How to Read an Income Statement and Balance Sheet

Read the income statement to see how much profit a business made over a period. Read the balance sheet to see what it owned and owed on a particular date. Together, they help you judge performance and financial position, but they answer different questions.

Income statement

Start with revenue, the money earned from sales. Subtract cost of sales, the direct cost of the goods or services sold, to find gross profit. Then subtract operating expenses, such as rent and wages, to find operating profit. Interest and tax are accounted for before arriving at profit for the year.

For example, if revenue is £100,000\pounds 100{,}000£100,000 and cost of sales is £60,000\pounds 60{,}000£60,000, gross profit is £40,000\pounds 40{,}000£40,000. If operating expenses are £25,000\pounds 25{,}000£25,000, operating profit is £15,000\pounds 15{,}000£15,000. Ask whether profits are improving and what is driving any change: sales, direct costs or expenses. Compare figures across periods. Higher revenue does not necessarily mean higher profit: if cost of sales grows faster, gross profit may fall. Gross profit margin shows gross profit as a proportion of revenue, making businesses of different sizes easier to compare.

Balance sheet

Read assets as resources the business owns, liabilities as amounts it owes, and equity as the owners' stake. Non-current assets are held for longer-term use; current assets, such as cash and inventory, are expected to be used or converted into cash within a year. Current liabilities are due within a year. Check that:

$$Assets=Liabilities+Equity$$

For example, assets of £110,000\pounds 110{,}000£110,000, liabilities of £60,000\pounds 60{,}000£60,000 and equity of £50,000\pounds 50{,}000£50,000 balance. Then look at whether current assets can cover current liabilities, and how much the business relies on borrowing. This short-term ability to pay is called liquidity.

Common mistake: profit is not the same as cash. A business can report a profit while struggling to pay bills, so use both statements rather than judging its finances from profit alone.