Accounting Basics and How to Interpret Financial Statements

Setting up your records in an accounting software package is an essential step to keeping tabs on how your business is performing financially and to fulfill your requirement of keeping accurate records for tax purposes. Equally important is the knowledge of how to understand the Financial Statement so that you can make the right choices for your business.

Accounting software such as Quickbooks and Simply Accounting have a built-in Statement of Financial Position (SFP) and the Statement of Profit and Loss (P&L). These accounting packages also have budget modules in order to create a budget that reflects your business plan that can then be compared against your actual results. Either program is good for small business but I favor Quickbooks because of its flexibility.

While I'm not going to go into the specifics of setting up either Quickbooks or Simply Accounting, both have set-up wizards that will guide you through the process. Instead, I'm going to focus on some basic concepts that will enable you to understand the accounting principles used by both programs.

Basics About Accounting

Accounting functions under a double-entry system that always keeps the Statement of Financial Position in balance. Every transaction recorded in the accounting system is called a journal entry and each journal entry must be in balance where the debits equal the credits. A debit (DR) is a positive number and a credit (CR) is a negative number often expressed with parentheses around the number like ($1,500). If you pay John $2,100 ($2,000 + $100 for sales tax) for a website you would record the following entry:

Sign Account Amount
DR Website expense 2,000
DR Sales tax 100
CR Cash (2,100)

Notice how the debits and credits both add to $2,100. If the transaction is not in balance the accounting software will not allow you to record it until it is corrected. When the accounting program records an entry it is actually posting it to the General Ledger that keeps a running tally of all your transactions by each account.

All categories of accounts are naturally in a debit or credit position. For example, Cash, which is an asset, is naturally in a debit position. In order to increase Cash by depositing money to the bank you would debit it to the General Ledger and in order to decrease Cash you would credit it to the general ledger by issuing a check.

In order to increase a liability account like Mortgage Payable, you would credit it (say when you originally take out the mortgage) or to decrease the same account you would debit it (when you make a payment).

Take note that sometimes an account can be in a position opposite to its natural position. For instance, if cash is in a credit position you would likely owe money to the bank in the form of a bank draft. Please view the chart below for a full list of all the natural positions of the different categories of accounts.

Natural positions for account types
Account Category Natural Position Increase Decrease
Assets Debit Debit Credit
Liabilities Credit Credit Debit
Equity Credit Credit Debit
Revenues Credit Credit Debit
Expenses Debit Debit Credit

Understanding the Accounting Behind the Transactions

When you record an invoice payable the accounting program records an entry in the General Ledger as follows:

Sign Account Amount Effect
DR Expense (ie. Insurance) 1,000 Expenses are increased on P&L
CR Accounts Payable (1,000) Liabilities are increased on the SFP

When you pay the above invoice the entry recorded is:

Sign Account Amount Effect
DR Accounts Payable 1,000 Liabilities are increased on the SFP
CR Cash (1,000) Assets are decreased on the SFP

When you record a sales invoice the accounting program records the following entry:

Sign Account Amount Effect
DR Accounts Receivable 5,000 Assets are increased on SFP
CR Sales Revenue (5,000) Revenues are increased on the P&L

When you receive payment for the invoice the entry recorded is:

Sign Account Amount Effect
DR Cash 5,000 Assets are increased on the SFP
CR Accounts Receivable (5,000) Assets are decreased on the SFP

Note: For the sake of simplicity these transactions do not include sales tax. There are many other types of entries that can be made to your records but these are the most common ones.

Interpreting the Financial Statements

The importance of learning how to interpret the financial reports that are produced by your software package cannot be overstated.

The Statement of Financial Position (SFP) tracks all your assets, liabilities, retained earnings/ deficit. The Statement of Profit/Loss (P&L) reports all your expenses and revenues and the resulting net income or net loss. There is also a third financial report called the Statement of Cashflows that will not be discussed in this article.

The Statement of Financial Position (SFP)

The Statement of Financial Position, formerly known as the balance sheet, is important because it summarizes at a single date in time what a company owns, owes and the value it has accumulated (retained earnings). The statement is actually a mathematical formula presented as Assets = Liabilities + Equity. Please view the sample statement for clarity:

Sample Statement of Financial Position (SFP)
Assets Liabilities
Cash 4,500 Accounts Payable 52,000
Accounts Receivable 10,500 Deferred revenue 3,000
Prepaid Expenses 1,000 Wages Payable 5,000
Inventory 40,000 Current Liabilities 60,000
Investments 15,000 Mortgage Payable 90,000
Current Assets 71,000 Total Liabilities 150,000
 
Notes Receivable 3,000 Shareholder's Equity
Capital Assets 100,000 Shares 100
  Retained Earnings 23,900
Total Equity 24,000
 
Total Assets 174,000 Total Liabilities & Equity 174,000

The assets are listed in order of liquidity which means the more easily they can be converted to cash the higher on the list the account appears. The assets and liabilities are separated between current assets/liabilities and non-current assets/liabilities in order to help analyze the financial position of a company through ratios. Current assets are those that will be converted into cash within one year and current liabilities are those obligations that will be paid within one year.

The SFP is most often presented vertically with the Assets, Liabilities and Equity all shown vertically one on top of the other but in this example the horizontal presentation has been used to help a beginner visualize how the two sides of the report balance.

Shareholder's Equity includes the shares issued to shareholders. If the company is a sole proprietorship or partnership there would not be any shares issued, otherwise called share capital.

