Define income statement and balance sheet? How are they different? What are they used for?
An income statement is simply designed to show the overall performance of a business over the course of a given amount of time, usually a fiscal year. On the other hand, a balance sheet gives a snapshot of a business’ financial situation at a specific moment in time. They are used by interested parties to track a business' performance over time and to take the financial "temperature" of a company at a given moment, respectively.
How do you read these financial statements and what conclusions can be drawn from them?
In order to read an income statement (also called a profit & loss sheet in the UK and much of Europe) one must begin at the top, with total revenue for the given time frame, also known as “gross revenue”. This is the total cash value amount of earnings brought in through sales of goods or services. This amount is a “gross” value because it is presented without deductions for taxes or other liabilities.
The next entry is the cost of revenue, which is the price for the goods or services that had value added to them and were sold to create the aforementioned total revenue. This cost includes the overhead involved with producing the product or service. The cost of revenue is then subtracted from the total revenue and the remainder is call the gross profit. This concludes the revenue section.
Next we move on to the operating expenses section. This section details the multiple lines denoting additional expenses involved in running the business (R&D, administrative expenses and non-recurring expenses). These expenses are then subtracted from the gross revenue and the remaining value is called the operating income.
After the operating income is calculated we move on to additional expenses, such as interest and tax liabilities. After these have been subtracted from the operating income we are left with the final net income. This is where we get the phrase “the bottom line”. (SEC 2016)
An example of an income statement:
(NASDAQ 2016)
Whereas an income statement tracks a company’s performance over time, a balance sheet is designed to detail the financial position of a company in a specific moment in time. This snapshot will show a company’s assets, liabilities and equity. As we learned last week, the golden rule of accounting is Assets = (Liabilities + Equity). A balance sheet (or statement of financial position) is a tool designed to show interested parties a company’s level of solvency (ability to pay for its long term liabilities) and liquidity (its ability to meet it short term obligations), as well as the overall structure of its operating capital.
Here are a few examples of equations used to measure solvency, liquidity and capital structure:
(Jun 2013)
A great lesson on financial statements and their relationships with each other, along with interactive exercises to better help you understand how the numbers interact: https://www.khanacademy.org
Drawing conclusions from these documents requires a little critical thinking and a little detective work. Heather Liston at Bplans.com recommends keeping an eye out for income sources outside of the primary business activities and looking for discrepancies between salary fluctuations and benefit expenses as possible warning signs. A company with dropping benefits expenses may be tightening its belt by dropping a benefit plan or hiring new employees without benefits and may be a sign of a struggling enterprise. A company with high liquidity and low solvency may only be able to keep the lights on and production rolling, and is much more likely to face the prospects of bankruptcy rather than growth.
How can you make your business activities visible and accountable to ensure business performance?
To ensure transparency and performance, a business must practice diligent and thorough double entry accounting. For a quick overview of double entry accounting please see last weeks post. In order to effectively practice double entry accounting an enterprise will need to generate a chart of accounts. This chart lays out all of the accounts used by the business for its ledger. Each account is associated with an account number or a general ledger number. These numbers should flow in a logical order, preferably starting with balance sheet accounts (Assets => Liabilities => Shareholder equity) and move on to income statement accounts (operating revenue, operating expenses, other income, etc) (Averkamp 2016). Each account should have some space in between its associated G/L number allowing for additional accounts to be added along the way.
An example of a chart of accounts:
(Double Entry Bookkeeping 2015)
Averkamp, H (2016). Chart of Accounts | Explanation | AccountingCoach. [online] Available at: http://www.accountingcoach.com/chart-of-accounts/explanation [Accessed 7 Nov. 2016].
Double Entry Bookkeeping. (2015). Sample Chart of Accounts Template | Double Entry Bookkeeping. [online] Available at: http://www.double-entry-bookkeeping.com/coa/sample-chart-of-accounts-template/ [Accessed 7 Nov. 2016].
Liston, H. (2014). How to Read and Analyze an Income Statement - Bplans Blog. [online] Bplans Blog. Available at: http://articles.bplans.com/how-to-read-an-income-statement/ [Accessed 7 Nov. 2016].
