Reading an income statement in 5 minutes
The income statement (P&L) tells a story in cascade: it starts from what you sell and goes down, line after line, until what is left for you. Five levels are enough: revenue, gross margin, EBITDA, EBIT, net result. Each one answers a precise question about the performance of your activity.
Revenue opens the dance: it is the sum of your sales over the period, excluding VAT. Important, but misleading on its own, because it says nothing about what these sales cost. The gross margin subtracts the direct cost of the products or services sold (purchases, materials, subcontracting). If you sell for EUR 1,000,000 and your direct costs weigh EUR 600,000, your gross margin is EUR 400,000, or 40%. It is the first health signal: what each euro sold leaves before paying for the structure.
The EBITDA then deducts the current operating expenses (salaries, rents, marketing) but not depreciation or interest. It is often presented as the cash generated by the business: that is a shortcut, because it remains an accounting figure that ignores the change in working capital requirement, taxes and investment. The EBIT, or operating result, additionally deducts depreciation: it measures operating performance, wear and tear of the equipment included. The net result, right at the bottom, arrives after the financial result, exceptional items and taxes. It is the share that goes to the shareholders, whether it is paid out to them or kept in the company.
Reading a P&L in 5 minutes means going down these five floors and spotting where the money evaporates. A solid gross margin but a feeble EBIT betrays a structure that is too heavy. The next time you are presented with accounts, start from the top and ask at each line the question: what have we just subtracted, and why.
Understanding the balance sheet: assets, liabilities, equity
The balance sheet is a snapshot of the company at a given date. The liabilities side, on the right, says where the resources come from: equity, contributed or retained by shareholders, then provisions and debts owed to third parties. The assets side, on the left, says what those resources were used for: fixed assets and current assets. The two totals are always equal, since every resource has a use.
Read it by broad blocks. On the assets side, fixed assets (machines, buildings, software, shareholdings) serve the business for several years; current assets (inventories, trade receivables, short-term investments and cash) turn over with the operating cycle. On the liabilities side, equity, provisions and amounts payable after more than one year form the long-term resources; amounts payable within one year include operating debts (suppliers, tax, payroll and social security liabilities) and short-term financial debts. Financing a factory durably with short-term credit exposes the company to its bank refusing to renew. Fixed assets partly financed short term are not always a danger, though. In mass retail, customers pay cash while suppliers are paid on credit: this supplier credit finances part of the stores without threatening liquidity. What settles the question is how net working capital compares with the working capital requirement, detailed in the next section.
Structure ratios help place the company, provided you do not lend them a universal threshold. Leverage can be measured in several ways (debts / equity, debts / total assets, total assets / equity): pick one definition and stick to it. Financial autonomy (equity / total balance sheet) says what share of the resources comes from shareholders. A healthy level in one sector is not healthy in another: compare these ratios over time and with genuinely comparable companies. Bear in mind too that equity is an accounting figure. High reserves say nothing about the cash available: they may have financed a machine, inventories or receivables. Their book value may also differ widely from the market value of the shares.
Concretely, when you look at the balance sheet of your BU or of a partner, do not stop at the total. Ask three questions. Do long-term resources cover the fixed assets with a margin for the operating cycle? Is the resulting net cash positive or does the company depend on the renewal of its short-term credit? How do these figures change from one year to the next? A balance sheet remains a snapshot: to know whether the business generates cash, you also need the cash flow statement.
Working capital and cash: the vital difference
A positive net profit does not guarantee survival. A company can be profitable on paper and run out of cash the same month. The reason has a name: the working capital requirement (WCR). It is the money tied up by the operating cycle: what the company advances to its inventories and its customers, minus what its suppliers, the State and its staff advance to it.
The full formula: WCR = inventories + trade receivables − trade payables − tax, payroll and social security liabilities. You have advanced the money for the inventory and you are waiting for your customers' payments, but your suppliers grant you a delay, as do the State and your staff, paid after the fact (VAT, taxes, wages, contributions). If your customers pay at 90 days while you settle your suppliers at 30, the requirement deepens. On the other side, net working capital (NWC = equity + provisions + amounts payable after more than one year − fixed assets) measures the long-term resources left once fixed assets are financed. The two are linked by an equation: NWC = WCR + net cash, net cash being cash and short-term investments minus short-term financial debts. When the WCR exceeds the NWC, net cash turns negative: the gap relies on short-term credit, which the bank has to agree to renew.
Let us take an illustrative case. A company generates EUR 60,000 of net result, but its growth swells inventory and receivables by EUR 200,000 over the year without its operating debts keeping pace. Leaving depreciation and investment aside for the example, its cash falls by EUR 140,000: EUR 60,000 of profit minus EUR 200,000 tied up in operations. The income statement smiles, the bank account empties. Each new order consumes cash before bringing any in. This is how profitable companies go bankrupt: not for lack of profit, but because they can no longer pay their debts when they fall due.
Remember the distinction: the result measures an accounting performance, cash determines the ability to pay each debt when it falls due. As a manager, monitor the change in WCR as much as the profit line; follow the cash flow statement too, which shows whether operations generate cash. Unfinanced growth is dangerous: yet it is often the growth one is most proud of. Conversely, very comfortable net cash is not a goal in itself: it is money not invested, financed by long-term resources that cost more than supplier credit.
Building and defending an annual budget
An annual budget translates a strategy into committing figures. Two approaches build it: top-down, where management sets the objectives that the teams break down, and bottom-up, where each department feeds up its forecasts, consolidated afterwards. Most companies combine the two: a top-down framing, refined by field estimates.
