UNDERSTANDING FINANCIAL STATEMENTS: A Beginner’s Guide

Yogi Berra once said, "it's like déjà vu all over again".? Why is this a perfect quote for this article?? Because I re-write this article every year.

A cardinal rule for social media posts is don’t re-post the same information.? So, why have I re-written this article every year since 2012?? Because every day I speak with small business owners who still don’t understand their financial statements.

A company’s financial statements are like a child’s school report card.? If you never look at, or understand, a school report card, how do you know how well the child is doing in school?

Somehow, I must think that if I re-write this article “perfectly”, business owners will finally understand how important understanding their financial statements is to the success of their companies.? Perhaps, I should take to heart a quote for myself.? Albert Einstein said, “The definition of insanity is doing the same thing over and over and expecting different results.”

So, here’s to insanity!

The two basic financial statements — the Balance Sheet and Income Statement — often confuse business owners. This guide has been written for beginners to provide a basic understanding of these two financial statements.

1. The Basics Defined

Balance Sheet: Think of it as a snapshot or picture of an entity’s financial health at a specific date. It details what a business owns (assets), owes (liabilities), and the net worth or equity of the owners.

Income Statement: This is like a movie, detailing the financial performance of a business over a period (a month, quarter, or year). It itemizes revenues, expenses, and, ultimately, profit or loss.

2. Distinguishing Features

• Balance Sheet: Assets: Valuable items owned by the company, classified as either short-term (current) or long-term. Liabilities: What the company owes, again, either short-term or long-term. Equity: The value that remains after subtracting liabilities from assets.
• Income Statement: Revenues: Income from the sales of goods/services. Expenses: Costs related to earning said revenues. Net Profit/Loss: The result after subtracting expenses from revenues.

3. Illustrative Example

Let’s consider a fictitious enterprise, 'Techtronix Innovations’. The following are its Balance Sheet and Income Statement:

4. Addressing Common Confusions

Distinguishing certain accounts between the Balance Sheet and Income Statement can be challenging. Let's demystify some commonly confused accounts:

• Vehicles (asset) vs. Vehicle Expense (expense): Vehicles, when purchased, are considered a long-term asset and belong on the Balance Sheet. Over time, they may incur maintenance or fuel costs; such costs are recognized as Vehicle Expense on the Income Statement.
• Accumulated Depreciation (asset) vs. Depreciation (expense): As assets like vehicles or equipment age, they lose value. This loss in value is captured as an expense (Depreciation) on the Income Statement. However, the total value that the asset has lost since its acquisition is accumulated and shown as a deduction from the asset's value on the Balance Sheet, termed as Accumulated Depreciation.
• Dividends vs. Salaries: Dividends are a distribution of profits to shareholders and are not considered an expense. They are not on the Income Statement but reduce Equity on the Balance Sheet. In contrast, Salaries are a regular business expense and appear on the Income Statement.
• Rent vs. Mortgage: Rent is an operational expense and is part of the Income Statement. However, if a business takes a mortgage to purchase a property, the property becomes an asset, and the mortgage becomes a liability on the Balance Sheet.

5. Conclusion

A Balance Sheet and an Income Statement are two sides of the same financial coin, providing complementary perspectives. One captures a singular moment, and the other narrates a story over time.

Understanding your financial statements can significantly empower you in making informed business decisions. Remember, a little knowledge can go a long way, and a strong foundation will carry you even further.

If you are interested in a discussion of financial statements, check out this 4 article series:

Part 1 - Financial Statement Literacy (Introduction)?

Part 2 - Financial Statement Literacy (Balance Sheet)?

Part 3 – Financial Statement Literacy (Income Statement)?

Part 4 – Financial Statement Literacy (Cash Flow Statement)?

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