Balance sheet, income statement, cash flow statement

You can explain what the balance sheet, income statement and cash flow statement each show, and read the main lines of each.

Three statements, three questions

Every listed company publishes its accounts at least once a year. The numbers can look endless: hundreds of lines, notes and footnotes.

At their core are three statements, and each answers one simple question. What does the company own and owe? Did it make a profit? Where did the cash actually go? Once you know which statement answers which question, every annual report becomes much easier to read.

Snapshot, profit, cash

The balance sheet is a snapshot of one day, usually the last day of the financial year. It lists:

assets: what the company owns, such as cash, factories, stock in the warehouse and money customers still owe it,
liabilities: what it owes, such as loans, bonds and unpaid bills,
shareholders' equity: what is left for the owners, also called book value.

It always balances, because equity is defined as the difference: assets = liabilities + equity. The SEC's beginners' guide calls this the basic equation of the balance sheet.

The income statement covers a period, a quarter or a year. It starts with revenue, the money earned from sales, and subtracts costs step by step:

cost of sales gives gross profit,
operating costs, including depreciation, give operating profit, the profit before interest and tax,
interest and tax give net income, the "bottom line".

The cash flow statement also covers a period, but counts cash instead of profit. It has three sections: operating activities (cash from the business itself), investing activities (buying or selling long-term assets such as machines) and financing activities (borrowing, repaying, dividends, issuing or buying back shares).

Why a third statement? Profit is recorded when a sale is made, even if the customer pays months later. Depreciation reduces profit without any cash leaving. The cash flow statement shows what really happened in the bank account.

From 500 to 50

A fictional bicycle maker reports a year with revenue of 500 million.

Cost of sales, the bikes' materials and factory work, is 300 million. Gross profit: 200 million.
Operating costs for staff, marketing and depreciation are 120 million. Operating profit: 80 million.
Interest and tax take 30 million. Net income: 50 million.

Its cash flow statement tells a slightly different story. The business brought in 90 million in cash, more than its profit, partly because depreciation of 20 million reduced profit without costing cash. It invested 40 million in new machines and paid out 30 million for dividends and loan repayments. Its cash rose by 20 million.

The balance sheet at year-end shows assets of 800 million, liabilities of 480 million and equity of 320 million.

Common mistakes

Treating profit as cash. A company can report profits and still run out of cash if customers pay late or investment eats up the money.
Reading one statement in isolation. Profit growth paid for with ever more debt looks fine on the income statement and shows up only on the balance sheet.
Forgetting that the balance sheet is one day. Cash can look high on the reporting date and much lower a month later.
Ignoring the notes. They explain how the numbers were measured, and two companies can measure the same thing differently.

The takeaway

The balance sheet shows what a company owns and owes on one day. The income statement shows profit over a period, the cash flow statement real cash.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the line that shows profit before interest and tax.

Tap the chart.

Operating profit, 80 million here, is what is left after all operating costs but before interest and tax.
2A company has assets of 800 million and liabilities of 480 million. What is its shareholders' equity?

Assets = liabilities + equity, so equity = 800 − 480 = 320 million.
3Which statement shows a single day rather than a period?

The balance sheet is a snapshot at the end of the period. The other two add up everything that happened during it.
4Why can a profitable company still run short of cash?

That is why the cash flow statement exists. It shows the cash that actually came in and went out.

of 4 correct.

Sources

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