Basic Accounting Guide

While many financial statements can be extremely complicated, the most fundamental accounting items all businesses should be conscious of are contained in the balance sheet, the income statement, and the statement of cash flows.

Balance Sheet

This is the primary statement to look at when evaluating your business condition.  It rolls all activity into one report for a specific point in time. It contains assets, liabilities, and equity. These items essentially paint a picture about future cash inflows and outflows and the net worth of the business.  The items common to most businesses are:

  1. Cash – Always the first asset listed. The amount in your accounting records should be reconciled to your bank balance.  This can be rolled up into one item or shown as separate items if there are multiple bank accounts.
  2. Accounts Receivable – The next most common asset. This is what your customers or clients owe you and is a future cash inflow. When an invoice is sent to a customer, an accounts receivable asset is created.
  3. Accounts Payable – This is the most common liability. When you receive a bill from a vendor an accounts payable liability is created.  It represents money you owe and a future cash outflow.
  4. Owner’s Equity – This section of the balance sheet represents the difference between all assets and liabilities and at its most basic level shows the net worth of the business.

Income Statement

The income statement, or Profit & Loss statement, breaks down all the financial performance for a given period of time.   It can be set up to track activity over any period but is usually prepared monthly, quarterly, and annually.  Items in the income statement can be thought of as what accounts for the change in balance sheet items between periods and ultimately the owner’s equity.  The major items are:

  1. Revenue – This amount is composed of all sales numbers. Both credit and cash sales are included.
  2. Expenses – Any costs to the business recognized during the period. This can include any administrative costs that aren’t paid ahead of time, depreciation from equipment, taxes, and interest.  If the business deals with inventory then cost of goods sold will also be included.
  3. Net Income (Or Loss) – This is the bottom line. Every business wants to see a profit and the net income number will reflect that if its sales outweigh its expenses.  A loss or smaller than expected profit can be explained through careful analysis of income statement.

Cash Flow Statement

The statement of cash flows explains and presents all the detail behind the change in cash amounts on the balance sheet between periods.  Many businesses consider this to be the most important statement as they live by the mantra of “cash is king” and the ability to successfully manage and plan transactions contained in it will often be the deciding factor in their success. This statement has three sections:

  1. Operating Activities – This section essentially presents all the cash aspects of the income statement. It can be presented in either the direct or indirect format. The indirect format presents only the cash portion of all items on the income statement and cash inflows and outflows related to some balance sheet items.  The direct format is arranged into more general categories such as cash paid and received from customers and vendors.
  2. Investing Activities – Includes cash inflows and outflows related to the sale and purchase of capital assets like land or property, plant, and equipment.
  3. Financing Activities – If a business sells or buys shares of ownership in itself or issues debt to fuel growth, it will appear in this section.

These are all the major pieces of the financial puzzle that when combined provide an accurate portrayal of the state of your business.  Understanding the basics is a great step you can take to help improve your bottom line and increase your business’s net worth.