Financial Statements: Building Blocks for Level-Headed Investing
Understanding the key financial reports companies publish and how they help level-headed investors to evaluate investments
“Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: they invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.”
— Warren Buffett, chairman of Berkshire Hathaway, Shareholder Letter, 1986
This quote from Warren Buffett captures the essence of why financial statements are indispensable in business evaluation and investing. Accounting numbers (revenue, expenses, assets, liabilities, etc.) are the building blocks that help investors understand the financial landscape of a company. Yet, as Buffett and his lifelong business partner Charlie Munger remind us, these numbers are only a starting point. Financial statements provide valuable insights, but they don’t tell the full story; interpreting them requires context and a critical mindset.
For investors, financial statements are tools to analyze a company’s past and current performance and, together with a realistic narrative, its future potential. They form the groundwork for understanding profitability, stability, and growth over time. However, while accounting metrics can quantify performance, the qualitative aspects, like business strategy, market position, and competitive advantage, are equally critical in forming a comprehensive thesis on a business and its future prospects.
What Are Financial Statements?
Financial statements are official records that provide insight into a company’s financial performance over a specific period, such as a quarter or a year. There are three main types of financial statements, each serving a unique purpose:
Income Statement: Also known as the Profit and Loss (P&L) statement, it shows a company’s revenue, expenses, and profit (or loss) for a period. It reveals how much a company earned from its operations, how much it spent, and its overall profitability.
Balance Sheet: This statement provides a snapshot of a company’s financial position at a specific point in time. It lists assets (what the company owns), liabilities (what the company owes), and shareholders’ equity (the net worth of the company). The balance sheet reflects the company’s financial health and stability.
Cash Flow Statement: This report details the flow of cash in and out of a business. It breaks down cash flow into three categories: operating activities (core business operations), investing activities (purchase and sale of assets), and financing activities (debt, dividends, and stock issuance). Cash flow is crucial as it shows the company’s liquidity, its ability to generate cash to pay its bills, invest, and return money to shareholders.
These three statements together provide a comprehensive view of a company’s operations, financial health, and cash generation.
Why Do Companies Publish Financial Statements?
Financial statements are essential for transparency and accountability. They allow investors, financial analysts, market commentators and the public to understand how a company operates and performs financially. Here’s why companies publish these statements:
Investor information: Financial statements give investors the information they need to assess a company’s past and current profitability, stability, and growth.
Transparency and accountability: By sharing their financial performance, companies build trust with shareholders and the public. Financial statements provide a standardized, detailed view that allows comparison across companies and industries.
Regulatory compliance: Publicly listed companies traded on stock exchanges must follow strict regulations, which require them to disclose financial performance. These requirements help protect investors and maintain the integrity of financial markets.
Informed decision-making: Management can use financial statements internally to make strategic decisions. Financial information helps management plan for the future, allocate resources, and assess areas for improvement.
When Are Financial Statements Published?
The frequency of financial statement publication depends on the country and stock exchange where a company is listed.
Companies listed on U.S. stock exchanges like the New York Stock Exchange (NYSE) and Nasdaq are required by the Securities and Exchange Commission (SEC) to publish financial reports quarterly and annually. These reports are called 10-Q (quarterly) and 10-K (annual) filings and must be submitted on specific dates. The quarterly reports provide updates, while the annual report gives a full year’s summary and is more comprehensive.
Companies listed on European exchanges generally follow International Financial Reporting Standards (IFRS) and are often required to publish financial statements semiannually and annually. Some exchanges may require additional quarterly updates, but the semiannual reporting aligns with European standards for transparency and comparability.
In both the U.S. and Europe, annual reports are audited by an independent auditor to ensure accuracy and reliability, while quarterly or semiannual reports may be reviewed but not fully audited.
Where to Access Financial Statements
For public listed companies, financial statements are readily available to the public, providing transparency for investors and analysts. Here’s how to access them:
Company websites: Most companies publish their financial statements in the Investor Relations section, including annual and quarterly reports.
Stock exchange websites: Major exchanges like the NYSE and Nasdaq in the U.S., or Euronext and London Stock Exchange (LSE) in Europe, often have links to recent filings.
Regulatory databases: In the U.S. you can access quarterly (10-Q) and annual (10-K) reports on the SEC EDGAR database, whereas in Europe reports are available through national regulators (e.g. FCA in the U.K., AMF in France) in line with IFRS standards.
Financial platforms: Sites like Yahoo! Finance provide summaries of financial statements, news and financial analysts forecasts. Great platforms to consume and review financial statements data in a structured format are Stock Unlock and FinChat.
