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Analyzing Business Performance Using Financial Statements


We offer customized on-site training in all aspects of financial statement analysis for investors, bankers, and corporate finance professionals. For analysis of financial institutions, please click here. For an in-depth coverage of credit risk analysis, click here. Our approach links analysis to modeling and valuation because analysis feeds into models used for valuation.

Identifying and analyzing key value drivers of businesses


Are sales or assets the determinants of size? That is, is the size driven by the income statement or the balance sheet? How do economies of scale and scope and network externalities affect size?


How do product life cycle, product diffusion, market share, geographic and demographic expansion, and changes in per capita income affect growth?


How do pricing power, operational efficiencies, buying power, and accounting choices affect margins?

Net asset intensity

Net asset intensity is the ratio of net assets to sales, i.e., it is the inverse of net asset turnover. How do days of receivables, days of prepayments, and PP&E/sales drive up funding needs? How do days of deferred revenues and days of payables reduce funding needs?

Business risk

How do factors such as operating leverage, cyclicality, unpredictable customer preferences, regulation, unionization, technology intensity make a business riskier?

Financial risk

How do levels of debt and its structure affect credit risk?

Analyzing an income statement to understand drivers of size, growth, and margins

Recurring income

Separating recurring items from non-recurring items such as restructuring charges, gains and losses on sale of PP&E, gains and losses on bond buybacks, acquisition-related charges, lawsuits and contingencies, tax rate changes, release of allowances

Core income

Separating core income from non-core income. The drivers of core income are likely to differ from the drivers of non-core income.

Intermediate non-GAAP metrics

Computing non-GAAP metrics such as EBITDA, Adjusted EBITDA, and Funds from Operations

Unlevered net income

Separating operating income from financial income and expenses. Identifying the source of income or expense. Determining if the source is financial asset or financial liability.

Unlevered margins

Understanding drivers of gross margin, EBITDA margin, EBIT margin, and unlevered net income margin

Analyzing a balance sheet to understand the drivers of net asset intensity and funding needs

Timing differences

  • How do the timing differences between receipts and payments give rise to assets and liabilities on the balance sheet?
  • How do these accruals and deferrals affect financing needs?
  • How does the gap between revenues and receipts give rise to receivables and deferred revenues? How do days of receivables and days of deferred revenues affect cash flows?
  • How does the gap between expenses and payments give rise to prepayments and payables? How do days of prepayments and days of payables affect cash flows?
  • How does capital intensity affect cash flows?

Nature of assets and liabilities

  • Are the assets and liabilities current or non-current? How does this influence choice of financing and liquidity policies?
  • Are the assets good collateral? Are the assets tangible or intangible? How does this affect choice of financing?

Analyzing cash flows

Levered versus unlevered cash flows

Two levels of analysis of cash flows: Levered or equity free cash flows and unlevered or enterprise free cash flows

Drivers of unlevered cash flows

Analyzing how the following value drivers affect cash flows: Size, Growth, Margins, and Net Asset Intensity (inverse of asset turnover)

Understanding how ROI and growth affect cash flows

Computing sustainable growth rate, i.e., the growth rate that the business can sustain without having to raise external funding. Understanding how growth can make cash flows a poor indicator of performance

Financing needs

Understanding why a business needs external financing and how should a business match its outflows and inflows

Analyzing drivers of discount rates

The discount rates are used to compute the present value of cash flows. The discount rates reflect the systematic risk of those cash flows. The systematic risk of enterprise free cash flows depends upon the business risk while the systematic risk of dividends depends on both the business risk and the financial risk.

Business risk analysis

This is discussed in detail in the credit analysis section here.

Financial risk analysis

This is discussed in detail in the credit analysis section here.

