Reading financial statements

The income statement shows revenue, expenses and profit over a period. The balance sheet shows what a company owns and owes at a point in time. The cash flow statement reconciles profit to the actual change in cash. Profit is an opinion shaped by accounting choices; cash is a fact.

Net income from the income statement starts the cash flow statement and flows into retained earnings on the balance sheet. Non-cash items such as depreciation are added back in the cash flow statement. Changes in working capital, capital spending and financing activity complete the cash bridge, and ending cash lands on the balance sheet.

Interviewers love 'depreciation rises by $10; walk me through the statements'. Answer with tax: pre-tax income falls $10, and at a 25% rate net income falls $7.50. In the cash flow statement, net income is down $7.50 but $10 is added back, so cash rises $2.50. On the balance sheet, cash is up $2.50, PP&E down $10, so assets fall $7.50, matched by retained earnings down $7.50.

Working capital is the cash tied up in running the business: receivables and inventory minus payables. When receivables grow, the company has booked revenue it has not collected, so cash falls. Fast-growing businesses often show strong profits and weak cash for exactly this reason.

Compare operating cash flow with net income over several years. Persistent gaps, rising receivables relative to revenue, capitalised costs, or frequent 'one-off' charges are signs that earnings are weaker than reported. Always read the notes: revenue recognition, leases and debt terms live there.