Let’s begin with a foundation on which we can agree. There are two financial things every company must do both to survive and be in compliance with the law. It doesn’t matter the size of the company, its industry, or whether it is for profit or not for profit. The company must generate cash and it must report its earnings to the government for a number of reasons including, but not limited to taxes, providing financial performance data if the company is public, and as proof of financial transactions for nonprofits. Failure to do either or both of these will limit your company’s ability to exist long term. I trust you will agree with me on these two ideas. Let’s look at each of these individually.
Generating cash, cash flow, is the lifeblood of any company. All companies need positively flowing cash to ensure they are able to survive and, ideally to grow.
Generating cash comes from two primary sources. One source is investors who infuse cash in various ways including debt and money for equity. The other is to make more money than you are spending by selling products and services. The former may involve getting capital to address a tactical or strategic need. A key consideration is that this money is expected to be paid back in some way. Although it may provide needed sources for survival or growth, it comes at a price. The latter is a requirement and necessary capability for all companies.
The government requires companies to report their earnings. In the United States, some may have to report to governing agencies such as the Securities and Exchange Commission (SEC) and, at a minimum, to the Internal Revenue Service (IRS). To ensure everyone does so in a standard, consistent way, there are rules and guidelines established by these agencies. The primary objective of the reports is to represent what the company did, according to the agency guidelines, over a fixed analysis period. Doing this will help the company describe how well it performed during the analysis period. This information may also be used by the investment community as a way to understand and assess company performance. Whether looking at reports prepared for the SEC or looking at statements for loans, this information becomes a basis for how lenders assess the financial viability of your company. The most commonly used are the income statement, the balance sheet, and the statement of cash flows. Often, we focus on the income statement—the description of profits and losses.
Abstractly, the way your business operates is seen in Exhibit 2.1. In this diagram, you see that the company buys resources and performs work, and the desire is that this process leaves the company in the position to make more money than it spent. When this happens, you had a generally positive analysis period. There may be unmet expectations about how much money was made, but in general, the objective is to be profitable—to make more money.
We consider the income statement to determine whether we made money. The basic idea is that if the revenues you generate are greater than costs you have, you have made money. Logically, this makes sense. If you make $100 and you spend $60, you have $40 left. This information allows you to make decisions such as how much you have to spend on other things. The problem is the income statement does not tell you how much money you made. In fact, the whole notion of profit may have little to do with making money at all.
Exhibit 2.1 When we buy a resource, we have a defined amount we will have access to. It is from what we buy that we do work to create output in various forms. Sometimes the output is products or services, it may be information, and it could be offices created from space we lease