Why read financials, and what the three statements each answer
The answer
A company's annual report contains 3 statements, and each one answers a different question. The balance sheet says what the company owns and owes on one day. The income statement says what it earned over a year. The cash flow statement says what money actually moved.
You need all 3, because the first 2 contain judgement and the third one mostly does not.
Why this costs you money
Here is the most expensive habit in retail investing, and almost everybody has it.
You buy a company because the profit is growing. You saw the number in a headline, or on a screener, or in the "Financials" tab of your broker app. Profit up 22%. That is the whole reason.
Two years later the company announces that it cannot pay a loan instalment. The stock falls 40% in a week. You go back and read the annual reports you skipped, and you find that in both of those years the profit was rising and the cash coming in from customers was falling. The gap was printed, in the same document, about 8 pages apart. Nobody hid it. You did not look.
This is not a rare event. It is the ordinary shape of most Indian and American corporate failures. The profit line held up almost until the end, because profit is calculated. The cash line went first, because cash is counted.
The sentence to carry out of this entire cluster is this one: profit is an opinion, cash is a fact.
Profit is an opinion because getting to it requires dozens of decisions. When is a sale a sale? How fast does a machine wear out? Will this customer pay? Is this cost an expense this year or an asset for 5 years? Management makes every one of those decisions, inside rules that allow a range. Two honest companies with identical businesses can report different profits.
Cash is a fact because a bank balance is either there or it is not.
Investors who read only the profit line are reading the most edited number in the document and ignoring the least edited one.
How it works
Every set of financial statements answers 3 questions. Learn which question goes with which statement and you will never open the wrong page again.
| Statement | The question it answers | The period it covers |
|---|---|---|
| Balance sheet | What do we own, what do we owe, and what is left for shareholders? | One single day |
| Income statement | Did we make a profit over the year, and from what? | A period, usually 12 months |
| Cash flow statement | Where did money actually come from and go? | The same period |
The balance sheet is a photograph
It is taken on one date, normally 31 March in India and 31 December for most large American companies. It lists assets on one side, and liabilities plus equity on the other. It tells you how much debt there is, how much cash, and how much of the value is property rather than an accounting entry called goodwill. It says nothing about the 364 other days.
The income statement is a film
It starts with revenue, which is what customers were billed, and subtracts costs in layers. Gross profit is revenue minus the direct cost of the product. Operating profit is what remains after running the business. Profit after tax is what is left for shareholders.
Every subtraction on that page involves an estimate. That is not fraud. That is how accounting works. It does mean the final number is the end of a long chain of judgements.
The cash flow statement is the bank statement
It has 3 sections, and the split is the useful part.
- Operating. Cash from selling things to customers, after paying suppliers, staff and tax. This is the business itself.
- Investing. Cash spent on factories, machines and acquisitions, or received from selling them.
- Financing. Cash raised from lenders and shareholders, and cash returned to them as loan repayments and dividends.
A company that shows small or negative operating cash and large positive financing cash is being funded by lenders rather than by customers. That can be correct for a young company. It is a warning for an old one.
How the 3 connect
They are one document, not three. Profit after tax from the income statement is added to retained earnings on the balance sheet. The cash flow statement usually starts at that same profit figure and then adjusts it, item by item, until it arrives at the actual change in the cash line on the balance sheet.
That adjustment section is the most informative half page in the report. It is literally a list of the differences between the opinion and the fact.
What it tells you, and what it does not
Financial statements tell you what has already happened, measured under an agreed set of rules, checked by an auditor. That is a great deal.
They do not tell you 4 things.
The future. A company with 10 excellent years can lose its market in 2. The statements are a record, not a forecast.
Whether the price is right. A company can be superb and still be too expensive. Valuation is answered nowhere in the annual report.
Whether the numbers are true. An audit is an opinion formed from samples and tests. It reduces the chance of a lie. It does not remove it.
