What Is the difference between a balance sheet, income statement, and cash flow and why should you combine the three for the full picture of a company’s financials?
‘I don’t understand! We have heaps of work to do, but we still have a huge cash flow problem every month?’
When I ask my client how they organise their financial statements, they start stuttering and tell me that they do have a balance sheet somewhere…….
Do you recognise this?
You are not the first entrepreneur who has a successful start-up or business that gets lost in the financial abracadabra of the financials.
Most of my clients are in some form of growth. Growth is the phase of sharpening your position in the market, hiring more people, thinking about your cash flow, savings, making short & long-term decisions.
It is all about reaching the next level for their business but the financial part of business is a core element that is often forgotten or neglected.
Do you invest in R&D and your performance in the P&L is low? Sometimes that’s a choice: we call that strategy.
I want to share some information about the financial basics that are vital to check the health of your business and how to get usable insights from the numbers.
Of course, I highly recommend working with a financial specialist. Still note that you need to know what you are talking about; you have to understand at least the basics yourself.
Really understanding you own financials
If you really want to know where your money is coming from and where it all goes you need to exactly know how you are pricing your products and services and how you’re spending your money.
Let me introduce to you the financial holy trinity:
1. the balance sheet
2. the income statement
3. the statement of cashflow
The balance sheet
Balancing is exactly what it does.
One part of the balance sheet shows what the organisations owns, the assets the company owns economically, for example buildings, machinery or other inventory.
The other part shows how it came to own these things (liabilities and owners ‘equity).
Good to know & how to read the balance sheet
These two parts of the balance sheet -assets on the one side and liabilities and owners’ equity on the other side- are always in balance. Simply because owners’ equity is the difference between assets and liability.
Owners ‘equity = Assets – Liabilities
You have assets that easily can be converted into cash & long-term assets that not easily can be converted into cash.
Account’s receivable are listed on the balance sheet as a current asset.
Keep in mind that the balance sheet is like a snapshot, a statement of financial value at a point in time.
Reading the balance sheet, can provide a good sense of the company's financial condition; gives you knowledge about the net worth of a business.
I want to pinpoint some key financial indicators, based on the balance sheet, like:
Solvency ratio, helps to assess a company's ability to meet its long-term financial obligations.
Liquidity ratio refers to an enterprise's ability to pay short-term obligations—the term also refers to a company's capability to sell assets quickly to raise cash.
The income statement (Statement of profit and loss, P&L)
As the name implies, this is where you can find details about a company's income.
The income statement is the summary of the results of an entire year or other period. It is also called statement of profit and loss.
Good to know & how to read the income statement:
If you want to know how your business is performing financially you will find the answer in the income statement.
Keep in mind that you can make a profit, and at the same time you underperform) or vice versa. Whether or not to perform well depends on more than just profitability. The market and industry in which you operate is also important. Also comparing against your competitors.
One of the most valuable companies in terms of stock market for example Tesla. They have only been making a profit for a few quarters. They have invested an enormous amount in R&D, technology and consumer network. But the potential is great, and that is sometimes more important than simply performing on P&L.
The ‘net profit margin’ is the proverbial ‘bottom line’ and it could be positive (profit) or negative (loss).
Increasing market share can also be more important than making a profit (just look at TakeAway.com or DeliveryHero.com. In the meal delivery market, making a profit is not the most important thing now, but becoming the market leader is. Profits will come later.
Note that only inventory that is sold impacts the income statement. If it is produced and not sold it is considered an asset. Is neither revenue nor an expense. (the purchased raw materials are shown on the income statement) The faster inventory is converted the better. This leads to the discussion of cash flow.
The statement of cash flow
A cash flow statement tells you about the overall flow of money into and out of a company. The statement is divided into three sections — operations, investing, and financing.
Cash flow refers to outflows and incoming money. These are booked at the moment that they actual pay out or flow back in to the company. Income relates to the result in a certain period. Expenses are payments you make. Costs do not necessarily have to be an expense.
The overall cashflow of a company can tell you whether the company is cash-flow positive or negative. Keep in mind that a negative cash flow isn't automatically a bad thing.
For example, if a company invests a lot of money to expand its factories, that can be a positive long-term development.
However, several consecutive time periods of negative cash flow are good cause for further investigation.
Good to know & how to read the statement of cashflow:
The main components of the cash flow statement are cash from operating activities, cash from investing activities, and cash from financing activities.
Unlike the figures on the income statement, the cash flow statement ignores non-cash "income" such as depreciation.
From a manufacturing standpoint, cash is invested in purchase of raw materials. From a service standpoint direct labour will be the biggest cash pay-out.
The investing section contains expenses related to purchasing new equipment or buildings, as well as buying securities and other types of investments that involve cash leaving the company's accounts.
The financing section shows changes in a company's debt, loans, or dividends. For example, when a company receives cash as a result from issuing debt, this adds to the cash coming in. Later, when the company makes payments to debtholders, cash is reduced.
The cash flow statement complements the balance sheet and income statement and is a mandatory part of a company's financial reports
Tracking your money might reveal a gap between expectations and actual spending habits. Only then you can work toward goals that are important to you, from saving for a rainy day to traveling the world and or re-invest profit back into the company.
Answer these questions for your business and you know what to do:
1. Do you really know where your money is going?
2. Do you really know where your money is coming from?
3. Do you really know what your products or services cost you to produce them?
4. Do you carry a balance? Take action immediately, make sure it’s a top priority. Selecting the right repayment strategy can help you cross the finish line sooner.
5. Annual Savings (15-20% of gross income) Can’t spare much? Start anyway. The idea is to practice the habit, so when your income grows, you’ll naturally save and invest more.
6. Do you have short-term liquidity? Make sure you at least have 3-6 months of cash, 6-12 months of near-liquid assets.
Thanks for reading.