Financial Statement Analysis
Read balance sheets, income statements, and cash flows
1. The Three Financial Statements
Warren Buffett reads hundreds of financial statements each year. These three documents—Balance Sheet, Income Statement, and Cash Flow Statement—tell you everything about a company's financial health. Together, they reveal if a company is profitable, solvent, and generating real cash.
📊 Core Concept
Financial statements are like a medical checkup for companies. The Balance Sheet shows what you own and owe (snapshot in time). The Income Statement shows profits and losses (over a period). The Cash Flow Statementtracks actual cash moving in and out (the truth detector).
🔍 Interactive: Explore Each Statement
Balance Sheet: Snapshot of Wealth
2. Building an Income Statement
🏗️ Interactive: Adjust Company Performance
$100M
$40M
$15M
$12M
📈 Interactive: Industry Benchmarks
3. Balance Sheet Ratios
📚 Understanding the Balance Sheet
The balance sheet is a snapshot of a company's financial position at a specific moment in time. Think of it as a photograph of everything the company owns (assets), everything it owes (liabilities), and what's left over for shareholders (equity). Unlike the income statement which shows performance over a period, the balance sheet captures a single point in time—typically the last day of a quarter or fiscal year.
The Fundamental Accounting Equation
This equation ALWAYS balances. That's why it's called a balance sheet.
Every transaction affects at least two accounts, keeping the equation balanced. Buy equipment for $100K cash? Assets stay the same (+$100K equipment, -$100K cash). Borrow $50K? Assets up $50K (cash), liabilities up $50K (loan). Issue $1M in stock? Assets up $1M (cash), equity up $1M (shareholders' equity). The equation never breaks.
Assets: What the Company Owns
Assets are resources that provide economic value. They're listed in order of liquidity (how quickly they can be converted to cash). The split between current and non-current assets tells you about the company's operations and capital intensity.
Asset mix varies by industry: Software companies (Adobe, Microsoft) have 60-80% current assets—mostly cash and receivables, minimal PP&E. Manufacturing companies (Ford, Boeing) have 40-60% fixed assets—factories, equipment, plants. Retailers (Walmart, Target) have high inventory but low PP&E (they lease stores). Banks (JPMorgan) have 90%+ financial assets (loans, securities).
Liabilities: What the Company Owes
Liabilities represent obligations to pay cash or provide services in the future. Like assets, they're split into current (due within 12 months) and long-term. The ratio between these categories reveals financial stress and debt maturity schedules.
Watch current liabilities vs current assets: If current liabilities exceed current assets (current ratio < 1), the company faces a liquidity crisis. They can't pay their bills due in the next 12 months with assets they can convert to cash in the same timeframe. This triggers emergency fundraising, asset sales, or bankruptcy.
Shareholders' Equity: What's Left Over
Equity is the residual claim after subtracting liabilities from assets. It represents the shareholders' ownership stake. Positive equity means assets exceed liabilities (solvent). Negative equity means liabilities exceed assets (insolvent, technically bankrupt).
Minimal value (often $0.01 per share). Represents legal capital that can't be distributed as dividends.
If you sell $50 stock with $0.01 par, $0.01 goes to Common Stock, $49.99 goes to APIC. The real money.
All net income since inception, minus dividends paid. Grows every profitable year. Shrinks with losses or payouts.
Shares repurchased and retired. Reduces equity (negative number). Apple has bought back $500B+ since 2012.
Unrealized gains/losses on securities, foreign currency translation, pension adjustments. Doesn't flow through income statement.
Negative equity isn't always bad: Tesla had negative equity from 2016-2019 due to accumulated losses, but survived by raising capital and then becoming profitable. However, General Electric's negative equity in 2018-2019 signaled deep financial distress and forced massive asset sales. Context matters—growth companies can have negative equity temporarily, but mature companies shouldn't.
Real-World Balance Sheet Comparison
| Item | Apple (AAPL) | Ford (F) | JPMorgan (JPM) |
|---|---|---|---|
| Total Assets | $353B | $257B | $3,875B |
| Current Assets % | 72% | 48% | 91% |
| PP&E % | 12% | 15% | 3% |
| Total Liabilities | $290B | $228B | $3,510B |
| Total Equity | $63B | $29B | $365B |
| Debt-to-Equity | 1.6x | 3.8x | 1.2x |
| Current Ratio | 0.98 | 1.14 | N/A |
Data from latest annual filings (2023). Apple: Asset-light tech model, high cash. Ford: Capital-intensive manufacturing, high inventory/PP&E. JPMorgan: Financial assets dominate, deposits = liabilities, equity = capital buffer for losses.
