Within any business, there is a natural accounting flow. In some cases, entrepreneurs prefer to do it the old fashioned way – keep all original receipts and write everything down in journals and ledgers. Some like the digital age way of accounting with Excel spreadsheets and accounting software.
Whichever way you do your accounting process, there are two financial statements that have always been the most important in operating a business: the Balance Sheet and Income Statement.
Within any accounting system there are five basic types of accounts:
- Assets
- Liabilities
- Capital/Equity
- Income
- Expenses
The first three accounts are called permanent or real accounts, and stay on the books forever. They carry over every financial period. The last two accounts are temporary or nominal accounts, and exist only during a specific accounting cycle, usually a fiscal quarter or year, after which they close out and transfer their balances into the permanent accounts.
And as a small business owner, it is important to know the statements that encompass these accounts, and how you can use them to improve your business.
THE BALANCE SHEET
The balance sheet consists of the first three types of accounts: Assets, Liabilities, and Equity, otherwise known as the “permanent accounts”, since they carry over month after month, year after year. As the name implies, it is a statement that balances two sides of the basic accounting equation: Assets = Liabilities + Owners Equity. These two sides of the balance sheet must ALWAYS, balance.
When a balance sheet is created, it tells a snapshot picture of the business’ financial position at any given time, rather than a historical analysis of accounts (like an income statement). For instance, you can run a balance sheet today and then operate your business tomorrow, but it will look differently because money will have been taken in and paid out, giving a slightly different “snapshot” after a day’s operation.
Ultimately, the balance sheet is used to determine whether there are enough assets to cover debts. Put another way, the balance sheet basically tells the owner, or any viewer (including potential buyers of your business), how much cash liquidity you have in the business, how much debt exists at the time the balance sheet was created, and ultimately how much the owner equity is left after subtracting liabilities from assets.
INCOME STATEMENT
The income statement is pretty self-explanatory as well. It tells how much income you made after subtracting total expenses from gross revenues. But while a balance sheet gives a snapshot in time, the income statement presents data over a period of time, such as a month, a quarter, or a full fiscal year.
The accounts used in this statement are temporary accounts because once the income statement is run for the chosen period of time, the accounts are “closed” or brought back to a balance of zero to begin the new fiscal cycle. The balances are transferred to the balance sheet.
For instance, if your income statement showed a net income of $50,000 after subtracting total expenses from gross sales revenues, you would transfer that $50K into your owners equity account on the balances sheet with another journal entry, thus closing all income/expense accounts, and adjusting the equity account accordingly.
Of course, if you had more expenses than revenue over a course of a fiscal period, you would transfer a negative balance to your owner’s equity account, thus reducing your worth in the business.
The income statement gives you the bottom line and answers the question, “how much did my business make?”
Both the balance sheet and income statement can work in tandem. For instance, that piece of equipment you bought for $5,000 five years ago is not worth that much today. But accounting practices allow you to write off the declining value of your assets as an expense, also called depreciation. You can use depreciation to adjust a more accurate value of your assets, and use it as an expense to reduce your tax liability without actually spending any money.
Learn to use your balance sheets and income statements frequently. The wiser you are about what the numbers mean on each statement, the better you’ll be to make decisions that will help your small business grow.
