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How are the three financial statements linked ?

How are the three financial statements linked ?

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From my experience working with my clients doing revenue ranging from £40k to £53.8m based in the United Kingdom over the last two decades as their trusted accountant, I am sharing comprehensive information about how three financial statements are linked to each other.

Apparently, this is one of the most common questions I often get when I sit down with my clients who are small business owners going through their financials.

If you are confused about linking the three statements together, you are in the right place.

Before going forward, why would you listen to me?

As a cash flow specialist for the last two decades, I have helped hundreds of clients build customised templates for their specific cash flow needs. I have been featured on this topic in major sites like QuickBooks Online, Independent, Zoho, and Floatapp.

I review my client’s financial statements and devise a plan of action to fuel long-term growth. I do this all day, every day, for a living. So, don’t worry. You are in safe hands.

By the end of this guide, you will have comprehensive information on how three financial statements are linked to each other so that you analyse financial statements like a pro.

Let’s dive in.

One of my clients, a career coach, sent me this email where she mentioned her struggle to understand the difference between profit and loss, balance sheet, and cash flow statement from an entrepreneur’s point of view. Her message prompted me to include this section in the cash flow hub.

The three financial statements are the income statement, balance sheet, and statement of cash flows.

To determine whether the business is financially healthy or not, understand the relationship between the income statement and balance sheet and the relationship between the income statement and balance sheet cash flow.

Below, I have explained the relationship between income statement, balance sheet, and cash flow in a simple way using the concepts of Score, Stamina, and Status.

Understanding The Linkage Between Three Financial Statements

Business is a sport like football. Football is a physical sport. Business is an intellectual sport. To play a business sport, you need skills to perform well and stamina to last long, like in any other sport.

In football, players play for 90 minutes and get a score that decides whether they won, lost, or drew. The score is dependent on skill and stamina. Players play every week, and at the end of the year, they get points that ultimately decide their standing position in the league. The standing in the league decides the status of a team

Think of your financial statements precisely like that.

A cash flow statement tells you how much STAMINA your business has. It tells whether you have the cash to invest in a business to keep it going.

The profit and loss statement tells you the SCORE in your business.

The balance sheet tells about the STATUS. At the end of the year, just like a football team finds its standing in the football league. With a balance sheet, you get a status of your business’s worth at year-end.

The balance sheet tells about the STATUS. At the end of the year, just like a football team finds its standing in the football league. With a balance sheet, you get a status of your business’s worth at year-end.

None of these three statements can show how well your business performs in isolation.

Most entrepreneurs look at only one statement at a time and never at all three together. That’s why they are not aware of the financial health of their business.

For example, your profit and loss statement may tell you your business is profitable. Looking at this statement, you’d think you are in a good place. Still, you may be struggling to pay the bills.

Why?

Because a business may be profitable without being cash-rich.

Because a business may be profitable without being cash-rich.

Now, you might be wondering why a profitable business has cash flow problems.

Even for a profitable business on paper, the cash may be tied up in debtors, stocks, and investments. Such a business doesn’t have the cash to support the business.

The opposite is also true.

Just because the business is cash-rich doesn’t mean it’s financially healthy and is profitable. Because the business may have borrowed money, taken out a loan, or delayed paying suppliers.

Basics out of the way, let me explain how the three statements are linked with the help of an example.

An Example To Show Linkage Of Three Financial Statements

I’ll be using company A LIMITED to explain this.

Imagine looking at company A LIMITED’s balance sheet on 1 January 2021.

You notice that in the financial year Jan-Dec 2020 Company A LIMITED did £500,000 in sales. As of December 2020 for the financial year 2019, A LIMITED generated a net profit of £100,000 and has a cash balance of £80,000 on £500,000 in sales. That profit of £100,000 is now being carried forward in the balance sheet. The balance sheet shows net assets of £95,000 i.e., how much the business is worth on paper. For the uninitiated, net assets tell us the worth of a business at a given point in time. It is arrived at by deducting total liabilities from the total assets a business has.

Like profit, any loss is also carried forward.

The financial performance of a company is often reflected in its retained earnings, which appear on the income statement and ultimately adjust the cash flow. Retained earnings are a portion of net income that is not distributed as dividends but is added back to the balance sheet to be used for the company’s business operations and future investments. This ties into the interconnections between the three financial statements.

Image showing profit and loss and balance sheet as of 31 Dec 2020

Image of profit and loss statement

Image of balance sheet


After this, you’ll not see any part of the profit and loss on the balance sheet again. 

The only thing that is taken from the profit and loss into the balance sheet is net profit after allowing for taxes.

The cash balance of £80,000 goes to the balance sheet, as an asset.

Fast forward to 1 April 2021.

Company A LIMITED generated revenue of £100,000 and profit of £15,000 between 1 Jan 2021 and 31 March 2021 and has a cash balance of £75,000 and the balance sheet shows net assets of £110,000. The net assets increased from earlier £95,000 as of 31 Dec 2020, to £110,000 because the profit of £15,000 in Q1 2021 was added to it.