Everything the company owes. Some obligations sit in a note at the back called contingent liabilities, and never appear on the balance sheet at all.
The decision rule
Read the income statement and the cash flow statement together, for the same years, or do not read either.
If profit after tax is rising and cash from operations is flat or falling, that gap is the single most important fact in the report — unless the company is genuinely growing fast and is funding new stock and new customers, in which case the gap should shrink as growth slows. If growth slows and the gap does not shrink, the gap was never about growth.
Try this now
Ten minutes, on a company you actually hold. You need nothing but a browser.
- Pick 1 holding. Search for its name plus "annual report". In India go to the company's own Investors page, or use the BSE or NSE website. In the United States use the SEC's free EDGAR database and open the most recent 10-K.
- Find the 3 statements. In an Indian annual report they sit together in the Financial Statements section, usually after the auditor's report. Note that India calls the income statement the Statement of Profit and Loss. In a 10-K they are in Item 8.
- On the income statement, write down profit after tax for the latest year and the year before. Both are printed side by side.
- On the cash flow statement, write down net cash generated from operating activities for the same 2 years. It is the subtotal at the end of the first section.
- You now have 4 numbers. Divide operating cash by profit after tax for each year. That gives you a ratio.
What you should see. For most established, honest, boring companies the ratio is above 1. Operating cash is usually larger than profit, because profit has been reduced by depreciation, which is a cost that moves no money.
If the ratio is below 1 in both years, ask why. If it is below 1 and falling while profit rises, you have found the exact gap this article is about, in a company you own, in under 10 minutes. That is not proof of anything wrong. It is the question you now have to answer before you buy more.
Keep those 4 numbers. Every article in this cluster adds to them.
Three real cases
1. Satyam Computer Services, 7 January 2009 (India) — the cash was not there Chairman B. Ramalinga Raju sent a letter to his own board admitting the accounts had been manipulated over several years, in the region of ₹7,000 crore. The largest single piece was cash and bank balances that did not exist. The company had reported growing profits for years, audited by PricewaterhouseCoopers. The profit was an invented opinion. The cash was a fact, and the fact was zero. Raju and 9 others were convicted on 9 April 2015.
2. Enron Corporation, 16 October 2001 (United States) — profit recognised before any money arrived Enron used mark-to-market accounting on long-term energy contracts. That let it record the estimated present value of a contract's future profits in the year it was signed, before a dollar was collected. On 16 October 2001 it restated past results, cutting reported earnings by $613 million and reducing shareholders' equity by $1.2 billion. It filed for Chapter 11 bankruptcy on 2 December 2001. Reported profit had been rising throughout. Operating cash had not.
3. Luckin Coffee, 2 April 2020 (China, listed in the United States) — the revenue itself was fabricated The short-seller Muddy Waters published a report on 31 January 2020 alleging inflated sales. On 2 April 2020 Luckin announced that an internal investigation had found its chief operating officer had fabricated about RMB 2.2 billion of 2019 sales, roughly $310 million. The shares fell about 75% in a day. It was delisted from Nasdaq on 29 June 2020 and settled with the SEC for $180 million on 16 December 2020. The revenue line is not automatically true either.
The question that resolves it
A novice reads an annual report and asks: how much profit did it make?
An expert reads the same report and asks: how much of that profit arrived as money, and if it did not, where is it sitting instead?
The answer to the second question is always somewhere in the same document. It is sitting in receivables, or inventory, or an asset that was capitalised. Finding where it went is most of financial analysis.
What would make this wrong
If cash were always the better measure, then companies with weak operating cash would reliably fail and companies with strong operating cash would reliably succeed. Neither is true.
Three honest limits.
Growing companies consume cash legitimately. A retailer opening 200 stores must buy stock before it sells any. Operating cash can be negative for years while the business is genuinely excellent. The test is whether the cash gap narrows as growth slows.
