Financial statements made simple: sales, profit and cash flow
Three documents tell a company's story: how much it sells and earns, what it owns and owes, and how much cash it really generates.
Fundamental analysis seeks to understand how much a company is worth based on its business: what it sells, what it earns, what it owes and what it can earn in the future. Its raw material is the financial statements, which public companies file every quarter and every year. There are three, and each answers a different question.
1. Income statement: how much does it sell and earn?
It shows a period's sales and everything subtracted on the way to profit. It's read from top to bottom:
| Line | What it is | Example (millions) |
|---|---|---|
| Sales (revenue) | What it charged for its products or services | 1,000 |
| − Cost of sales | What it cost to produce what it sold | −600 |
| = Gross profit | What's left after producing | 400 |
| − Operating expenses | Salaries, rent, marketing, research | −200 |
| = Operating profit | What the business itself earns | 200 |
| − Interest and taxes | The cost of its debt and what it pays in taxes | −80 |
| = Net income | What's left for shareholders | 120 |
Earnings per share (EPS) is net income divided by the number of shares. It's one of the figures the market watches most in every report.
2. Balance sheet: what does it own and owe?
It's a snapshot on one day: what the company owns (assets), what it owes (liabilities) and what's left for the owners (shareholders' equity).
Assets = Liabilities + Shareholders' equity
- Assets: cash, receivables, inventory, factories, patents.
- Liabilities: bank debt and bonds, payables to suppliers.
- Equity: what shareholders put in plus the profits kept in the company.
From the balance sheet comes net debt (debt minus cash), one of the most useful measures of financial risk.
3. Cash flow statement: how much money really comes in?
Accounting profit isn't the same as money in the bank: a sale on credit counts as a sale even if it hasn't been collected. The cash flow statement shows the real money coming in and going out, in three parts:
- Operating: the cash the business generates day to day.
- Investing: what it spends on factories, equipment or acquisitions (and what it receives if it sells assets).
- Financing: debt it takes on or repays, dividends and buybacks.
Free cash flow = operating cash flow − capital expenditures (capex)
Free cash flow is the money left over after the company maintains and grows its business. It's what it can use to pay dividends, buy back shares or reduce debt. Many people consider it the best measure of what a company generates for its owners.
Signs worth checking
| Sign | Why it matters |
|---|---|
| Sales growing year after year | The business has demand |
| Stable or rising margins | It has pricing power or controls its costs |
| Profit that turns into cash flow | Profits are real, not just on paper |
| Manageable net debt | It can survive a bad year |
| Stable or falling share count | It doesn't dilute its shareholders |
Test what you learned
1. Sales of 1,000, net income of 120. What's the net margin?
- 12%
- 40%
- 120%
Show the answer
12%. 120 ÷ 1,000 = 12%.
2. Which financial statement shows the real money coming in and going out?
- The balance sheet
- The cash flow statement
- The annual sustainability report
Show the answer
The cash flow statement. It separates operating, investing and financing.
3. How is free cash flow calculated?
- Sales − costs
- Operating cash flow − capital expenditures
- Assets − liabilities
Show the answer
Operating cash flow − capital expenditures. It's what's left after maintaining and growing the business.
Track your progress in ARCO
With a free account you save the lessons you finish, your streak and your achievements, and answer the question of the day.
Everything in this section is educational: it explains how investing works, it doesn't tell you what to buy.