Financial statement basics
Each financial statement tells one part of a company’s story:
The income statement shows how much profit the company earned over a specific period.
The balance sheet is a snapshot of what the company owns, owes, and retains at a specific point in time.
The cash flow statement explains how those profits translate into actual cash moving in and out of the company.
You can’t just look at one piece of the puzzle. To truly understand the company’s financial well-being, you need to evaluate all three statements together.
Income statements
An income statement shows how much money a company made or lost over a specific period of time, usually a quarter or a year. It starts with revenue, subtracts costs and expenses, and ends with net income (or profit).
From top to bottom, the statement usually flows something like this:
Revenue: The total amount of money a company earns from selling its goods/services before expenses are deducted.
Gross profit: What’s left of revenue after subtracting the cost of goods sold (COGS, the direct costs of producing or delivering products/services).
Operating income (or earnings before interest and taxes [EBIT]): What’s left of gross profit after subtracting all operating expenses but before deducting interest and taxes.
Pre-tax income: The company’s earnings before income taxes are deducted. Pre-tax income includes operating income.
Net income: The company’s total profit after all expenses, including taxes and interest, have been deducted.
Earnings per share (EPS): An income statement may or may not include EPS, which shows how much profit a company makes for each share of stock. There are two versions of EPS: basic and diluted. Basic EPS uses the number of shares that currently exist. Diluted EPS assumes all possible new shares (like employee stock options or convertible bonds) have been created, which spreads the profits over more shares and usually makes EPS a bit lower.
How to read income statements
When assessing an income statement, pay attention to the following line items:
Revenue and growth rate: Reveals steady or up-and-down growth, and possible seasonal trends.
COGS and gross margin: Shows how efficiently the company is producing its goods/services.
Operating expenses and operating margin: Indicates how well the company is managing its day-to-day operating costs.
Non-operating items and taxes: Reflects interest, unusual gains or losses, and tax impacts that can influence the company’s profit but that aren’t part of regular business operations.
Net income and EPS: Shows the bottom line.
Strengths and limitations of income statements
Strengths
They offer a clear, line-by-line view of what is driving a company’s performance.
They’re easy to compare across periods of time and from company to company.
Limitations
They use accrual accounting, which means they record sales and expenses when they happen, not when cash actually moves. Sometimes profits on an income statement don’t show how much cash the company actually made.
Major one-time events (like mass layoffs or the sale of a property) can make profits look much higher or much lower.
Some companies use adjusted figures that leave out certain costs in order to reflect what they believe is a more accurate picture of performance. This can make comparisons between companies (or time periods) tricky.
Example of an income statement
Here’s a simplified look at how the numbers could break down:
Line item | Amount |
|---|---|
| Revenue | $100 |
| Cost of goods sold (COGS) | -($60) |
| Gross profit | $40 |
| Operating expenses | -($25) |
| Operating income (EBIT) | $15 |
| Interest expense | -($2) |
| Taxes | -($3) |
| Net income | $10 |
Balance sheets
A balance sheet shows what a company owns (its assets) and owes (its liabilities) at a specific point in time, as well as its shareholders’ equity. It offers a look at a company’s financial position by showing what resources it has and how those resources are financed.
Like the name suggests, a balance sheet always has to balance. The company’s assets are always equal to its liabilities, plus what belongs to its shareholders.
Assets = liabilities + shareholders’ equity
Assets: What the company owns, such as cash, inventory, property, or equipment.
Liabilities: What the company owes, like loans, accounts payable, or other debts.
Shareholders’ equity: Shows the owners’ (investors’) share of the company, which is what’s left after all debts are paid. Shareholders’ equity usually includes common stock, which is the money investors originally put into the company by buying shares, and retained earnings, which are the profits the company has kept (not paid out as dividends) and reinvested back into the business over time.
How to read a balance sheet
These are the sections you’ll find and what they represent:
Current assets and current liabilities
Current assets include items like cash, accounts receivable, and inventory. These are things the company expects to turn into cash or use up within a year.
