How to Read Financial Statements

What financial statements are

Financial statements are the reports a company publishes to show how its business performed and what it owns and owes. Listed companies, including those on the Pakistan Stock Exchange, publish them in annual and quarterly reports. If you are new to listed companies, start with PSX basics and What Stocks Are.

The main statements are:

Income statement (also called profit and loss account): revenue, costs and profit over a period.
Balance sheet (statement of financial position): assets, liabilities and equity on a specific date.
Cash flow statement: cash coming in and going out over a period.

Each statement answers a different question. You need all of them, because a company can show a profit and still run short of cash.

Income statement explained

The income statement covers a period, such as a quarter or a year. It starts with sales and subtracts costs step by step.

Line	What it means
Revenue (sales)	Money earned from selling goods or services
Cost of sales	Direct cost of producing what was sold
Gross profit	Revenue minus cost of sales
Operating expenses	Salaries, rent, marketing, administration
Operating profit	Gross profit minus operating expenses
Finance cost	Interest paid on borrowings
Tax	Income tax for the period
Net profit	What is left for shareholders

What experienced readers check:

Gross margin = gross profit ÷ revenue. A falling margin can mean rising input costs or weaker pricing power.
Operating margin = operating profit ÷ revenue. It shows how well the core business covers its overheads.
Finance cost against operating profit. If interest takes a large share of operating profit, the company is sensitive to interest rate changes. For the current policy rate, see SBP rates and economy.
One-off items. Gains from selling property or exchange gains can inflate net profit for a single period. Read the notes to separate them from recurring profit.

Earnings per share (EPS) is net profit divided by the number of shares. It is covered with P/E and ROE on Valuation Ratios.

Balance sheet explained

The balance sheet is a snapshot on the closing date of the period. It always balances:

Assets = Liabilities + Equity

Assets are what the company controls: cash, receivables (money customers owe), inventory, property, plant and equipment.
Liabilities are what it owes: supplier payables, short-term and long-term loans, lease obligations, tax due.
Equity is the owners' share: paid-up capital plus retained earnings (profits kept in the business rather than paid as dividends).

Assets and liabilities are split into current (due or usable within the next year) and non-current.

What to check:

Current ratio = current assets ÷ current liabilities. It shows whether short-term assets cover short-term debts.
Debt-to-equity = total borrowings ÷ equity. Higher debt raises the fixed interest burden and the risk in a downturn.
Receivables and inventory growth against sales growth. If they grow faster than sales, cash is getting tied up, or goods are not selling.
Intangibles and goodwill. These can be large after acquisitions and may later be written down.

Cash flow statement explained

Profit uses accrual accounting: a sale counts when it is made, even if the customer has not paid. The cash flow statement shows real cash movements, in sections:

Operating activities: cash from the core business. It starts with net profit and adjusts for non-cash items (such as depreciation) and changes in working capital (receivables, inventory, payables).
Investing activities: buying or selling equipment, property or other businesses.
Financing activities: taking or repaying loans, issuing shares, paying dividends.

What to check:

Operating cash flow against net profit. Over several periods, healthy companies usually convert most profit into operating cash. A persistent gap deserves an explanation.
Free cash flow = operating cash flow minus capital expenditure. It is the cash available for debt repayment, dividends or growth.
Dividends funded by borrowing. If dividends are paid while operating cash is weak and loans rise, the payout may not be sustainable.

How the statements connect

Net profit from the income statement adds to retained earnings on the balance sheet (after dividends).
Net profit is the starting point of the operating section of the cash flow statement.
The closing cash on the cash flow statement equals the cash line on the balance sheet.
New loans appear in financing cash flow and as higher liabilities on the balance sheet.

If these links do not reconcile in your own notes, re-read the figures before drawing conclusions.

A simplified example

Take a fictional clothing retailer and compare its latest year with the year before. No figures are needed to see the pattern:

Item	Change	Reading
Revenue	Up	Sales are growing
Gross margin	Slightly down	Costs rose faster than prices
Net profit	Up	Headline looks good
Receivables	Up sharply, faster than revenue	Customers are paying more slowly, or credit terms were loosened
Inventory	Up	Stock building; possible unsold goods
Operating cash flow	Down	Profit is not turning into cash
Short-term loans	Up	Borrowing to cover the cash gap

A reader who only looks at net profit sees a growing business. A reader who checks all the statements sees a company funding slow-paying customers and unsold stock with short-term debt. That is not proof of trouble, but it is a reason to read the notes, management commentary and the next quarterly report.

To put your own figures into ratio form, use the tools on Calculators rather than estimating in your head.

Company financial analysis: a reading order

Read the auditor's report. A qualified opinion or an emphasis-of-matter paragraph is an important signal.
Scan the income statement for revenue trend, margins and one-off items.
Check the balance sheet for debt, liquidity and working capital.
Compare operating cash flow with net profit.
Read the notes: accounting policies, related-party transactions, contingent liabilities, borrowing terms.
Compare across several periods and against similar companies in the same sector.
Only then look at valuation ratios.

Watch for corporate actions that change per-share figures, explained on Splits and Rights Issues. For the wider picture of macro data and company analysis, see Fundamental analysis.

Limits and risk

Financial statements describe the past. They do not predict share prices, and a sound balance sheet does not guarantee a rising share price. Accounting choices can make results look better or worse within the rules.

If you trade share or index CFDs with leverage rather than owning shares, losses can exceed what the analysis suggested and can happen fast. Read Risk management before using any analysis for trading decisions. Terms you do not know are explained in the Trading glossary.

Frequent questions

Which financial statement matters most?

None on its own. The income statement shows profitability, the balance sheet shows financial strength, and the cash flow statement shows whether profit becomes cash. Read them together.

Why can a profitable company run out of cash?

Profit counts sales when made, not when paid. If customers pay slowly, inventory builds up, or large investments are made, cash can fall while profit rises.

Where do I find statements for Pakistani listed companies?

Listed companies publish annual and quarterly reports, usually on their own websites and through the exchange. See PSX basics for how listings work.

What are the notes to the accounts?

They are detailed explanations that follow the main statements: accounting policies, breakdowns of loans, tax, related-party deals and possible future liabilities. Many warning signs appear only there.

Is a high debt-to-equity ratio always bad?

Not always. Some sectors normally carry more debt. Compare with similar companies and check whether operating cash flow comfortably covers interest.

Does good analysis remove trading risk?

No. Analysis can improve understanding, but prices move on many factors, and leveraged trading can lose money quickly.