By Myles Powell
Does positive net income equate to success?
A common misconception among owners is that a positive net income at the bottom of the Profit and Loss statement automatically equates to a healthy business. “We are profitable, so we are successful!” This statement is not always true and can lead to inadequate – and sometimes dangerous – decision-making.
By focusing solely on the last line of the profit and loss statement, we fail to fully recognize and understand the business’s true cash position. And no, simply looking at our bank balance does not count. Have you ever asked yourself, “We’re profitable, but why is our cash so tight every month?”
Your business’s health: If P&L is the blood flow, the balance sheet is the heartbeat
To break the issue down to its core, net income measures accounting profitability. This reflects the operational health of the business. Consider it to represent the blood flow within the human body. Our cash position, however, is reflected on our balance sheet. In addition to net income, our cash position is impacted by our assets and liabilities.
If the profit and loss statement represents blood flow, the balance sheet represents the heartbeat. The health of that heartbeat becomes the centerpiece of the business’s overall well-being.
What is net income?
In basic terms, net income is revenue minus expenses. This includes non-cash items such as depreciation and amortization. Net income is useful for measuring profitability and evaluating the company’s long-term performance.
When we look at the balance sheet, it includes cash on hand at a given point in time, accounts receivable and accounts payable balances, debt obligations, and the company’s overall equity position, among other items. The balance sheet provides insight into the company’s true financial position and allows us to properly evaluate the business’s health in the marketplace.
Revenue now, cash later
Another key aspect of evaluating net income relates to timing. Your accounting system typically operates either on a cash basis or an accrual basis. If it operates on a cash basis, revenue is recognized when cash for services is received. However, under the accrual basis, revenue is recognized once the service is performed and invoiced.
What owners need to know about the accrual method
The accrual method is generally preferred because, once a service is performed and invoiced, we want to recognize that future revenue as an asset. This approach provides a more accurate snapshot of the company’s financial performance.
That said, when operating on an accrual basis, net income may be significantly higher than the actual cash balance. There are several factors that can create this difference, one of which is accounts receivable. Under accrual accounting, accounts receivable are recorded on the balance sheet because they represent services rendered or products sold for which payment has not yet been collected.
As a result, net income reflects the value of that future cash, while the cash balance reflects only the money currently on hand. The difference between the two is recorded as accounts receivable on the balance sheet. This is why it is critical to review both the balance sheet and the profit and loss statement in order to understand the full financial picture.
The same relationship holds true for accounts payable. While net income may show one value, accounts payable appear on the balance sheet under accrual accounting. In this case, cash on hand may appear higher than net income because certain expenses have been recorded but not yet paid.
Inventory follows a similar pattern. A company’s cash may be tied up in inventory that has already been purchased but not yet sold. In addition, principal debt payments are not recorded on the profit and loss statement; they are reflected on the balance sheet. If we ignore both short-term and long-term debt obligations by focusing only on the profit and loss statement, we risk misunderstanding our true cash position.
Why your decisions should be based on the balance sheet
Decisions regarding growth, capital expenditures, and owner distributions should be evaluated using the most accurate representation of the company’s financial position – the balance sheet. Recall that the profit and loss statement evaluates operational performance, while the balance sheet speaks to the core financial health of the company.
When evaluating a growth strategy, it is important to recognize that increased revenue can also lead to increases in accounts receivable and inventory, which may tie up available cash. If ownership fails to account for potential cash flow gaps, growth itself can become financially stressful and even detrimental to the business.
Similarly, many growth strategies involve some level of debt financing, whether for equipment purchases, facility expansions, or hiring additional staff. The debt burden associated with these decisions appears on the balance sheet rather than the profit and loss statement. It is therefore critical to maintain a clear debt-reduction plan aligned with the company’s growth strategy to prevent liabilities from becoming overburdened.
What to ask yourself before making any major financial decision
Before making any major financial decision, owners should review their balance sheet and ask themselves a few key questions:
1. How will this decision impact our assets and liabilities on the balance sheet?
2. Will this decision reduce our operating cash cushion?
3. Can the business sustain this decision if future revenue does not meet projections?
Profitability analysis through the profit and loss statement, combined with cash flow evaluation through the balance sheet, are essential tools for business owners. However, they serve different purposes.
By incorporating balance sheet analysis into the decision-making process, owners gain a deeper understanding of their true financial position and are better equipped to make strategic, sustainable decisions.
