When it comes to understanding a business, there are few financial statements more

important than the balance sheet. The balance sheet offers critical insight into the health of a
business that can be used by:

 Potential investors to decide whether to invest in a company

 Business owners to craft more effective organizational strategy
 Employees to adjust their processes to better reach shared organizational goals
Whether you’re a business owner, employee, or investor, understanding how to read and
understand the information in a balance sheet is an essential financial accounting skill to
have.

Here’s everything you need to know about understanding a balance sheet, including what it
is, the information it contains, why it’s so important, and the underlying mechanics of how it
works.

WHAT IS A BALANCE SHEET?

A balance sheet is a financial document designed to communicate exactly how much a

company or organization is worth—its so-called “book value.” The balance sheet achieves
this by listing out and tallying up all of a company’s assets, liabilities, and owners’ equity as
of a particular date, also known as the “reporting date."

Typically, a balance sheet will be prepared and distributed on a quarterly or monthly basis,
depending on the frequency of reporting as determined by law or company policy.

The Purpose of the Balance Sheet

A balance sheet provides a summary of a business at a given point in time. It’s a snapshot of
a company’s financial position, as broken down into assets, liabilities, and equity. Balance
sheets serve two very different purposes depending on the audience reviewing them.

When a balance sheet is reviewed internally by a business leader, key stakeholder, or

employee, it’s designed to give insight into whether a company is succeeding or failing.
Based on this information, an internal audience can shift their policies and approach:
doubling down on successes, correcting failures, and pivoting toward new opportunities.

When a balance sheet is reviewed externally by someone interested in a company, it’s

designed to give insight into what resources are available to a business and how they were
financed. Based on this information, potential investors can decide whether it would be wise
to invest in a company. Similarly, it’s possible to leverage the information in a balance sheet
to calculate important metrics, such as liquidity, profitability, and debt-to-equity ratio.

External auditors, on the other hand, might use a balance sheet to ensure a company is
complying with any reporting laws it’s subject to.
It’s important to remember that a balance sheet communicates information as of a specific
date. By its very nature, a balance sheet is always based upon past data. While investors and
stakeholders may use a balance sheet to predict future performance, past performance is no
guarantee of future results.

THE BALANCE SHEET EQUATION

The information found in a balance sheet will most often be organized according to the
following equation: Assets = Liabilities + Owners’ Equity.

While this equation is the most common formula for balance sheets, it isn’t the only way of
organizing the information. Here are other equations you may encounter:

Owners’ Equity = Assets - Liabilities

Liabilities = Assets - Owners’ Equity

A balance sheet should always balance. Assets must always equal liabilities plus owners’
equity. Owners’ equity must always equal assets minus liabilities. Liabilities
must always equal assets minus owners’ equity.

If a balance sheet doesn’t balance, it’s likely the document was prepared incorrectly.
Typically, errors are due to incomplete or missing data, incorrectly entered transactions,
errors in currency exchange rates or inventory levels, miscalculations of equity, or
miscalculated depreciation or amortization.

Here’s a closer look at what's typically included in each of those categories of value: assets,
liabilities, and owners’ equity.

1. Assets

An asset is defined as anything that is owned by a company and holds inherent, quantifiable
value. A business could, if necessary, convert an asset into cash through a process known as
liquidation. Assets are typically tallied as positives (+) in a balance sheet and broken down
into two further categories: current assets and noncurrent assets.

Current assets typically include anything a company expects it will convert into cash within a
year, such as:

 Cash and cash equivalents

 Prepaid expenses
 Inventory
 Marketable securities
 Accounts receivable
Noncurrent assets typically include long-term investments that aren’t expected to be
converted into cash in the short term, such as:

 Land
 Patents
 Trademarks
 Brands
 Goodwill
 Intellectual property
 Equipment used to produce goods or perform services
Because companies invest in assets to fulfill their mission, you must develop an intuitive
understanding of what they are. Without this knowledge, it can be challenging to understand
the balance sheet and other financial documents that speak to a company’s health.

Related: Financial Statement Analysis: The Basics for Non-Accountants

2. Liabilities

A liability is the opposite of an asset. While an asset is something a company owns, a liability
is something it owes. Liabilities are financial and legal obligations to pay an amount of
money to a debtor, which is why they’re typically tallied as negatives (-) in a balance sheet.

