Most financial analysis starts from three statements: the balance sheet, the income statement and the cash flow statement. Each answers a different question about the business, and every ratio on this site takes its figures from one or two of them.
The three statements at a glance
| Statement | Question it answers | Time basis | Typical lines |
|---|---|---|---|
| Balance sheet | What does the business own and owe, and what is left for shareholders? | One date | Cash, receivables, inventory, equipment, payables, borrowings, shareholders’ equity |
| Income statement | Did the business make a profit or a loss? | A period, such as a year or a quarter | Revenue, cost of goods sold, operating expenses, interest, tax, net income |
| Cash flow statement | Where did cash come from, and where did it go? | The same period | Cash from operating, investing and financing activities |
The balance sheet is also called the statement of financial position, and the income statement the profit and loss account or statement of operations. A full set of statements usually also includes a statement of changes in equity and the notes, which explain the accounting policies and break down many of the totals.
The balance sheet
The balance sheet lists what the business owns (its assets), what it owes (its liabilities) and the difference, which belongs to the shareholders (equity). It always balances: total assets equal total liabilities plus shareholders’ equity. Every asset is funded either by money the business owes or by money that belongs to its owners.
Assets and liabilities are usually split into current and non-current. Current assets are cash and the items the business expects to turn into cash or use up within a year, such as receivables and inventory. Current liabilities are the amounts due within a year, such as supplier bills, short-term loans and the part of long-term debt that falls due in the next twelve months. Non-current items include property and equipment, long-term loans and other obligations due later.
Equity has two main parts: the money shareholders have put in, and retained earnings, the profits the business has kept rather than paid out as dividends. Equity is a book figure. It usually differs from what the business or its shares would sell for.
The income statement
The income statement reports revenue and expenses for a period and the profit or loss that results. It is usually laid out in steps, each giving a profit figure that ratios use:
- Revenue minus cost of goods sold gives gross profit.
- Gross profit minus operating expenses, such as wages, rent and marketing, gives operating income.
- Operating income minus interest expense, plus or minus any other non-operating items, gives profit before tax.
- Profit before tax minus income tax expense gives net income, the bottom line.
The statement is prepared on the accrual basis. Revenue is recorded when it is earned and expenses when they are incurred, not when cash changes hands. Depreciation and amortization spread the cost of long-lived assets over the years they are used, so they reduce profit without any cash leaving the business in that period. They may sit within cost of goods sold or operating expenses. Accruals and non-cash expenses are the main reasons net income and cash flow differ.
Of $600,000 of revenue, $360,000 goes on the cost of goods sold, leaving gross profit of $240,000. Operating expenses of $150,000 leave operating income of $90,000, and after interest and tax, net income is $60,000: 10 cents of every revenue dollar. Illustrative company, not actual results.
The cash flow statement
The cash flow statement shows how cash moved during the period, in three sections:
- Operating activities: cash from the main business, such as receipts from customers and payments to suppliers and employees.
- Investing activities: cash spent on or received from long-term assets and investments, such as buying or selling equipment.
- Financing activities: cash from or to lenders and shareholders, such as new borrowing, loan repayments, share issues and, usually, dividends paid.
Many companies present operating cash flow using the indirect method. It starts from net income, adds back non-cash expenses such as depreciation, and then adjusts for changes in working capital. A rise in receivables or inventory means cash is tied up, so it reduces operating cash flow. A rise in payables increases it, because the business has not yet paid for some of what it used. Where interest and dividends appear can depend on the accounting framework, so check before you compare two companies.
How the three statements connect
Net income from the income statement, less any dividends paid, adds to retained earnings within equity on the balance sheet. The cash flow statement explains how cash on the balance sheet changed between the start and the end of the period.
Following the links between the statements is a quick way to understand a set of accounts.
- Net income and retained earnings. Net income for the period, less any dividends declared, is added to retained earnings on the balance sheet. A business that earns 60,000 and declares dividends of 20,000 adds 40,000 to retained earnings, apart from less common items that go directly to equity.
- Cash. The cash flow statement explains the change in cash between the opening and closing balance sheets. If cash was 30,000 at the start of the year and the three sections together brought in a net 10,000, the closing balance sheet shows cash of 40,000.
- Long-term assets and borrowing. Equipment bought for cash appears under investing activities and adds to property and equipment; depreciation then reduces its carrying amount and appears as an expense. New loans appear under financing activities and add to debt, while their interest appears on the income statement.
