BUSI 170 - Financial Analysis for Leaders (Section 5.1)
August 21, 2026
When a student or an analyst hands me income statements and balance sheets, just raw naked numbers of them, saying, “Hey, we’ve got some information here,” I have to tell them: you have not even gotten started yet.
This might be a little bit disappointing. You have spent all this time learning how to curate these beautiful financial statements with figures that tie and that balance. They are a really great representation of what is going on in the business. We can get some insights out of here. Here is the thing. You do not have any insights yet, because a number is just a number.
You got me some numbers? That is a pile of numbers. Tell me what they mean.
With just looking at financial statements and doing some basic comparisons as our eyes roll over, there is only so much you can get. This is not information. This is not insight. This is data. This is the raw material from which we can put on a layer of our own thinking, combined with the context of what we understand about the business, the narrative of how it works. We can then apply some commonly used accounting analytics on top of that to get some layers, to get some insights about what is going on in this business:
Out in the future there is a very good chance that a lot of this data comes to you already. We spent a lot of time trying to understand how this data arises. This is the wheelhouse of bookkeepers. They take a bunch of transactions and they turn it into this data. I am not training you to be a bookkeeper. I am training you to use this data and come with these insights. This is when the real interesting journey begins.
You may have been asking, why did we have to do this? That is because I have learned that people cannot take this journey meaningfully without having an intuition of where this number comes from. We build that by actually going through the steps of how transactions become this information, basic bookkeeping. If you do not know that, it turns out that your ability to draw insights and get deeper is really fragile.
One thing I have learned from students in the past is that you can get them to do analyst work. You can get them to do analytics on financial statements while they have a very thin idea of what financial statements are. They will be able to generate numbers and then tell you back what it is, like a procedure. They are not able to take the second step of “what is the so-what of that? What does that mean about a business?”
It is not because they do not understand the formula. It is because there is a fundamental basis for connecting the narrative of what a business does, how it creates value, to the transactions it makes, how those run and get booked into financial statements, and then finally what the insight tells you. It is that foundation that is weak, and that is why we have done it.
Now we are at the fun part, where we get to look at what insights we can get out of this data now that we understand how it gets made: a good diagnosis, and what are some possible levers of improvement moving forward - the prescription.
Every single number that we ever generate has got to be accurate, but it is meaningless unless we can put it into context. “In context” means comparisons.
Compared to what? This is a number. It is high, it is low, it is a million, it is a half a million. Why is that meaningful? What is some comparison, some context, that I can compare this to in order to put meaning in what I am seeing?
Almost all measures of performance have that. Take for example when you drive a car. What do we look at? It is our speedometer. It tells us a component measure of distance and time. It is miles per hour. We are always taking a ratio, because that is what makes it interesting. It is not how far we have gone. It is how far we have gone in what period of time. That is what speed is. That is interesting. That tells us a measure of performance.
A measure of speed tells you something beyond the component measures of distance and time. What you are going to find is that we are going to talk a lot about ratios. We take two numbers and compare them, because in that we get some insight about something interesting about a business’s performance.
I want to go back to the last chapter, when we talked about cash flows. What would happen if we tried to take these ratios on a cash basis? Suppose we looked at a revenue number that was not about what we had earned but about what cash we had collected, and compared that to the amount we happened to spend - not expenses incurred, just whatever we paid out over that period.
That whole thing would be vulnerable to the timing of the cash flows. If we happened to collect a lot in advance, and we deferred our expenses, then when we look at that ratio of revenue to the expenses we have incurred, it is broken. Some of those expenses in the denominator are not related to those revenues, and there are going to be some revenues that are not related to the expenses.
Remember, the differences between accrual and cash basis are really about timing differences.
It is almost like if we go back to the car and the speed analogy. If we were trying to come up with how fast we were going, and we looked at the distance, and we had a stopwatch, and we just turned off the stopwatch for a little bit of time and then turned it back on - we are relating two things unreliably. That does not give us any information on our current speed. It erodes our basis for being able to compare this thing over time and see if it is improving. It erodes the basis of comparing it against other peers.
Think about it this way. Could you make these comparisons if you were on a cash basis? The period you purchased big fixed assets, the expense and profits would swing wildly. You would have needed to get the full narrative story about what happened, rather than make conclusions based off the numbers alone. Trend analysis would be a lot less useful, and a lot harder to do, without consistently applied accruals.
