
in times of turbulence?
How vulnerable or fragile is the company, particularly to unexpected events?
That’s where financial analysis of solvency and liquidity can help, but only for those
elements of risk that are in plain view on the financial statements, as hidden risk is
by definition hidden.
Some of the answers are found on the balance sheet, the overview of what a company owns
and what a company owes.
The balance sheet example you see here on the screen has many of the line items you
would frequently find.
For example: what was the cash balance on the latest balance sheet, and how many months
can this keep the company operating versus the expenses on the income statement?
Cash is part of a larger balance sheet category called current assets (cash and other assets
that are expected to be converted to cash within a year).
These current assets you can compare to current liabilities (amounts due to be paid to creditors
within twelve months).
The ratio between the two is called the current ratio, which when it is very low can give
an indication of liquidity issues.
A key solvency metric is the debt-to-equity ratio.
The idea here is to take the total liabilities and divide them by the total equity.
The higher the debt-to-equity ratio, the higher the financial leverage.
You have now arrived in the world of financial ratio analysis, which provides a set of tools
to analyze the relative financial performance of a company.