| Statement | Question It Answers | Key Lines to Read |
|---|---|---|
| Income Statement | How profitable was the business this period? | Revenue, Gross Profit, Operating Income, Net Income, EPS |
| Balance Sheet | What does the business own and owe right now? | Cash, Total Assets, Total Debt, Shareholders' Equity |
| Cash Flow Statement | Where did cash come from and where did it go? | Operating Cash Flow, Capital Expenditures, Free Cash Flow |
Income Statement basics: Revenue is what customers paid. Gross Profit = Revenue − Cost of Goods Sold (direct production costs). Operating Income = Gross Profit − Operating Expenses (overhead, R&D, marketing). Net Income = Operating Income − Interest − Taxes. Profit margins are expressed as a percentage of revenue. A 20% net margin means the company keeps $0.20 of every revenue dollar as profit.
Balance Sheet basics: Assets = Liabilities + Shareholders' Equity. Always. This equation never breaks. Assets are what the company owns (cash, inventory, equipment, intangibles). Liabilities are what it owes (debt, accounts payable, deferred revenue). Equity is what would remain for shareholders if every liability were paid off today. A healthy balance sheet has manageable debt relative to assets and earnings.
Free Cash Flow = Operating Cash Flow − Capital Expenditures
The Cash Flow Statement is the most honest of the three statements because cash cannot be easily manipulated through accounting choices. Net income can be managed — revenue recognition timing, depreciation methods, and accrual assumptions all affect it. Cash flow simply shows money in versus money out. Warren Buffett focuses almost entirely on free cash flow when evaluating businesses.
Sit with the ideas.
A company reports $500M in net income but only $80M in free cash flow. The difference is $420M. What are the most likely explanations, and should you be concerned?