Three statements and how they connect

The income statement

Also called the profit and loss statement (P&L), it starts with revenue and subtracts costs in layers:

1. Revenue minus cost of goods sold equals gross profit.
2. Gross profit minus operating expenses, such as wages, rent and marketing, equals operating income.
3. Operating income minus interest and income tax equals net income, the bottom line.

The balance sheet

A snapshot of the business on one date, organized around the accounting equation: Assets = Liabilities + Equity.

• Current assets can become cash within a year: cash, accounts receivable and inventory.
• Non-current assets are used for longer, such as equipment and buildings.
• Current liabilities are due within a year, such as supplier bills and this year's loan payments.
• Long-term liabilities are due later, such as the rest of a bank loan.
• Equity is the owners' investment plus profits kept in the business.

The cash flow statement

It shows how cash moved during the period, in three groups:

• Operating activities: cash from day-to-day business.
• Investing activities: buying or selling equipment and other long-term assets.
• Financing activities: borrowing, repaying loans and money from or to owners.

Profit isn't the same as cash

A business can be profitable and still run short of cash. Money can be tied up in inventory on the shelves or in invoices customers haven't paid yet, and loan repayments use cash even though they aren't expenses.

How the statements connect

Net income from the income statement increases equity on the balance sheet. The ending cash on the cash flow statement matches the cash on the balance sheet. Together, the three give a complete picture.

Three useful ratios