Just as assets are categorized as current or noncurrent, liabilities are categorized as current
liabilities or noncurrent liabilities.

Current liabilities typically refer to any liability due to the debtor within one year, which may
include:

 Payroll expenses
 Rent payments
 Utility payments
 Debt financing
 Accounts payable
 Other accrued expenses
Noncurrent liabilities typically refer to any long-term obligations or debts which will not be
due within one year, which might include:

 Leases
 Loans
 Bonds payable
 Provisions for pensions
 Deferred tax liabilities
Liabilities may also include an obligation to provide goods or services in the future.
3. Owners’ Equity

Owners’ equity, also known as shareholders' equity, typically refers to anything that belongs
to the owners of a business after any liabilities are accounted for.

If you were to add up all of the resources a business owns (the assets) and subtract all of the
claims from third parties (the liabilities), the residual leftover is the owners’ equity.

Owners’ equity typically includes two key elements. The first is money, which is contributed
to the business in the form of an investment in exchange for some degree of ownership
(typically represented by shares). The second is earnings that the company generates over
time and retains.

How To Read a Profit and Loss (P&L) Report: With Examples

A profit and loss (P&L) report is a critical piece of information for a company that states
whether a company is profitable. The P&L report lists revenue, expenses and other
information to provide insight into the company's performance. Learning how to read a P&L
report can help you ensure it successfully achieves its financial goals.
What is a P&L report?
A P&L report contains a company's income and expense information for a specific time. It
specifically breaks down revenue and expenses and measures whether a company is
profitable. Quarterly profit-and-loss statements compare current information against
projected budgets, so a company can track whether it's on pace for a profitable year and how
it's performing compared to previous years. Companies may also track their income and
expenses on a weekly, monthly or yearly basis. The components of a P&L report include:

Revenue
Cost of goods sold (COGS)
Gross profits
Operating expenses and income
Other income and expenses
Net profit
The formula for a P&L report is:

Revenue - expenses = net profit or net loss

Related: What Is a Profit and Loss Statement?

Who prepares the P&L report?
The person who creates a P&L report depends on the company's structure. The chief financial
officer (CFO) and the chief executive officer (CEO) prepare the P&L report for most publicly
traded companies. The top company executives then present the P&L report to board
members or company shareholders.

In companies organized by divisions, each one might have its own P&L for which the
president is responsible. Here, the presidents file their P&Ls with the CEO, who then might
compile an overarching P&L statement for the entire company and present it to the board. In
this structure, the company can look at each division to see if it's profitable and whether it's
contributing to the company's overall financial goals.

How to read a P&L report?

Use these seven steps to help you read and analyse a P&L report:
1. Define the revenue
The revenue or top-line portion of the P&L report documents company revenue for analysis.
Revenue details the income from sales and activity for the reporting period. If a company has
diversified revenue streams, the P&L statements might separate each stream and combine
them for overall revenue. A structure like this allows executives to evaluate each revenue
stream in addition to an overall revenue analysis.
2. Understand the expenses
Operating expenses include all costs associated with operating a company, like salaries,
benefits and utilities. Direct costs are the cost of creating the tangible product or the COGS.
For example, if a company makes pens, the plastic and ink that goes into the product are the
direct costs. Essentially, COGS is the cost of an inventory item. This category doesn't apply
to service-focused companies. An insurance company, for example, isn't creating a tangible
product and doesn't have inventory.
3. Calculate the gross margin
Some P&L statements include a line listing gross margin, which are direct costs subtracted
from revenue. This calculation shows a company how much money it has for operating
expenses. A service company without COGS has no direct cost line or gross margin. Instead,
the P&L report likely lists the operating expenses and revenue-generating expenses, such as
the cost of a sale.
4. Calculate the operating income
The operating income, also known as earnings before interest, taxes, depreciation and
amortization (EBITDA) is a company's adjusted revenue after accounting for the operating
expenses and deprecation. You can find the operating income by subtracting the operating
expenses from the gross margin for businesses with COGS. Without COGS, subtract
operating expenses from revenue.
5. Use budget vs. actual for insight
Using the budget versus the actual for insight allows you to see how well the company is
performing compacted to its original performance budget. If you want to know whether the
company is not meeting, meeting or exceeding expectations, this is the category to check.
One point of doing a quarterly P&L report is to gauge how a company's year is going and
adjust the budget if needed. Publicly traded companies use this information to project
earnings, and these projections can change throughout the year.
6. Check the year-over-year (YoY)
YoY compares a company's moments in time. Sometimes, seasonality and other factors cause
a company's fiscal quarters to fluctuate. Comparing how the company performed at the same
time of year in previous years is one way to determine whether the quarterly earnings are in
line with prior years.
For example, the fiscal year might start slowly in the first quarter but perform much better in
the second quarter. If there's a year when there isn't a surge in quarter two, this may tell the
company that it might not meet the budget and may make up the revenue in quarters three
and four.
7. Determine net profit
Determine the net profit by taking the operating income and subtracting taxes, interest on
debt, depreciation and amortization. While operating income shows a company's income
related to the expense of running the business, net profit is the bottom line profit number.
Each number is valuable in evaluating a company, but the net profit might not fully reveal a
company's health. For example, a company might have a positive cash flow but a negative net
profit because of existing debt.
Importance of reading a P&L report accurately
The P&L report is a fundamental measure of a company's success. It's a report that articulates
the company's bottom line. Effective executives can read through a P&L statement and
understand a company's financial health. This is critical information conveyed to team
members, board members and shareholders. When read correctly, a P&L report can
determine whether a business is successful and provide an important perspective on how the
information relates to expectations and prior years.

