How to Read Financial Statements

How to read financial statements? What is a financial statement, understanding financial statements, interpreting financial statements.

Want to become a billion dollar investor? Start by learning to read financial statements. Warren Buffett was an expert at skimming through financial statements and picking out the tell-tale signs of a company’s likely success or failure.

Understanding Financial Statements

A full set of accounts consists of four important documents:

Opening balance sheet and Closing balance sheet

More on Reading a Balance Sheet and What is a Balance Sheet.

Profit and Loss Account

The profit and loss account is a measure of the company’s profits or losses over the financial year or the period of time bound by the opening and closing balance sheets. The profit and loss statement thus complements the balance sheets; any change of values in one will affect the values in the other.

Operating or trading profit is arrived at by deducting total operating cost from total revenue. While there is usually little confusion with regard to total revenue, total operating cost is a little more vague, as costs can be divided into costs that relate directly to sales revenue and costs that relate directly to the time period. While the former would include costs of goods sold, the latter would include employee remuneration.

Distribution of profits

Profits are usually distributed first to lenders, then to the government, then to shareholders. Based on that, we have four main figures to consider on the profit and loss account:

Profit before Interest and Tax

These profits would then be distributed to lenders to offset the long term and short term loan portions of the balance sheet. Deduct interest to arrive at the next figure.

Profit before Tax

These profits would tend be distributed to the taxation authorities. Deduct tax to arrive at the next figure.

Profit after Tax

These profits would then be distributed to shareholders. Deduct dividends to arrive at the next figure.

Retained Earnings

Finally, retained earnings are credited to the owners’ funds, and sometimes reinvested in the business to stimulate growth.

Cash Flow Statement

How to read financial statements? The cash flow statement further links the profit and loss account and the balance sheets. The cash flow statement measures the flow of cash through the company – the sources or inflows of cash and the outflows of cash.

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