Apr 02

Basic Financial Statement Analysis. Overview

by David Harper, CFA, FRM, CIPM

FinStatements |

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This series updates my Investopedia tutorial on Financial Statement Analysis (a popular series that is referenced in several college curricula). You can also watch along by viewing movie tutorials; the first movie tutorial is an 11-minute overview of the financial statements.

It's important to start to see the financial statements in relation to each other, as part of a whole system of documents. In particular, the relationship among the income statement, cash flow statement, and balance sheet.

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In practice, it's all too easy to develop and isolate on a favored metric (e.g., free cash flow-to-sales) or valuation bias (e.g., forward P/E ratio). But a holistic view pays dividends: it allows you to adjust your analysis to different businesses, circumstances and analytical objectives. Is revenue recognition always important? Not really. Is free cash flow margin without flaws? Nope. Is operating cash flow (OCF) better than earnings? Not so fast. Is economic value-added (EVA) superior? Not always. When you understand how the statements impact each other, you are better able to take a situational approach to financial statement analysis.

In this series, I will focus on the following core elements:

  1. Who's in charge (governance)? How the SEC & FASB set the rules of the game.
  2. The circular system. How the statements document transaction flow of cash as it pulses, in a circular cycle, from investors to the business and back to investors
  3. The cash flow statement.
  4. Income statement: Revenue
  5. Income statement: Earnings
  6. Balance sheet: working capital
  7. Balance sheet: long-lived assets
  8. Balance sheet: long-term liabilities
  9. Balance sheet: other
  10. Conclusion

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Along the way, we'll explore the following ideas:

  • Financial statement analysis is better at waving red flags than waving green flags. Qualitative considerations (e.g., strategy, economic moat, product differentiation) tend to inform growth opportunities, or what I am calling green flags. Red flags, on the other hand, are lurking landmines. Rigorous fundamental analysis can help you identify red flags. (Avoiding losses is key to outperformance.)
  • A company's business model should shape your analytical focus. For example, in retail, working capital and inventory management are primary; in software, investments are often expensed; in telecom, fixed assets are critical and therefore depreciation methods are primary.
  • Cash flows can be a leading indicator of earnings quality

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