Numbers, numbers, numbers! Our journey into accounting continues with the three financial statements. You as a small-business leader do not have to be an accounting wizard, but we strongly encourage you to get a general understanding of what these documents are, and how you can use them to your benefit. Find the rest of this series of blog posts here: First Steps Into Accounting.
In This Post
We will cover the following in this blog post:
- An Overview Of The Financial Statements
- 1. The Income Statement
- 2. The Balance Sheet
- 3. The Cash-Flow Statement
- Why Care?
- Intuition In Accounting
An Overview Of The Financial Statements
There are three financial statements of importance to any business, no matter its size:
- The Income Statement (sv. resultaträkning, fi. tuloslaskelma)
- The Balance Sheet (sv. balansräkning, fi. tase)
- The Cash-Flow Statement (sv. kassaflödesanalys, fi. kassavirtalaskelma)
1. The Income Statement
The income statement is created for a specific accounting period, typically a year or quarter.
It covers the revenues and the expenses of an enterprise.
Mathematically, it looks like this: Net Income = (Total Revenue + Gains) – (Total Expenses + Losses).
Key points to track are:
- Revenue (+)
- Gains (+)
- Expenses (-)
- Losses (-)
In Swedish and Finnish, the name of the “income” statement is a bit more reflective: “result calculation” roughly translated.
The purpose is to calculate the result of the period to track and if it is negative, perhaps a change of course would be a good idea.
2. The Balance Sheet
The purpose of the balance sheet is to show a snapshot in time of how the enterprise is doing by covering:
- What the company owns (product inventory, office gear, buildings, anything of economic value.
- Something owed to other businesses.
- Own or others’ capital (private investors, bank, etc.)
Whereas the income statement follows the calendar year normally, and accounts in bookkeeping are zeroed at its end so to speak, the balance sheet starts on day 1 of registering for business, and simply continues.
The vocabulary is a lot to learn especially when you start digging deeper into calculations such as Return on Investment/Assets/Equity, inventory turn-over, debt turn-over etc.
Then it helps to return to these two financial statements as well as the third, cash-flow statement, coming up next.
3. The Cash-Flow Statement
The cash-flow statement is the easiest of the three to grasp, as basically it is about cash only: what comes in and what goes out.
It is possible to prettify the other two such that when you own stuff and calculate its value decreasing yearly over for example ten years, it ends up affecting expense accounts in the bookkeeping. Even when it is synthetic in a sense.
Let’s say your laptop is owned by the business, so how do you calculate wear and tear, tell accounting that its value is decreasing a bit each year? Who said it should decrease to zero in 5-10 years? It is synthetic. When a business grows and owns a lot more, it starts to add up and affect overall numbers in their own right.
You can sort of hide reality there, but not in this cash-flow statement. This one is real numbers on the table, facts straight up about the health of a business.
Why these statements? Why the math formulas? Why care?
As a person with a degree in science I appreciate the need for both quantitative investigations and subjective experiences shared through qualitative research. In business, people are of course key to the profitability of a firm, but in order to keep serving customers the firm needs to be more than a hobby endeavour.
The numbers in these financial statements don’t lie and you may have a beautiful offering, but the firm must stay afloat to remain in business.
How is the business doing honestly? Should you make changes? That is for business-strategy people to decide (aka you in your leader hat). The numbers give guidance, but my final point before wrapping up is on intuition. It is a balance.
Intuition In Accounting
What is Intuition in accounting, you might ask? Frankly, investing time on extrapolating from existing numbers into the unknown future can be futile. And said time could be better spent on experimentation. Why? We don’t know what we don’t know.
Predictions are great, but they can take you only so far. Suddenly a pandemic hits us and all the risk management efforts in the world could still have prepared a firm for only a part of its current ordeals.
Sometimes your intuition in terms of what could sell is far more useful than the prettiest of spreadsheets full of ifs and maybes.
Fact is you know what worked in the past, if you’re relying on your financial statements, but who says the same will work in the future and/or the behavioural pattern will remain unchanged? It could work still, but a competitor could pop up, people discover they don’t want that thing replaced when one is enough and will last for years to come, or your expertise is a one-time service such as a brand identity graphically designed for the customer.
Especially when starting in business it can be tricky to find out what works, so adopting a researcher’s mindset of testing and analysing results is a fantastic approach to dealing with the uncertainty.
You are also forgiven something resembling erratic behaviour thanks to this status of a beginner and I warmly encourage you to put instincts to good use.
Finally, remember that you are not necessarily your ideal customer. Do your best to avoid getting stuck in what you love making and selling, and instead keep an open mind with regard to customers’s wishes.
Please share your thoughts on financial statements in the comments!
This is a blog post in our beginner-level series First Steps Into Accounting on accounting and bookkeeping.
Photo credit: Fabian Blank.