The Balance Sheet, Profit and Loss, and Statement of Cash Flows reports could be considered as the most essential reports to use. Any picture that leaves out all three of these financial reports is incomplete. At the same time, almost every business owner knows how to read profit and loss (P&L) reports. Many, but not enough, really understand balance sheets. Almost no company owners seem to know about, much less understand, the statement of cash flows.
1. Profit and Loss
You probably are well-acquainted with the Profit and Loss report, however you might want to check this article for more tips on how to make the best of it. It gets into specific ways to analyze your profit and loss statement to analyze and maximize profitability. That should cover your need for understanding profit and loss.
2. Balance Sheet
In essence, your balance sheet is a snapshot of your finances. It shows you your assets, liabilities, and equity at a given moment. While that sounds simple, understanding it on a deeper level is the key to growing your company.
When you analyze the profit and loss, you are looking at things from the perspective of how much money you made. The balance sheet then answers the next logical question (among others): How much money did you keep? If you spent everything you've made, then your bank balances don’t increase. They'll likely decrease, because while you had no profits to retain in the bank, you were probably paying for things like credit cards and other liabilities.
The goal when you're analyzing the profit and loss is to make a profit. The goal when you're analyzing the balance sheet is to increase net worth. Net worth is equity. How can you increase equity?
Make a profit.
If you pay for a fixed asset, it has no effect on your net worth. You simply shifted money from your bank account to the fixed assets section of your balance sheet. The net effect on equity is $0.
Next, you're going to depreciate that fixed asset. That hurts your equity twice. It reduces your asset value, and it also decreases your profit (this is a depreciation expense). Decreased profit reduces equity.
So the strategy is not to buy fixed assets. Rather, it is to buy a fixed asset that will produce a return. That fixed asset has to perform. This is why it's important to look at things like RoA (return on assets), which helps determine if an asset is performing. It has to increase your bottom line by more than the depreciation expense in order for it to pay off.
Earning a profit is a great start with a business, but in the bigger picture, you have to build equity in the company. This means that the cash in the business has to be invested well. When you buy a fixed asset that produces a significant return, that means you have invested well. For example, if you purchase printing equipment that saves money compared to using an outside printer, that is a great investment. You increased assets while reducing an expense. That means your net income will increase.
Income / Assets = Return on Assets (RoA)
This is why the balance sheet is so important.
3. Statement of Cash Flows
This is where it all comes together. You start with net income (on an accrual basis) and you reconcile that with the cash in the bank at the end of the period. You can do this by analyzing changes in account balances on the balance sheet. In short, this lets you see where the cash flows are coming from.
You'll want to see the bulk of cash flows coming from operating activities. This means the company is producing enough cash flow on its own to sustain itself.
Then, look at investing activities. This should be negative. That means you're investing your money. If cash flows from investing activities is positive, it means you sold or disposed of assets. That might or might not be a good thing depending on why you got rid of those investments. More importantly, you'll want to see cash outflows here, because it means you're investing money into assets, which will hopefully produce a return.
Positive cash flows from operating activities with negative outflows from investing activities are great, especially if the net cash flow is positive overall.
The last part of the statement of cash flows is your financing activities. This is how much money the company owners or partners are putting in or taking out of the business. Oftentimes, business owners wonder how they made such a big profit but have so little in the bank. This is the first place to look to find the answer. Usually in these cases, the owner has taken the profits out in distributions.
The statement of cash flows has a way of removing the nonsense from the financial picture. It adjusts for non-cash items, like depreciation, and it shows you where you may be profitable, given that you're collecting your receivables. On the other side, you can be profitable, but if you have too much debt service, your cash flow can still be negative.
Looking at these reports gives you a 360-degree view of your business. Everything else is just getting into the details of what is shown on the Balance Sheet, Profit and Loss, and the Statement of Cash Flows reports.