Module 2 · Reading the Three Statements Foundation

Valuation is only as good as its inputs. This module is a treasure map: exactly where revenue, profit, cash, debt and share count live — and how to pull out the one number the rest of the course revolves around.

Three statements, three questions. The income statement asks: did the company make a profit? The balance sheet asks: what does it own and owe right now? The cash flow statement asks: how much actual cash moved, and where did it go? A valuer reads all three together, because any one alone can mislead.

The income statement, top to bottom

The income statement flows from the top line to the bottom line, subtracting costs at each step:

EBIT matters because it isolates the operating business from how it happens to be financed — the basis for EV/EBITDA (Module 3) and the DCF (Module 6). Net income divided by diluted shares gives you earnings per share (EPS). Always take the diluted figure: it counts the shares that options and convertibles will create, so it doesn't flatter companies that pay staff in stock.

The balance sheet: what a valuer actually reads

The balance sheet is a snapshot on one day, and it always balances: assets = liabilities + shareholders' equity. You don't need every line. A valuer zeroes in on:

• Cash & equivalents — subtracted in enterprise value; a cushion in bad times.
• Short- and long-term debt — added in enterprise value; the claim ahead of you in line.
• Shareholders' equity — the accounting net worth; divided by shares gives book value per share.
• Goodwill — the premium paid in past acquisitions. A large goodwill balance is a reminder the company bought growth; a later impairment write-down means it overpaid.

Book value is a weak guide for an asset-light software firm (its value is people and code, not on the balance sheet) but a strong one for a bank or insurer, whose assets are financial. We'll use it heavily in Modules 8 and 9.

The cash flow statement — and the most important number in this course

Net income is an opinion; cash is a fact. The cash flow statement starts from net income and strips out the accounting to reveal real cash movement. Two lines matter most:

• Cash flow from operations (CFO) — cash the business actually generated running day to day. It adds back non-cash charges like depreciation and adjusts for working-capital swings.
• Capital expenditures (CapEx) — cash spent on property, plant and equipment to keep the business running and growing.

Subtract one from the other and you have the number this whole course revolves around:

FCF is the cash left over after the company has paid to maintain and expand its asset base — the cash genuinely available to owners, whether paid out as dividends, used for buybacks, or reinvested. It is what a DCF discounts.

How the statements connect

The three statements are one system. Net income from the bottom of the income statement is the starting point of the cash flow statement. The cash the business retains flows into shareholders' equity (retained earnings) on the balance sheet. CapEx on the cash flow statement becomes property and equipment on the balance sheet, which then depreciates back through the income statement. When something looks too good on one statement, the other two usually tell on it.

The red-flags checklist

Before trusting any valuation, run this quick screen:

• Receivables outrunning revenue. If money owed by customers grows much faster than sales, the company may be booking revenue it hasn't collected.
• Chronic “one-time” charges. A restructuring charge every single year isn't one-time — it's a cost of doing business dressed up to flatter “adjusted” earnings.
• Share-count creep. Heavy stock-based compensation quietly dilutes you. Watch diluted share count over several years.
• Positive net income, negative free cash flow. Profit on paper with no cash arriving is the classic warning to dig deeper.