Reading Financial Statements
How to understand a company's P&L, balance sheet, and cash flow · 18 min
The Three Core Statements
Every public company files quarterly (10-Q) and annual (10-K) reports with the SEC. Inside are three interconnected financial statements that together tell the complete story of a company's financial health. Learning to read them is the single most useful skill in fundamental investing.
1. Income Statement (P&L)
The income statement shows how much money a company made and spent over a period. Key line items:
- Revenue (Sales): Total money received from customers before any deductions
- Cost of Goods Sold (COGS): Direct costs of producing what was sold
- Gross Profit = Revenue − COGS
- Operating Expenses (OpEx): R&D, sales, marketing, G&A — the costs of running the business
- EBIT (Operating Income) = Gross Profit − OpEx
- EBITDA = EBIT + Depreciation + Amortization. Widely used because it removes non-cash charges and shows "cash earnings" from operations.
- Net Income = Revenue − all expenses − taxes − interest
Gross margin = Gross Profit / Revenue. A software company might have 70%+ gross margins (near-zero COGS per additional user). A grocery chain might have 25% gross margins. Margins reveal business model quality.
2. Balance Sheet
The balance sheet is a snapshot of what a company owns (assets) and owes (liabilities) at a single point in time. The fundamental equation:
Assets = Liabilities + Shareholders' Equity
Assets include:
- Current assets: cash, accounts receivable, inventory (can be converted to cash within a year)
- Long-term assets: property, plant & equipment (PP&E), goodwill, intangibles
Liabilities include:
- Current liabilities: accounts payable, short-term debt, accrued expenses
- Long-term liabilities: long-term debt, deferred revenue, pension obligations
Shareholders' equity is what's left for shareholders after subtracting all liabilities from assets. It includes retained earnings (cumulative profits kept in the business) and paid-in capital (from stock issuances).
3. Cash Flow Statement
Net income can be manipulated through accounting choices. Cash is harder to fake. The cash flow statement tracks actual cash in and out:
- Operating Cash Flow (OCF): Cash from core business operations. The most important section — start here. Good businesses generate consistently positive OCF.
- Investing Cash Flow: Cash spent on capital expenditures (buying equipment, buildings), acquisitions, or investments. Usually negative for growing companies.
- Financing Cash Flow: Cash from issuing/repaying debt, issuing stock, or paying dividends/buybacks.
Free Cash Flow (FCF) = Operating Cash Flow − Capital Expenditures. FCF is the cash available to return to shareholders or reinvest in the business. Many professional investors consider FCF the ultimate measure of business quality.
How the Statements Connect
The three statements are deeply interlinked. Net income flows into retained earnings on the balance sheet. Depreciation is added back in OCF (it's a non-cash expense). Capital expenditures appear in investing activities and reduce FCF. Changes in working capital (inventory, receivables) show up in operating cash flow. Understanding these connections prevents you from being fooled by companies that report profits but burn cash.
Red Flags to Watch For
- Net income growing faster than operating cash flow (possible earnings manipulation)
- Accounts receivable growing faster than revenue (collecting money slower)
- Inventory growing faster than COGS (demand may be weaker than reported)
- Rising debt without corresponding revenue growth
- Goodwill that's large relative to total assets (often from overpriced acquisitions)