How to read financial statements: A guide to reading the 3 key reports

Financial statements are formal records that show how your business earns, spends, and manages its money. The three major financial statements are the income statement, balance sheet, and cash flow statement, each providing a different view of your company’s financial position.

Whether you're a new founder, small business owner, or team lead at a larger company, financial literacy helps you make smarter business decisions. Here's how to read and interpret financial statements to do just that.

What are financial statements?

Financial statements summarize what your company earns, spends, owns, and owes. At their core, financial statements help answer one critical question: Is your business on solid financial ground? If not, where are the problems?

The three key financial statements—the income statement, balance sheet, and cash flow statement—provide a complete picture. Together, they help you move beyond gut instinct by providing the numbers needed to evaluate performance, manage costs, plan for growth, and make more informed decisions.

For example, reviewing your income statement might reveal shrinking profit margins, while the balance sheet can flag rising debt. The cash flow statement shows whether your business generates enough cash to stay operational. This visibility enables you to take proactive steps to correct any potential issues rather than reacting to financial problems after they happen.

Who uses financial statements?

Internal and external stakeholders rely on financial reports to stay informed. Investors use them to understand your company’s profitability and growth potential. Lenders examine them to assess credit risk. Internal teams use them to measure progress against company initiatives and justify strategic decisions.

On top of that, for companies operating in highly regulated industries or seeking outside funding, timely and accurate financial reporting is a compliance requirement.

How to read a balance sheet

The balance sheet shows what a business owns, what it owes, and its owner's equity. It’s a snapshot of your company’s financial position at a specific point in time, not over a period.

A balance sheet contains three sections: assets, liabilities, and equity.

• Assets include everything your business owns or controls, such as cash, inventory, equipment, and accounts receivable
• Liabilities are what you owe, including loans, credit lines, and unpaid bills
• Equity is the difference between the two, or the value that remains if your business pays off all its debts

The balance sheet always balances because of one formula:

Assets = Liabilities + Equity

Known as the accounting equation, it ensures everything your company owns is either financed by borrowing (liabilities) or by the owners (equity).

From this equation, you can calculate simple ratios that reveal your business’s financial health. For example, the current ratio shows whether your business can cover short-term bills, while the debt-to-equity ratio highlights how much you rely on borrowing versus owner financing.

Current assets vs. non-current assets

Assets break down into current and non-current categories:

• Current assets: Cash, accounts receivable, and inventory, or resources your company can convert into cash or use up within a year
• Non-current assets: Property, equipment, patents, and long-term investments, or resources that provide value beyond one year

This distinction matters because you can use current assets to pay near-term debts, while non-current assets support long-term growth. If your company has insufficient current assets, it may struggle with liquidity, even if it owns valuable long-term assets.

Short-term vs. long-term liabilities

Liabilities also break down into short- and long-term obligations:

• Short-term liabilities: Debts due within 12 months, including accounts payable, wages payable, taxes due, and credit card balances
• Long-term liabilities: Obligations that stretch beyond a year, including bank loans, bonds, or long-term leases and mortgages

Understanding the difference helps measure financial health. For example, your business may face cash crunches if short-term liabilities outweigh current assets. A heavy load of long-term debt may signal higher financial risk if your profits don’t keep up.

How to read an income statement

The income statement shows whether your business is making money or losing money. It reports revenue, expenses, and net profit over a set period, usually monthly, quarterly, or annually.

Overall, you prepare an income statement to show profitability and help you understand where your money comes from and where it goes.

Revenue vs. expenses

Revenue is the total income your business earns from sales or services. It appears at the top of the income statement, which is why it's often called the top line. Expenses are the costs your business incurs to generate that revenue, and they're further broken down into categories.

The first category is the cost of goods sold (COGS), which includes the direct costs of producing the goods or services you sell. Beyond COGS, expenses also include operating and non-operating costs. Comparing revenue to all these expenses shows whether your business is turning sales into sustainable profit.

Operating vs. non-operating expenses

Next comes operating expenses (OpEx), which include salaries, rent, and marketing. Deducting those from gross profit gives you your operating income. This key number shows how much profit your business generates from its core operations without outside investments or financing.

