The three business scorecards

‘Never be fooled by profits reported on the income statement. The most important figure in judging the viability of a business is the cash flow.’
Issue date: 10 Octobe 2008

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ONE OF THE GREAT MYSTERIES OF BUSINESS is that good, profitable companies go bust. But consistent profitability doesn’t always signify long-term sustainability. Confused? Then it’s time to do a bit more work on your financial literacy. Let’s revisit some of the basics. You’ll be familiar with the three basic business scorecards – the income statement, balance sheet and cash flow statement – but do you really understand them?

The income statement
A better name would be the “income and expenditure statement” as it includes both expenses and income. It’s often also called the “profit and loss account”. The most important thing to grasp about it is that it reflects the performance of a business over a clearly stated period – normally a month, a quarter, a half year or a full year. In fast-moving, high-turnover enterprises such as broiler production for example, this account should be produced monthly. In relatively slow-moving enterprises such as fruit farming, a quarterly report is normally adequate.

The income statement also reports on all income and expense transactions, cash and non-cash. Sales on credit and purchases on account are typical examples of non-cash items. So while the income statement may signal a profit over the period concerned, the business could still be in trouble cashwise, due to, for example, some of the customers not having paid their bills. So never be fooled by profits reported on the income statement. Always look behind these numbers at the balance sheet and cash flow statement.

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The balance sheet
Contrary to the income statement which covers a period of time, the balance sheet is like a snapshot of the company at a particular moment in time. Only when you compare balance sheets do you get a full understanding of the way in which the business has changed with regard to assets and liabilities. The balance sheet is normally drawn on the last day of any stated period and it could be a month, a quarter, a half year or a year. It provides vital information about what the business owns; what it is owed; how much it owes to others; how much stock is on hand and how much cash is in the bank. You can’t get any of this information from an income statement.

The cash flow statement
You might have heard the saying, “Turnover is vanity, profit is sanity, but cash is reality”. Managers love to boast about their company turnovers or total sales figures. They often sound impressive, but actually mean nothing. Without generating a profit, no business is sustainable in the long term. But even profits can be misleading as profitable businesses can still go bust if they don’t have enough cash to service their debts.

Ultimately the most important figure in judging the viability of a business is the cash flow. In most farming businesses there will periods of the year where cash in, minus cash out, is a negative figure, but if this happens over the entire year or season, you’re in trouble. The cash flow statement, like the income statement, covers a specified period. It’s sourced from the income statement and balance sheet and more than any other, it tells the story about the health of the business. It’s by far the most important of the three scorecards. – Peter Hughes ([email protected] or call (013) 745 7303). |fw