Here’s what profit and loss, balance sheet, and cash flow statements look like and how they are linked together again.

Image of P&L – Q1 2021

 

Image of Balance Sheet – Q1 2021

Now, the question is how you are going to use your understanding of financial data linkage to your advantage?

We come back to score, stamina, and status.

Let’s say you want to increase your profit (SCORE) from £15,000 to £25,000.

What can you do?

It is vital to plan effectively and understand the change in net working capital to ensure the business process is efficient and the cash basis accounting reflects the true amount of cash available for reinvestment.

Invest Cash As Stamina In Sales And Marketing.

Be careful when doing it because by investing in sales and marketing, a business may make more revenues and still not collect cash because of the time lag between making revenue and cash collection. Make sure you have enough cash for day-to-day operations.

By reviewing profit and loss and cash flow statements side by side, you can decide how much cash you can reinvest and still pay the bills on time if the cash investment doesn’t perform as expected.

A football player uses their stamina to play and win a match.

Similarly, a business owner invests cash to increase sales, launch new products, and run campaigns to create a profitable, cash flow rich, growing business.

Having skin in the game and stamina will get you far and improve your ranking in sports.

Similarly, in business, investing cash in the right ways to drive profitability progressively quarter by quarter will increase your status, which is your net assets.

Like in sports, you get points when you win the game, and over time, based on the number of games played, you gather more points, and finally, at the end of the league, you have a standing position.

It’s the same in business. Your net assets increase or decrease every month, and at the end of the year, you have a standing position, your current status, i.e., your net assets that tell you how much your business is valued on paper.

So that’s how the three financial statements are linked together and how you can use this understanding to improve your score, stamina, and status in your business.

How are the Income Statement and Cash Flow Statements Linked?

Income statement is a concept where gross income from customers, operating expenses incurred from services received from vendors are recorded as financial transactions.

Where as cash flow statement shows when the money hit the bank account when the customer pays the invoice.

An simple example is: 

Expense like interest expense is recorded in the income statement as a part of operating expense while the payment made is recorded as a cash going out in the bank account , which you will find in the current asset section of the balance sheet.

Let’s take another example.

When you pay for capital expenditures, a financial transaction is recorded only in the balance sheet. In this case, money goes out of the bank account- so bank balance decreases and therefore current asset balance decreases . While fixed assets increases. It is recorded in a document called fixed asset registar account on the balance sheet. 

You can use application software like Quickbooks online accounting software to record the financial transaction.

TIP

Depreciation is not included in the cash flow statement but is included in the profit and loss statement along with other expense on the income statement.

When you make debt payment, principal amount of debt decreases and therefore liabilities on the balance sheet decreases too. When this happens, in the cash flow from financing activities, you will show money going out to section as loan repayments.

But when you account for this properly, you need to separate the payment into two types: interest expense and principal amount.

How are the Cash Flow Statement and Balance Sheet Linked?

Did you know that preparing a cash flow statement does not fall under regulation ? It is not a law to prepare the cash flow statement for small business owners at least for the ones you do not meet the audit requirement threshold.

Meanwhile, the profit and loss statement and the balance sheet are.

Cash flow and balance sheet are linked when receiving or paying balance sheet items.

Let me explain.

The principal amount of debt owed is recorded in the balance sheet, whereas loan payments are recorded in the cash flow statement and the balance sheet.

Another example is a dividend.

As accountants, we call it a balance sheet item, as it is recorded under the equity section of the balance sheet.

When the corporation pays to the shareholder, it is recorded as a distribution to the shareholders.

Companies may set their internal policy to pay dividends when certain criteria are met for overall business and cash flow management.

Summary 

This section looked at how three primary financial statements, cash flow statement, profit and loss, and balance sheet, are linked together from a business owner’s point of view.

We looked at the concept of score, stamina and status from a sports point of view.

Cash Flow statement is mainly prepared as a part of financial risk management practice. You perform cash calculation like cash flow forecasting to identify cash utilisation across different business areas and the business’s financial viability.

One thing is for sure: you need to be updated across all three statements on a regular basis, and thanks to information technology, there are accounting software and tools which you can help you to achieve just that.

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Shishir Khadka, qualified as a chartered certified accountant in 2009. He is the creator of cashflow hub– the world’s most comprehensive cash flow resource online and is one of the UK’s leading cash flow specialist who helps busy business owners and entrepreneurs generate more profit and create consistent positive cash flow without over relying on getting new sales.

He has delivered a masterclass to a global software Zoho’s audience to create consistent cash flow. He has written articles for floatapp– one of the leading cash flow software and has also been featured in the major publications such as Independent. He has been sharing his learning and insights on his youtube channel.

He wrote about his learnings from helping an e-commerce client scaled the business cash flow positive from £500k to £1.6m in four years in “The Three Key Obstacles to Faster Growth: How You Can Overcome Them Using Cloud Accounting.

In his career spanning 18 years as the cash flow specialist, he has helped businesses of all sizes, ranging from £40K to £40M.

How are the three financial statements linked ?

By Shishir Khadka, FCCA.