Company analysis step by step

This lesson explains how to pull a handful of numbers out of three financial statements that describe the quality of a company’s profit and the risk in its balance sheet. It is for a trader and an individual investor who wants to use fundamentals as a filter before entering a position — not for someone building a full valuation model. The point is twenty minutes of work per company, not a week of research.

The three statements and what they tell you

A company’s periodic report contains three connected documents that have to be read together:

• The income statement shows how profit was generated in the period: from revenue, through costs, down to net income.
• The balance sheet shows the state on a specific day: what the company owns (assets) and how it financed that (equity and liabilities).
• The cash flow statement shows the movement of cash, split into operating, investing and financing activities.

The connection is simple but easy to lose: net income from the income statement is not cash. Profit is recognised on an accrual basis — revenue is booked at the moment of sale, even if the money arrives later. Operating cash flow shows how much of that profit actually turned into cash. A company can report rising profit and still have a liquidity problem when receivables grow faster than sales.

That is why the first question is not “what is the profit” but “where does this company get its money from, and does that profit turn into cash”.

How to calculate margins

Margins are the percentage that remains from sales at the successive stages of the income statement. Always calculate them for the same period — year on year or quarter on quarter — and always from the same statement.

gross_margin     = (revenue − cost_of_goods_sold) / revenue
operating_margin = operating_profit / revenue
net_margin       = net_income / revenue

Interpretation requires a trend, not a single reading. A rising operating margin alongside rising revenue means the company has operating leverage — it sells more without losing efficiency. A falling margin alongside rising revenue signals growing competition, discounting or rising costs. A company can improve net income once only: by selling assets, by revaluing holdings or through a tax event. You exclude such items from the assessment, because they do not repeat in later quarters.

Treat the margins of companies with different business models separately. A retailer with a net margin of a few per cent and a services company with a margin of several tens of per cent can be equally healthy — compare only with companies of a similar model.

How to calculate debt and its servicing

Debt in itself is not a flaw: it is often cheaper than equity, as long as the company services it out of profit. Three ratios are enough to start with.

net_debt        = interest_bearing_debt − cash_and_equivalents
net_debt_EBITDA = net_debt / EBITDA
interest_cover  = operating_profit / interest_cost

EBITDA is operating profit plus depreciation and amortisation, that is an approximation of cash flow before investment. The net debt to EBITDA ratio tells you how many years of cash flow it takes to repay the debt; interest cover, also called the interest coverage ratio, shows how many times operating profit covers interest. The higher the net debt to EBITDA and the lower the interest cover, the greater the company’s sensitivity to higher rates: a rising loan rate pushes up interest cost, and with low coverage it quickly eats into net income.

The second dimension is the structure of the debt: not only the amount but also the maturity matters. Short-dated liabilities have to be rolled over, and that makes the company dependent on market conditions at the moment of refinancing. Look at the liabilities falling due within the next twelve months separately in the balance sheet — that is where liquidity risk hides.

How to calculate cash conversion

Cash conversion checks whether profit turns into real money. Two numbers: free operating cash flow and the ratio of its conversion from profit.

FCF        = operating_cash_flow − capital_expenditure
conversion = operating_cash_flow / net_income

FCF is the cash left after maintaining the asset base, so it is what funds a dividend, a share buyback or debt repayment. A conversion ratio close to one means profit turns into cash in full. A value persistently below one calls for checking why: rising receivables, rising inventory or aggressive revenue recognition. A reading clearly above one in a single period also requires caution, because it may have come from delaying payments to suppliers, and that does not repeat in the next quarter.

A worked exercise with illustrative numbers

A company with revenue of 1,000 million, cost of goods sold of 700 million, operating profit of 120 million and net income of 80 million. Gross margin: (1000 − 700) / 1000 = 30 per cent. Operating margin: 120 / 1000 = 12 per cent. Net margin: 80 / 1000 = 8 per cent.

With interest-bearing debt of 400 million and cash of 100 million, net debt is 300 million. With EBITDA of 180 million, the net debt to EBITDA ratio is 300 / 180 ≈ 1.7. With interest cost of 20 million, interest cover is 120 / 20 = 6.

