is the net worth of the business. Another way of valuing net worth is to subtract what the business owes (liabilities) from what the business owns (assets).
Assets – Liabilities = Owner’s equity
or
Assets = Liabilities + Owner’s equity
One final note to keep in mind about the balance sheet is its valuation. In most countries, accounting rules (called Generally Accepted Accounting Principles or GAAP) require that the balance sheet be valued at historical cost. That means, for example, that if your business bought the building in which it resides in 1982 for $100,000 and it’s now worth $295,000, it will still be recorded in the balance sheet at its historical cost of $100,000 (minus depreciation). For this reason, a balance sheet does not always give a business owner the true picture of the value of a business. We will discuss valuation principles in later chapters.
The Income Statement
The income statement shows the revenue and expense activities of the business for a period of time — be it a day, week, month, or year. See Sample 2 for an example of an income statement.
Sample 2: Income Statement
The first section of the income statement shows the business’s revenues. This is the amount of sales it has made in the period, regardless of whether or not the money has been collected. For example, if your business sold $50,000 worth of product or services, but you weren’t going to collect the money until 90 days after the period end, you would still show the $50,000 as revenue (and you would have $50,000 in Accounts receivable on the balance sheet).
The next section of the income statement shows the business’s total expenses for that period, again, regardless of whether or not they have been paid.
The number at the bottom of the income statement is the net profit for the period, calculated by subtracting the total expenses from the revenue.
The Cash Flow Statement
The cash flow statement is the most misunderstood statement in your financial statement package. Its purpose is to show a summary of the sources and uses of a business’s cash during a particular period. It answers the critical question, “Where did my cash go?” See Sample 3 for an example of a cash flow statement.
Sample 3: Cash Flow Statement
The cash flow statement can take many formats but the most common one breaks the statement into three sections:
• Cash from operating activities. This could include the collection of receivables, payment of payables, and purchase of inventory.
• Cash from investing activities. This could include the purchase or disposal of equipment.
• Cash from financing activities. This could include borrowing new money from lenders, repaying debt to lenders, new capital investments from the owners, and cash distributions to owners.
The sums of all three sections of the cash flow statement plus the net income minus non-cash expences are combined to show the net increase or decrease in cash for the period. For example, if you started your year with $5,000 in the business’s bank account and now there was $2,700, the cash flow statement would summarize all the inflows and outflows that make up the net decrease in cash of $2,300.
Chapter Summary
• The three major financial statements for a business are the balance sheet, income statement, and cash flow statement.
• he balance sheet represents a snapshot in time of what a business owns and owes, usually recorded at historical cost.
• The income statement represents a business’s operating activity for the period leading up to the related balance sheet.
• The cash flow statement answers the question, “Where did the money go?” It shows cash inflows and outflows from all activities for the period leading up to the related balance sheet.
2
Basic Budgeting
In this chapter, you will learn —
• The importance of budgeting
• How to prepare and update a monthly budget report
• What to do with the information
The purpose of this book is to take the basic information that you have about your business’s financial position and create a structured plan to maintain, track, and improve your financial performance.
Under half of all businesses that have fewer than five employees maintain a working budget, the most basic of management reports. These businesses give many reasons, including, “I can’t predict my sales” and “It takes too much time.” However, businesses that have been around for a long time understand the importance of tracking and planning. Without a solid understanding of your impending performance, it is nearly impossible for you to make intelligent financial decisions for your business.
Case Study
“See? I told you that budgeting was useless.” Joe banged his half-empty coffee cup down on the desk. “Over the last three months we’re nowhere close to where our budget says we should be.”
“Vivian, our accountant, explained that it was an ongoing process,” said Becky. “This is the first time we’ve ever sat down and looked at our operating performance. She said we’ll get better
at budgeting the more we understand our numbers.”
“Well, it all seems ridiculous to me.” He paced the floor of the office. “We said we were going to do $21,000 in revenue last month, and we only did $18,000 — which is pretty much the same as last year.”
“When we prepared the budget,” Becky explained, “we said that we were going to do a large mail-out to attract new customers. That’s why we budgeted an increase in sales.”
“Well, I just got too busy to do that,” Joe said quietly.
“And here is the impact on our numbers,” replied Becky. “That’s the point of budgeting. To understand what the numbers are telling us.”
The Monthly Budget Report
The monthly budget report is the most basic of all financial planning tools. It shows what the projected revenues and expenses
