Understanding Cash Flow Statement. Balance Sheet vs Profit and Loss Statement
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Three main statements of the financial position of a business help entrepreneurs understand the internal state of the company and its cash flow processes. These main reports allow you to be aware of where the problems are and promptly anticipate a disaster. These statements are called - the Balance Sheet, the Profit and Loss (P&L) statement, and the Cash flow statement.
Balance Sheet statement
It contains information about what the company owns, what the company's debt, what funds balance is, the profit and loss (in our post "The main causes of financial failures" you'll read more detailed about business profit and false profit). All this information is crucial for making a compelling business plan.
For example, a revision of the company's Balance Sheet is necessary when the demand for goods and services changes.
Let's imagine an average clothing manufacturer. Everything flows according to the plan. A new batch of flapper pants is waiting to be sold. The sales team understands when, how, and how fast it will be possible to get profit from the goods. But at some point, demand sharply grows on narrow jeans. I mean yes, in the global market, there is no sudden moves, and usually, there's specialized staff to predict possible risks, but "split happens." Employees have not enough experience, or many batches of pants were made in advance - the result is the same. People don't buy the outdated stuff anymore, and the business has a bunch of pants that can't cover even the spent expenses.
The clothing manufacturer needs to invest funds that haven't yet been earned to produce a new product attractive to the buyer. Therefore, the business needs to take funds in some bank or put the entrepreneur's own money to sew the narrow jeans to sell them and successfully make money. The balance sheet statement shows this in numbers: what the company possesses, what the company has available that aren't yet sold, the debt at a specific date, and the company's equity. All information about what was invested in the business.
In other words, the balance sheet is about the financial state of the company at a specific point of time without giving any balance progression or regression information for this period. So when we are working with the balance sheet, it's usually compared to the balance sheets within the company in different periods or with competitors in the same direction.
What Balance Sheet shows us?
Business isn't considered as profitable even if you have funds on the account. The balance sheet helps to understand at a certain point whether the industry burns funds or earns them. By analyzing it, we can see what debts are there and how much funds the business has. If the debt is more significant than the company has funds, at some point, the market begins to burn the capital and instead of earning.
Besides, the balance is also known as "financial magic," because the assets will always be equal to liabilities.
Profit and Loss (P&L) statement
Like a balance sheet statement can be compared to a static photo, the P&L be more like a movie about the path that led to this photo.
Let's imagine a basketball game video. You watch how teams play, and at some point, the ball hits the ring. Now you can set a pause and view a particular picture. You can analyze how exactly the player put his feet and arms up as he threw the ball. You also have the opportunity to rewind the video of the whole game to the beginning. Analyze what was wrong and the right to use that knowledge in the future. In the same way, we can work with the P&L.
P&L is an income statement that shows how does the business moved to the current balance sheet. It explains what happened before and predicts what will happen with business later in the future. Also, P&L shows the financial success of the company. Here we can see how much the company has earned, how much it cost, what is the production cost and the amount of expenses.
How to make wrong calculations of the profit?
If you think that the sum of money that you have on your account at the end of the month after all the expenses - is your profit, then you'll get a cash gap in the nearest future. Why? Because that is how cash flow works. Today, the company has received the money and will send them tomorrow to cover the expenses. The profit has another story because there's an accrual accounting method used by many businesses.
The
accrual accounting method involves accounting for the income and outcome regardless of the moment of receipt of funds in the business, and the moment of payment for goods (works, services). In this case, the income will be taken into account when selling the products, even without an actual amount for it. It means, these funds will not be available in cash flows yet, but at the same time, they have already recorded in P&L. The funds will come later, and the receipt will guarantee that. It was an example of income.
An example of expenditure looks different. It's possible that in some cases, the company cannot pay in advance. For example, there were extra expenses for the previous month because you bought new production instruments. The landlord doesn't mind to wait four months till you earn enough to pay the debt. So, you can pay in four months, BUT in P&L you will still write the sum you pay for rent every month. P&L is formed for you to understand not just when the funds came and when they spent, but how much you earned and how much you've paid for the bills, even if there were no actual cash flow.
Cash Flow statement
It's the statement from which one everyone should start: to record transactions, costs, payments, etc. The cash flow statement shows three main activities: operating, financial, and investment. Operating activity shows your cash flows based on the leading company's operation and scope of funds that are available in the business at the moment.
Investment statements show how your business is invested or what your company is investing in. It shows the financial stability of the company. Financial statements show your loans that you take to cover the cost of your business functioning.
For the sake of clarity, let's imagine the company launches an innovative product. They invented safes with a unique and very efficient locking mechanism. In the beginning, the company invests $300 000 for the release of the first safes batch. Business is very successful, there are no competitors, and it's growing. The company recruits new employees, buys everything additional for production, and orders more materials.
During the first month of operation, the company implemented the first batch of safes and sent invoices to all buyers for a total amount of $ 100,000. Payment from customers comes to the company in 45-47 days after the invoice was sent. These conditions were agreed-upon contracts. At the same time, the company pays its bills as soon as the payments from customers received.
The business is developing rapidly, and sales increase by $50 000 monthly. Expenses increase at a lower rate because no changes in production occur; therefore, the profit is increasing.
It seems like everything is good, but there is a problem. Three months later, unexpectedly, it turns out the companies' bank account is empty. There are no funds to pay salaries to cover the rent and continue production. How could this happen?
Companies don't go bankrupt because of unprofitableness. It happens because there's a shortage of funds when they can't pay for their production activities. The longer the successful coverage period lasts, the longer the company survives.
The situation in our case was because the payment arrives much later than the actual shipping of the product. That is, the reason was in a very long period of payment from customers. The e-commerce company produces new safes batches, business is growing, investing more, and the money comes too late. And the sale remains a gift for the client until the funds are on the account.
The funds go through a cycle inside the company. You invest, you produce and form the price, and only after a while, the funds returned to you. In each company, this cycle takes a certain number of days, and each company has a different period for that process. If you know this number of days, you can forecast everything. It allows you to take a loan and then invest these funds, and at the same time, you can manage your money and not get into a cash gap.
If you find this information helpful, you should also read more about finance at the company in our articles:
The whole topic of Financial Management aimed at saving businesses from all the difficulties and failures associated with the inability to handle finances. Without accurate accounting, there will be no business scaling, no investments, and growing.
The company needs to start planning from the moment when the idea came up. You want to understand: Where and how much I have to invest? How will I earn? How do I make a financial plan? etc.
Why do we try to escape planning? Because we have a biased attitude and some fears. It seems to us that Financial Management is complicated, we have to think and spend too much time on it, or facing the possible truth terrified us.
For instance, the fear of realizing that there is no "business component" in the idea, but you want to do it. Also, we can have a sort of adrenaline dependence. We imagine that every business person always in a rush, doing something, have interesting meetings and plans. At least no entrepreneur posts his photos on Facebook as he sits in front of the Excel table and plans his budget. It cannot be attractive.
It's challenging for business people to postpone all current affairs and allocate several days to accomplish with the financial statements. It's challenging to do, but it must be done. When the time for that is finally here, there are only two ways. Or get scared or get yourself together and move on to change something in the business and make it profitable.
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