Session 5 — Financial Statements Analysis

Part of: Accounting Analysing company health using ratios, financial modelling, and investor metrics Key concepts: Horizontal Analysis, Vertical Analysis, Ratio Analysis, Current Ratio, Quick Ratio, Working Capital, Gross Profit Margin, EBITDA, ROA, ROE, ROCE, Rule of 40, MRR, NRR, Churn Rate, CAC, LTV, DCF Model

1. Why Analyse Financial Statements?

The whole point of building and publishing financial statements is to make better decisions. Analysis cuts through the raw numbers and answers three questions:

Taken together, the answers let you assess the future position and profitability of the business — which is what investors, lenders, and management all need.

2. Three Types of Analysis

Why ratios, not just raw numbers?

A company with $1M revenue and a $200K profit looks very different from one with $100M revenue and $200K profit — same profit, wildly different efficiency. Ratios standardize the numbers so you can compare apples to apples.

Horizontal vs. Vertical — Quick Illustration

Suppose Company A's revenue and cost of goods sold (COGS) are:

	Year 1	Year 2	Horizontal change
Revenue	$1,000	$1,200	+20%
COGS	$600	$800	+33%
Gross Profit	$400	$400	0%

Horizontal analysis shows revenue grew 20% but COGS grew 33% — margins are being squeezed even though gross profit is flat.

Vertical analysis (as % of revenue):

	Year 1	Year 2
Revenue	100%	100%
COGS	60%	67%
Gross Profit	40%	33%

The vertical view makes the margin compression obvious: gross margin fell from 40% to 33%.

3. Liquidity Ratios

Liquidity = the ability to pay short-term obligations. These ratios ask: "If bills came due tomorrow, could the company pay them?"

3.1 Current Ratio

• Current Assets: Cash, accounts receivable, inventory, prepayments — anything convertible to cash within 12 months.
• Current Liabilities: Bills due within 12 months (payables, short-term debt, accrued expenses).

Current ratio alone can be misleading

If a company's current assets are mostly slow-moving inventory, the ratio looks healthy but the cash isn't actually there. This is why we also use the Quick Ratio (§3.3).

Current Ratio Example

Company Balance Sheet extract:

• Current Assets: Cash $50K + Receivables $80K + Inventory $120K = $250K
• Current Liabilities: Payables $70K + Accrued expenses $30K = $100K

$\text{Current Ratio} = \frac{\$250K}{\$100K} = 2.5$

Interpretation: For every $1 of short-term debt, there is $2.50 of current assets. Strong liquidity position.

3.2 Working Capital

Working capital is the absolute dollar amount of liquidity buffer (as opposed to the ratio). It answers: "How many dollars of liquid assets are available above and beyond what we owe in the short term?"

Working Capital Example

Using the same figures above: $\text{Working Capital} = \$250K - \$100K = \$150K$

This $150K is what the company can deploy to fund operations, inventory purchases, or invest in growth — after covering all near-term obligations.

Working capital can be negative — and sometimes that's fine

Amazon famously ran negative working capital for years: customers pay immediately, but Amazon pays suppliers 30–60 days later. It uses supplier credit as a free funding source. This only works if the business has strong, reliable cash flows.

3.3 Quick Ratio (Acid Test)

The Quick Ratio is the tougher version of the current ratio — it strips out inventory and prepayments (assets that can't be quickly converted to cash) and keeps only the most liquid assets.

Quick Ratio Example

Same company as above. Inventory = $120K, which is excluded:

$\text{Quick Ratio} = \frac{\$50K + \$80K}{\$100K} = \frac{\$130K}{\$100K} = 1.3$

Without the inventory, the ratio drops from 2.5 to 1.3 — still above 1.0, but the picture is tighter. This shows that the company is somewhat dependent on selling its inventory to meet obligations.

4. Profitability Ratios

Profitability ratios measure how well the company converts revenue into profit at different stages of the income statement.

4.1 Margin Ratios — The Income Statement Cascade

Think of the income statement as a waterfall — revenue flows in, and various costs are deducted at each level:

Revenue (Net Sales)
  – Cost of Goods Sold (COGS)
  ────────────────────────────
  = GROSS PROFIT

  – Operating Expenses (SG&A, R&D, etc.)
  ────────────────────────────
  = OPERATING INCOME (EBIT)

  + Depreciation & Amortization (added back for EBITDA)
  ────────────────────────────
  = EBITDA

  – Interest Expense
  – Tax
  ────────────────────────────
  = NET INCOME

4.2 Gross Profit Margin

This ratio shows how much money is left after paying to produce or deliver the product/service, before any other overhead.

Gross Profit Margin Example

	Company A (Software)	Company B (Supermarket)
Revenue	$10M	$100M
COGS	$2M	$75M
Gross Profit	$8M	$25M
Gross Margin	80%	25%

Both companies might be equally profitable at the net level, but Company A has far more room to absorb R&D, marketing, and sales costs before running out of margin.