What is a Profit and Loss (P&L) Statement?

A profit and loss statement shows whether a business is profitable or not. According to
Investopedia, “a profit and loss statement is a financial statement that summarizes the
revenues, costs and expenses incurred during a specific period of time, usually a fiscal quarter
or year.”
This statement goes by many names, including P&L, income statement, earnings statement,
revenue statement, operating statement, statement of operations, and statement of financial
performance.
Cash vs. Accrual Basis
One important thing to know before you get started analyzing your profit and loss statement
is whether you are on a cash or accrual basis of accounting.
With a cash basis, revenue and expenses are recognized when there’s movement of cash (for
example, if you agree to pay a vendor $50 for a service in a month, you don’t account for that
until the $50 leaves the bank).
The accrual method accounts for revenue when it is earned (before the money reaches the
bank) and expenses when they are incurred (but before the vendors have been paid).
Analyzing a P&L Statement
How do you analyze a P&L statement? Let’s look at an example:
Many people get overwhelmed by the numbers, but a few quick tips and tricks on where to
look and why will have you feeling confident and analyzing statements like a pro.
Below are some of the easier things to analyze in your profit and loss statement:
1. Sales
This may seem obvious, but you should review your sales first since increased sales is
generally the best way to improve profitability. If you see a month was particularly good, try
to remember why so you can duplicate what you did in the future.
In this example, we see that June was the best month in terms of sales, gross profit, net
income, and profit margin. Upon review of the other numbers, we see that this might have
been due to seasonality (see more below) and/or increased marketing.
2. Sources of Income or Sales
Another factor related to sales that you should analyze are your sources of income.
Ask yourself if all of your sources of income make sense and are profitable for your business.
Are any of them overly time-consuming with very low margins? In this example, the sources
of income include selling lemonade and chips. Neither of these are negatively impacting the
business, but if the chips weren’t selling, they should be eliminated or changed to a different
type of chips, ones that are more popular, perhaps.
3. Seasonality
Seasonality is the fact that things change based on the season. This can be seen in many parts
of a business including but not limited to both sales and expenses.
In the lemonade example, you see seasonality in sales. As the summer months approach and
the temperatures rise, so do the sales. This example does not show seasonality in expenses,
but if it were to show up it could be in increased prices of lemons because of heightened
demand and lower production in the summer months. You might also see seasonality in
decreased cost of lemons in the fall and winter quarters due to increased production of
lemons and lower demand.
4. Cost of Goods Sold
Next you should review your cost of goods sold. It would make sense for cost of goods sold
to go up as revenue goes up since these expenses are directly related to your product. The
opposite would not make sense and should be a red flag.
Additionally, when you review cost of goods sold you can ask yourself questions like, “Is
there a way I can reduce these expenses?” Finding ways to decrease your cost of goods sold
will ultimately increase your bottom line and profit margin.
In this example, the business owner may want to consider purchasing items that won’t go bad
(chips, cups, and sugar) in bulk to reduce costs throughout the year and increase their yearly
profit margin.
5. Net Income
Net income is your profit and is one of the most important parts of your business if you want
it to succeed and be sustainable over time.
You want to see your profit positive (also known as “in the black”) in most cases. Some
exceptions where it’s acceptable to see a loss is when the company made a strategic
investment during one period to decrease costs or increase sales in a later period.
In our lemonade stand example, the business owner could’ve bought chips, sugar and cups in
bulk for the entire year in the month of April. If this was done it could bring the company into
a loss for the month, but that expense would be recouped with savings and higher margins
throughout the rest of the year.
6. Net Income as a Percentage of Sales (also known a profit margin)
Net income is simply your bottom line, but it’s important to do a quick calculation to
determine your net income percentage so that you create a baseline and compare “apples to
apples” across time periods and across other companies in your industry.
To determine net income as a percentage of sales simply divide net income by net revenue
