Which is the most important financial statement? Profit and Loss, Balance Sheet or Cash Flow!
Not that long ago I was discussing the Profit and Loss, Balance Sheet and the Cash Flow Statements with a client’s staff member. They asked me which financial statement I viewed as the most important.
I asked which one they would look at first. They answered the profit and loss statement, prompting me to say, “that’s interesting and what about the others”? They didn’t look at these.
In my opinion all of these financial statements are important. Personally I put more weight on the Balance Sheet and the Cash Flow statement than the Profit and Loss statement.
Here is why I rate the Balance Sheet the most important financial statement!
The balance sheet is a snapshot of where your business is, and how it is travelling right now! Derived on the formula Assets = Liabilities + Equity. The equity section the heading year to date earnings tells you how the business is travelling right now. However it is the Asset & Liability position that holds the key to the future of your business.
The assets and liabilities are broken down into current & non-current categories. Current turns into cash within 12 months. The non-current categories takes longer to convert into cash. Accounting convention dictates that this time frame is greater than 12 months or 1 year.
Have you heard the saying “Cash is King”?
Well, your cash position is perhaps the most important financial indicator in your business. Unfortunately the profit & loss report does not tell you this. However you can extract this information from the balance sheet.
You see, just divide the Current Assets by your Current Liabilities. This shows you the ability of your business to pay for its current liabilities with its current assets. Known as the Working Capital or Current ratio. A number greater than one means you have a positive working capital and can pay your bills. If the ratio is less than 1 your working capital is negative and you will find paying your bills challenging. This is a must know indicator!
Is there a calculation that provides my cash position over a shorter time frame, let’s say three months?
Yes there is. It’s a calculation that measures the businesses short term liquidity. It measures the businesses ability to use its quick assets, its cash, cash equivalents, marketable securities and accounts receivable to pay its current liabilities. These are the Current Assets that will converted into cash within 90 days. Known as the Quick or Acid Test Ratio. Cash, cash equivalents, marketable securities and accounts receivable divided by Current Liabilities.
Higher quick ratios are more favourable for your business because it shows there are more quick assets than current liabilities. Thus, a quick ratio of 1.5 means that a company has $1.50 of liquid assets available to cover each $1 of current liabilities. This also shows that the business could pay off its current liabilities without selling any long-term assets.
So is there an equation that tells me my ability to repay debt?
Yes there is. The Times Interest Earned or Interest Coverage Ratio, is a solvency indicator. What you are trying to work out with this calculation is the extent to which earnings are available to meet the interest payments. In this instance we will use the Profit and Loss Statement to calculate this ratio. We need to determine what the interest charge is and divide it by what is referred to as EBIT or Earnings before Interest & Taxes. If your Profit and Loss Report does not spell it out don’t despair! Easily calculated it by taking Revenue, deducting Operating Expenses excluding Interest and adding Non-Operating Income.
This ratio indicates how many times a company could pay the interest with it’s before tax income. Larger ratios are considered more favourable than smaller ratios. A ratio of 4 means that a company makes enough income to pay for its total interest expense 4 times over. Said another way, this company’s income is 4 times higher than its interest expense for the year.
As interest payments are made on a long term basis they are treated as ongoing fixed expenses. As with most fixed expenses if the company cannot make the payments, it could go bankrupt or cease to exist. Thus, this ratio is considered a solvency ratio, and an important one to remember for anyone with a business debt.
In the next article I’ll talk more about your cash position and how it relates to the Profits & Loss Statement.