Monday, November 28, 2011

Operating a Business: Understanding Financial Statements


When operating a business, whether online or offline, understanding financial statements is an essential skill if you are to be able identify its strengths and weaknesses. A financial statement can offer a great deal of information about a business if you have been trained to read it properly.

Understanding financial statements is distinctly different from analyzing them, and you must have that understanding before you can operate a business properly and maintain a feel for its progress. There are several types of financial statement involved in operating a business, the principal of which are Aging Reports, Profit and Loss statements, the General Ledger and the Balance Sheet.

Each of these is important in keeping track of the financial state of a business:

The Balance Sheet

The balance sheet provides a snapshot of the assets, liabilities and equity of a business at a stated period of time, usually a stated date at the end of each financial year.

Assets: Current and Fixed

Current Assets: those that can be realized as cash or used to pay current liabilities relatively quickly, usually within one year. Examples are cash assets, bank accounts, accounts receivable, inventory and any prepaid expenses for services that will be provided within a year.

Fixed Assets: assets that cannot easily be converted to cash, such as real estate, plant and equipment, biological assets (animals and plants), certain investments and others that are amortized over an extended period.

Liabilities:

A liability is an obligation arising out of past transactions and not anticipated future transactions. Settling such obligations may involve the use of assets. Examples of liabilities are accounts payable, current and deferred tax liabilities and assets, promissory notes and payments received by customers for services yet to be provided.

Equity:

The Equity is the third part of the balance sheet, and is the amount of capital used to finance the company by owners and shareholders.

Fundamentally, the assets will balance the sum of the liabilities and equity. Understanding the balance sheet enables you to see how much money a company has and how much it owes others over both the short and longer terms. It can tell how the assets were paid for: either by borrowing money or from owner or shareholders' equity, and the trained eye can judge the financial health of a business from these figures.

The Profit and Loss Statement

Also referred to as the Income Statement, this shows the profit or loss made by a business over a specified time period. Fundamentally, a simple equation would be:

Income - Costs (accrued in achieving that income) = Profit or Loss.

This is oversimplified, of course, but explains in fundamental terms what a Profit and Loss statement is. Net income is that for which all taxes and other costs have been deducted, also known as the 'bottom line'. Among the costs to take into account are labor costs, other overheads such as power and maintenance costs, depreciation/amortization, raw materials and so on.

However, you do not have to know how to create a Profit and Loss statement in order to understand it and it use to determine whether a business is making a profit or a loss. Simply checking whether the income figure for the period is positive or negative gives an immediate idea of its performance for that period, a critical aspect of operating a business.

Understanding Aging Reports

An aging report lists the balance due by each customer, and for how long the balance has been outstanding. This will be broken down into individual debts if a customer has more than one outstanding balance. Aging reports can be used to prioritize bad debts and help you read more into your Profit and Loss statement. They can also help you analyze your outstanding debts for your Balance Sheet.

An apparent loss can be remedied by prioritizing debts according to the period they have been outstanding. Your Balance Sheet will show these as account receivable, but by analyzing your Aging Report, you will get a better idea of how much is overdue from customers and for how long.

The General Ledger

Fundamentally, the General Ledger holds a record of every financial transaction carried out by your company. The General Ledger will likely be linked to other subledgers, so that, for example, accounts receivable will be entered into an accounts receivable subledger, and when paid, the transaction will be entered into a cash ledger. Each of these entries will also appear in the consolidated General Ledger.

The General Ledger will maintain a running record of credits and debits plus a running balance. It provides an internal audit trail of all financial transaction carried out, and is the source of transactions included in the Profit and Loss statement and the Balance Sheet. In the event of discrepancies such as double billing and unpaid bills, the General Ledger will be used to trace the transactions and sums involved.

Understanding financial statements such as these is essential for anybody operating a business, large or small. Without such an understanding it will be difficult to analyze the financial health of the company, or to predict potential problems. Each of these four different forms of financial record and statement are important in provided a proper record and source of analysis of the worth and potential of a business.

There is a lot involved in operating a business. An important factor is understanding financial statements so you can assess the health of your company. More information on this topic is available on B&M Financial Management’s website http://www.bmfms.com

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