In step three of our guide to basic accounting for SMEs, we used a balance sheet to demonstrate the invaluable insight provided by financial statements into the financial health of a business.
While balance sheets are indeed important, at minimum, business owners should learn to interpret three essential financial reports:
- Balance sheet
- Cash flow statement
- Profit & loss statement
In this post, we’ll be explaining what information each statement provides, and how a business owner can use this knowledge to make informed business decisions.
Let’s begin!
Balance sheet
A balance sheet displays all assets, liabilities, and owner equity of a business at a specific moment. At one glance, a balance sheet allows stakeholders to know what is:
- owned
- owed, and
- invested
By knowing the ratio of what the business ownes versus what it owes, decision makers can evaluate whether or not to take on more debt for growth, to downsize and consolidate, or during economic downturns, how much runway the business has to operate at a loss.
Cash flow statement
A cash flow statement shows all cash inflows and outflows over a given period, and is usually broken down into monthly, quarterly, or anual movements. It is the embodiment of the saying ‘follow the money’!
Cash flow statements consist of three sections:
- Operating Activities: cash flow from core operations such as revenue, expenses, and taxes
- Investing Activities: cash flow from investments in assets such as property, equipment, and shares
- Financing Activities: cash flow from financing activities such as dividends, share buybacks, and loans
As SMEs often deal in cash without credit extensions, a cash flow statement is incredibly useful. After all, a business bleeding money in one area can still be misleadingly cash flow positive overall if losses are mittigated.
Profit & loss statement
It’s also known as an Income Statement and summarises revenues, costs, and expenses incurred over a business quarter or year. A profit and loss statement has one job: show if a business operated at a profit or loss during a specified period.
A business can generate hundreds of millions in revenue and still be operating at a loss, and that is why we have profit and loss statements.
Practice time: Fictional business
Lets pretend you recently set up an F&B outlet and are about to close out your first 12 months of operating.
You want to assess the financial health of your business and evaluate how close you are to existing business goals. You may even want to set new ones.
Lets see how a balance sheet, cash flow statement, and profit and loss statement for this business might look like, and what you can learn from them.
Balance sheet
| Assets | Amount (RM) | Liabilities and Equity | Amount (RM) |
|---|---|---|---|
| Cash and Cash Equivalents | 205,800 | Accounts Payable | 504,000 |
| Inventory | 120,000 | Loan Payable | 21,000 |
| Property, Plant, and Equipment | 148,000 | ||
| Total Assets | 473,800 | Total Liabilities | 525,000 |
| Owner’s Equity | (51,200) | ||
| Total Liabilities and Equity | 473,800 |
Based on this balance sheet, the biggest three takeaways are:
- the cafe has assets totaling RM473,800
- the assets are spread across cash and cash equivalents as well as long-term assets
- the cafe has liabilities totaling RM473,800
This shows the cafe’s assets and liabilities are equal, not great but not terrible either!
Of course, in the real world, it’s highly unlikely you’ll find such identical figures.
Cash flow statement
| Operating Activities | Amount (RM) | |
|---|---|---|
| Cash received from sales of food and beverages | 1,260,000 | |
| Cash paid to suppliers for inventory | (504,000) | |
| Cash paid to employees for wages and salaries | (336,000) | |
| Cash paid for rent of premises | (151,200) | |
| Cash paid for utilities (electricity, water, etc.) | (50,400) | |
| Cash paid for other operating expenses (marketing, maintenance, etc.) | (84,000) | |
| Net cash provided by operating activities | 134,400 | |
| Investing Activities | ||
| Cash used to purchase new kitchen equipment | (42,000) | |
| Cash received from sale of old kitchen equipment | 8,400 | |
| Net cash used in investing activities | (33,600) | |
| Financing Activities | ||
| Cash received from owner’s investment | 84,000 | |
| Cash paid for loan repayment | (21,000) | |
| Net cash provided by financing activities | 63,000 | |
| Net Increase in Cash for the Year | 163,800 | |
| Beginning Cash Balance | 42,000 | |
| Ending Cash Balance | 205,800 | |
Crucially, our cash flow statement shows positive net cash flow from both operating and financing activities
This means there is no drag on company cash flow being artifically propped up by overall performance.
Profit and loss statement
| Revenue | Amount (RM) |
|---|---|
| Sales of Food and Beverages | 1,260,000 |
| Total Revenue | 1,260,000 |
| Expenses | Amount (RM) |
| Cost of Goods Sold (Inventory) | (624,000) |
| Wages and Salaries | (336,000) |
| Rent Expenses | (151,200) |
| Utility Expenses | (50,400) |
| Other Operating Expenses | (84,000) |
| Total Expenses | (1,245,600) |
| Net Profit | 14,400 |
The Profit and Loss Statement shows that after deducting the cost of goods sold and operating expenses, the cafe still achieves a net profit of RM14,400.
This shows the cafe is profitable, which we would argue is the main thing that matters at the end of the day.
And at the end of the day, this was all just a theoretical exercise and this F&B outlet doesn’t exist!
Time to practice making balance sheets, cash flow statements, and profit and loss statements based on your own business – and it never hurts to get a reliable accounting software to help.
Let MISHU manage your accounting
The MISHU team is here to help Sole Proprietorship and Enterprise owners looking to self-manage or outsource their business accounting and bookkeeping needs. Get in touch!