Being in charge, running the show, the top honcho are terms describing the president or owner of a business. Most people aspire to be at the top of their field, be the boss, and call the shots. However, perception and reality are not the same. With the leadership role comes responsibility for all aspects of a company. The one area of business ownership that trips most people up is accounting. Words such as debits, credits, and equity are new terms. As you work your way through the unfamiliar terminology, you’ll find you need to produce the financial statements. What makes up financial statements, and why do you need them?
Financial statements are the language of capital. They provide a picture of a company, which includes a business’s profitability, ability to pay debts, net worth, and inform stockholders and lenders about their investment. When a company needs a loan, the lending institution will ask to see the financials. Before taking a risk, they need to know if it is a smart bet.
While there are many types of accounting reports when referring to “the financials”, the big three are balance sheet, income statement, and cash flow statement. Each report tells a different story about the company. Here are the basics you need to know.
The balance sheet is a picture of the company on one day. The information listed includes assets, liabilities, and equity. Assets are things of value owned by a company. Examples of assets are checking accounts, equipment, supplies, in addition to many other items. If a business has borrowed money or purchased assets on credit, that shows up in the Liability column. But if an owner is investing additional funds or purchasing assets with company profit that shows up in the equity section on the balance sheet. Equity and liabilities on one side should equal the value of assets on the other side. That’s why it’s called a balance sheet and it tells banks that your numbers are in order.
The other important thing about balance sheets however is that, for a business to grow and handle unexpected costs, an additional source of funding is often necessary, other than just profit or owner contributions. For these situations, companies use notes payable, lines of credit, and credit cards. Reviewing the balance sheet, you can see if you are using too much debt to fund the company. Ask if the profit is adequate to sustain the current business model.
The income statement is a picture of the company’s revenue and expenses over a specific period of time. The time specified could be monthly, quarterly, yearly, or any period indicated on the statement. Revenue is the money received for products or services, and expenses are the cost of doing business. Expenses are current or long-term. Current expenses are purchasing items or services with a useful life of less than a year and include payroll, rent, and utilities. Long-term expenses have a useful life of more than a year and include equipment, improvements, automobiles. The long-term expenses are handled differently by depreciation, and we will cover it next week. Generating more revenue than expenses is a net profit, and if you spend more than you receive, it is a net loss.
The cash flow statement shows cash and cash equivalents (CE) coming into and out of a company over a specific time period. The report shows how well a company can pay debts and fund operating expenses. On the statement, the resources are broken down by operating, investing, and financing. Operating includes cash and CE from a company’s products or services. Investing involves funds from a company’s investments and included in this category is the purchase or sale of an asset or equipment. Financing includes loans received and paid, as well as payments of dividends. For many banks, cash flow is critical. When lending money, knowing a company has the resources to pay is vital.
Recording of accounting transactions into a program is only one step in the accounting process. Understanding the data in the system is imperative for a company’s success. Learning how to read the balance sheet, net income, and cash flow statement is a requirement for all business owners. As the top dog, you lead your business down the road of success.