How to read financial statements

Financial statements are not one document. A full published set also carries a statement of changes in equity and the notes, but three statements do the work here, and at any given moment a business can answer the three questions they ask very differently.

The balance sheet is a photograph. It reports what a business owned, what it owed and what was left over on one named date, and nothing about the road taken to get there. The income statement is a film. It reports revenue earned and costs incurred between two dates, and says nothing about what the business owns. The cash flow statement covers the same stretch of time as the income statement, but counts only money that actually moved.

A business can be profitable and short of cash, cash-rich and losing money, or solvent on paper and unable to pay a supplier on Friday. Each of those is a different pair of statements disagreeing, and a reader who only ever opens one of the three will not see it.

Read together the three are a closed system. The period covered by the income statement and the cash flow statement is exactly the gap between two balance sheets, so every figure on one statement leaves consequences on the others. Everything below uses one invented distributor, Harbour Tools, so the same set of numbers can be followed from statement to statement.

One line runs the whole statement:

$$\text{Assets} = \text{Liabilities} + \text{Equity}$$

Read it as a sentence about funding. Everything the business controls sits on the left, and the claims on it sit on the right, creditors first and owners last. Equity is not measured separately. It is whatever remains once the liabilities are counted, which is why a balance sheet always balances. Balancing is arithmetic, not an achievement, and on its own it says nothing about health.

Both sides are ordered by time. Current assets are the ones expected to become cash within a year, or within the normal trading cycle where that runs longer: cash itself, money owed by customers, inventory. Current liabilities are what falls due in the same window. Everything else is non-current.

Harbour Tools closes its year with total assets of $4,200,000 and total liabilities of $2,800,000, so equity is $1,400,000.

Two thirds of the assets are funded by somebody other than the owners, which is the subject of financial leverage. Because equity is the residual, it takes the full force of a fall in asset values for as long as any equity is left, while the debt stays exactly where it is. Assets at three times equity means a 10 percent fall in asset values costs 30 percent of the equity. The leverage ratio calculator above runs that shock on any pair of figures.

The income statement starts at revenue and works down to profit, subtracting a different kind of cost at each step. Each subtotal answers its own question, which is why the ladder is worth reading rather than jumping to the last line.

Revenue is recorded when a sale is earned, not when the customer pays. That single rule, accrual accounting, is what makes this statement a measure of performance rather than a record of money.

Harbour Tools sold $6,000,000 and the goods it sold cost $3,900,000, leaving gross profit of $2,100,000. Gross margin answers whether the product itself makes money. Operating margin answers whether the business built around the product makes money, since it also carries wages, rent and marketing. Net margin is what is left for owners once interest and tax have been charged: $360,000, or six cents in every dollar of sales. Charged, not necessarily paid, which is what the next section is about.

Writing every line as a share of revenue, as the table does, is common-size analysis. It is what makes two businesses of different sizes comparable, and one business comparable with itself three years ago.

One line deserves suspicion by design. Depreciation spreads the cost of an asset bought years ago across the years it is used, so it lowers profit in a year when no money moves. Measures such as EBITDA exist to strip it out, which helps when comparing two companies that borrowed different amounts and bought their machinery in different years, and is what most loan covenants are written against. It also strips out a real cost of staying in business, because the machine does wear out and does have to be bought again.

Profit and cash differ for reasons that are structural rather than suspicious. Three of them do most of the work.

• Timing. A sale counts as revenue when it is made, and the customer may pay 60 days later. Until then the profit exists and the money does not.
• Non-cash charges. Depreciation and amortisation reduce profit in a year when nothing left the bank account.
• Working capital. Inventory has to be bought before it can be sold, so stock on the shelves is cash that has gone out and not yet come back. The money tied up in stock and unpaid invoices, net of what the business itself owes short-term, is its working capital.

Put those together and Harbour Tools turns $360,000 of profit into $160,000 of cash.

Nothing in that column is an error and nothing is a loss. Every line is the same trading recorded on two different clocks.

Notice which way the pressure runs. This business grew, and growth is what put the extra inventory on the shelves and the extra unpaid invoices in the ledger. A shrinking business does the reverse: it releases working capital and can look strong on cash while its income statement deteriorates.

Which way it runs depends on the trade rather than on growth by itself. A distributor buys stock and then waits for its customers to pay. A supermarket or a subscription business collects from its customers before it settles with its suppliers, so growth hands it cash instead of taking cash away. Read the working capital lines to see which kind of business is in front of you, then read growth and cash generation side by side, because a fast-growing business of the first kind can fail while reporting a profit every quarter.

The cash flow statement splits the year's money into three sections, and the split is most of its value.

• Operating is cash produced by the trading itself. A business that cannot generate cash here has to find it somewhere else, every year, indefinitely.
• Investing is cash spent on or received from long-lived assets: equipment, buildings, acquisitions, and the sale of any of them.
• Financing is cash raised from or returned to lenders and owners: new borrowing, repayments, share issues, dividends.

The pattern across the three tells a story faster than any single number. Operating positive and investing negative is a business funding its own growth. Operating negative and financing positive is a business being funded by someone else, which describes both a young company and a slow failure, and the statement alone will not say which. Operating cash less the cash spent on equipment is free cash flow, broadly what is left once the asset base has been kept going. Broadly, because the line moves: some versions subtract debt repayments, others add interest back, and a year of postponed maintenance flatters every version. Check which one a published figure means before setting it against another company's.

Cash is the hardest line to flatter because most accounting judgement lives in timing rather than in the bank statement. How many years an asset is depreciated over, when a contract counts as earned, how doubtful a debt has to be before it is provided against: each is a defensible estimate, each moves profit, and none of them moves a cent.

Hardest is not impossible, and the openings are worth naming. Paying suppliers late, selling receivables to a finance company and deferring maintenance and equipment purchases all raise the reported figures without the trading behind them improving. Capitalising a cost rather than expensing it changes no total at all, since the money left the bank either way, but it moves the outflow out of the operating section and into investing, which lifts the one figure a reader trusts most. The defence is the same every time: read three years rather than one, read the three sections separately rather than netted, and read the notes.

The statements are one system seen from three angles, and the joins between them are exact.

Harbour Tools made $360,000. Leaving aside dividends, new shares and the revaluations that bypass the profit line, that is the amount by which equity grew on its way to the closing $1,400,000, while the cash flow statement explains why the cash line moved by something quite different.

A workable order for reading a set of statements:

• Cash from operations, for three years. Is it positive, and is it growing?
• Revenue and margins over the same three years, written common-size.
• The balance sheet: what falls due within a year and what covers it, which is a question about liquidity.
• The notes, which are part of the statements rather than an appendix. Debt maturities, lease commitments, contingent liabilities and changes of accounting policy live there.

Packaging is jurisdictional. In the United States, listed companies file audited annual statements with the securities regulator under United States accounting standards, while many other countries require international standards, where the same statements carry different names such as statement of financial position. Presentation rules also differ over where interest and dividends sit in the cash flow statement, and standard setters revise them, so check which framework a set of statements was prepared under before comparing it with another. An audit opinion says the statements are fairly presented under a stated framework. It is not an opinion on whether the business is a good one.