Reference Files
references/industry-benchmarks.md - Ratio benchmarks by industry (SaaS, manufacturing, retail, professional services, healthcare). Read this in Step 4 when calculating ratios and when you need industry-specific thresholds to compare against.
Overview
Based on "Financial Intelligence" by Karen Berman & Joe Knight and "The Interpretation of Financial Statements" by Benjamin Graham. Financial statements are not just numbers - they are a compressed story of business decisions. The goal of a review is not to recite figures but to answer three questions: Is this business profitable in a way that will last? Is it financially stable? Is the reported profit converting to real cash?
Graham's core principle: always read all three statements together. The income statement shows profit; the balance sheet shows what was built with it; the cash flow statement shows whether the profit is real.
Workflow
Step 1: Read the Income Statement for quality of earnings
Start with the income statement and look beyond the headline net income number.
Revenue: [amount] - Is it growing? At what rate? Is growth organic or acquisition-driven?
Gross Margin: [%] - Is it stable, expanding, or compressing? Why?
Operating Income (EBIT): [amount] - Is operating leverage positive (margins growing faster than revenue)?
Net Income: [amount] - What is the effective tax rate? Are one-time items inflating it?
Flag immediately:
- Revenue growing but gross margin compressing (pricing power loss or cost problem)
- Net income higher than operating income (non-operating gains masking operations)
- Large "other income" or restructuring charges that recur every year (not truly one-time)
Step 2: Read the Balance Sheet for financial stability
Assess the quality and composition of assets, and whether the capital structure is sustainable.
Current Ratio: Current Assets / Current Liabilities - below 1.0 is a liquidity warning
Quick Ratio: (Cash + AR) / Current Liabilities - strips out inventory; below 0.8 is a stress signal
Debt-to-Equity: Total Debt / Total Equity - above 2.0 warrants scrutiny in most industries
AR Days (DSO): (AR / Revenue) x 365 - rising DSO means slower collections or revenue recognition issues
Inventory Days: (Inventory / COGS) x 365 - rising inventory days can signal demand weakness
Goodwill as % of Total Assets - high goodwill (>30%) reflects acquisition risk
Look for the balance sheet to tell a different story than the income statement. If AR is growing much faster than revenue, earnings quality is declining - customers are not paying.
Step 3: Read the Cash Flow Statement to verify earnings quality
The cash flow statement is where accounting choices cannot hide. Real businesses convert profit to cash.
Operating Cash Flow (OCF): [amount]
Net Income: [amount]
OCF / Net Income ratio: [calculate] - below 0.8 consistently is a red flag
Capital Expenditures: [amount] - how much is maintenance vs. growth capex?
Free Cash Flow: OCF - Capex = [amount] - the real measure of financial health
Key patterns to flag:
- Net income positive but OCF negative (profit not converting to cash)
- Large swings in working capital driving OCF (AR, inventory, AP changes)
- Capex declining while depreciation rises (underinvestment in the business)
Step 4: Calculate the core ratio set
Run these ratios and compare against prior periods and industry benchmarks:
Profitability
- Gross margin %: Gross Profit / Revenue
- EBITDA margin %: EBITDA / Revenue
- Return on Assets (ROA): Net Income / Total Assets
- Return on Equity (ROE): Net Income / Total Equity
Liquidity
- Current ratio, Quick ratio (calculated in Step 2)
- Cash conversion cycle: DSO + Inventory Days - AP Days
Leverage
- Debt-to-EBITDA: Total Debt / EBITDA (above 4x is high leverage)
- Interest coverage: EBIT / Interest Expense (below 2x is distress territory)
Efficiency
- Asset turnover: Revenue / Total Assets
- Revenue per employee (if headcount is available)
Step 5: Write the findings summary
Structure the output as a short, opinionated memo - not a list of numbers:
FINANCIAL REVIEW: [Company / Period]
HEADLINE: [One sentence on overall financial health]
STRENGTHS
- [Specific strength with supporting metric]
- [Specific strength with supporting metric]
CONCERNS
- [Specific concern, what it means, what to watch]
- [Specific concern, what it means, what to watch]
EARNINGS QUALITY
OCF/Net Income: [ratio] - [interpretation]
[1-2 sentence verdict on whether reported earnings are backed by cash]
KEY RATIOS SUMMARY
[table of 6-8 ratios with current period vs. prior period vs. benchmark]
RECOMMENDED NEXT STEPS
- [Specific action or investigation]
- [Specific action or investigation]
Anti-Patterns
1. Reporting numbers without interpretation
Bad: "Revenue was $10M, up from $8M last year."
Good: "Revenue grew 25% but gross margin compressed from 42% to 37%, suggesting the growth was bought through pricing concessions or higher input costs - not through operating leverage."
2. Treating net income as the primary signal
Bad: Leading with "the company is profitable" because net income is positive.
Good: Cross-check OCF against net income. Positive net income with negative OCF means profit is not converting to cash - a red flag for earnings manipulation or structural problems.
3. Looking at ratios without trend or benchmark
Bad: "The current ratio is 1.4."
Good: "The current ratio is 1.4, down from 2.1 two years ago and below the industry median of 1.8. Liquidity is deteriorating."
4. Missing the cash flow statement
Bad: Reviewing only the income statement and balance sheet.
Good: The cash flow statement is the most manipulation-resistant of the three. Always read it last to validate what the other two are saying.
5. Ignoring footnotes
Bad: Treating the face of the statements as complete.
Good: Revenue recognition policy, lease commitments, contingent liabilities, and related-party transactions live in the footnotes. Material issues are often disclosed there and nowhere else.
Quality Checklist