Financial Statement Analysis

The Income Statement

The income statement (also called the profit and loss statement or P&L) is arguably the most closely watched financial statement by research analysts. It summarizes a company's revenues, expenses, and profits over a specific period, providing a clear picture of the company's operating performance and profitability. For the Series 86 exam, you must understand every major line item and be able to analyze trends, margins, and the quality of reported earnings.

The income statement follows a top-down structure that begins with revenue and progressively subtracts costs to arrive at net income. Each intermediate subtotal provides a different measure of profitability:

Revenue (Top Line)

Revenue represents the total amount earned from selling goods or services before any costs are deducted. Revenue recognition is governed by ASC 606 (Revenue from Contracts with Customers), which establishes a five-step framework: (1) identify the contract, (2) identify performance obligations, (3) determine the transaction price, (4) allocate the price to obligations, and (5) recognize revenue when obligations are satisfied. Analysts must understand whether revenue is recognized at a point in time or over time, and whether the company acts as a principal (reports gross revenue) or an agent (reports net revenue).

Key revenue metrics analysts examine include organic revenue growth (excluding acquisitions, divestitures, and currency effects), recurring vs. non-recurring revenue, and the composition of revenue by product, geography, and customer segment. Analysts should be skeptical of revenue that is growing faster than industry peers without a clear explanation, as it may indicate aggressive accounting practices.

Cost of Goods Sold and Gross Profit

Cost of Goods Sold (COGS) represents the direct costs attributable to producing the goods or services sold, including raw materials, direct labor, and manufacturing overhead. Gross Profit equals revenue minus COGS, and the Gross Margin (gross profit divided by revenue) measures the profitability of the company's core products before operating expenses.

Gross margin trends are a critical indicator of pricing power, cost management, and competitive positioning. Declining gross margins may signal rising input costs, increased competition, or a shift in product mix toward lower-margin offerings. Improving gross margins may indicate successful pricing increases, economies of scale, or operational efficiencies.

Operating Expenses and Operating Income

Operating expenses include selling, general and administrative (SG&A), research and development (R&D), and depreciation and amortization (D&A). Operating Income (also called EBIT or Earnings Before Interest and Taxes) equals gross profit minus operating expenses. The Operating Margin measures how efficiently a company converts revenue into operating profit.

Research analysts pay close attention to operating leverage, which is the relationship between revenue growth and operating income growth. A company with high fixed costs (and thus high operating leverage) will see operating income grow faster than revenue when sales increase, but also decline faster when sales decrease. Understanding a company's cost structure is essential for building accurate earnings models.

Non-Operating Items and Net Income

Below operating income, the income statement includes non-operating items such as interest expense, interest income, gains or losses on investments, impairment charges, restructuring costs, and income tax expense. Net Income (the "bottom line") represents the total profit after all expenses, and Earnings Per Share (EPS) divides net income by the weighted average number of shares outstanding.

Analysts distinguish between basic EPS (using actual shares outstanding) and diluted EPS (which assumes conversion of all dilutive securities such as stock options, convertible bonds, and restricted stock units). The difference between basic and diluted EPS indicates the potential dilution from these instruments, which is important for understanding the true per-share economics of the business.

The Balance Sheet

The balance sheet (statement of financial position) presents a snapshot of a company's assets, liabilities, and shareholders' equity at a specific point in time. The fundamental accounting equation states that Assets = Liabilities + Shareholders' Equity. For research analysts, the balance sheet reveals the company's financial strength, capital structure, and the resources available to support future growth.

Current Assets

Current assets are expected to be converted to cash or consumed within one year or one operating cycle (whichever is longer). Key current assets include:

• Cash and cash equivalents: The most liquid asset. Large cash balances provide financial flexibility but may also indicate a lack of investment opportunities
• Short-term investments: Marketable securities that can be readily sold
• Accounts receivable: Amounts owed by customers. Growing receivables faster than revenue may indicate collection problems or aggressive revenue recognition
• Inventory: Goods held for sale. Rising inventory relative to sales may indicate slowing demand or obsolescence risk. Analysts should understand the inventory valuation method (FIFO, LIFO, weighted average) and its impact on reported profits
• Prepaid expenses: Payments made in advance for future expenses

Non-Current Assets

Non-current (long-term) assets provide economic benefits beyond one year:

• Property, plant, and equipment (PP&E): Reported at historical cost less accumulated depreciation. The age and condition of fixed assets can be estimated by comparing accumulated depreciation to gross PP&E
• Goodwill: The premium paid above fair value of identifiable assets in an acquisition. Subject to annual impairment testing rather than amortization. Goodwill impairment charges can be significant and indicate that an acquisition has underperformed expectations
• Intangible assets: Include patents, trademarks, customer relationships, and technology acquired in business combinations. Finite-lived intangibles are amortized; indefinite-lived intangibles are tested for impairment
• Operating lease right-of-use assets: Under ASC 842, companies must recognize lease assets and liabilities on the balance sheet for virtually all leases

Liabilities

Liabilities represent obligations the company owes to external parties. Current liabilities are due within one year and include accounts payable, accrued expenses, short-term debt, current portion of long-term debt, and deferred revenue. Non-current liabilities include long-term debt, operating lease liabilities, pension obligations, and deferred tax liabilities.

