The basics of the balance sheet

A balance sheet is a snapshot of a business's financial condition at a specific moment in time, usually
at the close of an accounting period. A balance sheet comprises assets, liabilities, and owners' or
stockholders' equity. Assets and liabilities are divided into short- and long-term obligations including
cash accounts such as checking, money market, or government securities. At any given time, assets
must equal liabilities plus owners' equity. An asset is anything the business owns that has monetary
value. Liabilities are the claims of creditors against the assets of the business.

What is a balance sheet used for?

A balance sheet helps a small-business owner quickly get a handle on the financial strength and
capabilities of the business. Is the business in a position to expand? Can the business easily handle
the normal financial ebbs and flows of revenues and expenses? Or should the business take
immediate steps to bolster cash reserves?

Balance sheets can identify and analyze trends, particularly in the area of receivables and payables.
Is the receivables cycle lengthening? Can receivables be collected more aggressively? Is some debt
uncollectable? Has the business been slowing down payables to forestall an inevitable cash
shortage?

Balance sheets, along with income statements, are the most basic elements in providing financial
reporting to potential lenders such as banks, investors, and vendors who are considering how much
credit to grant the firm.

 Assets: Assets are subdivided into current and long-term assets to reflect the ease of
liquidating each asset. Cash, for obvious reasons, is considered the most liquid of all assets.
Long-term assets, such as real estate or machinery, are less likely to sell overnight or have
the capability of being quickly converted into a current asset such as cash.
 Current assets: Current assets are any assets that can be easily converted into cash within
one calendar year. Examples of current assets would be checking or money market accounts,
accounts receivable, and notes receivable that are due within one year's time.
o Cash
 Money available immediately, such as in checking accounts, is the most
liquid of all short-term assets.
o Accounts receivables
 This is money owed to the business for purchases made by customers,
suppliers, and other vendors.
o Notes receivables
 Notes receivables that are due within one year are current assets. Notes
that cannot be collected on within one year should be considered long-term
assets.
 Fixed assets: Fixed assets include land, buildings, machinery, and vehicles that are used in
connection with the business.
o Land
  Land is considered a fixed asset but, unlike other fixed assets, is not
depreciated, because land is considered an asset that never wears out.
o Buildings
 Buildings are categorized as fixed assets and are depreciated over time.
o Office equipment
 This includes office equipment such as copiers, fax machines, printers, and
computers used in your business.
o Machinery
 This figure represents machines and equipment used in your plant to
produce your product. Examples of machinery might include lathes,
conveyor belts, or a printing press.
o Vehicles
 This would include any vehicles used in your business
o Total fixed assets
 This is the total dollar value of all fixed assets in your business, less any
accumulated depreciation.
 Total assets: This figure represents the total dollar value of both the short-term and long-
term assets of your business.
 Liabilities and owners' equity: This includes all debts and obligations owed by the business
to outside creditors, vendors, or banks that are payable within one year, plus the owners'
equity. Often this side of the balance sheet is simply referred to as "liabilities."
o Accounts payable
 This includes all short-term obligations owed by your business to creditors,
suppliers, and other vendors. Accounts payable can include supplies and
materials acquired on credit.
o Notes payable
 This represents money owed on a short-term collection cycle of one year or
less. It may include bank notes, mortgage obligations, or vehicle payments.
o Accrued payroll and withholding
 This includes any earned wages or withholdings that are owed to or for
employees but have not yet been paid.
o Total current liabilities
 This is the sum total of all current liabilities owed to creditors that must be
paid within a one-year time frame.
o Long-term liabilities
 These are any debts or obligations owed by the business that are due more
than one year out from the current date.
o Mortgage note payable
 This is the balance of a mortgage that extends out beyond the current year.
For example, you may have paid off three years of a 15-year mortgage note,
of which the remaining 11 years, not counting the current year, are
considered long-term.
o Owners' equity
  Sometimes this is referred to as stockholders' equity. Owners' equity is
made up of the initial investment in the business as well as any retained
earnings that are reinvested in the business.

o Common stock
 This is stock issued as part of the initial or later-stage investment in the
business.
o Retained earnings
 These are earnings reinvested in the business after the deduction of any
distributions to shareholders, such as dividend payments.
 Total liabilities and owners' equity: This comprises all debts and monies that are owed to
outside creditors, vendors, or banks and the remaining monies that are owed to
shareholders, including retained earnings reinvested in the business.
How to Understand an Income Statement
At its most basic, the income statement is a breakdown of revenue and
expenses. But there's a lot more to be gleaned from it. Here's how to start
digging in.
Every business owner wants to know what the bottom line is. That all-important number is, of
course, kept on the income statement. Though the income statement is simple enough on the
surface, there's a lot more going on than just revenue less expenses equaling net income. And all
income statements are not created equally.

