How to Read a Company Before Investing: A Financial-Statement Framework

The Usual Starting Point Is Backwards

Most people start reading a company with its share price. They check the P/E, glance at last quarter's profit and form a view. The annual report, if it gets opened at all, is used to confirm what they already think.

This order is backwards. The price tells you what the market expects. It cannot tell you whether those expectations make sense until you understand the business behind them.

The framework below works through a company in seven layers. Each layer builds on the one before it. The price comes last.

Layer 1: The Business Before the Numbers

Start in plain words. What does the company sell? Who pays for it? Why do customers choose it over rivals, and what could make them stop?

Three parts of an Indian annual report help here:

• Management Discussion and Analysis (MD&A) explains the industry, the company's position and the year's results in management's own words.
• The segment note (under Ind AS 108) breaks revenue, profit and assets down by business line or region. It often shows that one segment earns most of the profit.
• The Business Responsibility and Sustainability Report (BRSR), required for India's largest listed companies, lists the main products, the number of plants and offices, and the markets served.

If you cannot explain in two sentences how the company makes money, stay on this layer.

Layer 2: Revenue and Margins

Now the profit and loss statement. Look at five years, not one.

• Revenue growth. Split it into volume, price and acquisitions where the company discloses enough.
• Gross and EBITDA margins. Margins that hold up in a downturn suggest pricing power. Margins that swing with raw material costs suggest a commodity-like business.
• Other income. Keep it separate from operating profit. A company whose profit leans on treasury income or one-off gains is weaker than its headline.
• Exceptional items. Count how often "one-off" items appear. If they show up every year, they are not one-offs.

Layer 3: Cash Flow

Compare cash flow from operations with net profit over five years. Work out free cash flow, which is operating cash flow minus capex. Track receivable, inventory and payable days. These checks show whether profit is turning into cash.

Layer 4: The Balance Sheet

The balance sheet shows what the company owns, what it owes and how it is funded.

• Debt. Total borrowings net of cash, compared with EBITDA and with equity. Read the maturity profile in the notes.
• Working capital. Receivables and inventory relative to sales.
• Contingent liabilities. Disputed tax demands, guarantees and legal claims sit in the notes, not on the balance sheet. Large ones can matter more than reported debt.
• Goodwill and intangibles. Large balances from past acquisitions can later be written down.
• Capital work in progress. Projects that are not yet earning. Check how long they have been under construction.

Layer 5: Returns on Capital

This layer brings the first four together. Two ratios matter most.

Return on capital employed (ROCE) = EBIT ÷ Capital employed

Capital employed is equity plus debt. Some analysts also subtract surplus cash.

Return on equity (ROE) = Net profit ÷ Average shareholders' equity

ROCE shows how well the business uses all of its capital. ROE shows what shareholders earn, but debt can push it up. Breaking ROE into three parts shows where it comes from:

ROE = Net profit margin × Asset turnover × Leverage

A high ROE driven mainly by leverage carries more risk than the same ROE driven by margins and turnover. Compare ROCE with the company's cost of capital. A business that earns below it for years is not creating value, however fast it grows.

Layer 6: Capital Allocation and Governance

What management does with the cash matters as much as how much cash it makes.

• Use of cash. Reinvestment, acquisitions, dividends, buybacks, or cash piling up. Look at ten years if you can.
• Past acquisitions. Check whether old deals earned their keep or were later written down.
• Related party transactions. Read the related party note (Ind AS 24) and Form AOC-2.
• Promoter holding and pledges. The quarterly shareholding pattern filed with the exchanges shows how much the promoters own and how much of it is pledged.
• The auditor's report. Read the Key Audit Matters, which are the areas the auditor found most significant, and any qualification or emphasis of matter.
• Pay. Compare management pay with profit growth over several years.

Layer 7: Only Then, the Price

By now you know what the business is, how it earns, how much cash it makes and how well it uses capital. Only now can the price be judged. Work out what growth and returns the current valuation assumes, using the P/E ratio or a reverse DCF, and check whether layers 1 to 6 support them.

Shortcuts That Mislead

• Standalone instead of consolidated. Indian annual reports carry both. For a company with subsidiaries, standalone figures can leave out large parts of the business and its debt. Use consolidated.
• Only one year. A single year can be distorted by a commodity cycle, a big order or a one-off item.
• Management's adjusted numbers. "Adjusted EBITDA" in investor presentations can leave out real costs. Start from the audited statements.
• Ignoring minority interest. In consolidated accounts, part of the profit belongs to other owners of subsidiaries. Use the profit attributable to owners of the company.
• Comparing across industries. A 20% ROCE is ordinary for a consumer company and excellent for a utility.

A One-Page Worksheet

The Reframe

The share price is the last thing to read, not the first. Until you understand the business, a price is just a number.