Financial Statements

There are two documents you'll become very familiar with when reviewing your small business's financials: the income statement and the balance sheet.

Neither the income statement nor the balance sheet, by itself, is adequate to measure business financial health. However, together they reveal much more about a business than either document could alone. A few years' income statements and balance sheets, together with the business's tax returns, offer a much more complete financial picture of the business.

The Income Statement

The income statement is also known as the profit and loss statement (or "P&L"). It's a record of your business's financial activity during a period of time, such as a quarter or a year.

The income statement is an invaluable document for:

• Tax preparation
• Providing financial information to investors, creditors, appraisers and others about the operational performance of the business
• Providing the business owner(s) or management with the information they need to make business decisions on future small business operations (purchasing, hiring, management, etc.)

Classified Income Statements

The presentation of an income statement should conform to certain standards. For example, income and expense items should be classified as follows:

• Revenue
• Cost of Goods Sold (COGS)
• Gross Margin
• Operating Expenses (may be divided into sales and administrative items)
• Other Income and Gains
• Other Expenses and Losses
• Provision for Income Tax
• Net Income

Revenue

Revenue is the dollar measure of operations that represents an increase in your business's assets through the sale of goods and services through normal trade or business. Revenue typically is derived from the sales of products or services. Gains from the sale of assets and from extraordinary or non-recurring receipts are not considered to be operating revenues. In other words, revenue includes all of the gross receipts derived from the principal trade or service of your business.

Business owners or managers may not distinguish between revenue and expenses and cash flow. This is especially true for a business using the cash accounting method, where many cash receipts may be mistaken for revenues, and many cash disbursements may be improperly classified as expenses.

For example, the following cash receipts have no effect on the income statement (although they do have an effect on the balance sheet), and should not be listed as revenue:

• Proceeds from loans or lines-of-credit
• Cash received from accounts-receivable items already recorded in revenue
• Loans or capital contributions from the owner(s)
• Cash received from the sale of assets that are not normally sold by the business as inventory

The Balance Sheet

The balance sheet presents your business's assets and liabilities. Some examples of the uses of a balance sheet are as follows:

• Creditors may examine it to determine the level of existing debt, as well as whether or not the debt is secured and the borrower's liquidity to repay the debt. (Liquidity refers to how quickly and efficiently an asset may be sold or converted to cash with minimal loss of value.) Assets such as cash, investments and inventory are much more liquid than real estate and operating equipment.
• Appraisers and potential buyers of the business may be interested in the inventory, equipment, buildings, vehicles and other assets. They may also want to know whether these assets are secured by any loans. This allows them to establish a fair price for your business.
• Investors may look at the capital structure of your small business, that is, the proportion of debt to equity.
• The IRS may use your business's balance sheet to gauge the consistency and accuracy of your federal income tax return, as a whole. For instance, an increase in cash without a corresponding increase in either sales or loans might indicate that you are underreporting sales.

Date

The balance sheet, often referred to as the "statement of financial position," is a snapshot of assets, liabilities and equity, at a certain date. The balance sheet will display a date "as of" when the financial snapshot was taken. This date is the last day of the accounting period in question (the fiscal year, quarter, or month).

Name

A balance sheet will also display the business's name. This seems like a trivial point, but businesses with multiple operating divisions or segments often will maintain their own accounting systems and sets of accounts. Investors or creditors who are considering investing in or lending to a specific business will want to be sure that the financial statements they are examining belong to the correct business segment(s).

The Balance Sheet Equation

The balance sheet "balances" because an organization's total assets must always equal its total liabilities and equity. In equation form, Assets = Liabilities + Equity, or
Assets - Liabilities = Equity

An asset is what your business owns. Assets may be tangible (such as buildings, machinery, inventory, computers) or intangible (such as accounts receivable, patents and copyrights, formulas or goodwill).

Assets are also classified as short-term or long-term. Accountants classify an asset as short-term if you expect to convert the asset into cash within one year of the balance sheet date.

All other assets are classified as long-term.

A liability is what your business owes. This includes:

• Payroll that is owed to employees
• Taxes that are owed to federal, state and local authorities
• Bills that are due to vendors
• Debts that are due to lenders

Liabilities are also classified as short-term or long-term in the same way as assets. If a liability is expected to be paid within one year of a balance sheet date, it is classified as short-term. Otherwise, it is long-term.

Equity is the difference between assets and liabilities. It is a residual balance. For example, on a personal level, your "equity" in your home is the difference between the value of your house (an asset) and the amount you owe on your mortgage (a liability).

According to Generally Accepted Accounting Principles (GAAP), the value of an asset is booked (recorded in an account) at its historic cost, the cost when purchased. This measure of value is objective, verifiable and documented. However, personal financial statements, which are not prepared according to GAAP, reflect assets and liabilities at their current (market) value, not their historic cost.

Businesses and individuals with negative net worth have liabilities that exceed their assets. In other words, they owe more than they own.