Analyzing drivers of return on investment (ROI)

Understanding the two levels of ROI: Levered and unlevered

  • Return on investment is measured at two levels — unlevered and levered.
  • Unlevered ROI is called return on invested capital (ROIC) while the levered ROI is called the return on equity (ROE).
  • ROIC is the product of operating margin after tax and the net operating asset turnover. That is ROIC is the product of profit per dollar of sales and sales per dollar of investment needed by the business to finance the net operating assets.
  • ROE = ROIC + (ROIC - net interest rate after tax)*Net debt/Equity. The

Computing and analyzing operating margin after tax

Operating margin after tax = Operating profit * (1-tax rate)/Sales. Operating margin after tax is the unlevered net margin, i.e., it equals what the net margin would be if the company had no interest income and no interest expense.

Computing and analyzing net operating asset turnover

Net operating asset turnover = Sales/Net operating assets. Net operating assets equal non-financial assets less non-financial liabilities. Net operating assets reflect the level of equity investment that a business would need if it had no financial assets such as cash and short-term investments and no financial liabilities such as short-term debt and long-term debt.

Understanding the effect of conservative accounting on ROI

Both the numerator and the denominator of ROIC can be biased by conservative accounting. The exact nature of the bias depends on the growth rate and the underlying internal rate of return. Thus, one must be careful in interpreting accounting ROI.

Financial leverage

ROE depends on two factors: (i) the spread between ROIC and net interest rate after tax, and (ii) the ratio of net debt to equity. A positive spread and a positive leverage make ROE exceed ROIC.

Detailed analysis of MD&A and notes to the financial statements

Deferred taxes

  • Understanding the determinants of effective tax rate
  • Removing non-recurring tax items using the rate reconciliation table
  • Understanding sources of deferred tax assets and liabilities to project their future growth
  • Understanding tax credits and loss carryforwards

Leases and off-balance sheet commitments

  • Capitalizing operating leases
  • Understanding the downside risk of off-balance sheet commitments
  • Understanding the impact of leases and commitments on future cash flows

Acquisitions, goodwill, and intangible assets

  • Determining how the financial metrics such as sales growth and EPS have been affected by recent acquisitions and dispositions
  • Understanding the type and magnitude of intangible assets and goodwill

Foreign currency translation and transactions

  • Effect of foreign currency translation on sales growth, margins, and ROE
  • Effect of foreign currency transactions and remeasurements on financial statements

Pensions and health-care liabilities

  • Finding out the extent of over-funding or under-funding and its impact on future cash flows
  • Determining the sensitivity to expected returns, discount rates, rate of increase in compensation, rate of increase in health care costs

Derivatives and hedging activities

  • Determining the types of risks that the company has chosen to hedge or not hedge
  • Forecasting future performance when the existing hedges roll off

Debt including convertible debt

  • Understanding the company's financing policy
  • Understanding the structure of debt: tenor, fixed vs. floating, major covenants, secured versus unsecured, public versus private
  • Effect of debt maturities on cash flows in the next five years

Share-based compensation

  • Understanding the types of share-based compensation used by a company and their classification
  • Understanding the financial statement consequences of grant-date accounting for share-based compensation
  • Understanding the tax and cash flow consequences of share-based compensation

Earnings per share

  • Effect of dilutive securities such as stock options and convertible debt on earnings per share
  • Effect of mergers and acquisitions on earnings per share

Forensic analysis and earnings management

Our discussion of forensic analysis and earnings management links back to modeling and valuation by describing how companies try to manipulate projections of key value drivers


Boost size by grossing up revenues


Boost growth by booking revenues too early or by booking fictitious revenues


Boost margin by delaying booking of expenses or by booking higher revenues without booking higher costs

Net asset turnover

Inflating revenues or deflating expenses usually deflates net asset turnover. Net assets can be deflated by classifying debt as operating liabilities such as deferred revenue or accounts payable. This also boosts enterprise cash flows by classifying financing receipts as enterprise receipts or by classifying enterprise payments as financing payments.

Business risk

Appear low risk by smoothing income flows and cash flows

Financial risk

Keep debt-like commitments off balance sheet