What do your business’s financial statements actually tell you?
Your accountant sends three reports every month or quarter, and it’s tempting to glance at the bottom line of one and move on. But each statement answers a different question about your business, and the real insight comes from reading them together. You don’t need to be an accountant to get a lot out of them.
Three statements, three questions
The income statement, also called the profit and loss statement or P&L, answers: did the business earn more than it cost, over a period of time?
The balance sheet answers: what does the business own and owe, at a single point in time?
The cash flow statement answers: where did cash come from and where did it go, over a period of time?
The same questions apply to a household. A budget is a personal income statement, a net worth calculation is a personal balance sheet, and your bank statements are a rough cash flow statement.
The income statement
It starts with revenue, subtracts the direct cost of what you sold to show gross profit, then subtracts operating expenses like salaries, rent and software to show operating profit, and finally interest and taxes to arrive at net profit.
The most useful things to look at are trends and ratios rather than single numbers. Is gross margin, gross profit as a share of revenue, holding steady as you grow? Are operating expenses rising faster than revenue? A business can grow revenue and become less profitable at the same time, and the income statement is where that shows up first.
The balance sheet
It lists assets, what the business owns, such as cash, money customers owe you, inventory and equipment. It lists liabilities, what the business owes, such as bills to suppliers, credit cards, loans and taxes owed. The difference is equity, the owners’ stake.
The balance sheet shows things the income statement can’t. A profitable business with growing unpaid invoices and a thin cash balance may be heading for a cash crunch. A business whose debts are rising faster than its assets may be funding losses with borrowing.
The cash flow statement
It starts from profit and adjusts for everything that affected cash differently. It adds back non-cash expenses like depreciation, subtracts increases in unpaid invoices and inventory, and adds increases in unpaid bills. Then it shows cash spent on equipment, and cash from borrowing, repaying loans or owner contributions and withdrawals.
This is the statement that explains why the bank balance changed, and why it may not match the profit.
Reading them together
Imagine a business that reports a $40,000 profit for the year. Its balance sheet shows customer invoices outstanding up by $25,000 and inventory up by $10,000. Its cash flow statement confirms that operations produced only about $5,000 of cash, and the owner took out $30,000. The business is profitable but its cash fell, and the statements together show exactly why.
Reading only the income statement, the owner would see a good year. Reading all three, they’d see a business that needs to collect from customers faster or hold less inventory before cash runs out.
A monthly habit
Each month, it helps to look at revenue, gross margin and net profit compared with the previous month and the same month last year; cash, money owed to you and money you owe on the balance sheet; and cash from operations on the cash flow statement. Over time, those few numbers tell most of the story.
There’s more on the difference between profit and cash in why a profitable business can be short of cash, and on how revenue and expenses are timed in cash vs. accrual accounting. For a household version of the balance sheet, the net worth calculator adds up what you own and owe.
The takeaway
The income statement tells you whether you’re earning, the balance sheet what you own and owe, and the cash flow statement where the money went. Each one alone can mislead; read together, they show how the business is really doing.
Keep reading
This article is general education about US personal finance, based on the assumptions and sources described in it. It isn’t financial, tax or legal advice, and examples use hypothetical people and figures.