Be Your Own Hero: The Benefits of Understanding Basic Accounting
by The Bean Team on April 06, 2021
5 MIN READ
Having a cape-wearing, ever-available CPA on speed dial is the stuff of most business owners’ dreams. Unfortunately, number-savvy superheroes aren’t always this available or want you to have unlimited access to their bat signal. Fortunately, we’re here today to empower you to throw on that cape yourself. Having a basic understanding of accounting comes with many benefits, one of which is eliminating the mystery that often shrouds your financial statements, enabling you to better understand your company’s financial position make more informed (better) business decisions.
There are four basic financial statements, and today, we will discuss three of those four. We will be taking a step back into that long-forgotten accounting classroom today and learning more about the Balance Sheet, the Profit and Loss Statement (also known as an Income Statement), and the Statement of Cash Flows. The fourth statement is the Statement of Shareholder’s Equity, which shows the amount of assets available to shareholders, owners, or stockholders. Because this information can be easily viewed on your Balance Sheet, we have decided not to discuss this statement today. Let’s get started by discussing what information these statements provide and defining some basic terminology!
Basic Definitions for Accounting Terminology
The balance sheet is the heartbeat of your company. It summarizes your company’s asset, liability, and equity accounts for a given period of time. The asset account shows what a business owns in order of liquidity or how quickly that asset can be turned into cash. Assets are split into cash, accounts receivable (money owed to you by the customer), land, equipment, and much more. Cash has the highest liquidity, while other categories like equipment or land are illiquid. The liability-type accounts contain everything the business owes. This can be split into accounts payable (money due to vendors for goods or services received but not paid for), loans payable (money due on loans), salaries payable (money due to employees), and many more categories.
Lastly are the equity accounts. You have probably heard it called “Stockholder’s Equity,” “Owner’s Equity,” or “Shareholder’s Equity” at some point. Equity accounts are simply the stake a shareholder, owner, or member has in your company. Owner’s equity can be split into two account categories: contribution accounts and distribution accounts. Contribution accounts increase the value of owner’s equity, such as Owner’s Investment. In contrast, distribution accounts are accounts that decrease the value of the owner’s equity, such as the Owner’s Distribution or the Owner’s Drawing account. You can check the balances of these accounts at any time by viewing the balance sheet.
The Profit & Loss Statement, also known as the Income Statement, is exactly what it sounds like. This statement shows how profitable a company is based on its revenue minus all its expenses and losses (profit), either quarterly or annually. This is one of the more straightforward statements, but the information it provides is extremely important. The Profit & Loss Statement lists all the expenses incurred by your business during that period, allowing you to see the business activities in detail. If you’re a Quickbooks user, you’re able to see the Profit & Loss Statement broken down by month, which allows you to compare previous months with the current month. This feature can help you see if your revenues and expenses are consistent throughout the year. Understanding the components of the Profit & Loss Statement aids a company in deciding where it is spending too much and where it isn’t earning enough.
Lastly, we have the Statement of Cash Flows. This shows all the cash and cash equivalent transactions a company has made or received and measures how well the company generates the cash to pay for its debt obligations and expenses. It is broken down into three categories: operating activities, investing activities, and financing activities. The operating activities are all cash payments related to revenues and expenses. If you receive money for providing a service or need to pay a utility bill, both will fall under this category. The investing activities consist of all cash payments related to investments—whether you pay for an acquisition, equipment, or land. Finally, there are financing activities. These include cash from banks or investors like loans and cash paid to shareholders like dividends.
Applications for Accounting in Business
Now that we’ve discussed the statements in a little more detail let’s go ahead and apply that information to your business! Understanding your balance sheet allows you to see what you own versus what you owe. You can use the information from your balance sheet to calculate several different ratios that help with decision-making and determining your company’s financial health. For example, let’s look at solvency ratios. Solvency ratios help you ensure your company has enough cash and assets to continue running. One main solvency ratio is the current ratio. Your company’s current ratio can be calculated by dividing the difference between your current assets by your current liabilities (current typically refers to assets used in one year or liabilities paid within one year). If the ratio is below 1, this is a warning sign that your company may be taking on too many liabilities. If your company is not maintaining a healthy current ratio, you may want to find ways to increase your current assets and lower your current liabilities.
Just like your balance sheet, the profit & loss statement also helps you calculate ratios. You can calculate profit margin by dividing net income after tax by net sales. This ratio indicates how many cents you make per dollar of sales. For example, if you have a profit margin of 25%, then you are making a profit of 25 cents for every dollar generated. Furthermore, understanding your profit and loss statement can help you determine your company’s financial health and position. If you are not turning over a solid profit, you need to reevaluate how much you’re spending versus how much you’re making.
Last but not least, understanding your Statement of Cash Flows allows you to see how much cash your company has generated during an accounting period. This again helps you evaluate the health of your company’s financial position. The statement of cash flows will allow you to determine if your business is generating enough cash to sustain itself, purchase more assets, or take out additional liabilities.
All three financial statements we discussed today are invaluable tools that allow you to assess your company’s current financial position and health. These three financial statements and the information obtained from each statement aid in making well-informed business decisions. Whether you take a look at your Profit & Loss Statement and decide to cut some expenses or keep an eye on your Statement of Cash Flows to see where your cash is really going, we hope this has been a help to you and your business. While there is still plenty of work for those superhero CPAs, feel empowered to save the day for your business yourself through understanding the basics of your financial statements.
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