Financial Statement Analysis: Horizontal, Vertical, EBITDA and DuPont

What you'll learn

How to track a company's evolution with horizontal analysis.
How to calculate and interpret EBITDA, and its limits.
The debt metrics lenders use: net debt to EBITDA and interest coverage.
How the DuPont model breaks ROE into margin, turnover and leverage.
How to spot red flags in a set of financial statements.

In lesson 10 you learned the basic ratios. Now you'll combine them the way analysts, lenders and investors do: comparing years, breaking profitability down into its drivers and looking for the signals numbers tend to hide. We'll use Lakeside Home Co., the Minneapolis online store from lesson 10's exercise, now with two years of data.

+50%growth in Lakeside's operating income on +26% sales

38.5%return on equity, explained by three DuPont levers

76 dayscash conversion cycle, driven by 91 days of inventory

Horizontal analysis: how did it change?

Horizontal analysis compares each line with the previous period, in dollars and in percentage:

Line	Year 1	Year 2	Change	%
Sales	$950,000	$1,200,000	+$250,000	+26.3%
COGS	$550,000	$720,000	+$170,000	+30.9%
Gross profit	$400,000	$480,000	+$80,000	+20.0%
Operating expenses	$300,000	$330,000	+$30,000	+10.0%
Operating income	$100,000	$150,000	+$50,000	+50.0%

Year-over-year growth by line

Sales+26.3%

COGS+30.9%

Gross profit+20.0%

Operating expenses+10.0%

Operating income+50.0%

Read it together with vertical analysis (lesson 8):

The good news: sales grew 26% while operating expenses grew only 10%, so operating income jumped 50%. The operating margin rose from 10.5% to 12.5%.
The warning: COGS grew faster than sales. The gross margin slipped from 42.1% to 40.0%. Is growth coming from discounts and free shipping? Did suppliers raise prices? Did tariffs or freight costs increase?

1. Sales grow 15% and COGS grows 20%. What happens to the gross margin?

It rises
It falls
It stays the same

If costs grow faster than sales, each dollar of sales leaves proportionally less gross profit.

EBITDA: everyone's favorite number, and its limits

EBITDA stands for earnings before interest, taxes, depreciation and amortization:

EBITDA = Operating income + Depreciation + Amortization
Lakeside, year 2: $150,000 + $30,000 = $180,000
EBITDA margin = $180,000 ÷ $1,200,000 = 15%

It's popular because it lets you compare companies with different debt levels, tax situations and asset bases, and it's a rough proxy for the cash generated by operations. Lenders and business buyers use it constantly. Note that EBITDA isn't defined by GAAP; it's a "non-GAAP" measure, and public companies that report it must reconcile it to net income.

EBITDA is not cash

EBITDA ignores three real uses of cash: capital spending on equipment that will need replacing, increases in working capital (inventory and receivables, as you saw in lesson 10) and interest and taxes. A company can post a big EBITDA and still run dry. Always read it alongside the cash flow statement.

The debt metrics lenders watch

Assume that of Lakeside's $350,000 of liabilities, $120,000 is bank debt and the rest is supplier credit and other operating liabilities, and that it holds $30,000 of cash.

Metric	Formula	Lakeside (year 2)	Reading
Net debt / EBITDA	(Interest-bearing debt − cash) ÷ EBITDA	($120,000 − $30,000) ÷ $180,000 = 0.5×	It could repay its net debt with half a year of EBITDA. Above about 3× is usually considered high, depending on the industry.
Interest coverage	Operating income ÷ Interest expense	$150,000 ÷ $20,000 = 7.5×	It earns 7.5 times its interest bill: comfortable.

2. A company has operating income of $400,000, depreciation of $100,000 and interest expense of $250,000. What is its interest coverage, and what does it suggest?

2.0×: very comfortable
1.6×: tight; a drop in sales could put it in trouble
0.6×: it can't pay its interest

$400,000 ÷ $250,000 = 1.6. With so little room, a bad stretch could leave operating income short of the interest bill.

The DuPont model: where does ROE come from?

Two companies can earn the same return on equity for completely different reasons. DuPont analysis, developed at the DuPont company in the early 20th century, splits ROE into three levers:

ROE = Net margin × Asset turnover × Equity multiplier
    = (Net income ÷ Sales) × (Sales ÷ Assets) × (Assets ÷ Equity)

With Lakeside's figures (net income $96,200, sales $1,200,000, assets $600,000, equity $250,000):

Lever	Calculation	Result	What it measures
Net margin	$96,200 ÷ $1,200,000	8.02%	How much each sale earns
Asset turnover	$1,200,000 ÷ $600,000	2.0×	How much it sells per dollar of assets
Equity multiplier	$600,000 ÷ $250,000	2.4×	How much it relies on borrowed money
ROE	8.02% × 2.0 × 2.4	38.5%	Same as the ROE from lesson 10

DuPont shines when you compare business models:

Grocery storeThin margins, fast turnover

Net margin: ●●●●
Asset turnover: ●●●●
How it wins: Selling huge volumes quickly, with inventory that turns over in days.

