The three financial statements and how they link
Financial statements are photos of a company taken from three angles.
- Income statement: how much it sold and how much it kept over a period (a quarter or a year) — the report card
- Balance sheet: what it owns (assets) and what it owes (liabilities) at a point in time, and the difference (equity) — the bank balance and loan record
- Cash flow statement: where cash actually came from and where it went — the household ledger
The three are connected. Net income on the income statement (minus dividends) increases retained earnings on the balance sheet, and the cash flow statement starts from net income, recalculates it into the actual change in cash, and ends with the cash on the balance sheet. Looking at one statement alone makes you easy to fool; you see the company when you check that the three agree.
How the three statements connect
- Income statementMoney earned over the period → net income
- Balance sheetRetained earnings (equity) rise by net income
- Cash flow statementStarts from net income, works out the actual change in cash
- Balance sheet cashMatches cash at period end
The income statement: from sales to net income
| Line | Calculation | How to read it |
|---|---|---|
| Revenue | Amount sold | Size and growth. Tell apart price increases from volume growth |
| Gross profit | Revenue − cost of sales | Gross margin = profitability of the product itself, pricing power |
| Operating profit | Gross profit − selling, general and administrative expenses | Profit from the core business. The operating margin shows competitiveness within the industry |
| Pre-tax profit | Operating profit ± finance, other and equity-method gains and losses | Mixes in interest costs, exchange rates, gains on asset sales, etc. |
| Net income | Pre-tax profit − corporate tax | The final profit belonging to shareholders (on a consolidated basis, split into controlling and non-controlling) |
EBITDA (earnings before interest, taxes, depreciation and amortization) is operating profit plus depreciation, used to compare cash-generating power among capital-heavy companies. But equipment eventually has to be replaced, so don’t conclude a company “makes good cash” from EBITDA alone.
From 1,000 in revenue to 100 in net income (example)
The balance sheet: what it owns and what it owes
Assets = liabilities + equity
- Current assets and current liabilities: items that become cash or must be paid within a year. A low current ratio (current assets ÷ current liabilities) suggests short-term funding pressure.
- Borrowings: debt that carries interest. Borrowings and their maturity structure matter more than total liabilities. Interest-free liabilities such as customer advances can even be a sign the business is doing well.
- Inventory and receivables: if they grow faster than sales, unsold stock and unpaid customer bills are piling up.
- Goodwill and intangibles: goodwill created by acquisitions can be written down (expensed) heavily at once if the acquired business underperforms.
Whether debt is manageable is seen in the interest coverage ratio (operating profit ÷ interest expense). Below 1, the company can’t even pay its interest from operating earnings; companies stuck in that state for several years are often called “zombie companies”.
The cash flow statement: profit is not cash
| Section | Content | Healthy pattern (typical) |
|---|---|---|
| Operating cash flow | Cash actually brought in by the core business | Positive, and similar to or larger than net income |
| Investing cash flow | Capital spending, buying and selling stakes in other companies and financial products | Negative (investing) when growing |
| Financing cash flow | Borrowing and repayment, share issues, dividends, buybacks | Negative when paying down debt and paying dividends |
Free cash flow (FCF) = operating cash flow − capital expenditure (CAPEX). It is the cash left after the company maintains its business, which can be returned to shareholders and creditors. Whether dividends and buybacks are sustainable is judged more accurately from FCF than from net income.
Working capital (receivables + inventory − payables) is money tied up in running the business. A company whose sales grow fast also sees working capital grow, so it easily runs short of cash. That is where the phrase “profitable bankruptcy” comes from.
A company with profits but shrinking cash (example)
Consolidated vs separate, and net income to owners
When a company controls subsidiaries, it prepares consolidated financial statements that add up all their sales, assets and liabilities. The company’s numbers on its own are the separate financial statements. For holding companies and groups with many subsidiaries the two differ a lot, so make sure you compare on the same basis.
If the company doesn’t own 100% of a subsidiary, the part of consolidated net income belonging to other shareholders is net income to non-controlling interests, and the part belonging to our company’s shareholders is net income to owners of the parent. For P/E, EPS and ROE, use net income to owners of the parent. Using consolidated net income as is overstates profit.
One-off items and “adjusted earnings”
Items such as gains on selling a factory or property, lawsuit settlements, asset impairments, restructuring costs and currency valuation gains or losses don’t repeat every year. Calculating P/E from net income that includes such one-off items makes a company look cheaper or dearer than it really is.
Companies sometimes publish separate “adjusted earnings” excluding one-off items. In the US these are called non-GAAP earnings and are very common (chapter 11). Check what was excluded, and whether the same cost is being excluded as “one-off” every year.
A checklist of warning signs in the statements
- Is net income steady while operating cash flow stays small or negative?
- Are receivables and inventory growing much faster than sales?
- Are there consecutive years with interest coverage below 1? Is the share of short-term borrowing large?
- Are goodwill and intangibles excessively large relative to equity?
- Are transactions and loans with related parties (companies tied to the largest shareholder) large?
- Does the auditor change often, or do accounting policies change often?
- Does the gap between “adjusted earnings” and actual earnings widen every year?
Numbers that matter differently by industry
Even with the same statements, the key numbers differ by industry. Using a general manufacturing yardstick as is leads to odd conclusions.
| Industry | Numbers to check first | Why |
|---|---|---|
| Banks | Net interest margin (NIM), credit costs, capital ratios | The interest gap between money lent and money taken in is the revenue, and bad loans are the key cost |
| Insurance | Loss ratio, value of new business, capital adequacy | The claims payout ratio and the value of long-term contracts drive profit |
| Pharma and biotech (loss-making stage) | Cash on hand, quarterly cash burn, pipeline timeline | With no profit, “how many quarters can it last” is the key |
| Software and platforms | Gross margin, recurring revenue growth, customer retention | Low cost per extra sale, so margins rise sharply with scale |
| Manufacturing and capital-intensive industries | Utilization, capital spending, inventory days | Large fixed costs mean utilization swings profit hard (operating leverage) |
| Retail | Same-store sales growth, inventory turnover, payables turnover | A business that makes up for thin margins with fast turnover |
How long a loss-making company can last (₩60 billion cash, ₩7.5 billion used per quarter)
A short case: reading a company from three numbers
Here are two companies’ numbers for the same year (a fictional example).
| Item | Company A | Company B |
|---|---|---|
| Revenue growth | +30% | +8% |
| Operating margin | 5% (9% the year before) | 18% (17% the year before) |
| Operating cash flow ÷ net income | 0.4 | 1.2 |
- A: growing fast, but margins are falling and profit isn’t turning into cash well. It may have cut prices to grow sales, or sold more on credit. Next, check how fast receivables and inventory are growing.
- B: growing slowly, but margins are rising and more cash comes in than profit. It may have pricing power or a customer-prepayment model. Next, check why growth is slow (a saturated market or underinvestment).
Rather than concluding from a single number, creating “the next question to check” like this is what reading financial statements really looks like.