Further down, the statement accounts for income taxes, interest, and other non-operating expenses or income. These items don’t directly relate to daily business activities, but they affect profitability nonetheless. Separating them allows you to see how well your core business performs versus outside factors.

Gross profit vs. net profit

Gross profit is what remains after subtracting COGS from revenue, and it shows how efficiently your company produces and sells its products or services. Net profit, on the other hand, is what’s left after taking all expenses into account, including COGS, operating costs, interest, and taxes.

This bottom-line number reflects your company’s overall profitability. Comparing gross profit to net profit helps you understand whether challenges come from high production costs or broader issues such as overhead, financing, or tax burdens.

How to read a cash flow statement

The cash flow statement shows how money moves in and out of your business. It tracks actual cash, not revenue or expenses on paper, making it one of the most useful tools for managing day-to-day operations. It consists of three sections: operating activities, investing activities, and financing activities.

Unlike the income statement, which includes non-cash items such as depreciation, the cash flow statement deals only with real cash activity. This makes it easier to see whether your business can cover expenses, pay employees, and invest in growth.

You can also use it to calculate your cash runway, or how long your business can operate without new funding. If monthly cash burn is high and reserves are low, that’s a red flag that requires immediate action.

Operating activities

Operating cash flow reflects the money generated or used in core business activities, such as receiving customer payments or paying suppliers. Positive operating cash flow is a sign that your business can sustain itself through normal operations.

Negative operating cash flow may signal trouble, even if your profits look strong on the income statement. For early-stage companies, this can be the first warning sign of unsustainable growth or poor cost control.

Another key metric to watch is free cash flow, which shows how much cash remains after covering operating costs and long-term investments. This number highlights your business’s ability to pay down debt, reinvest, or build a cushion for the future.

Investing activities

Investing activities cover purchases or sales of long-term assets such as equipment, property, or securities. For example, buying new machinery shows up here as a cash outflow, while selling old equipment or an investment would be an inflow. These activities reveal how a business is investing in its future growth.

Financing activities

Financing activities include debt repayments, loan proceeds, or investor funding. Issuing stock, taking out a loan, or paying dividends all show up in this section. Together, these entries show how your company raises money to operate and grow, and whether it relies more on borrowing or equity financing.

What financial statements don’t show

Financials are important, but they don’t tell the whole story. They focus on past performance and measurable data, which means key risks and context often go unseen:

• Timing risks: Income statements prepared using the accrual method of accounting show revenue when you earn it, not when the cash arrives. If customer payments are late, the numbers won’t reflect the resulting cash gap, even though it can disrupt day-to-day operations.
• Business context: The reports show what changed but not why. A spike in costs could be from a planned investment, not overspending. Without context, it’s easy to misread a positive or negative trend.
• Assumptions behind the numbers: Many line items rely on internal estimates, like depreciation, amortization, or revenue recognition. These choices affect reported results but often aren’t obvious unless you review the footnotes or disclosures.
• External risks: Your company’s financial statements don’t capture supply chain disruptions, pending lawsuits, or lost customers unless those events have already impacted the financials. That makes it harder to see future threats.
• Sustainability of performance: Your company might report strong earnings while relying on temporary cost cuts or short-term borrowing to stay afloat. Financials can show that your business is profitable, but not whether that success will last.
• Market conditions and reputation: Financial statements don’t reflect factors such as shifting industry trends, competitive pressures, or customer trust. Your company may have strong numbers today, but it could face declining demand or reputational challenges that threaten its long-term success.

Streamline financial reporting with Ramp

Understanding financial statements is important, but the bigger challenge is keeping them accurate, current, and useful as your business grows. Ramp’s accounting automation software can handle these tasks for you, keeping your financial statements up to date and correct.

With Ramp, you can speed up your monthly close by automatically collecting receipts, categorizing expenses consistently, and syncing data directly into your ERP in real time. Our software learns from thousands of past transactions to suggest the right categories, helping prevent employee mistakes and freeing your finance team from repetitive tasks.

Instead of combing through line items, your team can focus on reviewing flagged issues, ensuring compliance, and preparing accurate reports faster than ever.

Ready to get started? Try an interactive demo to see how Ramp's accounting automation can save you time and money.