Financial statements – P&L, balance sheet and cash flow

Lesson 1: Financial Statements – P&L, Balance Sheet, Cash Flow

At the advanced level, stock picking is not about headlines and opinions, but about the ability to read what a company reports about itself. The three statements – the income statement (P&L), the balance sheet and the cash flow statement – are one coherent system. Profit without cash, revenue growth without control of the balance sheet, and margins without cost context are typical sources of bad decisions. This lesson teaches you to read them together and to judge quality, not just the size of the result.

Lesson goal

After this lesson you will be able to break the statements down to first principles, tell accounting profit from cash profit, assess the structure of the balance sheet and identify qualitative warning signs that affect how you measure risk in your plan.

1. The income statement (P&L) – from revenue to net profit

The P&L shows profitability over time. What matters is not how much the company earned, but HOW.

P&L structure:

Base formulas:

Gross margin % = (Revenue - COGS) / Revenue * 100
Operating margin % = EBIT / Revenue * 100
Net margin % = Net profit / Revenue * 100
Operating leverage = % change in EBIT / % change in Revenue

Measuring revenue quality: 1) Is revenue recognised as one-off or as subscription? 2) Does revenue growth require a proportional increase in receivables? 3) Is the company changing its revenue recognition policy? You will find all of this in the notes to the statements, not in the headline.

2. The balance sheet – structure of assets and financing

The balance sheet is a snapshot on a given day: Assets = Liabilities + Equity. For stock picking, the balance sheet answers the question: how durable is the business and what insolvency risks does it carry.

Balance sheet formulas:

Net working capital = Current assets - Current liabilities
Current ratio = Current assets / Current liabilities
Net debt = Interest-bearing liabilities - Cash and equivalents
Equity ratio = Equity / Total assets

On the GPW (Warsaw Stock Exchange) and in the US, IFRS and US GAAP apply – the differences concern, among other things, leasing, R&D (capitalisation vs expense) and revenue recognition. Always check the reporting standard in the footer of the statements.

3. The cash flow statement (Cash Flow) – the truth test

Profit is an opinion, cash is a fact. Cash flow is divided into three sections.

Key formulas:

Free cash flow (FCF) = CFO - CAPEX (maintenance + growth in the simplified version)
Free cash flow to the firm (FCFF) = EBIT * (1 - tax) + Depreciation - CAPEX - Change in Working Capital
Cash conversion = CFO / Operating profit
Earnings quality = (CFO - CFI - non-cash CFF) vs reported profit

If for 3-4 quarters in a row net profit rises while CFO falls and receivables/inventory grow, that is a classic signal of deteriorating earnings quality, regardless of management’s narrative.

4. Links between the three statements

You have to read them together. Revenue in the P&L without cash in CFO is reflected in receivables on the balance sheet. CAPEX in CFI increases non-current assets on the balance sheet and future depreciation in the P&L. A share issue in CFF raises equity on the balance sheet but dilutes shareholders.

Quarterly consistency checklist:

1. Does revenue growth correlate with CFO growth?
2. Is the gross margin stable when inventory changes?
3. Is net debt falling while FCF is positive?
4. Is goodwill not growing faster than equity?

5. Warning signs in the statements

• Capitalising operating costs as assets (propping up the margin at the expense of the balance sheet).
• Frequent “one-off” events that repeat every quarter.
• A change of auditor, a delayed report publication, a large increase in the “other” line.
• On the GPW (Warsaw Stock Exchange): high “other receivables from related parties”.

When the plan says “do not trade”

• You do not trade a company on the day it publishes its report if you have no defined scenario for reacting to a deviation from consensus and no plan for a price gap.
• You do not trade when the statements are incomplete, delayed by >30 days, or when there are no explanatory notes – you have no basis for measuring risk.
• You do not trade when CFO is negative for 4 quarters in a row while net profit is positive, and you do not understand the cause of the divergence.
• You do not trade when net debt / EBITDA > 4.5 and debt maturity is <12 months – liquidity risk is outside your risk limit.
• You do not open a long-term position before checking the balance sheet for covenants and security over assets.

The mistakes that cost the most

1. Judging the P&L alone, without the balance sheet. A company can show profits while being technically insolvent. Measuring only one statement inflates your conviction.
2. Confusing EBITDA with cash. EBITDA ignores CAPEX and changes in working capital. A manufacturing company with EBITDA of 100 million and CAPEX of 90 million has a completely different quality than a software company with EBITDA of 100 million and CAPEX of 5 million.
3. Ignoring the notes. The notes hold the information about M&A, management options and transactions with related parties.
4. Year-over-year analysis without the quarter-over-quarter sequence. Seasonality and one-off events distort the trend. Measure the 4-quarter moving average.
5. Not tracking dilution. The share count grows by 5-8% a year from the incentive programme – your EPS falls even if net profit rises.

Measurable exercise

Take 2 companies listed on the GPW (Warsaw Stock Exchange), for example from the WIG20 and mWIG40, and 1 from the US (S&P 500). For each one, over the last 4 quarters:

1. Enter in a spreadsheet: Revenue, EBIT, Net profit, CFO, CAPEX, Net debt, Equity.
2. Calculate: operating margin %, FCF, cash conversion (CFO/EBIT), net debt/EBITDA (annual EBITDA = the sum of 4Q EBIT + depreciation from CF).
3. Mark in red the quarters where: CFO < net profit, inventory grows faster than revenue by >15 p.p., goodwill >40% of assets.
4. Write in your journal: the 3 main balance sheet risks for each company with a measurable threshold (for example, “if net debt/EBITDA >3.5, I do not increase the position”).

Time: 90 minutes. Output: 1 spreadsheet with the comparison and 3 sentences of conclusions about earnings quality, not about valuation.

Check yourself

1. Why can a company have positive net profit and negative CFO in the same quarter?
2. Give two reasons why high goodwill on the balance sheet increases the risk to future results.
3. How does maintenance CAPEX differ from growth CAPEX and where do you look for information about the split?
4. What does a falling current ratio mean when short-term debt is rising?
5. How will you check whether revenue growth is cash-backed?

Frequently asked questions

Do I have to read the full 80+ page reports? Not to begin with. Start with the condensed statement, then CFO, the balance sheet, and the notes on debt and segments. Read the full report when you plan a position >1% of the portfolio or hold for >3 months.

IFRS vs US GAAP – does that change the analysis? Yes, in the details: for example, US GAAP capitalises R&D less often, and IFRS 16/US GAAP differ in how they treat leases. For advanced stock picking the key is comparing companies under the same standard, or normalising for leases/depreciation.

Where do I download GPW and US filings? GPW: ESPI/EBI plus the issuer’s investor relations section (PDF and XBRL). US: SEC EDGAR – 10-K (annual), 10-Q (quarterly). Use primary sources, not just aggregators.

Is a high gross margin always better? No. A high margin with low scale and high R&D/SG&A costs can produce a lower operating margin than a company with a lower gross margin but a lean operation. Judge the whole P&L.

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