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Business Accounting Explained

Having a good understanding of business accounting is essential to run a successful company. Even with the best products and services and millions of dollars in sales, without knowledge and ...
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The Types Of Financial Statements And Why Each Is Important

Your company’s financial statements provide you with a wealth of information. They help you control expenses, allocate resources towards profitable business lines, and act as an important aid in decision-making - and that’s just for starters.

Unfortunately, many business owners don’t appreciate the significance of financial statement analysis and the many ways in which their review can help in improving business performance.

This could be due to a lack of understanding of how a balance sheet or an income statement is made. Often, entrepreneurs think that the preparation and study of financial statements are best left to the experts. So, they delegate the entire activity to a professional accountant or a CPA. While you can do that, it’s advisable to remain involved in your firm’s bookkeeping activities. 

To learn more why, check this read on 5 Things Accountants Should Focus on Today

Spend a little time in closely examining your company’s accounting records. What do your Balance Sheet and Income Statement reveal? Will a quick examination of your Cash Flow Statement tell you that your company could face a shortage of funds soon and that you need to take preemptive action quickly? Will it say everything is alright? 

(If you’re not very familiar with finance and accounting, it may be a good idea to review the information on the Business Planning and Financial Statements Template Gallery. This could be a useful resource for new entrepreneurs and those looking to learn more about finance.)

In this post, we’ll talk about the four primary financial statements and describe the significance of each for your business.

Before we begin, it’s critical to address a basic accounting issue.

Your accounting transactions can be recorded on either a cash basis or an accrual basis. What’s the difference?

Cash accounting: Revenue is recorded when money is received. So, a credit sale would be accounted for when cash is received and not when the goods are shipped. Similarly, expenses are accounted for when the payment is made. This method can be used not only for accounting, but for tax purposes as well. This method IS NOT an accounting method allowed in the accounting system by GAAP (Generally Accepted Accounting Standards) by FASB. 

Cash Method of Accounting, as defined by the financial-dictionary.thefreedictionary.com, is A system of accounting that recognizes revenue and expenses in the order in which they are received or made.

Let's look at an example to put things into perspective. 

  • Company A receives a bill for the building of office furniture. Using Cash Method Accounting that transaction becomes recorded when the company pays that bill.  
  • Company A receives a bill from Utility of $800 on September 18th,
  • Company A pays the bill from Utility of $800 on November 3rd, 
  • The cash transaction of $800 is recorded on November 3rd, and not September 18th, since the Utility was paid in November.

Accrual accounting: Revenue is recorded when it is earned. Expenses are accounted for when the cost is incurred. In other words, revenues and expenses are matched so that the accounts reflect sales, costs, and profits accurately.

The Accrual Method of Accounting, as defined by the accountingcoach.com, refers to adjustments that must be made before a company's  financial statements are issued.

Let's look an example to put things into perspective

  • Company A sends a bill to Client B for website creation. Using the Accrual Method Accounting the taxes are paid for the bill which is sent out, even if payment hasn’t been made.
  • Company A sends a bill to Client B of $600 on April 4th,
  • Client B pays the bill of $600 on July 16th, 
  • The taxes are paid for the bill sent on April 4th, despite the Client paying the bill on July 16th.

The accrual method provides more reliable financial data. Accrual method is the only method supported in the accounting system by GAAP. Furthermore, this method applies similarly to taxes. 

  • Company A sends a bill to Client B for website creation. Using the Accrual Method Accounting the taxes are paid for the bill which is sent out, even if payment hasn’t been made.
  • Company A sends a bill to Client B of $600 on April 4th,
  • Client B pays the bill of $600 on July 16th, 
  • The taxes are paid for the bill sent on April 4th, despite the Client paying the bill on July 16th.

In this post, we have assumed that the accrual basis of accounting is followed.

Balance Sheets

Think of a Balance Sheet as a document that provides a snapshot of your financial position at a specific point in time. A glance at this document can tell you:

  • The details of your company’s assets
  • Your liabilities
  • And the equity you hold in the company.

Why is this financial statement referred to as The Balance Sheet? The document presents assets on one side and liabilities + owner’s equity on the other. The two figures always balance out.

Balance Sheet Formula

Assets = Liabilities + Owner’s or shareholders’ equity

The preparation of your company’s Balance Sheet would be simplified with the use of a good accounting software package. Here are some advantages of using accounting software. The software would organize your financial accounts to create a Balance Sheet report based on your transactions and Journal entries. It’s also useful to know that the figures in The Balance Sheet are derived from the Trial Balance, which is a list of all the accounts in the company’s ledgers.

