Reading Financial Statements

The Three Core Statements

Every publicly traded company must file three financial statements: the income statement, the balance sheet, and the cash flow statement. Together, they tell the complete story of a company's financial health.

The income statement shows profitability. The balance sheet shows what the company owns and owes. The cash flow statement shows actual money movement. Understanding all three gives you a true picture that relying on earnings alone cannot provide.

The Income Statement: Profitability

The income statement reports revenues, expenses, and net income over a period (usually a quarter or year). It answers the question: Is the company profitable, and by how much?

Look beyond just net income. Examine gross margin (revenue minus cost of goods sold) and operating margin (profit from core business). A company might be profitable overall but losing money on its main operations—a warning sign.

The Balance Sheet: Assets and Liabilities

The balance sheet is a snapshot at a specific date. It shows what the company owns (assets), what it owes (liabilities), and the difference (shareholder equity). A strong balance sheet means the company can weather downturns.

Pay attention to the ratio of debt to equity. A company with excessive debt is riskier, especially during recessions when revenues decline. Benjamin Graham advocated for companies with manageable leverage.

The Cash Flow Statement: Reality Check

Earnings can be manipulated through accounting, but cash doesn't lie. The cash flow statement shows whether the company actually collected cash from customers and how it spent that cash.

A company can be profitable on paper but burning cash. Conversely, a company might report low earnings but generate significant free cash flow. Always analyze both.