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 concept of Score, Stamina, and Status.
Understanding the Linkage between Three Financial Statements Using the Concept of Score, Stamina, and Status
Business is a sport like a football. Football is a physical sport. Business is an intellectual sport. To play the business sport, you need skills to perform well and stamina to last long, like in any other sport.
In football, players play for 90 mins 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.
None of these three statements can show how well your business is performing in isolation.
Most entrepreneurs look at only one statement at a time and never look 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 that your business is profitable. If you looked at just 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.
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 you are looking at the balance sheet of company A LIMITED 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.
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.
Add the image in the balance sheet showing a cash balance of £80,000.
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?
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.
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.
