May 29, 2025

Three foundational business equations everyone thinks they know well

Many people I have encountered throughout my professional and personal life believe in having a job, making money by hustling a side gig or creating a new business. Very few question the economic principles underlying their respective businesses and why they are sound. This is n…

This is not a fault nor a mistake. It’s just that these principles, expressed in very three simple equations, are so obvious that many have this false sense of knowing them deeply. I say false sense because, sometimes, one thinks one knows something when in fact and practice there is a lot of room to learn and improve.

But, what are these three equations and why are they so important? Well, as you will see, they are well known and you will – almost undoubtably – roll your eyes and be tempted to stop reading when presented with them.

And they are:

Income Statement: Profit = Revenue – (Costs and Expenses)
Balance Sheet: Assets = Debt + Equity
Cash Flow Statement: Change in Cash = Cash in – Cash out

Now, you will say: “I know these equations and what a lame way to get me to read half of you article, baiting me into thinking you were presenting something cool, new and different.” I beg you to continue, as in my experience 100% of the time (yes, all the times!) I go through these with my clients, they acknowledge gaining a new perspective for building a better intuition about their business.

Understanding the meaning of and interrelations between these equations will make your business life better. Here is their fundamental meaning in a nutshell:

The first equation, the Profit and Loss Statement, reflects the contractual obligations of the business
The second, the Balance Sheet, points to claims or rights on the assets of the business
The third, the Cash Flow Statement, manifests the impact of contracts on the cash of the business

Profit and Loss Statement: Contractual Obligations

Profit = Revenues – (Costs and Expenses)

This statement is widely used and referred to, but more as an accounting tool that highlights what happened in the past, which may not be as relevant looking forward (believe me, I’ve seen people pay little attention to it). However, what people often miss is the meaning behind the numbers. This equation tells you the contractual arrangements, reflected in money, the business has earned or incurred during a specific period.

Let’s talk about Revenues, which is one of the two components of the equation. Revenues are defined as the income generated from normal business operations and includes discounts and allowances for returns. This income is “earned,” that is, you have had to do something for someone or deliver something to someone to call that earned income. This is where explicit or implicit contractual obligations come to play.

For example, if you “sell” a car to someone, for let’s say, $100k and you sign a contract, you can be happy, right? Well, it depends on whether you delivered the car or not, and also on whether, if you delivered the car, they have paid or not. These variables pop up from the contractual obligation to deliver the car and to collect the cash. You can only “earn” revenue once the car is delivered and accepted.

Now, turning to Costs and Expenses. The same principle as Revenues applies here. When someone is supposed to deliver something to you (product or a service), you owe them once you have used or accepted their offering. This obligation can be implied by accepting the service or product or explicit as part of statement of work on a contract. Costs are typically associated with quantities that vary with items purchased or demanded and expenses are typically linked to a business period (week, month, quarter, year). Contracts govern what you pay for quantity and periods for things and people, so it’s very important to know what obligations you are getting yourself into.

The Balance Sheet: Claims on the Asset

Assets = Debt + Equity

This is a simple yet potent equation, as it tells you who has claims on the business’ assets at a specific point in time (typically, end of a period like a month, quarter or year). An asset is anything that can be converted to cash. Short-term assets are those that can be converted to cash in less than 1 year, and long-term assets are those take more than 1 year to convert to cash. I am not going to cover the whole gamut of assets that exist here, but one important one is cash! Cash is the fundamental, simplest asset a business owns. In addition to cash, a business can own property (both physical and intellectual), and other things that are needed for operations.

Assets are owned by “the business”, but it in turn the business is owned by people or other entities. People that hold equity typically have claims on the assets as owners, which means that I we were close the business, converting all assets into cash and distributing the cash to owners, people holding equity will receive the cash in exchange for their shares and the business would cease to exist. This class of ownership claim is called equity.

Debt, on the other hand, has also a claim on the assets of the business (there are many types of debt I will not get into here), but only if the business does not fulfill the obligation to the debt-holder. That is, if the business does not pay the interest or principal it agreed to pay on a given period, then the debt-holders (those people or entities who own the debt), can have a claim on the assets they had secured as collateral for making the loan. This claim has priority over the Equity holders, which means they have first-dibs at the cash proceeding from any liquidation event.

The Cash Flow Statement: Impact of Contracts

Change in Cash = Cash in – Cash out

You often hear people say “cash is king.” Well, that is very true. It means the cash account of your business is the reservoir that provides it with the necessary funding to run. Running the business, in this case, means understanding how the contractual obligations you have incurred, on revenues, expenses, costs, equity and debt, manifest themselves in cash flow.

For example, if you are very good at selling, but not good at delivering your product, you may start inadvertently accumulating debt that may hinder your ability to operate in the future. Let’s say you sell a set of large pipes to a refinery, but fail do deliver them on time, you can’t recognize the revenue until you deliver them. If the customer gave you cash, you have incurred a prepaid revenue liability. That is, you have cash in your bank account that is not yours yet! Imagine if you spend that cash on a retreat you promised your staff and you found out that something happened at the pipe plant that increased costs of production. If you realize you will not be able to produce enough pipes, you may end up in breach of contract, which may incur penalties and trigger remedies…not a good scenario. This is why knowing how your business’ cash flow works is key.

The whole point of looking at these equations through this new lens is to help you build the intuition of how various contractual obligations and claims on the assets impact your cash position. Without cash, a business cannot survive. Cash is like blood. You need an optimal range to live (not too little, not too much).

Your goal as a business owner, leader, or manager is to make sure these equations are balanced for the industry you are in, which signals a healthy business. There are prototypical de-facto standards that emerge for each type of industry, function and business configuration. Knowing which of those are relevant for your business can help you determine whether you are doing a good job or not.

Hope this helps you think differently about the financial statements.