Understanding your numbers - Part 3

Connecting the profit and loss to cash in the balance sheet – why a profit doesn't always mean more cash in the bank

This is Part 3 of understanding your numbers. Blog 1 covered the profit and loss, blog 2 explained the importance of accrual accounting.  

The next step in understanding your business numbers is connecting what your bank balance is doing relative to your profit. Often a business is reporting a profit but you have a cash drain, which can be really concerning for a business owner who is focusing on managing the business. This blog gives you some guidance of what to look for.

All businesses have three key financial statements that should be produced monthly:

• the profit and loss
• the balance sheet
• the cashflow statement

The profit and loss

In simple terms, the profit and loss is the record of your operational activity.  It is sales less the costs including overhead expenses that you incur to run your business and produce the sales. A profit and loss represents a period of activity, basically over time. This can be daily, monthly, quarterly or annually.  Check out blog 1 for the key parts to a profit and loss.

The balance sheet

The balance sheet is made up of three sections that represent a point in time.

Section 1: Assets - what the business owns: these are for example fixed assets or positive bank balances in cash or people who owe you money or inventory/stock. These are represented as positive numbers (or debits).

Section 2: Liabilities - what the business owes: these are for example creditors you owe money to for supplies and expenses, overdrafts, loans from the bank or hire purchases (HP), and tax liabilities. These are represented as negative numbers (or credits).

Section 3: Equity - what you as the business owner own of the business:  what's left over after you take the liabilities from the assets. It represents the owner’s share of the business. This includes the current year's profit and retained earnings (usually represented as negative numbers).

Basically the balance sheet is Assets equals Liabilities plus Equity.

The cash flow statement

This is a representation of what happens to the cash in the business, and links the profit and loss to the balance sheet. It represents the movement in cash between two points in time (or two balance sheets).

< >opening cash plus/minus operating cash financing cash investing cashequals closing cash

Operating cash:

Operating cash is the cash generated and used by the operation of the business: sales plus/minus the movement in debtors, purchases plus/minus the movement in creditors and inventory, and payment for employees.

Financing cash:

Financing cash is the cash movement related to financing activities of the business and are related to the payment or drawdown for bank loans and hire purchasing.

Investing cash:

Investing cash is the cash related to investment activities including the purchase (or sale) of fixed assets, and the cash inflows or outflows from the owners of the business such as drawings.

Link to the profit and loss and balance sheet:

Hopefully you would have noticed that those items in your profit and loss are mainly in operating cash.  Additionally, the balance sheet items Creditors, Debtors and Inventory impact operating cash. For example, having a growing inventory without sales or having late debtors will impact negatively on operating cash as this generates a negative movement. 

This is key for any business – operating cash must be positive to generate a sustainable business.  Without positive operating cash you need to get additional cash by either getting bank loans or the business owner increasing their investment; at some stage this funding dries up.

Though I've only touched on the connection between your cash flow balance sheet and profit and loss in this blog,  to make sense of your numbers you need to understand all these financial statements. Ensure you receive these monthly so you can see how you are going. This is where a CFO can be invaluable in your business, ensuring you're keeping an eye on the things that matter.