The composition and maturity schedule of a company's debt is critically important. Analysts examine the debt-to-equity ratio, interest coverage ratio, and upcoming maturity dates to assess refinancing risk. Companies with large amounts of debt maturing in the near term face refinancing risk, particularly in periods of rising interest rates or tightening credit markets.

Shareholders' Equity

Shareholders' equity represents the residual interest in assets after deducting liabilities. Major components include common stock (par value), additional paid-in capital (the premium above par value received from issuing shares), retained earnings (cumulative net income less dividends), accumulated other comprehensive income (unrealized gains/losses on certain items), and treasury stock (shares repurchased by the company, reported as a negative amount).

The Cash Flow Statement

The cash flow statement reconciles net income to actual cash generated (or consumed) during the period. Many analysts consider it the most important financial statement because, unlike the income statement and balance sheet, it is largely immune to accounting manipulation. Cash is cash — it either came in or went out. The statement is divided into three sections based on the nature of the cash flows.

Cash Flow from Operating Activities (CFO)

Operating cash flow represents cash generated from the company's core business operations. Under the indirect method (used by the vast majority of companies), the statement starts with net income and adjusts for non-cash items and changes in working capital:

• Add back non-cash expenses: Depreciation, amortization, stock-based compensation, impairment charges, deferred taxes
• Adjust for working capital changes: Increases in current assets (like receivables and inventory) consume cash and are subtracted; increases in current liabilities (like payables and accrued expenses) generate cash and are added

A healthy company should generate strong, consistent operating cash flow that exceeds net income over time. When net income significantly exceeds operating cash flow, it may indicate aggressive accounting (e.g., capitalizing expenses that should be expensed) or deteriorating working capital efficiency.

Cash Flow from Investing Activities (CFI)

Investing cash flow captures spending on long-term assets and investments. Key items include capital expenditures (purchases of PP&E), acquisitions, purchases and sales of investments, and proceeds from asset dispositions. Capital expenditures (capex) is the most important item for research analysts because it represents the ongoing investment required to maintain and grow the business.

Analysts distinguish between maintenance capex (spending required to maintain existing operations at their current level) and growth capex (spending on new capacity, new products, or expansion into new markets). This distinction is important because maintenance capex is a necessary cost, while growth capex is discretionary and should generate returns above the cost of capital.

Cash Flow from Financing Activities (CFF)

Financing cash flow includes debt issuance and repayment, equity issuance and repurchase (buybacks), and dividend payments. This section reveals how the company funds its operations and returns capital to shareholders.

Earnings Quality and Red Flags

One of the most important skills for a research analyst is the ability to assess the quality of earnings. High-quality earnings are sustainable, repeatable, and backed by cash. Low-quality earnings are inflated by aggressive accounting, one-time items, or unsustainable practices. Identifying earnings quality issues early can help analysts avoid companies that may face future earnings disappointments or, in extreme cases, fraud.

Indicators of High-Quality Earnings

• Operating cash flow consistently exceeds or closely tracks net income
• Revenue growth is supported by unit volume increases, not just price increases
• Margins are stable or improving due to operational improvements, not one-time items
• Working capital metrics (days sales outstanding, days inventory outstanding, days payable outstanding) are stable or improving
• Conservative accounting policies (e.g., shorter useful lives for depreciation, timely recognition of losses)

Red Flags for Earnings Quality

• Growing gap between net income and operating cash flow: This divergence may indicate aggressive revenue recognition, capitalization of expenses, or deteriorating working capital
• Receivables growing faster than revenue: May indicate channel stuffing (shipping products to customers who have not ordered them) or overly lenient credit terms
• Inventory growing faster than revenue: May indicate slowing demand, product obsolescence, or overproduction
• Frequent changes in accounting policies or estimates: May be used to smooth earnings or delay recognition of deteriorating fundamentals
• Significant related-party transactions: Transactions with affiliates may not be at arm's length and could inflate revenue or reduce expenses
• Qualified or adverse audit opinions: Any qualification in the auditor's report warrants serious investigation
• Unusual items and non-recurring charges that recur regularly: If a company takes "restructuring charges" every year, they are effectively recurring expenses being excluded from adjusted earnings

Common-Size Analysis and Trend Analysis

Common-size analysis expresses each line item as a percentage of a base figure, allowing meaningful comparisons across companies of different sizes and across time periods. For the income statement, each line item is expressed as a percentage of revenue. For the balance sheet, each item is expressed as a percentage of total assets.

Common-size income statements reveal the margin structure of a business. If a company's SG&A as a percentage of revenue is 30% while its peers average 22%, the analyst can immediately identify a potential area for improvement or further investigation into the cost structure.

Trend analysis (also called horizontal analysis) examines changes in financial statement items over multiple periods. By tracking key metrics over three to five years, analysts can identify acceleration or deceleration in growth, margin expansion or compression, and shifts in capital allocation priorities. Trend analysis is most powerful when combined with industry analysis — a company's slowing revenue growth is less concerning if the entire industry is decelerating, but alarming if the company is losing market share.

Analysts also employ indexed analysis, which sets a base year equal to 100 and expresses subsequent years relative to that base. This technique makes it easy to compare growth rates across different line items and across companies. For example, if a company's revenue index is 130 (30% growth since the base year) but its accounts receivable index is 180 (80% growth), the divergence warrants investigation.