A company's three main financial statements are the balance sheet, the income statement and the cash flow statement. The balance sheet shows what the company owns and owes at a single date. The income statement shows revenue and profit over a period. The cash flow statement shows the cash that came in and went out over the same period. Each one answers a different question, and reading them together gives a much fuller picture than any one of them alone.
This guide explains what each statement contains, shows how the figures link together with invented numbers, and lists the warning signs that investors check before they form a view. It does not tell you whether any company is a good investment. It describes the tools a reader needs to ask the right questions.
What are the three main statements?
The balance sheet is a snapshot at a date. It lists assets, liabilities and equity, and the three always balance: assets equal liabilities plus equity. The income statement covers a period, usually a quarter or a year, and records revenue, costs and profit.
The cash flow statement covers the same period and reports how much actual cash moved, split into operating, investing and financing activities.
Profit and cash are different measures. A company can report a profit in the income statement while receiving little cash, because sales are recorded before the money is collected, or because costs are deferred. The cash flow statement is the check on the income statement, and the balance sheet shows whether the company has the resources to keep going.
What does the balance sheet show?
The balance sheet lists what the company owns (assets), what it owes (liabilities) and the residual claim of shareholders (equity). The equation assets equal liabilities plus equity always holds. Assets include cash, money owed by customers, inventory and property. Liabilities include loans, amounts owed to suppliers and other obligations.
Equity is what remains after the liabilities are deducted from the assets.
The table below uses an invented balance sheet to show the structure. The figures are illustrative.
| Item | Amount | What it means |
|---|---|---|
| Total assets | 500 | Everything the company owns or is owed |
| Total liabilities | 300 | Everything the company owes |
| Shareholders' equity (500 − 300) | 200 | The residual claim of owners |
| Current assets | 150 | Assets expected to convert to cash within a year |
| Current liabilities | 100 | Obligations due within a year |
| Current ratio (150 ÷ 100) | 1.5 | Short-term resources relative to short-term debts |
Investors look at debt levels, the amount of cash and short-term resources, and the quality of the assets. A company with large short-term debts and few liquid assets has less room for error, even if its profits look healthy.
What does the income statement show?
The income statement records revenue, costs and profit over a period, usually a quarter or a year. Revenue minus the cost of sales gives gross profit, and further deductions lead to net profit. A company can report a profit and still struggle with cash, which is why the other statements matter.
The example below uses invented figures for a single year. Gross profit is 400, a margin of 40 percent, and net profit is 90.
| Line | Amount | What it means |
|---|---|---|
| Revenue | 1,000 | Sales for the year |
| Cost of sales | −600 | Direct costs of the goods or services sold |
| Gross profit | 400 | Revenue minus the cost of sales (40% margin) |
| Operating costs | −250 | Running costs such as staff and premises |
| Operating profit | 150 | Profit from the core business |
| Interest and tax | −60 | Financing costs and taxes |
| Net profit | 90 | The profit left for shareholders |
The margins at each level show where the business earns and spends. A falling gross margin can signal rising costs or weaker pricing, while a rising operating cost line can show that overheads are growing faster than sales. Compare the margins over several years and with other companies in the same sector.
What does the cash flow statement show?
The cash flow statement reports the actual cash received and paid, divided into three groups. Operating activities cover the cash generated by the core business. Investing activities cover the purchase and sale of long-term assets. Financing activities cover borrowing, repaying debt and paying dividends or issuing shares. The total shows how much the company's cash balance changed over the period.
The statement is the check on profit. A company whose operating cash flow is consistently below its net profit may be recognising sales before it collects the money, or spending heavily on working capital. That is not proof of a problem, but it is a reason to read the notes and find out why the two measures differ.
What warning signs should you check?
Common warning signs include debt rising faster than earnings, falling operating cash flow while reported profit grows, large one-off gains that lift a single year's result, and frequent changes to accounting policies. None of these proves that a company is in trouble, but each is a reason to read the notes and the management explanations in the annual report.
Check the notes to the accounts, which explain how the figures were calculated. They often contain the detail behind a sudden change, such as a revised estimate or a contingent liability. Read the auditor's opinion as well, since a qualified or unusual opinion is an important signal, even though most audits are routine.
How do you compare a company with its own history and its peers?
A single year's figures mean little until they are compared with the company's own history and with similar companies. Trends in revenue, margins and debt show direction, and comparisons show whether a company is unusually strong or weak. Use the same definitions each time, or the differences may reflect accounting rather than performance.
Compare at least three to five years of results, so that one unusual year does not dominate the picture. Look at whether revenue growth, margins and debt have moved together, and what management said about any change.
Compare with peers in the same sector, because a margin that is normal in one industry may be poor in another. Check that the peers report on a similar basis, and note any differences in year-end dates or accounting policies.
Common mistakes
Reading one statement in isolation. Profit, cash and the balance sheet tell different parts of the story. Read all three.
Ignoring the notes. The explanations of how figures were calculated often matter as much as the headline numbers.
Judging a company by a single year. One year can be distorted by a one-off gain or loss. Compare several years before drawing a conclusion.
Checklist
- Read the balance sheet first, and note total debt, cash and current assets.
- Work down the income statement and calculate the gross and operating margins.
- Compare net profit with operating cash flow for the same period.
- Check whether any large one-off items affect the result.
- Read the notes on accounting policies and any changes to them.
- Compare the figures across several years and with similar companies.
- Note any unusual items for further reading before forming a view.
Key takeaways
The balance sheet shows what a company owns and owes at a date, the income statement shows profit over a period, and the cash flow statement shows the cash that actually moved. The three must be read together, because profit and cash can differ. Warning signs such as rising debt, falling operating cash and large one-off gains are reasons to read the notes, not proof of a problem.
This guide is for general information, not financial advice. See the disclaimer.