Understanding Financial Statements

Importance of Financial Statements

Most businesses must file financial statements to satisfy lenders and to file annual tax returns. However, an understanding of financial statements also provides business owners with the ability to determine the financial state of their business and how it is performing. Financial statements are a valuable management tool. They provide a “picture” of your business and reflect its financial performance. This information can be used to enhance the quality and timing of business decisions.

Balance Sheet vs. Income Statement

The two basic components of financial statements are the balance sheet and the income statement, or statement of earnings.

The balance sheet is often described as a “picture of your business taken at a specific point in time.” It shows:

  • What you own (assets),
  • What you owe (liabilities), and
  • The resulting net worth of your business (equity).

The balance sheet should always be balanced. This means that assets should equal liabilities plus equity.

The income statement summarizes the income and expenses of your business or operations over a period of time. Unlike the balance sheet, which is a picture at a specific point in time, the income statement tells you what has happened over a period of time.

The balance sheet and income statement are related to each other. The income, or loss, shown on the income statement is reflected on the balance sheet as an increase, or decrease, in equity. The balance sheet always remains balanced over time as the income or loss for a period of time will result in an increase or decrease in equity offset by corresponding changes in assets and liabilities.

Key Elements of Financial Statements

  • Balance Sheet Elements:

  • Assets – Items that have future value to the business, such as cash, inventory, accounts receivable, property and equipment, and goodwill.
  • Current assets – Those assets that are expected to be converted to cash within the next year, such as accounts receivables and inventory.
  • Liabilities – Obligations of the business such as accounts payable and loans.
  • Current liabilities – Liabilities that must be paid within a year. These usually include accounts payable, taxes payable, and short-term loans.
  • Long term debt – Debt that will be repaid over more than one year, such as bank loans, mortgages, and lease arrangements.
  • Working capital – The amount of current assets minus current liabilities. This shows a company’s ability to pay its current liabilities.
  • Equity – Assets minus liabilities equals equity, or the net worth of a business.
  • Income Statement Elements:

  • Sales – How mush of your product or service you sold over a period of time.
  • Cost of Sales – Expenses directly related to sales over this same period of time, such as purchases and direct labour.
  • Gross profit – Sales less Cost of Sales. This figure gives you an indication of how efficiently you are producing your product. The gross profit should be in line with industry standards. Most well run companies will have adequate and consistent gross profit percentages over many periods.
  • Operating Expenses – These are general expenses not related to producing your product, such as Advertising, Insurance, Interest, Administration and Management Salaries, Office Costs, Rent, Professional Fees, Telephone and Utilities, and Travel Costs.
  • Net income – Sales less all expenses of the business.

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Categorised as Accounting

By Robert J Rutledge

I am a Canadian Chartered Accountant practicing from Winnipeg, Manitoba, providing a wide range of accounting, taxation, and financial services to individuals, small businesses and associations.