Without analyzing financial data from your small business firm, you, as the owner, would be flying blind. Even if the financial end of things is not your favorite part of your business and you intend to outsource as much of it as possible, you still have to understand it. Why? Because you have to understand the output you receive from your accountant or other financial professional in order to operate your business. For example, if your accountant tells you that your profit is $1,000 for the year, you must understand what went into allowing you to make that $1,000. You may not have to know as many details as the accountant, but you certainly have to understand the big picture.
Learning the Basics
It's best to start with the basics in order to understand your financial position. Maybe you've been schooled in finance and accounting and, if so, consider this a review. If not, then here we go on a short course in understanding and analyzing your financial position.
The first thing you have to get up to speed on is the financial statements that you or your financial professional will generate for your business firm. These financial statements will help you determine your firm's financial position at a point in time and over a period of time as well as your cash position at any point in time. Many small businesses fail because the owner loses a grip on the firm's financial position. If you understand financial statements, that won't happen to you.
The income statement is also called the profit and loss statement. It is the major statement for measuring your firm's profitability over a period of time. You develop the income statement in a step-by-step process starting with the amount of revenue you have earned. Then you subtract each item your firm has expensed to see what your profit or loss is after each is deducted. You can prepare income statements for a short period of time like a month, if you need that type of information. For tax purposes, you can extend that out and develop your income statement for the tax year.
How to Prepare the Statement of Retained Earnings
The Statement of Retained Earnings is the second financial statement you prepare in the accounting cycle. After you arrive at your profit or loss figure from the income statement, you prepare this statement in order to see what your total retained earnings to date are and how much you will pay out to your investors in dividends, if any. Total retained earnings are then transferred to the balance sheet.
The balance sheet is a statement showing what you own (assets) and what you owe (liabilities and equity). Your assets must equal your liabilities (debt) plus your equity (owner's investment). You have used your liabilities and equity to purchase your assets. The balance sheet shows your firm's financial position with regard to assets and liabilities/equity at a point in time.
Even if your company is turning a profit, it may be falling short because you don't have adequate cash flow. It is just as important to prepare a Statement of Cash Flows as it is to prepare the income statement and balance sheet. This statement compares two time periods of financial data and shows how cash has changed in the revenue, expense, asset, liability, and equity accounts during those time periods.
The statement divides the cash flows into operating cash flows, investment cash flows, and financing cash flows. The final result is the net change in cash flows for a particular time period and gives the owner a very comprehensive picture of the cash position of the firm.
These four financial statement are prepared at the end of the accounting cycle and should be prepared in this order. Information from the Income Statement comes from the revenue and expense accounts on the general ledger and information for the Statement of Retained Earnings comes from the Income Statement and the dividend account.
The Balance Sheet is prepared next and the information is taken from the asset, liability and equity accounts on the general ledger as well as from the Statement of Retained Earnings. Last, the Statement of Cash Flows is prepared from all the previous financial statements.
Financial statement can be prepared for a company for any length of time and at any point in time. Some companies prepare financial statements monthly to keep a tight handle on the financial position of the firm. Other companies have a longer accounting cycle. Financial statements must be prepared at the end of the company's tax year.