These sources provide convenient ways to find up-to-date information, whether you’re looking for comprehensive reports or a quick overview of a company’s financial health. Accessing these statements regularly is an important part of becoming an informed investor.
Accounting Standards: GAAP and IFRS
North American and European companies follow different accounting standards, although both aim to ensure transparency, consistency, and comparability.
Generally Accepted Accounting Principles (GAAP): In the U.S., publicly traded companies must prepare financial statements according to GAAP. Developed by the Financial Accounting Standards Board (FASB), GAAP is a set of standardized accounting guidelines for revenue recognition, and expense matching. GAAP mandates the use of accrual accounting rather than cash accounting. This approach records revenues when earned and expenses when incurred, regardless of when cash transactions occur. GAAP is known for being rule-based, providing specific guidelines on many aspects of financial reporting.
International Financial Reporting Standards (IFRS): European-listed companies follow IFRS, set by the International Accounting Standards Board (IASB). Like GAAP, IFRS requires the use of accrual accounting. This aligns financial reporting across different industries and countries. IFRS is used in over 160 countries, including the European Union, and is known for being principle-based, offering more flexibility in interpretation while promoting global comparability.
These standards are in place to ensure that financial statements provide a true and fair view of a company’s performance. They help investors compare companies across different regions and sectors by creating a uniform language for financial reporting.
Using Financial Statements as Part of Investment Decisions
Here’s how each statement can be useful:
Income Statement: Investors look at metrics like revenue growth, gross and profit margins, and net income to evaluate profitability and operational efficiency. This statement provides insight into how effectively a company generates earnings from its core business.
I dissect the income statement and highlights the key insights investors can gain, from understanding revenue growth to spotting red flags in expenses.
I explore the often-overlooked non-operating activities, interest expenses and tax obligations items of the income statement.
Balance Sheet: The balance sheet helps investors assess a company’s financial strength. Key figures include total assets, total liabilities, and shareholders’ equity. For example, a high level of debt compared to assets may signal financial risk, while a strong equity base indicates stability.
Cash Flow Statement: Investors use it to understand a company’s cash generation. Positive cash flow from operations shows that a company is capable of supporting its operations, reinvesting in growth, or returning capital to shareholders. A strong cash flow is essential for long-term durability.
Financial statements provide a solid quantitative foundation, offering essential insights into a company’s past performance, cash flow, and current financial position. However, level-headed investors recognize that these numbers are only one piece of the puzzle. To make sound investment decisions, financial data should be viewed alongside the broader business context, industry conditions, competitive positioning, and intrinsic value.
Using financials in companies’ valuation helps investors estimate a company’s intrinsic value and compare it to its stock price, which can reveal potential investment opportunities. This approach aligns with the principles of quality investing: combining disciplined financial analysis with a thoughtful understanding of the company’s qualitative factors. By integrating both perspectives, level-headed investors can build a well-rounded, insightful view of a company’s long-term potential and make decisions rooted in both factual analysis and strategic foresight.
Interrelationships Between Statements
Financial statements are interconnected, each providing context and detail that complements the others. By examining these interrelationships, investors can identify patterns, validate reported figures, and assess how effectively a company uses its resources to support both immediate returns and future growth. Understanding these relationships helps level-headed investors form a holistic view of a company’s financial health, resource allocation, and long-term value creation. This comprehensive analysis enables investors to spot potential discrepancies and make informed evaluations of a company’s overall stability and strategy over time.
Here are some examples of how each statement interacts with the others to provide a fuller picture of a business.
Revenue, Net Income, and Cash Flow
Revenue and net income appear on the Income Statement, showing how much a company earned in a given period and its profitability. However, the Cash Flow Statement is necessary to understand how much of this revenue actually translated into cash. The distinction between a company’s reported earnings and actual cash earnings, also known as cash conversion ratio, is crucial because, at times, a company may report high net income, yet may not be generating real cash flow, potentially signaling financial trouble.
A company can report high net income while generating little to no cash if it’s heavily reliant on credit sales, or if its working capital requirements (e.g. inventory buildup) consume cash. For example, an increase in accounts receivable (sales made on credit) will boost revenue but won’t increase cash until customers pay.
By comparing a company’s free cash flow with its reported earnings, investors can assess the quality of earnings and determine whether the revenue is truly cash-generative. A close alignment between the two is generally a positive indicator (high cash conversion ratio). If there’s a significant disparity, it can be a red flag, prompting investors to investigate further to understand the source of the discrepancy in the company’s profits.
Net Income and Retained Earnings
Net income from the Income Statement flows directly into the Balance Sheet’s Retained earnings.
