Lesson 5 - Intermediate Accounting Course 

5. How to Analyze a Company’s Financial Health Using Statements

Understanding a company's financial health is essential for investors, business owners, and financial analysts. The three primary financial statements—Income Statement, Balance Sheet, and Cash Flow Statement—provide a complete picture of a company’s performance and stability.

By analyzing these statements, you can determine if a company is profitable, financially stable, and capable of sustaining growth. This guide explains how to assess financial health using key financial metrics and ratios.

1. Income Statement: Profitability Analysis

The income statement (also called the profit and loss statement) shows a company's revenues, expenses, and net income over a period of time.

Key Metrics to Analyze

• Revenue (Sales): Measures the total money earned from selling products or services. A growing revenue trend indicates a strong business.

• Gross Profit Margin: (Gross Profit ÷ Revenue) × 100

  • Shows how efficiently a company produces goods/services.

  • Higher margins mean the company controls production costs well.

• Operating Profit Margin: (Operating Income ÷ Revenue) × 100

  • Indicates how well the company manages operating expenses.

• Net Profit Margin: (Net Income ÷ Revenue) × 100

  • Measures overall profitability after all expenses, taxes, and interest.

  • A higher net profit margin means the company keeps more profit from each dollar of sales.

✅ What to Look For:
✔ Increasing revenue and profit margins over time.
✔ Controlled expenses with steady or improving profit margins.
✔ Positive net income (profitability).

⚠ Red Flags:
✖ Declining revenues over time.
✖ Falling profit margins (suggesting rising costs or weaker pricing power).
✖ Consistent net losses, which indicate the company isn’t profitable.

2. Balance Sheet: Financial Stability & Liquidity

The balance sheet shows a company’s financial position at a specific point in time. It provides details on assets (what the company owns), liabilities (what it owes), and equity (the owner’s stake).

Key Metrics to Analyze

• Current Ratio: (Current Assets ÷ Current Liabilities)

  • Measures short-term liquidity. A ratio above 1.5 is ideal, meaning the company can cover short-term debts.

• Debt-to-Equity Ratio: (Total Debt ÷ Total Equity)

  • Indicates how much debt the company uses to finance its operations.

  • A lower ratio means less financial risk, while a high ratio suggests dependence on borrowed money.

• Return on Equity (ROE): (Net Income ÷ Shareholder’s Equity) × 100

  • Shows how well a company generates profits from shareholders' investments.

  • A higher ROE means efficient use of capital.

✅ What to Look For:
✔ A strong current ratio (above 1.5), indicating good liquidity.
✔ A manageable debt-to-equity ratio (below 1.5 in most industries).
✔ A consistent or increasing ROE, showing efficient management.

⚠ Red Flags:
✖ A current ratio below 1 (suggesting possible liquidity problems).
✖ A high debt-to-equity ratio (meaning the company relies too much on borrowed funds).
✖ A declining ROE, which could mean poor use of equity.

3. Cash Flow Statement: Liquidity & Cash Management

The cash flow statement tracks the movement of cash in and out of the business. It is divided into:

1. Operating Cash Flow – Cash generated from core business activities.

2. Investing Cash Flow – Cash spent on or received from investments (e.g., buying assets, selling securities).

3. Financing Cash Flow – Cash from investors, loans, or dividend payments.

Key Metrics to Analyze

• Operating Cash Flow (OCF):

  • Positive OCF means the company generates enough cash from its business to sustain operations.

• Free Cash Flow (FCF): (Operating Cash Flow - Capital Expenditures)

  • Shows how much cash is left after investing in business assets.

• Cash Flow to Debt Ratio: (Operating Cash Flow ÷ Total Debt)

  • Measures the ability to repay debt with cash flow.

✅ What to Look For:
✔ Positive and growing operating cash flow.
✔ Strong free cash flow, allowing for reinvestment and dividends.
✔ A high cash flow to debt ratio, meaning the company can repay debts.

⚠ Red Flags:
✖ Negative operating cash flow (suggests the company struggles to generate cash).
✖ Low free cash flow (indicates limited growth potential).
✖ High cash flow volatility (could mean unstable financial management).

4. Financial Ratios: Overall Health Assessment

Beyond individual statements, financial ratios help compare companies and track performance over time.

5. Comparing with Industry Benchmarks

To get a clearer picture, always compare these financial metrics with industry benchmarks.

• A retail company might have lower profit margins but higher cash flow.

• A tech company might have higher debt-to-equity ratios due to research and development spending.

Looking at historical trends within the same company is also important. A decline in performance over time may indicate financial distress.

Final Thoughts

A healthy company should show:
✔ Growing revenues and profits in the income statement.
✔ A strong balance sheet with manageable debt.
✔ Positive cash flows to sustain operations and growth.

By analyzing these financial statements and key ratios, you can make informed decisions about investing in, managing, or working with a company.