Profit making is the soul of entrepreneurship. All businesses are ultimately driven by only one motive; maximizing profits. This obviously implies that a businessman would be keen on knowing whether he is earning profits. And that is where accounting begins. Basically, accounting is the practice of recording all financial transactions carried out by a business over a period. It is probably one of the most essential activities of a business.
But merely recording transactions does not tell where the business is going. To clearly understand whether a business is making profits, all these financial transactions are summarized and narrowed down to what we call financial statements. Typically, financial statements are prepared at the end of a period, say a year. They are summarized reports that tell whether the business earned profits over the year or incurred losses.
Why Prepare Financial Statements?
Preparing financial statements is not just important to determine the financial health of an organization, they are useful for several other reasons.
- Financial statements are required by law in many countries. Financial statements provide a clear picture of the market worth of a business and are a proof that its transactions are legal and lawful. A good accountant can help you prepare these financial statements. But it’s important for the entrepreneur to understand them.
- Shareholders and investors use financial statements to determine the risk and benefits associated with investing in a business.
- Financial statements influence the credit decisions of creditors and financial institutions.
- Since financial statements represent the financial wellness of a business, it enables businesses to compare their performance with that of competitors.
- Financial statements enable better decision making. Based on the financial health of an organization, entrepreneurs can make better financial plans for future.
The Important Financial Statements:
The Income Statement
The Income Statement, or the Profit and Loss account is a financial statement prepared at the end of the year. The purpose of the Income statement is to report whether the business made profits or incurred losses. Typically, the income statement is a summary of the incomes and expenses of a business. The difference between the incomes and expenses is the profit earned during that period.
The income statement mainly contains incomes and expenses from operating and non-operating activities. Operating activities are the core business activities, like manufacturing, selling, marketing. Non-operating activities, on the other hand, are the activities outside of the main business operations, like interest on loan, depreciation, income from selling an asset, income from dividends, etc. The profit and loss statement determines profitability and financial success over a period, and therefore is a core financial statement of a business.
The Balance Sheet
The Balance Sheet is a statement of a firm’s assets, liabilities, and capital at the end of a period. A company’s assets are what it owns, it’s liabilities are what it owes, and the capital is the amount that its shareholders have invested. In contrast to the Income Statement, the Balance Sheet shows the financial position at the end of a period, say, at the end of the financial year.
- Assets – In accounting, an asset is a possession of a business that adds some value to it in the present or in the future. Assets are typically a blend of fixed assets and current assets. Fixed assets are properties that have a long life, usually more than 5 years. Land, building, plant and machinery, etc. are examples of fixed assets. Current assets, on the other hand are assets that are expected to be converted into cash within a year, like stock-in-hand, receivables, cash equivalents, etc.
- Liabilities – A liability is a legally binding obligation that is payable to another person or entity. In other words, the liabilities of a business are what it owes to outsiders. The current and long-term liabilities show the total amount that a business owes to outsiders. Like current assets, current liabilities are debts that are expected to be paid off within a year. For example, interest on loans, bank overdrafts, bills payable, etc. are all short-term debts. On the other hand, long term liabilities are moneys due to outsiders for a longer period. These include long-term loans, debentures, bonds, etc.
- Capital – Generally, capital refers to the owner’s equity. It is the investment made by the owner for the benefit of the business. From accounting point of view, the capital of a business is treated as a liability. The logic behind this is that it is the owner’s funds and should be returned to him when the company is winded up.
The Cash-Flow Statement
The Cash Flow statement is a systematic record of cash and cash equivalents entering and leaving the business during a period. The purpose of a Cash Flow Statement is to determine the inflow an outflow of cash through operating, investing, and financing activities in a year.
- Operating Activities – The cash inflow and outflow from the core business activities. It includes cash sales, cash purchases, and other cash paid or received during operating activities.
- Investing Activities – Purchase and sale of assets, loans made to suppliers and advances received from customers are examples of investing activities.
- Financing Activities – Financing activities are basically funds received by the business in the form of bank loans, purchase of shares, debentures, etc. Moneys paid in the form of dividends to shareholders, and repayment of loans are also financing activities.
The closing balance of the cash flow statement is the exact value of cash or cash equivalents left with the business at the end of the period.
These are the key financial statements that are analyzed by businesses and financial experts to determine the financial position of a business. Not all entrepreneurs are accounts. So, if you’re not sure what your financial statements are indicating, it is better to get your financial statements audited by an auditor or finance expert. A clear understanding of the financial statements and their underlying implications is very important for the monetary health of an organization, because that’s how the future business decisions, financial planning and operational activities will be carried out.