Liquidity vs Solvency
Can the company pay its bills in the next 12 months? Measured by current ratio (current assets / current liabilities) and quick ratio (excludes inventory). Target: Current ratio ≥ 1.5, quick ratio ≥ 1.0.
Do total assets exceed total liabilities? Measured by debt-to-equity and equity-to-assets ratios. Positive equity = solvent. Negative equity = insolvent (technically bankrupt, though may still operate).
⚖️ Interactive: Adjust Balance Sheet
Assets
Liabilities & Equity
📊 Mastering Financial Ratios
Financial ratios transform raw balance sheet and income statement numbers into actionable insights. A company with $1B in assets sounds impressive—until you learn it has $950M in liabilities (weak). A company with $10M profit sounds small—until you learn it's generated from just $50M in equity (20% ROE = excellent). Ratios reveal efficiency, leverage, liquidity, and profitability that absolute numbers hide.
Category 1: Liquidity Ratios
Liquidity ratios measure the ability to meet short-term obligations. They answer: "If creditors demand payment tomorrow, can the company pay?" Critical for assessing bankruptcy risk and creditworthiness.
Most basic liquidity test. Ratio ≥ 1.5 is healthy (150% coverage). Ratio < 1 means insolvent in the short-term.
More conservative than current ratio. Excludes inventory because it's hard to liquidate quickly without discounts. Ratio ≥ 1.0 is strong. Below 0.5 signals distress.
Most stringent liquidity test. Only counts cash and securities (instantly liquid). Ratio ≥ 0.5 is excellent. Below 0.2 means dependent on operations or financing.
Industry context matters: Supermarkets (Kroger, Albertsons) have current ratios of 0.7-0.9 because inventory turns over in 2-3 weeks and suppliers give 30-60 day payment terms. They operate on negative working capital (current liabilities > current assets) by design. Software companies (Adobe, Salesforce) target 2.0+ because they have no inventory and want cash buffers for acquisitions.
Category 2: Leverage (Solvency) Ratios
Leverage ratios measure long-term financial stability. They reveal how much debt the company uses and whether it can service that debt. High leverage amplifies returns in good times, but magnifies losses and bankruptcy risk in downturns.
Shows capital structure mix. Ratio of 1.0 means equal debt and equity. Ratio > 2.0 is risky (over-leveraged). Ratio < 0.5 is conservative (underleveraged).
What percentage of assets are financed by debt? Ratio > 0.6 (60%) is aggressive. Ratio < 0.3 (30%) is conservative. Banks target 0.9+ (they operate on thin equity).
How many times can the company pay its interest with operating profits? Ratio ≥ 3.0 is healthy. Below 1.5 signals distress (can barely cover interest). Below 1.0 means default risk.
Part of DuPont analysis. Shows financial leverage. Multiplier of 2.0 means $2 assets per $1 equity (50% equity ratio). Higher multiplier = more debt leverage = higher ROE (if profitable).
Optimal leverage varies: Utilities (Duke Energy, NextEra) run 1.5-2.0 D/E because revenue is stable and regulated. Tech companies (Google, Meta) target 0.2-0.5 D/E because they generate massive cash and don't need debt. Real estate (REITs) use 2.5-4.0 D/E to juice returns from rental income.
Category 3: Profitability Ratios
Profitability ratios measure how efficiently a company converts resources into profits. They answer: "How much profit per dollar of assets, equity, or sales?" Essential for comparing companies of different sizes.
Warren Buffett's favorite metric. Measures profit generated per dollar of shareholder capital. ROE ≥ 15% is good. Above 20% is excellent. Below 10% is mediocre. Berkshire Hathaway targets 20%+.
Measures profit per dollar of total assets (debt + equity funded). ROA ≥ 5% is solid for most industries. Below 2% is inefficient. Neutralizes capital structure differences (useful for comparing leveraged vs unleveraged firms).
Most sophisticated profitability metric. Uses NOPAT (Net Operating Profit After Tax, excludes financial engineering) and invested capital (excludes excess cash). ROIC > WACC creates value. ROIC ≥ 15% is world-class.
What percentage of each sales dollar becomes profit? Net margin ≥ 20% is exceptional (software, pharma). 10-15% is good (tech hardware). 5-10% is average (consumer goods). Below 5% is commodity (retail, airlines).
ROE can be artificially inflated: High debt reduces equity (denominator), boosting ROE even if actual profits don't improve. Buybacks also reduce equity, inflating ROE. Check ROA and ROIC alongside ROE. If ROE is 30% but ROA is 5%, it's just leverage, not operating excellence.
Category 4: Efficiency (Activity) Ratios
Efficiency ratios measure how effectively a company uses its assets to generate revenue. They reveal operational excellence (or waste). Fast asset turnover = efficient. Slow turnover = capital trapped unproductively.