That is why the accrual thing is so important. It is what makes meaningful comparisons possible, both over time and across different entities.
For the rest of this chapter we are going to talk about a small wholesale distributor that sells dry goods, packaging and light equipment to independent restaurants and cafes, on credit. To make things simple: one owner, a part-time driver, a van and a rented unit.
Here are three years of her income statement.
For the years ended December 31. All figures in dollars.
| 2020 | 2021 | 2022 | |
|---|---|---|---|
| Revenue | 400,000 | 460,000 | 528,000 |
| Cost of goods sold | 320,000 | 352,000 | 400,000 |
| Gross profit | 80,000 | 108,000 | 128,000 |
| Operating expenses | 60,000 | 80,000 | 108,000 |
| of which depreciation | 10,000 | 11,000 | 12,000 |
| Operating profit | 20,000 | 28,000 | 20,000 |
| Interest | 4,000 | 4,650 | 6,550 |
| Earnings before taxes | 16,000 | 23,350 | 13,450 |
| Taxes | 4,000 | 5,840 | 3,360 |
| Net profit | 12,000 | 17,510 | 10,090 |
And here is her balance sheet at the end of each of those years. We will not need all of it in this section, but it is worth having in front of you, because by the end of the chapter every line of it will have said something.
As at December 31. All figures in dollars.
| 2020 | 2021 | 2022 | |
|---|---|---|---|
| Cash | 40,000 | 28,310 | 13,800 |
| Accounts receivable | 48,000 | 72,000 | 104,000 |
| Inventory | 64,000 | 88,000 | 128,000 |
| Current assets | 152,000 | 188,310 | 245,800 |
| Equipment and fit-out, at cost | 105,000 | 119,000 | 134,000 |
| Less accumulated depreciation | (60,000) | (71,000) | (83,000) |
| Net equipment and fit-out | 45,000 | 48,000 | 51,000 |
| Total assets | 197,000 | 236,310 | 296,800 |
| Accounts payable | 40,000 | 48,000 | 60,000 |
| Accrued expenses | 5,000 | 6,800 | 9,200 |
| Current liabilities | 45,000 | 54,800 | 69,200 |
| Bank loan | 52,000 | 64,000 | 100,000 |
| Total liabilities | 97,000 | 118,800 | 169,200 |
| Paid-in capital | 40,000 | 40,000 | 40,000 |
| Retained earnings | 60,000 | 77,510 | 87,600 |
| Total equity | 100,000 | 117,510 | 127,600 |
| Total liabilities and equity | 197,000 | 236,310 | 296,800 |
Look at these quickly and a few things stand out. The balance sheet balances. This has been a growing business - total assets go from about 200,000 to about 300,000, and top line revenue has grown from around 400,000 to about 530,000.
But here are some things we are going to think about, and it is definitely worth diving in. Gross profits have gone up. Operating profit has been flat. And net profit is going down. This is something that is growing but is becoming less profitable. Definitely something to look into.
Gross profits seem to have gone up a little bit, and then flat from year two to year three. But the story is not great once we include operating expenses. Operating expenses went up from 60,000 to over 100,000. That is a huge jump, and that is something worth getting into.
On the balance sheet, total assets are going up and total liabilities are also going up. This is definitely a growing business, but one of the concerns I see right off the bat is that we have moved up 50 percent in total assets, and when we look at total equity it has only gone up around 30 percent.
Other things that seem to be an issue: our receivables are definitely going up, so maybe there is going to be a problem with our collections, and cash is going down. That is always something that alarms me. Accrued expenses are going up and we need to find out what is going on there. We are financing with more debt, because the bank loan has basically doubled. No more paid-in capital has gone in, so we do not have to worry about that changing things. It is a matter of what the business has generated.
None of that is analysis yet. It is a set of things to look into. So let us start looking.
Let us start with horizontal analysis, sometimes called trend analysis, where we are going to put some meaning in these financial statements by a comparison against yourself over time.
If we look at the income statement, we pick 2020 as the base year. All we do is take every column and divide it by the 2020 column and recast the numbers. It is going to look like this.