Your Balance Sheet provides a summary of what your company owns and owes. So, it will include particulars of cash, accounts receivable, inventory, machinery, and land and buildings. These are your firm’s assets. Additionally, The Balance Sheet reveals your company’s liabilities. There may be certain expenses you haven’t paid for yet. Or sums that you have borrowed from a bank or financial institution. Or salaries for previous month that due next week.

The third section of The Balance Sheet is about shareholders’ equity. This figure includes your initial capital as well as the retained earnings. Man examining balance sheet data with ZarMoney App

The Balance Sheet can tell you a lot about your business. For example, you could compare the current year’s Balance Sheet with that of the previous year. Has shareholders’ equity increased or decreased? What about accounts receivable? Are inventories rising without a proportionate increase in sales? 

The analysis you carry out could also extend to comparing your company’s Balance Sheet to that of firms in the same industry. Select a few financial statements examples from companies that are in a similar line of business. Reviewing these carefully could provide you with valuable insights about your competitors’ operations, what could you do better and where do you excel. 

Learn more about The Balance Sheet in this read by Wikipedia. 

Income Statements

While The Balance Sheet presents a company’s financial data on a specific date, an Income Statement, which is also known as a Profit and Loss Statement, tells you about its performance over a specific period. The period that The Income Statement covers could be of any length for which information is required. But it’s usually a year or a quarter. 

The particulars that The Income Statement include are:

  • Sales during the given period.
  • The costs and expenses associated with that period’s sales. 
  • Net earnings. 

So, you can see it’s a critical financial statement. Your business performance during the year is distilled into this statement. Income statement reveals profit details with ZarMoney

There is a couple of key things that you must remember about Income Statements. Firstly, they don’t differentiate between cash and non-cash receipts. So, a sale made on credit will also go towards increasing the company’s revenues during the period that The Income Statement covers. Secondly, one-off gains like the profit you make from selling land or your firm’s old equipment are also considered as revenue.

Discover more about The Income Statement in this guide by Corporate Finance Institute. 

Cash Flow Statements

Cash Flow Statements provide details about how cash was generated and used during a specific period. In other words, the cash flow statement tells you:

  • How the company spent its cash.
  • Where this cash came from.

Examining a cash flow statement with ZarMoney

Remember that for a business, CASH IS KING! A firm can boost its profitability by managing its cash efficiently. And The Cash Flow Statement, which is also known as The Statement of Cash Flows, is an essential aid for this task. 

Typically, The Cash Flow Statement would be broken up into three sections. The following table tells you what these are and provides examples.

The three major sections in a cash flow statement

Sources and uses of cash from

Explanation

Operating activities

Cash inflows and outflows from the company’s business operations

Investing activities

Cash flows from buying and selling property, equipment, and land and buildings. 

Financing activities

Cash flows from raising equity and debt and payment of dividends. 

Sometimes, there may be a fourth category as well. This fourth category would address any cash flows that don’t fall under the first three. 

Learn more about The Cash Flow Statement in this guide by Investopedia. 

Statements of Shareholders’ Equity

The Statement of Shareholders’ Equity provides details of the changes in the stockholders’ equity accounts over a period. During the accounting year, a company’s equity could be affected by various factors. These include:

  • Issue of stock.
  • Repurchase of stock.
  • An increase in retained earnings.
  • Payment of dividends.
  • Accounting for unrealized gains or losses on the company’s investments.

At this stage, let’s take a minute to revisit the first financial statement that we discussed in this post - The Balance Sheet. You would recollect that we presented The Balance Sheet formula: Assets = Liabilities + Owner’s or shareholders’ equity. Or, in other words:

Shareholders’ equity = Assets - Liabilities

Essentially, The Statement of Shareholders’ Equity provides information about the assets that could be available to the company’s owners after all its liabilities have been paid. This is why the statement of shareholders’ equity is important. It provides investors with information regarding the financial health of the company. Additionally, it can help the management decide about issuing additional stock. 

Learn more about Shareholders' Equity in this guide by Investopedia. 

The bottom line

Business owners should familiarize themselves with the four financial statements described above. Even if it takes some time to do this, it will be well worth the effort. You could gain valuable insights into your company’s financials. And it's quite likely that you'll also be able to determine the steps that could help you improve business operations and raise profitability.

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