To gauge the financial performance of a business, you need to understand the basic financial statements. Owners, investors, banks, and other entities look to these reports to examine the health of a company’s finances. Therefore, their significance is relevant to a company beyond just accounting purposes. The basic financial reports are the balance sheet, income statement, statement of owner’s equity, and the cash-flow statement. Here we focus on the first two.
The balance sheet presents a company’s financial position on a specific date, such as the last day of the month or year. It lists the business’s assets, liabilities, and owner’s equity.
Assets represent value for the company and can, in most cases, be converted to cash. Cash itself is obviously an asset. Other examples include customer receivables, equipment, furniture, and in the case of a merchandiser or manufacturer, inventory. Intangible assets include investments, goodwill and intellectual property rights. Liabilities are amounts owed. Examples include insurance company payables, producer payables, loans, accrued payroll, taxes, and invoices payable.
To understand the balance sheet, you need to know the basic accounting equation: Assets = Liabilities + Owner’s Equity. Bookkeeping relies on this equation to keep the books in balance, hence the report’s name. The equation can also be written as Equity = Assets – Liabilities. In other words, owner’s equity, or capital, can be determined by taking the value of the company’s assets and subtracting all amounts owed to other entities.
The layout of the balance sheet mirrors the accounting equation, with the assets listed on the left and all liabilities and equity to the right. Some versions put the assets at the top of the page. Assets are usually listed in order of liquidity, with cash first followed by accounts receivable. Typically, all short-term liabilities are listed before long-term liabilities.
The income statement shows a company’s revenue and expenses over a specified period of time (usually a month, quarter, or year). The report typically lists all categories of revenue at the top. That’s the gross income taken in for sales of goods or services.
Of course, revenue alone does not equal profit, so all expenses for the period must also be taken into account. The report lists these next, grouped in categories such as expenses related to sales, operating expenses, interest expenses, etc.
Total revenue minus expenses gives us the income statement’s bottom line: net income. That’s the company’s total profit for the period. If the company didn’t make a profit, that’s a net loss.
Comparing income statements reveals patterns and trends. A sudden spike in one expense category is noteworthy, for example.
The balance sheet, the income statement, and the other financial reports each examine a company’s finances from different angles, but they are interconnected. Considered together, they reveal the bigger picture used by investors, banks, and other entities in decision-making.