The reading level for this article is Moderate
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 Balance Sheet:
Assets = Liabilities + Net worth |
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).
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.
Balance Sheet Categories
Assets and liabilities are broken down into categories as described as follows:.
Assets: An asset is anything the business owns that has monetary value.
Current Assets include cash, government securities, marketable securities, accounts receivable, notes receivable (other than from officers or employees), inventories, prepaid expenses, and any other item that could be converted into cash within one year in the normal course of business.
Fixed Assets are those acquired for long-term use in a business such as land, plant, equipment, machinery, leasehold improvements, furniture, fixtures, and any other items with an expected useful business life measured in years (as opposed to items that will wear out or be used up in less than one year and are usually expensed when they are purchased). These assets are typically not for resale and are recorded in the Balance Sheet at their net cost less accumulated depreciation.
Other Assets include intangible assets, such as patents, royalty arrangements, copyrights, exclusive use contracts, and notes receivable from officers and employees.
Liabilities: Liabilities are the claims of creditors against the assets of the business (debts owed by the business).
Current Liabilities are accounts payable, notes payable to banks, accrued expenses (wages, salaries), taxes payable, the current portion (due within one year) of long-term debt, and other obligations to creditors due within one year.
Long-Term Liabilities are mortgages, intermediate and long-term bank loans, equipment loans, and any other obligation for money due to a creditor with a maturity longer than one year.
Net Worth is the assets of the business minus its liabilities. Net worth equals the owner’s equity. This equity is the investment by the owner plus any profits or minus any losses that have accumulated in the business.
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/vehicleexpenses, 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 (or Loss) before Tax (the figure on which your tax is calculated)
Less Income Taxes (if any are due)
Equals Net Profit (or Loss) After Tax
Calculating the Cost of Goods Sold
Calculation of the Cost of Goods Sold category in the Statement of Income (or Profit-and-Loss Statement as it is sometimes called) varies depending on whether the business is retail, wholesale, or manufacturing. In retailing and wholesaling, computing the cost of goods sold during the accounting period involves beginning and ending inventories. This, of course, includes purchases made during the accounting period. In manufacturing it involves not only finished-goods inventories, but also raw materials inventories, goods-in-process inventories, direct labor, and direct factory overhead costs.
Regardless of the calculation for Cost of Goods Sold, deduct the Cost of Goods Sold from Net Sales to get Gross Margin or Gross Profit. From Gross Profit, deduct general or indirect overhead, such as selling expenses, office expenses, and interest expenses to calculate your Net Profit. This is the final profit after all costs and expenses for the accounting period have been deducted.
