Reading Financial Statements

Income statement

Covers a period of time. Revenue at the top, costs subtracted along the way, profit at the bottom. Key lines: revenue, gross profit, operating income, net income and earnings per share.

Revenue is sales the company has recognised under accounting rules — not cash collected. Hypothetical example: a company delivers $100 of goods on credit and has collected $0 by year end. The income statement shows $100 of revenue; the balance sheet shows a $100 accounts receivable (money owed by the customer); the cash flow statement shows $0 of cash from that sale.

Margins matter more than absolute numbers: gross margin shows pricing power, operating margin shows operational discipline.

Balance sheet

A snapshot at a single date. Assets equal liabilities plus equity. Liabilities are obligations the company owes — not only borrowed money. Debt is one kind (a loan to repay with interest); accounts payable is another (bills owed to suppliers for goods already received); others include taxes owed, deferred revenue and lease obligations.

The equation always balances, so it proves nothing about health. Positive equity does not prove a company can pay its bills on time (liquidity) or meet its obligations over time (solvency). Look at cash, the timing of debt and whether short-term obligations are comfortably covered.

Debt is not automatically bad. Debt that requires perfect conditions to service is.

Cash flow statement

Tracks actual cash moving in and out in three sections: operating activities (cash from running the business), investing activities (buying or selling equipment, businesses and investments) and financing activities (borrowing, repaying debt, issuing or buying back shares, paying dividends). Most companies use the indirect method, so the operating section often begins with net income and then adjusts for non-cash items and changes in working capital.

Free cash flow is commonly defined as operating cash flow minus capital expenditure. It is not a standardised GAAP line — companies and data providers define it differently — and it is not cash guaranteed to be available for shareholders after every obligation, such as debt repayments.

Profit involves accounting judgement. Cash is harder to manufacture, which is why experienced investors read this statement first.

Revenue, earnings and cash flow are three different questions

Revenue answers: how much the company earned from delivering goods or services in the period, recognised when it satisfies its obligations to customers — which is not the same as the cash customers paid in that period (payments can arrive earlier, as deferred revenue, or later, as receivables). Earnings (net income) answers: what was left after every cost, including non-cash accounting items like depreciation. Free cash flow answers: how much actual cash was generated after the spending needed to keep the business running.

A company can grow revenue while earnings shrink, if costs are rising faster than sales. It can also report positive earnings while free cash flow is negative, if profit relies on non-cash items or if capital spending is heavy. None of these patterns is automatically bad, but each demands an explanation before you move on.