Keeping track of the money in your business is essential if you want to prosper. However, most small business owners have skills or a specialty that inspired them to start a company—and it was not number crunching.
Understanding finances and basic accounting is a critical skill, as important as making and marketing your product. To stay informed on your business finances without the help of an accountant or financial planner, you need a solid grounding in basic accounting statements. Here is an overview of the four most important.
The point of the balance sheet is to provide a detailed look at your business financial situation on a given date. It is made up of three main components: assets, liabilities, and equity.
There are two primary categories of assets. The first are called current or liquid assets. These all have the ability to be easily and quickly converted to cash. These are typically cash, marketable securities, accounts receivable, inventory, notes receivable, and items like prepaid insurance.
The second type are called fixed assets, like land, equipment, and buildings. Fixed assets get listed on your books at their historical cost, which is often less than what you could sell them for on the market.
Liabilities are what the business owes others, your creditors. There are also two types of these. Current liabilities, also called short-term, include the wages you owe, accounts payable, notes payable, and interest payable. Long-term liabilities are debt that are due in more than a year from the balance sheet date. These include items such as your mortgage or bonds payable.
Equity is what the business owes its owners. After the assets are used to pay all your creditors and outstanding liabilities, what remains belongs to you.
A simple formula is:
Equity = Assets – Liabilities
Often called the Profit and Loss or P&L, this gives a look at your company in terms of net profit or loss for a particular period. The two parts are:
Income: what you earned, such as revenue from sales or income from dividends.
Expenses: what your business paid out for items such as wages, rent and other costs of doing business. Depreciation expenses are also included here, which are typically accounting adjustments to asset values.
The simple formula for this is:
Income – Expenses = Net Profit
Statement of Owner’s Equity
Also called a Statement of Retained Earnings, this accountant report lists in detail the change or movement of an owner’s equity over a given period. It has five parts:
- Net profit or loss, which gets reported in the income statement
- Share capital, which is the portion of a company's equity that has been obtained by trading stock for shareholder cash
- Dividend payments
- Gains and losses in equity
- Results attributable to a change in accounting policy or a correction of a previous accounting error
Cash Flow Statement
The Cash Flow Statement documents the changes and movement of your cash and bank balances during a specified period. It has three parts:
Operating activities: these include the flow of cash from the main activities of your business
Investing activities: these include cash flow involved in the sale and buying of assets unrelated to inventory. An example would be buying a new factory.
Financing activities: these include money made or spent on raising share capital, issuing or repaying debt, as well as paying interest and dividends
All four financial statements are closely inter-related. While the intricacies may be confusing, a fundamental understanding of the essential accounting statements and the information included in them is beneficial for the small businessperson to master. Making a skilled accountant part of your team is the best way to stay on top of the arcane, confusing world of numbers that tell the story of how your company is doing.