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Financial Statement Analysis

Innhold
Balance Sheet Analysis ............................................................................................................................ 2
Assets................................................................................................................................................... 3
Liabilities .............................................................................................................................................. 3
Shareholders' equity............................................................................................................................ 4
Income statement Analysis ..................................................................................................................... 7
Revenues / Net sales ........................................................................................................................... 7
Costs of Goods Sold (COGS) ................................................................................................................ 7
Operating expenses (OpEx) ................................................................................................................. 8
Operating Income (EBIT) ..................................................................................................................... 8
Net income .......................................................................................................................................... 9
Cash Flow Statement Analysis ............................................................................................................... 11
What is a cash flow statement? ........................................................................................................ 11
Operating Cash Flow or Cash from operations ................................................................................. 12
Working Capital ............................................................................................................................. 13
Cash flow from investing activities .................................................................................................... 14
Cash from Financing Activities .......................................................................................................... 15
Cash and cash equivalents by the end of the period ........................................................................ 15
The importance of cash flow ................................................................................................................. 16
Free cash flow................................................................................................................................ 16
Capital Expenditure (CapEX) .......................................................................................................... 17

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Balance Sheet Analysis

Peter Lynch once said:
«Never invest in a company without understanding its finances. The biggest losses in stocks
come from companies with poor balance sheets. »
Let’s break down how to analyze a balance sheet:

The Balance sheet consists of 3 components:

• Assets
• Liabilities
• Shareholders' equity
Assets: What the business owns
Liabilities: What the business owes
Shareholders' equity: What the owners have invested in the business.
The simple formula explains how these 3 components are interconnected:
Shareholders' equity = total assets - total liabilities

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Assets
Assets can be categorized into 2 subcomponents:
1. Current assets: Assets that can be made liquid within 12 months.
Examples: Cash & Equivalents, marketable securities, accounts receivable

2. Non-current assets: Assets that can't be liquidated within 12 months

Examples: Property, plant & equipment, Investment properties, Intangible assets, good will.

Essential questions to ask yourself about the assets:

1. Does the cash cover the short-term obligations? (Good sign)
2. Are inventories piling up over time? (Bad sign)
3. Are accounts receivables growing faster than sales? (Bad sign)

Liabilities
Component 2: Liabilities can also be divided into 2 subcomponents:
1. Current liabilities: Liabilities that needs to be paid within 12 months.
Examples: Accounts payable, accrued expenses, other current liabilities.

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2. Non-current liabilities: Liabilities that is not due within the next 12 months.
Examples: Long-term debt, bonds payable, deferred tax liabilities.

Essential questions to ask yourself about the liabilities:

1. Are the current liabilities higher than current assets? (Bad sign)
2. Is the cash position higher than current liabilities? (Good sign)
3. Are short-term liabilities growing faster than assets? (Bad sign)

Shareholders' equity
Shareholders’ Equity is often referred to as the "Book value" of a company.
Shareholders’ Equity = total assets - total liabilities

Examples:
Paid-in capital: Investments paid using equity.
Treasury shares: Shares bought back by the company.
Retained earnings: Earnings of the business minus the dividends paid.

Essential questions to ask yourself for the shareholders' equity:

1. Is the retained earnings growing every year? (Good sign)
2. What is the retained earnings used for (Capital allocation)?

3 ratios to consider for a quick analysis:

1. Interest coverage
2. Net debt to free cash flows
3. Debt to equity

Interest coverage

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Tells us how many times over the company can cover its interest expenses with the last 12
months EBIT.
Formula: EBIT / Interest expenses
Both items are found on the income statement.
We would like to see the interest coverage be >10x, indicating that the business is reasonably
levered.

Net debt to free cash flow

This ratio tells us how many years’ worth of FCF it would take for the company to pay off its
debts. Net debt is short and long-term debt, minus cash (Found on the balance sheet)
FCF is cash flow from operations minus capex (Found on the cash flow statement and stock-
based compensation)
We would like to see net debt to free cash flow below 3 times. This indicates that if the
business wanted to, it could pay down all debts in 3 years or less.

Debt to equity
Warren Buffett is known to use the debt-to-equity ratio to quickly determine how leveraged
the business is. “Total debt” and “shareholders' equity” is found on the balance sheet. The
ratio tells us how much debt a business has in relation to the equity. If this ratio is above 1, it
indicates that there is more debt than equity in the business.
Ideally, we want a business that has a debt to equity below 1.5. This indicates a reasonable
levered business.

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A business with:
o Interest coverage +10x
o Net debt / FCF <3
o Debt to equity <1.5
Is likely to be a healthy company with low leverage and high solvency.

Note: There will be great businesses that are levered above the levels we have set here, but
our base should be that we want to own businesses that don’t depend on leverage to
outperform. The best businesses have low debt levels and are gushing out cash that
can be used for buybacks, dividends, reinvestments, and acquisitions to compound
shareholder value.

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Income statement Analysis

Accounting is the language of business. If you invest in individual businesses, you must learn
how to read & analyze an income statement. Here is a breakdown of how to read & analyze
an income statement:

The income statement shows the business' revenues and expenses for a specific time period.
By analyzing the income statement, you will understand how fast the business is growing, and
whether that growth is profitable.

