Financial Analysis: Reading a Company’s Health Report 🏥
Imagine a company is like a person. To know if they’re healthy, you visit a doctor. The doctor checks their heartbeat, blood pressure, and asks questions. For companies, we use financial statements instead of a stethoscope!
Let’s become company doctors together. By the end, you’ll know exactly how to check if a company is strong and growing or weak and struggling.
🗺️ Our Adventure Map
Think of financial analysis like checking three different parts of a person’s health:
graph TD A["🏥 Company Health Check"] --> B["📝 Income Statement"] A --> C["⚖️ Balance Sheet"] A --> D["💧 Cash Flow"] B --> E["Profit Margins"] C --> F["ROA & ROE"] D --> G["Free Cash Flow"]
📋 Financial Statements Overview
What Are Financial Statements?
Think of financial statements like a report card for companies!
Just like your school report card shows how you did in Math, English, and Science, a company’s financial statements show how they did with money.
Three Main Report Cards:
| Statement | What It Shows | Like Asking… |
|---|---|---|
| Income Statement | Did we make money? | “How much allowance did you earn and spend this week?” |
| Balance Sheet | What do we own vs. owe? | “What toys do you own, and do you owe anyone money?” |
| Cash Flow | Where did money go? | “Show me where all your coins went!” |
Simple Example:
- Lemonade Stand makes $100 selling lemonade
- Income Statement shows: $100 earned, $30 spent on lemons = $70 profit
- Balance Sheet shows: $70 cash + $20 equipment owned
- Cash Flow shows: $100 came in, $30 went out
📊 Income Statement Analysis
The Money Story
The income statement tells a simple story: Did the company make money or lose money?
Think of it like your piggy bank at the end of the week:
- Money IN (what you earned) = Revenue
- Money OUT (what you spent) = Expenses
- What’s LEFT = Profit (or Loss)
The Income Statement Formula
Revenue (Sales)
- Cost of Goods Sold
= Gross Profit
- Operating Expenses
= Operating Income
- Interest & Taxes
= Net Income (Final Profit!)
Real-World Example: Pizza Shop
PizzaPal’s Monthly Income Statement:
| Item | Amount |
|---|---|
| Pizzas Sold | $10,000 |
| - Ingredients (cheese, dough) | -$3,000 |
| = Gross Profit | $7,000 |
| - Rent, Wages, Utilities | -$4,000 |
| = Operating Income | $3,000 |
| - Interest & Taxes | -$500 |
| = Net Income | $2,500 ✨ |
PizzaPal kept $2,500 out of every $10,000! That’s like keeping 25 cents from every dollar!
⚖️ Balance Sheet Analysis
The Snapshot of Stuff
The balance sheet is like taking a photo of everything a company owns and owes on ONE specific day.
The Magic Equation (Always True!):
Assets = Liabilities + Equity
(What you OWN) = (What you OWE) + (What's truly YOURS)
Think About Your Bedroom
| Your Stuff | Value |
|---|---|
| Assets (What You Own) | |
| Video Games | $200 |
| Bike | $150 |
| Savings | $50 |
| Total Assets | $400 |
| Liabilities (What You Owe) | |
| Owe brother for game | $50 |
| Total Liabilities | $50 |
| Equity (Truly Yours) | |
| $400 - $50 = $350 |
The equation works: $400 = $50 + $350 ✓
Company Example: TechStart Inc.
| Item | Amount |
|---|---|
| Assets | |
| Cash | $50,000 |
| Equipment | $100,000 |
| Building | $200,000 |
| Total Assets | $350,000 |
| Liabilities | |
| Bank Loan | $100,000 |
| Bills to Pay | $50,000 |
| Total Liabilities | $150,000 |
| Equity | $200,000 |
Check: $350,000 = $150,000 + $200,000 ✓
💧 Cash Flow Analysis
Follow the Water
Cash flow is like tracking water through pipes. Money flows IN and OUT through three pipes:
graph TD A["💰 Cash Flow"] --> B["🏭 Operating"] A --> C["🔧 Investing"] A --> D["🏦 Financing"] B --> E["Day-to-day business"] C --> F["Buying/Selling stuff"] D --> G["Loans & Investors"]
The Three Cash Pipes
1. Operating Activities (Running the business)
- Cash from selling products
- Cash paid for supplies, wages, rent
2. Investing Activities (Buying/Selling big items)
- Buying new machines
- Selling old buildings
3. Financing Activities (Dealing with money sources)
- Getting loans
- Paying back loans
- Money from investors
Cookie Shop Example
| Activity | Cash |
|---|---|
| Operating | |
| Sold cookies | +$5,000 |
| Paid for flour, sugar | -$1,500 |
| Paid workers | -$1,000 |
| Operating Cash | +$2,500 |
| Investing | |
| Bought new oven | -$2,000 |
| Investing Cash | -$2,000 |
| Financing | |
| Bank loan received | +$1,000 |
| Financing Cash | +$1,000 |
| Total Cash Change | +$1,500 |
The cookie shop has $1,500 more cash than before. Water is flowing in! 💧
📈 Return on Equity (ROE)
Your Money’s Report Card
ROE answers: “For every $1 the owners put in, how much profit came back?”
Formula:
ROE = Net Income ÷ Shareholders' Equity × 100%
Piggy Bank Example
You put $100 in your lemonade business. At the end of summer, you made $20 profit.
