20 questions I ask myself when looking at financial statements

A friend recently asked me what I look for when evaluating company income statements and balance sheets. This is an area where I've reached unconscious competence so I never thought about it before.

Here's a sketch of what's going on in my head when I look at a company's financials:

Income Statement Analyses

1.      Net Income

Was bottom line income positive or negative? Was it large or small, just at first glance?

A business losing money, or making a very small amount of money, is a red flag (unless it’s a new business). A business making money is a green flag.

2.      Trend of Net Income over the past 3 years

Has net income been going up or down in the last 3 years? If it’s growing, how quickly has it been growing? If it’s been shrinking, I immediately want to know why.

Depending on the firm, I will also look at 5- and 10-year trends.

I want to know what the general trajectory of the business is. If income has been shrinking, we are in triage mode and want to find ways to stop the bleeding. If income is flat, and there are multiple product lines, I want to analyze the relative profitability of each business line. Alternately, flat income could point to a distribution/sales/marketing strategy issue. If net income is growing at a respectable pace, we just want to guard against expense bloat.

3.      Net Income divided by Gross Revenue

This gives the profit margin, as a percentage, of the company. A number below 10% is cause for concern for most small businesses.

I also want to benchmark this number against businesses of similar type. A food service business will typically have low profit margins. An independent consulting business should have very high profit margins (however, a consulting business will have high costs in terms of sales time that don’t show up on the financial statements).

4.      Variance in Monthly Revenue

How lumpy is revenue? Is it stable from month to month, or does it vary a lot?

Most businesses will have some seasonal variability in revenue. High seasons are different for each type of business, however—travel and hospitality businesses will do better at times of kids’ holidays, for example.

The more variability in top-line revenue, the larger the business’s cash balance or short-term credit lines need to be.

5.      Revenue Lines

How many different products/revenue lines are there? What is the breakdown of revenue between the different lines?

If the owner feels frazzled that they can’t keep up with everything going on in the business, I want to look at the amount of time they are spending working on small revenue items. In many cases, intentionally deprioritizing weak business lines to spend more marketing and product energy on the biggest items can be worthwhile.

6.      Gross margin: Cost-of-goods-sold as a percentage of total revenue

This is the margin on the business’s core product offerings, before administrative and overhead expenses.

This number also varies based on business type. In a food-service business, we are looking for gross margins of 60-70%. Businesses that sell intangible products or services (e.g. online courses, consulting) should have near 100% gross margins if you only count tangible costs. However, what gets counted as an administrative expense and what gets counted as COGS is a choice. For online courses, marketing can be a significant expense and should be counted in COGS rather than admin, whereas in consulting, labor hours should be counted as COGS.

7.      Other expenses as % of total revenue

This is the other big expense category I want to look at, particularly if profits are low. Is there administrative bloat in the company? Is there something here that can be reduced or moved to a lower-cost vendor?

8.      Biggest buckets in other expenses

Within other expenses, what are the biggest drivers of cost?

Other expenses usually have a lot of small line items, like software, phone & internet, professional services, etc. However, there are usually one or two big ones—rent being the largest, typically. I want to quickly look at the big ones and see if there’s a problem.

For brick & mortar businesses that are struggling, rent is often the biggest factor. A tenant who signs a bad lease (sometimes retail leases give a revenue share to the landlord) will find it nearly impossible to run a profitable business, no matter how good the product is, the marketing is, or how efficient the operations are. Since leases also tend to run for at least a year, it’s not an expense item that’s easily fixed. If the landlord is not amenable to modifying terms of the lease, then the tenant needs to prepare to move the operation as soon as the lease is over or even consider breaking the lease if the penalty is manageable.

To analyze whether a lease is too expensive or not, I usually want to go into more detailed metrics—things like price per square foot (compared to the area and compared to competing businesses), foot traffic, and so on. I also want to go see the business location itself and ask the owner if the space is being used efficiently. If there’s a lot of empty space, then the right strategy is to see if other revenue drivers can be added to the space to improve utilization.

9.      Is the owner taking a salary?

I believe that small business owners should be taking salary. If a business looks reasonably profitable but the owner is not taking a salary, that means the business is probably not that profitable.

10.  Interest expense relative to other expenses

A high level of interest expense tells me that the business has a high debt burden, and I will look at the balance sheet next to find the total amount of debt.

