How to read financial statements

The income statement tells you if the business is profitable. The balance sheet tells you what it owns and owes. The cash flow statement tells you where the money actually went. Read together, they answer almost every important investment question.

Why they matter

Every serious investment thesis eventually reduces to a claim about future cash flows. Financial statements are the historical record from which those forecasts are made. Skip them and you're speculating on price, not investing in a business.

The income statement

Shows revenue, expenses, and profit over a period (usually a quarter or year). Read top-to-bottom:

• Revenue (top line) — total sales.
• Cost of goods sold (COGS) — direct costs of producing what was sold.
• Gross profit — revenue minus COGS. Gross margin = gross profit ÷ revenue.
• Operating expenses — R&D, sales & marketing, general & administrative.
• Operating income — profit from the core business.
• Net income (bottom line) — profit after interest and taxes.

The balance sheet

A snapshot at a point in time. Follows the identity: Assets = Liabilities + Shareholders' Equity.

• Current assets — cash, receivables, inventory (turned to cash within a year).
• Non-current assets — property, equipment, goodwill, intangibles.
• Current liabilities — accounts payable, short-term debt (due within a year).
• Long-term liabilities — long-term debt, pension obligations.
• Shareholders' equity — what's left for owners after paying all debts.

The cash flow statement

Reconciles net income to actual cash. Three sections:

• Operating activities — cash generated by the core business.
• Investing activities — capital expenditure, acquisitions, asset sales.
• Financing activities — debt raised or repaid, dividends, buybacks, share issuance.

Reading them together