Financial Statements record the performance of your business and allow you to diagnose its strengths and weaknesses by providing a written summary of financial activities. There are two’ primary financial statements: the Balance Sheet and the Statement of Income.
The Balance Sheet
The Balance Sheet provides a picture of the financial health of a business at a given moment, usually at the close of an accounting period. It lists in detail those material and intangible items the business owns (known as its assets) and what money the business owes, either to its creditors (liabilities) or to its owners (shareholders’ equity or net worth of the business).
Assets include not only cash, merchandise inventory, land, buildings, equipment, machinery, furniture, patents, trademarks, and the like, but also money due from individuals or other businesses (known as accounts or notes receivable).
Liabilities are funds acquired for a business through loans or the sale of property or services to the business on credit. Creditors do not acquire business ownership, but promissory notes to be paid at a designated future date.
Shareholders’ equity (or net worth or capital) is money put into a business by its owners for use by the business in acquiring assets.
At any given time, a business’s assets equal the total contributions by the creditors and owners, as illustrated by the following formula for the
Assets = Liabilities + Net Worth
(Total (Funds (Funds funds supplied supplied invested in to the to the assets of business business the by its by its business) creditors) owners)
This formula is a basic premise of accounting. If a business owes more money to creditors than it possesses in value of assets owned, the net worth or owner’s equity of the business will be a negative number.
The Balance Sheet is designed to show how the assets, liabilities, and net worth of a business are distributed at any given time. It is usually prepared at regular intervals; e.g., at each month’s end but especially at the end of each fiscal (accounting) year.
By regularly preparing this summary of what the business owns and owes (the Balance Sheet), the business owner/manager can identify and analyze trends in the financial strength of the business. It permits timely modifications, such as gradually decreasing the amount of money the business owes to creditors and increasing the amount the business owes its owners.
All Balance Sheets contain the same categories of assets, liabilities, and net worth. Assets are arranged in decreasing order of how quickly they can be turned into cash (liquidity). Liabilities are listed in order of how soon they must be repaid, followed by retained earnings (net worth or owner’s equity), as illustrated in Figure 2-1, below, the sample Balance Sheet for ABC Company.
The categories and format of the Balance Sheet are established by a system known as Generally Accepted Accounting Principles (GAAP). The system is applied to all companies, large or small, so anyone reading the Balance Sheet can readily understand the story it tells.
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The Statement of Income
The second primary report included in a business’s Financial Statement is the Statement of Income. The Statement of Income is a measurement of a company’s sales and expenses over a specific period of time. It is also prepared at regular intervals (again, each month and fiscal year end) to show the results of operating during those accounting periods. It too follows Generally Accepted Accounting Principles (GAAP) and contains specific revenue and expense categories regardless of the nature of the business.
Statement of Income Categories
The Statement of Income categories are calculated as described below:
- Net Sales (gross sales less returns and allowances)
- Less Cost of Goods Sold (cost of inventories)
- Equals Gross Margin (gross profit on sales before operating expenses)
- Less Selling and Administrative Expenses (salaries, wages, payroll taxes and benefits, rent, utilities, maintenance expenses, office supplies, postage, automobile/vehicle expenses, insurance, legal and accounting expenses, depreciation)
- Equals Operating Profit (profit before other non-operating income or expense)
- Plus Other Income (income from discounts, investments, customer charge accounts)
- Less Other Expenses (interest expense)
- Equals Net Profit (Loss) Before Tax (the figure on which your tax is calculated)
- Less Income Taxes (if any are due)
- Equals Net Profit (Loss) After Tax
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