Revenues / Net sales

Revenue is what a business receives from selling its products and services. In our example, the
business has made $200,000 of revenues for the year 2020.

Costs of Goods Sold (COGS)

All costs a business makes to produce the products and services they offer. For our example,
the business has COGS of $110,000

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Gross Profit
What is left after you subtract the COGS from the revenue: If you buy stuff for $110k (COGS),
apply your value to the stuff, and sell that stuff for $200k (Revenue), you are left with $90k in
Gross profits.
If we want to calculate the Gross Margin, we use the following formula:
Gross profit margin = Revenue - COGS / Revenue x 100

Operating expenses (OpEx)

OpEx is the expenses a business uses to run its day-to-day operations; it consists of 4 main
categories: I) Sales & Marketing, II) Research & Development, III) Depreciation &
Amortization, and IV) General & Administrative Expenses.
In our example, the business has total operating expenses of $48.2k. We should ask ourselves
2 questions about the operating expenses:
1. Is the business using excessive amounts of S&M? (Bad sign) For example, some
businesses use more on S&M than their operating cash flow. This is not sustainable.
2. Are the R&D investments paying off in any material way? This will show up as new
product developments & product/services that create new or expand existing
revenues streams (Good sign). Not good if the business is using billions on R&D while
not producing material results.

Operating Income (EBIT)

Operating income is also called "EBIT" or "Earnings Before Interest & Taxes". EBIT tells us how
much the business is making from its day-to-day operations. We can easily calculate the
operating income with the following formula:
Revenue - COGS - Operating expenses
In our example, the operating income, or EBIT is: $200k - $110k - $48.2k = $41.8k. From this
we can easily calculate the “Operating Margin” by using the following formula:
EBIT / Revenue x 100 = $41.8k / $200k x 100 = 20.9%

Non-Operating Income & Expenses

Items that are not related to the day-to-day operations of the business. In this post, there can
both be positive contributors to net income, or contractors. There are 4 categories: I) Other
income (positive), II) Foreign currency (Positive or negative), III) Interest expenses (negative),
and IV) Financial instruments (Positive or negative).

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Income before income taxes (EBT)

All other expenses are now considered, the only missing element is taxes. The formula:
Income before income taxes = Operating Income - Non-operating income & expenses.
In our example: $41.8k + $3.5k (Interest revenues of 2k + Gains from Investment sales of 1.5k)
- $0.6k (Interest expense of (0.6k)) = $44.7k (EBT = $44.7k)

Income Tax Expenses

Taxes the business must pay to the right entity. In our example, they pay an income tax of
$0.2k. In our example, taxes are included in “Non-operating and other”, but taxes are usually
separate in its own post. We can calculate the tax rate with the following formula:
Tax rate = Income Tax Expenses / EBT x 100 Ex: 0.2k / 44.7k x 100 = 4.47%

Net income
Net income is revenue minus all expenses and taxes. This is what investors usually refer to as
the profit of the business. Formula:
Net income = Revenue - COGS - Operating Expenses - Other expenses – Taxes
In our example: 200k – 110k – 48.2k + 3.5k – 0.8k = 44.5k

2 Important questions to consider for the income statement:

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1. Is revenue, operating income, net income, and earnings per share (EPS) growing at a steady
phase? The ideal business grows every year with very few exceptions.
2. Is the gross-, operating-, and net margins stable or (even better) expanding over time?

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Cash Flow Statement Analysis

Investors tend to focus on profits from the income statement. However, the cash flow
statement is more important in many cases, as it reflects the cash earnings a business make.
Let’s break down how you read & analyze the cash flow statement:

What is a cash flow statement?

It shows you how much cash goes in and out of a business in a certain time period. You must
understand that businesses can’t pay its bills with "earnings", they can only pay them with
cash.
When I refer to “earnings”, it is specifically the popular measure “EBITDA”, or “Earnings
before Interest, taxes, depreciation and amortization”. Charlie Munger famously referred to
this proxy as “Bullshit earnings”. EBITDA can be manipulated by clever accounting. It is very
hard to be deceitful when it comes to the in- and outflows of cash. Although EBITDA can have

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its useful areas (for example when comparing earnings across industries), I much prefer to
look at the operating cash flow and Free cash flow of a business.
"EBITDA is an opinion, cash is a fact."

The cash flow statement consists of 3 key elements:

o Operating cash flow
o Investing cash flow
o Financing cash flow
All 3 are important to understand the ins and outs of the business.

Operating Cash Flow or Cash from operations

This section shows what the business generates from its normal operating activities. For
example: Apple's operating activities are to sell its iPhones and Macs.
The formula:

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The cash from operations is similar to net income, but it adds back non-cash items that net
income includes.
Examples of what is added back: Depreciation and amortization, non-cash adjustments,
Changes in Working Capital
Note: OCF also adds Stock-based compensation back in, as it is not a cash expense. This is
however not a good thing in my opinion, as SBC will dilute you as a shareholder. This means
that you will end up owning less % of the business, and therefore there is a real cost to
investors. Investors should exclude stock-based compensation from operating cash flows.

