Every year, a business receives a set of accounts from its accountant. It usually gets glanced at, signed and filed. Which is a pity, because those few pages contain a remarkably complete picture of the business, if you know how to read them.
The key is to understand that there are three statements, that each one answers a different question, and that they're connected. Read one alone and you see a slice. Read all three together and you see the whole.
What I want to do here is take each statement in turn, in plain words, and then show how the three fit together, because that's where the understanding really lives.
Three questions, three statements
The profit and loss statement answers: did the business make money over the period?
The balance sheet answers: what does the business own and owe at a moment in time?
The cash flow statement answers: where did the cash come from and go over the period, and why is the bank balance different from the profit?
A useful image: the balance sheet is a photograph, taken on the last day of the year. The profit and loss and cash flow statements are films of what happened between last year's photograph and this year's, one in terms of profit and the other in terms of cash.
Does that make sense? Think of a photograph and a video of the same cricket match. The photograph shows the scoreboard at the end. The video shows how the match got there, ball by ball. The balance sheet is the photograph. The profit and loss statement and the cash flow statement are two videos of the same match, one following the score and the other following the money.
The profit and loss statement
Also called the P&L or income statement, it runs from top to bottom like a story of where each rupee of sales went.
Revenue: what the business sold.
Minus cost of goods sold: the direct cost of what was sold.
Equals gross profit.
Minus overheads: rent, salaries, utilities, marketing and so on.
Equals operating profit.
Minus interest and tax.
Equals net profit.
For our retailer, in a month: revenue LKR 2,000,000, cost of goods LKR 1,200,000, gross profit LKR 800,000; overheads LKR 650,000; profit before interest and tax LKR 150,000.
The questions to ask: Is revenue growing? Is the gross margin holding, or slipping? Are overheads growing faster than revenue? And compared with last year, which lines moved most, and why?
One thing the P&L doesn't show: cash. It counts sales when they're made and costs when they're incurred, whether or not money has changed hands.
The balance sheet
The balance sheet lists what the business owns (assets), what it owes (liabilities), and what's left for the owners (equity). It always balances, because everything the business owns was paid for either by money it owes or by money the owners put in or left in.
Assets are usually split into current assets, which turn into cash within a year (cash, receivables, inventory), and non-current assets, which last longer (equipment, vehicles, property).
Liabilities are split the same way: current liabilities due within a year (payables, short-term loans, tax due) and non-current liabilities due later (long-term loans).
Equity is assets minus liabilities: the money the owners have put in, plus profits kept in the business over the years.
The questions to ask: How much cash is there, and is it enough? How much are customers owing, and is it growing faster than sales? How much stock is there, and is it moving? How much does the business owe, and when is it due? Is equity growing year on year, meaning the business is building value, or shrinking?
Here's why the balance sheet matters so much for cash. When a business grows, more money gets tied up in receivables and stock. That money is visible on the balance sheet and invisible on the P&L. So a business can show a healthy profit on the P&L while the balance sheet shows its cash draining into what customers owe and what's sitting on the shelves.
The cash flow statement
This is the statement that explains the difference between profit and the change in the bank balance. It has three sections.
Operating activities: cash generated by running the business. It starts from profit and then adjusts. It adds back costs that weren't paid in cash, like depreciation. It subtracts increases in receivables and inventory, because that's cash that went into them. It adds increases in payables, because that's cash you haven't paid out yet.
Investing activities: cash spent on long-term assets, like equipment and vehicles, and cash from selling them.
Financing activities: cash from loans and from the owners, and cash paid back to them: loan repayments, owner drawings or dividends.
Add the three sections together and you get the change in the bank balance over the period.
The questions to ask: Is cash from operations positive and roughly in line with profit? If profit is healthy but operating cash is weak, look at receivables and inventory. Is the business funding its equipment from its own operating cash, or from borrowing? And after paying for equipment, is there free cash flow left over?
There's a chain hidden in these three statements, and it explains a lot of cash surprises. A sale on credit raises profit on the profit and loss. It also raises receivables on the balance sheet. And that rise in receivables reduces operating cash on the cash flow statement. One event, three statements, and only one of them shows it as a problem.
How the three connect
The connections are where the insight is.
Net profit from the P&L flows into equity on the balance sheet, because profits kept in the business add to what the owners own.
Net profit is also the starting point of the cash flow statement, which then explains how that profit turned, or didn't turn, into cash.
The change in cash on the cash flow statement equals the change in the cash line between last year's balance sheet and this year's.
Once you see these links, the statements stop being three separate documents and become one description of the business seen from three angles. A rise in receivables on the balance sheet shows up as a drain in operating cash flow. A new loan on the balance sheet shows up as cash in from financing. A big equipment purchase shows up as a new asset, as cash out in investing, and, over the following years, as depreciation on the P&L.
The bigger point
The three statements are distinct, and they aren't separable. A single sale on credit appears as revenue on the profit and loss, as a receivable on the balance sheet, and, weeks later, as cash on the cash flow statement. It's one event, seen from three angles. Owners who read only the profit and loss tend to be surprised by their bank balance. Owners who watch only the bank balance tend to be surprised by their accounts. Reading all three together is how the surprises stop.
Make them monthly
Annual accounts tell you what happened up to a year ago. A simple monthly version of all three, even an informal one, tells you what's happening now, while you can still act on it. A one-page monthly snapshot, with the key figures and ratios for the last twelve months side by side, is one of the most useful tools an owner can have. (Our guide to financial ratios and KPIs shows what to put on it.)
How Gridwerk helps
Preparing management accounts and draft financial statements, building the monthly snapshot, and walking you through what your statements are saying is part of our Financial Intelligence service. If your accounts get filed without being read, start with the free diagnostic. It's eighteen questions, about seven minutes, and then we call you to go through the rest.
Gridwerk diagnostic