The short answer
The profit and loss statement shows income and expenses over a period. The balance sheet shows what you own, what you owe and your equity on one date. The cash flow statement explains why cash went up or down. Read them together: owner draws, loan principal, equipment purchases and sales tax collected all move cash without appearing as income or expense on the profit and loss.
Three reports, three questions
Most owners open the profit and loss, look at the bottom line, and close the file. Then the bank balance does not match the profit, and nobody can say why. The answer is almost always in the other two reports. Each statement answers a different question, and none of them tells the whole story alone.
- Profit and loss (income statement): did we make money? IRS Publication 583 describes it as showing the income and expenses of the business for a given period of time, such as a month, a quarter or a year.
- Balance sheet: what do we own and owe? Publication 583 says it shows the assets, liabilities and your equity in the business on a given date. The SBA calls it a snapshot of your business finances.
- Cash flow statement: where did the cash go? An SBA guide describes it as showing the timing of all cash going in and out of the business over a period. It is the report that explains the gap between profit and the bank balance.
How the three connect
The balance sheet always balances: assets equal liabilities plus equity, as the SBA guide puts it. When the business earns a profit, equity goes up by that amount. When the owner takes money out, equity goes down. So the bottom line of the profit and loss flows into the equity section of the balance sheet.
The cash flow statement starts from that same profit and adjusts it. The SBA guide's sample statement is organized into three parts: operating activities (the day-to-day business), investing activities (buying equipment or other long-term assets), and financing activities (loans and owner money in or out). In the operating part, a rise in assets such as receivables or inventory reduces cash, and a rise in liabilities such as unpaid bills increases it. The final cash figure should match cash on the balance sheet.
Picture a month where the profit and loss shows a solid profit but the bank balance fell. The cash flow statement might show that customers paid less than you billed, so receivables rose. It might show a loan paydown under financing and a truck purchase under investing. None of those is an expense, and all of them used cash.
The same SBA guide makes the point that matters most to a small business: even profitable businesses can fail if they do not have the right amount of cash available at the right time.
| What you see | What it usually means | Where to look |
|---|---|---|
| Profit on the P&L, but less cash in the bank | Cash went to things that are not expenses, or customers have not paid yet | Cash flow statement, then receivables and equity on the balance sheet |
| Owner draws missing from expenses | Correct: draws reduce equity, not profit | Equity section of the balance sheet |
| Loan payments smaller on the P&L than the checks | Only interest is an expense; principal reduces the loan | Loan balance on the balance sheet |
| Sales tax collected not shown as income | Tax collected for the state is money owed, not earned | Sales tax payable on the balance sheet |
| A large equipment purchase missing from expenses | Recorded as an asset; depreciation spreads the cost over time | Fixed assets on the balance sheet |
| A negative bank or payable balance | Usually a coding error, a duplicate or a missing entry | The reconciliation for that account |
Reading the profit and loss
Compare, do not just read. Put this month next to last month and next to the same month last year, then find the two or three lines that moved most. A line nobody can explain is the first question to ask. If you sell products, look at gross profit (sales minus the cost of what you sold) as well as the bottom line, because that is where pricing problems show up first.
Check which basis the report uses. On the cash basis, income appears when customers pay. On the accrual basis, it appears when you earn it. The same month can look very different either way, and cash vs. accrual accounting explains the difference.
Know what should never be on it. IRS Publication 334 says money borrowed through a bona fide loan is not income, and that state and local sales taxes imposed on the buyer, which you were required to collect and pay over, are not income. Owner draws and contributions are not income or expense either: Publication 334 describes a drawing account as a separate account for the business income you withdraw for personal use.
Reading the balance sheet
A balance sheet is where errors hide, because few people read it. A few minutes each month catches most of them. Equity deserves a look too: it shows what the owners have put in, what they have taken out, and the profits kept in the business over time. If draws keep running ahead of profit, equity shrinks. Then look down the rest of the report and ask:
- Does cash match what the bank shows at month end, allowing for checks that have not cleared?
- Are receivables made up of invoices you expect to collect, and are payables bills you really owe?
- Do loan balances match the lenders' statements? Only the interest part of a loan payment is an expense; the principal part reduces the loan.
- Is sales tax payable roughly what you will owe on the next return, and are payroll liabilities clearing each period?
- Do equipment and other fixed assets appear as assets, with depreciation figures your CPA has set?
- Is anything negative that should not be? A negative bank or payable balance is almost always a coding error or a missing entry.
Churches, boards and the monthly packet
Church reports use the same building blocks, with one addition: fund balances that show what was given for a purpose, what was spent and what remains. A board reading the packet still needs the budget-versus-actual report and the balance sheet together. What a monthly report for church leadership should include covers the church version in detail.
If you want to know what a complete monthly packet should hold for a business or a church, see what your bookkeeper should send monthly. The balance sheet review steps a bookkeeper works through before sending it are in the monthly close.
Danielson Bookkeeping's small business bookkeeping includes financial reporting: profit and loss, balance sheet and the few numbers you actually watch, explained in plain language.
