Financial statement is a formal and comprehensive statement describing financial activities of a business organization. Financial statement provides important information for a wide variety of decision. Investors rely very significantly on the degree of reliability and credibility of the published financial statement by an auditor or financial expert. Investor should be able to analyze, read and interpret these financial statements. Financial statement analysis in investment decision is considered as core tool which assists all stakeholders. It helps in evaluating past, present and future performance of companies, also in discovering weakness and strength points of the company.

The financial statement comprises of balance sheet, profit and loss statement, and cash flow statement. We shall explore in detail the financial statement to discover whether or not the company has a durable competitive advantage.

Profit And Loss Statement 

The P&L statement is a financial statement that summarizes the revenue, cost, and expenses incurred during a specified period, usually a fiscal quarter or year. The P&L statement is synonymous with Income Statement. An income statement has three basis components. It begins with an entry for revenue, knows as top line. Second is subtracts the cost of goods sold and all expenses. Third, as the bottom line, is net income.

Revenue

Revenue will be recognized in Income Statement when goods and services have been sold and received by Customer. A company has a lot of revenue that does not mean it is earning profit. Total revenue balance don’t tell us anything until we subtract the expenses and find out what the net incomes are

Cost of Revenue

It is the total cost of manufacturing and delivering a product or service to consumers. That represents as direct costs associated with the goods and services the company provides. Cost of Revenue is different from Cost of Goods Sold (COGS). COGS are cost of materials and labor directly used to produce good only. While Cost of Revenue takes into account COGS plus additional costs incurred to generated sale such as commission, sale discounts.

Gross Profit

Gross Profit Margin = (Revenue – Cost of Revenue) / Revenue

It is a key number that helps to determine whether or not the company has a long-term competitive advantage. We should track the annual gross profit margin within last ten years to ensure that there is “consistency”.

A company with high consistent gross profit margin is freedom to set price structure of products and services which is excess of cost of revenue. It leads them to be in durable competitive advantage. Any gross profit margin of 20% and below is usually good indicator of a fiercely competitive industry, where there is no company that can create a sustainable competitive advantage over the competition.

Operating Expenses

Operating expenses are incurred through its normal business operations. It includes rent, equipment, inventory cost, marketing, payroll, insurance and funds allocated for research and development.

In the search for a company with a durable competitive advantage, the lower of company operating expense is better. Research & Development expense also affect to your investment decision. If the competitive advantage is created by patent, when the patent will expire and the competitive advantage will disappear. If competitive advantage is result of some technology advancement, there is always threat that newer technology will replace it. The technology company such as Apple or Samsung have spent huge sum of money on R&D that is technological race. It will always put their long-term economics at risk.

Customer Acquisition Cost

Customer Acquisition Cost = Sale and Marketing Expenses / Number of Customer Acquired

It tells us how much the company spends to get one new customer. We must prefer to Customer Acquisition Cost as it is key business metric. We can analyze how management controls the most cost-effective way to acquire customers and understand marketing campaign run.

Depreciation

It is allocating of the cost of fixed asset to expense in the accounting period that are within the asset’s useful life.

As with any expenses that hits into income, less is better than more.

Interest Expense

It is the cost incurred for borrowed fund. Interest expense is non-operating expense. It is called a financial cost. Interest is reflective of the total debt that the company is carrying on. The more debt the company has, the more interest it has to pay.

Interest coverage ratio indicates a company’s ability to cover interest charges

Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

In general, the higher the ratio, the greater the likelihood that the company could cover its interest payments without difficulty.

Another ratio as percentage of interest payments to operating income must be considered. It provides information related to level of economic danger that a company is in. It varies greatly from industry to industry. In any given industry the company with the lowest ratio of interest payments to operating income is usually the company with competitive advantage.

Gain (Or Loss) On Sale of Assets and Other

It is recorded when a company sells an asset and get profit or loss. That is a nonrecurring gain or loss. It is excluded from earning per share (EPS) calculations. It must be taken out for considering investment decision.

Net Income

It is called net earnings. This is where we find out how much money the company made after it paid income taxes.

Profitability Ratio

Net Profit Margin = Net Profit After Taxes / Revenue

By considering both ratios Gross Profit Margin (GPM) and Net Profit Margin, we are able to gain considerable insight into the operations of the firm. If the GPM is essentially unchanged over a period of several years, but Net Profit Margin has declined over the same period. We know that the reason is either higher selling, general & administrative expenses, research & development expense, or a higher tax rate

Return on Equity = Net Profit After Taxes / Shareholders’ Equity

Return on Equity is kind of Profitability Ratios. Net profit after taxes must minus preferred stock dividend, if any, when calculate the return on equity ratio. This ratio tells us the earning power on shareholders’ book value investment. It is frequently used in comparing two or more companies in same industry. A high return on equity often reflects the firm’s acceptance of strong investment opportunities and effective expense management. However, if the firm has chosen to employ a level of debt that is high by industry standards, a high ROE might simply be the result of assuming excessive financial risk.

