In 2013 I went into a business of selling clothing and I went bankrupt. All my hard earning money I’ve gathered was gone and I was buried in debt. It was a painful experience.
When I was in the business, there were tremendous pressures upon me. I was in a race between making money and paying the bills. In that kind of situation it was very easy to lose track of my current money situation. I didn’t know how much money I had burned, how much was the worth of my inventory, how much I had loss, and my personal and business cash get mixed. It was a financial disaster.
I don’t understand about accounting and it was one of the school subjects I hated. Because I can’t make sense out of it.
But, all good business men say, “You have to know your numbers.” and “Accounting is the language of business.”
For that reason, I start to learn the fundamentals and I want to share with you what I’ve learned.
In this post I don’t cover about bookkeeping, instead I want to share about how to read the financial statements. I think, it’s a better way to give us the big picture, to understand how all these things fit altogether.
Your business is like a plane. In the plane’s cockpit there are dials. Those dials are tools telling the pilot about the current situation of the plane, do we have still enough fuel, are we going to crash, etc.? In business, these dials are your the financial statements. It can show you the health of your business, such as: do you still have cash to pay the bills? Are you winning or loosing, etc.?
By knowing the current situation of your business, it will help you to decide, what to do next.
In financial statements there are 3 big dials:
- Balance Sheet
- Income Statement
- Cash flow
1. Balance sheet
This statement shows you:
- On the left side: things and stuffs (assets) in the business.
- On the top right side: how much you owe for the things and stuffs
- On the bottom right side, how much you own the things and stuffs.
It takes a snapshot of your business in one point in time.
Why this statement called as the balance sheet? Because the total of the right side is always equal to the left side.
Every financial transaction in the business impacts this scorecard.
2. Income Statement
This statement comes with many different names: P&L / Profit and Loss / Statement of Operation / Operating Statement.
In the statement, in general you’ll see the sales, aka: revenue or turn over, deducted it with all other expenses. The left over at the bottom is your profit aka: net income, or loss. This is what people often refer as the bottom line.
Profit in this statement is just a theory. It just says, does the revenue exceed expenses, if yes, by how much.
The reason why it’s a theory, because you can’t spend them. Let’s go to a restaurant and say, gee… I don’t have cash, would you take some of my profits? They will definitely say no. You and the restaurant can’t spend profits.
When people made a purchase order, that’s already recorded as a sale in the income statement. Even though you haven’t received the cash. So, on paper you may profit, but you can’t pay the bill unless you go and get the cash.
The income statement shows what happens over a period of time, for example: in the month of July, in the year of 2008. It has a beginning and an end.
3. The cash flow
This statement shows the flow of your cash, the in and out. There are 3 kinds of cash:
- Operating Cash – The cash based on your business operation: revenue – expenditures (salary, water bills, etc).
- Investing Cash – The cash based on your capital investment, such as: buying and selling equipment, plant, property, etc. The things to keep the business running and last for a long time.
- Financing Cash – The cash based on line of credits.
The health of your business depends on your ability to turn your profits into cash.
In order for a business to have a long life, is by generating operating cash.
4. The relationship between balance sheet, income statement and cash flow
This image tries to show you where the numbers you see on the balance sheet come from:
- On the left column of a real balance sheet you’ll see an item says “Cash”. It shows you only the total cash the business have. In this case the cash is 10. If you want to know the details about from where you get the cash, you look at the cash flow.
- The right column below of the balance sheet tells you the total profit or loss you have. In this case your profit is 4. If you want to know about the details how you get there, you look at the income statement.
If you read the financial statements, you’ll see many terms that might confuse you. So in this section I want to give you some of them to get you a better understanding when reading them.
Assets – based on its liquidity or how quickly an asset can be turned into cash, they are split into two:
- Current assets – liquid, such as: cash and inventory.
- Non Current assets – less liquid, such as:
- Fixed assets: furniture, fixtures (something attached to the building, such as: bookcases, lighting, plumbing), properties, equipment.
- Money that customers owe you.
- Assets depreciation, aka: asset loses value.
- Advances to owner, aka: the money the owner takes as a loan from his own company.
Liabilities – how much do you owe people. Based on the due time, they are split into two:
- Current – due within one year (short term), such as:
- Account Payable (purchased but not yet paid)
- Accrued Tax
- Current Portion of long term payable
- Note payable
- Non Current – due more than one year (long term), such as: Loan Payable
Net Worth / Equity
- Owner Investment – The money that the owner puts into the business.
- Retained Earning – Money left in the business accumulated over the year.
Net sales – the sales after returns and allowances.
Returns mean people returning the product they’ve purchased back to the company, due to certain reason, for example: defect, wrong product, etc.
Allowances are the commission or the money paid to a sales after they sold a product or service.
I hope this post can give you a kickstart to dig deeper on the language of business. If you have any questions or corrections or even great information which can help others to become more proficient in the subject, please comment below.