Reported profit is partly a matter of judgement. The cash that actually moved through a business is not. The companies that blow up usually said so in these three statements, in plain numbers, years before the price admitted it. This chapter teaches you to read them.
How the three statements connect
Source: Penman; Buffett & Clark
A company reports its numbers in three statements, and each one answers a different question. The income statement asks whether the company made a profit over a period of time, say a year. The balance sheet asks what the company owns and owes on the last day of that period. The cash flow statement asks how much actual cash moved in and out over the period.
The three are not separate reports. They lock together. The profit at the bottom of the income statement flows into the balance sheet, where the part the company keeps adds to retained earnings, the pile of past profits the owners have left in the business. The cash flow statement then starts from that same profit and adjusts it back to real cash, which changes the cash line on the balance sheet. Read one in isolation and you see a slice. Read all three together and you see the whole business.
Profit, what you own, and cash are three windows onto one business. The truth is where they agree.
Two habits make any statement easier to read, and we cover both below. The first is to read it over time, several years side by side, so trends show up. The second is to common-size it, turning dollars into percentages so you can compare a company to its past self and to rivals of any size. After that, each statement gets its own page.
- The income statement — Is it profitable, and is the profit durable?
- The balance sheet — Can it survive a bad year, and is it compounding?
- The cash flow statement — Is the reported profit real?
Common-size statements
Source: Penman; Greenwald
Raw dollars are hard to compare. Apple's sales are in the hundreds of billions and a small bank's are in the billions, so they do not line up. Even one company grows so much over time that a question like "did inventory rise faster than the business?" gets lost in the big numbers. Common-sizing fixes this. You divide every line on a statement by one anchor, which turns a list of dollars into a clear picture of the shape of the business.
We offer two anchors, because they answer different questions:
% of Sales
Every line is divided by sales for the same period. On the income statement this shows the shape of profit. You can see what fraction of each sales dollar goes to costs, and how much falls through to the bottom. On the balance sheet, dividing by sales shows how much money the business ties up to support its sales. For example, "inventory is 9% of sales" means the company holds $9 of goods for every $100 of yearly sales. A rival at 3% gets more done with less.
Applies to: income statement, balance sheet, and cash flow.
% of Assets
Every balance-sheet line is divided by total assets for the same period. This shows what the company is made of and how it is paid for. You can see how much of the asset base is cash versus money owed by customers versus buildings versus goodwill, and whether it is funded by bills, debt, or owners' money. Both halves of the balance sheet have to add up to 100% by the basic accounting rule that assets equal what you owe plus what owners put in. When they do not, we flag a warning on that period.
Applies to: balance sheet only.
How to read it. The "% of Sales" income statement is where you catch a margin shrinking. A gross margin sliding from 45% to 41% over five years is an edge wearing away that you would miss in raw dollars. The "% of Assets" balance sheet tells you what kind of company you own. A software firm is mostly cash and goodwill, a railroad is mostly track and equipment, and a bank is mostly loans funded by deposits. The "% of Sales" balance sheet shows whether growth is efficient or whether the cash tied up in the business is ballooning faster than sales.
Why we show "pp". In this mode, the year-over-year change is shown in percentage points (for example "+1.2pp"), not as a relative percent. If gross margin moves from 40.0% to 41.2%, the number that matters is the 1.2-point rise in the ratio itself. Calling it "3% growth in the margin" is technically true but useless.
Where this comes from. Common-sizing is standard accounting practice that every textbook covers. The framing here follows Stephen Penman's Financial Statement Analysis and Security Valuation and Bruce Greenwald's Value Investing. Both treat common-sized statements as the first step in reading a business, not an optional extra.
Breaking down ROE
Source: DuPont Corporation, 1920s; Damodaran
Return on equity, or ROE, is the profit a company earns for each dollar the owners have in the business. It is the single number most often quoted as a sign of quality, and it draws on all three statements at once: profit from the income statement, assets and equity from the balance sheet. The trouble is that ROE is a blend, and a high ROE can come from very different places. A 30% ROE built on fat margins and an efficient operation is a world apart from a 30% ROE squeezed out of a mediocre business by piling on debt.
The DuPont breakdown, named after the company whose finance team invented it in the 1920s, splits ROE into the parts that drive it so you can see where the return really comes from. There are two versions. The 3-step gives you a quick read. The 5-step opens up the profit part for a closer look.
The 3-step
It answers one question. Is the ROE driven by fat profits, by busy use of assets, or by debt?
- Net Margin (profit divided by sales) is how much profit the company keeps from each sales dollar.
- Asset Turnover (sales divided by assets) is how much sales the company squeezes from each dollar of assets.
- Equity Multiplier (assets divided by owners' money) is how much the company controls for each dollar the owners put in. This is the debt part. A bigger number means more borrowing.
Multiply just the first two, net margin and asset turnover, and you get return on assets, or ROA, which is profit divided by total assets. ROA is ROE with the debt part stripped out: it measures how well the company earns on everything it owns, before any boost from borrowing. That is why ROE can sit far above ROA at a company that leans on debt, and why the two stay close at a company that barely borrows. Comparing the gap between them is a quick read on how much of the return is coming from leverage.
The 5-step
It splits the profit part further, separating the core business from the effects of borrowing and taxes:
- Tax Burden is the share of pre-tax profit the company keeps after tax.
- Interest Burden is the share of operating profit the company keeps after paying interest.
- Operating Margin is the profit from the core operations, before interest and tax.
Reach for the 5-step when the 3-step tells you "profits are high." It shows whether that strength comes from a genuinely strong operation (a high operating margin), from a light tax bill, or from low interest costs. Two companies with the same net margin can have very different stories underneath.
A timing note. Income-statement figures cover a whole period, while balance-sheet figures are a snapshot of one day. To line up the timing, the section uses the average of the start-of-year and end-of-year balance for assets and owners' money. That is also what makes the two versions add up exactly to profit divided by average equity. Start with the 3-step, find which part drives the return, then click any part to see its trend over several years. That trend usually tells you more than the level.