The three financial reports every small business owner should understand

Updated: Jun 1

There are several financial reports that a business owner needs to be aware of. The big three are;

  1. Profit & Loss

  2. Cash Flow

  3. Balance Sheet


These financial reports can do more than just record what has happened to a business. Any report which looks at past business activity can also be projected into the future to get a sense of where the business is heading. In fact, this is an essential part of financial planning and one of the reasons why financial forecasting is important for startups.



1. Profit and Loss Statement (P&L)


The profit and loss statement is also known as the income statement. This report shows revenue generated, expenses incurred, and the resulting profit or loss for a specific period. Often, businesses create these reports quarterly, but you should make it a habit to issue your P&L statement monthly so that you can take action to correct issues, or see what is working well so that you can do more of it.


Ideally, the goal is for your revenue to exceed your expenses (a.k.a. a profit). There are two kinds of profit:


Operating Profit


Operating profit records the profit made from the normal operating activities of the business – which will generally be its income from sales, minus the cost of goods, services and salaries.


Operating profit is a very useful measure of a business. It shows how well the business can support itself by its activities alone. For a business heavy in debt, a healthy operating profit might be a sign that the business will be able to work itself free of its debt given time, while a slim or fluctuating operating profit may be a cause for concern.

Operating profit can also be a useful gauge for whether a business is in a healthy condition to take on investments and new projects.


Net Profit


Net Profit adds non-operating income and expenses to the operating profit figure. This gives a full picture of the business’ profit and loss generating activities – including investments, interest charged, interest received and taxation.


Profit not distributed as dividends to shareholders is called the ‘Retained Surplus’ for the period in question. This is the total amount of money that can be ploughed back into the business and gives a good indication of growth.



2. Cash Flow


The Cash Flow is perhaps the easiest to understand of the ‘big three’, but there are some subtleties to it which need to be mentioned.


Where the P&L Statement describes the state of the business from an accountant’s eye view of what the business owes or is owed at any given time, and is based on what has already happened, the Cash Flow is based on when these payments are actually made and received and forecast the future cash flows, to allow the business owners(s) to estimate the cash available to the business to meet it obligations or invest in growth.


The Cash Flow Statement is usually divided into three sections, each with its own totals:


Operational Activities


Cash received or spent as part of everyday business activities, including sales, direct costs of selling, operating costs, salaries and interest payments.


Investment Activities


Cash received or spent through investing activities, including the purchase of assets, investments, return on investments, interest received.


Financing Activities


Cash received through debt and debt repayments, including taking out and repaying loans, issuing shares for cash and paying dividends to shareholders.


Splitting out these different kinds of business activities allows them to be viewed in isolation, helping identify where cash flow issues may arise in the business.



3. Balance Sheet


The Balance Sheet shows what the business owns (Assets), what it owes (Liabilities) and how much has been invested into it (Equity).


Assets

Firstly, it shows the value of the business in terms of its assets. It’s worth remembering that assets include any surplus (unspent) cash the business generates.


If an asset, such as an investment, increases in value this is shown on the Balance Sheet. Conversely, if an asset loses value from depreciation, or being sold or written off, this reduction in value is also shown.


Liabilities

The business’ liabilities record what the business owes. If you pay your suppliers immediately then these payments do not need to appear on the balance sheet, but if you owe money, either for goods/services or repayments on a loan, this will be recorded as a liability.


Using the Balance Sheet, you can track how big your liabilities are, and hopefully identify ways to reduce them over time. A business with a large ratio of liabilities to assets may be seen as risky as it funds its assets with debt rather than Equity.


Equity

The final part of the equation, Equity, is simply the money that has been invested into the business. This could be profits made by the business in the past, money that the owner has invested into the business, the cash from shares sold in the business, or investments from outside investors.


A business that relies heavily on continuous new investments to fund itself may be in trouble, but a high ratio of equity to liabilities could be an indicator of a strong business, as it is not so reliant on debt to fund itself.


Summary


The combination of your P&L statement, balance sheet, and cash flow statement make up the standard financial statement package. Alone, each of these statements reveals valuable—sometimes hidden—insights into your business’s health. Combined, there are very few questions about your business that they can’t answer.


In the best-case scenario, your reports will verify that your business is operating smoothly and on a healthy growth trajectory. At worst, you’ll discover significant weaknesses to act on and improve. Uncovering these vulnerabilities early on will give you time to make strategic business decisions to recoup and recover.


Here we have an example of how all three financial statements work together to give you the best overview of your business.