Corporate Finance Fundamentals: Reading Financial Statements for Decisions

Why Financial Statements Matter for Corporate Finance Decisions

Financial statements translate day-to-day operations into numbers that support decisions about pricing, cost control, investment, financing, and cash management. The three core statements answer different questions:

• Income statement: Did we generate profit over a period?
• Balance sheet: What do we own and owe at a point in time, and how is it funded?
• Cash flow statement: Where did cash come from and where did it go over a period?

Reading them together helps you diagnose performance (profitability), resilience (liquidity), risk (leverage), and execution (operating efficiency).

Income Statement: Purpose and Key Line Items

The income statement (also called P&L) summarizes performance over a period (month, quarter, year). It is built around the idea that profit = revenue − expenses, but the structure matters because different lines signal different drivers.

Common line items

• Revenue (Sales): Value of goods/services delivered in the period.
• Cost of Goods Sold (COGS): Direct costs to produce what was sold.
• Gross Profit: Revenue − COGS; indicates pricing power and production efficiency.
• Operating Expenses (SG&A): Selling, general, administrative costs (payroll, rent, marketing).
• Depreciation & Amortization (D&A): Non-cash expense allocating past capital spending over time.
• Operating Income (EBIT): Profit from operations before interest and taxes.
• Interest Expense: Cost of debt financing.
• Taxes: Income taxes accrued for the period.
• Net Income: Bottom-line accounting profit after all expenses.

What corporate finance learns from it

• Profitability: margins (gross, operating, net) and trend.
• Cost structure: fixed vs variable cost pressure (e.g., SG&A rising faster than sales).
• Debt burden: interest expense relative to operating income.

Balance Sheet: Purpose and Key Line Items

The balance sheet is a snapshot at a point in time. It follows the accounting identity:

Assets = Liabilities + Equity

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Assets (what the company controls)

• Cash: immediately available liquidity.
• Accounts Receivable (A/R): sales made but not yet collected.
• Inventory: goods held for sale or production.
• Prepaids/Other Current Assets: payments made in advance.
• Property, Plant & Equipment (PP&E), net: long-term operating assets after accumulated depreciation.

Liabilities (what the company owes)

• Accounts Payable (A/P): bills owed to suppliers.
• Accrued Expenses: expenses incurred but not yet paid (wages, taxes).
• Short-term Debt: borrowings due within a year.
• Long-term Debt: borrowings due beyond a year.

Equity (owners’ residual claim)

• Common Stock / Paid-in Capital: amounts invested by shareholders.
• Retained Earnings: cumulative profits kept in the business (net of dividends).

What corporate finance learns from it

• Liquidity: ability to meet near-term obligations (cash, current assets vs current liabilities).
• Leverage: reliance on debt vs equity; refinancing risk.
• Working capital intensity: how much cash is tied up in A/R and inventory.

Cash Flow Statement: Purpose and Key Line Items

The cash flow statement explains the change in cash over a period. It separates cash movements into three categories:

• Operating Cash Flow (CFO): cash generated/used by core operations.
• Investing Cash Flow (CFI): cash spent on or received from long-term assets (e.g., equipment purchases).
• Financing Cash Flow (CFF): cash from or to lenders and shareholders (debt issued/paid, equity issued, dividends).

Why it differs from net income

Net income is based on accrual accounting (revenue recognized when earned, expenses when incurred). Cash flow adjusts net income for:

• Non-cash expenses: depreciation and amortization reduce net income but do not use cash in the period.
• Working capital changes: changes in A/R, inventory, A/P, and accruals shift cash timing.

How the Three Statements Connect

1) Net income flows into equity (retained earnings)

Retained earnings typically change as:

Ending Retained Earnings = Beginning Retained Earnings + Net Income − Dividends

This is a key bridge from the income statement to the balance sheet.

2) Working capital links the income statement to cash

Working capital items live on the balance sheet, but their changes affect operating cash flow:

• Increase in A/R: cash outflow (you sold, but haven’t collected).
• Increase in inventory: cash outflow (you bought/produced more than you sold).
• Increase in A/P: cash inflow (you delayed paying suppliers).

3) Depreciation: expense on the income statement, accumulated on the balance sheet, added back on cash flow

• Income statement: D&A reduces EBIT and net income.
• Balance sheet: accumulated depreciation reduces PP&E net book value.
• Cash flow statement: D&A is added back in CFO because it is non-cash.

Step-by-Step Walkthrough: Simplified Statements

Use the following simplified example for one year. The goal is to practice reading the statements as a connected system and extracting decision-relevant signals.

1) Income Statement (Year 1)

2) Balance Sheet (End of Year 0 vs End of Year 1)

3) Cash Flow Statement (Year 1, indirect method)

Note: The balance sheet above shows ending cash of 30, while the cash flow statement shows 10. This mismatch is intentional for a learning checkpoint: in real work, statements must reconcile. A mismatch indicates missing items (e.g., asset sale proceeds, equity issuance, FX effects) or an error in inputs. For the analysis below, assume the cash flow statement is correct and ending cash should be $10.

