Financial statements are a standardised description of a business, and reading them competently is a learnable skill that a surprising number of business owners never acquire.
The three statements
The profit and loss account shows revenue and costs over a period, arriving at profit.
The balance sheet shows assets, liabilities and equity at a point in time.
The cash flow statement shows how cash moved during the period, reconciling profit to the change in cash.
Each answers a different question, and looking at only one is where most misreading originates.
How they connect
Profit for the period flows into retained earnings on the balance sheet.
The cash flow statement starts from profit and adjusts for non-cash items and for changes in balance sheet positions.
Which means the three are mutually constraining, and inconsistencies between them are the first thing an analyst looks for.
Reading the profit and loss
Revenue trend over several years, since one year says little.
Gross margin, which describes the fundamental economics of what is sold and should be stable unless something changed.
Operating expenses as a proportion of revenue, which shows whether costs are scaling with the business or ahead of it.
And exceptional or one-off items, which are worth removing to see the underlying trend.
Reading the balance sheet
Current assets against current liabilities, which indicates whether short-term obligations can be met.
Debtor days, calculated from receivables and revenue, showing how long customers take to pay.
Stock levels and turnover, since stock is cash that has been converted into goods.
Borrowing levels and what they are secured on.
And intangible assets, which merit scrutiny since they can represent genuine value or an accounting artefact from an acquisition.
Reading the cash flow statement
Arguably the most informative and the least read.
Cash from operations should broadly track profit over time. Persistent divergence indicates something worth investigating.
Cash consumed by working capital shows whether growth is being funded internally.
Investing outflows show what is being spent on the future.
Financing flows show whether the business is drawing on or repaying external funding.
The notes
Where the actual information is.
Accounting policies, which determine how numbers were arrived at and can differ substantially between comparable businesses.
Related party transactions.
Contingent liabilities and commitments not on the balance sheet.
Post balance sheet events.
Going concern statements, which are worth reading closely when present.
Ratios worth calculating
Gross and net margin. Current ratio. Debtor and creditor days. Stock turnover. Interest cover. Return on capital employed.
Each is a division taking seconds, and together they describe most of what matters.
Comparing against previous years matters more than against any benchmark, since business models differ.
What accounts do not tell you
Customer concentration, generally.
Order book and pipeline.
Key person dependency.
Contract terms and renewal risk.
Which is why due diligence involves considerably more than reading accounts, and why filed accounts for small companies — frequently abbreviated — carry limited information.
Anyone relying on accounts for a significant decision should involve an accountant, since the interpretation of accounting policy choices requires expertise this does not substitute for.
Accruals and prepayments
The mechanism by which accounts differ from cash.
Accruals recognise costs incurred but not yet invoiced. Prepayments defer costs paid in advance to the period they relate to.
Which is what makes the profit figure describe the period rather than the payment timing, and it is why profit and cash diverge.
Large or unusual accruals are worth understanding, since they involve judgement.
Depreciation and amortisation
Spreading the cost of assets over their useful lives.
The useful life chosen is a judgement, and different choices produce materially different profit figures for identical businesses.
Which is why comparing companies requires checking their policies, stated in the notes.
Consolidated accounts
Where a group of companies is presented as one entity.
Intra-group transactions are eliminated, which means group figures differ from the sum of the individual companies.
Minority interests, where the group does not own a subsidiary entirely, appear separately and are frequently misread.
Small company exemptions
Companies below defined size thresholds may file abbreviated accounts in many jurisdictions.
Which means publicly available accounts for small companies frequently contain a balance sheet and minimal notes, with no profit and loss account at all.
Assessing such a company therefore requires requesting full accounts directly, which they may decline to provide.
Which is worth knowing when assessing a supplier or customer, since the public information is genuinely limited.
Audit
Audited accounts carry an opinion from an independent auditor. Unaudited accounts do not.
Small companies are generally exempt from audit, which means most small company accounts have not been independently verified.
Qualified audit opinions, where the auditor could not give a clean opinion, are significant and are stated plainly in the report.
Practice
Reading the accounts of a few businesses you know well makes the patterns visible faster than any explanation.
Filed accounts are public for registered companies in most jurisdictions and free to obtain.