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Each financial statement tells a story. The income statement tells you about the profitability of a company. Revenue minus expenses equals profit. Or sales minus costs equals income. The income statement covers a specific period, a month, a quarter, or a year. It's like a movie about profitability. The balance sheet tells you what the company owns OWN and what it owes owe. The balance sheet covers a specific date, month end, quarter end, or year end. It's like a picture at a point in
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time of a company's financial position. The cash flow statement tells you about the inflows and outflows of cash during a period. The cash flow statement is also like a movie covering a specific period, but this time the topic is cash rather than income. Let's see what we can learn by reviewing the 2025 financial statements of Microsoft. Here's the income statement, also known as profit and loss statement or P&L for the fiscal year that ended on June 30, 2025.
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The income statement provides you with answers to important questions like how much did they sell the top line and how much did they earn the bottom line. For Microsoft 2025 revenue was $281.7 billion. 2025 net income was $11.8 billion. Remember that number. Not only is it important in the review of the income statement, but it also plays a role in both the balance sheet and the cash flow statement. Let's start with revenue and then make our way down the income statement. Let
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me ask you a question. Where does most of Microsoft's revenue come from? Most likely you guessed that wrong. The number one revenue generator for Microsoft in 2025 is server products and cloud services. And the number two is Microsoft 365. These two segments together make up 2/3 of revenue. When can you count something as revenue? Revenue is recognized upon transfer of control of promised products or services to customers. What is important to understand is that
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revenue is not the same as the amount of cash received from customers during the period. Two examples to illustrate this. They may have build certain amounts and recognize these as revenue but not received the cash yet by year end. This will lead to an item called accounts receivable on the balance sheet. Accounts receivable is close to cash but not cash yet or they may have received cash up front which is not recognized as revenue yet. For example, revenue related to cloud
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services provided on subscription basis is recognized ratably over the contract period. In other words, they don't count this as revenue in one go, but step by step over time. This leads to an item called unearned revenue on the balance sheet, which we will review later. Let's start moving down the income statement. Next line item is cost of revenue, also known as cost of goods sold, COGS, or cost of services sold. What exactly goes into cost of revenue depends on the business you are in. Two
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simple examples of how this works. If you manufacture boxes, then cost of goods sold consists of materials, labor, and machine hours. If you provide cleaning services, then the cost of services sold consists of labor costs and cleaning products consumed in providing the service. Guess what? For a tech company like Microsoft, the cost of revenue relates to operating data centers, product support, product distribution centers, traffic acquisition costs, and other costs of providing their goods or
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services. The first subtotal of profitability in the income statement is gross margin. How much did they earn on the level of products and services? You calculate gross margin by taking revenue and deducting cost of revenue. In this case, $281.7 billion minus $87.8 billion equals 193.9 billion. Below gross margin we have three sizable expense lines of research and development, sales and marketing and general and admin administrative. All of these do not go into cost of
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revenue but have their separate place in the P&L. Deducting these expenses gets us to the next subtotal of operating income. How much did they earn operationally as a business? You calculate operating income by taking gross margin and deducting R&D, SNM, and GNA. 193.9 billion minus 32.4, 25.7, and 7.2 equals 128.5 billion. Below operating income are other expense and the provision for income taxes. Other expense for Microsoft in 2025 included interest and dividend income,
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interest expense, and losses on equity method investments, including open AI. The provision for income taxes represents an 18% effective tax rate, which is mostly a mix of the US federal statutory rate of 21% and earnings taxed at lower rates in foreign juris jurisdictions, more specifically Ireland. Now that we have done a detailed run through of the income statement by line item, it's time to zoom out and look at the big picture. A great way to put the income statement numbers in perspective
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is to perform some vertical analysis. Let's calculate each of the profitability metrics as a percentage of revenue. Gross margin is 69% of revenue. Operating income is 46% of revenue. Net income is 36% of revenue. From the perspective of the company and its shareholders, these are very healthy margins. From the perspective of the customer, remember these numbers next time you pay for your Microsoft subscription. Another way to put the income statement numbers in perspective is to perform
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some horizontal analysis. Put the prior year income statement next to the current year and calculate the growth. 15% growth in revenue, 16% growth in net income. You can extend this horizontal analysis by going down to the line item level.
