What are the best practices for analyzing a company's financial health using notes to financial statements?

2 Review the estimates and judgments

The second step is to review the estimates and judgments that the company makes in preparing its financial statements. These include the useful lives and residual values of fixed assets, the allowance for doubtful accounts, the inventory valuation methods, the impairment tests, the deferred taxes, the pension obligations, and the fair value measurements. These estimates and judgments involve a high degree of uncertainty and subjectivity, and they can affect the quality and reliability of the financial statements. Therefore, you need to assess the reasonableness and consistency of the estimates and judgments, and identify any potential biases or errors that could distort the financial results.

4 Analyze the segment and geographic information

The fourth step is to analyze the segment and geographic information that the company provides in its notes to financial statements. These information can help you understand how the company diversifies its sources of revenue, profit, and growth across different products, services, markets, and regions. They can also help you identify the strengths and weaknesses of each segment and geographic area, and how they contribute to the overall performance of the company. Therefore, you need to compare the segment and geographic information with the industry trends and benchmarks, and determine the competitive advantages and disadvantages of the company.

5 Compare the non-GAAP measures

The fifth step is to compare the non-GAAP measures that the company uses in its notes to financial statements. Non-GAAP measures are financial metrics that do not conform to the generally accepted accounting principles (GAAP), and they are often used by management to highlight certain aspects of the financial performance that they consider more relevant or favorable. Examples of non-GAAP measures are EBITDA, adjusted earnings, free cash flow, and organic growth. However, non-GAAP measures are not standardized or regulated, and they can vary widely among companies and industries. Therefore, you need to understand the definitions and calculations of the non-GAAP measures, and reconcile them with the GAAP measures, to get a more accurate and comparable view of the financial health of the company.

6 Evaluate the trends and ratios

The sixth step is to evaluate the trends and ratios that the company reports or implies in its notes to financial statements. Trends and ratios are useful tools to measure and compare the financial performance, efficiency, liquidity, solvency, and profitability of a company over time and against its peers and industry averages. Examples of trends and ratios are revenue growth, gross margin, operating margin, return on equity, current ratio, debt-to-equity ratio, and earnings per share. However, trends and ratios are not absolute or definitive, and they can be affected by various factors such as accounting methods, estimates, judgments, risks, contingencies, non-GAAP measures, and seasonality. Therefore, you need to interpret the trends and ratios in the context of the notes to financial statements, and avoid drawing hasty or misleading conclusions about the financial health of the company.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?