Three statements, three questions

Every annual report answers three questions with three statements. What did the business earn? What does it own and owe? Where did the cash actually go? This chapter ties the three together so a single flattering number cannot stand in for the set.

The profit and loss statement asks what the year earned

Start at revenue, the money the company recorded for goods and services it delivered. Subtract the cost of those goods, and you have a gross profit. Subtract operating costs — staff, rent, selling — and you have an operating profit. Then interest, other income, and tax produce the profit that belongs to shareholders. Each line is a different question. A company can grow revenue and shrink operating profit if it bought the growth with discounts and advertising. A company can show a large profit that came from selling a building, which will not happen again.

Read at least three years side by side. One year is an event. Three years is a direction. If revenue is flat and profit is up, ask whether costs were genuinely cut or whether a one-time item arrived. If revenue is up and profit is flat, ask whether the new sales are worse sales.

The balance sheet asks what is owed on a single date

The profit statement covers a year. The balance sheet is a photograph on 31 March, or whichever date the company closes. Assets are what it owns and what it is owed: cash, inventory, plant, money customers have not paid yet. Liabilities are what it owes: suppliers, lenders, taxes. Equity is the residual, and it should equal assets minus liabilities. If a company earned a profit and did not pay it all out, equity rises. That link is the bridge between the two statements. Profit that never shows up in equity or in cash is a reason to slow down and read the notes.

A photograph can be posed. A retailer can look light on inventory the week after a big sale and heavy the week before. Compare the date with the same date in prior years, not with a quarter that sits in a different season.

The cash-flow statement asks whether profit became cash

Profit uses accrual accounting. A sale counts when it is earned, not when the customer pays. A machine is not an expense on the day you buy it; it is depreciated over years. The cash-flow statement rebuilds the year in cash. It is usually split into three piles: cash from running the business, cash spent on or received from investments such as plants and acquisitions, and cash from borrowing, repaying, or issuing shares.

A healthy pattern, for a business that is not in a heavy building phase, is cash from operations that is in the same neighbourhood as profit, investment cash that is negative because the company replaces and expands its assets, and financing cash that is quiet. A dangerous pattern is profit without operating cash, year after year, while debt rises to fill the hole. The business is reporting earnings and funding itself by borrowing. That can continue until it cannot.

One company, three answers

In that sketch you would not conclude ‘the company had a good year’ and stop. You would open the notes on revenue recognition, the ageing of receivables, and the debt schedule. The three statements are a map to the notes. They are not a substitute for them.

What to remember

• Profit says what was earned under accounting rules. The balance sheet says what is owned and owed on one date. Cash flow says where rupees moved.
• Profit should show up later as equity or as a dividend. If it shows up as neither, find it.
• Operating cash that stays far below profit, while debt rises, is a funding story, not an earning story.
• Read three years, and read the same season against the same season.
• The notes explain the lines. A chapter cannot list every policy a company may be using.