Reading Financial Statements

The Three Core Statements

Every public company is legally required to file a report with the SEC every quarter (the 10-Q) and every year (the 10-K). Buried inside are three documents that, read together, tell you almost everything about whether a business is actually healthy. This is the single most useful skill in this whole track — more useful than any formula later on — because every valuation model in Lesson 4 is just an opinion built on top of these three statements.

1. Income Statement (P&L)

This one answers the question everyone actually cares about first: did the company make money? It's a ladder, and each rung subtracts a different bucket of costs.

• Revenue — everything customers paid, before any costs are subtracted
• Cost of Goods Sold (COGS) — the direct cost of producing what got sold
• Gross Profit = Revenue − COGS
• Operating Expenses — R&D, sales, marketing, the overhead of just running the place
• EBIT (Operating Income) = Gross Profit − Operating Expenses
• EBITDA = EBIT + Depreciation + Amortization — a rough stand-in for "cash earnings," since D&A is an accounting charge, not money actually leaving the building
• Net Income = Revenue − everything: costs, taxes, interest, all of it

One ratio worth memorizing here is gross margin — Gross Profit divided by Revenue. A software company can clear 70%+ because serving one more user costs almost nothing. A grocery chain might live at 25%. That gap isn't an accident; it's telling you something structural about how each business actually makes money.

2. Balance Sheet

Where the income statement covers a period of time, the balance sheet is a photograph — what the company owns and owes at one specific moment. Everything on it has to balance around one equation:

Assets = Liabilities + Shareholders' Equity

Assets split into current (cash, receivables, inventory — things that turn into cash within a year) and long-term (buildings, equipment, goodwill, patents). Liabilities split the same way: current (bills coming due soon, short-term debt) and long-term (debt that's years out, pension obligations, deferred revenue).

Whatever's left after subtracting liabilities from assets belongs to shareholders — retained profits the company chose to keep rather than pay out, plus whatever cash came in from selling stock in the first place.

3. Cash Flow Statement

Net income is an opinion. It depends on accounting choices — when revenue gets recognized, how depreciation gets scheduled — that a company has real discretion over. Cash is much harder to fake, which is exactly why this third statement exists: it tracks money that actually moved.

• Operating cash flow — cash generated by the actual business. This is the section to read first. A healthy company produces this consistently, quarter after quarter.
• Investing cash flow — money spent on equipment, buildings, acquisitions. Usually negative for a company that's still growing, which is normal, not alarming.
• Financing cash flow — debt issued or repaid, stock issued, dividends and buybacks paid out.

How the Statements Connect

These three aren't independent — they're the same business described three different ways, and they check each other. Net income flows into retained earnings on the balance sheet. Depreciation gets subtracted on the income statement but added back on the cash flow statement, because it never actually left the bank account. Capex shows up as an outflow in investing activities and directly reduces free cash flow. A company reporting a healthy profit while its cash flow statement tells a completely different story is exactly the kind of thing these connections are built to expose.

Red Flags

• Net income rising faster than operating cash flow — a classic tell for earnings that were massaged rather than earned
• Receivables growing faster than revenue — customers are paying slower than they used to
• Inventory piling up faster than COGS — maybe demand isn't what the headline numbers claim
• Debt climbing with no matching growth in revenue
• Goodwill that dwarfs the rest of the balance sheet — often the fingerprint of an overpriced acquisition