Practical Reading Process: What to Look for, in Order

Step 1: Profitability (Income statement)

Compute a few quick margins:

• Gross margin = Gross Profit / Revenue = 400 / 1,000 = 40%
• Operating margin = EBIT / Revenue = 100 / 1,000 = 10%
• Net margin = Net Income / Revenue = 60 / 1,000 = 6%

Interpretation: the business is profitable, but operating margin is modest; small changes in pricing, COGS, or SG&A could materially affect net income.

Step 2: Liquidity (Balance sheet)

Start with working capital and near-term coverage.

• Current assets (using cash, A/R, inventory): End of Y1 = 10 + 140 + 160 = 310
• Current liabilities (A/P + short-term debt): End of Y1 = 90 + 40 = 130
• Current ratio = 310 / 130 ≈ 2.38

At first glance, liquidity seems fine. But look deeper: a large portion of current assets is A/R and inventory, which may not convert to cash quickly if collections slow or inventory becomes obsolete.

Step 3: Leverage (Balance sheet + income statement)

• Total debt End of Y1 = 40 + 260 = 300
• Debt-to-equity = 300 / 270 ≈ 1.11
• Interest coverage (simple) = EBIT / Interest = 100 / 20 = 5.0x

Interpretation: leverage is meaningful but not extreme; interest coverage suggests the company can service debt under current earnings, but a downturn could tighten flexibility.

Step 4: Operating efficiency (Working capital behavior)

Use changes in balance sheet accounts to infer operational execution.

• A/R increased by 140 − 80 = 60 on revenue of 1,000: collections may be slowing or credit terms expanded to drive sales.
• Inventory increased by 160 − 120 = 40: possible buildup from forecasting errors, production inefficiency, or planned growth.
• A/P increased by 90 − 70 = 20: the company is taking longer to pay suppliers (a short-term cash benefit that can strain supplier relationships).

Mini-Checkpoint: Spotting Red Flags

Red flag 1: Positive net income but weak/negative operating cash flow

In the example, net income is $60 and CFO is $30 (still positive, but much lower). A more severe version is net income positive while CFO is negative. The typical cause is cash tied up in working capital (A/R and inventory rising faster than payables) or aggressive revenue recognition.

How to diagnose quickly (indirect method):

• Start with net income.
• Add back non-cash items (depreciation).
• Check whether working capital changes are consuming cash (A/R up, inventory up) more than payables are providing.

What it means for corporate finance choices:

• Tighten credit and collections: adjust payment terms, improve invoicing, increase collection efforts, consider factoring selectively.
• Reduce inventory cash lock-up: improve demand planning, reduce SKUs, renegotiate lead times, implement tighter reorder points.
• Reassess growth quality: sales growth that requires heavy working capital may need more financing than expected.
• Liquidity planning: secure revolving credit capacity before cash becomes constrained.

Red flag 2: Rising leverage without corresponding operating improvement

Debt increased by 70 in the year. If debt rises while EBIT is flat or falling, the firm may be borrowing to fund operating shortfalls or shareholder payouts rather than productive investment.

What it means for corporate finance choices:

• Revisit dividend policy or buybacks if they are funded by incremental debt.
• Consider covenant headroom and refinancing timelines.
• Prioritize projects with faster cash payback and lower execution risk.

Red flag 3: Statement reconciliation issues

If the cash flow statement does not reconcile to the change in cash on the balance sheet, treat it as a control failure until explained. Common missing pieces include asset sale proceeds, equity issuance, foreign exchange effects, or classification errors.

What it means for corporate finance choices: avoid making funding or investment decisions until the numbers tie out; implement a reconciliation checklist as part of monthly close.

Interpreting the Example: Turning Numbers into Decisions

Profitability signal

Margins are positive, suggesting the core model works. The key question becomes: can the company grow without eroding gross margin or letting SG&A scale too quickly?

Liquidity signal

Despite a decent current ratio, cash fell (per cash flow statement). The company is profitable but not converting enough profit into cash because working capital is absorbing cash and CapEx is significant.

Leverage signal

Debt issuance helped fund CapEx and dividends. This increases financial risk and reduces flexibility if collections worsen or inventory cannot be sold quickly.

Operating efficiency signal

Working capital expansion (A/R and inventory) is the main operational story. Corporate finance would typically partner with sales and operations to set targets such as:

• A/R days reduction (faster collections)
• Inventory turns improvement (less cash tied up)
• Supplier terms optimization without damaging supply continuity

Hands-On Checklist: What to Compute and Ask Every Time

Income statement checks

• Are gross and operating margins stable or trending?
• Is interest expense rising faster than EBIT?
• Are there large non-recurring items masking core performance?

Balance sheet checks

• Is cash growing or shrinking?
• Are A/R and inventory growing faster than sales?
• Is debt increasing, and when does it mature?

Cash flow checks

• Is CFO consistently close to or above net income over time?
• Is CapEx aligned with strategy and funded sustainably?
• Are dividends/buybacks funded by true free cash flow or by borrowing?

Connection checks (must reconcile)

• Does net income roll into retained earnings after dividends?
• Does the cash flow statement’s ending cash match the balance sheet?
• Do working capital changes explain differences between net income and CFO?