Why you need to understand P&L, Balance Sheet, and Cash Flow

Accounting
Written By Christian Wattig

We don’t need to be accounting experts and know every rule in the book to be successful in FP&A. But to be able to explain how the business is doing, it’s essential to understand accounting basics. Specifically, we need to know how P&L, Balance Sheet, and Cash Flow statements are structured, what their purpose is, and how they connect with each other. Otherwise, we lack the vocabulary to explain why actuals, as booked by the Accounting team, are different from our forecast - a core responsibility of FP&A. Additionally, our business partners in other functions may have questions about the application of accounting principles that we need to be able to explain, for instance why we have to record expenses in the same month we received the services.

Let’s take a closer look at the three statement model. 

P&L

The Profit and Loss statement is used to record revenues, expenses and derives from that what the profit is. P&Ls are prepared to reflect business activity in a given period, for example in a month, quarter, or year. The main components of the P&L are:

Revenue

How much money the business makes in the form of cash or receivables. What differentiates revenue from cash inflow is that the former matches goods or services provided with financial benefits we received, while the latter simply records cash coming in and going out without adjusting journal entries for when benefits were actually provided or received. 

Cost of Goods Sold (COGS)

Expenses that are necessary to be able to provide goods or services to customers are summarized under COGS. Examples include production cost, cost related to providing discounts to customers, certain transportation costs, or infrastructure expenses. The accounting rules that differentiate between COGS and Operating Expenses are complex - connect with the Accounting team if you are unsure. When subtracting COGS from Revenue we arrive at Gross Profit and can calculate Gross Margin, an important profitability ratio. 

Operating Expenses

Expenses that are related to generating revenues are called operating expenses, typically abbreviated as OPEX. They include salaries and benefits for employees, travel expenses, or sales and marketing expenses, which are commonly summarized under the line item “Selling, general and administrative expenses” or short SG&A. Additionally, many companies record research and development expenses, depreciation and amortization as well as certain interest expenses under OPEX.  

It’s important to understand all operating expense lines that your company deals with, even if you don’t directly manage some of them. Telling the whole story of a change in business performance requires looking beyond the silos of our own responsibility and making the appropriate connections. 

When we subtract COGS and OPEX from revenue, we arrive at Operating Profit. Further down the P&L, we encounter other line items such as interest income and tax provisions. Typically, these are managed by accounting and treasury departments and less relevant for FP&A. 

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Balance Sheet

Companies record the value of their assets and debt on the balance sheet (BS). What differentiates the balance sheet from the P&L is that the BS is a point-in-time report, while the P&L shows performance over a period of time. 

The BS and P&L are connected via the double-entry bookkeeping principle, a fundamental rule of accounting. It states that any journal entry must be recorded in two accounts, one as a debit and the other one as a credit. To illustrate with an example, say a company purchases the services of a marketing agency. The corresponding journal entries may be Debit marketing expenses on the P&L & Credit Accounts Payable on the Balance Sheet. As a result of the double-entry bookkeeping principle, the following equation is always satisfied: Assets = Liabilities + Equity. 

Journal entries are analyzed using T-Accounts. While we may not need to use them every day, it‘s critical that FP&A teams understand how T-Accounts work to make sense of unusual accounting situations we encounter when analyzing changes in our budgets. 

Typically, FP&A manages, reconciles, and explains the P&L, while the Accounting team does the same for the balance sheet. That said since the two statements are directly linked, FP&A needs to understand some essential Balance Sheet mechanics. For instance, expenses can be “parked” on the balance sheet, meaning that the P&L impact is delayed. This happens in the case of pre-payments when we have to pay for a product or service before we receive the benefit. For instance, a translation service may require 50% of the invoice amount as an upfront payment before starting the work. In this case, the transaction would be recorded only on the balance sheet, without a P&L impact. The journal entries would read Debit Prepayments and Credit Cash. Once we receive the translation as ordered, the P&L is debited by the entire amount, including what was pre-paid, and the prepayment account on the balance sheet is credited accordingly. You are probably already familiar with the inverse of this principle, that is accruals. We create accruals in the period we receive goods or services that have not yet been paid for. In this case, the P&L is debited and the BS is credited. The entry will be reversed and the accrual released once the invoice has been received and the payment process initiated. 

Cash Flow Statement

You may have heard this phrase before: “Cash is King”. There are two sides to why the statement is true. 1) Receiving cash instead of a promise (via Accounts Receivable) is king, because the risk of potentially not getting paid is removed. 2) Looking at working capital, cash is king, because receiving cash from customers earlier than we have to pay our suppliers means we can invest the surplus to generate even more sales - and create a flywheel effect in the process.

We use the Cash Flow Statement to measure these advantages. Other than the P&L, it excludes accounting entries that are necessary to match expenses with revenues. That leaves us with raw cash in and out-flows, allowing us to determine how much cash we have left to reinvest in the business or payout to shareholders.  

FP&A Analysts need to understand how Cash Flow is derived from the P&L. To name a few use cases, Net Present Value modeling requires calculating cash in-flows and out-flows, and Return on Investment analysis typically makes use of one-year cash flows associated with the activity we are evaluating. 

Christian Wattig
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