11. Understanding Financial Statements

Characteristics of Successful Entrepreneurs

aWhat are Financial Statements?

The basic financial statements used by a small business are the balance sheet, income statement, and cash flow statement. The balance sheet can be compared to a snapshot taken of a business at one point in time, while the income statement is like a moving picture which summarizes the activities of a business for a certain period, typically a quarter or a year. The cash flow statement is disconnected from the first two statements, is that it only measures cash inflows and outflows from your account. It is also essential to manage cash flow to fund day-to-day operations

The Balance Sheet

The balance sheet lists the assets and liabilities of a business and the owner’s equity at one point in time. It shows the net worth and general health of the business. Assets are the resources of a business such as inventory, cash or equipment, which will be used to generate revenues. Liabilities are the debts, such as accounts payable or financial institution loans, which a business owes to its creditors.

Owner’s equity represents the investment of the owner(s) in the business. It may also be called net worth or capital. There are two sources of owner’s equity. These are the actual investment by the owner of assets, such as contributed capital, and the reinvested profits of the business, such as retained earnings. Essentially, liabilities and owner’s equity represent the claims of creditors and owners on the assets of a business. The following equation may be derived from this simple formula: Assets = Liabilities + Owner’s Equity

Format of Balance Sheet

Company X Balance Sheet
December 31, 20XX
Cash  $1,000
Office Equipment  $3,000
Land $6,000
Total Assets  $10,000
Accounts Payable $600
Financial institution Loan $6,000
Total Liabilities $6,600
Owner’s Equity
John Doe, capital $3,400
 Total Equity $3,400 
Total liabilities and owner’s equity $10,000

Profit & Loss Statement

The Income Statement measures expenses against revenues over a specified period to report the net income or loss of the business for a given period. Revenues are sales of products and/or services for which payment has been or will be received (cash and credit sales). Expenses are costs incurred in producing and delivering these products and/or

services. The cost of goods sold (or purchases) is variable, dependent on sales; while overhead costs, such as rent or equipment, are fixed, regardless of sales. Income is simply the difference between revenues and expenses. If revenues exceed expenses, a Net Income is reported; if expenses exceed revenues, a Net Loss is reported.

Format of Profit & Loss Statement

Company X Profit & Loss Statement
For Year Ended December 31, 20XX
Sales  $66,000
Advertising $2,000
Depreciation $600
Insurance $500
Interest $720
Purchases $30,000
Rent $6,000
Utilities $600
Wages and Benefits $15,000
Total Expenses $55,420
Net Income: $10,580

The Cash Flow Statement

Cash is required to operate your business day-to-day, so understanding the cash flow statement is essential for business success. To learn about the cash flow statement and projections, click on the “Read next article” below to visit Article 12 – Maintaining Business Records.

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