If you are in business, you know that financial statements are a source of valuable information. Not only can you track the progress of your business but you will also be able to determine which areas of the business require restraint or what is bringing in the most income. However, if you don’t understand these financial statements, you are not going to be able to obtain this important information.
Accounting is not everyone’s forte, but the basics can be learned in order to give you a leg up in the business world. You may think that it would be easier to get someone else to decipher it for you, and whilst that may be true, it’s just an unnecessary cost. It is possible for you to learn accounting and this book summary is a great start to give you the key points to learn.
In this summary readers will discover:
- The accounting equation
- Income Statements
- Cash Flow Statements
- Financial Ratios
- Double-entry Accounting
Key lesson one: The Accounting Equation
Accounting is actually pretty simple if you know what to look out for. There are, for example, certain keywords or terms that you should learn. The accounting equation is a good place to start.
An accounting equation uses assets, liabilities and owner’s equity to measure the financial position of a business. Assets refer to everything that a business owns, properties, inventory and cash. Liabilities refer to all debts such as loans. The Owner’s equity or also sometimes called Shareholders Equity is the difference between assets and liabilities. To put the accounting equation simply then is to say that Assets minus Liabilities is equal to Owner’s equity.
This equation works no matter the size of your business. To give you a simple example to demonstrate, imagine you have an orange juice stand. Your assets total $100 and include your juice, the stand, cups and uniforms. You took out a loan of $60 to start your business – this would be your liabilities. Therefore to calculate the owner’s equity you would subtract your liabilities (which is $60) from your assets (which total $100). Owner’s equity is thus $100 – $60 which is equal to $40.
Importantly, when using the accounting equation, you need to remember that somebody’s asset may actually be another person’s liability. The reverse is also possible. This may sound confusing but consider something like a mortgage on a new home. The mortgage may be your liability but t is the bank’s asset.
The accounting equation also forms the basis for the balance sheet for your business. Now, if you don’t know what your balance sheet is, it’s basically your business’s core financial statement. By expanding the accounting equation, you can use it to generate your balance sheet and track your business’ financial position.
Using theorange juice business from earlier as an example, assets will include cash, cash equivalents, inventory, accounts receivable, property, plants and equipment. To break this down further, we would list the money that is available in bank accounts, soon-to-be-mature investments, the orange juice, payment for an event completed the previous week, the orange juice stand and your juicing equipment. Liabilities will include everything that is payable. This would include the amount you owe for purchasing oranges and any loans you took out. If you have any common stock or retained earnings, these would fall under owner’s equity.
One important rule in the accounting equation is that no matter what values you have calculated for everything, liabilities plus owner’s equity must always equal assets.
Key lesson two: Income Statements
The next document to understand following the accounting equation and balance sheets are income statements. Balance sheets show you the financial position of your business at any given point in time. Income statements, on the other hand, allow you to track your business’ performance in terms of finances within a specific timeframe. They are also referred to as a profit and loss statement because you basically take what you have earned and subtract what you have spent.
To look at this in detail, your income statement begins with your revenue or income from sales. The Cost of Goods Sold or CoGS will be listed as the costs linked with the production of the goods which are sold. In order to get your Gross Profit, you need to subtract the CoGS from the revenue. Next on the statement are the expenses. Expenses include things like rent, salaries, marketing and insurance. To get your net income, you will need to subtract these expenses from your gross income.
Putting this all in an example is an easier way to see it in action and understand it completely. If you want to generate an income statement after selling t-shirts for a month, you have to first calculate how much it cost you to manufacture them. Let’s say you made 100 t-shirts that cost $12 each to manufacture. Therefore, your CoGS is $1200. By the end of the month, you have sold all the t-shirts at $25 each giving you $2500 in revenue. Your expenses for marketing and salaries totalled $1000.
Your gross profit is thus $2500 minus $1200 which is $1300. And your net income is $1300 minus $1000 in expenses which equals $300. This $300 indicates that you have made an overall profit. If it turned out to be a negative number, it is indicative of your business losing money.
Key lesson three: Cash Flow Statements
Firstly, do you know what a cash flow statement is? Well, it’s exactly what it states: the inflows and outflows of cash. You might think that this sounds just like an income statement, but it differs because there might be a difference in time when cash actually moves in and out of the business account. Just imagine that your business completes some work in October but the client only pays in November. As much as the amount would occur in your income statement and balance sheet in October, it will not be in October’s cash flow statement because the money had not been paid in October.
Cash flow statements are further separated into three categories. These are operating activities, investing activities and financing activities.
Operating activities includes all transactions covered in the net income part of your income statement. It will include sales, payments to suppliers and employees and tax payments to name a few.
Investing activities refers to cash movements regarding investments and capital assets. Capital assets are those assets that last longer than a year. So investing activities therefore covers cash flow from the purchase or sale of stocks and bonds, property, factories or equipment.
Financing activities refers to cash flow from company owners and creditors. It includes dividends paid to shareholders and any loans.
The amounts recorded in these three categories are used to calculate your business’ net increase in cash. This is your cash flow statement. This statement is important to track your actual cash flow and could potentially let you know if and when you are going to run out of money.
Key lesson four: Financial Ratios
Once you finally understand all the terms and your statements are in order, you can analyse them. One way of doing this is by calculating financial ratios for your business. Here, the higher the ratio, the better.
Liquidity ratios will give you an idea of how easily a business can meet its short-term financial obligations. Current ratios are a type of liquidity ratio and assess your business’ ability to pay current liabilities using current assets. That means whatever is currently available. So, your current ratio is equal to your current assets divided by your current liabilities.
Quick ratios calculate worst-case scenarios. It does this by leaving out any inventory balances from your current assets. So a quick ratio would first subtract inventory from current assets before driving by current liabilities. The lower the quick ratio is the harder it will be for your business to pay for its liabilities if you cannot sell your inventory.
Profitability ratios will calculate a business’ profitability relative to its size. A return on assets ratio will indicate how efficiently a business uses assets to make a profit. To calculate a return on assets ratio you just have to divide the net income by the total assets. And, if you substitute the total assets with shareholder equity, you can then calculate the return on equity ratio as well.
By analyzing all these ratios, you will be able to look at your business’s financial health holistically.
Key lesson five: Double Entry Accounting
The Generally Accepted Accounting Principles or GAAP is a set of best practices followed by many countries. There is one key aspect of GAAP and that is double-entry accounting.
Double-entry accounting documents any increases and decreases in order to balance out the accounting equation. For example, a computer purchase is a spend of $1000 for the business and is, therefore, a negative in the business accounts. However, the computer is now an asset for the business and will be recorded as an increase in $1000 in business assets.
You also need to get used to using the terms debit and credit when referring, respectively, to increases and decreases. These debits and credits are recorded in a General ledger. According to GAAP when recording your debits and credits in the General ledger, debits occur first and are visible on the left and credits occur in the next line, indented to the right.
This general ledger will be used to creates your financial statements.
The key takeaway for Accounting made Simple is:
Accounting does not have to seem like a foreign language to you. It basically uses assets, liabilities, and owner’s equity to see where a company is financially, prepare for taxes, and find ways to improve. If you learn the basic terminology and calculations, you will be able to gain a tremendous amount of insight into your business’s financial health.
How can I implement the lessons learned in Accounting made simple:
Take the time to learn the basic terms. You also need to ensure that all the information you need is easily accessible. Things like bank statements, accounts, receipts and invoices must be documented to ensure that you have accurate data to begin with.
