When it comes to the operation of your business, the need for a line of credit, loan or investment, or the sale of your company, your financial statements should be or will become the major driver of the outcome. Quick caveat – If you prepare your income statement entirely on a cash basis (i.e., no accounts receivable, nothing capitalized, etc.), you will not have balance sheet other than shareholders’ equity and cash and thus not have need of a cash flow statement.
The Balance Sheet (BS) is a snapshot of your business’s financial health on a particular date. It shows what the company owns (assets) and owes (liabilities) and your equity. It indicates how effective your company is using its debt and assets to eventually generate revenue that gets carried over to the income statement.
Assets = Liabilities + Equity
Why is BS Important?
If you wish to get a loan, investment or even sell your business and the Liabilities greatly exceed the Assets (without reasonable explanation), Creditors most likely will not be able to lend you the money, investors may not…or may lend at high interest rates, and a Buyer will likely pay less for your business or decide to pass on purchasing your business.
The Income Statement (IS aka Profit and Loss) summarizes your company’s revenues, costs and expenses for a particular time period, such as a month, quarter, or year. It begins with your revenues and then subtracts the costs of goods/services sold (COGs) and any expenses incurred in operating the business. The bottom line of the income statement shows how much profit (or loss) your company made during that month, quarter or year accounting period.
Revenue – COGs = Gross Margins – Operating Expenses = Net Income
Why is IS important?
Cost of goods sold and gross margins are two values you want to watch. The gross margin is the amount of revenue left over after paying for the cost of goods. Is this amount consistent with your industry average? If you notice that your cost of goods have increased, you need to increase your prices, renegotiate cost with your supplier or find a less expensive good to sell.
If you wish to get a loan, investment or even sell your business and the Net Income is minimal or negative, Creditors most likely will not be able to lend you the money, investors may not…or may at high interest rates, and a Buyer will likely pay less for your business or walk away.
The Statement of Cash Flows (aka cash flow statement (CFS)) shows the cash sources and uses during a specific period of time — how your company brings in cash and for what costs the cash goes back out the door. It contains certain components of both the IS and the BS. The CFS measures how well your company manages its cash position, in other words, how well your company generates cash to pay its debt obligations and fund its operating expenses. It is a valuable measure of strength, profitability, and the long-term future outlook for your company.
Please note that the CFS is distinct from the income statement and balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net income, which on the income statement and balance sheet, includes cash sales and sales made on credit.
CFS has 3 different sections classifying all your cash receipts and payments.
Operating: The sources and uses of cash come from revenue, expenses, gains, losses, and other costs. In other words, it reflects how much cash is generated from your company’s products or services.
Investing: The sources and uses of cash which were due to debt and equity purchases and sales; purchases of property, plant, and equipment; and collection of principal on debt. In short, changes in equipment, assets, or investments relate to cash from investing.
Financing: Your long-term liability activities (paying or securing loans longer than 12 months from BS date) and equity items (sale of company stock and payment of dividends) are shown in the financing section. Changes in cash from financing are “cash in” when capital is raised from bank or investors, and they are “cash out” when dividends are paid.
Why is CFS Important?
The CFS allows you to understand how your company’s operations are running, where money is coming from, and how money is being spent. It’s important since it helps you determine whether your company is on a solid financial footing. You can use a cash flow statement to predict future cash flow, which helps with budgeting.
Creditors use the CFS to determine how much cash is available (your liquidity) for your company to fund its operating expenses and pay its debts. For investors, the CFS reflects your company’s financial health and typically the more cash that’s available for business operations, the better. However, this is not a hard and fast rule. Sometimes a negative cash flow results from a company’s growth strategy in the form of expanding its operations.