Break-Even Point

Break-Even Point = Fixed Costs / (Sales Price per Unit – Variable Cost per Unit)

It is also used by investor to determine at what price they will break even on a trade or investment.

It is measurement system that calculates the margin of safety by comparing the amount of revenues or units that must be sold to cover fixed cost associated with sales.

Balance Sheet

Balance Sheet is also known as the statement of financial position at a given date. It is comprised of three main components: Assets, liabilities, and equity. It helps users of financial statements to assess the financial soundness of an entity in terms of liquidity risk, financial risk, credit risk and business risk.

Assets

It is under entity owns or control in order to get economic benefit. There are many different kinds of assets. Assets must be classified as current and non-current. Current asset can be or will be converted into cash in a very short period of time (usually within a year). Non-current asset will deliver economic benefit over the long term. They include cash, receivables, inventory, PPE (property, plant & equipment).

Current Assets

Cash -> Inventory -> Account Receivable -> Cash

They are in the cycle of cash going to buy inventory. Then inventory is sold to customers recorded as Account Receivable. When collected from customers, account receivable will turn back to cash. This cycle repeats itself over and over again. It describes how the money is made

A high number for cash or cash equivalents tells us one of two things

1. Company has a competitive advantage that is generating tons of cash. It is good thing
2. Company just sold a business or a ton of bonds. It is not good thing

A low amount of cash usually means that the company has poor economics.

To determine what case the company is in, we must look at the past seven years of balance sheets. This will reveal whether the cash hoard was created by one-time event, such as the sale of new bonds or shares, or sale of an asset or an existing business, or whether it was created by ongoing business operations

If we see a lot of cash, and there is little or no debt on Balance sheet, no sales of new shares or asset. It means that is good chance to invest. But if we see a lot of debt even there is a lot of cash, we probably are not dealing with an exceptional business. Cash balance may be come from debt.

Liquidity Ratios

It is used to measure a company’s ability to meet short-term obligations

Current Ratio = Current Assets / Current Liabilities

The higher the current ratio, the greater the ability to pay its bills. If a company with current ratio is less than one, it means there are fewer current assets than current liabilities. It is sign of financial risk. Because it might not be able to easily pay down its short-term obligations. However, this ratio is a crude measure. Because it does not take into account the liquidity of the individual components of the current assets. A company having current assets composed principally of cash and non-overdue receivables is generally regarded as more liquid than a company whose current assets consist primarily of inventories.

Quick Ratio = (Current Assets – Inventories) / Current Liabilities

Quick Ratio is a more conservative measure of liquidity than Current Ratio. This ratio serves as a supplement to the current ratio in analyzing liquidity. Inventories are subtracted out of current assets. It concentrates primarily on the more liquid current assets – cash, marketable securities and receivable – in relation to current obligations.

Inventory

That is the company’s products that it has warehoused to sell to customer. To help determine how effectively the company is managing inventory, we compute the inventory turnover ratio

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Average Inventory = (Beginning Inventory + Ending Inventory) / 2

It tells us how many times inventory is turned over into receivables through sales during the year. This ratio, like other ratio, must be judged in relation to past and expected future ratios of the company and in relation to ratios of similar companies, the industry average, or both.

A higher ratio implies the inventory management is more efficient and more liquid inventory. However, sometimes a high inventory turnover indicates a hand-to-mouth existence. Therefore it might actually be a symptom of maintaining too low a level of inventory and incurring frequent stock-outs. Its ratio is low that is often a sign of excessive, slow-moving, or obsolete items in inventory. Manufacturing companies with a durable competitive advantage don’t have obsolete item which require substantial write-down affected to company’s income.

An alternative measure of inventory activity is Inventory Turnover in Days (ITD)

ITD = Days in the year / Inventory Turnover

Or, equivalently

= (Inventory x Days in the year) / Cost of Goods Sold

It tells us how many days, on average, before inventory is turned into accounts receivable through sales.

Accounts Receivable

It is created when a company sells products or services to customer on credit. It represents money due to a company in the short-term. Since there are some bad debts caused by customer who has not paid for goods or services sold. Receivables less Bad Debts will give us Net Receivables.

