Reading financial statements is the foundation of fundamental analysis. Understanding the income statement, balance sheet, and cash flow statement allows you to assess company health, identify risks, and make informed investment decisions.
The Three Core Statements
The income statement shows profitability over a period (quarter or year). The balance sheet shows financial position at a point in time. The cash flow statement shows actual cash movements. Together, these three statements provide a complete picture of company financial health. All three are interconnected—net income flows to the balance sheet as retained earnings, and cash changes appear on both cash flow statement and balance sheet.
Income Statement Deep Dive
Revenue (top line) represents total sales. Cost of goods sold (COGS) represents direct production costs. Gross profit equals revenue minus COGS. Operating expenses include SG&A, R&D, and depreciation. Operating income (EBIT) equals gross profit minus operating expenses. Interest and taxes are subtracted to reach net income (bottom line). Earnings per share divides net income by shares outstanding.
Key Income Statement Metrics
Gross margin (gross profit/revenue) measures pricing power and operational efficiency—higher is better. Operating margin (operating income/revenue) shows core business profitability. Net margin (net income/revenue) shows overall profitability. Look for consistent or improving margins over time. Declining margins signal competitive pressure or operational issues. Compare margins to industry peers for context.
Balance Sheet Deep Dive
Assets equal liabilities plus equity—this equation must always balance. Current assets include cash, receivables, and inventory convertible to cash within one year. Fixed assets include property, plant, equipment, and intangibles. Current liabilities include payables and short-term debt due within one year. Long-term liabilities include debt and pension obligations. Shareholder equity represents net worth.
Key Balance Sheet Metrics
Current ratio (current assets/current liabilities) measures short-term liquidity—above 1.5 is healthy. Debt-to-equity ratio measures leverage—below 0.5 is conservative, above 2.0 is risky. Return on equity (net income/shareholder equity) measures capital efficiency—above 15% is excellent. Book value per share (equity/shares outstanding) provides a baseline valuation metric.
Cash Flow Statement Deep Dive
Operating cash flow shows cash generated from core business—this should be positive and growing. Investing cash flow shows capital expenditures and acquisitions—typically negative. Financing cash flow shows dividends, buybacks, and debt changes. Free cash flow (operating cash flow minus capital expenditures) represents cash available to shareholders—the most important metric for valuation.
Why Cash Flow Matters Most
Earnings can be manipulated through accounting choices, but cash flow is objective reality. Companies with strong cash flow can fund growth, pay dividends, and weather downturns. Divergence between earnings and cash flow signals potential accounting issues. Free cash flow yield (free cash flow per share/stock price) above 5% suggests potential undervaluation.
Red Flags to Watch For
Declining revenue combined with growing receivables suggests aggressive revenue recognition. Rising inventory relative to sales indicates slowing demand. Frequent goodwill impairments signal overpaying for acquisitions. Negative or declining operating cash flow despite positive earnings indicates accounting manipulation. High debt combined with low cash raises bankruptcy risk.
Putting It Together
Compare current quarter/year to same period last year for apples-to-apples comparison. Look at 5-year trends to identify long-term patterns. Compare metrics to industry peers to assess relative position. Read the management discussion and footnotes for context. No single metric tells the whole story—analyze all three statements together.
Conclusion
Mastering financial statement analysis is a superpower for investors. While it takes practice to become proficient, the ability to independently assess company financial health provides enormous edge. Start with one company in an industry you understand. Read their last 8 quarters of financials and track key metrics. Within 3-6 months of consistent practice, financial statement analysis will become second nature.
Stock News Plus Editorial
Expert financial analysis and market insights from the Stock News Plus editorial team.