How many dollars of revenue per dollar of assets? Higher is better. Retail/restaurants: 2-3x. Manufacturing: 0.8-1.5x. Capital-intensive utilities: 0.3-0.5x. Compares operational efficiency.
Average days to collect payment from customers. Lower is better (faster cash collection). DSO = 30 days is strong. 60-90 days is standard B2B. Above 120 days signals collection problems.
How many times inventory is sold and replaced per year. Higher = less capital tied up. Grocery: 10-15x. Fashion: 4-6x. Auto: 6-8x. Luxury: 1-2x. Rising turnover = efficiency. Falling turnover = obsolete inventory.
Watch for deteriorating efficiency: If inventory turnover drops from 8x to 4x, product demand is weakening or production is overrunning sales. If DSO rises from 40 to 70 days, customers are paying slower (weak demand, credit quality issues). These are early warning signals before they hit the income statement.
DuPont Analysis: Decomposing ROE
DuPont formula breaks ROE into three components: profit margin (profitability), asset turnover (efficiency), and equity multiplier (leverage). This reveals HOW a company achieves its ROE—through operations, efficiency, or financial engineering.
What % of revenue becomes profit? High margin = pricing power, operational efficiency. Low margin = commodity business.
How much revenue per dollar of assets? High turnover = capital efficient. Low turnover = asset-heavy model.
How much assets per dollar of equity? High multiplier = more debt leverage. Low multiplier = equity-financed.
High-margin software business. ROE driven by profitability (30% margin), not turnover (asset-light model needs fewer assets).
Low-margin, high-volume model. ROE driven by efficiency (2.5x turnover = inventory turns fast, assets sweat).
🧮 Interactive: Key Financial Ratios
Current Ratio = Current Assets / Current Liabilities
Measures ability to pay short-term obligations. $150M / $80M = 1.88
4. Spotting Trends & Red Flags
📊 Interactive: Multi-Year Trend Analysis
🚩 Interactive: Financial Red Flags
💵 Cash Flow: The Truth Detector
"Profits are an opinion. Cash is a fact." Net income can be manipulated through aggressive revenue recognition, capitalization tricks, or reserve releases. But cash flow doesn't lie. A company reporting $100M profit while bleeding $50M in cash? The income statement is fiction. The cash flow statement reveals the truth. Warren Buffett calls it the most important financial statement.
Three Categories of Cash Flow
Every dollar that enters or leaves a company is categorized into three activities: operating (core business), investing (buying/selling assets), and financing (raising/returning capital). The pattern across these three categories tells you the company's life stage and financial health.
Cash generated (or consumed) by selling products/services and paying suppliers/employees. Starts with net income, adjusts for non-cash items (depreciation, stock comp), and working capital changes (receivables, inventory, payables). Positive CFO = sustainable. Negative CFO = burning money.
Cash spent buying (or received from selling) long-term assets: PP&E, acquisitions, investments. Usually negative for growing companies (investing in future). Positive CFI can signal asset sales (distress or portfolio optimization).
Cash from debt issuance, equity raises, dividends, and buybacks. Positive = raising capital (growth stage or distress). Negative = returning capital (mature, cash-rich).
Formula: Net Cash Flow = CFO + CFI + CFF. This equals the change in cash on the balance sheet from one period to the next. If Q1 ended with $100M cash and Q2 ends with $120M, net cash flow for Q2 must be +$20M.
Cash Flow Patterns by Business Stage
Different life stages produce different cash flow signatures. A startup, growth company, mature business, and declining company have distinct patterns across CFO/CFI/CFF. Recognizing these patterns helps you assess whether cash flow is healthy or alarming.
| Stage | CFO | CFI | CFF | Interpretation |
|---|---|---|---|---|
Startup Pre-profitability | Negative | Negative | Positive | Burning cash from operations, investing in growth, funding with VC/debt. Example: Uber 2015-2019. |
High Growth Profitable, expanding | Positive | Negative | Mixed | Generating cash, investing heavily in CapEx/M&A, may raise debt for expansion. Example: Tesla 2020-2022. |
Mature Cash cow | Positive | Small Negative | Negative | Strong cash generation, maintenance CapEx only, returning cash via dividends/buybacks. Example: Apple, Coca-Cola. |
Declining Struggling | Negative | Positive | Positive | Losing money operationally, selling assets to stay afloat, raising emergency debt. Example: Sears 2016-2018. |
The ideal pattern: Positive CFO > Negative CFI (absolute value) → generates excess cash after funding growth. This Free Cash Flow can be returned to shareholders or saved. Companies with consistently negative CFO (unless early-stage) are unsustainable without constant external funding.
