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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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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.
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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.
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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.
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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