Plain English
Four views of one business
Financial statements describe different aspects of the same business. The income statement reports revenue and expenses over a period. The balance sheet reports assets, liabilities and equity at a particular date. The cash-flow statement explains movements in cash over the period, while the statement of changes in equity explains movements in owners’ residual interest.
These views connect, but they are not interchangeable. Revenue can be recognised before a customer pays. A business can borrow cash without earning revenue. Profit can increase equity without producing an equal increase in cash. Separating the timing of activity from the timing of payment is central to reading the statements together.
An asset is a resource recognised by the business, such as cash or a customer receivable. A liability is an obligation, such as an unpaid bill. Equity is what remains after liabilities are deducted from assets. The balance-sheet relationship is therefore assets equal liabilities plus equity, rather than assets equal cash.
Worked Example
A small service business with unpaid invoices
Consider a fictional service business at the start of a reporting period. It has £100 cash and £100 equity, with no liabilities or other assets. During the period it completes services and recognises £100 revenue. Customers pay £60 of that amount; the other £40 remains collectible and unpaid at the reporting date.
The business incurs and immediately pays £50 of expenses relating to those services. Assume no taxes, inventory, depreciation, borrowing, owner contributions, dividends, impairment or other transactions. All services meet the assumptions for revenue recognition, and the expenses belong entirely to this period. The opening £100 is already in place before the period begins.
The income statement shows £100 revenue minus £50 expenses: £50 profit. The cash-flow statement shows £60 receipts minus £50 payments: a £10 operating cash inflow. Closing cash is therefore £110. The remaining £40 customer receivable brings closing assets to £150. With no liabilities, closing equity is also £150: opening equity of £100 plus retained profit of £50.
| Revenue |
£100 |
| Expenses |
£50 |
| Profit |
£50 |
| Net cash inflow |
£10 |
| Closing cash |
£110 |
| Closing receivables |
£40 |
| Closing assets |
£150 |
| Closing liabilities |
£0 |
| Closing equity |
£150 |
Reading the result
Following the £40 difference
The gap between £50 profit and the £10 cash increase is the £40 of revenue not yet collected. Using an indirect reconciliation, subtract the £40 increase in receivables from profit to reach the £10 operating cash flow. This does not reverse the revenue; it explains why recognised income and collected cash differ.
The changes-in-equity statement provides another connection. With no distributions or other equity movements, the entire £50 profit increases retained earnings within equity. The balance sheet then balances: £110 cash plus £40 receivables equals £150 equity. Each statement answers its own question while remaining consistent with the others.
If the customer pays the £40 in the next period, cash rises and receivables fall by the same amount. Collecting that already-recognised receivable does not create another £40 of revenue. This timing example explains why comparing cash and profit requires attention to movements between reporting dates.
Limits and assumptions
A reconciliation is a starting point
Actual statements contain more moving parts. Equipment purchases, depreciation, deferred revenue, working-capital changes and financing can all affect the connection between profit and cash. Reporting frameworks and recognition judgements also matter. This example removes those complications so the basic links remain visible; it is not a complete set of accounts.
A receivable is not identical to cash. Collection could be delayed or fail, and the reported amount may require an allowance for expected losses under the relevant rules. Our example explicitly assumes the £40 is collectible. A balanced set of statements shows internal consistency, but that consistency alone does not demonstrate business quality, liquidity or the reliability of every estimate.
Common Mistake
Adding profit to cash without checking timing
Adding the £50 profit directly to opening cash would produce £150 cash, even though only £60 was collected and £50 was paid. That would overlook the unpaid customer amount. Equally, recognising revenue again when the invoice is collected would double-count it. Trace both the underlying activity and its payment before explaining a change in cash.
Self-check
Check your understanding
Why is profit £50 but cash rises only £10?
£40 of recognised revenue remains unpaid. Subtracting the increase in receivables from profit reconciles this example’s operating cash flow.
What balances the closing £150 of assets?
There are no liabilities, so £150 equity balances the assets. It consists of £100 opening equity plus £50 retained profit.
Does later collection create new revenue?
No. It exchanges a receivable for cash; the revenue was already recognised when the service was provided.
Continue learning
Connect the ideas
Follow the related articles below to explore the assumptions behind this example.
Disclaimer
Educational Use Only
This article is for informational and educational purposes only. It does not provide personalised investment advice.
