One of the main products of any accounting system is the financial statements. These are used by companies of all sizes to measure and monitor the health and well-being of the organization. The most important statements are the Balance Sheet, the Income Statement and the Cash Flow Statement. This is the first installment of a multi-part series on understanding and using financial statements.
Balance Sheet
The Balance Sheet is like a picture of the organization at a point in time. The end result of the operation of the business since its inception. It contains two major sections, the Asset section, and the Liabilities and Equity section. Total Assets equals, or balances to, the total of the Liabilities plus the Equity, hence the name. Assets are things that belong to the entity: bank accounts and investments, inventory, furniture and equipment, accounts receivable, etc. Liabilities are amounts that the business owes to others: accounts payable, loans from owners and others, mortgages, leases, etc. The Equity section is a recap of the owners interest in the company from an accounting standpoint. It is made up of amounts invested by the owners, plus the net income of the company since its inception, less any withdrawals by or distributions to the owners. Reviewing the balance sheet can show you where your funds came from and where you invested it in the business. Comparing multiple periods can show you trends and changes in the operation of the business.
Income Statement
The Income Statement, or Profit and Loss Statement, is the scorecard of the business for a given period. Typically, a month and/or a year. The Income Statement has three major sections, the income section shows the total income of the business, generally sales or fees. Various discounts that reduce the sales can be included in this section. The next section is the Cost of Goods Sold. This section details the cost to produce the goods or services sold sold during the period. The last section contains operating expenses. These are the other expenses that are incurred in running the business and include: rent, employee expenses, advertising, education, dues, utilities, postage, etc. A good way to think of this is that the Sales less the Cost of Goods Sold provides the income to fund the remaining expenses of the business. As long as there is money left over, Net Income, the business is operating at a profit. The Net Income, or bottom line, is added to the Equity section to keep the balance sheet in balance. The Income Statement shows very directly how well the business is doing. Comparing similar periods allows you to determine if the operation of the business is improving or declining.
Cash Flow Statement
Cash is the lifeblood of any entity. If you do not have more cash coming in than going out the business will ultimately fail. The cash flow statement is all about the cash, where it comes from and where it goes. It uses information from both the Income Statement and Balance Sheet to arrive at the change in cash for the period. Entities that keep their accounting records as cash basis may not use the cash flow statement as much as one that keeps accounting records as accrual basis. Cash flow statements are generally broken down between operating results, investing activities and financing activities. Cash from operating activities begins with entity income, adjusted for non-cash elements of the activity. Investing activities, or uses of cash, details the outflow of cash for capital assets like equipment or actual investments. Financing activities, or sources of cash, details the non-operating activity like borrowing or raising equity that increases cash balances. Ideally funds from operations will meet the cash needs of the entity except for special circumstances.
Summary
Understanding and regularly reviewing your financial statements is key to managing your business. You will be able to tell if the business is making a profit, how the money is being spent and if the business is improving over time. I have spent literally thousands of hours learning about, preparing, and using financial statements to guide business owners. Let me help you through the process of using and understanding yours.