You may not be interested in the technicalities of record keeping or the procedures for preparing financial statements, but you should at least understand and know how to use them if you are running your own business.
[related|post]Financial statements are the instrument panel of the business that reports on managerial success or failure, and that flashes warning signals of impending difficulties. To be able to read that panel, you must understand the gauges and their calibrations to make sense out of the data it conveys. In other words, you must understand accounting and financial relationships to interpret the data in the panel.
Financial statements include the balance sheet and the income statement. The balance sheet is a statement of the financial condition of a business at a given time, and it shows the assets, liabilities, and the ownership interest as they are reflected in the accounting records. However, the reported assets or properties of the business do not reflect their current market worth; they are generally entered under the accounting rule of cost.
You must consider the difference between book value and market value when such figures are used as a basis for financial decisions. The ownership interest as it appears in the balance sheet is the net amount after liabilities, or debts, are subtracted from the assets. As a result, any difference between the asset book value and its current worth reflects a corresponding difference between the book value of the ownership interest and what it would be if assets had to be acquired at market value on the date of the balance sheet. The longer an asset is held, the greater the possibility that market prices will have changed.
The assets may be thought of as the uses to which the business has put the funds at its disposal. Liabilities show the sources from which the funds have been drawn, and these sources fall into three main categories: current liabilities, or debt that will fall due within a year; long-term liabilities, which mature after one year or more from the date of the balance sheet; and the owners’ interest or equity.
Through a careful study of financial statements, it is possible to obtain a fairly complete understanding of the financial position of your business and to become aware of significant changes that have occurred since the date of the preceding balance sheet. Bear in mind, however, that financial statements have their limits. Only those factors that can be reduced to monetary terms appear in the balance sheet.
By studying the amount and kinds of assets in relation to the amount and payment dates of liabilities, you can figure out what your creditor’s opinion will be as to the ability of your business to pay its debts promptly. A creditor pays particular attention to your cash and other assets such as accounts receivable, which will be converted into cash, and then compares these assets with your liabilities falling due in the near future. The creditor is also interested in the amount of the owner’s equity, as this ownership capital serves as a protecting buffer between the banks and any losses that your business may incur.
The financial statements also tell the owners how successful their business has been and summarize its financial position. Their goal is to determine whether your company is gaining or losing ground in the unending struggle for profitability and solvency.
Significant changes in financial data are easy to see when financial statement amounts for two or more years are placed side by side in adjacent columns, with the most recent or current year placed at the leftmost column. Such a statement is called a comparative financial statement.
Few figures in a financial statement are highly significant in and of themselves. It is their relationship with other quantities, or the amount and direction of changes since a previous date, which is important. Analysis is largely a matter of establishing significant relationships and pointing up changes and trends.