How to Read a Company’s Financial Statements

Fundamental analysis is the attempt to work out what a business is actually worth by examining the business, rather than by watching its share price. It rests on a simple proposition: a share is a claim on a company's future earnings, so the company's financial position and prospects ought to have something to do with what the share is worth.

This lesson explains the statements and the ratios. It names no company and recommends nothing, and the worked example is entirely hypothetical.

What fundamental analysis is

Listed companies in Pakistan publish audited annual accounts and periodic interim accounts. Those documents are the primary source. Fundamental analysis means reading them, calculating a handful of measures from them, comparing those measures against the same company's history and against similar companies, and forming a view.

It is worth being clear about what it can and cannot deliver. It can tell you whether a company is profitable, whether its profit converts into cash, whether it is carrying a dangerous amount of debt, and how its price compares to its earnings. It cannot tell you what the share price will do next month, and analysts using identical figures routinely reach opposite conclusions.

The three statements

Three statements answer three different questions, and confusing them is the most common beginner error.

• The income statement asks: did the company make a profit over the period?
• The balance sheet asks: what does the company own and owe at a single moment?
• The cash flow statement asks: where did cash actually come from and go?

A company can report a profit and run out of money. It can report a loss and be perfectly solvent. Only reading all three together tells you which situation you are looking at.

The income statement

Read top to bottom, it narrates how revenue becomes profit.

Revenue is what the company sold. Cost of sales is the direct cost of producing it, and revenue minus cost of sales is gross profit — the margin available before running the business. Operating expenses cover administration, distribution and similar; what remains is operating profit, the profit from the actual business.

Below that sit finance costs — the cost of debt — and then tax, leaving net profit. Divided by the number of shares in issue, that gives earnings per share.

The most informative habit is to read the same statement across several years rather than a single one. Revenue growing while gross margin shrinks tells you the company is buying growth by cutting prices. Operating profit healthy but net profit weak points at finance costs — the business works, but its debt is consuming the result.

The balance sheet

A snapshot on one date, structured so that assets equal liabilities plus equity.

Assets divide into current — cash, receivables, inventory, expected to convert within a year — and non-current, such as property, plant and equipment. Liabilities divide the same way: current liabilities are due within a year, non-current beyond it. Equity is what remains for shareholders after every liability.

Two things repay attention. Receivables growing much faster than revenue means the company is selling but not collecting, which is where cash problems begin. Inventory growing much faster than revenue means goods are accumulating unsold, which often precedes a write-down.

The cash flow statement

The least glamorous statement and, in the view of many experienced investors, the most honest. It has three sections.

Operating activities — cash generated by the actual business. Investing activities — cash spent on or received from assets, such as new plant. Financing activities — cash from borrowing or issuing shares, and cash paid out as dividends or debt repayment.

The single most useful comparison in fundamental analysis is operating cash flow against net profit. A company reporting healthy profits while operating cash flow is persistently negative is reporting profits it is not collecting. That divergence has preceded a great many corporate failures, and it is visible years in advance to anyone who looks.

Why profit and cash differ

Accounting recognises revenue when it is earned, not when the money arrives. Sell goods on credit in June and the revenue appears in June, though the cash may arrive in September or never. Depreciation, similarly, is a real cost recognised in the accounts without any cash leaving in that period.

Neither of these is improper — they are the accrual basis of accounting, and they exist to match costs with the revenue they generated. But they mean profit is an opinion informed by judgement, while cash is a fact. This is why analysts read the cash flow statement first.

Profitability ratios

Ratios turn absolute figures into comparable ones. A profit of PKR 500 million means nothing on its own; against the capital used to generate it, it means something.

• Gross margin — gross profit as a percentage of revenue. Pricing power and production efficiency.
• Operating margin — operating profit over revenue. How much of each rupee of sales survives running the business.
• Net margin — net profit over revenue, after finance costs and tax.
• Return on equity (ROE) — net profit over shareholders' equity. What the company earns on the money shareholders have in it. High ROE is attractive, but check whether it comes from genuine efficiency or simply from heavy borrowing, which flatters the ratio by shrinking the denominator.
• Return on assets (ROA) — net profit over total assets. Efficiency in using everything the company controls, regardless of how it was financed.

