Do you know what the three big numbers are that every business owner should know?
If you're in business, it's important to be able to read your financial statements to understand the state of your business.
Basically, financial statements (or financial reports) are a record of a business’ financial flows and levels and while they may be confusing at first glance, the information that's important is easy to find.
The big three statements that every business owner should be able to understand are:
- Balance sheet which describes a company's assets and liabilities.
- Income statement – this is commonly called the ‘profit and loss statement’, which describes a company's income and expenses.
- Statement of Cash Flow which describes how corporate operating, investment, and financing activities have affected the company's cash position.
For large public companies especially, these statements are often complex, so an extensive set of ‘Notes to the Financial Statements’ and management discussion and analysis is usually included. The notes will typically describe each item on the Balance Sheet and Income statement in further detail. In many cases the notes are much longer than the financial statement they are explaining.
For small businesses, financial statements are easier to read.
Balance Sheet
A balance sheet, in formal bookkeeping and accounting, is a statement of the book value of a business at a particular date in time, usually at the end of its ‘financial year’. This differs from the income statement, also known as a profit and loss account (P&L), which records revenue and expenses over a specified period of time.
The balance sheet describes a company’s assets and liabilities, from which you can work out the value of the business by subtracting the value of liabilities from the value of the assets. Ideally this number should be positive.
Assets
Assets are usually any items of value owned by the business that could be converted to cash. Examples include cash, securities, accounts receivable, inventory, office equipment, real estate, a car, and other property.
From an accounting perspective, assets are divided into the following categories:
- Current assets (cash and other liquid items)
- Long-term assets (real estate, plant, equipment)
- Prepaid and deferred assets (expenditures for future costs such as insurance, rent, interest)
- Intangible assets (trademarks, patents, copyrights, goodwill)
Liabilities
Liabilities in general, are something that you owe somebody else. They are defined as a company's legal financial debt, or obligations, that arise during the course of running the business. Liabilities include: loans, taxation and trade creditors.
Business owners should not confuse expenses with liabilities though.
Liabilities are listed on a company's balance sheet, whilst expenses are listed on the company's income statement. Expenses are the costs of a company's operation, while liabilities are the obligations and debts a company owes.
Income Statement
An income statement, otherwise known as a profit and loss statement, is a summary of a company’s profit or loss during any one given period of time, such as a month, three months, or one year.
The income statement records all revenues for a business during this given period, as well as the operating expenses for the business.
It is very important to format an income statement so that it is appropriate to the business being conducted.
Income statements, along with balance sheets, are the most basic elements required by potential lenders, such as banks, investors, and vendors, as they will use the financial reporting contained in them to determine credit limits.
Statement of Cash Flow
The ‘Cash Flow Statement’ reports the amount of cash coming in (cash receipts) and the amount of cash going out (cash payments or disbursements) during a specified period.
Business activities result in either a net cash inflow (receipts greater than payments) or a net cash outflow (payments greater than receipts) during a period.
The cash flow statement shows the net increase or decrease in cash during the period and the cash balance at the end of the period. It explains the causes for the changes in the cash balance. The cash flow statement covers a span of time.
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This article was written for a bookkeeping firm