Accounting & analysis
Reading financial statements
The income statement, balance sheet, and cash flow statement describe performance, position, and cash.
Definition
The income statement records revenue, expenses, and profit over a period. The balance sheet is a snapshot of what the business owns and owes at a point in time. The cash flow statement explains how cash actually moved.
Accrual accounting recognises revenue when it is earned and expenses when incurred, not when cash changes hands. That timing difference is exactly why a profitable month can still run out of cash.
Intuition
Profit is an opinion about timing; cash is a fact. The three statements are three views of the same business, and they must reconcile.
When to use it
- Judging whether a business is profitable, solvent, and generating cash.
- Feeding ratio analysis, valuation, and every Lab simulation.
When not to use it
- Treating a single statement in isolation: profitability, position, and cash answer different questions.
Formula
The balance sheet identity
Assets = Liabilities + Equity
The identity every balance sheet must satisfy.
Worked example
A small month, end to end
Revenue 2,400,000; direct costs 1,500,000; operating expenses 520,000; depreciation 120,000; interest 60,000; tax 25%.
- 1
Gross profit
2,400,000 − 1,500,000 = 900,000.
- 2
Operating profit (EBIT)
900,000 − 520,000 − 120,000 = 260,000.
- 3
Profit before tax
260,000 − 60,000 = 200,000.
- 4
Tax and profit after tax
Tax 50,000, so net income = 150,000.
Net income is 150,000 on revenue of 2,400,000: a 6.25% net margin.
Measured by
These scoreboard metrics track or interpret this idea across the Lab.
Common mistakes
- Reading profit as cash and assuming a profitable business cannot run short.
- Comparing a period statement (income) with a point-in-time statement (balance sheet) as if they covered the same span.
- Ignoring notes and one-off items that change what the headline figures mean.
How it connects
requires
Learn the source first; the target assumes it.
- How the three statements connect: Learn the statements before the links between them.
relates to
Useful to study together, in either order.
is an advanced form of
The source extends the target once the basics are secure.