The strength of a budget lies in its assumptions. A budget of EUR 800,000 based on sales growth of 15% is only worth something if this growth rests on something concrete: an order book, a sized sales team, a market that allows it. Always distinguish the volume assumptions (how many units), price assumptions (at what price) and cost assumptions (at what margin). An unquantified and unjustified assumption is a promise, not a budget.
The defence before the executive committee is prepared like a trial: you will be attacked on the weak link. Anticipate the three killer questions: what happens if revenue disappoints by 10%, where are the compressible costs, and what justifies the gap with last year. Present a low version, a target version, and the adjustment levers. A manager who arrives with a single scenario arrives unarmed.
In practice, defending a budget is not about justifying it line by line, it is about demonstrating that you master your assumptions and your room for manoeuvre. The executive committee does not finance spreadsheets, it finances a lucid reading of risk. Arrive with your figures, but above all with your plan B.
Evaluating an investment project (NPV, IRR)
Evaluating an investment means answering one question: does this project create value once time and risk are taken into account. Three tools answer it: the net present value (NPV), which decides; the internal rate of return (IRR), which illuminates within its limits; and the discounted payback period, as a complement for liquidity. The simple payback, computed on undiscounted flows, is a trap: it ignores the cost of capital and the time value of money.
The NPV rests on a principle: a euro tomorrow is worth less than a euro today. You therefore discount each future flow, then subtract the initial investment. NPV = sum of discounted flows − investment. If you invest EUR 500,000 to recover flows whose total discounted value is EUR 560,000, the NPV is worth EUR 60,000: the project creates value. A positive NPV validates, a negative NPV invites you to give up. It is the most robust decision rule.
The IRR is the discount rate that sets the NPV to zero: if the project's expected IRR is 12% and your cost of capital is 8%, the margin is comfortable. The IRR has its traps (projects with alternating flows, implicit assumption of reinvestment at the same rate): when it conflicts with the NPV, the NPV decides. The discounted payback indicates in how many years the discounted flows repay the investment; useful to gauge liquidity, silent on profitability beyond, never sufficient on its own. Its simple version remains widespread in finance departments; that is an inconsistency, not a validation. The choice of the discount rate is decisive: for a manager, it reflects the opportunity cost of capital: what the company's money would earn elsewhere at comparable risk, project risk premium included. Too low, you validate bad projects; too high, you kill the good ones.
Concretely, never defend a project on its payback alone or its expected revenue. Present the NPV at the rate retained, say why this rate, and show from which assumption the project tips into negative. It is this transparency that gets a case through the executive committee.
The 7 ratios a manager must track
Seven ratios cover most of what a manager needs to track: two measure profitability, three shed light on the operating cycle, two describe the financial structure. None is enough on its own. A ratio is computed in one line, but it only makes sense when compared, over time or with genuinely comparable companies. And one of them, the most quoted, does not measure what its name suggests.
Do not track these seven ratios in isolation: it is their combined evolution that speaks. A stable EBITDA margin while WCR / revenue climbs and net cash deteriorates describes a profitable business whose operations tie up more and more cash, financed short term. Always compute them with the same definitions, since several coexist. Remember too that they rest on past accounting data: they raise questions more than they answer them. Choose your two or three priority ratios according to your activity and track them every month: you will speak the same language as your CFO.
- ROIC (return on invested capital) = operating result (EBIT) × (1 − tax rate) / (equity + financial debts). Measures what the funds entrusted by shareholders and lenders return, regardless of how the company is financed. Comparing it with the cost of capital gives a first indication, but the ratio rests on book values: largely depreciated assets inflate it without the business creating more value.
- EBITDA margin = EBITDA / revenue. Indicates operating profitability before depreciation and financing. Track its trend more than its absolute level: a margin that erodes quarter after quarter is a signal. It does not, however, tell you how much cash the business generates.
- DSO (customer payment period) = trade receivables / revenue × 365. Average number of days to get paid. Balance sheet receivables include VAT whereas revenue does not: add VAT to revenue before concluding. A DSO of 75 days when your terms are at 30 signals cash stuck with customers, unless a seasonal effect at the closing date explains it.
- DPO (supplier payment period) = trade payables / purchases × 365, with the same VAT adjustment. Average number of days before paying your suppliers. Compared with the DSO, it shows who finances whom between your customers, you and your suppliers. Paying later relieves cash, provided you respect the agreed terms: the relationship with your suppliers has value too.
- Gearing = net financial debt / equity. It is one of the measures of leverage, alongside debts / equity or total assets / equity. Above 1, debt exceeds equity, but no threshold is healthy everywhere: the acceptable level depends on the sector and on the ability of operations to cover interest and repayments. As long as the return on invested capital exceeds the after-tax cost of debt, leverage raises the return on equity together with the risk.
- Current ratio = current assets / current liabilities. The most quoted, but also the most misleading: above 1, it only says that net working capital is positive, not that the company will be able to pay its debts when they fall due. With net working capital of 5 million and a WCR of 9 million, net cash is −4 million despite a reassuring ratio; a supermarket can stay below 1 without the slightest payment problem. To judge liquidity, follow net cash and the cash flow statement.
- WCR / revenue = working capital requirement / revenue. Indicates the share of sales tied up in the operating cycle; multiplied by 365, it expresses it in days of revenue. As long as it is positive, any sales growth consumes cash; if it climbs, each additional euro sold ties up more.