Financial Analysis

Financial Statements Overview

Financial statement analysis is a core competency for investment banking professionals. Whether advising on an M&A transaction, underwriting a securities offering, or providing a fairness opinion, the ability to analyze and interpret financial statements is fundamental. The Series 79 exam tests your understanding of the three primary financial statements, their interrelationships, and how they are used in investment banking analysis.

The three primary financial statements are the income statement, the balance sheet, and the cash flow statement. Together, they provide a comprehensive view of a company's financial performance, financial position, and cash generation. Public companies are required to file these statements quarterly (Form 10-Q) and annually (Form 10-K) with the SEC, following Generally Accepted Accounting Principles (GAAP) in the United States or International Financial Reporting Standards (IFRS) for international companies.

The Income Statement

The income statement (also called the profit and loss statement or P&L) reports a company's revenues, expenses, and net income over a specific period. It follows a top-down structure:

Revenue (Top Line): Total sales of goods or services. Analysts focus on organic revenue growth, pricing versus volume growth, and revenue mix by segment or product line.
Cost of Goods Sold (COGS): Direct costs attributable to producing the goods or services sold. Revenue minus COGS equals gross profit.
Gross Profit: Revenue minus COGS. The gross margin (gross profit / revenue) measures the profitability of the company's core products or services before operating expenses.
Operating Expenses: Selling, general, and administrative (SG&A) expenses, research and development (R&D), depreciation and amortization. Revenue minus COGS minus operating expenses equals operating income (EBIT).
EBIT (Earnings Before Interest and Taxes): Also called operating income, this measures the profitability of the company's core operations before the effects of capital structure (interest) and taxes.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): EBIT plus depreciation and amortization. EBITDA is widely used in investment banking as a proxy for operating cash flow because it removes the effects of non-cash charges, capital structure, and taxes.
Net Income (Bottom Line): The final profit after all expenses, interest, and taxes have been deducted. Earnings per share (EPS) is calculated as net income divided by the weighted average number of shares outstanding.

EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. A widely used measure in investment banking that serves as a proxy for a company's operating cash flow. EBITDA removes the effects of financing decisions (interest), tax jurisdictions (taxes), and non-cash accounting charges (D&A), enabling more comparable analysis across companies.

The Balance Sheet

The balance sheet provides a snapshot of a company's financial position at a specific point in time. It follows the fundamental accounting equation: Assets = Liabilities + Shareholders' Equity.

Assets are resources owned or controlled by the company that have future economic value. They are classified as current assets (expected to be converted to cash within one year, such as cash, accounts receivable, and inventory) and non-current assets (long-term assets such as property, plant, and equipment, intangible assets, and goodwill).

Liabilities are obligations owed to third parties. They are classified as current liabilities (due within one year, such as accounts payable, accrued expenses, and the current portion of long-term debt) and non-current liabilities (long-term obligations such as long-term debt, deferred tax liabilities, and pension obligations).

Shareholders' Equity represents the residual interest in the company's assets after deducting liabilities. It includes common stock, additional paid-in capital, retained earnings, and accumulated other comprehensive income (loss). In investment banking, the book value of equity is often compared to the market value of equity to assess whether a company is trading at a premium or discount to its book value.

The Cash Flow Statement

The cash flow statement tracks the actual cash inflows and outflows of the business during a period. It is organized into three sections:

Cash Flow from Operations (CFO): Cash generated by the company's core business activities. Starts with net income and adjusts for non-cash items (depreciation, amortization, stock-based compensation) and changes in working capital (accounts receivable, inventory, accounts payable).
Cash Flow from Investing (CFI): Cash used for capital expenditures, acquisitions, and investments, as well as cash received from the sale of assets or investments. A key metric is capital expenditures (CapEx), which represents spending on property, plant, and equipment.
Cash Flow from Financing (CFF): Cash flows related to the company's capital structure, including debt issuance and repayment, equity issuance and buybacks, and dividend payments.

A critical concept in investment banking is Free Cash Flow (FCF), which represents the cash available to all capital providers (debt and equity holders) after the company has funded its operations and capital expenditures. The most common formulation is:

Unlevered Free Cash Flow = EBIT x (1 - Tax Rate) + D&A - CapEx - Changes in Net Working Capital

Levered Free Cash Flow = Net Income + D&A - CapEx - Changes in Net Working Capital - Debt Repayments

Understand the difference between unlevered free cash flow (used in DCF analysis to value the entire enterprise) and levered free cash flow (cash available to equity holders after debt obligations). The Series 79 frequently tests the components and uses of each.

Ratio Analysis

Ratio analysis is a fundamental tool for evaluating a company's financial health, profitability, efficiency, and leverage. Investment bankers use ratios extensively to compare companies within an industry, assess trends over time, and identify potential issues or opportunities. Understanding these ratios is critical for the Series 79 exam.