Valuation ratios

These relate the share price to the business, and they are the ones most often misused.

Price to earnings (P/E) is the share price divided by earnings per share — what the market is paying for each rupee of annual earnings. It is not a verdict. A low P/E may mean a share is cheap, or it may mean the market expects earnings to fall. A high P/E may mean overvaluation, or it may mean the market expects rapid growth. P/E is only informative against the company's own history and against genuinely comparable companies.

Price to book (P/B) compares the share price to net asset value per share. More meaningful for asset-heavy businesses such as banks than for businesses whose value is in people or brands.

Dividend yield is the annual dividend as a percentage of the share price. An unusually high yield is a warning as often as an opportunity — it can simply mean the price has collapsed, and the dividend may follow. Yields are also backward-looking: they describe what was paid, and no dividend is guaranteed.

Financial health ratios

• Current ratio — current assets over current liabilities. Whether short-term obligations are covered by short-term resources.
• Debt to equity — total debt against shareholders' equity. Leverage amplifies both gains and losses. What counts as high varies enormously by sector; a utility and a software company are not comparable on this measure.
• Interest cover — operating profit divided by finance costs. How many times over the company can pay the interest on its debt from its operating profit. This is the ratio that tends to move first when a leveraged company gets into difficulty.

A worked example

Hypothetical throughout. No real company is described, and the figures are chosen to be easy to follow.

A fictional manufacturer reports revenue of PKR 10,000 million, gross profit of PKR 3,000 million, operating profit of PKR 1,500 million, finance costs of PKR 500 million and net profit of PKR 700 million. It has 100 million shares in issue and shareholders' equity of PKR 5,000 million. The share trades at PKR 84.

• Gross margin = 3,000 / 10,000 = 30%
• Operating margin = 1,500 / 10,000 = 15%
• Net margin = 700 / 10,000 = 7%
• Earnings per share = 700 / 100 = PKR 7.00
• P/E = 84 / 7 = 12
• ROE = 700 / 5,000 = 14%
• Interest cover = 1,500 / 500 = 3 times

What does that describe? A business with a decent operating margin whose net result is materially reduced by debt: a third of operating profit goes on interest, and interest cover of three times is adequate rather than comfortable. If operating profit fell by half, interest cover would drop to 1.5 and the company would be in real difficulty.

Notice that the P/E of 12 tells you almost nothing by itself. Whether that is cheap depends entirely on what comparable companies trade at and on what you expect those earnings to do next.

What the numbers do not show

Financial statements are historical and incomplete. They will not show you the quality of management, whether the company's advantage over competitors is durable, whether a regulatory change is about to alter the industry, how concentrated the customer base is, or whether governance is sound.

The notes to the accounts are where a surprising amount of this surfaces — related-party transactions, contingent liabilities, the basis of significant judgements. The notes are longer than the statements and are usually the last thing anyone reads, which is precisely why reading them is worthwhile.

Where fundamental analysis fails

Being honest about the limits is part of using the method properly.

The accounts are backward-looking, and you are buying the future. Judgement is embedded throughout them, so two honest accountants can produce different numbers for the same business. A share that is cheap on the fundamentals can stay cheap indefinitely, or get cheaper — being right about value and wrong about timing is indistinguishable from being wrong, if you cannot wait. And in a market driven by sentiment, prices can ignore fundamentals for long periods.

None of that makes the method useless. It makes it a way of understanding what you own and what could go wrong with it, which is a more modest and more achievable goal than prediction.

Frequently asked questions

How to actually get better at this

Reading about ratios does not build judgement; reading accounts does. A practical approach is to take a single company, read three consecutive years of its annual report, calculate the same handful of ratios for each year, and write down what changed and why. Repeat that a few times and patterns start to become visible that no summary can teach.

Fundamental analysis will not tell you what a share will do next month. It will tell you what you own, and that is the more useful thing to know.

Continue learning

• Investment Strategies — how different investors use these measures differently.
• Technical Analysis — the other main analytical tradition, and what it claims.
• Financial Glossary — every term used above, defined plainly.
• Risk Management — what to do once you have a view.