If operating cash flow is 130 million and capital expenditure 50 million, free cash flow is 80 million. Conversion calculated by the formula in this lesson, that is operating cash flow divided by net income (80 million), is 130 / 80 = 1.6. That last result needs an explanation in the report — such high conversion often comes from a one-off shortening of the payment cycle, not from a lasting improvement. All the numbers in this example are illustrative; always read the financial data of a specific company from its periodic report.

A company sheet: fill it in with your own data

You fill in the financial columns from a single statement, in the same unit and for the same period. The “Liquidity / spread” and “Decision” columns come from quotes, together with the risk limit described in the lesson on the 1–2 per cent rule. A number on its own, without a recorded decision, does not change your plan — only the two columns together form a filter.

I develop the way to compare ratios with a company’s history and with its industry in the lesson Valuation ratios. One thing matters here: a ratio without a period and without a unit is not a measurement.

When a company says “do not trade”

Four conditions, each in the form of a rule. Meeting any one of them means skipping the company at that moment — not “a smaller position to give it a try”.

1. You cannot point to the source of the financial data. If you do not know which report a number came from and for which period, you do not have an analysis. Check data in the issuer’s periodic reports, not in tables posted on forums.
2. A report is due in the next few days and you have no plan for the outcome. Holding a position through a report without a written decision transfers risk to chance, not to a strategy.
3. The company is illiquid and you plan a leveraged position. Thin turnover and a wide spread on a CFD can eat the result even when the direction is right. Check how trading such a company looks in practice: Liquidity and spread on stocks.
4. Cash conversion is persistently below one and you cannot explain why. Profit without cash alongside rising debt is a configuration in which fundamentals give no edge and increase risk.

The order is the reverse of intuition: first you reject, then you plan. You record rejections just like entries, so that after a dozen companies you can see whether the filter works or merely sounds sensible.

The most common mistakes in company analysis

• Buying on the headlines about results alone. A press release describes one period, while the balance sheet and cash describe the company’s ability to survive the next ones.
• Comparing ratios across industries. A retailer and a services company have different natural levels of margin and debt.
• Ignoring debt maturities. The amount of debt without its maturity structure does not tell you whether the company will have to refinance at an unfavourable moment.
• Confusing a dividend with safety. A dividend is sometimes cut or suspended when cash flow deteriorates; it is a payout from profit, not a guarantee.
• Treating debt as purely a flaw. Moderate debt is often cheaper than equity; the problem is servicing it, not its existence.

Measurable exercise

Pick one company you already follow. In twenty minutes, complete a row of the company sheet: revenue year on year, operating margin, net margin, net debt to EBITDA, interest cover, free cash flow and conversion. Take every number from a single statement and write down exactly which one.

Then repeat the same measurement for one company in the same industry. Compare the two rows and write one sentence explaining why the ratios differ. Finally, add the date of the next report and a decision: watch, swing candidate or avoid. A rejection is a fully valid outcome of the exercise.

Check yourself

Common questions

Do I have to read the full annual report before every trade?

No. To begin with, the income statement, the balance sheet, operating cash flow and the date of the next report are enough. You extend the reading when you increase position size or lengthen your horizon.

Does a high dividend mean a safe company?

No. A dividend is a payout from profit, not a safety cushion: the board can cut or suspend it when cash flow deteriorates. Check its coverage by free cash flow, not the dividend yield alone.

Does a CFD on a share change how you read fundamentals?

It does not change the data, but it changes the risk product. The instrument price tracks the underlying market, yet you do not own the security, and financing costs and the broker's spread come on top. Fundamentals filter direction, while execution and costs follow their own rules.

Why calculate margins, debt ratios and cash conversion instead of assessing a company as a whole?

Because the impression of a "solid company" changes with the mood and the latest headline, while numbers from the same statement do not. Splitting the assessment into margins, debt servicing and cash conversion breaks a general opinion into three checkable questions: does the company earn on sales, will it service its obligations, and does profit turn into cash. That lets you compare companies with each other and the same company over time, and later verify your rejections against facts. Only from recorded ratios can you work out whether your filter actually protects capital or just looks careful. Financial data changes with every report, so return to the source each quarter.