Understanding Company Financials
Fundamental analysis involves evaluating a company's financial health to determine if a stock is undervalued or overvalued. The three main financial statements—Income Statement, Balance Sheet, and Cash Flow Statement—are your primary tools for understanding how a company makes money, what it owns and owes, and how cash flows through the business. Mastering these statements is essential for long-term investing success.
The Three Financial Statements
📊 Income Statement (P&L)
What it shows: Revenue, expenses, and profit over a period (quarter or year)
Key question: Is the company profitable? Is profit growing?
Think of it as: The company's report card for the period
📋 Balance Sheet
What it shows: Assets, liabilities, and equity at a specific point in time
Key question: Is the company financially healthy? Can it pay its debts?
Think of it as: A snapshot of everything the company owns and owes
💵 Cash Flow Statement
What it shows: Cash coming in and going out from operations, investing, and financing
Key question: Does the company generate real cash? Where does it come from?
Think of it as: Following the actual money (profits can be manipulated; cash flow is harder to fake)
Income Statement Deep Dive
The Income Statement shows how revenue flows down to profit through various expenses:
📈 Margin Analysis
| Margin Type | Formula | What It Tells You | Good Range |
|---|---|---|---|
| Gross Margin | Gross Profit / Revenue | Pricing power, production efficiency | 30-70% (varies by industry) |
| Operating Margin | Operating Income / Revenue | Core business profitability | 15-25%+ is strong |
| Net Margin | Net Income / Revenue | Overall profitability | 10-20%+ is healthy |
Balance Sheet Deep Dive
The Balance Sheet follows a fundamental equation:
Assets = Liabilities + Shareholders' Equity
📦 Assets (What the company OWNS)
Current Assets (can convert to cash within 1 year):
- Cash & equivalents: Actual cash and short-term investments
- Accounts receivable: Money owed by customers
- Inventory: Products waiting to be sold
- Prepaid expenses: Already paid for future services
Non-Current Assets (long-term):
- Property, Plant & Equipment (PP&E): Buildings, machinery, land
- Intangible assets: Patents, trademarks, software
- Goodwill: Premium paid for acquisitions
- Long-term investments: Stakes in other companies
💳 Liabilities (What the company OWES)
Current Liabilities (due within 1 year):
- Accounts payable: Money owed to suppliers
- Short-term debt: Loans due soon
- Accrued expenses: Expenses incurred but not yet paid
- Deferred revenue: Payment received for not-yet-delivered products
Non-Current Liabilities:
- Long-term debt: Bonds, loans due in 1+ years
- Pension obligations: Future retirement payments
- Lease obligations: Long-term lease commitments
💰 Shareholders' Equity (Net Worth)
What's left for shareholders after subtracting liabilities from assets:
- Common stock: Par value of shares issued
- Additional paid-in capital: Money raised above par value
- Retained earnings: Accumulated profits kept in business
- Treasury stock: Shares the company has bought back (negative)
Cash Flow Statement Deep Dive
The Cash Flow Statement tracks actual cash movement in three categories:
🏭 Operating Cash Flow (CFO)
Cash generated from the company's core business operations. THE MOST IMPORTANT number.
Starts with Net Income, then adjusts for non-cash items:
- + Depreciation & amortization (non-cash expense added back)
- +/- Changes in working capital (inventory, receivables, payables)
- +/- Other non-cash adjustments
Healthy sign: Operating cash flow > Net Income (earnings are backed by real cash)
🔧 Investing Cash Flow (CFI)
Cash spent or received from investments and capital expenditures:
- - Capital expenditures (CapEx): Buying equipment, property
- +/- Acquisitions or sales of businesses
- +/- Purchases or sales of investments
Usually negative: Growing companies invest in their future
🏦 Financing Cash Flow (CFF)
Cash from financing activities:
- +/- Debt issued or repaid
- +/- Stock issued or bought back
- - Dividends paid to shareholders
💎 Free Cash Flow (FCF) - The Golden Metric
Free Cash Flow = Operating Cash Flow - Capital Expenditures
FCF represents the cash a company can use for:
- Paying dividends
- Buying back shares
- Paying down debt
- Making acquisitions
- Building cash reserves
A company with growing FCF is generating real value for shareholders.