Some companies will attempt to gain an advantage by offering better payment terms to client in competitive industries. This will cause an increase in sales and an increase in receivables. If there is a lower percentage of Net Receivables to Gross Sales compared to competitors, it usually has some kind of competitive advantage that the competitor don’t have.

Accounts Receivable measures a company’s liquidity or ability to cover short-term obligation without additional cash flows.

Receivable Turnover Ratio = Annual Net Credit Sales / Average Receivables

Average Receivables = (Beginning Receivable + Ending Receivable) / 2

This ratio tells us the number of times accounts receivable have been turned into cash during the year. A high ratio can indicate that a company’s collection of accounts receivable is efficient. Company has a high proportion of quality customers who pay their debts quickly. In contrast, a low ratio might be due to a company having a poor collection process. It is important to compare this ratio of multiple companies in same industry to get what the normal rate is. If company has higher ratio than other, it is safe to invest.

Property, Plant and Equipment

They are also called fixed assets. PP&E are long term assets which has useful life more than 1 year. They can’t be easily liquidated into cash.

A company investing in PP&E is also good sign for investor. It describes that management has faith in long-term outlook as they expected to generate economic benefits and contribute to revenue for many years. Investment in PP&E is also called a capital investment. But if PP&E will be sold to fund business operation, that is signal for financial trouble

A company with a durable competitive advantage will be able to finance any new PP&E internally, without taking bank debt. It doesn’t need to constantly upgrade its PP&E to get more competitive when PP&E are no longer in good condition. But a company without competitive advantage will be forced to turn to debt to finance its constant upgrade to keep up with the competition.

In addition, producing a consistent product that doesn’t have to change equates to consistent profits. Because there is no need to spend a lot of money to upgrade the PP&E

Long-term Investment

It represents the company’s investment, including stocks, bonds, real estate, and cash. It can tell us a lot about the investment mind-set of top management. Whether they invest in other businesses with durable competitive advantage or not? Or they invest in business that is in highly competitive markets.

Current Liabilities

Current Liabilities are a company’s short-term financial obligations that are due within one year. It includes Accounts Payable, Accrued Expense, Short-term Debt, and other Current Liabilities.

Accounts Payable

It is the opposite of Accounts Receivable. That is money owed to Suppliers who have provided goods and service to the company on credit. Accounts payable is typically one of the largest current liability accounts on a company’s financial statement. Companies try to control cash flow by matching payment dates. So that they will collect money from accounts receivable before the accounts payable are due to suppliers.

The ratio of current assets to current liabilities is an important in determining a company’s ongoing ability to pay its debt as they are due. Analysts and creditors often use the current ratio to measure a company’s ability to pay its short-term financial debts or obligations.

Short-term Debt

It is such as bank loan or commercial paper issued to fund operation. It is possible to make money borrowing short-term and lending it long-term. We will face financial issue if short-term rates jump above what we lent. In addition, if we lend all this money long-term, then our creditors decide not to loan us any more money in short-term. It will lead to financial disaster over the long term as we have to pay back all the money we borrow short-term and lent long-term. The smartest and safest way to make money in banking is to borrow it long-term and lend it long-term.

Long-term Debt That Is Coming Due

It has to be paid off in the current year must be recorded as short-term debt on Balance Sheet. If there are too much debt coming due in a current year can lead to cash flow problems, which is also certain death to our investment. So we probably are not dealing with a company that has a lot of long-term debt coming due.

Long-term Debt

In contrast Short-term Debt, they are obligations that will not be paid off in the current year or accounting period. For Long-term Debt Balance, company has a durable competitive advantage that carries little or no long-term debt on their balance sheets. Because they are so profitable company that they are self-financing when they need to expand the business or make acquisitions. So they don’t need to borrow large sums of money.

Financial Leverage (Debt) Ratios

It is financial measurement that looks at how much capital comes in form of debt or assesses the ability of a company to meet its financial obligations.

Debt to Equity Ratio = Total Debts / Shareholders’ Equity

It shows the percentage of financing that comes from creditors and investors. This ratio helps us to identify whether or not a company is using debt to finance its operations or equity (which includes retained earnings). The company with durable competitive will use earning power to finance its operations. Debt to equity ratio will be lower than 1. In contrast, a higher ratio is considered more risky to investor.

There is problem when using this ratio. The company is so great competitive advantage. They will often spend their retained earnings to buy back their stock. That decreases in their equity, and in turn increases their debt to equity ratio. For this case, we must add back treasury stock to the shareholder’s equity to calculate debt to equity ratio. In addition, depending on the purpose for which the ratio is used, preferred stock is sometimes included as debt rather than as equity when debt ratio is calculated.