Knowing how to read and analyze an income statement isn't just important for keeping tabs on your
own company, but also sizing up the competition and even possible acquisitions.

To get the skinny on how a pro starts digging into an income statement, Inc.com spoke with Tom
Robinson, the managing director of the education division of the CFA Institute in Charlottesville,
Virginia. The institute is the gatekeeper of the Chartered Financial Analyst designation held many
stock analysts and portfolio managers. Here's how Robinson gets going on an analysis.

Understanding an Income Statement: Keep an Eye on Cash Flow

The first thing Robinson says he does when he looks at an income statement is put it next to the cash
flow statement. Simply put, the cash flow statement shows where you have cash coming in and
going out over a certain period of time.

The reason you look at both is that you want to see if all that profit being shown is supported by cold
hard cash coming into the company. Booming profits on the income statement and weak – or even
negative – cash flows means that the quality of the earnings being shown isn't very strong and
deeper analysis will likely be needed.

"If the company is a brand new start-up, it's not unusual to have positive, growing net income, and
negative cash flow," Robinson says. The simple reason for that is a new, growing company will have
to make substantial inventory investments and may not be collecting from its customers yet,
creating a lag in receivables.

But for a more established company, cash flow and net income should be fairly highly correlated.
"Once a company has matured, you should be receiving your cash from your old customers while
you're selling to your new customers," Robinson says. "The cash flow should catch up."

Dig Deeper: How to Fix Cash-Flow Problems

Understanding an Income Statement: Consider Accounting Methods

We've already established that the revenue on the income statement doesn't necessarily represent
the cash that's actually coming into the company, so you need to figure out how that revenue
number is determined. To do that, you'll need to know what accounting methods were used. If a
company uses the cash method of accounting, where income is only counted when cash is received,
cash flow and revenue should be equal. But let's assume the accrual method is used due to either
the company's size or the presence of inventory. Accounting rules allow for a lot of discretion under
the accrual method, which means you have to watch out for those who really stretch them to make
the numbers look better, Robinson warns.

The biggest area of concern is how the company recognizes revenue. That is, at what point during
the sales process does it reflect revenue on its income statement? Most firms recognize revenue at
the time of sale of a good or service. If that's the case, you need to know how they define a sale. Is it
when they take an order? When they actually deliver a good? What if the company is having a hard
time collecting their receivables? How do they record revenue for sales completed over a long
period of time? Understanding how aggressive a company is in their revenue recognition helps you
determine the quality of the numbers.

The same goes for expenses like depreciation and amortization. If the industry standard for
depreciating an asset is 10 years, but the company spreads it out over 30, they're going to look more
profitable until they have to replace that product.

In short, you need to identify the areas where a company has a lot of accounting discretion and
figure out how aggressive or conservative it's being.

Understanding an Income Statement: Perform a Common-Size Analysis

Step three for Robinson in looking at a company's earnings is performing a common-size analysis.
That entails taking the income statements for the last three years and expressing all the expenses as
a percentage of revenue for each year. The goal is to look for trends.

In a good scenario, revenue growth will outpace expense growth. Let's say in 2008, selling, general
and administrative (SG&A) expenses account for 20 percent of all revenue. Then in 2009, when sales
grew 25 percent, SG&A as a percentage of revenue is now 22 percent. The revenue growth is great,
but it's being outpaced by expense growth. The common-size analysis let's you easily identify
discrepancies that you'll want to explore further.

Understanding an Income Statement: Peer Comparison

The fourth step is to compare the company's data to its peers. For small businesses, this can be an
issue if they aren't competing with publicly traded companies. Even if they are, the comparison may
not be a clean one. Robinson says there are some good sources of data for privately held companies,
like Dun & Bradstreet and the Risk Management Association, formerly Robert Morris Associates,
which puts out an annual financial statement study of small- and mid-size businesses. (If you don't
want to shell out for these resources, check to see if your accountant gets them.)

Once you've obtained the data, you'll want to run through the same analysis you performed in the
first three steps to see how they all stack up. How much is your company spending on SG&A
compared to companies in your industry, not just in terms of total dollars, but as a percentage of
revenue?

How to Analyze an Income Statement: Crunch Some Numbers

There are lots of ways to break down the information provided by an income statement. Three of
the big profitability indicators you'll want to look at are gross profit margin, operating profit margin
and net profit margin. Again, you'll want to look at all of them over a period of time to see how
they're trending and figure out why they're going in a certain direction.