Cash can be managed too. A company can delay paying its suppliers in the last week of March and report better operating cash. The number is harder to manipulate than profit, not impossible.
Some industries are built differently. For a bank or a lending company, the ordinary cash flow statement is close to meaningless, because lending money out is an operating activity. Cash from operations for a growing lender is usually deeply negative and that is normal. Use different tools for financial companies.
In India
Under Section 2(40) of the Companies Act 2013, financial statements include the balance sheet, the statement of profit and loss, the cash flow statement, the statement of changes in equity and the notes. Very small companies and one person companies are exempt from the cash flow statement.
The format is not optional. Schedule III to the Companies Act prescribes the line items and their order. Every Indian company's balance sheet therefore has the same shape, so once you learn where "Trade receivables" sits, you know where it sits in every report you will ever open.
Large Indian companies report under Ind AS, the Indian Accounting Standards, which are closely modelled on the international IFRS standards. They came in 2 phases: companies with net worth of ₹500 crore or more from 1 April 2016, and all listed companies plus unlisted companies with net worth of ₹250 crore or more from 1 April 2017.
Listed companies also publish quarterly results under SEBI's listing regulations. Quarterly numbers get a limited review by the auditor, not a full audit.
The auditor's report in India carries something extra called CARO, the Companies (Auditor's Report) Order. It requires the auditor to answer a fixed list of specific questions in writing, including whether the company has defaulted on loan repayments, whether title deeds for property are in the company's name, and whether any fraud has been reported. CARO 2020 applies to audits of financial years beginning on or after 1 April 2021.
In the United States
The annual filing is the Form 10-K, filed with the Securities and Exchange Commission and available free on the EDGAR database. The quarterly filing is the Form 10-Q. Material events between filings go on a Form 8-K.
The 10-K has a fixed item structure and 3 of the items matter most to you.
- Item 1A, Risk Factors. The company lists, in its own words, what could go wrong. Most of it is written by lawyers and is generic. The value is in reading the same section 3 years apart and noticing what was added.
- Item 7, Management's Discussion and Analysis, usually called MD&A. Management explains the numbers in plain sentences: why revenue changed, why margins moved, what they expect. It is a required disclosure with legal consequences for being misleading, and there is no Indian equivalent of the same rigour.
- Item 8, Financial Statements and Supplementary Data. The 3 statements, plus the statement of stockholders' equity and the notes.
American companies report under US GAAP, set by the Financial Accounting Standards Board. Filing deadlines depend on size: 60 days after year end for large accelerated filers, 75 days for accelerated filers and 90 days for everybody else.
Since the Sarbanes-Oxley Act of 2002, the chief executive and chief financial officer must personally certify the accounts, and larger companies must have their internal financial controls audited separately.
Where they differ, and what that tells you
The 2 systems solve for different fears, and the difference tells you where to look first in each country.
The American system fears that management will tell a misleading story. So it forces management to write the story down, under its own name, in MD&A and Risk Factors, and makes them personally liable for it.
The Indian system fears that the promoter will take money out of the company. India's listed companies typically have a controlling family or group, called the promoter, holding a large stake. So Indian disclosure is heavier exactly there: detailed related-party reporting, shareholder approval for large related-party deals, disclosure of shares the promoter has pledged to lenders, and CARO questions aimed at loans and guarantees to connected parties.
What that tells you is where your attention is worth most.
In an American 10-K, read Item 7 and Item 1A first, then check the numbers against the story. The story is where the pressure is.
In an Indian annual report, go to the related-party transactions note and the contingent liabilities note first, then read the numbers. The connections are where the pressure is. Reading an Indian report with American habits means spending your time on a management discussion that is often promotional, and skipping the note that carries the risk.
Carry this
- Profit is an opinion. Cash is a fact. Read both or read neither.
- Balance sheet is one day. Income statement is a year. Cash flow statement is the bank statement.
- If profit rises and operating cash does not, that gap is the most important number in the report.