📒 The three financial statements, built from a lemonade stand

🎯 In 30 seconds: Every public company reports three statements. The income statement shows whether it made a profit over a period. The balance sheet shows what it owns and owes on one day. The cash flow statement shows where the actual cash came from and went. They are linked: profit feeds the balance sheet, and the cash flow statement explains the change in cash. Learn to read all three and you can check any story a company, an analyst or a social media post tells you about a stock.

Why a trader should care

A share is a piece of a business. The financial statements are the business's report card, written in a standard format and, for US public companies, filed with the SEC.

Even if you only hold stocks for days, the numbers matter. Earnings reports move prices more than almost anything else, and you cannot judge a "beat" or a "miss" if you do not know what the lines mean. See Earnings season for how that plays out on the day.

The good news: the core ideas fit in one small business. We will build a hypothetical lemonade company, Sunny Cup, and follow every dollar through its first year. All the numbers are made up, and every one of them ties out.

Meet Sunny Cup on day one

Two friends start Sunny Cup. They put in $10,000 of their own money and borrow $5,000 from a bank. Money the owners put in is called equity. Money borrowed is a liability, something the business owes.

On day one they spend $8,000 on a cart, juicers and a cooler. That is equipment, an asset that will be used for years. They keep the other $7,000 as cash.

That little table is already a balance sheet. Notice the two halves are equal. They always are, because of one rule:

Assets = Liabilities + Shareholders' equity

Everything the business owns was paid for either with borrowed money or with the owners' money. There is no third source. That is why the sheet "balances".

Statement 1: the income statement

The income statement (also called the profit and loss statement, or P&L) covers a period, such as a quarter or a year. It starts with sales at the top and subtracts costs until you reach profit at the bottom. That is where the phrases "top line" (revenue) and "bottom line" (net income) come from.

Here is what Sunny Cup did in year one:

• Sold $40,000 of lemonade. $38,000 was paid in cash. A catering client still owes $2,000.
• Used $12,000 of lemons, sugar and cups to make what it sold.
• Paid $14,000 in wages, $3,000 for permits and space, and $1,000 for flyers.
• Paid $400 interest on the loan (8% of $5,000) and $2,000 in income tax.

Three terms need a plain definition:

• Cost of goods sold (COGS): the direct cost of the things sold. Lemons used, not lemons bought.
• Depreciation: the $8,000 of equipment wears out over time, so accountants spread its cost over its useful life instead of counting it all in year one. Sunny Cup assumes 5 years: $8,000 / 5 = $1,600 a year. No cash leaves in year one for depreciation. The cash left on day one, when the cart was bought.
• Operating income: profit from running the business, before interest and tax. It tells you whether the core business works, regardless of how it is financed.

Revenue is counted when the sale is earned, not when cash arrives. That is why the $2,000 the caterer still owes is already in revenue. This rule is called accrual accounting, and it is the main reason profit and cash differ.

Statement 2: the balance sheet

The balance sheet is a snapshot on one date, usually the last day of the quarter or year. It lists:

• Assets: what the business owns or is owed. Cash, accounts receivable (customers who owe money), inventory (goods waiting to be sold) and equipment.
• Liabilities: what it owes. Accounts payable (bills from suppliers not yet paid) and debt.
• Shareholders' equity: the owners' claim. Money the owners put in, plus retained earnings, which is all past profit that was kept in the business rather than paid out.

During the year Sunny Cup also did four things that do not appear on the income statement: it bought $1,000 more of supplies than it used (inventory), owed a supplier $500 at year end, paid the owners a $1,000 dividend, repaid $1,000 of the loan and bought a second cart for $2,000 on the last day of the year.

Retained earnings went from $0 to $5,000: net income of $6,000 minus the $1,000 dividend. That one line is the bridge between the income statement and the balance sheet.

Statement 3: the cash flow statement

Sunny Cup earned $6,000 of profit, but its cash only rose $1,100. Where did the rest go? The cash flow statement answers that. It splits cash into three buckets:

• Operating activities: cash from running the business.
• Investing activities: cash spent on or received from long-term assets, like equipment. Spending here is called capital expenditure, or capex.
• Financing activities: cash from or to lenders and owners. Borrowing, repaying debt, issuing shares, paying dividends, buying back shares.

Most companies build the operating section by starting at net income and adjusting for everything that was not cash:

You can check the operating number a second way, by counting only cash in and out: $38,000 collected from customers, minus $12,500 paid to suppliers ($13,000 of supplies bought, $500 still owed), minus $14,000 wages, $3,000 permits, $1,000 marketing, $400 interest and $2,000 tax. That is also $5,100.

One more number analysts love: free cash flow, which is cash from operations minus capex. For Sunny Cup: $5,100 - $2,000 = $3,100. That is the cash the business produced that the owners could take out without shrinking the business. You will use it again in Valuation ratios and Building a stock thesis.

How the three connect

If you change one number, the others must change with it. That is why accountants call it a three-statement model, and why a company cannot easily fake one statement without the others looking strange.

Ten years later: Sunny Cup goes public

Say Sunny Cup grows into hundreds of shops and sells shares to the public in an IPO (see Why companies sell shares). The three statements look the same, just with more lines and bigger numbers. A few things change:

• It files reports with the SEC. An annual report on Form 10-K, with audited financial statements, and quarterly reports on Form 10-Q, which are unaudited.
• It reports earnings per share (EPS). EPS is net income divided by shares outstanding. Diluted EPS also counts shares that could be created from stock options and similar awards.
• It follows GAAP (US generally accepted accounting principles), the standard rules. Many companies also publish "adjusted" numbers that leave out some costs. Those are not GAAP, and companies decide what to leave out.

Prefer diluted EPS. It shows your slice if every option turned into a share, which is closer to what you actually own.

How to read a real set of statements

1. Find the latest 10-K on SEC EDGAR or the company's investor relations site. Market data sources shows where.
2. Read the business description first, so you know what the numbers are measuring.
3. Income statement: is revenue growing? Is gross profit growing at least as fast? Is operating income positive?
4. Balance sheet: how much cash versus debt? Are receivables or inventory growing much faster than revenue?
5. Cash flow statement: is cash from operations close to or above net income? What is free cash flow after capex?
6. Compare at least three years side by side. One year tells you almost nothing about a trend.
7. Read the notes for anything you do not understand. The notes are part of the audited statements and often hold the real story.

Try it

Rebuild Sunny Cup's year one with one change: the caterer pays the $2,000 before year end. Work out the new receivables, cash from operations and ending cash. (Answer: receivables $0, cash from operations $7,100, ending cash $10,100. Net income does not change, and the balance sheet still totals $19,500, because $2,000 moved from receivables to cash.)

Then pick a company you know from your Watchlist, open its latest 10-K, and write down five numbers: revenue, net income, cash, total debt and cash from operations. Do this for three years and see which way each is moving.

Sources

• SEC: Beginners' Guide to Financial Statements
• Investor.gov (SEC): How to Read a 10-K
• Investor.gov (SEC): Using EDGAR to Research Investments