Operating Cash Flow vs Net Income: Earnings Quality
High-quality earnings convert to cash. Low-quality earnings don't. If a company reports $100M profit but CFO is only $50M, where's the other $50M? Trapped in receivables (customers not paying), inventory (overproduction), or aggressive accounting (premature revenue recognition). The CFO/Net Income ratio reveals earnings quality.
Cash collection exceeds reported profits. Working capital improvements (faster collections, longer payables). Sustainable profitability.
Cash flow roughly matches profits (80-120% ratio). Working capital is stable. Typical for steady-state businesses.
Cash lags reported profits. Revenue recognized before cash collected. Inventory buildup. Aggressive accounting. Red flag.
Company recognizes $100M revenue, but only collects $70M cash. $30M stays in accounts receivable. DSO rising = customers paying slower (demand weakness, credit risk).
Company manufactures $50M of goods, but sells only $30M. $20M sits in inventory. Ties up cash. If demand stays weak, becomes obsolete inventory → writedowns.
Recording future obligations as current revenue (Enron special-purpose entities, WorldCom expense capitalization). Income statement looks good, cash flow exposes fraud.
Fast-growing companies temporarily have CFO < NI as working capital funds growth. Amazon 2000s: massive inventory/ receivables for expansion. Acceptable if growth is real and profitable.
Free Cash Flow: The Ultimate Metric
Free Cash Flow (FCF) is the cash left after a company pays all operating expenses and capital expenditures. It's the cash available to return to investors (dividends, buybacks) or save for acquisitions. FCF = CFO - CapEx. Consistently positive FCF = valuable business. Negative FCF = dependent on external financing.
CapEx (capital expenditures) is cash spent on PP&E to maintain or grow the business. Subtract it from CFO to see what's truly "free." Some analysts also subtract mandatory debt repayments (Levered FCF) or dividends (after-distribution FCF).
Example: Microsoft. Asset-light software model. Minimal CapEx (data centers only). Converts 90% of CFO to FCF. Can return $9B to shareholders.
Example: Telecom (Verizon, AT&T). Massive CapEx on 5G towers, fiber networks. Eats up 75% of CFO. Limited cash for dividends/buybacks.
FCF is more reliable than net income for valuation: Discounted cash flow (DCF) models value companies based on future FCF, not earnings. Why? FCF can't be manipulated with accounting tricks. You can fake earnings with depreciation games or reserve releases, but you can't fake cash in the bank.
Cash Flow Red Flags
Certain cash flow patterns scream "trouble ahead." These red flags often appear quarters or years before earnings collapse. Investors who watch cash flow can exit before disaster strikes. Here are the critical warning signals:
Reporting profits but burning cash from operations = earnings are fake or trapped in uncollectible receivables/ unsellable inventory. Cannot sustain without external financing.
If CFO/NI ratio stays below 80% for 2+ years, working capital is deteriorating. Customers paying slower, inventory piling up, or aggressive accounting. Low earnings quality.
If CFO is negative or barely positive, but company is growing via constant debt/equity raises (CFF always positive), it's a Ponzi scheme. Growth funded by investors, not customers.
Positive CFI from selling assets (unusual) combined with weak CFO = desperate for cash. Mortgaging the future to pay today's bills. Not sustainable.
💵 Interactive: Cash Flow Health Check
5. Key Takeaways
Cash Flow Never Lies
A company can manipulate earnings through accounting tricks, but cash flow shows the truth. Always check if operating cash flow exceeds net income. Negative cash flow while reporting profits? Big red flag.
Read All Three Together
Each statement tells part of the story. Balance sheet = financial position. Income statement = profitability. Cash flow = sustainability. High profits mean nothing if cash is hemorrhaging. Strong balance sheet is worthless if the company can't generate income.
Trends Beat Single Numbers
One year of data is useless. Look at 3-5 years minimum. Are margins expanding or shrinking? Is revenue growth accelerating or slowing? Is debt increasing faster than equity? Trends reveal the company's trajectory.
Compare to Peers
A 10% net margin sounds good, but not if competitors average 20%. Use industry benchmarks. Compare ratios to similar companies. A software company and a retailer have completely different "healthy" ratios.
Know the Red Flags
Current ratio < 1 = liquidity crisis. Debt-to-equity > 2 = over-leveraged. Operating cash flow < 0 = burning money. Revenue growing but margins shrinking = unsustainable. Learn to spot these automatically.
Read the Footnotes
The real story is often buried in the notes. Changes in accounting methods, pending lawsuits, off-balance-sheet liabilities, related-party transactions—companies must disclose these but hope you won't read them. Always do.