Financial Statements

Financial Statements are the formal report cards of a business. Think of them as a structured story, told in numbers, that reveals a company's financial health, performance, and cash-generating ability. For a value investor, these documents are not just boring paperwork; they are the primary source of intelligence for conducting fundamental analysis. The “Big Three” financial statements are the Balance Sheet, the Income Statement, and the Cash Flow Statement. Together, they provide a panoramic view of a company's operations, allowing you to move beyond the stock price hype and understand the actual business you are considering buying into. Learning to read them is like learning the language of business, a non-negotiable skill for anyone serious about investing.

To truly understand a company, you need to look at its finances from different angles. The three core financial statements work together like a detective's kit, each tool revealing a different piece of the puzzle.

The Balance Sheet is a snapshot of a company's financial position on a single day, usually the end of a quarter or year. It tells you what the company owns and what it owes. It's governed by a simple, unshakable formula: Assets = Liabilities + Shareholder's Equity

• Assets are the resources the company owns (e.g., cash, factories, inventory).
• Liabilities are what the company owes to others (e.g., loans, supplier bills).
• Shareholder's Equity is what's left over for the owners (the shareholders). It represents the net worth of the company.

A healthy balance sheet typically shows that a company's assets are growing and that it isn't burdened by an excessive amount of debt.

The Income Statement (also known as the Profit and Loss Statement or P&L) is like a movie of the company's performance over a period of time (e.g., three months or one year). It shows whether the company made or lost money during that period. It starts at the top with Revenue (total sales) and then subtracts various costs and expenses to arrive at the famous “bottom line”: Net Income. Key checkpoints along the way include:

• Cost of Goods Sold (COGS): The direct costs of producing what the company sells.
• Gross Profit: Revenue minus COGS. It shows how efficiently the company makes its products.
• Operating Expenses: Costs not directly tied to production, like marketing, salaries, and research.
• Net Income: The final profit after all expenses, including taxes and interest, have been paid.

Investors look for consistent revenue growth and healthy, stable profit margins.

This might be the most important statement of all because profit is an opinion, but cash is a fact. A company can report a profit but still go bankrupt if it runs out of cash. The Cash Flow Statement (CFS) tracks the actual cash moving in and out of the company from three activities:

• Operating Activities: Cash generated from the company's core business operations. This should almost always be a positive number for a healthy company.
• Investing Activities: Cash used for or generated from investments, like buying new equipment or selling old assets.
• Financing Activities: Cash from investors or banks, such as issuing stock or taking on debt, as well as cash paid out, like dividends or debt repayments.

Astute investors pay special attention to Free Cash Flow (FCF), a key metric often derived from the CFS that shows the cash a company has left over after paying for its operating expenses and capital expenditures.

For a value investor, these statements are not just numbers; they are the foundation for making intelligent decisions.

As the legendary investor Warren Buffett has stated, accounting is the “language of business.” If you can't read the financial statements, you can't truly understand the company's competitive advantages, profitability, or financial stability. You'd be investing based on stories and speculation, not facts.

Financial statements are the raw material for calculating critical financial ratios that help you assess a company's valuation and health. These include:

• Price-to-Earnings Ratio (P/E): Compares the company's stock price to its earnings.
• Debt-to-Equity Ratio: Measures a company's financial leverage.
• Return on Equity (ROE): Shows how effectively management is using shareholders' money to generate profits.

By comparing these ratios over several years, you can spot positive trends (like improving profitability) or uncover red flags (like rising debt or shrinking cash flow).

While essential, financial statements should be read with a critical eye. They are prepared by company management, and although checked by auditors, they can sometimes be influenced by Earnings Management, where accounting rules are used to make performance look better than it is. Always, always read the footnotes to the financial statements. This is where companies disclose their accounting methods, detail their debt, and provide other crucial context that might not be obvious from the main numbers.