- The three statements answer different questions and are all necessary.
- Profit and cash diverge because of timing, and the divergence is the interesting part.
- Working capital consumes cash as a business grows.
- Contribution margin tells you whether growth helps or hurts.
- Consistency of definition matters more than sophistication of method.
The three statements
The profit and loss statement measures performance over a period. The balance sheet shows position at a point in time. The cash flow statement reconciles the two by explaining where the money actually went.
Most operating confusion comes from reading only the first. It is the statement most people are shown, and it is the one least connected to whether payroll clears.
- Profit and loss — did we perform well over this period?
- Balance sheet — what do we own and owe right now?
- Cash flow — where did the money go, and why does it not match profit?
Profit versus cash
Accrual accounting recognises revenue when earned and costs when incurred, regardless of when money moves. That is correct for measuring performance and useless for measuring solvency.
The gap between them is created by timing: receivables, payables, prepayments, inventory and capital expenditure. Understanding which of those is moving explains almost every “we are profitable but broke” situation.
- Customers paying late increases profit before it increases cash.
- Paying suppliers early reduces cash without changing profit.
- Buying equipment reduces cash immediately and profit gradually.
- Annual prepayments create a large cash outflow in one month.
Working capital in one paragraph
Working capital is the cash tied up in operating the business: what customers owe you, plus stock, minus what you owe suppliers. Growth increases all three, which is why fast-growing companies consume cash even when profitable.
The full mechanics are in our working capital guide.
Contribution margin
Contribution margin is revenue minus the costs that vary directly with that revenue. It tells you what each additional sale contributes toward fixed costs and profit.
It is the number that answers whether growth improves the position. If contribution is negative, more volume makes things worse, and no amount of scale fixes it.
Vocabulary worth being precise about
Imprecise use of these terms causes more confusion than any complex concept.
- Revenue is earned, not received. Cash received in advance is a liability until earned.
- Margin means nothing without specifying which one: gross, contribution or operating.
- Burn should mean net cash outflow, and should be defined identically every month.
- Runway should be based on committed spend, not last month's average.
Frequently asked questions
For solvency, cash flow. For performance, profit and loss. For structure and risk, the balance sheet. Reading one without the others produces confident wrong conclusions.
It varies enormously by business model — software and distribution businesses are not comparable. The useful comparison is against your own trend and against companies with the same model.
Software records transactions; it does not exercise judgement on recognition, tax or presentation. Most companies need both, with the balance shifting as complexity grows.
Keep reading
Sources and further reading
Every factual statement on this page is checked against primary documentation. Terms change frequently, so confirm details with the provider before acting on them.
- FASB Accounting Standards Codification Reference point for accrual, expense recognition and close-process statements.
- Consumer Financial Protection Bureau — credit card resources Background on card terminology, billing cycles and consumer-vs-commercial distinctions.
- FDIC — deposit insurance and pass-through coverage Reference for how deposit insurance applies, including through third-party arrangements.