Knowing how to read your business’s key financial statements — a profit and loss statement, cash flow statement, and balance sheet — makes you a better business owner. Why? Because they can help you answer common dilemmas in business, like the profit-rich but cash-poor problem. They also give you the tools to make smarter and more informed business decisions.
Let’s look at how the financial statements are linked for your small business.
How each financial statement is linked
A profit and loss statement shows your business’s profitability; a cash flow statement shows where money comes in and out; and your balance sheet shows what your business owns and owes. Each statement matters in its own right, and while they serve different purposes, they are also sensitive to changes in the others. Let’s see how all three work together.
Profit & loss vs cash flow statement: how are they linked?
Your profit and loss statement shows how much money your business makes overall, while your cash flow statement shows how much money you have in the bank. Think of profit like your take-home pay and cash flow as your spending money. If you earn a lot of money but struggle to cover monthly bills, you have high profit and low cash flow.
Profit & loss takes your revenue and subtracts expenses like cost of goods sold, operating expenses, depreciation, amortisation, and taxes to find your net profit — the bottom line. In most cash flow statements, net profit is your starting line item. From there, under the indirect method for accrual accounting, you add back depreciation and amortisation. This gives you a figure that changes based on cash from operating, investing, and financing activities.
Interactive widget. Click the link to see how Marty's Cafe's net profit becomes the starting point of the cash flow statement.
Cash flow statement vs Balance sheet: How are they linked?
Your cash flow statement shows the cash flowing in and out of the business, which is directly affected by changes in working capital. Working capital is the amount of money available for a business to operate after subtracting your current liabilities from your current assets. You find this on your balance sheet.
This is where things get confusing for business owners who aren’t accustomed to accounting, as increases in working capital generally reduce operating cash flow. This is because cash gets tied up in assets that increase working capital but reduce available cash, like inventory and accounts receivable. So a decrease in net working capital increases cash from operations. When looking at the impact of working capital on cash flow, this is sometimes narrowed to operating working capital, which excludes cash and financing-related items.
Once you account for working capital, you can look at other connections. Capital expenditure also appears as a cash outflow in investing activities and is recorded on your balance sheet (i.e. a new coffee machine purchase).
Financing activities also affect your balance sheet, and vice versa. For example, securing a loan increases cash flow while also increasing liabilities on the balance sheet.
Interactive widget. Click each link to see how Marty's Cafe's cash flow entries land on the balance sheet as an asset and a liability.
Balance sheet vs profit and loss statement: How are they linked?
Your balance sheet and profit and loss statement link through retained earnings (for companies) or the capital account (sole traders/partnerships).
Retained earnings represents the cumulative earnings of a business, which is increased by net income from the profit and loss statement. Dividends (for companies) or owner drawings (sole traders/partnerships) decrease the account on the balance sheet.
Other links between statements include interest expenses, which reduce profit, while loan repayments reduce the debt balance shown on your balance sheet. So too is depreciation. Depreciation is featured on your P&L as a loss and reduces an asset’s carrying value over time on your balance sheet.
Interactive widget. Click each of the three links to see how Marty's Cafe's balance sheet and profit and loss statement connect through the capital account, loan repayment, and depreciation.
How all the financial statements work together: Marty’s Cafe Example
Each financial statement affects the others, most notably via net profit. Let’s see how this looks in one picture with Marty’s Cafe:
Interactive widget. Click each link between Marty's Cafe's profit and loss, cash flow, and balance sheet to see how they connect, then read the explainer for each. Once all three links are explored, the net profit versus net cash movement comparison unlocks.
Here’s a clear view of how financial statements influence each other, and how a business can be profitable while still experiencing cash flow issues. The purchase of the espresso machine doesn’t show up in a profit and loss statement: instead, it gets capitalised, and its cost is expensed over its useful life. The cash flow statement records the capital expenditure, and the balance sheet shows the carrying amount. This results in a net negative cash flow, but that doesn’t have to be the case forever. In this example, Marty bought the espresso machine to invest in the business and increase revenue over time with better equipment. The financial statements show what that decision cost him in the short term.
Mastering your financial statements
Whether you’re finding a cash flow issue in inventory that makes profit look nice but ties up cash, or balancing your books by correcting a line item, a stronger grasp of your financial statements gives you the tools to effectively run your business. Understanding how each financial statement works and affects the others helps you better understand your operations and financial position — leading to better business decisions.
