Preparing Financial Statements at the Cycle's End
You're flying blind if you don’t analyze financial data from your small business on a regular basis. Even if the financial end of things is not your favorite part of doing business and you intend to outsource as much of this work as possible, you still have to understand the output you receive from your accountant or other financial professionals. You may not have to know as many details as your accountant, but you certainly have to understand the big picture.
It's best to start with the basics. Maybe you've been educated in finance and accounting and, if so, you can consider this a review. If not, here’s a short course in understanding and analyzing your financial position. Your financial statements will help you determine your business’ financial position at a specific point in time and over a period of time.
Information from your accounting journal and your general ledger is used in the preparation of your business’s financial statements: the income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows. Information from the previous statement is used to develop the next.
The income statement, also known as a profit and loss statement, is almost uniquely important because it shows the overall profitability of your company for the time period in question. Information on sales revenue and expenses from both your accounting journals and the general ledger are used to prepare the income statement. It shows revenue from primary income sources, such as sales of the company's products. It also shows income from secondary sources: If the company sublets a portion of its business premises, this is included as secondary income. The income statement also shows any revenue during the time period in question from assets, such as gains on sales of equipment or interest income.
The income statement also shows the business's expenses for the time period, including its primary expenses, expenses from secondary activities and, finally, losses from any activity, including current depreciation. One thing to note about the depreciation shown on the income statement is that it only accounts for depreciation over the time period in question, not the total depreciation of an item from the time the asset was acquired.
The bottom line of the income statement is net income or profit. Net income is either retained by the firm for growth or paid out as dividends to the firm's owners and investors, depending on the company's dividend policy.
The statement of retained earnings is the second financial statement you must prepare in the accounting cycle. Net profit or loss must be calculated before the statement of retained earnings can be prepared. After you arrive at your profit or loss figure from the income statement, you can prepare this statement to see what your total retained earnings are to date and how much you’ll pay out to your investors in dividends, if any. This statement shows the distribution of profits that are retained by the company and which are distributed as dividends. As the name suggests, the amount of retained earnings is the profit retained by the firm for growth, as distinguished from earnings that are not retained but are distributed to shareholders as dividends or to other investors as the distributed share of profits.
The balance sheet is the financial statement that illustrates the firm's financial position at a given point in time -- the last day of the accounting cycle. It’s a statement showing what you own (assets) and what you owe (liabilities and equity). Your assets must equal your liabilities plus your equity or owner's investment. You have used your liabilities and equity to purchase your assets. The balance sheet shows your firm's financial position with regard to assets and liabilities/equity at a set point in time.
Entries on a balance sheet come from the general ledger, and the format mirrors the accounting equation. Assets, liabilities and owners' equity on the last day of the accounting cycle are stated.
A note about depreciation: In contrast to the depreciation shown on the income statement, the depreciation shown on the balance sheet -- which is a snapshot of the company at the end of the accounting cycle -- is the total accumulated depreciation from the day the item was acquired to the present.
Even if your company is turning a profit, it may be falling short because you don't have adequate cash flow, so it is just as important to prepare a statement of cash flows as it is to prepare the income statement and balance sheet. This statement compares two time periods of financial data and shows how cash has changed in the revenue, expense, asset, liability, and equity accounts during these time periods.
The statement of cash flows must be prepared last because it takes information from all three previously prepared financial statements. The statement divides the cash flows into operating cash flows, investment cash flows, and financing cash flows. The final result is the net change in cash flows for a particular time period and gives the owner a very comprehensive picture of the cash position of the firm.
The statement of cash flows shows the firm’s financial position on a cash basis rather than an accrual basis. The cash basis provides a record of revenue actually received, from the firm's customers in most cases. The accrual basis shows and records the revenue when it was earned. If a firm has extended billing terms, such as 30 days net, 60 days 1 percent, these two methods can produce substantially different results.