How to Read Financial Statements: A Beginner's Guide to P&L, Balance Sheet, and Cash Flow

Have you ever been curious why some of the most successful companies go bankrupt? More often than not, the reason is not profit; it's cash, debt, and what is really on the books. Financial statements address three important questions about any business: Are we making money? Do we have the assets to survive? And ultimately, do we have enough cash to keep the lights on?

These three documents, the Profit and Loss statement, Balance Sheet and Cash Flow statement, are the three core documents of financial analysis. They are not exclusively reserved for accountants, and if you are an investor, trader or entrepreneur, understanding these documents changes everything about how you are making decisions about opportunity and risk. 

The Profit and Loss (P&L) Statement: Measuring Performance

Gross Profit is Revenue (what you made) minus Cost of Goods Sold (what it costs to have the product made). Next is Operating Income, which is Gross Profit minus Operating Expenses (such as salaries, rent, and marketing expenses). You then add or subtract interest and taxes to get Net Profit (the bottom line).

Let's say you have a café. In January, you had $20,000 in total sales. Coffee beans and other supplies (e.g., cream, sugar, cups, etc.) cost $8,000. So, your total Gross Profit is $12,000. If you subtract $7,000 for rent, salaries, and utilities (these are your total Operating Expenses), that would give you an Operating Income of $5,000. After tax, for example, your Net Profit might be $4,200. That's what the profit and loss statement shows.

Balance Sheet: Your Financial Snapshot

The Profit and Loss statement can be thought of as a movie, as it shows activity and change over a period of time, while the Balance Sheet is more like a photograph, as it reflects your financial position at a single moment in time.

Returning to our café example, we will say you have $20,000 in equipment and $5,000 in cash, making $25,000 in assets. Your liabilities include a $10,000 loan you took out, leaving you with $15,000 in equity. The Balance Sheet "snapshot" shows you: what you have, what you owe, and ultimately, what is truly yours.

The Cash Flow Statement: Following the Money

The Cash Flow statement shows the cash flow into and out of the business in three areas: Operating Activities (cash from running a business), Investing Activities (cash used to acquire assets), and Financing Activities (cash received from and/or paid to investors and creditors).

For example, you have made a $10,000 profit this year. However, you bought some new equipment that cost you $8,000. The equipment purchase will not show up as an expense in your profit & loss statement, but it certainly reduces your available cash. After that purchase, your actual cash on hand is not $10,000 but $2,000. Your profit looks good, but your cash position tells a different story.

The Three Statements Compared: What's the Difference

The P&L statement indicates the level of performance, the Balance Sheet shows strength, and the Cash Flow helps estimate the length of the success both options can last. Each report accounts for different parts of the story. In the absence of one report, you are at a disadvantage in decision-making. A company can have an exceptional P&L but have a debt burden (Balance Sheet problem) or be burning cash (Cash Flow problem). Alternatively, even with assets and equity, a company may be okay taking short-term losses to build for the long-term. 

Why This Matters for Traders and Investors

For Investors: Financial statements allow you to assess whether a company is truly sound financially speaking. You can see if it is growing its earnings, if it is carrying manageable debt levels, and if it is generating cash. If you see a company growing revenue outdoors but carrying significant debt, tread lightly. If you see a company with modest growth but a fortress-like balance sheet, then that's the type of business to bet on.

For CFD Traders: Stock prices often move based on technical patterns, but what can often lead to these major price moves are fundamental shifts discovered in financial statements. A company with weakening cash flows could reveal a problem before the investors anticipate it. Similarly, a company with improved profitability could lead you into a breakout period.

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