2. The three financial statements of a company

Theory 3: Asset classes and how to read a company

A company can post positive net income quarter after quarter and, at the same time, run out of money in the bank. Both things at once, without a single figure being false.

When a listed company reports its quarterly or annual results, it does so through three documents. Together they tell three complementary stories about the same reality:

• What it earned.
• What it owns and what it owes.
• Where the money actually came from and where it actually went.

The income statement: was money made?

The income statement answers the most intuitive question: did the company make money this period?

It starts with revenue, the total amount billed in sales. From there it subtracts successive layers of costs:

• The direct cost of producing what was sold, which gives gross profit.
• Operating expenses such as marketing, R&D and administration, which give operating profit, or EBIT.
• And finally interest and taxes, arriving at net income, the figure that almost always makes the headlines.

A widely quoted intermediate figure is EBITDA: earnings before interest, taxes, depreciation and amortization.

It tries to isolate the purely operating profitability of the business, stripped of the effect of financing decisions and of how assets that depreciate over time are accounted for.

The balance sheet: a still photograph, not a film

The balance sheet answers a different question: what does the company own and owe at a specific instant, rather than over a period?

It is organized into two blocks that must always match each other:

• Assets: everything the company owns and that can generate future value, such as cash, inventory, machinery or intellectual property.
• Liabilities plus shareholders' equity. Liabilities are what it owes to third parties: bank debt, bonds issued, outstanding payments to suppliers. Equity is what would be left for shareholders if every asset were sold and every liability paid off.

That equality — assets equal liabilities plus equity — is not an accounting coincidence. It is a mandatory mathematical identity: everything the company owns has, by definition, been financed somehow, either with third-party debt or with shareholders' capital.

The cash flow statement: the most honest document

The cash flow statement is, for many experienced analysts, the most honest of the three. It answers a question that accounting profit can conceal: where did money actually come in from, and where did it actually go out?

It is split into three blocks:

• Cash flow from operating activities: the cash generated by the day-to-day business.
• Cash flow from investing activities: money spent or received buying or selling long-term assets, such as factories or acquisitions of other companies.
• Cash flow from financing activities: money in or out from issuing debt, repaying debt, issuing shares or buying them back.

Why profit and cash are not the same thing

The reason this document matters so much is simple. The accounting profit in the income statement does not always match the real money coming into the bank.

A company can record sales as revenue at the moment of invoicing — what is known as accrual accounting — even though the customer takes months to actually pay.

Hence the scene we opened with. A company can post positive net income quarter after quarter and, at the same time, run out of available cash. All it takes is customers who do not pay on time, or aggressive investment in growth.

It is a situation the cash flow statement reveals clearly, and that the income statement, on its own, can disguise.

The trap of reading a single number

This distinction between accounting profit and real cash is one of the most common traps when reading corporate results superficially. It works in both directions:

• A company that is 'profitable' on paper can go bust for lack of liquidity, if it does not generate enough operating cash to cover its short-term obligations.
• Another with modest or even negative accounting profit — common in growth companies investing aggressively — can have a robust and sustainable cash position.

Hence the practical conclusion of this module. No serious analysis of a company is done by looking at a single number in a single document: it is the three financial statements, read together, that start to tell the full story.