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The Three Main Financial Statements All Business Owners Should Understand
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Accounting is the language of business. One of the main purposes of accounting is producing financial statements that allow the individuals responsible for a business to make operational decisions. Without financial information, how can you make good business decisions? The answer is, you can’t. Numbers really do speak louder than words when it comes to business.
For this reason, understanding what financial statements are and using them effectively is a must for business success. More specifically, financial statements can help you keep track of expenses, manage your cash flow and track profits, among many other things. The size and nature of your business doesn’t matter either, any company can benefit from understanding and using financial information. If you’re a business owner and are looking to take the next step in your business, take a minute to understand what financial statements are and how you can use them to your benefit.
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What Are Financial Statements?
Financial statements are formal documents that describe the financial activities and position of an individual, business or other entity. Financial statements are meant to provide people with relevant, accurate and easy to read information to allow users, such as a business’s management team or an investor, to make decisions.
A decision that might need to be made is whether to hire employees, determine ways to become more profitable, whether to increase the cost of a product, whether to find a new vendor at a cheaper cost and so on. Every business has unique information needs, it’s up to you to decide what data is most valuable for decision-making purposes. As an example, if your business hasn’t been earning money lately, you’ll likely want to focus on the income and expenses your business incurs to find areas where you can spend less and earn more. In this situation, you would be most concerned with the profit and loss statement.
There are three main types of financial statements: balance sheet, profit and loss statement, and cash flow statement. Let’s explore these financial statement types below.
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A balance sheet shows the assets, liabilities, and equity a business has at a specific point in time. Think of a balance sheet as a snapshot of a business’s financial position on a particular date.
The formula that a balance sheet uses is as follows: Assets = Liabilities + Equity, it’s really that simple.
Assets are essentially everything a company owns that contributes value. Liabilities are debts and legal or financial obligations. Finally, equity is the portion of the company that the owners or shareholders own. Below are more detailed definitions of the components of a balance sheet.
- Current Assets. Cash or assets that can be converted into cash easily in a short period of time, typically a year. Examples of current assets include cash, accounts receivable, inventory, office supplies, and short term investments.
- Fixed or Long-Term Assets. Assets that will be held by the business for longer than a year. Examples of long-term assets include land, buildings, equipment, and long-term investments.
- Current Liabilities. Any obligations or debts that are payable in less than a year. Examples of current liabilities include accounts payable, taxes payable, short term loans, current portion of long term loans, and deferred revenue.
- Long Term Liabilities. Debts and obligations that are payable in over a year. Examples of long term liabilities include long-term loans and lawsuit debts due in over a year.
- Equity. Equity is broken down into the following subcategories: retained earnings and shares. Retained earnings are composed of all the profits and losses a company has incurred to date. Shares can have different classifications, such as preferred and common, and is the value an owner holds in the business.
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Profit and Loss Statement
Also commonly referred to as an income statement, this report communicates a company’s financial activity over a particular period of time, such as a month or year. An income statement has a more complex formula than the balance sheet which looks like this:
Income – Cost of Goods Sold = Gross Profit
Gross Profit – Operating Expenses = Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) – Interest, Taxes, Depreciation and Amortization = Net Profit or Loss
The simple version of the formula is: Income – Expenses = Net Profit or Loss
Let’s explore the components of a profit and loss statement further below.
- Income. Also known as revenue, income is the money a business earned selling their main products or services.
- Cost of Goods Sold. The money spent to directly produce the products or services a business sells. This could include raw materials and labour to produce.
- Gross Profit. The amount of money a business earned before considering indirect business expenses.
- Operating Expenses. All costs a business incurs that are not directly related to production but are required to do business. These costs could include employees’ pay, software, marketing, insurance, and so on.
- EBITDA. A value that is meant to represent a business’s operational health and earning potential without factoring in financing, accounting and tax decisions, or environments.
- Net Profit or Loss. The total amount of money a business earns after considering all expenses. This amount contributes to the retained earnings on the balance sheet.
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Cash Flow Statement
Last but not least, the cash flow statement portrays the cash that comes in and out of a business over a specific period of time. Accounting is typically done on an accrual basis which means that cash isn’t always paid or received, but the transaction is still recorded because it was incurred. This means that accounting doesn’t reflect the actual movement of cash which is why the cash flow statement was invented.
The cash flow statement classifies cash movement into three different categories: operating, financing, and investing activities. Let’s explore these in-depth below.
- Operating. Any cash received or used for a company’s main business operations will be reflected here. Keep in mind that no non-cash expenditures are considered here, such as depreciation or amounts earned but not paid by the customer yet.
- Financing. Any cash received or used for a company’s financing activities is reflected here. This includes changes to a company’s debt, dividends, or loans.
- Investing. Cash used or received for investment purposes is reflected here. The purchase of equipment or land is an example of an investment.
How to Start Producing Financial Statements
Most business owners don’t know the first thing about accounting – and you’re not alone. After all, what your business does is probably drastically different from anything to do with accounting or even math. Fortunately, there are tools and resources at your fingertips to help you.
To help you with your financial information needs, you can hire an accountant or bookkeeper, hire an external accounting or bookkeeping service, or purchase accounting software, such as Quickbooks. The option you choose depends on the amount you’re willing to spend and the level of financial information you wish to produce. If you’re willing to take a stab at learning the ropes yourself and want to save some money, your best bet is to use accounting software.
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