4.3 Cash Flow Margin

This measures the ability to convert revenue into actual cash. A company can be profitable on paper (accrual accounting) but cash-poor if customers take forever to pay. This ratio catches that gap.

Profit ≠ Cash

A company can report a healthy net income and still run out of cash if it's extending long credit terms to customers, or building up inventory. Cash flow margin links back to cash, not accounting profits.

4.4 EBITDA and EBITDA Margin

EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization

Why is EBITDA so widely used?

EBITDA is not the same as cash flow

EBITDA ignores capital expenditures (CapEx). A capital-intensive company that needs to spend $50M on new machinery every year will have much less real cash than its EBITDA suggests. Always look at Free Cash Flow (FCF = EBITDA − CapEx − Working Capital changes) for a fuller picture.

EBITDA Example

Company C's Income Statement (simplified):

	$M
Revenue	100
COGS	(40)
Gross Profit	60
SG&A	(20)
R&D	(10)
Operating Income (EBIT)	30
+ Depreciation & Amortization	8
EBITDA	38
Interest Expense	(5)
Tax (25%)	(6.25)
Net Income	18.75

Metric	Value
Gross Margin	60%
EBITDA Margin	38%
Net Margin	18.75%

4.5 Operating Income (EBIT)

Operating income captures the profitability of the core business operations — before the effects of financing (interest) and taxes. It answers: "How profitable is the business on its own, ignoring how it's funded?"

5. Return Ratios

Return ratios measure how efficiently the company uses its assets and capital to generate profit. These are the ratios that most interest investors.

5.1 Total Asset Turnover

Measures how much revenue is generated for each dollar of assets held. A high ratio means the company is "sweating" its assets efficiently.

Asset Turnover Example

	Company X (Retail)	Company Y (Tech)
Revenue	$500M	$100M
Average Total Assets	$250M	$200M
Asset Turnover	2.0×	0.5×

Company X generates $2 of revenue per dollar of assets — high turnover, typically associated with low margins (supermarkets, logistics). Company Y generates only $0.50 but likely has very high margins.

5.2 The Law of Competition — Margin vs. Turnover Trade-off

This is the DuPont decomposition of ROA. Competitive forces push companies to one of two strategic positions:

Why can't a company have both high turnover AND high margin?

Competition drives it out. If a company has high margins, competitors enter and drive prices down (reducing margin) or the company must invest more in assets to defend its position (reducing turnover). In equilibrium, ROA tends to converge across industries.

5.3 Return on Assets (ROA)

ROA answers: "For every dollar of assets the company owns, how much net profit does it earn?"

• Low ROA = asset-intensive (factories, machinery, real estate needed)
• High ROA = asset-light (software, consulting, marketplace businesses)

ROA Example

Company Z:

• Net Income: $20M
• Average Total Assets: $200M

$\text{ROA} = \frac{\$20M}{\$200M} = 10\%$

For every $1 of assets, the company earns $0.10 of profit. Compare: a bank might have ROA of 1%; a software company might have ROA of 20%+.

5.4 Return on Equity (ROE)

ROE answers: "For every dollar of equity investors have put in, how much net profit is earned?" This is the return on the owners' capital.

A high ROE is desirable — it means the company is generating strong returns for shareholders. Companies with high ROE can often fund their own growth internally and rely less on external financing.

Leverage artificially inflates ROE

A company can boost ROE by taking on more debt (reducing equity in the denominator). This looks good on paper but increases financial risk. Always check the debt level alongside ROE.

$\text{DuPont Identity: } ROE = \underbrace{\frac{\text{Net Income}}{\text{Revenue}}}_{\text{Profit Margin}} \times \underbrace{\frac{\text{Revenue}}{\text{Assets}}}_{\text{Asset Turnover}} \times \underbrace{\frac{\text{Assets}}{\text{Equity}}}_{\text{Financial Leverage}}$

A high ROE is only impressive if it's driven by the first two factors (efficiency), not the third (borrowing).

ROE Example

	Company A	Company B
Net Income	$10M	$10M
Shareholders' Equity	$50M	$20M
Total Debt	$0	$80M
ROE	20%	50%

Company B looks much better on ROE, but it has $80M of debt vs Company A's $0. Company B's high ROE is largely a result of financial leverage, not operational excellence.

5.5 Return on Capital Employed (ROCE)

Where:

ROCE measures how efficiently a company uses all the capital available to it (not just equity), to generate operating profit. It's particularly useful for capital-intensive industries.

Key rule: ROCE should be greater than the cost of capital (WACC). If not, the company is destroying value — it earns less on its investments than investors demand.

