Starting and running a business can be a daunting, albeit often rewarding, task. One of the most confusing parts of 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.
In fact, a survey from the National Small Business Association shows that nearly 70% of small businesses rely on financial statements to make internal decisions. Understanding these statements is crucial for steering your business in the right direction. Let’s break down the three essential financial statements so you can grasp their importance and use them effectively.
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 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 is the basic accounting terms on the balance sheet. These terms are called Accounts Receivable (AR) and Accounts Payable (AP).
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 (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 of 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.
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:
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 from consecutive periods so that you can view trends in the revenue and expense items.
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. This 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, this financial statement can be one of the best tools for running a business. There are profitable companies that can go out of business because they are not paying attention to their cash flow!
There are three sections in this financial statement. They are cash flow from:
These 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.
The three fundamental financial statements are intricately linked to provide a holistic view of a company's finances.
The income statement, balance sheet, and cash flow statement are interconnected to provide a comprehensive view of your company’s finances. Net income from the income statement starts the cash flow statement and flows into the balance sheet as retained earnings. Depreciation, listed as an expense on the income statement, also reduces asset values on the balance sheet. The cash flow statement’s ending cash balance appears as an asset on the balance sheet, reflecting your company’s financial position for the next period. This integrated approach helps you understand how your business is performing and where improvements are needed.
At Accounovation, we specialize in more than just basic accounting. We provide clear, actionable insights tailored to your business. Our team simplifies complex financial statements, helping you make informed decisions that drive growth. Ready to take control of your finances? Contact us today to discover how our unique approach can empower your business.
Previous balance sheets provide a historical view of a company’s financial position. By comparing balance sheets over time, you can assess trends in assets, liabilities, and equity. This helps identify growth patterns, financial stability, and potential areas of concern, such as increasing debt or declining assets. Analyzing these trends allows you to evaluate the company’s overall financial health and make informed decisions.
Cash flow from investing reflects the cash spent or earned from activities like purchasing or selling assets. Negative cash flow from investing often indicates that a company is investing in its future growth, such as buying new equipment or expanding operations. While it might reduce cash reserves in the short term, it can lead to increased profitability and business expansion in the long run.
Depreciation is an expense that spreads the cost of a tangible asset over its useful life. On the income statement, it reduces taxable income, lowering overall expenses. On the balance sheet, depreciation decreases the value of fixed assets, reflecting their declining usefulness over time. In the cash flow statement, depreciation is added back to net income because it’s a non-cash expense, ensuring an accurate representation of cash flow from operations.