Your ROE = $20 ÷ $100 × 100% = 20%
For every $1 you invested, you got 20 cents back as profit!
What’s Good?
| ROE | Rating |
|---|---|
| 15%+ | Great! 🌟 |
| 10-15% | Good 👍 |
| 5-10% | Okay 🤔 |
| Below 5% | Needs work 📉 |
Real Example
TechCorp:
- Net Income: $10 million
- Shareholders’ Equity: $50 million
- ROE = $10M ÷ $50M × 100% = 20% 🌟
The owners’ money is working hard!
🏢 Return on Assets (ROA)
How Hard Are Your Tools Working?
ROA asks: “For every $1 of stuff the company owns, how much profit does it make?”
Formula:
ROA = Net Income ÷ Total Assets × 100%
Toy Factory Example
Your toy factory has:
- Machines, building, inventory worth $1,000
- Makes $80 profit per year
ROA = $80 ÷ $1,000 × 100% = 8%
Every $1 of factory stuff makes 8 cents profit!
What’s Good?
| ROA | Rating |
|---|---|
| 10%+ | Excellent! 🌟 |
| 5-10% | Good 👍 |
| 2-5% | Average 🤔 |
| Below 2% | Low 📉 |
ROE vs ROA
| Metric | Question | Uses |
|---|---|---|
| ROE | How well does owner money work? | Shareholders’ Equity |
| ROA | How well does ALL stuff work? | Total Assets |
ROA is usually lower because companies have debt (borrowed money). ROE focuses only on owner money.
💰 Profit Margin Analysis
How Much Do You Keep?
Profit margin shows: From every dollar of sales, how many cents stay as profit?
Three Types of Margins
graph TD A["Revenue $100"] --> B["Gross Margin"] B --> C["Operating Margin"] C --> D["Net Margin"] B --> E["After product costs<br/>$100 - $40 = $60<br/>60% margin"] C --> F["After running costs<br/>$60 - $30 = $30<br/>30% margin"] D --> G["After ALL costs<br/>$30 - $10 = $20<br/>20% margin"]
The Formulas
Gross Margin:
(Revenue - Cost of Goods) ÷ Revenue × 100%
Operating Margin:
Operating Income ÷ Revenue × 100%
Net Margin:
Net Income ÷ Revenue × 100%
Bakery Example
BakeJoy sells $1,000 worth of cakes:
| Step | Amount | Margin |
|---|---|---|
| Revenue | $1,000 | - |
| - Ingredients | -$300 | - |
| Gross Profit | $700 | 70% |
| - Rent, wages | -$400 | - |
| Operating Income | $300 | 30% |
| - Interest, taxes | -$50 | - |
| Net Income | $250 | 25% |
BakeJoy keeps 25 cents from every dollar sold!
Industry Comparison
| Industry | Typical Net Margin |
|---|---|
| Software | 20-30% |
| Retail | 2-5% |
| Restaurants | 3-9% |
| Banks | 15-25% |
High margin = keeps more money. Low margin = very competitive business.
🚀 Free Cash Flow
The Money You Can Actually Use
Free Cash Flow (FCF) is the cash left over after:
- Running the business
- Keeping equipment in good shape
This is money the company can use for ANYTHING:
- Pay dividends to owners
- Buy other companies
- Pay off debt
- Save for later
Formula:
Free Cash Flow = Operating Cash Flow - Capital Expenditures
Toy Store Example
ToyWorld’s Cash Situation:
- Operating Cash Flow: $50,000 (from selling toys)
- Capital Expenditures: $15,000 (fixing shelves, new displays)
FCF = $50,000 - $15,000 = $35,000
ToyWorld has $35,000 of FREE money to do whatever it wants!
Why FCF Matters
| Scenario | What It Means |
|---|---|
| Positive FCF | Company generates extra cash 🎉 |
| Negative FCF | Company needs more money 😟 |
| Growing FCF | Getting stronger each year 📈 |
Real Example: Streaming Service
StreamFlix:
- Operating Cash: $200 million
- Building data centers: $80 million
- Free Cash Flow: $120 million
StreamFlix can use that $120 million to make new shows, pay investors, or save!
🎯 Putting It All Together
The Complete Health Check
When analyzing a company, check all parts:
| Check | What to Look For |
|---|---|
| Income Statement | Is profit growing? |
| Balance Sheet | More assets than debts? |
| Cash Flow | Positive operating cash? |
| ROE | Above 15%? |
| ROA | Above 5%? |
| Profit Margins | Stable or improving? |
| Free Cash Flow | Positive and growing? |
Quick Summary
graph TD A["🏥 Healthy Company Signs"] --> B["📈 Growing Revenue"] A --> C["💪 Strong Margins"] A --> D["💰 Positive Cash Flow"] A --> E["📊 Good ROE & ROA"] A --> F["🚀 Free Cash Flow"]
🌟 You’re Now a Company Doctor!
You’ve learned to read a company’s vital signs:
- Income Statement - Are they making money?
- Balance Sheet - Do they own more than they owe?
- Cash Flow - Is real cash coming in?
- ROE & ROA - Is money working hard?
- Profit Margins - How much do they keep?
- Free Cash Flow - Can they invest in the future?
Remember: Great investors don’t just pick exciting companies. They find healthy companies by reading their financial report cards!
Now you can spot the difference between a company that’s thriving and one that’s struggling. That’s powerful knowledge! 💪📊