Learn the basics: small business accounting.

Accounting is a useful business skill to have as a business owner.

 

Learning how to read financial statements can help you understand the financial health of your company, and it’s needed for tax purposes.

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Accounting can be overwhelming at first – seeing all those numbers may scare you away from even looking at them. Thankfully, by breaking these seemingly complex statements into small pieces, it can become a lot more manageable. There are three financial statements that everyone should understand to get started: Income Statements, Balance Sheets, and Cash Flow Statements.

Income Statement

The income statement shows your annual profit during the fiscal year. It is a general overview of all expenses and revenue. It is a straightforward statement with a structured format. The first thing to calculate in the income statement is the gross profit.

Gross profit is calculated by taking the total sales and subtracting the cost of goods sold to obtain it. Cost of goods sold (COGS) is the amount of money spent on the inventory sold. It is calculated using the costs of the following: (Inventory at the start of the period + additional inventory bought – inventory at the end of the period).

Example: XYZ Co. has €50,000 in revenue and €10,000 worth of inventory at the start of the period. They bought €15,000 worth of inventory and had €5,000 worth of inventory at the end. Their total COGS for the period would be €10,000 + €15,000 – €5,000 = €20,000. The gross profit at the end of the period is €50,000 – €20,000 = €30,000.

Now that we have finished the revenue calculation of the income statement, it is now time to get into the income statement’s operating expenses section. These are the expenses incurred as part of the daily operations of your business. These expenses include selling, administrative, marketing expenses, rent, insurance, depreciation, and utilities. 

After calculating total operating expenses, you should deduct them from your gross profit. This will give you the earnings before interest and tax – or EBIT for short.

We are almost done! The items following are interest income, interest expenses, and any other income not mentioned before. Adding and subtracting these items to the EBIT gives you net profit before tax.

The last thing on the income statement is the tax expense you paid for this fiscal year. Subtracting this number from your net profit before tax will give you your net profit. The tax expense can be zero or even negative if the company has tax breaks that are carried over. Subtotals such as gross profit, EBIT, net profit before tax, and net profit give you a great way to track your company’s financial health.

Read to find out more about the balance sheet and cash flow statement… 

"An accountant can take responsibility for your business finances, but it's always good to know the basics too."

balance sheet

There are three parts to a balance sheet: Assets, Liabilities, and Shareholders’ Equity. It is important that the total assets equal total liabilities plus shareholders’ equity when the balance sheet is finished.

Assets

There are two types of assets: Current Assets and Non-Current Assets/Fixed Assets. Current Assets are things that are readily convertible into cash within a year. Examples include cash, marketable securities, inventory, account receivables, and prepayments. Non-Current Assets or Fixed Assets are items that are assets that are long term and cannot be easily converted into cash. These types of assets include property, plant, and equipment, patents, and trademarks. It is essential to depreciate all property, plant, and equipment to show the current value. The sum of all these assets gives us total assets.

Liabilities

Like assets, there are two types of liabilities: Current Liabilities and Long-Term Liabilities. Current Liabilities are debts and obligations that are due within a year. The items include accounts payable, short-term debt, and interest payable. Long-Term Liabilities are debts that are due in over a year. Examples include mortgage payables, long-term debt, and long-term notes payables. In rare cases, there are things called contingent liabilities, which are liabilities that all depend on outcomes from future events. Examples of these liabilities are warranties because warranties will only become liabilities if the warranty claim is successful. 

Shareholders’ Equity

Shareholders’ equity (Net Worth) is basically what is left for the shareholders and owners of the company. It could also be viewed as the amount of money invested in the company is calculated from total assets – total liabilities. There are three items in this section, common stocks, retained earnings, and preferred shares. Retained earnings are the profits earned that are left within the company.

cash flow statement

This statement is vital to understand the inflows and outflows of cash. There are three sections: Operating cash flows, Financing cash flows, and Investing cash flows. This statement is more complicated and may be difficult to grasp at first.

Operating cash flows

Operating cash flows is the movement of cash generated from daily operations. This is the most vital and is known as the “engine” of the business, as positive cash operations are how the business generates money. You can determine operating cash flows with four easy steps:

  1. Start with adding net profit from the income statement
  2. Add back all non-cash expenses such as depreciation/amortization
  3. Add gain or losses from sales of assets
  4. Add or subtract any changes to accounts receivable, accounts payable, and inventory:
    • An increase in accounts receivable is a negative use of cash, while a decrease in accounts receivable is a positive use of cash.
    • An increase in accounts payables is an increase of cash, while a decrease in accounts payables is a decrease in cash.
    • An increase in inventory is a decrease in cash, while a decrease in inventory is an increase in cash.

Investing cash flows

Investing cash flows is the cash spent on (as the name suggests), investing related activities. It could also be cash generated from investments. Examples of purchase or sale of property, plant & equipment, and investments.

Financing cash flows

Financing cash flows is the cash received from company funding from sources such as loans, issue of common stock. It could also be the cash spent on paying debt or obligations. For example, things such as repayments of common stocks, repayments of debts, and dividend payments.

summary

We hope you found this basic introduction to accounting and the three financial statements useful. Once you’re feeling comfortable with this, you can look up more advanced topics such as ratios.

We are not experts in this, so if you have any questions and run into troubles when making your financial statements, be sure to seek professional help and advice.

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