Start with what the business does
Every ratio means something different depending on the business behind it. A 5% profit margin is thin for a software company and ordinary for a grocer; heavy borrowing is normal for a utility and alarming for a retailer.
In a US annual report, Form 10-K, the section headed Business describes what the company sells, to whom, and through which segments. Note whether revenue recurs — subscriptions, contracts, consumables — or depends on one-off sales, because that changes how much any single year can tell you.
Is it profitable?
Read the income statement from the top down. Revenue less the direct cost of sales is gross profit; less running costs, operating income; less interest and tax, net income. Each step has a margin: the share of each dollar of revenue that survives it.
Look at several years rather than one. Net income moves with one-off items — an asset sale, a legal settlement, a change in tax law — so operating income is usually the steadier read on the business itself.
- Gross margin reflects pricing power and the cost of inputs.
- Operating margin reflects how efficiently the business is run.
- Net margin is what is left for shareholders after everything else.
Is it growing?
Compare revenue with the year before, and with three years earlier to smooth out a single good or bad year. The notes to the financial statements say whether growth came from acquisitions, which add revenue without the original business growing.
Growth on a shrinking margin can mean a company is discounting to win sales. Growth with a steady or rising margin is a different situation, and the two are worth telling apart.
Does profit turn into cash?
Profit is an accounting measure; cash is harder to flatter. Over time, operating cash flow from the cash flow statement should broadly keep pace with net income. When profit keeps running ahead of cash, the usual explanations are customers paying more slowly or inventory building up, and both show in the balance sheet.
Free cash flow — operating cash flow less capital expenditure — is the cash left after maintaining and growing the business. It is what pays dividends, repurchases shares and repays debt.
How much does it owe?
Total liabilities include ordinary items such as unpaid supplier bills and payments customers made in advance, so they overstate what a company has borrowed. Net debt — borrowings less cash — and the years of operating cash flow it would take to repay it are more direct measures.
Interest cover, operating income divided by interest expense, shows whether the business earns its interest bill comfortably. Banks and insurers are a separate case: borrowing is their raw material, so these measures do not read the same way for them.
How is it valued?
Valuation is a question about the share price, not about the business. Price to earnings, price to free cash flow and enterprise value to EBITDA each set the market's price against something the company produces.
A multiple only means something against a comparison: the company's own history, or companies like it. A low multiple can reflect a business the market expects to shrink, and a high one a business expected to grow.
What changed, and what could go wrong?
Set the latest year beside the one before, and the latest quarter beside the same quarter a year earlier. Then read the risk factors and management's discussion of results, where the company explains the changes in its own words.
Statistical screens help decide where to look harder. The Beneish M-Score flags accounting patterns associated with overstated earnings, and the Altman Z-Score describes how close a balance sheet looks to distress. Neither is a finding; both are prompts.
Write down what you think, and check it later
A written thesis — what has to go right, what would change your mind, and the figures that would show it — turns the next annual report into a check rather than a fresh opinion. It also makes it harder to rewrite the reasons afterwards.