How does your business assess its financial strength? No doubt you refer to your income statement and your bank account for the basics, but the truth is most businesses ignore the most powerful financial tools in the accounting arsenal: the balance sheet and the cash flow statement.
Combined with the income statement, these statements provide the most comprehensive financial view of any business. That’s why they’re considered essential components of a business plan. But what role does each of these financial statements play and how do you interpret the data they produce?
Here’s an overview of the three key financial statements and how they can help you keep your finger on the pulse of your business’s fiscal position.
The business income statement, also referred to as a profit and loss (P&L) statement, is a useful tool for providing an overview of how your business is doing over time and breaks down the revenue generated by your business and the expenses incurred.
A well-maintained income statement will show how profitable your business isand inform any steps that can be taken to increase profitability (i.e., whether you should focus on more profitable product lines or curb unnecessary expenses). It also shows you how much cash is left over to grow the business, pay your salary as owner, and cover any debt. When investors look at your business plan, they will use your income statement to assess the level of risk involved in extending credit or venture capital your way.
What your income statement won’t tell you is whether your overall financial condition is weak or strong (refer to your Balance Sheet for this), the money you owe or that’s owed to you (refer to your Cash Flow Statement), or list any assets you own or liabilities you owe (again, see your Balance Sheet).
Think of the balance sheet as a window into your business’s financial strength.
Although investors may pay attention to your income statement, the balance sheet is actually their preferred starting point for building a picture of your business’s fiscal health. Why? Because at its simplest level, the balance sheet summarizes key financial information on a given date (as opposed to the income statement, which shows profitability over a period of time) and is a good indicator of company stability and liquidity (both important factors in determining your business’s ability to fund its own growth without requiring outside financing).
More businesses fail because of cash flow issues than for any other reason. That’s because cash doesn’t always flow into your business at the same rate that it exits it! In fact, your business can be profitable yet still have cash flow problems. While your income statement can tell you whether you made a profit, it doesn’t take into account delinquent or missing payments or help you determine whether you actually generated enough cash to stay afloat.
In order to understand and manage the flow of cash in and out of your business you’ll need to maintain a cash flow statement. Updated on a daily, weekly, or monthly basis, the statement can be a simple one-page spreadsheet or a more dynamic report created with accounting software like QuickBooks or FreshBooks.
Whichever template you use, you’ll rely on the following formula to calculate your end balance: