At a recent talk with one of my clients we were looking at the 2016 year end results, and then at the cash at hand in the bank account on 31 december. It was obvious that approximately 30.000 Euro were not there. However the owner of the business had expected them, because there was a profit of 50.000 Euro, including the 30.000. The owner then remembered that he had invested 30.000 thousand in his new office, in new computers, in new tables and chairs. We then concluded that the profit of 50.000 has been correctly calculated, and that is was clear why on the bank account there was 30.000 less, resulting in 20.000 plus on the bank account.
This simplified example shows the effect of investments on the profit and loss calculation. Investments are spent with cash from the bank account. And only a smaller part of them are to be found in the profit and loss calculation. Depending on the type of investment, the amount of the investment is divided into 3, or 5, or 10, years of depreciation. In the case of investment into a new computer, in Germany, the depreciation period is 3 years. That means that in case the computer, or laptop, costs 1.200 Euro, its amount of depreciation is 1.200 / 3 = 400. Those 400 will be part of the cost of the profit and loss calculation, while the 1.200 Euro were fully taken from the bank account to buy the laptop.
So in this example the cash used is 1.200 Euro, the depreciation as part of the profit and loss calculation is 400 Euro. Therefore the cash, the liquidity, differes from the profit and loss.
It is very important, especially for start-ups and strong growing companies, or initiatives, to have a profit and loss calculation, and parallely and separately from it, a cash flow calculation. This cash flow calculation should be calculated independently from the profit and loss, and should always be equal to the bank statements on each day (a trained bookkeeper or financial expert can also calculate the exact amount on the bank account with the help of the profit and loss calculation).
Sometimes young businesses believe that they can read their bank statement on each day and then know their cash at hand, and that is enough to manage the start-up well. At a very early stage that may be enough. But when the business is growing there will come the day where things will not be transparent anymore, where the question comes, where the money has gone. And than it is hopefully not yet too late to start with proper financial reporting, including balance sheet, profit & loss, and liquidity. Only the three together form a basic image of the financial situation of the business or initiative.