📊 Financial Statement Analysis: Your Detective Toolkit
Imagine you’re a detective. Companies are like people with secrets, and financial statements are their diaries. Today, you’ll learn 8 super tools to read between the lines and discover the real story!
🎯 The Big Picture: What’s Statement Analysis?
Think of a company like a lemonade stand. Just looking at how much money is in the box doesn’t tell you everything. You need to ask:
- Are we making more money than last summer?
- How much of each dollar becomes profit?
- Can we pay for more lemons if we need them?
Statement Analysis gives you the tools to answer these questions!
1️⃣ EBITDA: The “Real Earnings” Measure
What is EBITDA?
Earnings Before Interest, Taxes, Depreciation, and Amortization
Think of it like this: You have a pizza shop. At the end of the month, you want to know how good you are at making and selling pizzas—not how good you are at paying rent or dealing with banks.
EBITDA shows the pure power of a business, stripping away the extra stuff.
The Formula
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Simple Example 🍕
Your pizza shop made:
- Net Income: $10,000
- Interest paid to bank: $1,000
- Taxes: $2,000
- Depreciation (oven wearing out): $500
- Amortization (recipe license cost spread out): $300
EBITDA = $10,000 + $1,000 + $2,000 + $500 + $300 = $13,800
This tells you: “My pizza-making ability generates $13,800!”
Why It Matters 💡
- Investors love it: Shows operational strength
- Compare businesses: Different loans? Different tax situations? EBITDA levels the playing field
- Quick health check: Is the core business actually making money?
2️⃣ Horizontal Analysis: The Time Machine
What is Horizontal Analysis?
Imagine you take photos of yourself every year. Horizontal analysis is like putting those photos side by side and asking: “How have I changed?”
You compare the same line item across different time periods.
The Formula
Change = (This Year - Last Year) / Last Year × 100%
Simple Example 📸
| Item | 2023 | 2024 | Change |
|---|---|---|---|
| Sales | $100,000 | $120,000 | +20% 📈 |
| Expenses | $60,000 | $80,000 | +33% 🚨 |
| Profit | $40,000 | $40,000 | 0% 😐 |
Story Revealed: Sales grew, but expenses grew faster! That’s why profit stayed flat. Red flag!
Why It Matters 💡
- Spot trends: Are things getting better or worse?
- Find problems early: Costs rising faster than sales? Danger!
- Plan ahead: If sales grow 10% yearly, predict next year
3️⃣ Vertical Analysis: The Pie Chart View
What is Vertical Analysis?
Imagine cutting a pizza and asking: “How big is each slice compared to the whole pizza?”
You show each item as a percentage of a base number (usually total sales or total assets).
The Formula
Percentage = (Individual Item / Total) × 100%
Simple Example 🥧
Income Statement:
| Item | Amount | % of Sales |
|---|---|---|
| Sales | $100,000 | 100% |
| Cost of Goods | $60,000 | 60% |
| Operating Expenses | $25,000 | 25% |
| Profit | $15,000 | 15% ✨ |
Story Revealed: For every $1 of sales, you keep 15 cents as profit!
Why It Matters 💡
- Compare different-sized companies: A $1 billion company and $10 million company can be compared fairly
- Understand cost structure: Where is money going?
- Industry benchmarks: Is your 60% cost of goods normal?
4️⃣ Common Size Statements: Everyone Speaks the Same Language
What is Common Size?
Think of it as vertical analysis’s big sister. You convert every number into a percentage so you can compare any company to any other company.
Income Statement: Everything as % of Sales Balance Sheet: Everything as % of Total Assets
Simple Example 🏢
Two Ice Cream Shops:
| Item | Big Shop ($) | Big Shop (%) | Small Shop ($) | Small Shop (%) |
|---|---|---|---|---|
| Sales | $500,000 | 100% | $50,000 | 100% |
| Cost | $300,000 | 60% | $35,000 | 70% |
| Profit | $200,000 | 40% | $15,000 | 30% |
Story Revealed: Big Shop is more efficient! They keep 40 cents of every dollar vs Small Shop’s 30 cents.
Why It Matters 💡
- Fair comparison: Size doesn’t matter anymore
- Find the best performer: Who’s most efficient?
- Spot inefficiencies: Why is Small Shop’s cost 70%?
5️⃣ Trend Analysis: Connecting the Dots
What is Trend Analysis?
Imagine you’re tracking your height every year since you were 5. Trend analysis connects those dots to see the pattern over time.
You pick a base year (usually = 100) and measure everything against it.
The Formula
Trend = (Current Year / Base Year) × 100
Simple Example 📈
Base Year: 2020 Sales = $100,000 (set as 100)
| Year | Sales | Trend Index |
|---|---|---|
| 2020 | $100,000 | 100 |
| 2021 | $110,000 | 110 |
| 2022 | $125,000 | 125 |
| 2023 | $140,000 | 140 |
| 2024 | $130,000 | 130 ⬇️ |
Story Revealed: Steady growth for 4 years, then a dip! What happened in 2024?
graph TD A[2020: 100] --> B[2021: 110] B --> C[2022: 125] C --> D[2023: 140] D --> E[2024: 130 🚨]
Why It Matters 💡
- Long-term patterns: One year might be luck; five years show reality
- Predict the future: If trend is up, probably continues
- Catch reversals: Growth stopping? Time to investigate!
6️⃣ Ratio Analysis: The Quick Health Check
What is Ratio Analysis?
