Thinking about starting your own small business, but you’re intimidated by the thought of managing all your records and handling your own accounting? The good news is you don’t have to be a genius or a financial wizard to understand and prepare basic financial statements for your company. It’s not difficult to learn the basic elements of business accounting that go into preparing these documents, and knowing how they work will serve you well as you manage your company’s finances and make important business decisions.
The three financial statements that are most important to small businesses are balance sheets, income statements and cash flow statements. Here’s what you need to know about each one of them to ensure your business’ financial records are always accurate and current.
Balance Sheet: A Snapshot of Assets, Liabilities and Shareholders’ Equity
As a fundamental financial statement that contains detailed information about a company’s assets, liabilities and shareholders’ equity, a balance sheet is an essential part of your company’s financial records and should be one of the first documents you create. The information on a balance sheet is separated into sections, with all your company’s assets listed and totaled at the top and all its liabilities and shareholders’ equity listed and totaled at the bottom.
Assets are anything of value that your company owns as well as any cash in bank accounts. The term generally applies to anything that could be sold or used by the company itself to create value. Examples of assets include physical property, such as furniture, vehicles, equipment and inventory. Intangible items that have value and could be sold, such as patents and trademarks, are also included in a company’s assets. This also applies to any stocks, bonds or other financial investments a company makes. Accounts receivable amounts also count as assets, even if the funds haven’t been collected yet.
Your company’s liabilities consist of any debts owed to lenders, other businesses and individuals. This could include a variety of obligations, such as loans to purchase business property or launch a new product, outstanding balances owed to suppliers for materials, unpaid payroll expenses, and taxes owed to the government, just to name a few. Liabilities may also include obligations to provide goods or services to clients in the future.
Shareholders’ equity is the official term used in the liability section on a spreadsheet, but it may help to think of it as owner’s equity for your small business if you don’t have outside shareholders. This equity is the amount of profit that remains after all the company’s liabilities are paid — often referred to as net worth or net assets.
Although shareholders’ equity is a positive amount that indicates profit, it appears in the liabilities portion of the spreadsheet because it doesn’t belong to the company — a non-living entity. It belongs to the investors in the company, either the owners or its shareholders (or both), and it remains on the spreadsheet as a liability until it is paid out to the investors or invested back into the company.
The main rule of a balance sheet is that the two sections — assets and liabilities/shareholders’ equity — must always “balance” by totaling the same amount. It works in much the same way as a mathematical equation. Any amount added to the company’s assets at the top must also be added to the company’s liabilities at the bottom. A balance sheet doesn’t show how cash flows in and out of the company during any particular period, but it does provide an overall snapshot of a company’s general financial strength.
Income Statements: A Finger on the Pulse of Profits or Losses
An income statement outlines how much revenue a company earned during a specific time period. It also shows all the expenses that were associated with earning that revenue. The statement’s literal bottom line shows the company’s net earnings or loss after those expenses are deducted — which explains all those references to a company’s “bottom line” in relation to their financial success or failure.
Income statements also have lines for calculating earnings per share (EPS) for companies that issue stock. That number is the amount shareholders would receive for each share if the company decided to distribute all of its net earnings for the period. In most cases, those earnings are reinvested into the business, sometimes with a small amount per share known as a dividend paid out to the shareholders in cash.
When you create an income statement, you will include lines with the total sales, receipts and other gains at the top of the statement. Under the revenue section, you will detail all the expenses your company incurred during the period, such as rent, utilities, wages and cost of goods sold. Any cost associated with operating the business and earning the revenue goes in this section. The net income section at the bottom subtracts all those expenses from the company’s total income to calculate your profit or loss. You may also hear this process referred to as taking “gross revenues” and subtracting expenses to reach a “net revenue” number.
In general, income statements serve as an excellent way to take the pulse of a company to see where it stands on making a profit or suffering a loss during a specific fiscal accounting period. This provides helpful information about the overall viability of your company.
Cash Flow Statements: A Record of Cash In and Cash Out
While income statements reveal the total profit a company made during a period, this financial statement doesn’t actually provide any information about a company’s ability to pay its expenses and purchase assets with the cash it has on hand. In many cases, income doesn’t immediately translate into cash received, and expenses don’t immediately translate into cash spent, which is why cash flow statements are so important to a company’s operation.
A cash flow statement includes some of the same information found on your balance sheet and income statement, but it organizes the information based on how it impacts the amount of cash you have on hand and determines your net increase or decrease in cash for the period. Tracking your actual cash on hand is critical when you need to immediately pay an expense like wages. To be clear, cash on hand is exactly what it sounds like — the total amount you could walk into the bank and withdraw on the spot.
Cash flow statements are usually divided into three main parts: operating activities, investing activities and financing activities. Cash from operating activities comes from a company’s net income or loss, but instead of simply showing all the income and expenses for a period, it shows the actual income received as cash and the actual expenses paid out in cash by the company. It also adjusts the numbers to account for non-cash items included as income or expenses.
Cash from investing activities outlines the cash flow from all investing activities, such as asset purchases or sales and loan payments received from customers. Cash outflows of this type often involve cash purchases of long-term assets, such as equipment, property and investment securities. On the other hand, the sale of that type of investment would result in a cash inflow for investing activities as soon as the money is received.
Cash for financing activities generally relates to cash received or paid as loans from banks and financial institutions. Stock repurchases and dividends paid to shareholders are also included in cash flow from financing activities.
Putting the Three Financial Statements to Work for Your Business
When you’re starting your own small business, these three financial statements provide the core foundation for organizing and recording critical financial information for your company. Besides helping you personally monitor your company’s progress, they also contain the relevant information banks and financial institutions need to provide you with loans and credit as well as the figures the IRS needs for income tax purposes. Regardless of the type of business you own, learning how to complete these three financial statements will put you on the road to proper business accounting.