Financial statements may not immediately drum up feelings of elation—but at Bench, we think numbers can bring joy. We put this guide together to help improve your financial literacy by understanding your statements and how to put them to work for your small business. We’ll walk you through the difference between income statements and balance sheets, and show you how they work together.
Expanding your financial literacy and understanding these statements will help you accurately assess how profitable you are, see where you can adjust spending, and help your business grow. Where there’s growth, there’s usually cause for celebration. See? Numbers can be fun.
Income Statements: Understand Your Profitability
The first step in improving your financial literacy begins with understanding your income statement. The income statement shows you how your revenues and expenses contribute to profitability across a period of time. Most often, income statements are prepared monthly, quarterly, and annually, although, you can calculate them over any time period if the need arises.
Preparing an income statement is fairly straightforward—three steps to be exact. Here’s how to get started:
Step 1: Collect every journal entry made over the time period in question.
Step 2: Total all the categories of expense and categories of revenues.
Step 3: Calculate the profit by subtracting expenses from revenues.
Let’s look at a fictitious example to really break it down. We’ll use the video game maker Steam. First, Steam will organize all of their sources of revenue from the three types of games they make: First-person shooter (FPS) games, Real-Time Strategy (RTS) games and Role Playing Games (RPG).
The first part of the income statement would look like this:
|Revenue from FPS||$50M|
|Revenue from RTS||$50M|
|Revenue from RPG||$50M|
Then they’ll calculate the total expenses they incurred to generate revenue. To do that, all of the expense categories, including those that are indirectly related to game development, are added up:
|Game development expenses for FPS||$30M|
|Game development expenses for RTS||$30M|
|Game development expenses for RPG||$30M|
With revenues and expenses accounted for, the next step is calculating the profit by subtracting expenses ($97M) from revenues ($150M):
Total profit: $53M
In this example, the income statement shows that Steam earned $53 million dollars for the year. The income statement also shows the impact of certain costs, such as hosting, to the bottom line.
The next financial statement, the balance sheet, helps us get a full picture of what the retained earnings mean to the overall value of the company.
Balance Sheets: Show Your Assets and Liabilities
The second step to mastering the basics of financial literacy is understanding your balance sheet. By knowing what your small business owns (assets), what it owes (liabilities), and what is left over after paying off any financial obligations (owner’s equity), you can understand what your company is worth at a particular moment in time.
The balance sheet helps to clearly identify these numbers—which are especially important for people with a vested interest in the business, like creditors, investors, and owners.
Calculating a balance sheet is similar to calculating an income statement, with two notable differences. First, instead of the revenue and expense categories, the categories to be totaled are called assets, liabilities, and equity categories. Second, instead of only counting journal entries from a defined time period, the balance sheet takes into account every journal entry the company has ever made since it was founded.
Let’s continue with the example from video game maker Steam. Their asset categories are totaled as:
Next, their liabilities and equity categories are totaled as:
|Retained earnings (the sum of all revenue and expense ledgers of the company for all time)||$120M|
After expanding our financial literacy to understand both the income statement and the balance sheet, we can learn a lot about the health of a company. For example, Steam had a profitable year (from the income statement) and their assets outweigh their liabilities (from the balance sheet) which puts them in a strong financial position.
The Bottom Line
When you need a full picture of your company’s profitability, put these two financial reports to use. These statements give you insight into how each part of your small business is performing, so you can get a granular and high-level look. Your income statements and balance sheets can also illuminate opportunities to reduce costs and increase profit. Dive into the numbers, get curious, and adapt the way your small business operates when something isn’t right.
These statements hinge on the quality of the information that goes in them, which is why keeping up with your bookkeeping and maintaining organized financial records is so important. The more accurate your financial statements, the better decisions you’ll be able to make for the health of your small business.
About the Author: Ryan Smith writes for Bench, the online bookkeeping service that pairs you with a dedicated bookkeeping team and elegant software to do your books for you.
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