1.
Analyze the Balance Sheet
The balance sheet is a statement that shows a company’s financial position at a specific
point in time. It provides a snapshot of its assets, liabilities, and owners’ equity.
Assets are what a company uses to operate its business. Liabilities refer to money that’s
borrowed from other sources and needs to be repaid by the company. Owners’
equity represents the financing that owners, whether private or public, put into the
business. It’s important to note that assets should always be equal to the sum of
liabilities and owners’ equity. This relationship is the basis of the accounting
equation: Assets = Liabilities + Owners’ Equity
The balance sheet provides information on a company’s financial health by helping you
analyze the following:
How much debt the company has relative to equity
How liquid the business is in the short term (less than one year)
What percentage of assets are tangible and what percentage comes from
financial transactions
How long it takes to receive outstanding payments from customers and repay
suppliers
How long it takes to sell inventory the business keeps on hand
2. Analyze the Income Statement
The income statement shows a company’s financial position and performance over a
period by looking at revenue, expenses, and profits earned. It can be created for any
period using a trial balance of transactions from any two points in time.
The income statement generally starts with the revenue earned for the period minus
the cost of production for goods sold to determine the gross profit. It then subtracts all
other expenses, including staff salaries, rent, electricity, and non-cash expenses, such as
depreciation, to determine the earnings before interest and tax (EBIT). Finally, it deducts
money paid for interest and tax to determine the net profit that remains for owners.
This money can be paid out as dividends or reinvested back into the company.
The income statement provides information on a company’s financial health by helping
you analyze the following:
How much revenue is growing over certain accounting periods
The gross profit margin for goods sold
What percentage of revenue results in net profit after all expenses
If the business can cover its interest repayments on debt
How much the business repays to shareholders versus how much it reinvests
3. Analyze the Cash Flow Statement
The cash flow statement provides detailed insights into how a company used its cash
during an accounting period. It shows the sources of cash flow and different areas
where money was spent, categorized into operations, investing, and financing activities.
Finally, it reconciles the beginning and ending cash balance over the period.
The cash flow statement is one of the most important documents used to analyze a
company’s finances, as it provides key insights into the generation and use of cash. The
income statement and balance sheet are based around accrual accounting, which
doesn’t necessarily match the actual cash movements of the business. That’s why the
cash flow statement exists—to remove the impacts of non-cash transactions and
provide a clearer financial picture to managers, owners, and investors.
The cash flow statement provides information on a company’s financial health by
helping you analyze the following:
The liquidity situation of the company
The company’s sources of cash
The free cash flow the company generates to further invest in assets or
operations
Whether overall cash has increased or decreased
4. Financial Ratio Analysis
Financial ratios help you make sense of the numbers presented in financial statements,
and are powerful tools for determining the overall financial health of your company.
Ratios fall under a variety of categories, including profitability, liquidity, solvency,
efficiency, and valuation.
Some of the financial ratios you should know include:
Gross profit margin: The percentage of profit the company generates after
direct cost of sales expenses have been deducted from the revenue
Net profit margin: The percentage of profit the company generates after all
expenses have been deducted from revenue, including interest and tax from
revenue
Coverage ratio: The company’s ability to meet its financial obligations,
specifically to cover its debt and related interest payments
Current ratio: The company’s ability to meet short-term obligations of less
than one year
Quick ratio: The company’s ability to meet short-term obligations of less than
one year using only highly liquid assets
Debt-to-equity ratio: The percentage of debt versus equity that the company
uses to finance itself
Inventory turnover: How many times per period the entire inventory was sold
Total asset turnover: How efficiently the company generates revenue from
total assets
Return on equity (ROE): The company’s ability to use equity investments to
earn profit
Return on assets (ROA): The company’s ability to manage and use its assets to
earn profit
Financial ratios should be compared across periods and against competitors to see
whether your company is improving or declining, and how it’s faring against direct and
indirect competitors in the industry. No single ratio or statement is sufficient to analyze
the overall financial health of your organization. Instead, a combination of ratio analyses
across all statements should be used.
1. Gross Profit Margin
Gross profit margin is a profitability ratio that measures what percentage of revenue is
left after subtracting the cost of goods sold. The cost of goods sold refers to the direct
cost of production and does not include operating expenses, interest, or taxes. In other
words, gross profit margin is a measure of profitability, specifically for a product or item
line, without accounting for overheads.
Gross Profit Margin = (Revenue - Cost of Sales) / Revenue * 100
2. Net Profit Margin
Net profit margin is a profitability ratio that measures what percentage of revenue and
other income is left after subtracting all costs for the business, including costs of goods
sold, operating expenses, interest, and taxes. Net profit margin differs from gross profit
margin as a measure of profitability for the business in general, taking into account not
only the cost of goods sold, but all other related expenses.
Net Profit Margin = Net Profit / Revenue * 100
3. Working Capital
Working capital is a measure of the business’s available operating liquidity, which can be
used to fund day-to-day operations.
Working Capital = Current Assets - Current Liabilities
4. Current Ratio
Current ratio is a liquidity ratio that helps you understand whether the business can pay
its short-term obligations—that is, obligations due within one year— with its current
assets and liabilities.
Current Ratio = Current Assets / Current Liabilities
5. Quick Ratio
The quick ratio, also known as an acid test ratio, is another type of liquidity ratio that
measures a business’s ability to handle short-term obligations. The quick ratio uses only
highly liquid current assets, such as cash, marketable securities, and accounts
receivables, in its numerator. The assumption is that certain current assets, like
inventory, are not necessarily easy to turn into cash.
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
6. Leverage
Financial leverage, also known as the equity multiplier, refers to the use of debt to buy
assets. If all the assets are financed by equity, the multiplier is one. As debt increases,
the multiplier increases from one, demonstrating the leverage impact of the debt and,
ultimately, increasing the risk of the business.
Leverage = Total Assets / Total Equity
7. Debt-to-Equity Ratio
The debt-to-equity ratio is a solvency ratio that measures how much a company
finances itself using equity versus debt. This ratio provides insight into the solvency of
the business by reflecting the ability of shareholder equity to cover all debt in the event
of a business downturn.
Debt to Equity Ratio = Total Debt / Total Equity
8. Inventory Turnover
Inventory turnover is an efficiency ratio that measures how many times per accounting
period the company sold its entire inventory. It gives insight into whether a company
has excessive inventory relative to its sales levels.
Inventory Turnover = Cost of Sales / (Beginning Inventory + Ending Inventory / 2)
9. Total Asset Turnover
Total asset turnover is an efficiency ratio that measures how efficiently a company uses
its assets to generate revenue. The higher the turnover ratio, the better the
performance of the company.
Total Asset Turnover = Revenue / (Beginning Total Assets + Ending Total Assets / 2)
10. Return on Equity
Return on equity, more commonly displayed as ROE, is a profitability ratio measured by
dividing net profit over shareholders’ equity. It indicates how well the business can
utilize equity investments to earn profit for investors.
ROE = Net Profit / (Beginning Equity + Ending Equity) / 2
11. Return on Assets
Return on assets, or ROA, is another profitability ratio, similar to ROE, which is
measured by dividing net profit by the company’s average assets. It’s an indicator of
how well the company is managing its available resources and assets to net higher
profits.
ROA = Net Profit / (Beginning Total Assets + Ending Total Assets) / 2
