Every set of financial statements has three core parts. The income statement tells you whether you made a profit. The balance sheet tells you what you own and owe. The cash flow statement explains why your bank balance changed. Here is what each one shows, and how they fit together, using one small business as the example.
1. The income statement (profit and loss)
The income statement — also called the profit and loss account, or P&L — covers a period, such as a month or a year. It starts with revenue, subtracts the costs of earning that revenue, and ends with profit.
| Revenue | 120,000 |
|---|---|
| Cost of sales | (50,000) |
| Gross profit | 70,000 |
| Operating expenses (including 5,000 depreciation) | (45,000) |
| Net profit | 25,000 |
Profit is not the same as cash. Revenue is recorded when you earn it, even if the customer hasn’t paid yet, and depreciation reduces profit without any cash leaving the bank. (Tax is left out here to keep the example simple.)
2. The balance sheet
The balance sheet is a snapshot at a single date. It lists what the business owns (assets), what it owes (liabilities), and the owner’s stake (equity). It always balances: assets equal liabilities plus equity.
| Line | Start of year | End of year |
|---|---|---|
| Cash | 20,000 | 18,000 |
| Receivables (customers who owe you) | 14,000 | 22,000 |
| Inventory | 8,000 | 10,000 |
| Equipment (after depreciation) | 25,000 | 30,000 |
| Total assets | 67,000 | 80,000 |
| Payables (suppliers you owe) | 9,000 | 12,000 |
| Loan | 25,000 | 20,000 |
| Owner’s equity | 33,000 | 48,000 |
| Total liabilities and equity | 67,000 | 80,000 |
Equity grew from 33,000 to 48,000: the 25,000 profit, less 10,000 the owner took out as drawings.
3. The cash flow statement
The business made 25,000 of profit, yet its cash fell by 2,000. The cash flow statement explains the gap by sorting every movement of cash into three groups.
| Net profit | 25,000 |
|---|---|
| Add back depreciation (not a cash cost) | 5,000 |
| Increase in receivables | (8,000) |
| Increase in inventory | (2,000) |
| Increase in payables | 3,000 |
| Cash from operating activities | 23,000 |
| Equipment bought (investing) | (10,000) |
| Loan repaid | (5,000) |
| Owner’s drawings | (10,000) |
| Cash from financing activities | (15,000) |
| Net change in cash | (2,000) |
Opening cash of 20,000, less 2,000, gives the closing cash of 18,000 — exactly the figure on the balance sheet. That tie-out is how you know the three statements are consistent.
How the three connect
- Profit from the income statement flows into equity on the balance sheet.
- The cash flow statement starts from profit and ends at the cash line on the balance sheet.
- Changes in receivables, inventory and payables on the balance sheet explain most of the difference between profit and cash.
Which one do you need?
Lenders usually want all three, plus last year for comparison. Investors look closely at the cash flow statement. Auditors and tax advisors start from the balance sheet and want every balance supported. For running the business month to month, a monthly income statement and balance sheet with short commentary is usually enough.
Whatever the purpose, the statements are only as reliable as the books under them — which is why we prepare them from reconciled books, and why every set we produce is reviewed by a Chartered Accountant.