Where Did My Money Go?

How can your income statement show a profit when you don’t have any money in the bank? That’s a question most business owners ask at some point. The answer lies in the difference between profit and cash flow.

“Profit” is the difference between your income and your expenses (if your income is more than your expenses, that is—otherwise it’s a loss). There are a lot of things that can cause your statements to show a profit even if the cash balance is going down.

The first thing that can happen is that your books are being kept on the accrual basis. That means that you recognize income when it earned (even if you haven’t received the money) and your expenses when they are incurred (even if you haven’t paid the bill). So if you make more sales on account in a given month than you receive in payments, you will show revenue even though you haven’t gotten the money.

Seeing your reports on the cash basis takes care of that problem. But there are still items that affect that cash flow that aren’t reflected on the Profit and Loss (as well as items on the Profit and Loss that don’t affect cash flow). Those items will be reflected on the Balance Sheet instead, a financial statement that many small business owners don’t pay much attention to. If you are making loan payments, the interest portion will be on the profit and loss, but the principal portion (the part that reduces the amount you owe) will not—it will show up on the balance sheet. If you buy a new piece of equipment, it is usually capitalized, meaning that it will show up on the Balance Sheet as a fixed asset that will be depreciated over time. The depreciation expense will then show up on the Profit and Loss and will be offset by an increase in Accumulated Depreciation on the Balance Sheet.  If you pull money out of the bank account that isn’t payroll, it will reduce your cash but won’t affect your Profit and Loss—it will show up on the Balance Sheet (it could be a shareholder loan, distribution, or dividend if you’re incorporated, or a draw if you’re a sole proprietor).

The financial statement that explains cash flow is the Cash Flow Statement. This report typically starts with the Profit and Loss (P&L), and then starts adding and subtracting items that are either on the P&L but don’t affect cash flow, or that affect cash flow but aren’t on the P&L. These will include changes to Accounts Receivable and Accounts Payable, increases and decreases in loan balances, depreciation expense, owner draws, etc. So if you want to understand what happened to your money, you will need to run both a Profit and Loss and a Cash Flow Statement to get the whole picture.

The Profit and Loss Statement tells you how well your business is performing. The Cash Flow Statement gives you an indication of how well you are managing the cash. You should have goals and strategies in place to manage both in order to gauge how well you are doing when you review these statements.

What’s your biggest challenge in understanding your business’ cash flow?