How to Analyse Financial Statements?

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“Cash is King” when it comes to debt investing. 

As a debt investor, you must always seek information to help you understand the risks involved.

Debt investors should ask questions such as: 

Will the company I am going to invest in have the cash to pay me regular coupons?

Will the company I am going to invest in have the cash to repay me at maturity?

In order to help answer these questions, investors will need to look at a company’s accounts. 

A company’s accounts provide details about the current financial health of a company. 

Fundamental Analysis 

The current financial health of a company can be measured using Fundamental Analysis which is an important aspect of investing. 

A debt investor should look at the three main financial statements: the Balance Sheet, the Income Statement, and the Cash Flow Statement. 

Balance Sheet

The Balance Sheet is a summary of a company’s assets and liabilities. 

What are assets?

This includes the cash that is used to run the day-to-day operations of the business such as inventory and receivables, property, plant and equipment, and intangible assets such as intellectual property and trademarks. 

What are liabilities?

The liability side of the balance sheet summarises the value of the liabilities necessary to run the business. 

This is where you would find the debt that is issued by a business. 

Remember ALE

The value of a company’s liabilities, plus the value of its equity, is equal to the value of its assets. 

In other words, Assets = Liabilities + Equity – which spells out one of the nation’s favourite beverages!

They should balance out as if they were on a set of scales, hence the name, balance sheet. 

On the asset side of the balance sheet, knowing how much a company has is important because this is what contributes to the recovery value of the debt should the company default. 

On the liability side of the balance sheet, we care about the total amount of debt, where the bond sits in terms of seniority, and what security it has. 

We also want to know what the value of the equity is because this tells us how much loss can be absorbed by the company before debt holders have to share losses. 

This is referred to as the “equity cushion”. 

The balance sheet is the engine of a company

Companies generally report on a quarterly basis. 

The financial statements summarise the change over the reporting period. 

The balance sheet is a snapshot at the beginning and the end of the period. 

The assets can be highly skilled people, manufacturing plants, or online – they all generate revenue and earnings. 

The liability and equity side of the balance sheet can be thought of as the fuel needed to keep the engine ticking over. 

Debt and equity are financial obligations that a company owes to outside parties. 

A company owes its debt investors regular coupons and ultimate repayment, while it owes its equity investors a degree of ownership over the company. 

Funds from debt or equity financing can be invested in assets, which in turn can be used to generate revenue and earnings. 

The Income Statement

Now you know how to measure assets and liabilities, you will want to understand how to turn revenue into profit. 

The Income Statement helps explain how efficiently a company does this. 

It tells us how much revenue has been generated in a period – by our assets. 

It then deducts the cost of generating that revenue – by cost of running assets, cost of materials, or even the cost of borrowing. 

Here, we start at revenue and then deduct the cost of goods required to produce the product.

This leaves us with the gross profit.

Next, we deduct overheads – costs related to running the business that are not direct labour or production. 

This gives us Earnings Before Interest, Tax, Depreciation and Amortisation. 

EBITDA

This metric is used in several ratios when looking at a company’s health. 

Leverage

This is the ratio of debt to EBITDA. 

Debt can be adjusted by cash on a balance sheet which essentially tells an investor how many units of debt there are per unit of earnings. 

In this case, the ratio is Net Debt to EBITDA. 

The lower the ratio the better. 

Comparisons made within industries are preferred over comparisons across different industries. 

This is because different industries and business models can support different amounts of debt. 

Interest Coverage

This is the ratio of EBITDA to Interest Expense. 

It essentially tells us how many times the earning covers the cost of interest. 

Here, the higher the ratio the better. 

From EBITDA to EBIT

Next, we want to deduct the wear and tear on the company’s assets – Depreciation and Amortisation. 

This gives us EBIT. 

EBIT is the earnings out of which debt holders are paid. 

Net Income

After deducting Interest and Taxes we are left with Net Income. 

This is the cash that is available to pay dividends or increase retained earnings. 

In a nutshell…

  1. Revenue
  2. Deduct Cost of Goods sold
  3. This gives us Gross Profit
  4. Deduct Overheads
  5. This gives us EBITDA
  6. Deduct Depreciation and Amortisation
  7. This gives us EBIT
  8. Deduct Tax and Interest
  9. This gives us Net Income

The Income Statement is an accounting-based representation of changes in the balance sheet and earnings generated in each period. 

The Cash Flow Statement

This summarises the actual changes in cash that occur over the reporting period and it is comprised of three parts. 

Cash Flow from Operations, CFO

This is a summary of the cash generated from the business and it contains a reconciliation between the income statement’s accounting-based earnings and the actual cash flows. 

Cash Flow from Investments, CFI

This is a summary of all the cash flows associated with capital expenditure in the period. 

This is the cash used to purchase additional or replacement assets to ensure the growth or maintenance of the company. 

It will also include any cash proceeds from any disposal. 

Cash Flow from Financing, CFF

This is a summary of any changes in cash due to changes in amounts borrowed, equity issued or equity bought back, and dividends. 

If it includes interest paid to bondholders, we normally adjust this and subtract the interest paid from the CFO and add it back to CFF. 

Free Cash Flow, FCF

This is another metric worth highlighting. 

It tells us how much cash a company has remaining after the costs of running (CFO), maintaining (CFI) and investing (CFF) in the business. 

Free Cash Flow = Funds from Operations – Capital Expenditure

A common metric is to look at the ratio of free cash flow to debt or as a percentage of sales. 

These metrics give us an idea of how much debt the company can pay down and how much cash is generated per unit of sales respectively. 

Our next blog post…

We will look further into fundamental analysis and describe how well a business is doing in terms of earnings and cash flow. 

As usual, all of this content can be found on our free Bond Academy, a CPD accredited course that offers 5 hours of CPD activity.

If you have any ideas on topics that you’d like for us to talk about, please email me: anil@wisealpha.com.