then multiple your result by 100. Use the lemonade stand as an example. Take $206.07 (net
income in April) and divide it by $416 (total sales in April) to get 0.4954. Once you multiple
that number by 100 you get 49.54%.
Once you have your net income as a percentage of sales figured out for each period you can
use that information to assess if your profit margins are going up (usually a good thing),
going down (usually a bad thing), or staying the same.
Additionally, once you have your profit margin figured out you can use this data to compare
your profit margin to other companies in your industry. To compare your profit margin to
others in your industry simply try a Google search to find that data, or review a profit and
loss statement (and do the calculation discussed above) for a public company in your industry
since they publish their financial statements.
Whether you’re a working professional, business owner, entrepreneur, or investor, knowing
how to read and understand a cash flow statement can enable you to extract important data
about the financial health of a company.
If you’re an investor, this information can help you better understand whether you should
invest in a company. If you’re a business owner or entrepreneur, it can help you understand
business performance and adjust key initiatives or strategies. If you’re a manager, it can help
you more effectively manage budgets, oversee your team, and develop closer relationships
with leadership—ultimately allowing you to play a larger role within your organization.
Not everyone has finance or accounting expertise. For non-finance professionals,
understanding the concepts behind a cash flow statement and other financial documents can
be challenging.
To facilitate this understanding, here’s everything you need to know about how to read and
understand a cash flow statement.
WHAT IS A CASH FLOW STATEMENT?
The purpose of a cash flow statement is to provide a detailed picture of what happened to a
business’s cash during a specified period, known as the accounting period. It demonstrates an
organization’s ability to operate in the short and long term, based on how much cash is
flowing into and out of the business.
The cash flow statement is typically broken into three sections:
 Operating activities
 Investing activities
 Financing activities
Operating activities detail cash flow that’s generated once the company delivers its regular
goods or services, and includes both revenue and expenses. Investing activities include cash
flow from purchasing or selling assets—think physical property, such as real estate or
vehicles, and non-physical property, like patents—using free cash, not debt. Financing
activities detail cash flow from both debt and equity financing.
Based on the cash flow statement, you can see how much cash different types of activities
generate, then make business decisions based on your analysis of financial statements.
Ideally, a company’s cash from operating income should routinely exceed its net income,
because a positive cash flow speaks to a company’s ability to remain solvent and grow its
operations.
It’s important to note that cash flow is different from profit, which is why a cash flow
statement is often interpreted together with other financial documents, such as a balance
sheet and income statement.
How cash flow is calculated?
Now that you understand what comprises a cash flow statement and why it’s important for
financial analysis, here’s a look at two common methods used to calculate and prepare the
operating activities section of cash flow statements.
Cash Flow Statement Direct Method
The first method used to calculate the operation section is called the direct method, which is
based on the transactional information that impacted cash during the period. To calculate the
operation section using the direct method, take all cash collections from operating activities,
and subtract all of the cash disbursements from the operating activities.
Cash Flow Statement Indirect Method
The second way to prepare the operating section of the statement of cash flows is called
the indirect method. This method depends on the accrual accounting method in which the
accountant records revenues and expenses at times other than when cash was paid or received
—meaning that these accrual entries and adjustments cause the cash flow from operating
activities to differ from net income.
Instead of organizing transactional data like the direct method, the accountant starts with the
net income number found from the income statement and makes adjustments to undo the
impact of the accruals that were made during the period.
Essentially, the accountant will convert net income to actual cash flow by de-accruing it
through a process of identifying any non-cash expenses for the period from the income
statement. The most common and consistent of these are depreciation, the reduction in the
value of an asset over time, and amortization, the spreading of payments over multiple
