Finance I - Lesson 3: Understanding Financial Statements and Cash Flows

Financial statements are essential for understanding a company’s financial health, guiding investment decisions, and supporting strategic business choices. Three main statements—balance sheet, income statement, and cash flow statement—paint a comprehensive picture of how a firm invests its resources, generates revenue, and manages liquidity over time. Financial ratio analysis further refines this understanding by uncovering key insights into profitability, liquidity, and leverage.

Balance Sheet

The balance sheet (or statement of financial position) provides a snapshot of a firm’s assets, liabilities, and shareholders’ equity at a specific point. Assets represent resources with economic value, liabilities are obligations to creditors, and equity reflects owners’ residual interest. A balanced equation Assets = Liabilities + Equity must hold true, indicating that assets are financed by either borrowing (liabilities) or by ownership (equity).

• Assets: Current (cash, accounts receivable, inventory) plus long-term (property, plant, equipment).
• Liabilities: Current (accounts payable, short-term debt) plus long-term (bonds payable, long-term loans).
• Equity: Common stock, retained earnings, and other components reflecting owner contributions and accumulated profits.

Income Statement

The income statement (or profit and loss statement) details revenues and expenses, revealing the company’s net income (or net loss) over a reporting period. Key segments include:

• Revenue: Income from primary business activities (sales of products or services).
• Cost of Goods Sold (COGS): Direct costs tied to generating revenue (materials, labor).
• Operating Expenses: Selling, general, and administrative costs.
• Operating Income: Revenue minus operating expenses (often called EBIT: Earnings Before Interest & Taxes).
• Net Income: Final profit after subtracting interest and taxes.

Cash Flow Statement

While the balance sheet and income statement capture positions and performance, the cash flow statement focuses exclusively on actual cash inflows and outflows, dividing them into:

• Operating Activities (CFO): Cash generated or used in a firm’s core business (collecting from customers, paying suppliers, interest, taxes).
• Investing Activities (CFI): Cash used in capital expenditures (buying fixed assets) or cash received from selling assets.
• Financing Activities (CFF): Cash from issuing debt/equity or outflows from repaying loans, paying dividends, repurchasing stock.

Understanding where cash comes from and where it’s spent is crucial for assessing liquidity, sustainability, and capital requirements. Even profitable firms may run into trouble if their cash flows are not well-managed.

flowchart LR A((Balance Sheet)) --> B(Income Statement) B --> C(Cash Flow Statement) C --> A A ---|End of Period| B

The flowchart shows the interdependence: the balance sheet points in time, the income statement measures performance flows, and the cash flow statement reveals actual cash transactions. Together, they offer a full financial overview.

Key Financial Ratios

Ratios turn raw figures into insights, making it easier to compare companies or track trends over time. Different metrics shed light on different aspects of performance and risk.

Visualizing Cash Flow Components

The chart below displays a hypothetical breakdown of cash flows from operations, investing, and financing for a sample period. A consistently positive cash flow from operations usually indicates healthy underlying business performance, while investing and financing flows may fluctuate more significantly.

Summary

The balance sheet, income statement, and cash flow statement collectively reveal how a firm’s resources are allocated, whether its operations are profitable, and if it generates sufficient cash to fund growth or service obligations. By also incorporating ratio analysis, decision-makers can interpret these raw numbers more effectively, identifying trends, assessing risk, and forming a basis for forecasts. A strong grasp of financial statements prepares students for deeper exploration of valuation, budgeting, and capital structuring, where accurate projections of earnings and cash flows become vital.

Suggested Reading:
Financial Statement Analysis by K. R. Subramanyam (chapters introducing the major statements and methods of interpreting them).