The Profit & Loss Account and Cash Flow Statement
In this lesson, you’re expected to learn:
– the format and importance of a P&L (income) statement
– how to use a cash flow statement
– the difference between a balance sheet, P&L statement, and cash flow statement
Profit & Loss (Income) Statement
The income statement is one of the most commonly used financial statements by accountants and business owners. The other major financial statements are the balance sheet, statement of cash flows, and the statement of stockholders’ equity.
The income statement is also referred to as the profit and loss statement (P&L), statement of operations, or statement of income.
Importance of Income Statement
It is important because it shows the profitability of a company during a specified time interval.
Keep in mind that the income statement shows revenues, expenses, gains, and losses; it does not show cash receipts (money you receive) or cash disbursements (money you pay out).
People pay attention to the profitability of a company for many reasons. For example, if a company was not able to operate profitably—the bottom line of the income statement indicates a net loss—a banker/lender/creditor may be hesitant to extend additional credit to the company.
On the other hand, a company that has operated profitably—the bottom line of the income statement indicates a net income—demonstrated its ability to use borrowed and invested funds in a successful manner.
A company’s ability to operate profitably is important to lenders and investors, company management, competitors, government agencies, and others.
Format of a Profit & Loss (P&L) Statement
The format of the profit and loss statement varies according to the complexity of business activities.
However, most companies have the following elements in their income statements:
1) Revenues and Gains
• revenues from primary activities (known as operating revenues)
• revenues or income from secondary activities (known as non-operating revenues)
2) Expenses and Losses
• expenses involved in primary activities (operating expenses)
• expenses from secondary activities (non-operating expenses)
Net Income vs. Net Loss
• If the net amount of revenues and gains minus expenses and losses is positive, the bottom line of the P&L statement is labeled as net income.
• If the net amount is negative, there is a net loss.
The cash flow statement reports the cash generated and used during a specific time interval.
It organizes and reports the cash generated and used in the following categories:
1) Operating activities: converts the items reported on the income statement from the accrual basis of accounting to cash.
2) Investing activities: reports the purchase and sale of long-term investments and property, plant and equipment.
3) Financing activities: reports the issuance and repurchase of the company’s own bonds and stock and the payment of dividends.
4) Supplemental activities: reports the exchange of significant items.
What does the cash flow statement indicate?
Because the income statement is prepared under the accrual basis of accounting, the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid.
You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information. As a result, savvy business people and investors utilize this important financial statement.
Here are a few ways the statement of cash flows is used:
1) The cash from operating activities is compared to the company’s net income.
If the cash from operating activities is consistently greater than the net income, the company’s net income or earnings are said to be of a “high quality”.
If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash.
2) Some investors believe that “cash is king”. The cash flow statement identifies the cash that is flowing in and out of the company.
If a company is consistently generating more cash than it is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company. All of these are perceived to be good for stockholder value.
3) Some financial models are based upon cash flow.
Balance Sheet vs. P&L vs. Cash Flow Statement
• The balance sheet tells us what the assets and liabilities of a company are at a particular point in time.
• The P&L tells us how and why the retained profit of the company changed over the course of the last year.
• The cash flow statement tells us how and why the cash / overdraft* of the company changed over the last year.
The balance sheet is thus the definitive statement of a company’s financial position. It tells us where a company stands at any given moment.
The P&L and cash flow statement provide important information but they are only descriptive statements – they describe how certain balance sheet items changed during the year.
The balance sheet is the fundamental principle of accounting put into practice.
Its role as the core of the accounting system is the most important thing to understand about accounting. In fact, if you can understand a balance sheet and double entry, everything else becomes very simple.
How to account for a transaction?
If you’re ever confused about how to account for a transaction, just look at the impact on the balance sheet.
If the transaction affects retained profit, it affects the P&L; if it affects cash, you know it affects the cash flow statement.