What are financial statements you might ask. Perhaps you have heard the terms P&L and balance sheet before, but you wonder what they are and what they tell us about a business. Let me provide you with a few analogies to provide some insight about these two parts of the financial statements.
The Profit and Loss
First, the profit & loss “P&L” is analogous to how much money an employee is paid by their employer (income) minus all the expenses incurred maintaining their household. If the wages earned are greater than the expenses, then they have a surplus [this would be synonymous with net income for a business]. In the same way if you review a P&L for a business, it depicts all income earned and all expenses incurred. If the income earned exceed expenses, then the business has a net income. If income is less than total expenses the business has a net loss.
In the simple example below Clark Kent earns wages of $5,000 for the month. In the same month he incurs expenses of $4,000 for food, utilities, clothing, and interest expense on a bank loan for his home. Clark ended the period with a surplus of $1,000.
The Balance Sheet
While the P&L depicts cash coming in (income) and going out (expenses) the balance sheet reflects the assets, liabilities, and equity of the business as of a specific date. It is analogous to tallying up all of assets that you own. You might have cash in the bank, own the car you drive, and own the house where you live. These are all examples of assets that would be depicted on your personal balance sheet. On the other hand, you might owe the bank money for your car and home. These two loans are liabilities. If the value of your assets exceeds the value of your liabilities, then you have equity. In the example below the Clark Kent owns $280,000 worth of assets and has a balance due to Metropolis City Bank in the amount of $220,000 for borrowed funds to purchase the assets. The net of the assets $280,000 minus the liabilities of $220,000 is equity of $60,000.
The Statement of Cash Flows
The statement of cash flows is another part of the financial statements. Although arguably not as well-known as the P&L and balance sheet, the statement of cash flows is an important source of financial information. It depicts an entities’ overall change in cash. Recall in our P&L example Clark Kent had net income of $1,000. But if you look closely, you will discover there is no provision for the principal portion of the mortgage payment. Because the payment reduces the principal balance of a debt it is not an expense but rather a reduction in a liability. Since the P&L only records income and expense it stands to reason the payment will not show up on the P&L. Instead this outlay of cash is depicted on the statement of cash flows “SoCF”. The starting point for the SCF is the net income of $1,000. Cash expenditures to purchase assets like real estate are depicted on the statement of cash flows as well. The example SoCF below depicts the cash flows for Clark Kent during the period. As you can see the $500 in principal payments is an investing activity and reduced cash flow by -$500. To calculate the cash flow for the period; start with cash flow from operations of $1,000 and subtract the ($500) decrease in cash flow from investing. Thus, the net cash flow for the period was an increase of $500.
Highlights
A business uses these three parts of the financial statements to display its performance. It allows the owner and other interested parties to track the score of the business. If the business has net income, it is winning the game of business. If it has a net loss it is losing. The balance sheet is a snapshot of the assets, liabilities, and equity that are owned or owed by the business and how much worth the owner has as of a particular day. The statement of cash flows shows how the cash from net income has been utilized and it depicts the amount of cash that was used to buy assets or pay down debt. The statement of cash flows details where every dollar of cash was used and whether cash flow increased or decreased during the period. If properly understood the insight provided by the financial statements can help you run a business, buy a business, grow a business, or sell a business.
