Preparing a profit & loss forecast is a good 1st step in assessing the future operations & financial health of a business.
Net Profit ≠ Cash
Cashflow – the lifeblood of any business – is influenced by more than just profit. Depending on the industry, there can be significant differences between Net Profit and Cashflow. For example:
Working Capital
Revenue and expenses do not always align with cash inflows and outflows. Many businesses need to purchase inventory well before generating sales, often extending credit terms to customers. The capital required to bridge the gap between purchasing inventory and receiving payment from customers is known as “working capital lock-up.” This challenge also affects professional services and consulting firms, which typically incur staff costs to complete work months before receiving payment.
Debt repayments
While the P&L reflects interest expenses on financing, it does not account for loan repayments, such as trade finance facilities, term debt, and equipment financing. These repayments can represent a significant cash outflow for businesses.
Capital Expenditures (Capex)
To remain competitive, businesses must reinvest in their operations, whether through machinery, technology, or other assets. These upfront expenditures are not reflected in the P&L but are instead allocated over time as depreciation expenses.
To remain competitive, businesses must reinvest in their operations, whether through machinery, technology, or other assets. These upfront expenditures are not reflected in the P&L but are instead allocated over time as depreciation expenses.
Shareholder dividends
Ultimately, most for-profit businesses aim to generate returns for shareholders, often in the form of dividends. Since these payments fall outside the scope of the P&L, they represent additional cash requirements.
The Case for a Three-Statement Financial Model
To gain a comprehensive understanding of financial performance and cash flow, it is recommended to develop a three-statement financial model. This approach integrates the P&L, balance sheet, and cash flow statement into a cohesive framework. While each statement serves a distinct purpose, they are interconnected:
- Profit & Loss (Income Statement):
- Tracks revenues, expenses, and net income over a specific period.
- Key outputs: Gross profit, operating income (EBIT), and net income.
- Used to understand profitability and operational efficiency.
- Balance Sheet:
- Represents the financial position of the business at a specific point in time.
- Shows assets (what the company owns), liabilities (what it owes), and equity (shareholder’s stake).
- Cash Flow Statement:
- Tracks the movement of cash in and out of the business over a period.
- Divided into three sections: operating activities, investing activities, and financing activities.
- Explains changes in cash balance and connects to both the income statement and balance sheet.
- Linkages between Statements:
- The net income from the income statement flows into the balance sheet (retained earnings) and cash flow statement.
- Changes in working capital and other balance sheet items affect the cash flow statement.
- The cash flow statement reconciles the opening and closing cash positions on the balance sheet.
By building and linking these components together, the model becomes a powerful tool for financial analysis, forecasting, and strategic decision-making.