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At the very bottom of the income statement is the information on earnings per share, a useful metric for shareholders. $11.8 8 billion in net income divided by nearly 7.5 billion shares equals $1364 of diluted EPS. Let's move on to the next financial statement. The balance sheet. Read the balance sheet at the top level first by category. What we own is split into current assets and non-current assets. What we owe is split into current liabilities, non-current liabilities, and equity.
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Current assets are cash and other assets that are expected to be converted to cash within a year. Non-current assets are longerterm investments that cannot be converted into cash quickly. Current liabilities are amounts due to be paid to or settled with creditors within 12 months. Non-current liabilities are longerterm liabilities to be paid after the period of one year and equity is the book value of the shareholder capital.
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Let's populate those five balance sheet categories with the balances per June 30, 2025 for Microsoft. The balance sheet is balancing with $619 billion of assets on the left and $619 billion of liabilities and equity on the right. There are lots of balance sheet accounts going into each of these balance sheet categories. We're going to be focusing on materiality. Is the line item big enough to matter? If yes, we discuss it. If not, we skip it. 191.1 billion in current assets.
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Nearly half of the current assets are in cash, cash equivalents, and short-term reinvestments. Cash is cash and cash is king. You can use it straight away to pay employees, pay suppliers, pay taxes, build data centers, etc. Cash equivalents are very close to cash, but not quite the same thing. Cash equivalents are highly liquid interest earning investments with a maturity of 3 months or less at the date of purchase. Short-term investments have original maturities of greater than 3 months and
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remaining maturities of less than one year. So cash is money that's immediately available. Cash equivalents available within 3 months. Short-term investments available between 3 and 12 months. Accounts receivable invoices sent to customers that haven't been paid yet. And Microsoft specifies that the amount stated here in current assets is only the part that is expected to be collected within one year. Long-term accounts receivable are included in other long-term non-current assets.
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Non-current assets. The biggest line item here is property and equipment, also known as fixed assets, at $25 billion of net book value. Not only is this the single largest line item, it is also the fastest growing one. The total original spent on property and equipment was $298.6 billion, mostly buildings, building improvements, computer equipment, and software. Once property and equipment is placed into service, it gets depreciated. The original spent gets allocated to
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depreciation expense in the income statement over the useful life of the asset. Gross book value of $298.6 billion minus accumulated depreciation of $93.6 billion equals netbook value of $25 billion.
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What is important to understand for both the balance sheet as well as the income statement is the method of depreciation and the estimated useful lives. The method is simple. Microsoft uses the straight line depreciation method. The estimated useful lives or the time horizon for depreciation depend on the category of property and equipment. Land is not depreciated. Buildings and building improvements are depreciated over 5 to 15 years. This very large category gets depreciated
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relatively fast at Microsoft. I have seen estimated useful lives of up to 40 years in annual reports of other companies, but those were in industries that probably don't have the same rate of technological change as Microsoft. Computer equipment is depreciated over two to six years. Software in three years. The shorter the estimated useful life of an asset, the quicker you depreciate it and the higher the depreciation expense will be per year. There is a huge wave of depreciation
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expense that will hit Microsoft's income statement over the next years. The second largest line item in non-current assets is goodwill. The formal definition of goodwill is the excess of the purchase price paid for an acquired firm over the fair value of its separately identifiable net assets. A very informal definition of goodwill is the accounting plug to make an acquisition journal entry balance. An example might help. When Microsoft purchased Activision, a deal that closed
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in October 2023, the total purchase price was 75.4 4 billion based on Microsoft ex expectations for the future of the combined companies. Deduct net assets of $2.4 billion. Assign a value to intangible assets of $22 billion and by definition the remaining amount is goodwill of $51 billion. The right hand side of the balance sheet current liabilities 141.2 billion. a very significant accounts payable balance for invoices received from suppliers that haven't been paid yet and
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a huge balance in short-term unearned revenue, also known as deferred revenue. We talked about that earlier when we covered revenue recognition. Unearned revenue is the obligation to deliver goods or perform services in the future for which billing has already occurred and/or cash has been received. In other words, get paid first, work later. This is a liability to customers that is not to be settled in cash but in products and services. Non-current liabilities $134.3 billion.