Imagine your doctor checks your heart rate, blood pressure, and temperature. Ratio analysis is the financial health checkup—quick numbers that reveal a lot.
The Key Ratios (Grouped by What They Tell You)
💰 Liquidity: Can we pay bills?
Current Ratio = Current Assets / Current Liabilities
Example: $50,000 / $25,000 = 2.0 (Healthy! Can pay bills twice over)
📊 Profitability: Are we making money?
Profit Margin = Net Income / Sales × 100%
Example: $15,000 / $100,000 = 15% (Keep 15 cents per dollar)
⚡ Efficiency: How well do we use resources?
Asset Turnover = Sales / Total Assets
Example: $200,000 / $100,000 = 2.0 (Every $1 of assets creates $2 of sales)
🏦 Leverage: How much do we owe?
Debt-to-Equity = Total Debt / Shareholders' Equity
Example: $40,000 / $60,000 = 0.67 (For every $1 owned, we owe 67 cents)
Why It Matters 💡
- Quick diagnosis: One number, big insight
- Compare to competitors: Is your 15% margin good or bad?
- Track over time: Is health improving or declining?
7️⃣ DuPont Analysis: The Profit X-Ray
What is DuPont Analysis?
Named after the DuPont company that invented it. It’s like taking apart a machine to see which parts create your profit.
The magic formula breaks down Return on Equity (ROE) into 3 parts:
ROE = Profit Margin × Asset Turnover × Equity Multiplier
Or written out:
Net Income Net Income Sales Assets
----------- = ----------- × -------- × --------
Equity Sales Assets Equity
Simple Example 🔧
Two Coffee Shops, both with 20% ROE:
Café Luxury:
- Profit Margin: 20% (high prices, big margins)
- Asset Turnover: 0.5 (fancy equipment sits around)
- Equity Multiplier: 2.0 (some debt)
- ROE: 20% × 0.5 × 2.0 = 20%
Café Quick:
- Profit Margin: 5% (cheap coffee, tiny margins)
- Asset Turnover: 2.0 (fast service, efficient)
- Equity Multiplier: 2.0 (same debt level)
- ROE: 5% × 2.0 × 2.0 = 20%
Story Revealed: Same ROE, completely different businesses! Luxury makes money on margins; Quick makes money on volume.
graph TD A[ROE 20%] --> B[Profit Margin] A --> C[Asset Turnover] A --> D[Equity Multiplier] B --> E["Luxury: 20%"] B --> F["Quick: 5%"] C --> G["Luxury: 0.5x"] C --> H["Quick: 2.0x"]
Why It Matters 💡
- Diagnose problems: ROE falling? Which part broke?
- Strategy insight: Is this a margin or volume business?
- Find improvements: Low turnover? Use assets better!
8️⃣ Cash Flow Analysis: Follow the Actual Money
What is Cash Flow Analysis?
Profit is like promising to pay someone. Cash is the actual money in your pocket. Sometimes companies show profit but have no cash! (Scary, right?)
The Three Cash Buckets
graph TD A[Cash Flow Statement] --> B[Operating] A --> C[Investing] A --> D[Financing] B --> E["Day-to-day business<br/>Selling products, paying employees"] C --> F["Buying/selling big stuff<br/>Equipment, buildings"] D --> G["Money from/to owners & lenders<br/>Loans, stock sales, dividends"]
Simple Example 💵
| Activity | Cash Flow |
|---|---|
| Operating | +$50,000 ✅ |
| Investing | -$30,000 (bought equipment) |
| Financing | -$10,000 (paid loan) |
| Net Change | +$10,000 |
Story Revealed:
- Business generates good cash (+$50K) ✅
- Investing in growth (-$30K) ✅
- Paying down debt (-$10K) ✅
- Overall: Healthy cash situation!
Key Cash Ratios
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
Can the business pay bills from operations?
Free Cash Flow = Operating Cash - Capital Expenditures
Money left after keeping the business running
Warning Signs 🚨
- Negative operating cash: Business can’t generate cash!
- Profit but no cash: “Paper profit”—might be collecting IOUs instead of money
- Always borrowing to survive: Financing props up a weak business
Why It Matters 💡
- Cash is king: You can’t pay employees with “profit”
- Quality of earnings: Is profit backed by real cash?
- Survival check: Can the business sustain itself?
🎓 Putting It All Together
Your Analysis Checklist
| Tool | Question It Answers |
|---|---|
| EBITDA | How strong is the core business? |
| Horizontal | How have things changed over time? |
| Vertical | What % is each item? |
| Common Size | How do we compare to others? |
| Trend | What’s the long-term pattern? |
| Ratios | Quick health check numbers? |
| DuPont | Where does profit really come from? |
| Cash Flow | Is there actual money? |
The Detective’s Process
- Start with EBITDA: Is the core business solid?
- Use Horizontal Analysis: Getting better or worse?
- Apply Vertical/Common Size: How efficient vs. competitors?
- Check Trend Analysis: Any long-term concerns?
- Run Ratio Analysis: Quick health check
- Deep dive with DuPont: Where’s the profit coming from?
- Verify with Cash Flow: Is this backed by real money?
🚀 You’re Now a Financial Detective!
You’ve learned 8 powerful tools. Each one reveals a different piece of the puzzle. Used together, they tell the complete story of any company’s health.
Remember: No single tool tells the whole story. Great analysts use ALL of them together, like a doctor using multiple tests to diagnose a patient.
Now go forth and analyze! 🔍💪