3 Business Financials: The Balance Sheet, The Income Statement and The Cash Flow Statement.
There are a few financial statements which help to portray the financial and economic condition of a business. Yet, there are three main ones which were introduced in the previous post 40 Basic Accounting Principles. The main 3 Business Financials are the balance sheet, the income statement, and the cash flow statement. These are the top financials that business owners, business managers, and lending institutions look at. The following explains what these financials are, what they might look like and what they tell you:
The Balance Sheet:
The Balance Sheet follows the fundamental accounting equation (previously introduced in the 40 Basic Accounting Principles article): Assets = Liabilities + Equity (or Equity = Assets – Liabilities). Assets are any property that the business possesses with monetary value. Liabilities are money, products or services owed to other entities. Equity is the difference between assets and liabilities and/or the amount that the business actually owns upon which creditors have no claim. Each of these is divided into sub-categories called accounts, and some of these accounts are found in the other two financial statements. Recall this image which displays many of the accounts for a sample business:
Your business could have other accounts depending on your operations and your industry. The following is an example of a balance sheet for a fictitious company, adapted from the book Financial Accounting: A Mercifully Brief Introduction:
According to GAAP rules, assets and liabilities are divided into current and non-current classes (i.e the balance sheet follows a classified format). Current Assets are deemed likely to be converted to cash within one year (accounts receivable and inventory). Current assets are listed in order of liquidity, which is the ability to be converted into cash. Current Liabilities are expected to be paid off within a year.
A lender might look at the balance sheet to answer the questions, “does the company have sufficient liquidity to repay interest and principle?” and “what is the value of assets used to collateralize my loan?”
A business owner would look at the balance sheet to help answer the question, “what is my business worth?” However, the balance sheet doesn’t exactly state what the business is worth; it’s just a piece of the puzzle. Technically, the business in the image above could sell its assets piece by piece and realize a certain amount after liabilities. Yet, if the business is generating income over time it is actually worth more than just the value of its assets.
The liquidating value of a business is the amount that would be realized if the assets were sold. The going concern value is the price of all assets purchased together, under the assumption that the new owners could continue to operate the business. The difference between liquidating value and going concern value is called goodwill, which is the business’ ability to retain customers.
The Income Statement:
The income statement shows revenue and expense account balances (which are sub-accounts of equity). For many business owners, the income statement is a favorite of the three since the bottom line shows net income, or the income that the business generated after all expenses. Notice in the image below how the “net income” is the same number reflected as “current year income” in the balance sheet above.
The income statement is also called the profit and loss statement or P&L statement. It shows whether the business made a profit during that accounting period.
The Cash Flow Statement:
When a business uses accrual basis accounting, it will have accounts payable listed as liabilities and accounts receivable listed as assets. Yet, business owners and managers often need to know how much cash they have on hand to work with. In the image below, notice how most of the accounts are also listed on the other financial statements.
Operating activities are the ordinary buying and selling activities of the business. Investing activities comprise the purchase and retirement of fixed assets and investment in other businesses. Financing activities are cash flows derived from the issuance and repayment of long-term debt, and cash flows from equity contributions and draws to owners.
When a business wants to grow, a few options they have are to increase the sales force, increase their marketing, increase their operating equipment, add a new location, etc. If they don’t have the capital do grow at the pace they want, then they will probably look to investor capital or lending. That’s one of the reasons why the cash flow is important to know. When a business uses debt to finance its operations and grow, that’s called leverage.
The financial statements are used as guidelines or indicators of the performance and economic condition of a business. They show whether a business had good performance or poor performance during the accounting period. The financial statements do NOT explain why the business had good or poor performance. Business owners and managers must come to that conclusion based on additional information from marketing research, supervision of day-to-day operations, feedback from staff, and other information.
This article was not written by an accountant. Consult with an accountant or other qualified professional to perform accounting for your business.
Major source for this article: Financial Accounting: A Mercifully Brief Introduction by Michael Sack Elmaleh. Buying this book or a similar book would be beneficial to anyone who wants to learn accounting since the end-of-chapter examples and exercises can help to solidify the material in your mind. Another helpful resource is AccountingCoach.com.
For an explanation of why a marketing blog has posts on accounting, read September is Accounting Month.
If you have any questions on this article (or answers to questions), leave a comment below.