When you buy a share, you are buying a piece of a business. If the business does well over time, the share will do well over time. Fundamental analysis is the discipline of deciding — on the basis of the numbers — whether the business is one worth owning.
There is no single metric that identifies a great business. There is, however, a short list of financial indicators that, taken together, do a reliable job of separating great businesses from lousy ones. This article covers the three financial statements, the ratios that matter, the red flags to avoid, and a twelve-metric checklist to run on any company before it becomes a position.
01The three financial statements
Three statements sit at the heart of every company's filings. Each answers a different question.
- Income statement — how much the business earned and spent over a period.
- Balance sheet — what the business owns and owes on a given date.
- Cash flow statement — how cash actually moved through the business.
A great business shows strength across all three — consistent earnings, a conservative balance sheet, and real cash being produced by operations. Weakness in any one is usually a signal that the other two are masking a problem.
02The income statement
A great business shows consistently increasing sales revenue and net income over five to ten years. The trend matters more than any single year. If net income is lumpy — as it often is for speculative growth companies making heavy reinvestment — look at operating income instead.
Operating income reports profit from the business's ongoing operations. It excludes one-off items (lawsuits, restructuring charges, inventory writedowns) and non-operating income (dividends received, interest income, FX gains). Those items can distort profit in a single year; operating income strips them out.
Margins should be consistent or improving over five years. The two to watch:
Gross profit margin
Measures pricing power after direct costs. Declining gross margins often signal eroding competitive position.
Net profit margin
Measures profitability after all expenses. A stable or rising net margin across cycles is a strong signal.
03The balance sheet
The balance sheet answers: how financially strong is the company today? The accounting identity is simple — Assets = Liabilities + Shareholders' Equity — but the useful work is in three debt ratios.
Current ratio
Should be greater than 1. Below 1 means the company cannot cover short-term obligations with short-term assets.
Debt-to-EBITDA
Should be less than 3. Higher ratios suggest the company may struggle to service debt in a downturn.
Debt servicing ratio
Should be under 30%. Above that, interest costs are consuming too much of operating cash flow.
Exceptions
Banks, insurers, REITs, property developers, and commodity companies are structurally leveraged. These ratios do not apply cleanly — use the sector-specific metrics below instead.
Sector-specific debt ratios
| Sector | Ratio | Threshold |
|---|---|---|
| Banks | Common Equity Tier 1 Ratio CET1 ÷ Risk-Weighted Assets |
> 10% |
| Banks | Non-Performing Loan Ratio Non-performing loans ÷ Total loans |
< 5% |
| REITs | Gearing Ratio (Aggregate Leverage) Total Debt ÷ Total Assets |
< 45% |
04The cash flow statement
Profits can be accounting constructs. Cash cannot. A great business generates consistently positive and growing cash flow from operations, and converts a meaningful portion of it into free cash flow.
Cash flow from operations
Cash generated by the core business. Used to calculate intrinsic value. Should be positive and growing over a five-year trend. Banks, commodity companies and property developers show lumpy CFO — a known exception.
Free cash flow
What remains after the business has reinvested in itself. Should be consistently positive. Persistently negative FCF forces the company to raise debt, issue shares, or deplete cash reserves.
Cash flow from investing
Outflows into assets and equipment (capital expenditure); inflows from selling assets. Heavy capex is normal for growing businesses; persistent divestiture is usually not.
Cash flow from financing
Debt raised or repaid, shares issued or bought back. Consistent buybacks funded by FCF are generally bullish; dividends or buybacks funded by new debt are generally not.
05Return ratios that matter
Revenue and profit growth tell you a business is expanding. Return ratios tell you whether that expansion is creating value.
Return on Equity (ROE)
Above 12–15% is an excellent sign. Some companies — those that buy back heavily or have negative equity — produce distorted ROE; check the underlying drivers.
Return on Invested Capital (ROIC)
Measures how efficiently total invested capital generates profit. Above 12–15% is excellent. Does not apply cleanly to banks.
