The Three Core Statements
Every listed company is required to publish financial statements — structured reports of its financial position and performance. For investors, these statements are the primary source of objective, audited information about a business. There are three core statements, each telling a different part of the story.
The income statement (profit and loss account) shows revenues, costs, and profit over a period — typically a quarter or a year. It answers: did the business make money, and how much? Key lines include revenue (or "turnover"), gross profit (revenue minus cost of goods sold), operating profit (EBIT — earnings before interest and tax), and net income (profit after all charges including interest and tax).
The balance sheet (statement of financial position) shows the business's assets, liabilities, and equity at a single point in time. It answers: what does the company own, what does it owe, and what is left for shareholders? The fundamental equation is: Assets = Liabilities + Shareholders' Equity.
The cash flow statement shows how cash moved in and out of the business during the period. It reconciles accounting profit with actual cash generation — a critical distinction, since a company can be profitable on paper while running out of cash. The cash flow statement divides into operating, investing, and financing activities.
Why Cash Flow Matters More Than Profit
Accounting profit is a useful measure, but it is constructed using judgements and accounting conventions that can obscure the underlying cash reality. Depreciation, amortisation, working capital movements, and revenue recognition choices all affect reported profit without directly affecting cash.
Free cash flow — operating cash flow minus capital expenditures — represents the cash a business generates that can be returned to shareholders, used to pay down debt, or reinvested for growth. A business that generates consistent and growing free cash flow is generally healthier than one that reports accounting profits but consumes cash.
The relationship between profit and cash flow is revealing. A company whose net income is consistently much higher than its operating cash flow may be using aggressive accounting policies. A company whose cash flow significantly exceeds accounting profit is often a sign of high quality — good businesses tend to be cash generative relative to reported earnings.
Key Ratios from the Statements
Reading financial statements well means extracting ratios that allow comparison across time and across companies.
Gross margin (gross profit divided by revenue) measures how efficiently a company turns revenue into profit after direct costs. A falling gross margin may signal pricing pressure or rising input costs.
Operating margin (operating profit divided by revenue) captures the profitability of the core business after overheads but before financing costs. Comparing this across competitors reveals relative operational efficiency.
Return on equity (ROE) measures how much profit is generated per pound of shareholder equity — a key measure of management's effectiveness in deploying capital. High and stable ROE over many years is a characteristic of great businesses.
Debt-to-equity ratio measures financial leverage: how much the company relies on borrowing versus equity. Higher leverage amplifies returns in good times but raises default risk in bad ones.