Financial Statements Do Not Answer All Questions

March 1, 2018

An integrated understanding all of all the three components of a financial statement – Income statement, Balance sheet and a Cash flow statement is required to understand the operations of any business. The income statement reports the Profit or Loss for a period. The balance Sheet reports on the financial position of the business at any time; what the business owns and what it owes. The cash flow statement on the other hand tracks the movement of cash in the business, answering questions such as what has contributed to the cash inflows and what has contributed to the cash outflows. One should not treat all three statements as independent silos but understand the linkages between the statements.

Let us consider some linkages. Sales revenue is reflected in the income statement as sales for the period. Receivables are in the Balance sheet, indicating the value of receivables on a specific date. Receivables are amounts owed by the customers of the business. Businesses sell on credit. If all sales for a period are locked up in credit to customers, the business may have cash out situation. Cash out situation occurs when a business cannot meet its cash obligations. So technically a business could make a large profit, but if the debts are not collected may become bankrupt. In some situations, the reverse could also be true. A business may purchase the items that it sells on credit, sell to its own customers in cash or by credit card and pay its vendors only after realising the proceeds from its customers.

A Business manager’s task is therefore three fold. Earn good profits, reflected by a growing profitability percentage and increased market share. Control assets and liabilities and hold them at a relatively stable position- this will be different from industry to industry, business to business. Finally to ensure that there are no cash outs and the business is able to continue to meet its ongoing cash obligations.

Therefore understanding the linkages is critical for a business manager to ensure maximization of income and optimization of assets.

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