5 Things They Didn’t Teach You in Business School: Understanding Financial Statements | Part 3

As a business owner, understanding your financial statements is crucial to making informed decisions and ensuring long-term success. Many entrepreneurs focus on revenue and expenses but fail to see how all the pieces fit together. The Profit and Loss Statement (P&L), Balance Sheet, and Statement of Cash Flows work together to provide a complete financial picture of your business. Let’s break down what each statement represents and how they connect.

The Three Key Financial Statements

1. Profit and Loss Statement (Income Statement)

The Profit and Loss Statement (P&L) shows your revenue, expenses, and profitability over a specific period—monthly, quarterly, or annually. It helps answer questions like:

• Is my business making a profit or operating at a loss?
• What are my major sources of revenue?
• Where am I spending the most money?

Key components of the P&L:

• Revenue – Total income from sales or services.
• Cost of Goods Sold (COGS) – Direct costs associated with producing goods or services.
• Gross Profit – Revenue minus COGS.
• Operating Expenses – Costs like rent, utilities, payroll, and marketing.
• Net Profit (or Loss) – The final amount after subtracting expenses from revenue.

2. Balance Sheet

The Balance Sheet provides a snapshot of your business’s financial position at a given point in time. It highlights what you own and what you owe. The fundamental equation of a balance sheet is:

Assets = Liabilities + Equity

Key components of the Balance Sheet:

• Assets – What your business owns (cash, inventory, equipment, accounts receivable).
• Liabilities – What your business owes (loans, accounts payable, credit card balances).
• Equity – The owner’s investment in the business plus retained earnings.

The Balance Sheet helps answer:

• Do I have enough assets to cover my debts?
• How much does my business owe?
• How financially stable is my company?

3. Statement of Cash Flows

While the P&L shows profitability, it doesn’t reflect how cash is moving in and out of your business. The Statement of Cash Flows fill in this gap by tracking money flow in three key areas:

• Operating Activities – Cash generated from sales and spent on expenses.
• Investing Activities – Cash used to purchase assets like equipment or investments.
• Financing Activities – Cash received from loans, investments, or used for debt repayment.

The Statement of Cash Flows helps answer:

• Do I have enough cash to cover payroll and expenses?
• Where is my cash coming from and where is it going?
• Am I at risk of a cash shortfall?

How These Statements Connect

Each financial statement provides unique insights, but together they tell a complete story:

• The P&L shows profitability over time.
• The Balance Sheet shows financial position at a moment in time.
• The Cash Flow Statement shows how well you manage liquidity.

For example, a business might show a profit on the P&L but struggle with cash flow due to unpaid invoices (shown in the Balance Sheet). Similarly, a company may have strong cash flow but operate at a loss due to high expenses. Understanding how these statements interact allows business owners to make better financial decisions.

Why You Need to Monitor Your Financial Statements

Tracking financial statements regularly can help you:

• Spot trends in revenue and expenses.
• Identify cash flow issues before they become a crisis.
• Make informed decisions about growth, hiring, and investments.
• Prepare for tax season with accurate financial data.

Work With a Professional

Understanding financial statements can be overwhelming, but you don’t have to navigate them alone. A bookkeeper can ensure your records are accurate, provide financial insights, and help you make data-driven decisions.

If you need assistance organizing your financials, Lookout Bookkeeping is here to help. Schedule a consultation today and don’t forget to check out our free resource, Guide to Estimated Taxes, to stay on top of your tax strategy!

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Links to the entire series

Part 1 | Part 2 | Part 3 | Part 4 | Part 5