If you are planning to start a business in 2016 and aren’t yet familiar with the main financial statements that businesses use, here is a brief summary of how accounting is used to measure the financial position of your company.
Before we get to the statements, you need to understand the ‘accounting equation’. The accounting equation is the basis for all of your financial statements and is defined as:
Assets = Liabilities + Owners’ Equity.
Assets are basically all the things of value that your business owns or has a claim to. These can be cash, money that customers owe on their accounts (accounts receivable), bank interest on the money the business has, any property or land the business owns and any equipment, inventory or supplies the business has.
For most small or start-up businesses, liabilities will primarily be any amounts owed to suppliers (accounts payable) and any outstanding loans that the business has.
Owners’ equity is any money that the owner or owners of the business have invested in the company, plus any profits that haven’t been distributed back to the owners (retained earnings).
Another way to consider the accounting equation is that assets minus liabilities equal owners’ equity. Which really makes perfect sense when you think about it. If you add up everything of value that the business has and then deduct all the debts that the business owes, you are left with the amount of money that the owners have invested in the business, plus any money that the business has made.
In theory, the owners can withdraw all of the owners’ equity without causing financial difficulty for the business; but in reality, the fluid nature of money travelling into and out of the business means that it is wise to leave some owners equity in the business to cover any temporary shortfalls (when accounts payable are due before accounts receivable), unexpected costs (repairs and losses) and expansion plans for the business.
Now that we know the general categories that are used for the financial statements, Part II of this article will examine the main financial statements in more detail.
By Jennifer Lowe