6. The Big Picture — Financial Modelling

6.1 Why Individual Ratios Aren't Enough

Ratios give a snapshot, but they have a critical limitation: no single ratio tells the whole story. A company might look liquid (good current ratio) but unprofitable. It might have a high ROE due to dangerous leverage. None of the ratios above account for future cash flows.

6.2 DCF Model — The Gold Standard

The most comprehensive way to value a company is a Discounted Cash Flow (DCF) model, which projects future cash flows and discounts them back to today's value (Net Present Value).

A full DCF model typically includes:

Why discount future cash flows?

A dollar today is worth more than a dollar in 5 years — you can invest the dollar today and earn a return. The discount rate reflects the opportunity cost and risk of the investment. The higher the risk, the higher the discount rate, and the less future cash flows are worth today.

7. How Investors Look at You — Startup & SaaS Metrics

For technology and SaaS companies, traditional ratios may be less relevant (especially if the company isn't yet profitable). Investors use a set of bespoke metrics to evaluate health and trajectory.

7.1 Rule of 40

The Rule of 40 is the standard health check for SaaS businesses. It combines growth and profitability:

The target: score ≥ 40

Why this metric?

Early-stage SaaS companies often choose to lose money today by investing aggressively in growth — that's by design. The Rule of 40 ensures the growth justifies the losses. If you're growing 60%, losing 20% is fine. If you're growing 10% and losing 20%, something is broken.

7.2 MRR, NRR, and Churn

MRR, NRR, and Churn Example

Start of year: 100 customers each paying $1,000/month = $100K MRR

End of year (same cohort of 100 customers):

• 10 customers churned (lost $10K MRR)
• 20 customers upgraded (added $20K MRR)
• 70 customers stayed the same ($70K MRR)
• Total from same cohort: $80K (retained) + $20K (expansion) = $100K MRR

$\text{NRR} = \frac{\$100K}{\$100K} = 100\%$

If NRR > 100%, the company is growing from its existing base alone — this is the holy grail of SaaS.

Churn rate (monthly): If 2 customers cancel each month on a $100K MRR base, losing $2K: $\text{Monthly Churn} = \frac{\$2K}{\$100K} = 2\%$

7.3 CAC and LTV

CAC and LTV Example

A SaaS company spends $500K on sales and marketing in Q1 and acquires 100 new customers.

$\text{CAC} = \frac{\$500K}{100} = \$5{,}000 \text{ per customer}$

Average monthly subscription = $500. Average customer stays 3 years (36 months).

$\text{LTV} = \$500 \times 36 = \$18{,}000$

$\text{LTV:CAC ratio} = \frac{\$18{,}000}{\$5{,}000} = 3.6×$

✅ Above the 3× threshold — every dollar spent acquiring a customer returns $3.60 in lifetime revenue.

The LTV:CAC ratio — the key efficiency metric for growth:

LTV can be misleading if churn is high

LTV assumes customers stay for the modelled lifetime. If churn is high, actual lifetime is much shorter than the model. Always sanity-check LTV against your actual churn data.

7.4 Salesforce Productivity — The "Magic Number"

This metric ensures you're not over-investing in a sales team that isn't generating sufficient return. It's especially important as startups scale their go-to-market function.

8. Summary — Putting It All Together

The analyst's mental hierarchy

Start broad, then narrow:

1. Horizontal analysis — Is the company growing? Are margins expanding or contracting?
2. Vertical analysis — How does cost structure compare to peers?
3. Liquidity ratios — Can it survive short-term?
4. Profitability ratios — Is it making money at each level of the P&L?
5. Return ratios — Is it efficient with its capital?
6. DCF model — What is it worth, based on future cash flows?
7. SaaS/growth metrics (if applicable) — Is the growth engine healthy?

Key principles to remember:

1. Ratios are most useful in context — compare to the prior year (horizontal) or industry peers (vertical). A 15% gross margin is bad for software, great for grocery.
2. EBITDA ≠ Cash Flow — always check if CapEx is consuming the EBITDA.
3. High ROE from leverage is a red flag — use DuPont to decompose it.
4. ROCE must beat WACC — otherwise the company is destroying value.
5. Rule of 40 is the SaaS health check — score must be ≥ 40.
6. NRR > 100% means the existing customer base grows on its own — the gold standard.
7. LTV:CAC > 3× is required for sustainable growth economics.
8. A DCF model is the only way to get the full picture — ratios alone miss the future.

9. Master Ratio Reference Table

Related notes

• Accounting — subject hub
• Session 2 - Accounting Fundamentals — the financial statements that these ratios are built from
• Session 3 - Raising Debt and Capital — capital structure (relevant to ROE leverage effect and ROCE)
• Session 4 - Incorporation, Corporate Taxes & Employee Compensation — EBITDA is used in the Rule of 40 and MRR metrics
• _Wiki-Link Registry — concept-link tracker