How to Read Financial Statements

Why Trust Techopedia

Show me the money — it’s the fundamental demand any investor makes before backing a business venture. When you need to see revenues and expenses gathered in one place, Financial statements are the place to look.

Banks, investors, and customers use financial statements to assess a company’s commercial standing. They come in three forms — balance sheet, cash flow statement, and profit and loss statement (P&L). Together they paint a coherent picture of profitability and stability.

That may sound complex, but the truth is, if you can work out the carbs and calories on a cereal box label, you can read a financial statement. There are a few terms to learn, but after that, it’s no more difficult than following a recipe. In this article, we’ll explain the main elements and walk you through how to interpret them.

Key Takeaways

  • Understanding financial statements is vital if you’re thinking about starting or investing in a business.
  • There are three types you need to become familiar with — the profit and loss statement, cash flow statement, and the balance sheet
  • Financial statements tell you if a business is profitable, stable, and primed for growth. They also tell you if a business is struggling or where its profits are being hurt by high costs

Types of Financial Statements

A financial statement comprises several sub-statements, and you’ll need to review them all, from balance sheets to P&Ls to cash flow statements. Often they’re published as part of an annual report. Each one enables a different kind of analysis.

Balance Sheet

A balance sheet shows you the book value of a company, e.g., its total assets minus its total liabilities. For a specific date, it lists the resources the firm has and how they were financed under three major categories: assets, liabilities, and owner’s equity. In other words, what the business owns, how much it owes, and how much is left over.

Assets mean all the items a company owns that have a measurable value, e.g., that could be sold for cash, used to provide services and generate income, or used to make products for sale. Assets can be physical, like equipment, vehicles, real estate, or stock in a warehouse. Assets can also be intangibles like patents and trademarks, which could be licensed or sold. Of course, any cash sitting in the firm’s bank account would be considered an asset, along with any investments held in the company’s name.

Liabilities mean the money the firm owes to vendors and creditors. The term covers a range of debt obligations like payroll, bank loans, taxes, rents, or supplier invoices sitting in accounts payable. Liabilities can also cover contracts where there is an agreement to provide customers with goods or services at a future date.

Owners equity means the money left over if the company sold off all its assets and cleared all of its debts. Sometimes called net worth, the amount leftover belongs to the company’s owner(s).

The three categories are listed in the balance sheet in different ways.

Assets are the most complex. Normal practice is to prioritize them under three sub-categories based on how quickly they could be turned into cash:

  1. Current assets cover everything that could be sold for cash within a year. This typically refers to finished products or raw materials in the firm’s inventory.
  2. Noncurrent assets are things that would take more than one year to sell.
  3. Fixed assets are a subcategory of non-current assets that are necessary to operate the business and, as such, are not easily sold off. This could include factory equipment, vehicles, office furniture, buildings, and other physical property.

Liabilities, like bills, are listed according to their due dates and prioritized in the balance sheet under two sub-categories:

  • Current liabilities are debts and obligations the firm plans to pay off within 12 months.
  • Long-term liabilities are obligations that won’t come due for more than a year.

Shareholders’ equity, the amount leftover when total liabilities are subtracted from total assets, is usually listed last.

Cash Flow Statement

While a balance sheet tells you how much a company is worth, a cash flow statement tells you how well the company can generate cash. They’re designed to give a detailed account of where a firm’s cash has gone within a specified accounting period (usually a month, quarter, or year).

The point of maintaining one is to demonstrate that the business has enough cash flowing in and out to operate — both in the short and long term. If a company doesn’t have enough cash on hand, it won’t be able to purchase products or raw materials, pay bills, or pay its people.

The cash flow statement captures changes over time rather than the money available on a given date. To do that it takes information from the balance sheet and the profit and loss statement.

Cash flow statements are usually organized into three main sections for three types of activities:

  1. Operating activities
  2. Investing activities
  3. Financing activities

Operating Activities are listed first and calculate a company’s cash flow from the perspective of net income or net losses. In many cases, this section takes the net income from the P&L and reconciles it with the actual cash the company took in during the period.

Investing Activities come next and show the cash flow (in or out) from the purchase or sale of long-term assets like equipment, property, or any financial investments like stocks and bonds. If a company purchases a new delivery vehicle, for example, the cash flow statement would show the purchase as a cash outflow from investing activities. If a company sells the vehicle later, the proceeds would be listed as a cash inflow from investing activities.

Financing Activities capture the cash flow from financing activities. These can include cash raised by taking on a bank loan and the cash going out in monthly loan repayments.

At the bottom of a cash flow table, you’ll see a figure for net increase or net decrease in cash for the period.

Profit & Loss (P&L) Statement

A Profit & Loss Statement (P&L) is an essential tool for managing your business. It gives you a monthly, quarterly, or annual snapshot of business performance; and shows you how much revenue you’re bringing in — and from where.

Crucially, it also delves into the places where the business is incurring costs and eating into profits. At the end is the bottom line: the figure showing the company’s net earnings or losses over the period.