Current liabilities are obligations due within a year, such as accounts payable or short-term debt.
By comparing current assets to current liabilities, you can gauge whether a company can cover what it owes soon with what it owns now. This ability to pay short-term bills is called liquidity.
Non-current assets and long-term liabilities
Non-current assets include tangible assets that a company uses to generate revenue (such as property, plant, and equipment [PP&E]), as well as intangible assets, such as patents and trademarks. They are long-term investments that help the company operate and grow.
Long-term liabilities are debts the company expects to repay over several years, such as long-term loans or leases.
By looking at both categories, you can evaluate how the company is investing for the future and how it’s financing those investments.
Equity
This represents the owners’ (investors’) share of the company after the company’s debts are paid.
Equity includes common stock (money investors put in by buying shares), additional paid-in capital (the extra money shareholders paid the company when buying shares, above the stock’s face value), retained earnings (profits the company has kept and reinvested instead of paying out as dividends), and accumulated other comprehensive income (AOCI), which includes certain gains or losses such as currency or investment changes.
Equity shows you how much of the company’s value belongs to its shareholders and how much has been built up through past profits.
When evaluating these sections, there are a few key things to keep in mind:
Liquidity: look at whether the company has enough short-term assets on hand (like cash and receivables) to cover what it owes. Simple ratios like the current ratio (current assets ÷ current liabilities) can help you determine this.
Capital structure: pay attention to how much money comes from borrowing (debt) versus owners (equity). A company with a lot of debt might be taking on more risk, while one with little or no debt might be playing it too conservatively.
Asset quality: not all assets are equal. Check to see whether the company has had to reduce the value of any assets (called a write-down). You’ll also want to gauge how its assets are valued, since different accounting methods can change the numbers you see.
Strengths and limitations of balance sheets
Strengths
They provide an at-a-glance view of a company’s resources and liabilities at a certain point in time, which gives you a sense of the company’s overall financial position.
They make it easier to spot potential red flags, such as major debt or asset write-downs.
Limitations
They sometimes rely too heavily on estimates and valuations, so the numbers aren’t always entirely reliable.
They offer a point-in-time view, which can be useful for certain purposes but is limiting if you’re trying to build a more long-term opinion.
Balance sheet example
Remember: the balance sheet must always stay in balance, where the assets equal the liabilities, plus the shareholders’ equity. The ending cash balance should also match the final cash figure on a cash flow statement. (We’ll dig into cash flow statements in the next section.)
Here’s a simplified example of what the line items on a balance sheet could look like:
Section and line items | Amount |
|---|---|
| Current assets: Could list cash, accounts receivable, inventory, and non-current assets (like PP&E) | $500 |
| Liabilities: Could list accounts payable, short-term debt, and long-term debt | $300 |
| Shareholders’ equity: Could list common stock and retained earnings | $200 |
| Total Liabilities + Equity | $500 |
Cash flow statements
A cash flow statement reveals how cash moves in and out of a company over a period of time. It’s divided into three sections, each highlighting a different area of the business: cash from operations (CFO), cash from investing (CFI), and cash from financing (CFF).
CFO: cash generated or used by the company’s day-to-day activities.
CFI: cash used to buy or sell long-term assets like property, equipment, or investments.
CFF: cash raised from (or returned to) investors and lenders through activities like borrowing, repaying debt, issuing stock shares, or paying dividends.
Most companies prepare the cash flow statement using the indirect method, which starts with net income and adjusts for items that don’t involve actual cash (like changes in inventory) to show the true cash generated by the business.
How to read a cash flow statement
Here’s what you’ll find on a cash flow statement and how to interpret each section:
CFO. This section starts with net income and adjusts for non-cash items like depreciation and changes in working capital (such as receivables, inventory, and payables). A positive CFO means the company is generating real cash.
CFI. This section shows cash spent or received from buying or selling long-term assets. The biggest item is often capital expenditures (or CapEx), which is money the company spent on things like real estate property, equipment, or technology. While CapEx is money flowing out, it’s important because these big buys help the company scale and maintain its operations.