Retained earnings are the accumulated profits that a company has kept within the business over time instead of distributing them to shareholders as dividends. This figure reflects the company’s financial resilience and the amount it has saved for reinvestment. When a company makes a profit, it has two main choices: pay a portion to shareholders as dividends or retain it for future needs. The profits that are kept rather than distributed form the retained earnings balance.
Companies typically use retained earnings to fund growth projects, invest in research & development, repay debt, acquire other businesses, or support other strategic investments. By retaining profits, a company strengthens its financial base and enhances its long-term value.
In essence, retained earnings are the profits reinvested back into the company, representing accumulated earnings that haven’t been paid out to shareholders. This balance provides insight into the company’s financial health and its ability to support future growth.
The connection between net income and retained earnings helps investors track whether a company is using its profits to fund growth, reduce debt, or accumulate cash reserves.
Depreciation and Asset Values
Depreciation, recorded as an expense on the Income Statement under Operating Expenses (often within Selling, General, and Administrative expenses), represents the gradual reduction in value of fixed assets due to wear, usage, or obsolescence. This expense is linked to the Balance Sheet by reducing the book value of Property, Plant, and Equipment (PP&E). Depreciation allocates the cost of long-term assets over their useful life, matching expenses with the revenue they generate.
On the Cash Flow Statement, depreciation is added back to Net Income in the Cash Flow from Operations section because it is a non-cash expense, meaning it reduces profit without affecting cash flow. This adjustment helps show the true cash-generating capacity of operations, clarifying that while depreciation lowers reported earnings, it doesn’t impact cash reserves.
Depreciation also reduces taxable income, providing a tax benefit that can improve cash flow. Understanding how depreciation flows across financial statements helps investors evaluate the quality of earnings, distinguish cash versus non-cash expenses, and assess financial sustainability.
Capital Expenditures and Long-Term Assets
The Cash Flow Statement details Capital Expenditures (CapEx) under Cash From Investing Activities, showing cash outflows used to acquire or improve long-term assets like buildings, machinery, and technology. CapEx investments increase the company’s asset base, supporting both current operations and future growth by enhancing its revenue-generating capacity.
Unlike regular expenses, CapEx isn’t immediately recorded on the Income Statement. Instead, it appears as an outflow on the cash flow statement and adds to Property, Plant, and Equipment (PP&E) on the Balance Sheet. As these assets are used, their value is gradually reduced on the balance sheet through depreciation, a non-cash expense that lowers reported earnings without impacting cash flow directly.
CapEx is a critical component in calculating Free Cash Flow (FCF), where it’s subtracted from Operating Cash Flow to show the cash available for dividends, share buybacks, or reinvestment. Distinguishing between maintenance CapEx (for existing assets) and growth CapEx (for expansion) helps investors understand how a company is allocating cash. Consistent CapEx spending often signals commitment to growth, while minimal CapEx may indicate stagnation.
By examining CapEx across the Cash Flow Statement, Balance Sheet, and Income Statement, level-headed investors can assess a company’s reinvestment strategy, asset management, and long-term value creation, gaining insight into its overall financial health and potential for shareholder returns.
Debt Payments and Interest Expense
Debt and interest payments create an important link between the Balance Sheet, Income Statement, and Cash Flow Statement. When a company takes on debt, it’s recorded as a liability on the balance sheet, increasing both the company’s total liabilities and available cash, which may be used to finance operations, expansions, or other investments.
Each period, the company incurs interest expenses on this debt, recorded on the income statement under Operating Expenses. Interest expense reduces net income, impacting profitability. In addition to interest, the company also makes principal repayments on the debt, which appear on the Cash Flow Statement under Cash From Financing Activities. These repayments decrease both the cash balance and the debt liability on the balance sheet over time, reducing the company’s leverage.
This interconnected flow provides a full picture of how debt obligations affect a company’s financial health. By analyzing interest expenses on the income statement, debt levels on the balance sheet, and cash outflows on the cash flow statement, investors can gauge the impact of debt on profitability, cash reserves, and overall stability. High debt levels or rising interest costs can be red flags, potentially straining cash flow and limiting financial flexibility, while manageable debt levels may support growth initiatives without compromising financial health.
Dividends and Shareholders’ Equity
When a company pays dividends, the cash outflow appears on the Cash Flow Statement under Cash From Financing Activities, as it represents a distribution of profits back to shareholders. This outflow reduces the company’s cash reserves, directly impacting its liquidity. Additionally, dividends are deducted from Retained earnings on the Balance Sheet because they are paid out from accumulated profits, reflecting a reduction in the company’s reinvested earnings.