Profitability Ratios

Profitability ratios measure a company's ability to generate profits relative to its revenue, assets, or equity:

Gross Margin = Gross Profit / Revenue: Measures the percentage of revenue remaining after direct costs. Higher gross margins indicate stronger pricing power or more efficient production.
EBITDA Margin = EBITDA / Revenue: Measures operating profitability before non-cash charges and capital structure effects. Widely used in investment banking for comparability.
Net Profit Margin = Net Income / Revenue: Measures the percentage of revenue that translates to bottom-line profit after all expenses.
Return on Equity (ROE) = Net Income / Average Shareholders' Equity: Measures how effectively the company uses equity capital to generate profits.
Return on Assets (ROA) = Net Income / Average Total Assets: Measures how efficiently the company uses all its assets to generate profits.
Return on Invested Capital (ROIC) = NOPAT / Invested Capital: Measures the return generated on all capital invested in the business, regardless of how it was financed. NOPAT = EBIT x (1 - Tax Rate). Invested Capital = Total Debt + Equity - Cash.

Leverage Ratios

Leverage ratios assess the company's use of debt and its ability to service that debt. These ratios are critical in investment banking, particularly for evaluating credit risk and structuring transactions:

Debt-to-Equity = Total Debt / Total Equity: Measures the relative proportion of debt and equity used to finance the company.
Debt-to-EBITDA = Total Debt / EBITDA: Also called the "leverage ratio," this is one of the most commonly used metrics in investment banking and credit analysis. It measures how many years it would take to repay all debt from operating cash flow.
Interest Coverage Ratio = EBIT / Interest Expense: Measures the company's ability to pay interest on its outstanding debt. A ratio below 1.0x means the company cannot cover its interest payments from operating income.
Net Debt / EBITDA = (Total Debt - Cash) / EBITDA: A refinement of Debt/EBITDA that accounts for cash on hand that could be used to repay debt.

Ratio Category	Key Ratios	What It Measures	IB Use Case
Profitability	Gross margin, EBITDA margin, ROE, ROIC	Earnings power relative to revenue, equity, or capital	Comparable company analysis, performance assessment
Leverage	Debt/EBITDA, interest coverage, D/E	Debt burden and ability to service obligations	Credit analysis, LBO modeling, debt capacity
Liquidity	Current ratio, quick ratio	Ability to meet short-term obligations	Working capital assessment, credit analysis
Efficiency	Asset turnover, inventory days, DSO, DPO	How effectively assets are used to generate revenue	Working capital analysis, operational efficiency
Valuation	P/E, EV/EBITDA, EV/Revenue, P/B	Market value relative to financial metrics	Comparable analysis, pricing offerings

Liquidity Ratios

Liquidity ratios measure a company's ability to meet its short-term obligations:

Current Ratio = Current Assets / Current Liabilities: A ratio above 1.0x means the company has sufficient current assets to cover its current liabilities. Generally, a ratio between 1.5x and 3.0x is considered healthy, though this varies by industry.
Quick Ratio = (Current Assets - Inventory) / Current Liabilities: A more conservative measure that excludes inventory, which may not be quickly converted to cash.

Efficiency Ratios

Efficiency ratios measure how effectively a company uses its assets:

Days Sales Outstanding (DSO) = (Accounts Receivable / Revenue) x 365: Measures the average number of days to collect payment from customers.
Days Inventory Outstanding (DIO) = (Inventory / COGS) x 365: Measures the average number of days inventory is held before being sold.
Days Payable Outstanding (DPO) = (Accounts Payable / COGS) x 365: Measures the average number of days to pay suppliers.
Cash Conversion Cycle = DSO + DIO - DPO: Measures the total time to convert inventory investments into cash. A shorter cycle indicates better working capital management.

In investment banking, EBITDA and EBITDA-based ratios (EV/EBITDA, Debt/EBITDA) are the most commonly used metrics because they normalize for differences in capital structure, tax jurisdictions, and non-cash accounting policies, enabling more meaningful comparisons across companies.

Pro Forma and Adjusted Financial Statements

Investment bankers frequently work with pro forma financial statements, which present financial results as if a proposed transaction had already occurred. Pro forma statements are essential for modeling the impact of mergers, acquisitions, divestitures, and capital structure changes.

In an M&A context, pro forma financial statements combine the financial results of the acquirer and target, adjusted for the effects of the transaction, including purchase price allocation, financing terms, cost synergies, and one-time transaction expenses. These statements help the acquirer's management and board evaluate the financial impact of the deal and are required in SEC filings for material transactions.

