What are financial statements?

A US public company’s annual report on Form 10-K contains its audited financial statements: the income statement (also called the statement of operations or statement of earnings), the balance sheet, the statement of cash flows and the statement of stockholders’ equity, followed by notes that explain the numbers. US companies prepare them under Generally Accepted Accounting Principles (GAAP).

Each statement answers one question, and none is enough alone: profit without cash, or cash built on growing debt, tells a different story than either number suggests. Together they are the raw material of fundamental analysis.

  • Income statement: did the company make money over the period?
  • Balance sheet: what does it own and owe on the last day of the period?
  • Cash flow statement: where did the cash come from and where did it go?
  • Notes: how were the numbers built? Accounting choices, debt terms and one-off items live here.

How to read an income statement

Read it from the top down, as the drawing shows. Company A’s hypothetical year, in millions of dollars:

Then compare: with last year, with the same quarter a year earlier for quarterly reports, and with direct rivals. Revenue up 10% while gross margin slides from 40% to 34% means growth is being bought with lower prices or higher costs. Watch for one-off items, such as a gain on selling a building, that lift net income once and will not repeat. Revenue and EPS rising together with steady margins is the pattern the growth investing guide looks for.

  • Revenue (sales): 1,000.
  • Cost of sales −600 → gross profit 400, a 40% gross margin.
  • Operating costs (research, selling, administration) −250 → operating profit 150, a 15% operating margin.
  • Interest −20 and income tax −30 → net income 100, a 10% net margin.
  • Net income ÷ 50 million weighted-average shares → earnings per share (EPS) of $2.00.

Turn your phone sideways to read the drawing. Tap to close.

A hand-drawn waterfall from left to right: a green revenue bar, a red step down for cost of sales, the gross profit bar, a red step for operating costs, the operating profit bar, a red step for interest and tax, and a green net income bar; a note reads ÷ shares = EPS.

How to read a balance sheet

The balance sheet is a photo on one date, and it always balances: assets = liabilities + shareholders’ equity, the scale in the drawing at the top. Equity is what would be left for shareholders if every asset were sold at its book value and every liability paid.

Company A at year-end, hypothetical, in millions:

Three quick checks. Working capital = current assets − current liabilities = 200, so short-term bills are covered twice over. Debt-to-equity = total liabilities ÷ equity = 0.82 (or 0.55 counting only the 300 of borrowings). Receivables and inventory should grow roughly in line with revenue; if receivables jump far faster, customers may be paying slowly.

  • Current assets 400 (cash 150, receivables 120, inventory 130) + property and equipment 500 + other assets 100 = total assets 1,000.
  • Current liabilities 200 (payables 150, short-term debt 50) + long-term debt 250 = total liabilities 450.
  • Shareholders’ equity = 1,000 − 450 = 550.

How to read a cash flow statement

The cash flow statement starts from net income and adjusts it to the cash that actually moved, in three parts, as in the drawing:

Free cash flow, commonly operating cash flow minus capex, is 120 − 70 = 50 million, enough to cover the 30 million of dividends with room to spare. Accounting rules do not define free cash flow, so check how each company calculates it.

Now the warning case. Hypothetical Company B reports the same net income of 100, but its receivables rose by 120 because it sold on long credit terms. Its operating cash flow is only about 20, below its capex, so it may need to borrow to pay its dividend. Same profit, very different business: profit is not cash.

  • Operating: net income 100 + depreciation 40 (a cost that used no cash this year) − 20 more receivables − 10 more inventory + 10 more payables = 120.
  • Investing: capital expenditures (capex) on equipment −70.
  • Financing: dividends −30 and debt repaid −10 = −40.
  • Net change in cash: 120 − 70 − 40 = +10, which is why cash on the balance sheet rose from 140 to 150.

Turn your phone sideways to read the drawing. Tap to close.

Three hand-drawn streams flow into a box labeled cash: operating, a big green arrow in; investing, a red arrow out labeled capex; financing, an arrow out labeled dividends, debt repaid; a note reads profit is not cash.

How the three statements fit together

The statements are linked. Net income from the income statement is the first line of the cash flow statement. Profit kept after dividends (100 − 30 = 70) adds to retained earnings, part of equity on the balance sheet. The net change in cash (+10) explains the move in the balance sheet’s cash line. If a number does not tie, read the notes.

A reading order for a quick first pass:

  1. Revenue and its growth over three years.
  2. Gross, operating and net margins: rising, stable or falling?
  3. Operating cash flow against net income over several years.
  4. Debt, cash and working capital on the balance sheet.
  5. Free cash flow against dividends and buybacks.
  6. The notes and management’s discussion and analysis (MD&A) for anything that changed.

Where to find financial statements: 10-K, 10-Q and earnings releases

US companies file an annual report on Form 10-K, which includes audited financial statements, and a quarterly report on Form 10-Q, with unaudited statements, for each of the first three fiscal quarters. All of them are free on the SEC’s EDGAR database, and most companies also post them on their investor relations pages.

Inside a 10-K, Item 1A lists the main risk factors, Item 7 is management’s discussion and analysis (MD&A), and Item 8 holds the audited statements and the auditor’s report. Results usually reach the market first in an earnings press release, often attached to a Form 8-K, before the full report.

Each quarter, the market compares reported EPS with analysts’ average estimate, as the drawing shows: a beat when actual EPS comes in above it, a miss when it comes in below. A stock can still fall after a beat if the company’s outlook disappoints; the earnings season guide explains why.

Turn your phone sideways to read the drawing. Tap to close.

Four quarters, Q1 to Q4, each with a grey outline bar for the estimate and a filled bar for actual EPS: Q1, Q2 and Q4 are marked beat in green, and Q3 is marked miss in red.

Red flags in financial statements

No single item proves trouble, but each is a reason to read the notes before you buy:

A clean report is not a buy signal either: strong statements can come with a price that already assumes years of growth. Pair the numbers with valuation, as in the P/E ratio guide, and if you buy for income, check dividend coverage as in dividend investing.

  • Net income rising while operating cash flow falls, year after year.
  • Receivables or inventory growing much faster than revenue.
  • Debt rising faster than operating profit, or interest eating a growing share of it.
  • Dividends or buybacks larger than free cash flow, paid for with new debt.
  • Heavy reliance on “adjusted” (non-GAAP) figures; companies must show how they differ from the GAAP numbers, so compare both.
  • A qualified opinion or a disclaimer of opinion from the auditor, a restatement of past results, or a change of auditor.
  • A share count that rises every year, diluting EPS.