Why You Need One (and a Free Template): The starting point for using the balance sheet is to understand assets, liabilities and equity.
How Is a Balance Sheet Related to an Income Statement and Cash Flow Statement?
It can be really difficult for a business owner to step back, take a breath and look at the big picture. One big picture concept that’s important to understand is the connection between these three basic financial reports. If you’re clear about how the financial statements connect, you can make better decisions.
Consider the income statement and the balance sheet. Reliable Plumbing earned a 15% profit margin on $12 million in sales, or $1.8 million in net income. Net income from the income statement increases the equity balance in the balance sheet. When Joe prints his month end balance sheet, the $4,500,000 equity balance includes the month’s $1.8 million in profit. That makes sense, because earning a profit makes the company more valuable, and equity reports the company’s value in dollars.
In addition, the cash balance in the balance sheet is the ending balance in the statement of cash flows. The cash flow statement essentially takes the company checkbook and assigns cash inflows and outflows into these categories:
- Cash activity from financing: This category accounts for raising money to operate the business and paying it back. Issuing common stock is a cash inflow and repaying a loan is a cash outflow.
- Cash activity from investing: Investing refers to buying and selling assets. If Reliable pays cash for a truck, that’s a cash outflow, and if the company sells some equipment for cash, it’s recorded as a cash inflow.
- Cash activity from operations: This is the “everything else” category, because every cash transaction that is not related to financing or investing is posted here. Not surprisingly, this is the category that accounts for most of Reliable’s cash activity. Paying employees and collecting money from customers are posted here.
The formula for the cash flow statement is:
(Beginning cash balance) plus or minus (cash inflows and outflows for the month) equals (ending cash balance). The ending cash balance is also the cash balance on the balance sheet.
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Using Financial Analysis to Increase Cash Flow
For many owners, the most important metric for their business is the amount of cash they need to operate each month. That may be more important to the owner than profit, since no company can operate without sufficient cash. If that’s what keeps you up a night, you can do something about it using financial statement analysis.
Think about it this way: if Reliable Plumbing generates a 15% profit on every dollar sold, which also means that 85% of every dollar sold is an expense. $12 million in sales for the month means that Reliable incurs $10.2 million in expenses. And those expenses have to be paid in cash, either this month or sometime down the road.
A business can generate more cash to operate by reducing the two categories that tie up cash:
- Accounts receivable
Accounts receivable represents money owed by clients, and your inventory balance is the dollar amount of items that you buy for resale. Reliable Plumbing carries a large balance of parts and supplies in inventory, which are used to perform plumbing jobs.
Joe can take several steps to increase cash flow. He can offer discounts to clients who pay quickly and Reliable Plumbing can insist that all customers pay a 20% deposit before any work is performed. The company should also have a formal process for collections, including phone calls and emails to clients who have not paid their invoices. These steps will reduce the account receivable balance and increase cash. QuickBooks Online can help businesses track unpaid invoices, remind customers that a balance is due and take payments via credit card and bank transfer.
Reliable should also take a hard look at the dollar amount of inventory on hand. If Joe’s suppliers can ship inventory items faster, for example, the company can reduce the inventory levels and still meet customer needs. If a supplier can get orders to Reliable in five days rather than ten days, the plumbing company can carry less inventory and simply order more often.
Financial Analysis Pays Off
Taking steps to reduce accounts receivable and inventory levels increases available cash and makes it easier for Joe to manage the business each month. Understanding the balance sheet and its connection to the other financial statements has a big payoff. Joe can make more informed decisions and get better financial results.