Each line indexed to its own 2020 figure, which is set to 100.
| 2020 | 2021 | 2022 | |
|---|---|---|---|
| Revenue | 100 | 115 | 132 |
| Cost of goods sold | 100 | 110 | 125 |
| Gross profit | 100 | 135 | 160 |
| Operating expenses | 100 | 133 | 180 |
| Operating profit | 100 | 140 | 100 |
| Interest | 100 | 116 | 164 |
| Net profit | 100 | 146 | 84 |
Right away we see something interesting. Revenue goes from its 2020 index at 100 and everything else is a ratio of that. Everything is now in relative terms relative to 2020.
Revenue grew 32 percent over these three years. The cost of goods sold has grown 25 percent. In general that is good, because that means our revenue is growing faster than what we pay to buy stuff and sell it. What we sell is going up more and what we buy it for is growing at a slower rate. That should mean that our gross profit is increasing, and sure enough it does. Gross profit has grown 60 percent over this time.
But here is something that is interesting. Notice operating profit has stayed flat. Between 2020 and 2022 it is 100 and it is 100. It is like we have not moved anywhere. What is causing that?
What we find is that operating expenses have gone up more. They have gone up 80 percent. Our interest has also gone up 64 percent, which is going to hurt our net profit. And if we look at the net profit number, while there is a big growth story on revenue, we have in fact shrunk by 16 percent. We can see that because the last column in 2022 says 84, and we compare that to 100.
Operating expenses are outpacing the growth of revenue and of our gross profit. Do you have a sense of how this happened? Payroll expenses are a big item and they are growing. She also hired a driver, so a lot of this operating cost overrun is about people cost - in particular the owner. We will come back to that.
We are already learning a lot. We learn a lot before we even make a comparison of this business to others, just by comparing it to how it was doing, comparing it to itself at an earlier point in time. That is what horizontal analysis, or trend analysis, is all about.
Now let us talk about common size, which is what a lot of accountants call vertical analysis.
On the first one, we took one column as the base and then divided all the subsequent columns by that. We could see the trend over time. This time we are going to go on the opposite axis. We are going to take one row and divide everything by that row. What we are going to do here on the income statement is divide everything by revenue, so everything is a percentage of revenue.
Each line as a percentage of that year’s revenue.
| 2020 | 2021 | 2022 | |
|---|---|---|---|
| Revenue | 100.0% | 100.0% | 100.0% |
| Cost of goods sold | 80.0% | 76.5% | 75.8% |
| Gross profit | 20.0% | 23.5% | 24.2% |
| Operating expenses | 15.0% | 17.4% | 20.5% |
| Operating profit | 5.0% | 6.1% | 3.8% |
| Interest | 1.0% | 1.0% | 1.2% |
| Taxes | 1.0% | 1.3% | 0.6% |
| Net profit | 3.0% | 3.8% | 1.9% |
When we do that across all of these columns, something is going to jump out at us. What you get insight into right away is cost structure. This chapter is all about relative to what. How about relative to revenue?
Let us take 2022. When you see revenues at 100 percent and cost of goods sold underneath it, what does that mean? It means that for every dollar of revenue we make, about 76 percent goes into buying the stuff, which means about 24 percent goes into our pocket. Of those 24 percent, we have some operating expenses. About 21 percent goes into the expenses, which means we are only putting 4 percent in our pocket. We are only putting 4 percent of every dollar that we sell into operating profit. About 1.2 percent goes to interest. We have to pay some for taxes. And net net we are putting 2 percent as net profit into our pocket for every dollar of revenue we generate.
In the first year, for every dollar of revenue we had, it cost us 80 cents to get it. After that we had 20 cents left to run this business and make a profit. The next year we did better - the cost of goods sold was down to 76.5, which means we have more left. We were improving our revenue per the amount that we bought, and we still got a smaller amount of gains the next time. Basically it cost us about 76 cents in cost of goods sold for every revenue dollar we booked.
We are putting everything on a scale of revenue. That gives us insight about our cost structure and how much is left at the end of the day for profits for every dollar that we spent. In some sense this gives us scale independence. If we grew this business, if we doubled this business, we could immediately get a good insight into what the impact would be - what is linear, for operating expenses, for profits.