Different industries have different rates. A comparison of the debt-to-equity ratio for a given company with those of similar industry gives us a general indication of the creditworthiness and financial risk of company.

Debt to Total Assets Ratio = Total Debts / Total Assets

This ratio is also kind of Financial Leverage Ratios. It highlights the relative importance of debt financing. A higher the debt to total assets ratio, the greater the financial risk. The lower this ratio, the lower the financial risk.

Shareholder Equity

Shareholders’ Equity = Total Assets – Total Liabilities

Shareholder equity represents the amounts of money that would be returned to shareholders if all of the assets were liquidated and all of the company’s debt was paid off. Shareholders’ Equity can also be expressed as a company’s share capital and retained earning less the value of treasury shares.

Shareholder equity can be either negative or positive. If positive, the company has enough assets to cover its liabilities. If negative, the company’s liabilities exceed its assets and considered as insolvency. So a company with negative shareholder equity will be described as risky or unsafe investment.

Return on equity ratio is used to measure how well a company’s management is using its equity from investors to generate profit

Share Capital

They include common stock, preferred stock and additional paid-in-capital. A company’s share capital is the money raised from selling common or preferred stock.

Common Stock

It represents ownership in the company. Holder common stock are the owners of the company and have the right to elect a board of directors. They receive dividends if the board of directors votes to pay them. In liquidation, common stockholder do not receive money until the creditors, bondholders and preferred shareholders have received their respective share.

Preferred Stock

The person hold preferred stock don’t have voting rights, but they do have a right to a fixed or adjustable dividend that must be paid before dividend is paid for common stock owner. Preferred shareholders also have priority over common shareholders when company falls into bankruptcy. A company has a durable competitive advantage tend not to have any preferred stock in its capital structure as they make so much money that they are self-financing.

Common stock and preferred stock shares are reported at their par value at the time of sale. The actual amount received by a company in excess of par value is recorded as “additional paid-in-capital”

Retained Earnings

Net profit can either paid out as dividends or used to buy back the company’s share, or it can also be re-invested back into the company for growth purpose. The money not paid to shareholders counts as retained earnings. If the earnings are retained, not paid dividend to shareholder, they can greatly improve the long term economic picture of the business. The more earning that company retains, the faster it grows its retained earnings, which, in turn will increase the growth rate for future earnings.

High returns on equity mean that the company is making good use of the earning that is retaining. As time goes by, these high returns on equity will add up and increase the fundamental value of business, which will eventually be recognized by the stock market through an increasing price for the company’s stock.

Treasury Stock

Treasury Stock represents the number of shares repurchased from the open market. It reduces shareholder’s equity by the amount paid for the stock.

Companies with a durable competitive advantage have a lot of free cash that they can buy back their shares. They will be held as treasury stocks. It decreases the company’s equity effectively and increases the company’s return on shareholders’ equity. That is sign of competitive advantage. In summary, if we see the balance of treasury stocks on the balance sheet and refer a history of buying back shares, that is good indication of durable competitive advantage company

Cash Flow Statement 

The cash flow statement includes cash made by the business through operations, investment, and financing. It helps to track the cash that flow in and out of the business.

Cash Flow From Operating Activities

This first part begins with net income, then adds back in depreciation and amortization which are non-cash items. Operational business transaction such as buying, selling inventory, payment to supplier, employees are included in this first part.

Cash Flow From Investing

This is the second section of the cash flow statement. It includes cash spent on PP&E, regarding to Capital Expenditure (CapEx). CapEx is known as fund used to acquire, upgrade, and maintain physical assets such as property, building, technology, equipment. Capital expenditures of a company depend on the industry that it works. If CapEx remains high over a number of years, it can have deep impact on earnings. We look at CapEx for 10 year period and compare with net earnings with same 10 year period. For a company with Capex is less than 50% of its annual net earnings. It is good sign for a durable competitive advantage

Cash Flow From Financing

Last section provides an overview of cash used in business financing. It helps to track bond and stock sales and repurchase, how much paid out for dividend. It is useful to determine how a company raises cash for operational growth. If the company uses some of excess money to buy back share, number of capital share will be reduced. It leads the increase in earnings per share, which eventually makes the stock price go up. That is increase in the shareholders’ wealth.

In summary, financial statement analysis plays a vital role in investment decision making. Investors use it as a major parameter for assessing the profitability, risk of investing. No investment decision on a company should be taken without the consideration of a company’s financial statement analysis.