How to use financial statements to assess the quality of management contributions
Understanding the relationship between the P&L Statement and the Balance Sheet is crucial to establishing management effectiveness in converting sales into profits that build cash reserves and Owners’ Equity. By looking at both statements together, you get a complete picture of the results of management’s performance by the changes in its financial standing.
For example, if Retained Earnings increase, the business earned a profit, and Owners’ Equity grew. If they decrease, management causes the business to suffer a loss, which in turn destroys Owners’ Equity by burning through more cash than will be received. The following represent the key influences of the P&L Statement on the Balance Sheet:
- Net Income: Net Income is the total amount of money a business earns after deducting all expenses from Net Sales. It is also referred to as the “bottom line” on the P&L Statement.
- Retained Earnings: Retained Earnings represent the company’s accumulated profits that have not been distributed as dividends and are reported in the Equity section of the Balance Sheet.
- Net Income goes to Retained Earnings: The Net Income (or Net Loss) calculated on the P&L Statement is added to (or subtracted from) the Retained Earnings account on the Balance Sheet. Net Income is the only value on the P&L that moves to the Balance Sheet representing the only link between the two statements because the business profitability directly impacts Owners’ Equity.
- Cash: The P&L Statement indirectly affects the cash account on the Balance Sheet. While the P&L itself doesn’t show cash flows, the revenues (cash inflow) and expenses (cash outflow) recorded on it ultimately impact the amount of cash the company has on hand. For example, Net Sales increase cash, while expenses decrease it.
Here’s a simple illustration:
Imagine a company spending $96,000 to generate $100,000 in Net Sales for a month.
- P&L Statement: This would result in a Net Income of $4,000 reported on the bottom of the P&L Statement.
- Balance Sheet: This $4,000 Net Income would then be added to the Retained Earnings account on the Balance Sheet, increasing the Owners’ Equity. Ultimately the cash account on the Balance Sheet would be affected based on the time of cash collected from Net Sales ($100,000 in inflows) and expense payments ($96,000 in outflows) related to the revenues and expenses for the reported month.
Key Differences to Remember:
- Timing: The P&L Statement reflects the company’s financial performance over a period of time (I.e., a month or a year), while the Balance Sheet provides a snapshot of the company’s financial position at a specific point in time.
- Focus: The P&L Statement focuses on profitability, while the Balance Sheet focuses on the company’s Assets, Liabilities, and Equity.
By analyzing the P&L Statement and Balance Sheet together, you gain a powerful tool for evaluating management’s ability to generate sales at a profit, build equity, and cash reserves that will ensure the long-term financial health of your business. Start applying these insights to your financial analysis today!
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