How to evaluate company financial reports in 10 minutes

30 June 2015 Colin Bradbury

For B2B businesses seeking new customers, company financial statements are a great source of information. And while you could spend hours analysing a set of accounts, surprisingly useful insights can be gleaned in just a few minutes. Providing, that is, you know what to look for.

Let’s assume you’ve run a screen to identify companies who might be in the market for your products and now you want to find out which of those potential customers are worth pursuing. You should be asking these two questions about each of the companies:

  • Does this business meet the criteria for being a potential client?
  • Does the company appear to be financially sound?

There are three sources of information within company financial reports that can help you, namely:

  • Profit and loss account (P&L)
  • Cash-flow Statement
  • Balance sheet

Here are some key items from those reports which you can use in your ’10 minute analysis’.

1. Revenues

The top line of the P&L, annual sales, will tell you whether this company is the right size to be a potential customer. At the risk of stating the obvious, pitching your top-of-the-line, million pound IT package to a company with annual revenues of £250,000 is probably a waste of time.

While you’re looking at revenues, calculate how they have increased (or fallen) on average over each of the last few years.

A business which has been growing steadily is more likely to become a customer than one which has been shrinking. You can also compare the average growth rate to that of industry peers to identify the sector’s most dynamic players.

2. Profits

As the well – worn saying goes, ‘Revenues are vanity, profits are sanity.’ Why? Because impressive sounding sales numbers are only meaningful if they can be turned into profits. On that basis, the bottom of the P&L should be our next destination.

The net profit line tells us how much money the business has made after deducting all costs (that’s why it’s called ‘the bottom line’). Again, historic growth rates give us a picture of how the company has performed over the last few years.

It’s also worth looking a little further up the P&L at the operating profit line, which is arrived at by subtracting from revenues only the direct costs of making those sales (raw materials, wages and administrative costs).

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This gives a good view of the ‘pure’ operating part of the business, whereas net profit is calculated after accounting for non-operational items such as interest payments and investment activity.

3. Margins

Margins bring figures for sales and profits together in a single metric and tell us how good a company is at turning the former into the latter. The gross margin (gross profit as a percentage or sales) is also a proxy for pricing power, and a comparison of margins across similar businesses is a good indicator of which company is strongest within an industry.

4. Cash-flow

Profits are an important indicator of financial health, but since ‘profit’ is an accounting concept it is different to actual cash. In the final analysis, interest payments and other bills have to be paid with real money. That’s where cash-flow – how much cash flows in and out of the business in a year – comes in.

Cash-flow is arrived at by netting out a number of elements, including money raised through bank borrowings, money spent on new plant and equipment, and money generated by the core business.

The latter, called operating cash flow, is the most interesting for our 10 minute analysis. It is the lifeblood of a company since it is real cash generated by the basic business of selling products and not from borrowing money or selling off assets.

Negative operating cash-flow is a big red flag, especially if it continues for more than one year as it means the company will have to borrow or sell assets to stay in business.

Another warning signal is when operating cash-flow is significantly less than net profit. This suggests that accounting ‘trickery’ may be inflating profits.

5. Gearing / Leverage

The final piece of the puzzle is to determine whether the company is on a firm financial footing, specifically whether its debts have the potential to cripple the business. There are many ways to measure this, including ratios which dissect the financial structure of a business.

But if you were to select just one measure, the interest cover ratio (pre-tax profit divided by annual loan interest payments) would be a good choice. This shows how comfortably a business is able to meet its debt servicing obligations.

Bringing it all together

That’s more than enough for 10 minutes! But armed with those numbers, you will be better placed to focus your marketing efforts. Eliminating the companies which are clearly in financial difficulties is the obvious first step. Businesses with falling sales and revenues, weak cash-flow and high debt levels will not be prioritising new spending.

As for the others, companies with rapidly growing revenues could be in the market for products which help them to cope with the side effects of an expanding business. For example, customers finding that existing IT systems aren’t up to the job when the company they serve has expanded could well be in need of an expensive upgrade.

And if your potential customer also has industry leading gross margins, strong cash-flow and a healthy ability to cover its interest payments, it increases the likelihood that they are going to be able to afford your product

10 minutes well spent

Analysing a company’s financial statements is part art, part science. It’s not enough to just look at one part of the accounts, they all have to be considered together as that’s the only way to get a true picture of a business. One thing is clear though, it’s most definitely worth 10 minutes of your time.