TLDR: While the Profit & Loss (P&L) statement is critical for measuring performance, it doesn't tell the whole story. Net income doesn't always mean there is money in the bank. To truly understand a company's health, leaders must look at the P&L and the Statement of Cash Flows together.
Key Highlights:
- The complete picture: A P&L measures economic performance, while the Statement of Cash Flows measures liquidity. You need both to run a sustainable business.
- Timing matters: Accrual accounting records revenue when it is earned, not when cash is collected. This creates a gap between "profit" and "cash."
- The three buckets: The Statement of Cash Flows breaks down cash movement into Operations, Investing, and Financing, offering specific insights into where money is going.
- The operational check: Positive cash flow from operations is the best indicator that a business's core model is sustainable.
It is a common scenario in boardrooms everywhere. A founder or CEO reviews the P&L statement. Revenue is climbing, and net income is in the black. The business is healthy, and the strategy is working effectively.
However, when they review the bank balance, the numbers don't align with the optimism reflected in the profit and loss statement.
This disconnect occurs not because the P&L is incorrect, but because it only tells half the story. While the P&L is excellent for understanding economic profitability and margins, it is not designed to track liquidity. That is where the Statement of Cash Flows comes in. To run a business effectively, leaders need to give equal weight to both reports.
The Difference Between Profit and Liquidity
The reason for the discrepancy typically lies in the use of accrual accounting. Most modern businesses use this method because it matches revenues to the expenses incurred to earn them. It provides a smooth, accurate picture of performance over time.
However, it creates timing differences:
- Revenue vs. Receipts: Revenue is booked when the work is done or the product is shipped, not when the customer pays. A hefty invoice counts as revenue today, even if the cash doesn't arrive for 60 days.
- Expenses vs. Outflows: Expenses are recorded when they are incurred, not necessarily when the cash is withdrawn from the bank account.
- Non-Cash Items: The P&L includes figures like depreciation. This reduces reported profit to account for asset wear and tear, but it doesn't physically remove cash from the business.
Due to these factors, "Net Income" represents a calculation of economic value creation. It is not a measure of how much money is available to make payroll next Friday.
The Statement of Cash Flows: The Reality Check
If the P&L is the roadmap showing where the business is headed, the Statement of Cash Flows (SCF) is the fuel gauge indicating whether there is enough fuel to get there. It reconciles the beginning cash balance with the ending cash balance, detailing exactly where the money went.
It answers three critical questions that the P&L cannot:
- Is the core business generating cash?
- Is the business reinvesting in itself?
- Is the business relying on outside funding to operate?
It organizes these answers into three distinct sections.
1. Cash Flow from Operations (CFO)
This is the most crucial section for assessing the health of the business model. It starts with Net Income and adjusts it for non-cash items and changes in working capital.
For example, if a company sells a large amount of inventory on credit, the profit and loss statement (P&L) shows a high profit. However, if those customers haven't paid yet, Accounts Receivable increases, and Cash Flow from Operations decreases.
The Insight: A healthy, mature business should generally show positive Cash Flow from Operations. This means the day-to-day business is self-sustaining. If this number is consistently negative while the profit and loss (P&L) is positive, it often indicates that profit is tied up in unpaid invoices or excess inventory.
2. Cash Flow from Investing (CFI)
This section tracks cash spent on long-term assets. This includes purchasing equipment, real estate, or software development.
The Insight: Negative cash flow here is not necessarily a bad thing. In fact, for a growing company, it is expected. It signals that management is investing cash back into the business to fuel future growth. However, it is vital to ensure these investments align with the company's long-term strategy.
3. Cash Flow from Financing (CFF)
This section reflects cash exchanges with lenders and investors. It shows cash coming in from loan or equity sales, and cash going out for debt repayments or dividend payments.
The Insight: This reveals how the company is funded. For early-stage startups, this is often highly positive as they raise capital. For established firms, it might be negative as they pay down debt. It provides context on the company's runway and leverage.
The Power of the Pair
Focusing solely on the P&L can lead to a false sense of security, while focusing exclusively on cash flow can lead to short-term thinking that neglects long-term value.
A thorough financial review examines the relationship between the two.
The P&L asks: Are we pricing our products correctly and managing our margins?
The Cash Flow Statement asks: Are we collecting from customers efficiently and managing our capital wisely?
When these two reports are analyzed together, they provide the clarity needed to make confident, strategic decisions.
Ready to get a deeper understanding of your financial statements? Contact us. We can help you develop a comprehensive financial view that encompasses both performance and liquidity.
