Financial statement analysis – a crucial step in valuation As outsiders, investors and analysts do not get to observe directly what is going on inside a company. They rely on financial statements to get an understanding of a firm's economic reality. A key job of analysts is to identify warning signs in financial statements that might indicate that the financial health of the company is deteriorating.

However, in reality, we rarely find a tell-tale sign that something is wrong. Instead we have amber flags which suggest that there are areas of concern and the analyst’s job is to connect the dots between these amber flags to paint an overall picture of the company’s financial health and how future returns might behave. In this note, we provide 13 amber flags metrics for investors to analyse the financial health of a company.

Look at earnings quality and balance sheet when analysing returns Returns analysis is a key element of fundamental analysis, as a company only generates value for investors if it can generate returns above its cost of capital. When analysing returns, we should focus not just on the returns number itself, but also look on the firm's earnings quality, as well its balance sheet strength. The 13 metrics we have identified for financial statement analysis specifically cover these two areas, and assist in forecasting a company's future returns.

Quantitative approach to analysing financial statements But simply having the metrics alone is not sufficient: a metric value by itself does not convey much information. For example, we cannot know if an EBIT margin of 20% is high or low unless there is a reference class against which to compare it. We therefore look at two methods of comparison – industry peers and historical values. We can then identify outliers using the reference class, and perform a deep-dive analysis on the outliers identified.

Applying the framework to beverage companies We have collaborated with the UBS European Beverage team and applied our amber flags framework to nine beverage companies. We split them into two groups – spirits companies and brewers/soft drink companies – and calculated their metrics from four years ago. We then observed their ROE trends over the next three years to determine the effects of these metrics on returns.