CFF. This section reflects how the company raises capital, manages that funding, and rewards shareholders. It includes borrowing or repaying debt, issuing or buying back shares, and paying dividends to shareholders.
Then there’s free cash flow (FCF). FCF isn’t an official section of the cash flow statement, but it’s an important concept that you can calculate from it. There are a few different ways to calculate FCF, but the most common way is by taking the CFO number and subtracting the CapEx number from the CFI section. FCF tells you how much cash the company has left after investing in its operations, which you can use to get a sense of how much cash the company has to cover debts, pay dividends to shareholders, or reinvest in the business.
Strengths and limitations of cash flow statements
Strengths
They focus on the actual cash that comes in and out of the business.
They help you determine whether the company’s reported profits can be backed up by actual cash flow.
Limitations
They can be affected by the timing of things like big one-time payments or collections, which can make cash flow look unusually high or low.
They don’t offer details on profitability, so if you’re looking to understand how profitable certain business activities were, you’ll need to consult the income statement alongside the cash flow statement.
Example of a cash flow statement
Here’s a simplified look at what items on a cash flow statement could look like:
Section | Amount |
|---|---|
| Cash from operations (CFO) | $80 |
| Cash from investing (CFI) | -($30) |
| Cash from financing (CFF) | -($20) |
| Net change in cash | $30 |
| Beginning cash balance | $50 |
| Ending cash balance | $80 |
The beginning cash balance (last year’s cash balance) comes from the previous period’s balance sheet. The cash flow statement shows how that cash has changed during the current period. When you add the net change in cash to the beginning cash balance, you get the ending cash balance for the current year. That same number appears on the current year’s balance sheet.
IFRS vs. GAAP: differences in accounting standards
Companies can’t just make up their own ways of assembling financial statements. They have to follow sets of rules for how to record and report their financial results. These rules are called accounting standards, and without them, financial statements would tell wildly different — and incomparable — stories.
There are two main sets of standards: International Financial Reporting Standards (IFRS), which are used by most countries, and generally accepted accounting principles (GAAP), which are used in the U.S. You should always pay attention to the accounting policies and footnotes of financial statements to understand the definitions of terms that appear and what accounting standards were used.
Knowing the basics of these standards and how they differ can help you read and evaluate financial statements more accurately and better compare statements from companies in different regions.
Here are the key differences:
IFRS | GAAP | |
|---|---|---|
| Principles vs. rules | Principles-based, meaning it gives companies more room for judgment and interpretation when applying standards. | Rules-based, with detailed requirements for specific situations. |
| Naming conventions | Under IFRS, the statements may also have slightly different names, such as Statement of Profit or Loss instead of income statement and Statement of Financial Position instead of balance sheet. | U.S. GAAP, the naming is standardized (income statement, balance sheet). |
| Inventory | Prohibits the LIFO (Last In, First Out) method. | Allows companies to use the LIFO method for valuing inventory. |
| Development costs | Lets companies treat some development costs (like creating new products) as an asset if certain criteria are met. | Companies usually need to expense these costs right away (one exception would be for certain types of software). |
| Impairments | Lets companies increase an asset’s value again if it recovers after being written down (except for goodwill). This is called reversing impairments. | Does not allow reversals once an asset has been written down. |
| Leases | Companies show leases as assets and debts on a balance sheet, but they’re shown as two separate expenses (interest and depreciation). | Companies show leases as assets and debts on a balance sheet; they’re combined into one lease expense for operating leases. |
| Cash flow classification | Companies classify interest and dividends as operating, investing, or financing cash flows, as long as they use the same approach consistently. | Puts interest paid or received and dividends received under operating activities. Dividends paid go under financing activities. |
Financial statements tell the story of a company’s finances: how it earns money, spends money, and keeps money. The income statement shows profit, the balance sheet shows what the company owns and owes, and the cash flow statement shows how cash actually moves. When you read and evaluate these statements together, you get a complete picture of a company’s financial well-being, which can help you confidently make more informed investment decisions.
