How to Read Financial Statements

To read financial statements, start with three reports. The Profit and Loss statement shows whether the business earned money over a period. The Balance Sheet shows what the business owns and owes on a single date. The Cash Flow Statement shows where cash came from and where it went. Read together, they tell you whether the business is profitable, solvent, and able to pay its bills.

The three financial statements at a glance

How do you read a Profit and Loss statement?

Read it from the top down. Revenue comes first. Subtract the direct cost of what you sold to get gross profit. Subtract operating expenses such as rent, payroll, and marketing to get operating income. What remains after interest and taxes is net income.

• Gross margin is gross profit divided by revenue. A falling gross margin means costs are rising faster than prices.
• Operating expenses as a percent of revenue show whether overhead is growing in step with sales.
• Compare periods. One month means little alone. Compare it with the prior month and the same month last year.

How do you read a Balance Sheet?

The Balance Sheet follows one equation. Assets equal liabilities plus equity. Assets are what the business owns. Liabilities are what it owes. Equity is what is left for the owners.

• Current ratio is current assets divided by current liabilities. A result above 1 means the business can cover what is due within a year.
• Accounts receivable that grow faster than sales mean customers are paying more slowly.
• Debt should be read alongside the cash the business generates to repay it.

How do you read a Cash Flow Statement?

This statement explains why profit and cash differ. It starts with net income and adjusts for items that affect one and not the other.

• Operating activities show cash produced by the business itself. This number should be positive over time.
• Investing activities show cash spent on equipment and other long-term assets.
• Financing activities show loans received or repaid and money the owners put in or took out.

Why can a business show a profit and still run short of cash?

Profit and cash are measured differently. A sale counts as revenue when you invoice it, and the cash arrives later. Loan principal payments, equipment purchases, inventory, and owner draws all use cash and do not appear as expenses on the Profit and Loss statement. This gap is the subject of Jacqueline Oberst’s book, Looks Profitable.

Five numbers to check every month

1. Gross margin percentage
2. Net income compared with the same month last year
3. Cash balance and the change from last month
4. Accounts receivable older than 60 days
5. Current ratio

Common mistakes when reading financial statements

• Reading the Profit and Loss statement alone and ignoring the Balance Sheet
• Judging a single month without comparing it with other periods
• Treating the bank balance as profit
• Trusting statements built on accounts that have not been reconciled

Common questions

Once the statements make sense, our financial analytics service can show what they mean for your next decision.

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