Breaking Down a Company’s Financial Statements
One part of running or operating a business is accounting.
Business accounting includes managing the books, handling different accounts, and categorizing different transactions. Every transaction, every business deal, and anything that involves finance is also going to involve or incorporate accounting in some capacity.
The nature of the transaction, the corporate structure and the tax implications will determine the level of work or detail needed from an accounting point of view.
For a small business, accounting is either something that the owner/operator can do themselves, or they can outsource it to another company to do on their behalf.
However, there is a range of software and technology available today to make the process easier, which makes it possible to do your own accounting. A lot of software packages automate the process and make it easy for you to organize the three important financial statements: the balance sheet, the income statement, and the cash flow from operations statement. These three statements are at the core of accounting for every business.
Accounting is interconnected to finance. Companies financial departments or divisions usually work with or on tasks that involve accounting divisions. The different financial statements, like the balance sheet, income statement and cash flow statement, are often checked and confirmed as accurate by the accounting department. Whether its accounting or finance, its essential to understand a company’s financial statements.
To begin, we’d like to discuss the difference between debits and credits. A debit means add, and a credit means deduct.
The Balance Sheet
The balance sheet is a tool that shows you the different accounts and the balances within each.
It takes a present time view into what the business has and illustrates the assets and liabilities of each account. You’re able to see what the business owes, who they owe, and what they owe for. The equation that defines the balance sheet is assets equals liabilities plus owner’s equity (Assets = Liabilities + Owner’s Equity).
The asset account is where you categorize or input the different assets your company or business has. This can be cash, accounts receivable, inventory, or even prepaid expenses. Your assets are the resources that a business has or that is able to use. You or the business possess things to run and operate the business.
The liability account is for items or things that you owe others for. It’s your responsibility and your businesses to pay for them. Whether these are expenses you owe or interest you’ll have to pay back in the future, liabilities are things that either you have accrued (spent) or owe to other parties for one reason or another.
The Difference Between Asset Accounts and Liability Accounts
An asset account functions the way you’d expect it to. The more you add (debit) to the accounts, the more the balance increases, just as the more money you put into the bank, the more cash is in your account. When you spend or deduct (credit) money, the less cash you have in the bank.
A liability account functions in the opposite way. It’s considered a contra account. The more you add to a liability account, the more you owe and the less money you ultimately have. Think of a liability account as a credit card: when you spend money the balance increases and, as a result, you owe more money. How do you get the balance to decrease? You have to credit (deduct) from your cash (assets) to add (debit) money to the credit card.
The Income Statement
The income statement is the place where you organize the income during a particular period, and the expenses incurred during the same period. It’s the place to see all the transactions and the bottom line.
The income statement shows you the income you received, the expenses you’ve incurred, and the money you made. The goal is to organize all the transactions in one place and show the income earned during a period.
The importance of the income statement is that it shows the current state of a business’s operations. You’re able to see during a particular state or certain period how the business is functioning. Depending on the company, the stage of the business, and the marketplace, you’ll be able to see what a company is doing by seeing where they are earning their money, what they are spending their money on, and how much of the money that coming in they are retaining after everything is taken out.
You’re also able to glimpse the current stage of a company’s business cycle in the income statement. You can see by looking at past income statements whether they are in growth mode. You can see if they are reinvesting their profits into the business. You can see if they are trying to find new areas or places of growth. You’re able to see the expenses the company finds important or essential to their business. You’re also able to see where and how the company is experimenting with research and development.
The Cash Flow Statement
The cash flow statement is the place where you see the different activities the company is participating in. There are three categories in this statement: financing, investing, and operating activities.
The financing activities primarily deal with raising money, paying off interest, and the cost of banking or capital, like broker fees. A lot of companies or businesses will need to raise money or find people to invest in their company. It’s an important distinction that when others invest in the company, it’s a financing activity, but when the company invests its own capital, it’s an investing activity.
The investing activities primarily consist of the different investments a company could be making, whether this is in a piece of machinery, inventory, another company, or a piece of real estate. Anything that is a long-term investment that’s not part of the business’s normal operations will probably fall into the investing activity category.
The operating activities are the core functions of a business directly related to providing goods or services to its customers. This is the area where you get to see where the company needs to allocate capital to run the business, what expenses are critical to the business, and what is required of the company to operate the business day to day.
The cash flow statement is where all three types of transaction are categorized and organized. Its where you get to see the breakdown of the different expenses from the different perspectives, primarily the companies.
Running a business requires you to learn the basics of accounting and to become familiar with financial concepts and these statements. Accounting is a foundation of good business management and you should always be aware of your company’s financial position.
Organizing, categorizing and strategizing from an accounting viewpoint can be beneficial to your business when making important decisions, and lucrative. Understanding the basics of accounting will force you to think of different ways to manage the business and how you can maximize profit, hence improving the bottom line.
About the Author
Howie Bick is the founder of The Analyst Handbook. The Analyst Handbook is a collection of 16 guides created to help current and aspiring analysts advance their careers. Prior to founding The Analyst Handbook, Howie was a financial analyst.