Here are a couple of things that we learned from this. We made some more gains on the gross profit, but guess what? The operating expenses ate all of that. As we grew we were getting better at buying stuff, but the overhead costs basically nullified all of that.
Below the operating profit line, what is hurting net profits? It turns out that interest went up, whereas taxes went down, so that is the culprit there. What drives interest expense? It is how much we are borrowing. This is going to be related as we look on the balance sheet. Perhaps our debt is getting high, and the cost of carrying that is also eroding our bottom line.
Horizontal and vertical analysis are usually taught as two separate exercises, and they stop being separate the moment you put one on top of the other. The vertical view says what share each line takes. The horizontal view of those shares says which shares are moving.
| 2020 | 2022 | Change | |
|---|---|---|---|
| Cost of goods sold | 80.0% | 75.8% | -4.2 points |
| Gross profit | 20.0% | 24.2% | +4.2 points |
| Operating expenses | 15.0% | 20.5% | +5.5 points |
| Operating profit | 5.0% | 3.8% | -1.2 points |
| Interest | 1.0% | 1.2% | +0.2 points |
| Net profit | 3.0% | 1.9% | -1.1 points |
Gross margin gained 4.2 points. Operating expenses took 5.5. Overhead ate the entire product-side improvement, and 1.3 points more on top of it. That is why operating margin fell even though the product got more profitable every year.
A note on units, because this is where people get tangled. Say points, not percent. Gross margin went up 4.2 points, from 20.0 to 24.2. It is also true that gross margin went up 21 percent, because 24.2 divided by 20.0 is 1.21 - and that is a different statement about a different thing.
What is useful about common size is that it allows you to compare two businesses that have completely different scales. We are just talking about cost structure, not the cost itself. We could compare a mom-and-pop grocery store, or a small distributor, to a large distributor and ask: how are you doing on your cost structure?
Your cost as a percentage of revenue is a way to do benchmarks even when the businesses themselves differ in size. In the sense that they are all in the same business, cost structure should be comparable, and we can see where you do better or worse compared to peers even if they are much bigger or smaller than you.
You might find that one grocery store with dirty, crowded interiors and cheap prices looks different from a nice grocery store with high prices and nice displays. When you compare the common-size income statements, you might see that the nice store has higher revenues due to higher prices, but they also have higher expenses. That is what it takes to look nice in the store. This is not to say that one store is better than the other - customers have different preferences. But by looking at the numbers, you can start to understand how different businesses use resources to create value for their target customers.
Say we have the financial statements of some competition. Here is a table of two other distributors, common sized on revenue, so revenue is 100 and then we get the cost structure.
2022, each line as a percentage of that firm’s revenue. Peer figures are illustrative.
| Our distributor | Peer A | Peer B | |
|---|---|---|---|
| Cost of goods sold | 75.8% | 84.0% | 68.0% |
| Gross profit | 24.2% | 16.0% | 32.0% |
| Operating expenses | 20.5% | 11.5% | 27.5% |
| Operating profit | 3.8% | 4.5% | 4.5% |
| Asset turnover | 1.78 | 2.60 | 1.35 |
| Operating profit per dollar of assets | 6.7% | 11.7% | 6.1% |
What is the first thing we see? Two peers earn the same operating margin, but they get there in different ways.
Peer B has hard-to-source items. It is specialty goods, and they earn a higher profit on the stuff they are selling because that stuff is perhaps harder to find, or more valuable. On the other hand they have to spend a lot on operating expenses, because having a business that carries these specialty items is more expensive to run. We see that is going to be higher.
We flip that on Peer A, which sells more commodity-type goods. They are not making a lot on every item that they sell, only 16 percent, but they are also a lot more efficient when it comes to operating expenses.
From a financial standpoint neither is better. They are both making 4.5 percent on operating profit. But the point is that they have very different business models, and we can see that in the common-size income statement by making that comparison.
The second thing to notice is that our distributor is in between those two. We are not a real specialty business. We are not high-volume, high-efficiency. We are sitting somewhere in between.
And we were not always stuck in the middle. If you compare to the 2021 statements, the business looked like Peer A, with that cost structure almost exactly, that level of efficiency. That is where we lost this. One year of expense growth moved it from being very comparable to Peer A to something where we started losing control of our costs. We did not have the gross profit to support that and to justify it.