If the business has spare cash flow despite high interest expense, the business’s bottom-line profit can often be quickly improved by paying down expensive debt. Alternately, sometimes the business can take on new debt (at a lower interest rate) and use the proceeds to pay down expensive debt.

 

Balance Sheet Analyses

Shareholders’ Equity

11.  Is equity positive or negative?

What is the company worth?

The book value of equity is one way to determine what a company is worth. If equity is negative, that means the company is insolvent (at least on paper). Insolvency is a serious issue and could mean that the company needs to be shut down, particularly if the owners are putting more money into it to keep it afloat.

12.  What is the return on equity (ROE)?

Return on equity is a measure of the company’s profitability—what are they doing with what they have? I calculate ROE by taking the net income and dividing it by shareholders’ equity.

Rule of thumb, ROE above 10% is decent and above 20% is great. Below 5% is cause for concern.

ROE can be a misleading metric in companies that have grown with very little capital investment (e.g., IP-based or content businesses).

Liabilities

13.  What is the total amount of debt in the company?

Is this a number that gives me sticker shock?

I usually look at total liabilities and interest expense (from the income statement) together. I want to know if the company has a serious debt problem, and if it does, fixing it is usually the top priority.

14.  What is the interest rate on the debt?

A large amount of debt may not be a problem if the interest rate is relatively low. If there are enough earnings to easily cover debt service, the debt is probably not an issue.

Businesses that carry debt will often have multiple sources of debt—a business loan for a capital investment, a mortgage for a property, a business line of credit, and potentially credit card or other short-term debt. The interest rates on each of these debt sources will vary. I want to know the interest rate on each individual source of debt, as well as the weighted average of the interest rate on all of the sources of debt put together.

Often times, if the weighted average interest rate on the business’s debt is higher than the ROE, the company should divert cash flow to deleveraging.

15.  What is overall leverage like in the business?

Leverage can be calculated in many ways, but here I mean the relative amount of debt in the company versus equity. High leverage is not necessarily a problem if interest rates are low and the debt is long-term in maturity.

There is no specific amount of leverage that concerns me—a “normal” amount of leverage varies from industry to industry. However, the more unpredictable the business’s cash flows are, the lower leverage I want to hold in the business.

16.  What is the term of the debt?

Low interest rate debt is usually not a problem for a business, but it can become a problem very quickly if the debt is maturing soon and will have to be refinanced at a significantly higher interest rate.

In general, longer-term debt is less of a concern than short-term debt that has to get paid down soon (paying down debt will eat up a lot of cash).

Assets

17.  What is the total amount of assets in the company?

I will quickly look to see how large the balance sheet is (total assets = total liabilities + equity), and compare that to net income. This formula is known as “return on assets” (ROA) and is another measure of what a business is able to do with what it has, independent of financing decisions.

18.  What are the company’s most significant / largest assets?

Do the assets look appropriate for a business of this type? Digging deeper into assets can sometimes reveal problems within a company.

For example, if a brick and mortar business has a very high amount of inventory, it may be indicative of strategic problems within the business. If a large amount of that inventory is obsolete and hasn’t moved in many months, it could indicate that the business needs to reevaluate its purchasing strategy or its approach to pricing. It may be worth selling the obsolete inventory at a discount in order to free up cash to use for other purposes, while also saving on warehouse leasing expenses and so on.

19.  Are there significant amounts of intangible assets on the balance sheet?

Intangible assets—intellectual property, brands and trademarks, or goodwill—are difficult to value accurately.

In particular, high goodwill—which I think of as the amount by which a business has overpaid for acquisitions in the past—tends to be a red flag in larger businesses.

A small or medium-sized business placing a very high number on intangible assets can be risky, in that the amounts reported on the balance sheet don’t reflect the true value of the business in the marketplace. If the owner places a high value on intangible assets, they should expect that the valuation will be challenged by a counterparty in a financing transaction such as lenders and investors.

20.  How big are receivables?

How big are receivables as a percentage of assets? What is the term of receivables? 30, 60, 90 days? What percentage of receivables are past due?

A large amount of receivables past due is one way that a business can feel successful from a sales perspective but cash-poor at the same time. Lots of past-due receivables are a major operational issue and need to be addressed immediately, either by firing or negotiating with customers.