How to read a company’s financial statements in 15 minutes

Financial statements look dense, but they answer three plain questions. What does the company own and owe? How much did it earn? Where did the cash actually go? Once you know which statement answers which question, a quarter of an hour is enough to form a first view of almost any business.

Three statements, three questions

The balance sheet is a photograph taken on one day. It lists assets (what the company owns), liabilities (what it owes) and shareholders’ equity, which is simply assets minus liabilities. Assets and liabilities are split into current, meaning within a year, and non-current.

The income statement (also called the profit and loss account) and the cash flow statement are videos. They cover a period, usually a quarter or a year. The income statement tells you what the company earned under accounting rules. The cash flow statement tells you how much money actually came in and went out. When the two disagree for several years in a row, ask why.

Margins: the fastest test of quality

Margins compare profit with sales, so they let you compare businesses of very different sizes. Investors who follow Warren Buffett’s approach use a set of rules of thumb, popularised in recent years by Brian Feroldi’s visual summaries:

These are filters, not laws. A supermarket will never show a 40% gross margin and can still be a fine business. Use the rules to spot what is unusual, then find out why.

EBITDA: useful, and easy to misuse

EBITDA stands for earnings before interest, taxes, depreciation and amortisation. You can reach it two ways: revenue minus cost of sales minus operating expenses, or net income with interest, tax, depreciation and amortisation added back. It shows how much the operations generate before financing choices and accounting charges.

That is exactly why it needs care. A company with heavy machinery has real costs that depreciation stands for: the equipment wears out and must be replaced. EBITDA leaves that out. Use it to compare operating performance, and use net income and free cash flow to judge what owners actually keep.

Inventory methods change the profit number

Businesses that hold stock must decide which units they treat as sold. Under FIFO (first in, first out) the oldest units go first. Under LIFO (last in, first out) the newest go first. Weighted average cost blends them. When prices are rising, FIFO matches older, cheaper costs against today’s sales, so profit and stock values look higher. LIFO does the opposite, which is why some US companies use it to lower taxable profit. LIFO is not permitted under IFRS, which most countries outside the US follow.

In e-commerce the method matters for more than the accounts. Food, cosmetics and anything with a shelf life should physically move first in, first out, or waste eats the margin.

The balance sheet ratios worth two minutes

• Cash against debt. More cash than debt gives a company room to survive a bad year.
• Interest coverage. Operating profit divided by interest. Below about three, a small dip in profit can become a problem.
• Net debt to free cash flow. Roughly how many years of free cash it would take to repay the debt.
• Current ratio. Current assets divided by current liabilities. It shows whether bills due this year are covered.

Read in sets of five years

One year can be distorted by a big contract, a write-off or a currency swing. Five years side by side show the character of a business: steady margins, rising debt, cash that never quite matches profit. Building the habit takes a spreadsheet and patience, nothing more.