Almost everyone needs to have a basic understanding of financial statements. Even if you have accountants to assist you, it is important that you too can read the main financial statements like the balance sheet and income statement. Even if you have no accounting background, it is possible to understand the fundamentals with just a little effort.
To give you a brief introduction to the subject, here are some of the important things you should learn and why they are very useful to know:
Income statement. This is where you can see your sales and expenses. At the very bottom of the income statement is the net profit after taxes. This is why when you are asked for the bottom line, people will mean they want to know your net profit. The income statement shows you the performance of the business in a given period of time. Usually this is for a period of one year. Note that even if cash payment is not yet collected, it may still be considered sales if you have already earned it.
Depreciation. You will usually see depreciation in both the income statement and the balance sheet. Every tangible asset, excluding land, is subject to depreciation. This is because the value of most assets becomes less as time passes. To take this into account, this is recorded as an expense in the income statement, even if you do not spend cash directly. In the balance sheet, depreciation is shown as accumulated depreciation and shows the total amount of the reduction in value.
Balance sheet. If you want to know what your company owns, you look at the balance sheet. It contains what the business owns (assets) and what it owes (liabilities). It is called a balance sheet because the assets must equal the liabilities plus the owner’s equity (in Sole Proprietorship) or stockholder’s equity (in the case of corporations).
Asset. This is anything of value to the business. Usually this is categorized into current assets, which include those that can be turned into cash within a year; and long-term assets like property, plant and equipment, which take longer than a year to become cash. Assets include intangible items like goodwill, patents and copyrights.
Liabilities. These are what the business owes to other parties and are segregated into current and long-term liabilities. Like current assets, current liabilities have terms of one year or less. Long-term liabilities, on the other hand, are payable or due in more than a year’s time.
Financial ratios. To get more information from financial statements, you can get the proportion of the items to each other by dividing one item by another. For example, you can divide current assets by current liabilities to get the current ratio, which is one indicator of the liquidity of a company. There are many useful financial ratios and they are crucial to understanding a company’s financial situation.
Accrual basis of accounting. A lot of things in financial statements would be clear to you if you understand what the accrual basis of accounting means. It is an accounting principle that states to record revenue when they are earned, and expenses when they are incurred. This would explain why there are such things as depreciation expenses, and unpaid receivables being considered as part of sales.
The ability to read financial statements is almost as important as knowing how to read. Your financial status is at stake and you must invest a little of your time to understand this.
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Edgar Navarro Picache, CPA is a financial executive with 20+ years of practical experience in a variety of leadership positions in public accounting and private industry.
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