Who keeps track of your business numbers? It’s easy to just say, “I’m a craftsperson and I know my craft and that’s all I need to know. I’ll just hire someone to take care of the numbers for me.” The truth is, if you are in charge of making decisions about your business, then you need to understand the basics of accounting and what each of the financial reporting statements you receive as a small business owner means. In other words, even if you let someone else keep the books for you, you need to understand the meaning behind the math.
Here are a few reasons why you have to keep accurate books; and you'll notice that tax reporting is at the bottom of the list.
Keeping accurate books will help you:
- Price your products accurately.
- Know if you're making or losing money—in general, and on specific jobs.
- Know your cash flow—both in the short and long term—and work with bankers and investors.
- Let the tax agencies know how you're doing.
The important thing in accounting is to not let the terms and formatting of the financial information intimidate you. All you need to remember is that you need three basic financial statements to keep track of your money:
- The balance sheet shows your business at a particular point in time and outlines the assets you have and who owns them. Information on cash and earnings included in the balance sheet is drawn from the other two statements.
- An income statement shows your earnings over a period of time.
- The cash flow statement shows cash coming in and going out and what the net result is over a period of time.
Let’s take a look at this, broken-down in simple terms.
1. The Balance Sheet
As mentioned above, your balance sheet outlines your business assets, both current and fixed. Current assets are cash or other assets that can be converted into cash within one year (things like accounts receivable, inventory, prepaid expenses, etc.). Fixed assets are property and equipment owned by your business—things that you don’t intend to sell (furniture, manufacturing equipment, real estate, etc.). As you create your balance, remember that the left side will always equal the right side. If they do not equal, then you have made a mistake. It is that simple. This is called the “accounting equation.” It’s what makes your balance sheet always equal on both sides. The equation is this: Assets = Liabilities + Owner’s Equity Here’s a sample balance sheet:
Owner’s Equity covers the share of the business that you or other partners own.
2. The Income Statement
The second piece of essential accounting information you need is an income statement (or profit and loss statement), which is used to track sales and expenses. The difference between these two is your net profit. The formula for calculating this is: income minus cost of sales equals gross margin, and gross margin minus fixed operating expenses equals net profit. Remember, larger assets may be depreciated so that those bigger expenses don’t skew your profitability numbers. It is important to remember that your income statement presents sales and expense activities over a period of time as opposed to your balance sheet which shows your financial condition at a point in time.
3. The Cash Flow Statement
A cash flow statement is the financial document that presents income actually received and expenses actually paid. This statement (usually modified for a small business) generally shows beginning cash balances, cash inflows, cash outflows, and ending cash balances. In its simplest form, a cash flow statement is presented in the following format:
- Beginning cash balance
- Plus cash inflows
- Minus cash outflows
- Equals ending cash balance.
Sample cash flow statement for a new business (beginning cash balance is $0):
You can discuss your financial statements and any accounting questions you have with a business mentor (such as those available through SCORE) or get assistance from your local Small Business Development Center.