Every company's accounts rest on three statements. They describe the same business from three angles, and they are connected — which is what makes them useful rather than merely informative.
The income statement
Shows revenue and expenses over a period, arriving at profit.
What it answers: did the business make money this year, and from what?
The lines that carry the most information are usually:
- Revenue growth — and whether it came from volume or price.
- Gross margin — the difference between what things cost to make and what they sell for, which reveals pricing power.
- Operating margin — the same after running the business.
- The gap between operating profit and net profit — where interest costs and tax appear, and where one-off items are often placed.
Accounting choices live here. Depreciation schedules, revenue recognition timing and provisions can all change reported profit without changing the cash the business generated.
The balance sheet
A snapshot at a point in time: what the company owns (assets), what it owes (liabilities), and the residual (equity). It balances by construction.
What it answers: is the company financially sound, and what is it made of?
Watch:
- The composition of debt — how much is due soon, and at what rate.
- Goodwill, an asset created by acquisitions. It can be written down later, at which point it becomes a loss with no cash effect.
- Working capital — inventory and receivables. Growth here consumes cash even when profit is rising.
The cash flow statement
Reconciles profit with the actual movement of cash, split into operating, investing and financing activities.
What it answers: did the profit turn into cash, and where did the cash go?
This is the statement that is hardest to present favourably, because it is a reconciliation: it starts from reported profit and adjusts for everything that was not cash. Persistent divergence between profit and operating cash flow is worth investigating.
Free cash flow — operating cash flow minus capital expenditure — is the cash left for shareholders after keeping the business running. For a business that needs constant reinvestment to stand still, it can be a very different number from net profit.
How the three connect
The links are worth knowing because they let one statement be checked against another:
- Net profit from the income statement becomes the top of the cash flow statement and feeds into equity on the balance sheet.
- Depreciation reduces profit on the income statement, is added back in the cash flow statement, and reduces the value of assets on the balance sheet.
- Capital expenditure appears on the cash flow statement and increases assets on the balance sheet.
- Debt raised appears as a financing inflow and increases liabilities on the balance sheet.
A claim in one statement that is inconsistent with the others is a question worth asking.
Why this matters to an investor
A share is a claim on a business. Understanding the three statements is what allows an assessment of whether the business generates cash, whether it is financed soundly, and whether the reported profit reflects what actually happened.
The contrast with a bond is instructive: a bond's return is defined by the contract, and the analysis is largely about the ability to pay. An equity's return depends on the business, and the analysis has to go deeper.