Key Financial Metrics
EPS (Earnings Per Share)
Formula: Net Income ÷ Shares Outstanding
Profit attributed to each share. Higher = better.
Watch: Diluted EPS (includes stock options effect)
P/E Ratio
Formula: Stock Price ÷ EPS
How much you pay for each $1 of earnings.
Lower might mean undervalued; higher = growth expected
ROE (Return on Equity)
Formula: Net Income ÷ Shareholders' Equity
How efficiently the company uses investor money.
15%+ is good, 20%+ is excellent
ROA (Return on Assets)
Formula: Net Income ÷ Total Assets
How efficiently assets generate profit.
5%+ is good, varies by industry
Debt-to-Equity
Formula: Total Debt ÷ Shareholders' Equity
How leveraged the company is.
<1 is conservative, >2 is highly leveraged
Current Ratio
Formula: Current Assets ÷ Current Liabilities
Can the company pay short-term obligations?
>1.5 is healthy, <1 is risky
Quick Ratio
Formula: (Current Assets - Inventory) ÷ Current Liabilities
Like current ratio but excludes hard-to-sell inventory.
>1 is healthy
Interest Coverage
Formula: EBIT ÷ Interest Expense
Can the company afford its debt payments?
>3 is safe, <1.5 is dangerous
Where to Find Financial Statements
| Source | Description | Best For |
|---|---|---|
| Company IR Website | Investor Relations page with official filings | Most authoritative source |
| SEC EDGAR | Official US filings database | 10-K (annual), 10-Q (quarterly), 8-K (events) |
| Yahoo Finance | Free, easy-to-read summaries | Quick overview, comparison |
| Finviz | Stock screener with key metrics | Finding stocks meeting criteria |
| Seeking Alpha | Analysis and earnings call transcripts | Understanding management commentary |
| Morningstar | Detailed financials and ratings | Historical data, analysis |
Red Flags in Financial Statements
🚩 Warning Signs to Watch
- Revenue growing, net income declining: Costs out of control or declining margins
- Earnings growing, free cash flow declining: Accounting manipulation or capital-intensive business
- Debt increasing faster than revenue: Unsustainable leverage
- Receivables growing faster than revenue: Customers not paying, possible fake revenue
- Inventory growing faster than revenue: Products not selling, potential writedowns
- Frequent "one-time" charges: May be recurring problems disguised
- Related-party transactions: Potential conflicts of interest
- Auditor changes or qualifications: Serious accounting concerns
- CFO/CEO leaving suddenly: Rats leaving a sinking ship?
- Aggressive revenue recognition: Booking revenue before delivery
Comparing Financial Statements
💡 Analysis Best Practices
- Compare to history: Look at 3-5 years of trends, not just one quarter
- Compare to peers: A 10% margin is great in retail but poor in software
- Read management commentary: Earnings calls and MD&A sections explain the numbers
- Look at multiple metrics: No single number tells the whole story
- Focus on cash flow: Harder to manipulate than earnings
- Understand the business model: Numbers make more sense in context
Key Takeaways
- Income Statement shows profitability over time—watch revenue growth and margin trends
- Balance Sheet shows financial position at a point in time—Assets = Liabilities + Equity
- Cash Flow Statement shows actual cash movements—hardest to manipulate
- Free Cash Flow (Operating CF - CapEx) is the "golden metric" for value creation
- Key ratios: ROE (15%+ good), Debt-to-Equity (<1 conservative), Current Ratio (>1.5 healthy)
- Compare companies to their history, peers, and industry averages
- Watch for red flags: earnings without cash flow, fast-growing debt, auditor changes
- Always read management commentary to understand the story behind the numbers