Quality of Earnings Adjustments

Quality of earnings (QoE) analysis is a critical component of financial due diligence that adjusts reported earnings to reflect the underlying, sustainable economic performance of the business. Common adjustments include:

Non-recurring items: Removing one-time gains or losses (restructuring charges, litigation settlements, asset write-downs, gains on sale of assets)
Owner/management adjustments: Normalizing above-market compensation, related-party transactions, or personal expenses charged to the business
Revenue adjustments: Identifying non-recurring revenue, adjusting for contract timing differences, or correcting aggressive revenue recognition
Expense normalization: Adjusting for deferred maintenance, under-investment, or unusual cost items
Accounting policy differences: Adjusting for differences in depreciation methods, inventory accounting, or capitalization policies to enable comparability

Enterprise Value and Equity Value

Two fundamental concepts in investment banking financial analysis are enterprise value (EV) and equity value:

Enterprise Value = Market Capitalization + Total Debt + Preferred Stock + Minority Interest - Cash and Cash Equivalents

Enterprise value represents the total value of the company's operations to all capital providers. It is capital-structure neutral and is therefore used with capital-structure neutral metrics like EBITDA, EBIT, and unlevered free cash flow.

Equity Value = Enterprise Value - Total Debt - Preferred Stock - Minority Interest + Cash (or simply Market Capitalization for a publicly traded company)

Equity value represents the value attributable to common equity holders and is used with equity-specific metrics like net income and earnings per share.

A common mistake is mixing enterprise value metrics with equity value metrics. EV/EBITDA and EV/Revenue are correct pairings because both the numerator and denominator are available to all capital providers. P/E (Price/Earnings) is an equity value metric because both share price and EPS relate to equity holders only. Never divide enterprise value by net income or equity value by EBITDA.

Industry-Specific Financial Analysis

Financial analysis in investment banking must be tailored to the specific industry of the company being analyzed. Different industries have different key metrics, margin profiles, and analytical frameworks. Understanding these differences is important for the Series 79 exam.

Technology Companies

Technology companies are often valued on revenue growth and recurring revenue metrics rather than current profitability. Key metrics include annual recurring revenue (ARR), monthly recurring revenue (MRR), customer acquisition cost (CAC), lifetime value (LTV), net revenue retention, and the "Rule of 40" (revenue growth rate + profit margin should exceed 40%). Software companies with high recurring revenue typically command premium valuations.

Financial Institutions

Banks and financial institutions have unique financial statement structures. Key metrics include net interest margin (NIM), return on assets (ROA), return on equity (ROE), efficiency ratio (non-interest expense / revenue), loan-to-deposit ratio, and asset quality metrics (non-performing loans, charge-off rates). EBITDA is not meaningful for financial institutions because interest is a core operating item, not a financing item.

Real Estate Companies

Real estate companies (particularly REITs) are analyzed using funds from operations (FFO), adjusted funds from operations (AFFO), net operating income (NOI), and capitalization rates. Traditional earnings metrics are less meaningful due to the impact of depreciation on real estate assets.

Energy Companies

Energy companies are analyzed using metrics specific to their subsector: for exploration and production companies, key metrics include proved reserves, production volumes, finding and development costs, and depletion rates. For midstream companies, distributable cash flow and coverage ratios are critical. For utilities, rate base, allowed return on equity, and regulatory recovery mechanisms are key analytical inputs.

A SaaS company with $100M in ARR growing at 40% year-over-year with a net revenue retention rate of 120% would typically be valued at a significantly higher EV/Revenue multiple than a traditional manufacturing company with similar revenue. This is because the recurring revenue model provides greater visibility and predictability of future cash flows, and the high retention rate indicates strong product-market fit and expansion potential within the existing customer base.

Financial Modeling Fundamentals

Financial modeling is the process of building a mathematical representation of a company's financial performance, typically in a spreadsheet. Investment bankers build financial models to project future performance, value companies, analyze transactions, and support decision-making. While the Series 79 exam does not require you to build complex models, understanding the key concepts and outputs is essential.

The Three-Statement Model

The foundation of most financial models is the three-statement model, which integrates the income statement, balance sheet, and cash flow statement into a single dynamic framework. Key characteristics include:

Revenue is projected based on assumptions about growth rates, pricing, volume, and market conditions
Expenses are modeled as a percentage of revenue or based on specific assumptions about cost structure
Working capital changes flow from balance sheet assumptions about DSO, DIO, and DPO
Capital expenditures are modeled based on maintenance requirements and growth investments
Debt and equity balances are projected based on the financing plan
All three statements are dynamically linked so that changes in one statement automatically flow through to the others

Sensitivity and Scenario Analysis

Financial models typically include sensitivity analysis (examining how changes in key assumptions affect the output) and scenario analysis (modeling different cases such as base, upside, and downside). These tools help investment bankers and their clients understand the range of possible outcomes and the key drivers of value.

Common sensitivity variables include revenue growth rates, margin assumptions, discount rates, exit multiples, and leverage levels. Investment bankers present sensitivity tables that show how the implied valuation changes across different combinations of assumptions.

Remember the profitability waterfall with "Revenue Goes Every Place Nicely": Revenue, Gross Profit, EBITDA, eBIT (Pretax income), Net Income. Each level removes additional costs, giving a more refined view of profitability.