periods.
How to interpret a cash flow statement?
Whenever you review any financial statement, you should consider it from a business
perspective. Financial documents are designed to provide insight into the financial health and
status of an organization.
For example, cash flow statements can reveal what phase a business is in: whether it’s a
rapidly growing start-up or a mature and profitable company. It can also reveal whether a
company is going through transition or in a state of decline.
Using this information, an investor might decide that a company with uneven cash flow is too
risky to invest in; or they might decide that a company with positive cash flow is primed for
growth. Similarly, a department head might look at a cash flow statement to understand how
their particular department is contributing to the health and wellbeing of the company and use
that insight to adjust their department’s activities. Cash flow might also impact internal
decisions, such as budgeting, or the decision to hire (or fire) employees.
Cash flow is typically depicted as being positive (the business is taking in more cash than it’s
expending) or negative (the business is spending more cash than it’s receiving).
Positive Cash Flow
Positive cash flow indicates that a company has more money flowing into the business than
out of it over a specified period. This is an ideal situation to be in because having an excess of
cash allows the company to reinvest in itself and its shareholders, settle debt payments, and
find new ways to grow the business.
Positive cash flow does not necessarily translate to profit, however. Your business can be
profitable without being cash flow-positive, and you can have positive cash flow without
actually making a profit.
Negative Cash Flow
Having negative cash flow means your cash outflow is higher than your cash inflow during a
period, but it doesn’t necessarily mean profit is lost. Instead, negative cash flow may be
caused by expenditure and income mismatch, which should be addressed as soon as possible.
Negative cash flow may also be caused by a company’s decision to expand the business and
invest in future growth, so it’s important to analyze changes in cash flow from one period to
another, which can indicate how a company is performing overall.
Cash flow statement example
Here's an example of a cash flow statement generated by a fictional company, which shows
the kind of information typically included and how it's organized.
This cash flow statement shows Company A started the year with approximately $10.75
billion in cash and equivalents.
Cash flow is broken out into cash flow from operating activities, investing activities, and
financing activities. The business brought in $53.66 billion through its regular operating
activities. Meanwhile, it spent approximately $33.77 billion in investment activities, and a
further $16.3 billion in financing activities, for a total cash outflow of $50.1 billion.
The result is the business ended the year with a positive cash flow of $3.5 billion, and total
cash of $14.26 billion.
The importance of cash flow
Cash flow statements are one of the most critical financial documents that an organization
prepares, offering valuable insight into the health of the business. By learning how to read a
cash flow statement and other financial documents, you can acquire the financial accounting
skills needed to make smarter business and investment decisions, regardless of your position.
Data Tables
Company A - Statement of Cash Flows (Alternative Version)
Year Ended September 28, 2019 (In millions)
Cash and cash equivalents, beginning of the year: $10,746
OPERATING ACTIVITIES

Activity Amount

Net income 37,037

Adjustments to reconcile net income to cash generated by operating

activities:

Depreciation and amortization 6,757

Deferred income tax expense 1,141

Other 2,253

Changes in operating assets and liabilities:

Accounts receivable, net (2,172)

Inventories (973)

Vendor non-trade receivables 223

Other current and non-current assets 1,080

Accounts payable 2,340

Deferred revenue 1,459

 Activity Amount

Other current and non-current liabilities 4,521

Cash generated by operating activities 53,666

INVESTING ACTIVITIES

Activity Amount

Purchases of marketable securities (148,489)

Proceeds from maturities of marketable securities 20,317

Proceeds from sales of marketable securities 104,130

Payments made in connection with business acquisitions, net of cash acquired (496)

Payments for acquisition of intangible assets (911)

Other (160)

Cash used in investing activities (33,774)

FINANCING ACTIVITIES

Activity Amount

Dividends and dividend equivalent rights paid (10,564)

Repurchase of common stock (22,860)

Proceeds from issuance of long-term debt, net 16,896

Other 149

Cash used in financing activities (16,379)

Increase / Decrease in Cash and Cash Equivalents: 3,513
Cash and Cash Equivalents, End of Year: $14,259