by Sharon McNeal
Financials are standard reports summarizing money exchanges. There are three summaries having different perspectives.
- Income statements gather information about net profits for a time interval.
- Balance sheets gather information about net worth on a date.
- Cash flow statements focus on the sources and uses of cash for a time interval.
So much for the jargon. Let’s simplify net profit. Suppose you had a lemonade stand at one time. You made the lemonade and then sold it. This is a GREAT deal because your mother probably bought the lemonade, paid for the water and helped you set up the stand. You got pure profit. If only business was that easy.
Suppose you buy stuff to sell at flea markets. Your income is in the cigar box and your expenses include the cost of stuff you sell, your transportation costs, helpers (if any) and so forth. The net profit is what is left over.
Now for the vocabulary: the money in the cigar box is income, your cost for the stuff is cost of goods sold, the other things are fixed costs and net profit is what is left over. The formula is net profit = income – cost of goods sold – fixed expenses.
Net worth is harder to grasp. Income statements are based on transactions while balance sheets look at resources and debt. High net worth is good and low (or negative) net worth is bad. Net profits are all about margins and mark-ups. Resources produce income over time. Things get more complicated because we can use resources to buy more resources.
Suppose you buy a house. The asking price is $200,000 (a small house in Fairfield county). You pay $10,000 down and finance $190,000. The net worth of the house is $10,000 because that is what it is worth after you pay off the debt. That assumes you can sell it for the original price. If you can only sell it for $150,000 then its net worth is -$50,000. Not pretty.
All resources have an expected life-time. Consequently, they depreciate, or lose their value over time.
What about a car? The asking price is $35,000. You trade in another car for $5,000 and get a loan for $30,000.
These are personal resources and don’t generate an income. They can show you the principle of net worth. Many people do not consider a residence in net worth calculations because residences don’t generate income. I know, I can hear you scream from here!
Vocabulary time: Your purchase price is the value of the asset, debt is liability and net worth is equity. The formula is net worth = assets – liabilities.
Cash flow is harder to grasp. Cash flow terms include inflow, outflow, increase and decrease. Notice the references to water and water levels. The statement is organized by income streams. (More water lingo!). The major streams are cash from operations, from investments and from financing. Cash flows look at the effect profits have on the balance sheet. Well, you were warned!
Workers get cash from operating activities, their wages. The statement of cash flows calculates the changes in your bank account based on what you do with your wages. Cash comes in from wages but how does it flow out of your bank account and what is left at the end of the month?
A landlord made an investment and his cash comes from operating activities. His income is rent from tenants. His outflows include repairs & maintenance, mortgage payments and so forth. If he makes a profit, the cash in his bank account will go up. If he doesn’t make a profit, the cash in his bank account goes down.
A business buys commercial property, uses part of it and rents out the rest. The business gets cash from operating activities and cash from the building. These are two separate income streams. The outflows from operating activities look different form the flows from the investment.
Cash Flow Tips has more useful information about managing cash.
Putting it together
Does all this information come from the same sources? Obviously, most transactions eventually hit the cash accounts:
- Cash deposits are inflows and expenses are outflows.
- Cash accounts are on the balance sheet.
- Changes in cash are in the statement of cash flows.
What about debt?
- Short term debt is expenses from the income statement.
- Balance sheet liabilities summarize debt.
- Debt is good for cash flow because the money hasn’t left the cash accounts yet.
It takes all three to understand and operate a business. The different perspectives give owners the tools to diagnose and correct problems and to build value for the business.
Sharon McNeal, owner of Biz 4 the Rest of Us, helps small businesses keep their doors open. Attend one of Sharon’s Small Business Survivor distance seminars on planning/growing a business, running it better or understanding your finances. These seminars explore the business issues behind article and newsletter case studies. For details, visit Biz4theRestofUs or send request for a new topic to info@Biz4theRestofUs.com .
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