Analysing financial statements in practice

In simple terms

A single year's results can mislead. Several years, laid side by side and explained line by line, show how a business really behaves: whether growth is steady, whether margins hold, whether profit turns into cash, and how much capital the business needs.

This lesson is a method for doing that with a company's own filings.

Step 1: build your own table

From the annual reports, collect the same figures for five to ten years. A useful core set:

• Revenue, operating profit, net profit, earnings per share
• Operating cash flow, capital expenditure, free cash flow
• Receivables, inventory, payables
• Debt, cash, shareholders' equity
• Number of shares

Use consolidated figures, which include subsidiaries, and keep definitions consistent. Note restatements: companies sometimes revise earlier years after accounting changes, and the latest annual report's comparative figures may differ from the original.

Step 2: common-size the statements

Express income statement lines as a percentage of revenue, and balance sheet lines as a percentage of total assets. This shows trends that raw numbers hide, and lets you compare companies of different sizes, as the comparing companies lesson explains.

Step 3: explain every major change

For each big movement, find the explanation:

• Revenue: volumes, prices, mix, acquisitions, as the products and customers lesson explains.
• Margins: input costs, pricing, operating leverage, one-off items.
• Working capital: why receivables or inventory are rising faster than sales.
• Debt and equity: new borrowing, share issues, buybacks, acquisitions.

Look in the management discussion, the notes to the accounts and the segment data, as the notes lesson explains. Write the explanation and its source next to each change. If you cannot explain something, write it down as a question.

Step 4: reconcile profit with cash

Over a single year, profit and operating cash flow can differ for good reasons. Over five or more years, they should broadly match, as the profit and cash flow lesson explains. A persistent gap usually comes from:

• Receivables rising faster than sales: customers paying slowly, looser credit terms, or revenue recognised too early.
• Inventory building up: slowing sales or stock that may not sell.
• Costs being capitalised rather than expensed.

Then subtract capital expenditure to get free cash flow, as the free cash flow lesson explains. A company that needs all its cash, and more, to keep growing may need to borrow or issue shares.

Data websites and filings

Data websites save hours, but their numbers can differ from the filings because of:

• Standalone and consolidated figures mixed up.
• Different definitions, for example of operating profit or debt.
• Restatements not carried back.
• Exceptional items treated inconsistently.
• Simple errors.

Use them to start, and check every important figure against the annual report.

Why it matters

A careful multi-year analysis turns a pile of documents into a story you can test. It reveals whether reported growth is backed by cash and capital discipline, and it produces the questions that matter for the rest of your research.

Limitations

Past figures describe the past. Accounting changes, acquisitions and disposals can break comparisons. A company in rapid, healthy growth can legitimately have cash flow below profit for a time. The analysis tells you what to ask, not always what the answer is.

Common mistakes

• Relying on one year or on a data website alone.
• Mixing standalone and consolidated figures.
• Noting changes without explaining them.
• Ignoring the gap between profit and cash.

Try it yourself

1. For a company you are researching, build the table above for at least five years from its annual reports.
2. Calculate operating margin, receivable days and cash conversion for each year.
3. Write a one-line explanation, with a source, for each large change.
4. List the changes you could not explain as questions.