Three Basic Accounting Financial Statements Every Businessperson Should Know

Three Basic Accounting Financial Statements Every Businessperson Should Know

 Starting and running a business can be a daunting, albeit often rewarding, task. One of the most confusing parts being a small to mid-sized business owner can be getting your brain around the accounting terms your CPA throws at you. I am going to condense some basic accounting terms for you. This will allow you to comprehend the confusing, and sometimes seemingly gibberish terms that you need to know to maintain a healthy bottom line.

Balance Sheet

The Balance Sheet is one of the three most common financial statements that are produced by accountants and CPAs. It is used to reveal the financial status of a business at a specific point in time. The Balance Sheet shows assets (what the business owns) and liabilities (what the business owes). The business also shows equity. Equity is basically the difference between what you own versus what you owe (assets minus liabilities). 

When you look at a balance sheet you will see two columns. The left side shows assets (what you own) and the right side shows liabilities (what you owe). 

One issue that confuses people are the basic accounting terms on the balance sheet. These terms are called Accounts Receivable (AR) and Accounts Payable (AP). 

Accounts Receivable

Accounts Receivable (AR) is revenue for the sales and services you have provided even though you may not have collected payment yet. You would record this as an asset (left side) because Accounts Receivable will likely convert to cash in the short-term. Even though you may not have the cash in hand, it is still considered an asset. An asset is anything a company owns that has monetary value. Therefore, Accounts Receivable would be seen on the left side of the balance sheet. 

Accounts Payable

Accounts Payable (AP) on the other hand are listed on the right side. These are expenses and debts you owe but have not paid yet. These are liabilities.

On a balance sheet, assets are listed in order of liquidity from cash (the most liquid) to land (the least liquid). Liabilities are usually divided into two major categories – current liabilities and long-term liabilities. They are then listed in order of shortest term to longest term which helps you understand what is due and when. 

Finally, equity shows the value of the company after liabilities have been subtracted from assets. Equity is the portion of the company that is owned by the owners and investors.  While equity may give you some idea what the value of your company is, it is not a complete picture.  Equity does not account for any goodwill or other intangibles that you may have developed as part of your business.  

Income Statement

The second financial statement you will need to become familiar with is the Income Statement. An Income Statement summarizes the revenues, costs, and expenses incurred during a specific period. These are usually prepared quarterly or yearly. 

Revenue earned is shown at the top of the report and expenses are subtracted until all the expenses in a given period are accounted for. This includes:

• the cost of goods sold (expenses directly related to the creation of a product or service such as materials and direct labor, and overhead)

• sales and administrative expenses (also known as SG&A)

• depreciation (accounts for the loss of value of an asset such as equipment and vehicles) and taxes

This results in net income which is another basic accounting term and delineates the dollar amount earned in profits. 

The purpose of the Income Statement is to show how much profit or loss your company generated during a specific reporting period. This is an extremely valuable report when you group several Income Statements together from consecutive periods of time so that you can view trends in the revenue and expense items. 

Cash Flow Statement

A Cash Flow Statement is another basic accounting financial statement. It provides information regarding all cash inflows and outflows that a company receives or uses from its ongoing operations, investment, and financing activities during a given period. The Cash Flow Statement enables investors and creditors to understand how a company’s operations are run, where the money is coming from, and how the money is being spent. It measures how well a company manages its cash, as well as how it generates cash to pay its debt and operating expenses.  While often overlooked, the Cash Flow Statement can be one of the best tools for running a business.  There are profitable companies that can go out of business because they were not paying attention to their cash flow!   

There are three sections in a Cash Flow Statement. They are cash flow from:

1. Operating activities; cash earned or spent during regular business activity. In other words, this shows the main way your business makes money either by selling products or services.

2. Investing activities; cash earned or spent from investments such as purchasing equipment or investing in other companies.

3. Financing activities; cash earned or spent through financing your company with loans, lines of credit, and/or the owner’s equity.

Cash Flow Statements are essential as they show your liquidity, show changes in assets, liabilities, and equity, and help you predict future cash flows. All of these are important for making long-term business plans. 

All three of these financial statements are vital to running a successful and profitable business.  

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