Question: My Profit & Loss Statement shows a positive net income last month, so why do I not have any money in my bank account?
Answer: Many business owners struggle with this question, so you are not alone. The fact that you are reviewing your Profit & Loss Statement regularly is an excellent start. Not everyone realizes the importance of reviewing financial statements, so kudos to you for getting that done!
Let's talk about the Profit & Loss Statement, as well as the Statement of Cash Flows. When you understand these statements, you will know exactly where your cash went.
Profit & Loss Statement
The simplest formula for the Profit & Loss Statement is Total Revenue - Total Expenses = Net Income/Loss
Revenue is income generated from the sale of goods or services.
Expenses are costs incurred by the business to generate revenue. Examples include: cost of goods sold (COGS which is typically your direct material costs), payroll (wages paid to employees at your business and the associated payroll taxes), advertising, utilities, credit card processing fees, etc.
Example: If you have $1000 in revenue and $700 in expenses, you will show a net income of $300. However, this doesn’t necessarily mean that you have an extra $300 cash in the bank.
Expenses on the Profit & Loss Statement do not include other places your cash may have gone.
You may have made payments on credit card balances, loans, lines of credit, or owner draws/shareholder distributions. Revenue on the Profit & Loss Statement does not include cash received from loans, lines of credit, or shareholder investments. These assets, liabilities, and equity transactions appear on the Balance Sheet instead.
For instance, you may use credit cards to finance purchases over a longer period of time and carry a balance from month to month. In this case, the balance becomes a liability on the Balance Sheet. The payments you make on paying down that balance do not appear on the Profit & Loss Statement.
Similarly, let’s say that you finance the purchase of a business vehicle. A portion of your monthly payment on that vehicle is recorded against the vehicle liability account, and a portion goes into your interest expense account. Therefore, the full payment doesn’t show on the Profit & Loss Statement - you will only see the interest amount. The principal portion will show on the Balance Sheet and the Statement of Cash Flows.
Statement of Cash Flows
The Statement of Cash Flows combines the net result of the Profit & Loss Statement with the net result of Balance Sheet activity that affected cash or cash equivalents. This statement reconciles the cash balance by showing how the cash came into and went out of the business.
QuickBooks will start with the net income/loss for the time period of the report, and then add or subtract account activity for the period to arrive at the available cash at the end of the period.
From our example above, let’s assume that you have a $350 vehicle payment. The amount applied to the loan principal is $300 and $50 goes to interest. At the end of the period, your Statement of Cash Flows would show $0 net cash for the period, because all $300 of your profit went to pay down the balance of your vehicle loan. The remaining $50 is accounted for in Interest Expense on the Profit & Loss Statement.
The Statement of Cash Flows has three main categories: Operating Activities, Investing Activities and Financing Activities. The activity in your Balance Sheet accounts over the time period will affect your cash on hand.
Operating Activities
- Accounts Receivable net balance change is either added to or subtracted from Net Income, depending on whether you are carrying a smaller or larger Accounts Receivable balance. You haven’t yet received the cash, even though it was counted as “income” when the invoice was created. Having a larger Accounts Receivable balance than a prior period may explain why you don’t see the entire amount of net income in your bank account. Likewise, if you reduced the amount of Accounts Receivable on your books, you may see a larger increase in your bank account since you received payments, yet the income was posted in a previous period.
- Accounts Payable net balance change is either added to or subtracted from Net Income, depending on whether you are carrying a larger or smaller Accounts Payable balance. You haven’t paid these bills yet, but they were counted as an “expense” when the bill was entered. If you are carrying a smaller Accounts Payable balance than a prior period, then you likely paid more bills and thus, have less cash. If you are carrying a larger Accounts Payable balance than a prior period, then you likely have bills waiting to be paid and thus, have more cash.
- Credit cards net balance change is either added to or subtracted from Net Income, depending on whether the balance on the card increased or decreased. If the net balance change is positive, it means that you financed purchases on credit cards instead of using cash. Therefore, you would add this amount to Net Income. If the net balance change is negative, you would subtract from Net Income because you “paid down” on the outstanding liability, which negatively affected your cash flow.
- Short-term liabilities, which include taxes and wages, net balance change is typically added to Net Income because you haven’t yet issued the cash to pay those liabilities.
- Inventory net balance change is subtracted from Net Income if you see increase in your inventory balance. This is because you used cash to purchase more inventory. If the inventory balance was reduced over the time period, then the net balance change would be added to Net Income.
Investing Activities
- The purchase or sale of a Long-Term Fixed Asset would be subtracted or added to Net Income, respectively.
- Accumulated Depreciation related to Long-Term Asset purchases are added to Net Income. This is an expense that you have recorded, but no actual cash has been paid.
Financing Activities
- Long-Term Liabilities (trailers, vehicles, or other types of business equipment) net balance change is added to or subtracted from Net Income similar to how short-term liabilities are handled. Remember that only the interest shows on the Profit & Loss Statement, not the principal payments. The principal amount is reconciled on the Statement of Cash Flows.
- Owner/Shareholder Contributions will be added to Net Income.
- Owner Draws/Shareholder Distributions will be subtracted from Net Income.
Consider the following financial statements from a sample company.
Although the company's net income was $2,306.35, you can see that their cash was substantially more than that at the end of that time period.
The largest increase came from the Financing Activities section. The business chose to finance the truck purchase through an increase in Notes Payable, so more cash became available. They also received a significant Shareholder Contribution.
Obviously, a higher cash flow helps a business pay its expenses. However, a business that relies too heavily on items in the Financing Activities section, including loans and shareholder contributions, is less sustainable and carries more risk with the debt. A business that has a significant portion of cash flow coming from Operating Activities is much more sustainable and has more potential for growth.
The next time you wonder where your cash went, remember to check the Statement of Cash Flows. Transactions involving your business assets, credit cards, liabilities, or owner’s equity may be the culprit for your bank account balance not increasing, despite showing a net income on your Profit & Loss statement.
Make reviewing your Profit & Loss, Balance Sheet, and Statement of Cash Flows part of your regular monthly routine to keep a good eye on the progress of your business.
And if you need help, just ask! We are happy to review these statements with you and provide financial insight on the health of your business.