Business owners often limit their examination of financial statements to a single report. They rely solely on a statement of incoming revenue and paid expenses, commonly known as the profit and loss report, or P&L.
Making the best decisions for a business, however, depends on recognizing the limits of P&L evaluation. Many vital numbers depend on the type of P&L you obtain as well as other complementary financial information.
Some businesses operate on a cash basis. Customers pay at the time a sale is made. But many enterprises invoice for services and are paid at a future date. The true output for your business is the amount invoiced. The P&L you want, therefore, is accrual basis, which shows the total invoiced sales. And it will have the accrued but unpaid bills for expenses. Conversely, a cash basis P&L only shows the expenses already paid.
An accrual basis P&L reveals how effectively your time was deployed to realize a profit. The obvious number is the bottom-line profit that represents the amount by which revenue exceeds expenses. A few key ratios will unlock the context of the profit figure.
The most helpful profitability ratios depend on your industry. Some businesses depend mostly on personnel for their output. These businesses should measure profit as a percentage of employee hours. Other enterprises are primarily impacted by the quantity and type of equipment. They should determine the profit as a percentage of capital investment in fixed assets.
Comparing these ratios for various periods conveys the trend in business profitability. You will find out if working more hours or an investment in new equipment is delivering the improved results you expected. Be sure to consider seasonal factors. Contrasting your ratios from recent months to the same period in prior years is usually the best process.
The detail you’re missing, however, when examining the accrual basis P&L, is the cash impact of your operations. The companion of the accrual basis P&L is a cash flow statement. This report adjusts your accrued profit by showing changes that affect business cash. The cash flow statement is crucial to identifying how easily your business can pay its bills in the near term. A growth trajectory is nice to see on the accrual basis P&L, but it can trigger a cash constraint. Your business must pay its bills on time, even if your customers are late in paying your business.
Cash flow will be negative if you recently acquired new customers who are slow in paying your invoices, while you have paid the costs to acquire and serve those customers.
Your business cash flow may also be negative if you recently invested in new equipment. Eventually, these expansion efforts should pay off with rising cash flow. You merely need assurance that your company has enough cash to sustain a period of negative cash flow. Fortunately, cash flow statements tell you the amount of negative cash flow, and indicate when the trend is turning positive.
Use these financial statements to monitor and maintain healthy growth for your business.
If you need assistance, a financial professional can walk you through how to set these up and use them to foster ongoing business success.