The six essential financial terms work into three essential statements (for past results) or projections (in business plans or anything referring to the future). A pro-forma statement, by the way, is another way to say projection. TheProfit and Loss (also called Income) includes Sales, Costs and Expenses. The Balance includes Assets, Liabilities, and Capital.
And these three are conceptually linked and interconnected. The following illustration shows how they relate to each other:
The standards of accounting, like double-entry bookkeeping, make a delightfully automatic error check with the three statements. They link up conceptually so that if the balance doesn’t balance, it’s wrong. If assets are not the sum of capital plus liabilities, it’s wrong. If retained earnings don’t add up to profits less distributions to owners (as in dividends, or owners’ draw), it’s wrong. If your spreadsheet, or your software, doesn’t reflect every change in the profits to the cash and balance, and every change in balance to cash, then it’s wrong.
I’ve heard an intelligent successful lawyer claim that double-entry bookkeeping was the most important invention of the western world. I’m not going to go there in this book. I’m not doing debits and credits. But knowing how these statements link up is important.