Working Capital
Working capital is the capital a business needs to meet its short-term obligations. Working
capital consists of

• Accounts receivables
• + inventory
• - accounts payable
Accounts receivables is the money the customer owes the business.
Inventory is the total value of the product the business has not yet sold.
Accounts payable is what the business owes its suppliers.
Low levels of working capital are good as it indicates that the business is managing its money
efficiently and has control over its inventory. Low working capital requirements for a business
also mean it requires low levels of capital to operate, which can reflect that the business
model is capital light.
Changes in Working Capital
You will often see this on the cash flow statement. It means that there is a change from the
prior year in one of the following elements:

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1. Accounts receivable
2. Accounts Payable
3. Inventory
Accounts receivable is negative = Accounts receivables have increased since the previous
period. This means that customers owe the business more this period, than the previous
period. This can be a negative sign, but it depends on the context. As an example, it might
indicate that customers are not paying the business on time as they have in the past.
Accounts payable is positive = Accounts payable increase since the previous period. This
means that the business is not paying its short-term obligations to its suppliers as quickly as in
the previous period. This allows the business to keep the cash for a bit longer. This is a
positive for the business in terms of liquidity, but again, it might hurt the relationship the
business has with its suppliers that are waiting longer to get paid.
Inventory shows a positive number = Inventory is higher than the previous period. This can
mean that the business is unable to sell its product, in certain industries this is a bad sign. As a
rule, we want to see stable inventory levels and not that inventory is piling up. In retail for
example, if we see increasing inventories, it indicates that there is a limited demand for the
product. This might also indicate that the business has to write down the value of the product
at a later point (Which is a negative).
The formula for cash flow from operations is:
Cash flow from operations = Net Income + non-cash charges + / - changes in working capital (-
Stock based compensation)

Cash flow from investing activities

This section gives an overview of the company's investment-related cash in- and outflows
There are 3 key elements:
1. Capital Expenditure (CapEx)
2. Mergers & Acquisition (M&A)
3. Marketable securities

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o Capital Expenditure is the cash a company needs to maintain its ongoing operations.
This can be costs related to equipment, buildings, and licenses.
o M&As are the cash used to acquire other businesses.
o Marketable securities are buys & sells made in stocks by the company.

The formula:
Cash flow from investments = Sale of marketable securities + divestments - capital
expenditure - M&As - buys of marketable securities

Cash from Financing Activities

This section shows the cash movement between the shareholders and the bondholders of the
business. From this section, we can learn how the business is being financed.

There are 3 key elements:

1. Borrowing & repayment of debt
2. Issuing stock and stock buybacks
3. Dividends

The formula:
Cash flow from financing: Debt issuance + issuance of new stock - dividends - debt repayment
- share buybacks

Cash and cash equivalents by the end of the period

The final section of the cash flow statement shows the balance of cash from the last period.
This will show a positive number if the cash balance is up from the prior period.

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From our example cash flow statement, the cash flow in that given year is $1.522.000 The
only negative elements are an increase of $30.000 in inventory and a $500.000 investment in
equipment. We also want to know if that investment is a maintenance or a growth
investment.

The importance of cash flow

Cash is what pays the bills, not earnings. As mentioned, earnings metrics such as EBITDA can
be manipulated by clever accounting. It is very hard to manipulate how much cash a business
generates over a time period.
Operating cash flow is important to consider as this represents what the company’s operation
is generating in terms of cash. Operating cash flows concentrate on cash inflows and outflows
related to a company's main business activities, such as selling and purchasing inventory,
providing services, and paying salaries.
Free cash flow
Free cash flow is a simple calculation.
The traditional formula:
Free cash flow = Operating cash flow – Capital Expenditure
Adjusted formula:
Free cash flow = Operating cash flow – Capital Expenditure – Stock-based compensation
Or
Free cash flow = Operating cash flow – Maintenance Capital Expenditure – Stock-based
compensation (See next section for explanation)
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Free cash flow is often compared to net income. While net income is used as a measure of a
company’s profitability, free cash flow provides a better insight into the business model of the
business, and its financial health.
Capital Expenditure (CapEX)
CapEx are funds used by a company to acquire, upgrade, and maintain physical assets such as
property, plants, buildings, technology, or equipment (Investopedia).
We can divide CapEx into two elements:
1. Maintenance CapEx: Funds used to maintain the current position of the business. E.g.
technology or equipment upgrades that are required to keep serving the existing
business.
2. Growth CapEx: Funds used to grow the business. These are often capitalized on the
cash flow statement as CapEx. This can be acquisitions, new factories, or property that
will increase the future growth of the business.
Most companies won’t disclose what percent of the CapEx is used for growth and
maintenance, so it requires an educated guess to determine these 2. However, some
businesses do show us more details in terms of capital expenditure, Alimentation Couche-
Tard is one example:

For our Free cash flow calculation, we want to subtract maintenance CapEx, because this is
what is needed to maintain the business. The growth CapEx is considered investments in
future growth and should not go into the calculation of free cash flow.

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