Quick Path to Understanding Key Financial Documents
With a basic knowledge of financial management, you can validate account balances and learn how to make corrective action less painful.
Every business – even a small one – relies on a few essential financial documents. The two most important are your balance sheet and income statement, but accounts receivable, accounts payable, and bank statements are also important.
In a compact format, these documents convey the health of your business. The balance sheet lists your assets, liabilities, and equity on a specific day. The income statement (also called profit-and-loss statement) summarizes revenues, costs, and expenses over time, such as a calendar year or fiscal quarter. Other documents tally what you owe (accounts payable) and what others owe you (accounts receivable).
When managing a business, your expertise may lie more in the work you do than in the financial elements of your business. Yet it's important that you not only read but also understand what goes into financial documents. It's not as complicated as it sounds. Each document tells a story, and it's fairly easy to discern your financial status by following these tactics.
Know the parts
A balance sheet has two main sections: one listing the assets and one listing the liabilities and equity. Use this formula to summarize what your balance sheet shows: Assets = Liabilities + Equity. The balance sheet breaks down the assets into long and short term depending on how fast they can be liquidated for cash, and the liabilities into long and short term depending on when they are due.
An income statement is generally divided into two parts: one for income and one for expenses. If revenue exceeds expenses, a business has a net income or profit. If expenses exceed revenue, the business shows a loss. You can use the income statement to compare your business's most recent year with past trends and form a reasonable forecast for the next year or two.
Confirm the numbers
Each line item on your balance sheet represents various accounts, so take some time to confirm how those numbers got there, advises Larry Varone, a CPA with the Newport Beach, CA-based tax consulting firm Lyndon Group. "For every account, look at the transactions that flow through it to understand whether it's accurate and compare the transactions with the source data." No matter what kind of statement you review, apply this concept to it. This will help you ensure that all the numbers are reconciled, just as you do with your checking account statement.
"Reconciliation is everyone's Achilles' heel," Varone says. "There's an underlying assumption that everything works just fine, but that's not how it usually happens."
Understand the variances
Some accounts might not reconcile right away, whether because of timing, events that straddle calendar quarters, or other issues. For instance, an entry for accounts receivables on your income statement may show discrepancies between what has been billed versus what has been paid. You need to be continually aware of this in order to spot problems before they become more difficult to deal with.
Strive for visibility
The insight you gain from understanding your financial documents is valuable in other ways, Varone says:
- You can see when accounts receivable balances are piling up or identify when you might have extra cash on hand to place into an interest-bearing CD.
- You can identify accounting and posting errors more quickly.
- When it comes time to attract investors or sell your company, closely reconciled financial statements provide a higher comfort level than those with lingering questions.
Stay on schedule
To receive an accurate view of the financial health of your business, monitor your statements on a timely basis. Doing this also makes your month-end close easier. "You can spend one hour tracking variances rather than five hours if you've been dealing with outstanding items on an ongoing basis," Varone says.
Keep it simple
Another tactic Varone recommends to simplify your financial documents is to set up consistent formatting within the accounts. In other words, make sure identifiers such as payee names, account numbers, amounts, and "as of" dates appear the same way across all accounts. Having consistent formatting will allow you to compare information more easily and to quickly confirm that you are looking at substantiated data.
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