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There is just over $40 billion in long-term debt or borrowings. In relative terms, compared to $344 billion in equity, the debt to equity position of Microsoft is very low. Equity, the book value of the shareholder capital is a very robust 55% of the total balance sheet. In absolute terms as well as in growth versus the prior year, retained earnings is the largest component of the equity section. Retained earnings is that part of a company's cumulative historical
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profits that has not been distributed to shareholders. Retained earnings is also the account where income statement and balance sheet meet. Remember the $ 101.8 8 billion in net income that Microsoft made during their fiscal year 2025. That net income has to be added to retained earnings at the end of the year. Retained earnings at the start of the year were $173.1 billion and at the end of the year $237.7 billion. Adding net income to retained earnings makes it go up, while paying cash
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dividends and buying back stock make returned earnings go down. Generating huge amounts of profit year after year while only returning part of that to shareholders provides a recipe for solid retained earnings and total equity growth on the balance sheet. Income statement and balance sheet reviewed. Let's have a look at the cash flow statement. The purpose of the cash flow statement is to explain how the cash balance at the start of the fiscal year in the case of Microsoft July 1st
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turned into the cash balance at the end of the fiscal year. What happened during the year is called cash flow which get classified into cash from operating activities, cash from investing activities and cash from financing activities. Cash from operating activities is for day-to-day operational cash inflows like customers paying the company and cash outflows like paying suppliers and employees. Cash from investing activities is for cash outflows like capital expenditures and acquisitions.
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Cash from financing activities is for cash inflows from raising capital through issuing shares and taking out new loans and cash outflows like paying dividends, buying back shares, and paying back loans. If we fill in the numbers for Microsoft for 2025, we see an opening balance of cash of $18.3 billion turn into a closing balance of $30.2 billion. and net cash inflow of 11.9 billion. So, is that a good or a bad thing? Having your cash balance increase by nearly 12 billion?
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In most cases, that's a good thing, but it depends on how you got there. Maybe you generated no cash flow from operations and borrowed heavily from the bank, and that's what makes your cash balance go up. Not so in the case of Microsoft. 136.2 billion of cash inflow from operating activities. 100 36.2 billion $72.6 billion of cash outflow from investing activities. 51.7 billion of cash outflow from financing activities. If you generate a lot of cash from operating activities, then you can
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easily self-fund your investments, pay back loans, pay dividends, buy back shares, and still end up with more cash in the bank at the end of the year. How to read the information in the cash from operating activities section? Any positive numbers in this list are sources of cash, while negative numbers are uses of cash. The first line in COA is net income of $11.8 billion that we remember from the income statement. The rest consists of adjustments to reconcile net income to
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net cash from operations also known as adbacks. What that means is that on one hand not all the net income is received in cash in the same year and on the other hand not all expenses are necessarily paid in cash. For example, depreciation and amortization is an expense in the income statement but is not paid to anybody. You paid for the tangible and intangible assets when you bought them. Depreciation and amortization merely allocate the expense to the years of usage.
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Depreciation and amortization were included in the calculation of net income. This adjustment takes it out again. So the net effect on cash flow is zero. Same story with stock-based compensation, an expense that was deducted in the income statement, but not a cash salary payment. So, it needs to be added back. No cash is changing hands in an award of stocks or options. Same story with net recognized losses on investments and derivatives. These decrease the value of these assets on
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the balance sheet and lower net income, but no cash transfer is involved. If the income taxes paid in cash during a year are higher than the provision for income taxes in the income statement, then that is a use of cash that we need to account for in the cash flow statement. The bottom part of the adjustments covers changes in operating assets and liabilities. You review the changes by balance sheet line item and determine what effect those have on cash. For example, if accounts receivable go
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up on the balance sheet, then cash goes down. A use of cash. If unearned revenue goes up, then cash also goes up, a source of cash. The cash from investing activities outflow consists mostly of $64.6 billion in capital expenditures. On top of that, $6 billion cash outflow for acquisitions and $4.4 $4 billion net cash outflow between purchases of investments and outflow of cash, maturities of investments and inflow, and sales of investments and inflow. Cash from financing activities was an
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outflow of 51.7 billion. Repayments of debt, share buybacks, dividends paid. That's all there is to it for a mature and cashrich company like Microsoft. If you generate a lot of cash from operating activities, then you can easily self-fund your investments, pay back loans, pay dividends, buy back shares, and still end up with more cash in the bank at the end of the year. Each financial statement tells a story about the company's profitability, its financial position, and its in and
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outflows of cash.
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