Good financial statement analysis involves looking at details to understand the "big picture" of your customer's financial statement. The following are 10 tips to help you get a better "big picture" view while looking at the financial statement details.
  1. Determine whether the company is public or privately owned. Profitability goals of private companies may be different than public companies. A public company’s profit goals are related to return on shareholder value. A private company’s profitability goals generally involve tax saving strategies.
  2. Trend analysis is better when more years are analyzed. If possible, try to obtain at least 3 years of financial statements in order to complete good trend analysis.
  3. Remember to ask your customers questions. Financial statement analysis is not the "end all" to understanding your customer’s financial situation. Many times financial statement analysis raises more questions than it answers. Take the next step and ask your customer the questions that were raised during the analysis. This is where you find out what is going on with your customer.
  4. Compare your customer’s financial ratios with industry averages of like size companies. There are several books available that give industry averages which you will find in your local library. Industry averages are not the final ratio numbers that your customer should maintain, but, rather, a general rule of thumb to give you an indication of where other like size companies in their industry stand.
  5. What gets included in cost of goods sold may vary from company to company and from industry to industry. When analyzing gross margin, if this number appears lower than normal for your industry, try to determine if your customer (especially if you are looking at non-audited statements) includes an expense in cost of goods sold which generally is found in general and administrative expenses. If this is the case, year to year trends and the operating income percentage give a better picture than an industry comparison of the gross margin percentage.
  6. Try to find out the owner-related expenses if you are analyzing a private company. These expenses include owner’s salary and bonus, car expense and travel . It will give you a better picture of "true profitability." These amounts may be higher as a strategy to reduce the income taxed at a corporate rate (assuming the corporation is not a Subchapter S which would be taxed at an individual rate.)
  7. An analysis of the operating percentage (operating income divided by sales) will help you understand the profitability trend of a company before taking into account the financing and non-operating related activities.
  8. Sometimes operating efficiency ratios (days receivables outstanding, inventory turns, days payables outstanding) may look extremely high or low If this happens, it is important to ask questions which might shed light on how they manage their company or record their transactions. If days receivables outstanding (a/k/a DSO or days sales outstanding) are extremely low, find out if they are factoring their receivables. If high, do they have in-house extended financing to their customers? If inventory turns are extremely slow compared to industry averages, do they have old inventory on hand? If days payables outstanding is extremely high, are they receiving special terms from major suppliers or is there something other than trade vendors in accounts payable?
  9. Look below the surface of bank debt. Try to find out what their bank debt is made up of, how large their credit line facility is, how much of their credit facility is currently being used and when their loans are due. A company maxed out on their credit line may be a higher risk than a company using only half of their credit line, even if the amount of debt is the same. If their credit facility is coming due soon, you may want to follow up about the status of bank negotiations.
  10. When leverage is high, always try to understand what has caused the high leverage. If the company has been in the acquisition mode, or is a new company, it might be perfectly normal to see a higher leverage ratio. All factors must be taken into account.