P&Ls typically include the following calculations:

  • Gross revenue — This is where all the money the business makes is added up. The data comes from a general ledger under current account categories like cash on hand and the invoices sitting in accounts receivable. The time frame is important. A P&L for monthly review would only include revenue received or due within the month, and so on.
  • Cost of sales or Cost of Goods Sold (COGS) — This calculation captures what you’ve spent on less predictable business needs like raw materials or inventory management. They differ from fixed expenses like leases or salaries.
  • Gross profit — Subtracts total cost of sales from gross revenue to arrive at a gross profit figure for the period.
  • Overheads and operating expenses — These are the fixed costs a business must assume if they want to operate. This can include rent, payroll, insurance, travel, marketing, shipping fees, and utility bills.
  • Operating profit — This measure subtracts operating expenses from gross profit to give you a sense of whether or not the business is running profitably from day to day and week to week.
  • EBITDA — In addition to the revenue sources listed above, a business might also earn income from interest on assets or dividends from investments. If so, this section is where the P&L will list it. The ‘other’ income is added to operating profit for total earnings before interest, taxes, depreciation, and amortization figure (EBITDA).
  • Net profit — Finally, the P&L displays what’s left over from gross profit after all overheads and expenses are tallied. It calculates all outgoings, including interest payments, taxes, as well as depreciation and amortization expenses. By subtracting this figure from the EBITDA figure, net profit is the result.

How to Read a Balance Sheet

Balance sheets serve two very different purposes depending on the reader. When a balance sheet is reviewed within a company, it’s designed to show whether the firm is succeeding or failing. When a balance sheet is reviewed externally, it’s usually a potential investor deciding whether or not the business is worth putting money into.

Balance Sheet Example

An example of a balance sheet

Balance Sheet Terms to Know

To read a balance sheet, you’ll need to understand these three concepts:

  • Assets: all items the business owns that have a current or future value, including cash in the bank, invoices awaiting payment in accounts receivable, or things that could be sold for cash like office equipment, inventory, or furniture.
  • Liabilities: the opposite of assets. This refers to what the business owes, including payroll, bank loans, or bills in accounts payable.
  • Equity: the money the owner of a business retains after subtracting total liabilities from total assets.

Analyzing a Balance Sheet: One Practical Example

If you wanted to work out the value of your business’s current assets, the accounting equation you’d use is: Liabilities + Owners’ Equity = Assets

How to Read a Cash Flow Statement

When you review a cash flow statement, you’re trying to get an idea of the firm’s operational stability. Is there enough money coming in from week to week to pay bills and people?

The answer can reveal if the business is in a rapid growth phase, like a startup or a mature and profitable SMB. It can also signal if a company is going through a slow period.

Cash Flow Statement Example

An example of a cash flow statement

Cash Flow Statement Terms to Know

To understand all the line items that could appear in a cash flow statement, it’s useful to understand the following:

  • Depreciation: This is an accounting term you’ll see a lot in financial statements, especially for larger companies. It captures the decrease in an asset’s value over a given time frame.
  • Working Capital: This is the difference between a company’s current assets and its current liabilities.
  • Operating Cash Flow: The money generated from normal business operations
  • Investing Cash Flow: The money generated from investing activities, such as the sale of an asset
  • Financing Cash Flow: The money generated by financing a business, including things like bank loans and credit lines

Analyzing a Cash Flow Statement: A Practical Example

One common cash flow calculation is Operating Cash Flow. You arrive at it using this equation: (operating income + depreciation) – (taxes + change in working capital).

How to Read a Profit and Loss (P&L) Statement

The P&L is designed to tell the financial story of a business’s operating activities in a given time period. When you review one, you’re looking for proof that the business is profitable or if it’s spending more than it earns. In either case, it’s also useful to know if costs fluctuate on a seasonal basis, how much it costs to produce its products or deliver services, and whether there’s money available to put back into the business.

P&L Statement Example

An example of a profit and loss statement

P&L Statement Terms to Know

A P&L’s simplicity can be a blessing if you want a fast snapshot of overall performance — or a curse if you don’t understand all the labels in the table. In addition to basics like revenues and costs, knowing these terms will make things clearer:

EBITDA: A common accounting measure of a company’s ability to generate cash flow. It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

Gross profit: The profit after deducting costs associated with delivering a firm’s services or making and selling its products.

Analyzing a P&L Statement: a practical example

To arrive at an EBITDA figure, add interest, taxes, depreciation, amortization, and net profit together.

Conclusion

If you’re a stakeholder in a business, ‘show me the money’ is a standard request. Reliable businesses tend to be very good at capturing what they earn and spend in P&Ls, cash flow statements, and balance sheets.

If you’re a business owner, aspiring entrepreneur, or want to better understand how your retirement savings are being invested, the ability to read and understand them is absolutely essential.

To learn more about financial statements, read more of Techopedia’s accounting guides.

FAQs

What are the three main types of financial statements?

What are the three ‘golden rules’ of accounting?

What is the basic balance sheet format?

Related Terms

Mark De Wolf
Tech Writer
Mark De Wolf
Tech Writer

Mark is a freelance tech journalist covering software, cybersecurity, and SaaS. His work has appeared in Dow Jones, The Telegraph, SC Magazine, Strategy, InfoWorld, Redshift, and The Startup. He graduated from the Ryerson University School of Journalism with honors where he studied under senior reporters from The New York Times, BBC, and Toronto Star, and paid his way through uni as a jobbing advertising copywriter. In addition, Mark has been an external communications advisor for tech startups and scale-ups, supporting them from launch to successful exit. Success stories include SignRequest (acquired by Box), Zeigo (acquired by Schneider Electric), Prevero (acquired…