Three Main Statements

Chapter 14: About Business Numbers - Page 14.5

Three Main Statements

Most financial analysis, including the financials in a standard business plan, revolves around three main statements. Two of them, the Income Statement and Balance Sheet, put to use the basic financial building blocks from the previous section. The third, the Cash Flow, brings the other two forward from accounting semi-fiction to the real world of actual money.

Pro Formas

Elsewhere in this book we discuss the huge difference between planning and accounting. With the three main financial statements, specifically, financial analysts use the term pro forma to describe projected statements, projections, and predictions. An Income Statement, for example, is about past results. A pro-forma Income Statement is a projected income statement.

The Income Statement

The Income Statement is also called Profit and Loss. People often refer to the bottom line as profits, the bottom line of the Income Statement. It has a very standard form. It shows Sales first, then Cost of Sales (or COGS, or Cost of Goods Sold, or Direct Costs, which are essentially the same thing). Then it subtracts Costs from Sales to calculate Gross Margin (which is defined as Sales less Cost of Sales). Then it shows Operating Expenses, usually (but not always) subtracting Operating Expenses from Gross Margin to Show EBIT (Earnings Before Interest and Taxes). Then it subtracts Interest and Taxes to show Profit.

Sales – Cost of Sales (or COGS, Cost of Goods Sold, or Direct Costs) = Gross Margin

Gross margin – Expenses = Profits

Notice that the Income Statement involves only four of the seven fundamental financial terms we defined in a previous section of this chapter. While an Income Statement will have some influence on Assets, Liabilities, and Capital, it includes only Sales, Costs, Expenses, and Profit.

The Income Statement is about the flow of transactions over some specified period of time, like a month, a quarter, a year, or several years.

We discuss the Income Statement in detail in Financial Analysis: The Bottom Line.

The Balance Sheet

The Balance Sheet shows a business' financial position, which includes Assets, Liabilities, and Capital, on a specified date. It will always show Assets on the left side or on the top, with Liabilities and Capital on the right side or the bottom.

Balance Sheets must always obey the underlying formula:

Assets = Liabilities + Capital

Unless that simple equation is true, the Balance doesn't balance and the numbers are not right. We discuss the Balance Sheet in detail in Financial Analysis: Finish the Financials later in this book.

The Cash Flow

The Cash Flow statement is the most important and the least intuitive of the three. In mathematical and financial detail it reconciles the Income Statement with the Balance Sheet, but that detail is hard to see and follow. What is most important is tracking the money. By cash we mean liquidity, as in the balance in checking and related savings accounts, not strictly bills and coins. And tracking that cash is the most important thing a business plan does. The underlying truth is:

Ending Cash = Starting Cash + Money Received – Money Spent

What's particularly important in planning is that neither the Income Statement alone nor the Balance Sheet alone is sufficient to plan and manage cash. We discuss the Cash Flow in much greater detail in Financial Analysis: Cash is King.

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