Accountants, bankers and CFOs work with financial information daily, but a number of successful small business owners and managers may not understand financial statement differences or accounting terms that are often used to explain business performance.
Successful sales, marketing, operations and purchasing managers and owners may have an incomplete understanding of financial statements and terms, because they have had little accounting training. Some basic concepts are explained below from a non-accounting business perspective:
Accounting. This refers to the techniques and procedures used to communicate financial information. Accounting is sometimes referred to as the “language of business,” and this language is used by accountants and other financial people to build financial statements.
Financial Statements. These are reports that show the financial performance of a business. The most common reports are the balance sheet, income statement, and statement of cash flows. Most small businesses create a balance sheet and income statement at the end of each month, and larger companies create a statement of cash flows. Think of financial statements as scorecards showing if and where a business is winning or losing.
Cash basis vs. Accrual Basis. These are the two primary ways that revenue and expenses are measured. A company’s financial statements can be built using cash accounting or accrual accounting. Cash accounting records revenue when cash is received and expenses when cash is paid. Accrual accounting records revenue when earned and expenses when incurred, regardless of whether cash has been collected or paid. It is common for small businesses to use cash accounting, but mid-size and larger companies use accrual accounting.
Generally Accepted Accounting Principles (GAAP). These are accounting standards used by public accountants and internal accounting departments. Think of GAAP as a set of guidelines that attempt to create uniformity in financial statement preparation. Bankers often ask for GAAP statements, because they want financial reports prepared according to these common accounting “rules.”
Balance Sheet. This financial report shows a snapshot of a business’ account balances on a specific day. The report has three sections: Assets (what the business owns), Liabilities (what the business owes) and Equity (the difference between what the business owns minus what it owes). The balance sheet always “balances” because the total assets equal total liabilities plus equity.
Some owners think this report shows the net value of the company if all assets were sold or converted to cash and all debts or liabilities paid. This is not entirely correct, because the actual prices earned from selling assets could be higher or lower than the values on the balance sheet. The balance sheet, however, does give an indication of a company’s net asset value and accumulated earnings since the business began.
Income Statement / Profit and Loss Statement. This financial report shows a company’s performance during a particular period such as a month or year, and it has three section: Revenue (money received from the sale of goods and services), Expenses (all company costs incurred to make and sale the goods or services), and Profits or Net Income (revenue minus expenses). Some owners think profits equal cash, but this is incorrect if the company uses accrual accounting: the income statement compares revenue to expenses, calculates a profit and shows what income may eventually be converted to earnings or cash.
The income statement and balance sheet are connected by net income, such that profits (on the income statement) increase equity (on the balance sheet) and losses decrease equity.
Statement of Cash Flows. This financial report shows whether a company has generated or used cash during a period. The balance sheet and income statement are used to build the statement of bash flows, and this report breaks down actual cash that has come into the business or gone out of the business from operating, investing and financing activities. Bankers and investors often focus on a company’s cash flow, but many small businesses unfortunately do not often analyze their cash flow.
Financial statements are scorecards created by businesses to track financial performance. Accounting tools and techniques are used to build financial statements, but even owners and managers who are “accounting challenged” can use financial statements to better understand and improve their company’s financial performance.