Three statements, one business

A sale can increase profit, reduce inventory, create a receivable, and leave the bank balance unchanged. Until you can follow that chain, the business can surprise you while every report appears correct.

You do not need to become a chartered accountant. You do need to know what the accounts are claiming, how the claims connect, and which questions cannot be delegated.

Consider Kaveri Systems Private Limited, an explicitly fictional Bengaluru company that sells factory- monitoring kits with installation support. Its first year closes with ₹5 lakh of net income and ₹11.8 lakh in acthe bank. Those two numbers answer different questions. Profit measures performance under accrual counting. Cash records one asset at one date. Neither number, alone, tells you whether Kaveri can pay what falls due next month.

Three views of the same machine

The income statement covers a period. It records revenue when earned and expenses when incurred under the applicable accounting policy. It explains gross profit, operating profit, financing cost, tax expense, and net income. It does not promise that customers have paid.

The balance sheet is a snapshot. It records assets, liabilities, and the owners’ residual interest at a date:

Assets = liabilities + equity

The cash-flow statement explains the movement in cash during the period through operating, investing, and financing activity. A founder should also keep a direct thirteen-week cash forecast. Published or year-end cash flow explains history; a weekly forecast protects the next payroll. These are three views of one business, wired together by transactions. If one view changes, at least one of the others usually moves as well.

A set of accounts that ties

The following simplified statements are a worked example, not Kaveri’s real accounts. Figures are ₹ lakh, and there were no opening balances, dividends, deferred-tax movements, or other equity adjustments. The ₹1.7 lakh tax expense is a deliberately chosen teaching-case plug that makes the linked statements close; it implies about 25.4% of the ₹6.7 lakh profit before tax, but it is not a statutory rate or tax conclusion.

Income statement · Year 1

Balance sheet · End of Year 1

Cash-flow reconciliation · Year 1

The arithmetic tells a compact story. Kaveri earned ₹5 lakh, yet operations produced only ₹0.8 lakh of cash because ₹6 lakh sat with customers and ₹2 lakh sat in inventory; ₹3 lakh of unpaid supplier bills partly financed that gap. It bought ₹4 lakh of equipment. The bank balance remained comfortable because founders contributed ₹10 lakh and a lender advanced ₹5 lakh.

The ending cash in the cash-flow statement equals cash on the balance sheet. Net income increased retained earnings. The equipment purchase appeared immediately as investing cash outflow, while only one year’s ₹0.8 lakh depreciation reduced profit and the equipment’s carrying amount. That is the handshake among the statements.

Follow the transaction, not the label

Run every unfamiliar event through all three statements.

A credit sale. Kaveri installs a kit and earns ₹1.2 lakh on sixty-day terms. Revenue and receivables rise. The kit’s cost moves from inventory to cost of goods sold. Cash does not move. When the customer pays, cash rises and the receivable falls; revenue is not recorded a second time.

An equipment purchase. Paying ₹4 lakh for testing equipment reduces cash and adds a long-lived asset. The full payment appears in investing cash flow. Depreciation then allocates the asset’s accounting cost over its useful life; depreciation reduces profit without repeating the original cash payment.

A loan. Borrowing ₹5 lakh increases cash and interest-bearing debt. It creates no revenue and no profit. Interest becomes an expense over time; principal repayment reduces cash and debt but is not an operating expense.

A customer advance. Cash received before delivery increases cash and creates a contract or deferred- revenue liability until Kaveri performs. The money improves liquidity, but the company still owes the customer a product or service. acThat last distinction matters. Debt is one kind of liability; liabilities are not all debt. Accounts payable, crued payroll, tax payable, customer advances, lease obligations, and provisions may all appear as liabilities. If a ratio is called debt-to-equity, define debt as the relevant interest-bearing borrowings and use that definition consistently. A ratio using total liabilities answers a broader question and should be labelled accordingly.

Read the quality behind the totals

A statement can add up and still invite hard questions. Accounting contains estimates and timing judgments: when revenue is earned, whether a receivable will be collected, how quickly inventory becomes obsolete, which expenditure creates an asset, and how long equipment will remain useful. Cash reports also require judgment about classification and can be flattered temporarily by delaying suppliers, accelerating collections, selling receivables, or moving activity around the reporting date.

Use comparison, not a magic ratio. Review at least three periods where available. Compare:

• • revenue growth with receivables and cash collection;
• • gross margin with product mix, rework, warranty, and support cost;
• • net income with operating cash flow and the working-capital bridge;
• • capital expenditure with depreciation and operational capacity;
• • debt maturity with cash generation, not merely with the cash balance today;
• • reported performance with bank reconciliations, contracts, invoices, tax records, and the notes.

Free cash flow, commonly calculated as operating cash flow minus capital expenditure, is a useful starting measure. It is not manipulation-proof and it is not automatically distributable. Maintenance expenditure may be understated, customer advances may still need delivery, debt principal may fall due, and some cash may be restricted or reserved for statutory obligations.

The monthly founder close

By a fixed date each month, require one reconciled pack:

1. income statement, balance sheet, and cash-flow bridge; 2. bank and payment-account reconciliations; 3. receivables and payables ageing, with named owners;

4. inventory movement or work-in-progress where relevant; 5. debt, tax, payroll, and contractual obligations due in the next ninety days; 6. actual versus budget, with material variances explained; 7. a rolling thirteen-week cash forecast; 8. a short list of estimates, unusual entries, and transactions needing professional review.

Ask the accountant to explain the movement from profit to cash in plain language. Ask what assumption had the largest effect on profit. Ask which liability is due first. Ask what evidence supports the receivables and inventory values. If the answer depends on a filing, tax treatment, revenue-recognition judgment, or corporate-law step, have a qualified CA, CS, or lawyer review the actual records. Understanding the accounts does not replace professional work; it lets you commission and challenge that work intelligently.

· EF pp. 69–82 · FS pp. 3–27, 52–55 · GE ch. 25. Mechanisms paraphrased; Kaveri Systems and all of its figures are an explicitly fictional worked example.