I’ve taken you this far with just the basic business numbers. To be fair, that’s far enough. It certainly gives you some numbers to get a hold on and to manage, review, correct, and revise.

It’s likely that at some point you’ll want to go further, into the straight financial projections that are part of a complete formal business plan.

The good news is that with what we did with the basic numbers, you’re already a long way there.

The bad news is that here again the details and specific meanings of financial terms matter. You can’t just guess. So I warned you earlier about the importance of timing with sales, costs, and expenses. This is very true with standard financials. Also, it starts to matter what goes where. It can be confusing and annoying. For example, interest expense goes into the income statement but principal repayment goes into the cash flow, which then affects the balance, but never appears anywhere in income. That means a standard debt payment that includes both interest and principal repayment has to be divided up into both parts. Interest is an expense on the profit and loss. Debt payment reduces debt on the balance sheet.

Elsewhere in this book I discuss the huge difference between planning and accounting. With the three main financial statements, specifically, financial analysts use the term pro forma to describe projected statements and predictions. An income statement, for example, is about past results. A pro forma income statement is a projected income statement.

The Income Statement

The income statement is also called profit and loss. People often refer to the bottom line as profits, the bottom line of the income statement. It has a very standard form. It shows sales first, then cost of sales (or COGS, or cost of goods sold, or direct costs, which is essentially the same thing). Then it subtracts costs from sales to calculate gross margin (which is defined as sales less cost of sales). Then it shows operating expenses, usually (but not always) subtracting operating expenses from gross margin to show EBIT (earnings before interest and taxes). Then it subtracts interest and taxes to show profit.

Sales – Cost of Sales = Gross Margin

Gross margin – Expenses = Profits

Notice that the income statement involves only four of the seven fundamental financial terms. While an income statement will have some influence on assets, liabilities, and capital, it includes only sales, costs, expenses, and profit.

A Word about Words: Profit, Income, and so on
Some say income statement, some say profit & loss, or profit or loss. That’s the same thing. Accountants and financial analysts use those titles interchangeably. I use income and income statement, but you can read profit & loss if you like.

The income statement is about the flow of transactions over some specified period of time, like a month, a quarter, a year, or several years.

If you’ve done the basic numbers I recommended in the previous chapter — sales and cost of sales in the sales forecast, and expenses (including payroll) — then you’ve got the bulk of the income statement done. Take the sales and cost of sales from that table, and the expenses from that table, and If you have interest expenses, and taxes, add them in. And that’s about what it takes.

The Balance Sheet

The most important thing about a balance sheet is that it includes a lot of spending and money management that isn’t included in the income statement. It’s most of the reason that profits are not cash, and that cash flow isn’t intuitive. It’s all very much related to the cash traps.

The balance sheet shows a business’s financial position, which includes assets, liabilities, and capital, on a specified date. It will always show assets on the left side or on the top, with liabilities and capital on the right side or the bottom.

Balance sheets must always obey the following formula:

Assets = Liabilities + Capital

Unless that simple equation is true, the balance sheet doesn’t balance and the numbers are not right. You can use that to help make estimated guesses, and pull things together for projected cash flow.

The Cash Flow Statement

The cash flow statement is the most important and the least intuitive of the three. In mathematical and financial detail it reconciles the income statement with the balance sheet, but that detail is hard to see and follow. What is most important is tracking the money. By cash we mean liquidity, as in the balance in checking and related savings accounts, not strictly bills and coins. And tracking that cash is the most important thing a business plan does. The underlying truth is:

Ending Cash = Starting Cash + Money Received – Money Spent

What’s particularly important in planning is that neither the income statement alone nor the balance sheet alone is sufficient to plan and manage cash. I discuss the cash flow in much greater detail in the section Planning the Cash Flow.

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Tim BerryTim Berry
Tim Berry

Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.