If you’re like most business owners, you didn’t get into business to do your accounting. However, a basic understanding of accounting statements is essential to making sound business decisions. That’s because accounting statements provide critical information about your business’s financial health.
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What is a cash flow statement? A cash flow statement (which some might also know as a statement of cash flows) is a financial document that shows how your business is performing financially.
Knowing your cash flow is vital for understanding a company’s financial health and accurate forecasts. In addition, a cash flow statement can help you identify potential problems you may need to address.
Three main types of activities get reflected in a cash flow statement.
Operating activities include cash inflows and outflows from your business’s day-to-day operations. Operating activities include revenue from sales, suppliers’ payments, and rent and utility expenses.
These activities include cash inflows and outflows from investments made by your business. Examples of investing activities include the purchase of equipment, the sale of assets, and the payment of dividends.
Finally, financing activities include cash inflows and outflows from the financing of your business. Examples of financing activities include issuing new equity, debt repayment, and interest payment.
Businesses can prepare a cash flow statement using one of two methods: direct or indirect.
The direct method is the most straightforward way to prepare a cash flow statement. With the direct method, you list the cash inflows and outflows from each of the three categories of activities.
The indirect method is a bit more complex but provides more information. In the indirect way, you begin by preparing an income statement. From there, you adjust the income statement for items that did not involve cash. Finally, you add the resulting cash flows to the cash flow from operating activities.
The main difference between the two methods is how they treat non-cash items. Non-cash items are items that do not involve a cash transaction, but they still affect your business’s financial position.
Examples of non-cash items include depreciation and amortization. The direct method is the preferred method for preparing a cash flow statement, but the indirect method is still widely used.
A balance sheet is an accounting statement that shows your business’s assets, liabilities, and equity and can help you make relevant business decisions. The balance sheet can use either the accrual basis or the cash basis of accounting. The accrual basis of accounting is the most common method. With the accrual basis, you recognize income when it gets earned and expenses when you incur them. As a result, this method gives a more accurate picture of your business’s financial position.
The cash basis of accounting is less common but more straightforward. Cash only recognizes income and expenses when cash is received or paid. This method does not provide as accurate a picture of your business’s financial position, but it is easier to prepare.
The balance sheet has three main areas: assets, liabilities, and equity.
Assets are everything that your business owns. They can be either current assets or non-current assets.
Current assets will convert to cash within one year. Examples of existing assets include cash, accounts receivable, and inventory. On the other hand, non-current assets will not get converted to currency within one year. Examples of non-current assets include property, plant, and equipment.
Liabilities are everything that your business owes. They can be either current liabilities or non-current liabilities. While current liabilities are liabilities that will be due within one year, non-current liabilities are liabilities that will not be due in one year, such as long-term debt.
Equity is the ownership interest that shareholders have in a company. Equity can be either common equity or preferred equity. Common equity is the most common type of equity. It represents the ownership interests that common shareholders have in a company.
Preferred equity is a less common type of equity. It represents the ownership interests that preferred shareholders have in a company. Preferred shareholders have preferential treatment over common shareholders regarding dividends and asset liquidation.
Finally, the income statement is a financial statement that shows your business’s revenues, expenses, and profits. The income statement can use either the accrual basis or the cash basis of accounting.
As with the balance sheet, the accrual basis of accounting is the most common method. With the accrual basis, expenses are noted when they exist, and income is recognized upon earning it. As a result, this method provides a more accurate picture of your business’s financial performance than a straight cash basis of accounting.
The income statement has three main sections: revenues, expenses, and profits.
Revenues are the amounts that your business earns from selling goods or services. They are also called sales or turnover.
Expenses are the costs that your business incurs to generate revenue. They include the cost of goods sold, operating expenses, and interest expenses.
Profits are the difference between revenues and expenses. They represent the amount your business has earned after deducting its costs. There are two types of profits: net income and gross income. Net income is the profit that is available to common shareholders. Gross income is the profit available to all shareholders, including preferred shareholders.
The income statement is one of the most critical accounting statements because it shows whether your business is profitable or not. If your business is not profitable, it will not be able to survive in the long run.
The income statement is also essential because you can use it to calculate other financial ratios, such as the profit margin and the operating margin.
As you can see, accounting statements can give you many insights into your business’s finances. For example, they can help you understand your business’s assets, liabilities, equity, and profits. They can also help you calculate financial ratios that are important for making decisions about your business.