Accounting Terms You Should Know: Part 2

Welcome to the second part of our five-part series on accounting basics!  You don’t have to become a CPA to start a business, but after you’ve been running one for a while, you’re going to find that knowing the language helps.  You may not want to spend your valuable time doing your own books, but if you have a bookkeeper, accountant, or fractional CFO, then you’ll get more value out of them if you can keep up with the jargon they use.

Last time, we discussed the basic concepts that underlie the fundamental accounting equation, Assets = Liabilities + Owner’s Equity.  Today we’re going to talk about the major financial statements that will give you information about those accounts.

Before we do, a word about eating our vegetables and procrastination:  A lot of small businesses that started out as side hustles don’t start preparing financial statements because they dread accounting and don’t want to suffer through doing the books, and then as they grow, not having financial statements starts to hamper their growth.  For example, you aren’t going to get a loan from a bank if you don’t have a balance sheet.  And that’s why it helps to have a basic understanding of what these financial statements are and what they do.  Once you understand them, it’s a whole lot easier to extract valuable information from financial statements that someone else is preparing for you.

So without further ado, here are the main financial statements that you’ll want to have for your business:

Balance Sheet

The balance sheet is what a lot of people think of first when they think of financial statements, and for good reason.  In lots of ways, it’s the simplest of your financial statements because it’s the most intuitive.  The balance sheet is just a snapshot in time of all of your business’s assets and all of the obligations and liabilities that it owes to third parties.  You can prepare a simple balance sheet by adding up the value of your assets and then subtracting all of your debts.  This is why a lot of people think of a balance sheet as how they calculate their net worth.

But when a business starts preparing a formal balance sheet, the analysis gets a little more complicated.  The reason for that is that in general terms, accounting is about creating an historical record of past economic transactions so that at some point in the future, we can go back and see what happened.  In order to make sure that financial statements serve that purpose, there are a lot of rules about when and how you record transactions and how much you record when you do.

As a business owner, you probably don’t want to spend your time learning those rules, which is part of why Haven exists.  Haven shows you a balance sheet for you based on transactions that you conduct using Haven and by linking to your bank accounts.  All the time that you would’ve spent preparing your own balance sheet is time that we’d rather help you spend growing your business, so we take the preparation of the balance sheet off of your plate.

So when you look at that balance sheet, you’ll see all of your accounts for assets, liabilities, and owner’s equity, just like we discussed in the first part of our accounting series.  These basic accounts will give you the information that you’ll need to start calculating financial ratios and other metrics that can help you understand how well your business is running.

Income Statement

The second major financial statement is the income statement.  The income statement is exactly what it sounds like:  a way of telling you how much money you made.  Your revenue and expense accounts that we discussed in the first part of this series will show up here.  The very first line of your income statement is your revenue, which you’ll sometimes hear referred to as the topline number.  And then it’s death by a thousand cuts as all of your various costs of doing business show up on the lines below.  After we subtract those costs from your revenue, we end up with your net income.

Among the ways that your income statement is different from your balance sheet is the fact that an income statement gives you information over a period of time, whereas your balance sheet speaks only as of one distinct moment in time.  For example, you might have a balance sheet that speaks as of your most recent year, but your income statement might tell you about your revenue, expenses, and net income over the entirety of that year.

For that reason, it’s important to be careful to understand the historical timing of whatever financial statement you happen to be looking at.  Haven makes it easy for you to do this with your own financial statements by adjusting the dates right in the app.  For example, if you want to see a balance sheet for each of the last five years, then you can easily select that option, and then you can get an income statement for the entirety of each of those five years, too.

As businesses grow larger, however, the interpretation of the income tends to evolve.  Early on, a small business might start out by using what we call the cash method, which basically means that you record transactions when you actually get the cash in the door.  Larger businesses tend to switch to the accrual method, which means that you record transactions based on the timing of their economic effects, which might be different than when cash actually shows up.  But when that switch happens, the income statement doesn’t always provide the most important information that you want when thinking about how your business is doing.  And for that, we turn to the unsung hero of the financial statement…

Statement of Cash Flows

We started our discussion with the balance sheet because, well, everyone starts with the balance sheet.  In a lot of ways, it’s the simplest of the major financial statements and the most intuitive.  But one of the lesser known financial statements, the statement of cash flows, is one of the most important.  Whereas the balance sheet will show you how much cash you have on hand right now, and several historical balance sheets in a row can show you how your cash balances have changed over time, the statement of cash flows will break down where those changes in your cash flows are coming from.

There are two ways of presenting the statement of cash flows:  the direct method and the indirect method.  The direct method is generally considered to be the more intuitive method, showing you the effective all cash transactions grouped by operating, investing, and financing activities.  (This is the approach that Haven follows by default.)  The indirect method starts with net income and then makes adjustments to net income by backing out non-cash transactions to reconcile net income to cash flows.

The indirect method is a little less intuitive, but the thing that makes it less intuitive is the whole reason why the statement of cash flows is so valuable, and that’s the fact that revenue and cash flow aren’t the same thing.  You might have done a job for a customer and therefore have earned some revenue, but if you don’t collect that account receivable, then it didn’t do you any good.  In any business, cash is king, so keep that in mind and don’t forget to take a look at your statement of cash flows and think about where your cash is coming from and how you can keep it rolling in!

Statement of Owner’s Equity

The fourth financial statement is the statement of owner’s equity.  In a sense, the statement of owner’s equity does for your equity accounts what the statement of cash flows does for your cash accounts.  It shows you why your equity accounts changed over whatever accounting period you’re interested in.

Lots of things will affect your equity accounts.  For example, at the end of every accounting period, revenue and expense accounts get closed into your retained earnings account (or more frequently if you’re using Haven because Haven closes your revenue and expense accounts every time you look at your financial statements so that your numbers are always up to date!).  If you raise money from an investor, then your equity will increase, and if you pay yourself a dividend or other distribution, then your equity will decrease.

It might be tempting to go straight to the statement of owner’s equity to see what you’re worth, but try to keep in mind the fact that the number in your owner’s equity accounts is NOT what your business is worth!  Equity is a residual account, and by definition, when added to your liabilities, the sum total must equal the total of your asset accounts.  That’s what we mean when we say that your accounts are “in balance.”  And the accounts have to be in balance so that we have confidence that we’ve properly recorded all past transactions.

Remember, accounting is all about understanding what has happened in the past so that you can make reasonably informed guesses about the future and be better prepared to meet tomorrow’s challenges.