Revenue vs accounts receivable
Sales revenue should grow at the same rate or faster than accounts receivable. If receivables grow much faster than revenue, the company may be booking sales it has not been paid for — either by relaxing credit terms or, more seriously, by recognising revenue prematurely.
Cash conversion cycle
For businesses with physical inventory, the cash conversion cycle measures how many days it takes to turn investments in inventory back into cash. Shorter cycles are better. A stable or shortening CCC over time is a sign of operational discipline.
06Red flags that reliably precede trouble
No single red flag is definitive. Two or more in combination are usually enough to step away from a position.
Negative cash flow from operations & negative FCF
The core business is not generating cash. If this persists beyond the early-growth phase of a business model, something is structurally wrong.
Dividends paid with negative free cash flow
The company is funding shareholder payouts from debt or reserves. This is usually unsustainable and often precedes a dividend cut or capital raise.
Receivables growing much faster than revenue
Receivables outpacing sales by a large margin over a single period — especially in a weak economy — is a classic accounting-quality warning.
Debt-to-EBITDA above 3–5 in a non-leveraged sector
Outside of banks, REITs, utilities and property developers, sustained leverage of this order is unusual and typically reflects weakness rather than growth.
Margins declining over 2–3 consecutive years
A durable competitive advantage should protect margins against the cycle. Steadily compressing margins often signal moat erosion — lost pricing power, rising input costs, or competitive pressure.
Celebrity management, famous backers, positive analyst coverage, and "strategic national importance" are not fundamentals. They should never override what the financial statements are saying.
07The twelve-metric checklist
Before any position is opened, the business is measured against twelve metrics across profitability, financial strength, and management effectiveness. Not every great business passes every test — but a business that fails multiple tests is rarely a great one.
Profitability
- Sales revenue and net income increasing consistently (5+ years).
- Cash flow from operations increasing consistently (5+ years).
- Free cash flow consistently positive.
- Gross and net profit margins stable or rising over 5+ years.
- Return on Equity of 12–15% or higher.
- Return on Invested Capital of 12–15% or higher.
Financial strength
- Current ratio greater than 1.
- Debt-to-EBITDA of 3 or less (non-leveraged sectors).
- Debt servicing ratio under 30%.
- For banks: CET1 ratio > 10%. For REITs: gearing < 45%.
Management effectiveness
- Cash conversion cycle stable or declining (inventory-heavy businesses).
- Sales revenue growing at or faster than accounts receivable.
08What makes a great business model
Numbers describe outcomes. The business model describes why those outcomes are likely to continue. The five questions below come from the Porter framework and apply across sectors.
- Customers. Does the product or service command pricing power? Are there high switching costs? Is revenue recurring or contracted? Is the customer base large and growing? Concentrated into a few buyers, or diversified?
- Competition. How many competitors, and what market share does the business hold? Is there a defensible economic moat — brand, scale economies, network effects, regulatory barriers, high capital requirements?
- Substitutes. Can customers easily switch to an alternative? Is brand loyalty durable, or based on fashion?
- Suppliers. How much bargaining power do suppliers have? Are raw material costs volatile? Are there single-source dependencies?
- Financing. Can the business grow without issuing new shares or taking on new debt? Is the capital structure conservative? Is management buying back stock when it is undervalued?
A great business produces durable cash flow because the answers to those five questions are in its favour. Strong fundamentals without a durable moat are a snapshot; strong fundamentals with a durable moat are a compounding machine.
Six principles for fundamental analysis
- Read all three statements. Weakness in one is usually being masked by the others.
- Prefer consistency over peaks — a stable 15% ROE beats a volatile 30%.
- Real cash flow matters more than accounting profit. FCF is the honest number.
- Two or more red flags is usually enough to step away, regardless of the story.
- Use the 12-metric checklist as a filter, not a formula — exceptions exist, but they must be understood.
- Fundamentals answer the "what". The business model answers the "why it continues".