Simple financial statement fundamentals

You check out your income statement to see how much money your business is making and know about the balance sheet and statement of cash flows but would like to understand them a bit better.  You’ve come to the right place! This is the first in a series of posts that will familiarize you with some general financial statement concepts before focusing on individual financial reports.  The goal is to help you read your financial statements so you can make smart financial and management decisions.

What are financial statements?

Financial statements are a collection of reports which show the financial results, financial condition, and cash flows of your business. One statement alone does not provide a complete picture of your company’s financial health therefore it’s important to review the statements together in order to understand how your business is doing.  A complete set of financial statements consists of the following:

  • income statement – the financial results of your business over a period of time (i.e., for the year ended December 31, 2015). It shows revenue, expenses and net income (loss).
  • balance sheet – the financial condition of your business at a specific point in time (i.e., as at December 31, 2015). It shows what you own (assets), owe (liabilities) and what’s left over (equity).
  • statement of cash flows – shows the cash flows into and out of your company. Its particular focus is on the types of activities that create and use cash which are operations, investments, and financing. Like the income statement, the statement of cash flows is for a period of time (i.e., for the year ended December 31, 2015).

What are accounting methods?

Accounting methods are the rules that determine when and how your revenue and expenses are recorded.  The two main methods are cash and accrual.   Quite simply, cash-based accounting involves recording transactions when cash is received and paid; there are no accounts receivable or payable. While this method clearly shows the cash flow for your business, it doesn’t provide a good indication of longer-term profitability because your financial results are based on the timing of payments.  Accrual-based accounting involves recording revenue when it is earned and expenses are matched to the related revenue and/or recorded when they are incurred.  This results in an income statement that better measures the profitability of your business.  The accrual method is also required by the CRA (unless you’re a self-employed commission sales agent – see CRA accounting methods).

Future posts in this series will focus on individual financial reports to help you better understand their components and provide you with the ability to assess the financial position of your business so you can make informed decisions.

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