The Beginner’s Guide to Reading & Understanding Financial Statements

An accountant we know used to hold seminars on “How to Read Financial Statements” at a local university. It was held in one of those 300 seat lecture halls and every time he offered it, it was packed with business managers, and even CEOs. They recognized that while practically a lost art left up to the financial arm of the company, financial statements are a hotbed of knowledge for anyone in management who is making decisions about growth. There’s a reason why those 10-page case studies that form the foundation of Harvard Business School set up the case by telling a story up front… but the answers are invariably in the numbers found in the last few pages. In the financial statements. So is this article rudimentary? Perhaps. But maybe just take a look anyway and get a leg up on competitors that are too busy to look.

FROM HARVARD BUSINESS REVIEW / BY TIM STOBIERSKI

An ability to understand the financial health of a company is one of the most vital skills for aspiring investors, entrepreneurs, and managers to develop. Armed with this knowledge, investors can better identify promising opportunities while avoiding undue risk, and professionals of all levels can make more strategic business decisions.

Financial statements offer a window into the health of a company, which can be difficult to gauge using other means. While accountants and finance specialists are trained to read and understand these documents, many business professionals are not. The effect is an obfuscation of critical information.

If you’re new to the world of financial statements, this guide can help you read and understand the information contained in them.

Understanding Financial Statements

To understand a company’s financial position—both on its own and within its industry—you need to review and analyze several financial statements: balance sheets, income statements, cash flow statements, and annual reports. The value of these documents lies in the story they tell when reviewed together.

1. How to Read a Balance Sheet

A balance sheet conveys the “book value” of a company. It allows you to see what resources it has available and how they were financed as of a specific date. It shows its assets, liabilities, and owners’ equity (essentially, what it owes, owns, and the amount invested by shareholders).

The balance sheet also provides information that can be leveraged to compute rates of return and evaluate capital structure, using the accounting equation: Assets = Liabilities + Owners’ Equity.

Assets are anything a company owns with quantifiable value.

Liabilities refer to money a company owes to a debtor, such as outstanding payroll expenses, debt payments, rent and utility, bonds payable, and taxes.

Owners’ equity refers to the net worth of a company. It’s the amount of money that would be left if all assets were sold and all liabilities paid. This money belongs to the shareholders, who may be private owners or public investors.

Alone, the balance sheet doesn’t provide information on trends, which is why you need to examine other financial statements, including income and cash flow statements, to fully comprehend a company’s financial position.

Here’s more about how to read a balance sheet.

2. How to Read an Income Statement

An income statement, also known as a profit and loss (P&L) statement, summarizes the cumulative impact of revenue, gain, expense, and loss transactions for a given period. The document is often shared as part of quarterly and annual reports, and shows financial trends, business activities (revenue and expenses), and comparisons over set periods.

Income statements typically include the following information:

• Revenue: The amount of money a business takes in

• Expenses: The amount of money a business spends

• Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever a business sells

• Gross profit: Total revenue less COGS

• Operating income: Gross profit less operating expenses

• Income before taxes: Operating income less non-operating expenses

• Net income: Income before taxes less taxes

• Earnings per share (EPS): Division of net income by the total number of outstanding shares

• Depreciation: The extent to which assets (for example, aging equipment) have lost value over time

• EBITDA: Earnings before interest, taxes, depreciation, and amortization

Accountants, investors, and other business professionals regularly review income statements:

• To understand how well their company is doing: Is it profitable? How much money is spent to produce a product? Is there cash to invest back into the business?

• To determine financial trends: When are costs highest? When are they lowest?

More about how to read an income statement.

3. How to Read a Cash Flow Statement

The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified duration of time, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long term, based on how much cash is flowing into and out of it.

Cash flow statements are broken into three sections: Cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.

Operating activities detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses. Investing activity is cash flow from purchasing or selling assets—usually in the form of physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt. Financing activities detail cash flow from both debt and equity financing.

It’s important to note there’s a difference between cash flow and profit. While cash flow refers to the cash that's flowing into and out of a company, profit refers to what remains after all of a company’s expenses have been deducted from its revenues. Both are important numbers to know.

With a cash flow statement, you can see the types of activities that generate cash and use that information to make financial decisions.

Ideally, cash from operating income should routinely exceed net income, because a positive cash flow speaks to a company’s financial stability and ability to grow its operations. However, having positive cash flow doesn’t necessarily mean a company is profitable, which is why you also need to analyze balance sheets and income statements.

More about how to read a cash flow statement.