Because of these links, profit and cash can move in different directions. A growing business can report rising net income while its cash falls, if customers take longer to pay or it buys inventory faster than it sells it.
Period figures and point-in-time figures
Balance sheet figures are measured at one date; income statement and cash flow figures cover a period. The difference matters whenever a ratio uses both.
Return on assets, for example, divides a full year of net income by total assets. If assets grew sharply during the year, the closing figure overstates what the business had to work with for most of that year. That is why such ratios often use the average of the opening and closing balances. The guide to average vs ending balances explains when this matters.
A single balance sheet date can also mislead. A seasonal business may hold far more inventory just before its busy season than just after it, so ratios built on year-end balances describe that date, not the whole year. Compare the same point in each year, and remember that a quarterly income statement covers about three months rather than twelve.
Which line items feed which ratios
Knowing where each figure comes from helps you check a calculation and spot mismatched dates or periods.
Financial statement map
Choose a line item to see which ratios use it, or choose a ratio to see its line items and the calculation.
Illustrative example company, not actual results. Balance sheet ratios use year-end balances.
Balance sheet (end of year)
Assets
Liabilities and equity
Income statement (year)
Ratios
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Line items and the ratios that use them (text view)
- Cash and cash equivalents
- Quick ratio (numerator), Cash ratio (numerator)
- Short-term investments
- Quick ratio (numerator)
- Accounts receivable
- Quick ratio (numerator)
- Inventory
- Inventory turnover (denominator)
- Current assets
- Current ratio (numerator), Working capital
- Total assets
- Return on assets (denominator), DuPont analysis, Debt-to-assets ratio (denominator), Asset turnover (denominator)
- Accounts payable
- Days payable outstanding
- Current liabilities
- Current ratio (denominator), Quick ratio (denominator), Cash ratio (denominator), Working capital
- Total liabilities
- Debt-to-equity ratio (numerator), Debt-to-assets ratio (numerator)
- Shareholders' equity
- Return on equity (denominator), DuPont analysis, Debt-to-equity ratio (denominator)
- Revenue
- Gross profit margin (denominator), Operating profit margin (denominator), Net profit margin (denominator), EBITDA margin (denominator), DuPont analysis, Asset turnover (numerator)
- Cost of goods sold
- Inventory turnover (numerator), Days payable outstanding
- Gross profit
- Gross profit margin (numerator)
- Operating income
- Operating profit margin (numerator), Interest coverage ratio (numerator)
- Interest expense
- Interest coverage ratio (denominator), EBITDA
- Income tax expense
- EBITDA
- Net income
- Net profit margin (numerator), Return on assets (numerator), Return on equity (numerator), DuPont analysis, EBITDA
- Depreciation
- EBITDA
- Amortization
- EBITDA
- EBITDA
- EBITDA margin (numerator)
- Balance sheet only. The current ratio and working capital compare current assets with current liabilities. The debt-to-equity ratio and the debt-to-assets ratio compare liabilities with equity and with total assets. All of these use figures from the same date.
- Income statement only. Margins divide a profit line by revenue: gross profit margin uses gross profit and net profit margin uses net income. The interest coverage ratio divides operating income by interest expense. EBITDA is built from income statement lines too: net income plus interest, tax, depreciation and amortization.
- Both statements. Return on assets divides net income by average total assets. Inventory turnover divides cost of goods sold by average inventory, and days sales outstanding sets receivables against credit sales.
- Loan payments. The debt service coverage ratio sets income against scheduled interest and principal payments. Principal repayments are not an expense, so they come from the cash flow statement, the notes or the loan agreement rather than the income statement.
- Market data. Valuation ratios such as the price-to-earnings ratio combine a share price with a figure from the statements, such as earnings per share.
A practical reading order
- Check the basics: the entity, the period, the balance sheet date, the currency and the units, such as thousands or millions.
- Read the balance sheet totals: how assets split between current and non-current, and how much of them is financed by liabilities rather than equity.
- Read the income statement from top to bottom, comparing each line with the previous period. Statements usually show at least one earlier period for comparison.
- Compare operating cash flow with net income, and look for the reasons behind any gap that persists.
- Read the notes for the items behind the figures you care about: accounting policies, debt terms and any unusual or one-off items.
The guide on how to analyze financial ratios sets out a method for using these figures, and the financial ratio analysis example applies it to an illustrative company.