Volume game

Jewelry storeFat margins, slow turnover

Net margin: ●●●●
Asset turnover: ●●●●
How it wins: Earning a lot on each sale, even though pieces sit in the case for months.

Margin game

And if a company's ROE rises only because its equity multiplier rose, it's earning more for its owners by borrowing more, which also means more risk.

3. A company's ROE rose from 15% to 20%, but its net margin and asset turnover didn't change. What happened?

It raised its prices
It cut its inventory
Its equity multiplier rose: it's financing more with debt

With margin and turnover unchanged, the only lever left is leverage (assets ÷ equity).

The cash conversion cycle, with numbers

Lesson 9 introduced the idea. Now calculate it from the statements (assume receivables of $100,000, inventory of $180,000 and payables of $90,000):

Days sales outstanding (DSO)   = Receivables ÷ Sales × 365 = $100,000 ÷ $1,200,000 × 365 ≈ 30 days
Days inventory outstanding     = Inventory ÷ COGS × 365    = $180,000 ÷ $720,000 × 365   ≈ 91 days
Days payables outstanding      = Payables ÷ COGS × 365     = $90,000 ÷ $720,000 × 365    ≈ 46 days
Cash conversion cycle          = 30 + 91 − 46                                         ≈ 76 days

Lakeside's cash takes about 76 days to come back. The obvious problem is inventory: 91 days of stock. Bringing it down to 60 days (about $118,000 of inventory at this level of COGS) would free roughly $62,000 of cash without selling a single extra item.

Red flags in financial statements

Receivables growing much faster than sales: customers aren't paying, or sales were booked that may never be collected.
Inventory growing faster than sales: product that isn't moving.
Rising profits with negative operating cash flow for several years in a row.
A gross margin that keeps sliding.
Debt growing faster than EBITDA, or new loans used to pay old ones.
Frequent changes in accounting methods (depreciation lives, inventory costing) that happen to boost profit.
Loans to owners or related companies without a clear explanation.
An auditor's report that is qualified or raises "going concern" doubts.

4. A company reports sales up 10% and accounts receivable up 60% in the same year. What should you look into?

Whether customers are paying, or whether some sales may be hard to collect
Nothing: selling on credit is normal
Whether inventory costs went up

When receivables grow six times faster than sales, cash isn't coming in. It's one of the classic warning signs.

Practice exercise: your analyst report

Pick two years of financial statements: your own business, a client's, or a public company. Every U.S. public company files an annual report (Form 10-K) with the SEC, free to download on the SEC's EDGAR database. Write a one-page report with:

Horizontal and vertical analysis of the income statement.
Liquidity, leverage and profitability ratios (lesson 10).
EBITDA, net debt / EBITDA and interest coverage.
DuPont: which lever explains its ROE?
The cash conversion cycle.
Three conclusions and three questions you'd ask management.

See solution

There's no single answer, but here's how to work efficiently. Put both years in a spreadsheet, one row per line item and one column per year, and calculate changes and ratios with formulas so you can reuse the sheet for any company. For a 10-K, the numbers you need are in Item 8 (financial statements); the management's discussion in Item 7 often explains the variances you find.

As a model, here's the three-line conclusion for Lakeside: (1) growth is profitable, with operating income up 50% on sales up 26%; (2) the gross margin is eroding, down 2.1 points, so pricing and supplier costs need attention; (3) cash is trapped in 91 days of inventory, which explains why operating cash flow is less than half of net income. Questions for management: what's driving the margin decline, what's the plan for slow-moving stock, and how will growth be financed if inventory keeps rising?

Summary

Horizontal analysis compares periods; vertical analysis compares each line with sales. Use both together.
EBITDA = operating income + depreciation + amortization; it's useful for comparisons but it isn't cash.
Lenders watch net debt / EBITDA and interest coverage.
DuPont splits ROE into net margin × asset turnover × equity multiplier, revealing how a company earns its return.
Receivables or inventory growing faster than sales, and profits without cash, are classic red flags.

You've completed the Advanced level: you can now build, read and analyze a business's financial statements and talk numbers with CPAs, bankers and investors. Level 4 (Expert) covers what small business owners ask about most: taxes, payroll, product costing and valuation.

Next lesson: Small Business Taxes in the U.S.: Sales Tax, Income Tax, Self-Employment Tax and 1099s. You'll record sales tax, see how each business structure is taxed and plan estimated payments.