In this article, we will take a look at the three most important financial statements, all of which are crucial to evaluate any business.

These are:

1. The Balance Sheet
2. The Income Statement (also called Profit and Loss, or just P&L Statement)
3. The Cash Flow Statement

These three statements complement each other and understanding them provides a very valuable overview about how a company works financially.

Everybody has an opinion and talks about companies on a daily basis. Furthermore, most people are also — at least to some extent — either directly or indirectly affected by some business regarding their salaries. Therefore, I actually think that some basic knowledge in accounting should be part of any education.

What I mean is of course not that everyone should become an accounting expert. Diving deep into accounting and all its aspects gets quite complicated. And that’s what we have accountants for. But an accounting 101 course, that explains the basic concepts, would in my opinion be quite beneficial for everyone.

👍 Getting an understanding of the 3 major financial statements is already a substantial part of that.

So I’ll try my best. 😅

1. The Balance Sheet

In a nutshell, the Balance Sheet shows the financial position of the business at a specific point in time. It displays what the company owns and what it is liable for. Accordingly, it provides a good gauge at how healthy the company is.

More specifically, it compares the assets that the business has, to its equity and liabilities. Thus, it is structured as A = E + L (Assets = Equity + Liabilities).

To depict this, it is often presented in a T-shaped format, with the assets on the left side and equity & liabilities on the right side. However, many companies also just publish their balance sheet in a vertical format:

I personally prefer the T-shaped format, since I think it makes it more easy and clear to quickly get a sense of it and grasp the relevant information that it conveys.

Anyway, the important aspect is, that the A = E + L equation balances out correctly (hence, the name “Balance Sheet”):

The above Balance Sheet shows:

• Assets = $49,500
• Liabilities + Equity = $49,500
  • Total Liabilities = $27,000
  • Owner’s Equity = $22,500

The Assets category shows us what the company owns. Or in other words, it shows us, how the company has invested its capital.

Assets can be defined as items that:

1. Are controlled by the corporation
2. Are the result of a past transaction
3. Will result in a future benefit for the corporation

Further, the asset side is generally structured in categories, which are mainly based on the liquidity of the respective assets:

• Current assets: These are assets that are, or can be converted to cash within a short time-frame (usually one year or less is the criterion). Hence, they are often referred to as liquid assets. These could include things like:
  • Cash
  • Cash Equivalents (for instance a Treasury Bill)
  • Accounts receivable (sold products that have not been paid yet)
  • Short-term investments
  • Inventory
• Long-term/non current assets: These are assets, which cannot be sold easily and/or are expected to be held for a longer period of time, such as:
  • Buildings
  • Land
  • Machinery and equipment
  • Long-term equity investments
• Intangible Assets: These are assets such as goodwill, brands, trademarks, patents etc.

The Liability and Equity side of the Balance Sheet shows us, how these assets are financed.

Likewise the asset side, we can also divide the liabilities, based on the length of time, in which they have to be paid. Thus, there are:

• Current liabilities:
  • Accounts payable (the reverse of accounts receivable on the asset side)
  • Short-term loans payable
  • Current portion of long-term debt
  • Taxes payable
• Long-term liabilities:
  • Notes Payable
  • Bonds payable

The Equity section of the Balance Sheet is often referred to as “Shareholders Equity”.
It is all that remains after calculating the assets minus the liabilities and it consists of:

• Capital: The amount of money received through transactions of the shareholders to the company.
• Retained earnings: The accumulated net profits, which have not been paid out to shareholders in the form of dividends.

Here is a good example of a balance sheet, that shows it all:

As stated above, the Balance Sheet serves as kind of a health check. When analyzing it, the most important aspects to first look at are:

• A = L + E ✅
• Does the company have enough short-term assets to cover its short-term liabilities?
• How much retained earnings does the company have? This shows, whether the company has been profitable and it is part of its capability to pay dividends to shareholders in the future, buy back shares, or reinvest it to expand the business.

Depending on the industry, the general market condition and many other factors, there might be many different aspects to consider when looking at a balance sheet. Therefore, there is no clear agreement about what makes a perfect balance sheet. However, the Balance sheet does provide the investor with a lot of useful information about the business and he has to analyze it in accordance with his knowledge, judgement and investment strategy.

One more crucial point to consider is the amount of liabilities vs. the amount of equity, which is known as the Debt-to-Equity (D/E) Ratio. The average D/E ratio of the S&P 500 is about 1.6. However, this varies a lot depending on the industry.

A quick glance at the above Balance Sheet gives us a D/E ratio of 1.66 (481/289).
Thus, it is just slightly higher compared to the average of the S&P 500.

A high D/E ratio means that the company has taken on a lot of debt. Generally speaking, this means that its cost of capital is lower, because the rate of interest demanded by creditors, tends to be lower than the return expected by equity investors. During prosperous times, such a company tends to perform better.

However, while the cost of capital tends to be lower, the leverage, which the company is exposed to, is correspondingly higher. Accordingly, if market conditions get bad, the leverage imposes higher risk to the viability of the business. Therefore, if a Balance Sheet reveals a very high D/E ratio, this could be a red flag.

Last, it is also important to note that in case of a bankruptcy event, the shareholders are only compensated after all the liabilities have been paid out to the creditors.

