Financial Statements

Every equity research report starts with financial statements. Before you can form a view on a company's valuation or competitive position, you need to understand where it has been financially and where it is headed. The three statements — income statement, balance sheet, and cash flow statement — tell that story.

Analysts who read statements well can spot what others miss: a revenue line growing faster than cash collections, margins compressing before guidance reflects it, or debt quietly piling up off the headline numbers.

The income statement measures a company's financial performance over a period — a quarter or a year. It runs from revenue at the top to net income at the bottom.

• Revenue — Total sales. Watch for organic vs. acquired growth.
• Cost of Goods Sold (COGS) — Direct costs of producing goods or services. Revenue minus COGS equals Gross Profit.
• Gross Margin — Gross Profit ÷ Revenue. A key indicator of pricing power and business quality.
• Operating Expenses (OpEx) — SG&A, R&D, and other period costs. Gross Profit minus OpEx equals Operating Income (EBIT).
• EBITDA — Earnings Before Interest, Taxes, Depreciation, and Amortization. Widely used in valuation because it approximates cash profitability.
• Net Income — The bottom line after interest expense and taxes. Feeds into EPS.

The balance sheet is a snapshot of what a company owns and owes at a specific point in time. The fundamental equation is: Assets = Liabilities + Shareholders' Equity. This equation must always balance.

• Current Assets — Cash, accounts receivable, inventory. Expected to convert to cash within 12 months.
• Non-Current Assets — Property, plant & equipment (PP&E), intangibles, goodwill.
• Current Liabilities — Accounts payable, short-term debt, accrued expenses.
• Long-Term Debt — Bonds, loans, and other obligations due after 12 months.
• Shareholders' Equity — What's left for equity holders after all liabilities. Includes retained earnings.

Working capital (Current Assets minus Current Liabilities) tells you whether the business can meet its short-term obligations. Negative working capital is not always a red flag — retailers like Amazon collect cash before paying suppliers.

Cash is fact. Earnings are opinion. The cash flow statement shows actual cash movements and is the hardest statement to manipulate. It has three sections:

1. 1Operating Activities — Starts with net income, then adjusts for non-cash items (depreciation, amortization) and changes in working capital. This is the core earnings quality check.
2. 2Investing Activities — Capital expenditures (CapEx), acquisitions, asset sales. CapEx is critical for understanding reinvestment needs.
3. 3Financing Activities — Debt issuance or repayment, equity issuance, dividends, and buybacks.

• An increase in accounts receivable is a use of cash — customers owe more but haven't paid yet.
• An increase in accounts payable is a source of cash — the company owes suppliers but hasn't paid.
• D&A is added back to net income because it's a non-cash expense.

The three statements are deeply connected. Understanding the linkages lets you build and audit financial models.

• Net income flows from the income statement to the top of the cash flow statement (operating section) and increases retained earnings on the balance sheet.
• CapEx from the cash flow statement increases PP&E on the balance sheet.
• Depreciation reduces PP&E on the balance sheet and is an expense on the income statement.
• Debt raised in the financing section increases the debt balance on the balance sheet.
• Ending cash on the cash flow statement equals the cash balance on the balance sheet.