What are Financial Statements?
A primer on balance sheets, P&L, and cash flow.
TL;DR
A Balance Sheet, Profit & Loss Statement, and Statement of Cash Flows, or your financial statements, are the three essential financial documents of any business.
A Balance Sheet gives you a snapshot of a business's assets and liabilities at a specific point in time. It's what your business owns (assets!) vs. what your business owes (liabilities).
The Profit & Loss Statement (P&L) shows how a business made and lost money over a period of time.
The Statement of Cash Flows shows how cash moves in and out of the business from month to month and each year.
As a founder, make sure to know the 3-5 metrics that grow your business - the financial statements can be a resource to help you identify them!
Build your own personal financial statements, using an AI tool! Using numbers you know will help you understand these documents much better.
What are Financial Statements?
The best way to understand business finance is to do it for yourself. It's really hard to intuit what these terms mean without having a feel for the numbers behind them.
If you do one thing with this post, I would create your own personal Balance Sheet, P&L, and Cash Flow statement using your personal finances.
I used ChatGPT to create mine. With a little detail on my monthly income, expenses, and investments, ask AI to create these three documents for you. I find this so helpful because you already know the numbers behind the statements, so you won't get as lost in trying to follow the terms.
Ok, that said, here's some definitions to get you started.
Balance Sheet: The balance sheet provides a snapshot of what a company owns (assets) and owes (liabilities) at a specific point in time. It follows the equation: Assets = Liabilities + Equity. Assets are things like cash and product inventory. Liabilities are debt or bills you need to pay. Equity makes up the difference between the two, either through fundraising or owner investment.
Profit & Loss Statement (P&L): Shows a company's revenues and expenses over a specific period and tells you whether the business made a profit or lost money. This statement breaks down business revenue, but in reality, it provides more detail on expenses to help you understand overall profit. As a side note, it's important to be specific in business finance. Often the colloquial terms we use don't match perfectly to the financial ones. For example, the answer to the question "How much money did your company make?" could be any one of the following answers, all of which the P&L gives you. Let's take a lemonade stand as an example:
Revenue: The total amount of lemonade sold.
Gross Profit: Revenue minus the cost of goods sold (COGS). For the lemonade stand, this is total sales minus the cost of lemons, sugar, and cups.
Operating Income: For the lemonade stand, this would be gross profit minus operating expenses like rent for the stand and paying workers, but before taxes and debt.
Net Profit / Net Income: The bottom line. This is total profit after all expenses, taxes, and costs have been deducted from total revenue. For the lemonade stand, this is your operating income after paying taxes!
Cash Flow Statement: Tracks the actual flow of money in and out of a business so you know how much cash you have at any given time to pay bills, pay employees etc. It breaks down cash from operations, investing, and financing. If you run a business, you know the truth...cash is king!
These three documents work together to give you a financial picture of your business. The Balance Sheet shows the company’s financial position at a point in time. The P&L reveals how well the company performed financially over a period. The Cash Flow Statement explains how cash is generated and used, ensuring the company has enough cash on hand to pay bills and employees on time.
Why Financial Statements Matter:
Financial documents are important to give you the what and how of your business, but you need to understand the why behind the numbers. These documents provide a picture of a company's financial health, and it’s up to you to use these documents to dig deeper and understand the key metrics that drive your business.
Make sure you as a founder understand the why behind the numbers of the financial statements. For example, revenue went up. Why? Did you add a new customer or did an existing customer pay more? Or say costs went up, why? Did you spend more marketing dollars to acquire a customer? Will it pay off over time? Day to day, I find these key metrics more useful than the financial statements.
And of course, existing financial statements don’t say much about other impacts - like the environmental or social costs of doing business.
The best way to understand financial statements is to work from the bottom up. Create your own using your own personal finances. If you already understand the numbers behind the statements, you'll be able to more clearly understand the financial statements themselves.