All businesses need a system of recording transactions and of presenting
them in a coherent way which is widely understandable. The fundamental
business model, introduced in Chapter 2 and reproduced here as
Figure 4.1, shows the fl ow of transactions round the business.
The underlying transactions can be grouped into four categories as set
out in Table 4.1. The two columns split transactions according to whether
they involve money coming into the business or money going out of the
business. The two rows are split according to whether the effect of the
transaction has either a future or a current impact.
These categories provide the basis for the three core statements that
make up a set of accounts:
_ Balance sheet. A snapshot of the business showing the assets
owned, the liabilities owed and the money put in by investors.
A balance sheet represents the items that will provide a future
benefi t or have a future claim on the business.
The fundamental business model
_ Income (or profi t and loss) statement. A trading statement that
summarises the revenue earned and the costs incurred for a
period. The costs comprise all the items that have been consumed
or have been spent in earning the revenue. For example, the cost of
telephone calls would be shown as a cost in the income statement
as the benefi t is derived at the time they are made and there is no
future benefi t to be derived. However, the purchase of telephone
equipment such as a handset is an asset that will appear on the
balance sheet as the business will be able to continue deriving
benefi t from this equipment in the future.
_ Cash fl ow. A summary of the cash received and paid for a period.
This is effectively a summarised bank statement showing money
in and money out.
As shown in Figure 4.2 on the next page, the balance sheet is a
statement at a point in time whereas the income statement and cash fl ow
summarise the activity over a period of time (typically a month or year).
The priorities of three crucial items on these statements can be summarised
by the adage that:
_ Revenue is vanity
_ Profi t is sanity
_ Cash is reality
Thus revenue that does not generate a profi t or provide a basis for
earning future profi t (a loss leader) may fl atter a business in terms of
growth but generates no shareholder value. Profi t that has been earned
but is tied up in receivables cannot be reinvested until it is turned into
cash. Without cash a business cannot survive in the longer term.
The statements in practice
To illustrate the construction of the three statements, take an example of
a door-to-door salesman who sets up a cleaning products business with
$500. He goes to a wholesaler and buys 200 dusters for $2 each and a
holdall for $50. After a hard day on the road, spending $20 on bus fares
and fi nding only a few customers, he has sold 50 of the dusters for $5
each. At the end of the fi rst day he has a lot of dusters left, some cash and
some used bus tickets. Has it been a successful day?
The balance sheet – day 1
Adding up the items in his possession at the end of the day that have
a future benefi t for the next day and beyond, he would produce the
following.
Holdall $50
Inventory $300 150 dusters at cost of $2 each
Cash $280 Analysed in the cash fl ow
Total assets $630
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