2. The Income Statement

The Income Statement shows the financial performance of the business over a certain period of time. It shows whether the company made a profit, or a loss.

The above Income Statement looks at an imaginary company.

Let’s assume it is a company selling merchandise.

“Net sales” shows the total revenue that the company generates by selling its products. In the first step, all the “Cost of Sales” are subtracted from it. These cost might include things like:

• Raw materials
• Factory labor to create the product
• Products purchased for resale
• Service and transportation costs to distribute the products
• Storage costs

What remains, is the so termed “Gross Profit”.

In the next step, all the “Operating Costs” are deducted. These costs are the most basic costs of the business, which the company needs to pay regardless of how many products are produced and sold in a specific period. They usually include expenses such as:

• Overhead costs
• Salaries
• Benefits (e.g. health insurance, further education etc.)
• Rent
• Property purchases
• Marketing

(in the above Statement they are represented as “Selling, general and administrative expenses.)

After the subtraction of these expenses, what remains is the “Operating Income”.
(It is often referred to as EBIT: Earnings before Interest and taxes, or EBITDA, which additionally excludes depreciation and amortization.)

In the following step, “Non Operating Income (or Expenses)” are accounted for. These can be any gains or losses related to the company’s activities outside of its core business operations. For instance, a company might own stocks, bonds, or real estate.

In our example, the company has “interest expenses” as well as “losses on sale of equipment” in 2019 and 2021:

• “Interest expenses” means that it borrowed money.
• A “Loss on sale of equipment” means that the company sold some asset at a lower price than its book value, represented in the balance sheet.

Now, we are left with the “income before income taxes”.

Depending on the jurisdiction, where the company is registered, it needs to pay the applicable income tax.

What remains in the end, is the “Net Income” (or potentially also a net loss). When investors talk about whether a company is profitable or not, it usually refers to the net income.

A positive net income will appear on the balance sheet as “Retained earnings” (see the Balance Sheet above).

Finally, the above Income Statement gives us the periods of 2019, 2020 and 2021.

As we can see, the net income has been constantly rising. Hence, just looking at this statement suggests that it is a healthy business with growing profits.

3. The Cash Flow Statement

The Cash Flow Statement summarizes the cash flows over a certain period. It shows how much cash the company generated and how much it spent. Thus, it displays whether the cash balance increased or declined.

The Cash Flow Statement is somewhat similar to the Financial Statement, in that it also looks at the changes over a period of time.

However, it is possible that a company makes a profit on paper (Income Statement), while burning through its cash balances (Cash Flow Statement). This is due to the fact that the Cash Flow Statement only tracks the cash coming in and the cash flowing out.

For instance, a company might have stakes in other companies. This might lead to a situation in which it was spending more money than it generated through sales, but at the same time the valuation of its holdings have seen substantial increases resulting in an overall profit.

While a paper profit always looks good, it is crucial for every business to always have enough cash to cover its short-term liabilities. Therefore, it is an important part of every company to keep an eye on the cash flows.

Here is an example of how such a Cash Flow Statement might look:

As we can see, the Statement is divided into different groups. This helps to have a better understanding, where the cash is generated and where it is going.

For our example corporation, we have the following cash flows over the year:

• Cash flows from operating activities:
  • This is where usually most of the cash flows will be appearing.
  • The example corporation generates a net positive cash flow of $262,000.
• Cash flows from investing activities:
  • The company sold some of its equipment.
  • But it made way higher capital expenditures (CapEx):
    • E.g. a copper company might have invested in new coiling machinery.
    • Or an oil company might have purchased additional wells.
  • Thus, it had a net outflow of $260,000.
• Cash flows from financing activities:
  • The company issued debt (sold bonds) of $200,000.
  • It paid out $110,000 in dividends to its shareholders.
  • Thus, it generated $90,000

In total, the corporation has a positive cash flow of $92,000.

In the last step, it is added (or in case of a negative cash flows subtracted from the available cash at the beginning of the period.

We can see that the corporation ends the period with a cash balance of $193,000.

As a last thought: On the one hand, having adequate cash is important to avoid liquidity issues and stay solvent. On the other hand, carrying large amounts of cash comes with opportunity costs, since the cash could most likely be used more profitably in other ways.

Summary

The important insights to take away are:

• The Balance Sheet shows the financial position of the business at a specific point in time. It displays what the company owns and what it is liable for.
  Therefore, it provides a good gauge at how healthy the company is.
• The Income Statement shows the financial performance of the business over a certain period of time. It shows whether the company made a profit, or a loss.
• The Cash Flow Statement summarizes the cash flows over a certain period. It shows how much cash the company generated and how much it spent. Thus, it displays whether the cash balance increased or declined.

Here is a good overview to condense it:

Another comprehensible analogy could be made by comparing the company to the human body, its operations to exercising and its profits (or losses) to the training results: 💪

• In this analogy, the Balance Sheet would present the physical composition of the body at a certain time.
• The Income Statement provides results of the muscle adaptation over a certain training period. Further, it also gives a general idea about the causation.
• To be capable of exercising, the body always needs to take in an appropriate amount of nutrients in accordance with the energy required. This is what the Cash Flow Statement entails.

🧠 Hopefully, reading this was useful and you learned something valuable. 🙂