Now we have already moved from an accounting conversation to a conversation about strategy. We performed before like Peer A, as a more efficient low-premium distributor, but then our cost grew and our margins did not. If you are going to be carrying a lot of operating cost, you might have to look like Peer B, where you are going to get a lot of gross profit that is going to be able to support that. If you do not get that gross profit, then these operating expenses might not be warranted, and financially they are not viable. They cannot be supported.
Just from a comparison alone we can start getting some insights into what direction we might want to look at.
Here is another thing that is interesting about financial statements. You can look into the future and get a sense of where we think we would be - either to get a sense of what the future could look like, or to create a plan for the targets you are trying to hit.
It is very common for managers to create what they call a pro forma: what is going to happen in the future, and what those levels are going to look like. What is the structure going to look like? If you have some history of financial statements, you can do some projections using vertical analysis. If the cost structure is a certain percentage of revenue in the prior period, we could say that if nothing changes it will probably continue to be that way, even at a different revenue number if we grow.
If you are going to say that that cost structure is going to change, that the share of costs as a percentage of revenue is going to differ moving forward, you have to have a theory of why that is happening. Are you going to get more efficient and better at buying, and by how much? Or is it going to be less so, and why would that be the case?
When we do pro forma it is not just an exercise in producing numbers or making up numbers. It is about making our assumptions explicit and projecting into the future based on the past. This is what it would look like. If this differs, having good rationale of how much, and why.
You can use both of these techniques to measure performance against expectations. Using trend analysis and common sizing, managers can understand where they are on track, and deviations from plan highlight places to give more attention.
I want to come back to the question this whole chapter is built on. We look at the data from the income statement and the balance sheet. They are just raw numbers and we do not see things. When we talk about where the insights come from, it is compared to what?
We are comparing against ourselves over time. We might want to compare against a plan. We had an income statement that we were hoping to get to. How does it compare? If we are off, is it because our revenue numbers were too high or too low? Was it our cost? If it was the costs that were too high, which costs? Then we can ask what drove that.
We are also making comparisons against peers. If this is where we are, where are the companies that do something similar to us? If they are somewhat different, how are they different, and do we have a good justification of why that would be so? Or does that provide insight into where we could improve to match what other people have done?
We can make comparisons within ourselves if we have multiple divisions. Perhaps we can compare the income statement of how we did in Brazil versus how we have done in China, and that gives us a point of reference, separating out: are these differences in performance that would suggest there is improvement potential in one or the other, or do these reflect very specific differences in the market? If it is the latter, what are they, and why do they drive these differences that we see in the financials? We can learn something about local markets and what it takes to operate in them.
We can make the comparison even grander, because we all share the same financial statements. We can compare across industries. The cost of goods sold for manufacturers can be very different from that of retailers. Why is that different?
Think about it. Manufacturers are creating a totally new product in the world. They are taking a ton of input and a lot of risk, putting something in. This is their bread and butter of how they create great value. We are going to expect to see pretty good gross margins. If you are a retailer that sells somebody else’s stuff, all retailers can sell this stuff. You could buy direct. You could buy a box of pens from any given retailer. Why would you be making a lot of margin on this? Other people can do what you are doing - buy some good from a producer and then sell it for a given markup. What you will tend to find is that the margins on cost of goods sold are slimmer. It makes sense, because these types of retailers who sell commodities are not adding a whole lot of value on top of it.
Looking at financials across industries, across different places in the value chain, the different roles, we can get a sense of insight about the business, all because of these comparisons.
Here is a neat one. If you find that, between cost of goods sold and revenue, gross margins are increasing over time, what could we say about that? Perhaps over time they are becoming more valuable in the value chain, or getting more economic power. As we look at that margin over time it starts telling us something. Compare the temporal side of it - how are average margins on retailers changing, and how are the average margins of producers changing? What does that say about the balance of power between these two in an industry?
You start learning about how industries are being restructured, and how value chains are being restructured.
Remember this about ratios: calculating them is easy, but meaning only comes from comparisons, over time, and against peer businesses.
© 2026 Eric Lin. All rights reserved. This chapter is provided for students in BUSI 170 - please do not repost or redistribute without permission.