Retained earnings or deficit is often a hard concept to grasp but the best way to describe it is that any net income or net loss from the P&L flows to this account in order for the statements to remain in balance or harmony with each other. Assuming that it is this sample company's first year of operations you will see that the net income of $23,900 from the P&L below flows directly to the retained earnings account. If next year the company had a net loss of $10,000 that loss would then flow to retained earnings and become a balance of $13,900 (23,900-10,000). If in year 3 the company has a net loss $20,000 then the retained earnings would go into a deficit position of -$6,100 (13,900-20,000) and so forth. A healthy company remains in a positive retained earnings position. A company that continues in a deficit position for several years is at a high risk of becoming bankrupt.

Helpful Ratios to Analyze the Statement of Financial Position

The current ratio (current assets/current liabilities) measures the liquidity of a company. A healthy organization will usually have a current ratio of just below 2 which means that they have 2 times more current assets than current liabilities. This will ensure that the company continues to operate in the near future. However, each industry has a different average current ratio that indicates health such as a current ratio of 1.5 for industrial companies. If we use the numbers from the SFP above we will see that the current ratio is 1.18 (71,000 / 60,000), which could mean that our example company has room for improvement.

The debt ratio (total debt/total assets) analyzes how much debt you have in relation to total assets. This ratio checks your company's long-term ability to pay debts. A healthy company should have a debt ratio that is less than 1. For instance, if we use the number from the SFP above, the debt ratio is 0.86 (150,000 / 174,000), indicating that the business has $0.86 of debt for every $1 of assets. If the ratio is greater than 1 that means the company could potentially default on debt obligations and become bankrupt if they are not able to turn things around. This ratios is extremely important for bankers and other creditors and if your company is thinking about obtaining financing you will want to focus on keeping this ratio as low as possible.

There are many other ratios that can be used to determine the liquidity and health of an organization that are not covered here.

The Statement of Profit and Loss

On the Statement of Profit and Loss (P&L) the formula is total revenues + gains - total expenses - losses - income taxes = the net income or loss after taxes. This statement is important for determining the profitability of a company. If a company is in a net loss position it may deter lenders from extending credit or investors from investing in the company. Whereas a positive net income indicates that a company has been able to utilize the resources available to them in a successful manner and they are in a position to negotiate better terms.

The P&L is not prepared according to cash flows. If you paid out $12,000 for insurance today you would not record the $12,000 into insurance today rather you would set up an accrual of $1,000 for each month so that your P&L would correctly report that your insurance expense each month for the next 12 months is $1,000 rather than $12,000 for the current month and $nil for the next 11 months. This kind of expense smoothing is called the matching principle. Likewise, if you sold a service to a client for $1,200/ year you would record $100 in revenue each month for the next 12 months. However if you sold a product that was ready for sale today $12,000 you would record the total revenue of $12,000 in the P&L today rather than next month when you receive the cash.

A P&L is always for a period of time that is denoted at the top of the statement. Consider the following P&L that is "For the Quarter ended March 31st, 2009" which includes all the revenues and expenses from January 1, 2009 to March 31st, 2009.

A net income position is derived when the net amount of revenues and gains minus expenses and losses is positive and if the net amount (or bottom line) is negative, there is a net loss.

Sample Statement of Profit/Loss
Revenues 500,000
Materials (100,000)
Labor (250,000)
Cost of Goods Sold (350,000)
Gross Margin 150,000
Gain on sale of investments 10,000
Total Revenues 160,000
 
Expenses
Auto 2,000
Advertising 1,000
Amortization 15,000
Bad Debt 500
Computer Repairs 1,000
Dues and Subscriptions 500
Insurance 7,000
Interest 5,000
Leases 1,500
Repairs and Maintenance 1,500
Telephone 1,000
Travel 2,000
Wages 91,100
Total Expenses 129,100
 
Net income before tax 30,900
Less: Income taxes 7,000
Net income after taxes 23,900

(Please note that the format of the P&L will vary according to the complexity of the business activities.)

Gross Margin is an important diagnostic tool used to gage the heath of a company's P&L. Gross Margin is calculated by deducting the cost of goods sold from sales revenue. Cost of goods sold includes materials and labor costs directly associated with producing the goods or services sold by the company. Gross margin is most often presented as a percentage and the formula is (Gross Margin / Revenue).

The gross margin percentage for the above P&L is 30% [(150,000 / 500,000) * 100]. For a manufacturing firm this would be an extremely high percentage but for a software company or internet-based company this would probably be considered low. The higher the percentage, the more money that is available after direct costs to service other general and administrative expenses and dividends to shareholders. In our example, a 30% gross margin means that a company has $0.30 on every dollar after producing their product or service to pay for all other expenses of the company including taxes.

Conclusion

The Financial Statements for an entity are used by investors, creditors, government organizations and managers to gauge the health of a company. A business owner who has learned to interpret the statements and keeps a close watch on the ratios is more likely to spot any negative trends and will be able to take corrective action early. They are also better equipped to make the right decisions for business that will enable the company to expand and become more profitable over the long run.

Tags

  • Johanna Kuker

    Johanna Kuker

    Johanna Kuker is a professional accountant and the co-founder of Virtuosi Media. She is married to her husband Benjamin and enjoys traveling, skiing, and most outdoor activities.

    View Johanna's Bio

Help us spread the word.

Your Comments Are Valuable - Join The Discussion!

Here's the latest in business.

Check out our most recent business articles and resources.

Popular business articles.

Here are our most popular and useful business articles.

We're on the web.

We are where you are. Discover great content by becoming our fan on Facebook, following us on Twitter, or subscribing to our RSS feeds.

 

Copyright 2011 Virtuosi Media Inc.