Accounting is the language of business. Understanding accounting and its basic financial statements can be a very helpful skill. Financial statements are formal business reports that tell the activity that took place in a business. Regardless of the size of the business the structure of these reports is essentially the same. There are four financial statements, the balance sheet, the income statement, the statement of cash flow, and the statement of retained earnings. We will focus two of the most important, the balance sheet and income statement.
Balance Sheet
The balance sheet is a financial statement that reports what a business owns and it owes, at a particular day in time. Think of this financial statement as a picture or snapshot taken of the business that shows what it possesses and what its obligations are at a particular day and time. When you look at a balance sheet no matter what industry your looking at, there are three main sections in this statement, Assets, Liabilities and Owners Equity.
The first section of the balance sheet is what the company owns and has rights to, referred to as assets. Assets include cash, inventory, land, building, supplies, equipment and many other assets owned by a business. These assets can be divided into current assets and non-current assets. Current assets have a life span of 1 year or less and non-current assets are those with life span of more than a year.
The next section in the balance sheet is liabilities or what the company owes. As with assets, liabilities are divided into current and non-current liabilities. Current are all those liabilities that come due within the next year, and non-current are all those that are not due within the next year. This section includes all liabilities due within the next year, such as accounts payable, notes payable, income taxes due, and any other current debt due within the next year. Non-current liabilities or long term liabilities are those not due within the next year. These can be bank loans, deferred income taxes, or bonds issued not due within the next year.
The final section of the balance sheet is the owners’ equity, or stock holders’ equity. This section shows the total equity or interests the owner or owners have in the company. This ownership interest is shown by subtracting all assets from all liabilities. The remaining number is the ownership interest. This section is a little more confusing but not difficult to understand. This section varies from company to company depending on its legal structure.
If the business is a corporation the main accounts found in the owner’s equity section of the balance sheet are common stock and retained earnings. Common stock represents the ownership of the company in pieces if there is more than one owner. Retained earnings are the profits that were retained from a previous year or a previous period. When a business starts, this account is at a zero because there have been no earnings. What to learn from the balance sheet? The basic accounting formula for the balance sheet is assets = liabilities + owners equity, hence, “balance”. People for years have pictured accountants with the green visor crunching numbers for long periods of time in order to find out at the end of their calculations, the numbers didn’t balance. The balance sheet is a cornerstone report for business reporting and all business people should learn to use it.
Income Statement
The income statement is another very important financial statement. This statement’s purpose is to show the company’s bottom line the profit. Every industry has different accounts in its financial statements but the statements are essentially the same. Learning to read the income statement will help its reader to understand the health of the business. Unlike the balance sheet that takes a picture of the company, at a particular moment, the income statement shows activity for a period of time, usually quarterly or yearly. So the title of an income statement always has the phrase: “For the Period Ending."
The first section in the income statement is the revenue section. It represents the company’s main source of revenue for goods sold or services rendered. In manufacturing or re-sale companies, cost of good sold is the section just below revenue. Cost associated with the purchase or manufacturing of a good made available for sale are included in this account. Below these two accounts you will see a total called gross profit. It is simply the difference between revenues and cost of goods sold, never the less it is an important number. Gross profit shows how much income is left to cover all expenses.
The next section shows all operating expenses. Expenses are separate so the reader can see the extent of every expense. List of expenses include rent expense, supplies expense, gas expense, salary, payroll expenses, and any other expense incurred by the company is separated and accounted for in this section. All expenses are added and subtracted to gross profit and the total is called, operating income or income before income taxes.
This number is important to bankers, investors and other stakeholders of the company because it shows what is available to the owners before a few other items need to be paid such as stock dividends or income taxes. The last number and most likely the most important number to the income statement reader is the net income. This number represents the profit left to the owner or shareholders after all expenses have been paid. If it is a net loss, this means there is no profit and the company is losing earnings.
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