Whenever discussions come up with regards to finance in a start-up, there is no reference to any financial statement. Decisions are always based on opinions / perceptions. But during my research on small businesses in India, I have found all successful small business owners closely monitor their financials. In fact most of their decisions are based on numbers / facts. This has kept them in business over long periods of time, some spanning multiple generations. So what are these financial statements that these small business owners use in decisions that entrepreneurs miss?
Let me share with you an analogy first from the real world. We as individuals are born and grow up. There is nothing new about it. As we grow up, we go to school, college, work, etc and live life doing something that we enjoy (or at least in the hope) doing. There are three things that seem to capture the essence of life – being alive, being healthy and performing. In any aspect of life, be it personal or professional, all people want to know these three things. This is because they form the basis (or at least at a worldly level we assume that it forms the basis) for success and happiness. While philosophically it may be untrue, at the worldly level it is widely agreed.
Note: If you are interested in philosophy, read my weekly posts on ‘Vedanta’ here: https://rajshankar.wordpress.com/category/vedanta-and-me/
How do we know we are alive? How do we know we are healthy? How do we know we are performing? These become the questions that need an answer. If you are breathing today, you are alive! If you are having a bunch of health metrics within prescribed range, then you are healthy! If you are able to do your job above the average or to your own expectations, then you are performing! If you are a person who wants to live a successful live, you will constantly track all three.
In a similar fashion, every venture is born and turns into an organization as it grows. During the course of the journey, it also needs to be monitored for the same set of three parameters, namely: Is it alive? Is it healthy? Is it performing?
In order to understand the above three aspects in every organization, three statements are often generated and tracked. Let us go in the same order:
- To know if an organization is alive or is facing any fundamental challenges of life, one refers to a ‘Cash Flow Statement’. As you can see, a cash flow statement should be tracked all the time. It is like breathing and cash is like oxygen. Just as how we keep breathing in and out all the time one needs to always keep a tab on whether the organization has enough cash to stay alive.
- To know if the enterprise is healthy or unhealthy, we refer to a ‘Balance Sheet’. Since health is can always be known at a point in time, it is discovered at a point in time. We can know how healthy we are now or a year ago. So the health of an organization is always assessed at a point in time. Hence balance sheets are generally created on any particular date.
- To check if an enterprise is performing, one refers to a ‘Profit/Loss Statement’ or an ‘Income Statement’. Performance is always measured between two points in time. Someone would want to know your performance in graduation or matriculation; in a similar manner, one would want to assess how the enterprise performed in a particular year or period of time. Hence ‘Income’ or ‘Profit/Loss’ statements are always drawn between two dates.
If you have got the essence of what the three statements are and why they are needed, then you are ready to begin going through each of them in greater detail, which we will start next Friday!