Dividends provide insight into a company’s capital allocation priorities. Companies with stable or growing dividend payouts may signal strong cash flow and a commitment to returning cash to shareholders, often attracting income-focused investors. Conversely, companies that retain earnings instead of paying dividends may be channeling funds into growth initiatives, like research, acquisitions, or debt reduction, with the aim of long-term value creation.
Understanding how dividends impact cash flow and retained earnings helps investors assess whether the company has reinvestment opportunities or has exhausted them and is instead distributing its profits to shareholders.
Real-World Examples of Financial Statements’ Analysis
To see how financial statements reveal important information about a company’s performance and financial health, let’s look at some real-world examples of how investors have analyzed specific companies. These examples illustrate how each financial statement provides unique insights and how understanding them collectively helps level-headed investors make informed decisions.
Income Statement: Amazon’s Reinvestment Strategy
Amazon (AMZN 0.00%↑) is a great example of a company that prioritizes long-term value creation (revenue growth and reinvestment) over short-term profitability, a choice reflected on its Income Statement. For years, Amazon’s income statement showed substantial revenue growth, but net income remained low because the company continually reinvested profits into new initiatives, like expanding its Amazon Prime membership program, developing its cloud computing offering, Amazon Web Services (AWS), investing heavily in expanding its fullfilment centres and logistics network, and, more recently, building capacity in AWS to meet future demand for Generative AI’s computation. Investors who analyze Amazon’s income statement over time can see the company’s focus on growth, and many value the company for its long-term potential despite thin profit margins have dominated headlines for many years. Today, AWS is one of Amazon’s most profitable segments, Amazon Prime membership’s churn rate is low and forms a reliable source of profits, and its logistics improvements allow to serve with 1 or 2-days shipping millions of people worldwide, validating its reinvestment strategy.
Balance Sheet: Tesla’s Debt and Asset Management
Tesla’s (TSLA 0.00%↑) Balance Sheet provides a case study in the management of debt during a high-growth phase. In its early days, Tesla took on significant debt to fund the development of electric vehicles, build manufacturing facilities, and expand production capacity. This debt showed up on Tesla’s balance sheet, increasing its liabilities relative to assets and equity. While high debt levels can be risky, some investors saw this as a calculated risk for a company with substantial growth potential. Over time, as Tesla’s vehicle sales and revenues grew, it strengthened its balance sheet by reducing debt and improving its asset base, validating its growth strategy and boosting investor confidence.
Cash Flow Statement: Apple’s Strong Cash Generation
Apple’s (AAPL 0.00%↑) Cash Flow Statement highlights the power of strong operational cash flow and its impact on shareholders’ returns. Apple consistently generates high cash flow from its core operations, reflecting the profitability of its products like the iPhone and its services. This surplus cash flow has allowed Apple to engage in shareholder-friendly activities, such as dividend payouts and stock buybacks. In recent years, Apple has returned billions to shareholders through and dividends buybacks, which not only boosts share value but also signals financial stability and confidence in future earnings. Investors who analyze Apple’s cash flow statement can see this reliable cash generation as a sign of resilience.
Interpreting Retained Earnings: Microsoft’s Steady Growth
Microsoft’s (MSFT 0.00%↑) Balance Sheet and Income Statement illustrate the role of retained earnings in financing long-term growth. For years, Microsoft has generated substantial profits and has retained a large portion of these earnings rather than distributing them as dividends. This strategy is evident on its balance sheet, where retained earnings have accumulated over time, allowing Microsoft to fund research & development, make strategic acquisitions, and strengthen its product portfolio. This accumulation and reinvestment of retained earnings has helped Microsoft transition successfully into cloud computing becoming the second largest cloud provider with Microsoft Azure, enhancing its growth prospects and supporting long-term shareholder value.
Conclusion
Financial statements are powerful tools that provide a clear window into a company’s financial health, offering essential data to assess past and current performance. However, they tell only part of the story. Level-headed investors combine this quantitative analysis with qualitative factors, like market positioning, industry conditions, and management acumen, to form a holistic view of a company’s value. By integrating both aspects, investors can make informed, balanced decisions and achieve a more complete understanding of a business’s true potential for sustainable growth.
In conclusion, an impactful and somewhat provocative citation from Warren Buffett from the Berkshire Hathaway, Shareholder Letter, 1996 has stayed with me:
“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.”
This quote from Warren Buffett underscores his belief that successful investing doesn’t require a complex understanding of academic finance concepts like beta, modern portfolio theory, or option pricing, topics often emphasized in business schools. Instead, Buffett suggests that the core skills for investors boil down to two essentials: understanding how to value a business and thinking critically about market prices.
By simplifying investment principles to valuing businesses and developing a rational perspective on market prices, Buffett makes the case that anyone can invest successfully, without getting lost in financial jargon.