One of the biggest benefits of using accounting software is the ability to easily create financial reports.
There are many kinds of reports and each one serves a purpose. Two of the most commonly used financial reports are the following:
- Income Statement (or sometimes known as Profit & Loss Statement)
- Balance Sheet
When confronted with financial reports, sometimes an owner or manager may not understand what the report is communicating. The purpose of this post is to share some information that will help business owners and managers understand the key points from each of the aforementioned reports.
It is important to note that while I am briefly touching on specific features of each report, larger businesses will have reports that are bigger and contain more information than a small-to medium-sized business.
Let’s look at the difference between the two, and go over how to read financial reports.
The Income Statement is one of the most important financial reports for a business owner. The Income Statement provides a snapshot of any given period denoting the operations of the business. The Income Statement has two main sections and they are as follows:
- Revenues: The upper portion of the Income Statement is where a business reports all streams of their revenue. These revenue streams are then aggregated into Total Revenue.
- Expenses: The bottom portion of the Income Statement is where businesses report any and all operating expenses. These expenses are then amassed into Total Operating Expenses.
The difference of Total Revenue and Total Operating Expenses will derive the Net Profit.
This amount is important because if it is a negative the business is either not generating enough revenue, or they are accruing a large amount of operating expenses. If the amount is positive, then the business is generating enough revenue to cover operating expenses and accruing a profit for the owner.
An important thing to remember for the Income Statement is that this report helps business owners analyze the strength of their business for generating revenue which can help them cover operating expenses and generate a profit.
The Balance Sheet is another important report that helps business owners analyze the size of their business.
Accountants use an equation called the ‘Accounting Equation’ which helps us understand what the Balance Sheet shows. The Accounting Equation is written as follows:
Assets = Liabilities + Owners’ Equity
On a Balance sheet, the left-hand side or top of the report (depending on the layout), will report all Assets for a business. Generally, Assets are reported as Current or Fixed.
- Current Assets such as Cash or Accounts Receivables are more liquid, meaning the asset can be transferred to cash very easily.
- Fixed Assets are usually equipment, buildings, or land. The sum of all Assets equals Total Assets.
The right-hand side, or bottom of the report, shows Liabilities and Owners’ Equity. The Liabilities section contains any liability to the business.
- Liabilities can come in the form of current or long-term, such as Accounts Payable or Long-term Debt.
- Owners’ Equity shows any paid-in capital from the owner, as well as Retained Earnings from previous periods where a net profit was realized.
The Accounting Equation says that Assets will always equal Liabilities plus Owners’ Equity. This equation, in conjunction with the Balance Sheet, can help owners understand who claims the assets of the business. For example:
- If you divide Assets by Liabilities, the result of this will show how much (for every one dollar of assets) is funded by debt.
- The same is true for Owners’ Equity. Assets divided by Owners’ Equity will show how much (for every one dollar of assets) is funded by the owner.
Financial reports contain a lot of information. As a business grows and experience is gained, these reports will continue to assist owners in making the right decisions.
While the information presented in this article is only a brief glimpse into two reports, understanding the basics of the Income Statement and Balance Sheet will help business owners start the process of understanding these reports, and using them to help their business grow.