How to Read Financial Statements

The income statement (also called the profit-and-loss, or P&L) covers a period of time — a quarter or a year — and answers one question: did the company make a profit?

It starts at the top with revenue, sometimes called sales or the top line: the total dollar value of what the company sold. From revenue, the statement subtracts costs in tiers. First, the cost of goods sold (what it cost to produce or deliver the product) gives gross profit. Then operating expenses — salaries, marketing, research, administration — are subtracted to reach operating income.

Further down, the company subtracts interest on its debt and taxes owed. What remains is net income, the famous bottom line: the profit left for shareholders. Divide net income by the number of shares and you get earnings per share (EPS), the figure analysts watch most closely.

A term you'll hear constantly is EBITDA — earnings before interest, taxes, depreciation, and amortization. It strips out financing and accounting choices to show the raw operating profitability of the business, which makes comparisons across companies easier. It is useful, but it is not cash and not profit, so treat it as one lens among several.

When you read an income statement, look beyond a single number. Is revenue growing? Are profit margins — profit as a percentage of revenue — steady, expanding, or shrinking? A company can grow sales while becoming less profitable, and that trend matters more than any one quarter.

If the income statement is a video of a period, the balance sheet is a photograph of a single instant — usually the last day of the quarter. It lists what the company owns and what it owes.

The balance sheet has three parts bound by one rule. Assets are what the company owns: cash, inventory, equipment, buildings, and amounts customers owe it (receivables). Liabilities are what it owes: loans, bonds, and bills to suppliers (payables). Equity — also called shareholders' equity or book value — is what's left for owners after subtracting liabilities from assets. The rule that always holds: assets equal liabilities plus equity.

For an investor, a few relationships matter. How much debt does the company carry relative to its equity? A heavily indebted business is more fragile when sales fall or interest rates rise. Does it have enough liquid assets (cash and things easily turned into cash) to cover its short-term bills? That's the question of liquidity.

The balance sheet also reveals quality that the income statement hides. A company reporting healthy profits but piling up unpaid receivables or unsold inventory may be heading for trouble. Reading the balance sheet alongside the income statement gives you a fuller, more honest picture of the business.

Profit is an opinion; cash is a fact. A company can report net income while burning through cash, because accounting recognizes some revenues and expenses before money changes hands. The cash flow statement cuts through that by tracking the actual movement of cash.

It has three sections. Cash from operating activities shows the cash the core business generated — this is the one to watch, because a healthy business should produce cash from simply operating. Cash from investing activities covers money spent on or received from long-term assets, such as buying equipment or selling a division. Cash from financing activities tracks money raised from or returned to lenders and shareholders — issuing or repaying debt, issuing shares, or paying dividends.

A particularly useful figure investors derive from this statement is free cash flow: the cash from operations minus the capital spending needed to maintain the business. Free cash flow is what's genuinely available to pay dividends, reduce debt, or reinvest for growth. Many seasoned investors trust it more than reported earnings.

Reading all three statements together is the goal. The income statement tells you whether the business is profitable, the balance sheet tells you whether it is financially sound, and the cash flow statement tells you whether the profits are real. No single statement is enough on its own.