The gross profit margin is calculated by taking revenue minus cost of goods sold and then dividing
that by revenue. "The gross margin is really a measure of how the company is doing at its most base
level of activity," Robinson says. "Is it making a profit on the product it's selling?"

Next up is operating profit margin. Here you want to take revenue and subtract all the expenses
related to the day-to-day operations of the business like cost of goods sold, labor and SG&A. This will
exclude things like interest expense and one-time charges not core to your business operations. The
result is your operating earnings, which you'll divide by revenue to get the operating profit margin.
This gives you a sense of how the company is doing operating the business.

Finally, there's the net profit margin, which is the net income divided by revenue. It measures the
amount of income a company generated for each dollar of revenue.

Of course, all of this becomes more complicated the bigger and more complex a business is. For
example, conglomerate General Electric boasts five operating segments, all of which require their
own financial breakdown, not to mention all the geographic regions.

But your business probably won't have to worry about all of that for, well, at least a couple more
years.
Cash Flow Statement
A breakdown of the cash flow statement, and methods for simplifying the
procedure.
A cash flow statement is a financial report that describes the sources of a company's cash and how
that cash was spent over a specified time period. It does not include non-cash items such as
depreciation. This makes it useful for determining the short-term viability of a company, particularly
its ability to pay bills. Because the management of cash flow is so crucial for businesses and small
businesses in particular, most analysts recommend that an entrepreneur study a cash flow
statement at least every quarter.

The cash flow statement is similar to the income statement in that it records a company's
performance over a specified period of time. The difference between the two is that the income
statement also takes into account some non-cash accounting items such as depreciation. The cash
flow statement strips away all of this and shows exactly how much actual money the company has
generated. Cash flow statements show how companies have performed in managing inflows and
outflows of cash. It provides a sharper picture of a company's ability to pay creditors, and finance
growth.

It is perfectly possible for a company that is shown to be profitable according to accounting

standards to go under if there isn't enough cash on hand to pay bills. Comparing amount of cash
generated to outstanding debt, known as the "operating cash flow ratio," illustrates the company's
ability to service its loans and interest payments. If a slight drop in a company's quarterly cash flow
would jeopardize its ability to make loan payments, that company is in a riskier position than one
with less net income but a stronger cash flow level.

Unlike the many ways in which reported earnings can be presented, there is little a company can do
to manipulate its cash situation. Barring any outright fraud, the cash flow statement tells the whole
story. The company either has cash or it does not. Analysts will look closely at the cash flow
statement of any company in order to understand its overall health.

PARTS OF THE CASH FLOW STATEMENT

Cash flow statements classify cash receipts and payments according to whether they stem from
operating, investing, or financing activities. A cash flow statement is divided into sections by these
same three functional areas within the business:

 Cash from Operations - this is cash generated from day-to-day business operations.
 Cash from Investing - cash used for investing in assets, as well as the proceeds from the sale
of other businesses, equipment, or other long-term assets.
  Cash from Financing - cash paid or received from issuing and borrowing of funds. This
section also includes dividends paid. (Although it is sometimes listed under cash from
operations.)
 Net Increase or Decrease in Cash - increases in cash from previous year will be written
normally, and decreases in cash are typically written in (brackets).

Although cash flow statements may vary slightly, they all present data in the four sections listed
here.

CLASSIFICATIONS OF CASH RECEIPTS AND PAYMENTS

Cash from Financing

At the beginning of a company's life cycle, a person or group of people come up with an idea for a
new company. The initial money comes from the owners or is borrowed by the owners. This is how
the new company is "financed." The money that owners put into the company is classified as a
financing activity. Generally, any item that would be classified on the balance sheet as either a long-
term liability or an equity would be a candidate for classification as a financing activity.

Cash from Investing

The owners or managers of the business use the initial funds to buy equipment or other assets they
need to run the business. In other words, they invest it. The purchase of property, plant, equipment,
and other productive assets is classified as an investing activity. Sometimes a company has enough
cash of its own that it can lend money to another enterprise. This, too, would be classified as an
investing activity. Generally, any item that would be classified on the balance sheet as a long-term
asset would be a candidate for classification as an investing activity.

Cash from Operations

Now the company can start doing business. It has procured the funds and purchased the equipment
and other assets it needs to operate. It starts to sell merchandise or services and make payments for
rent, supplies, taxes, and all of the other costs of doing business. All of the cash inflows and outflows
associated with doing the work for which the company was established would be classified as an
operating activity. In general, if an activity appears on the company's income statement, it is a
candidate for the operating section of the cash flow statement.

Methods of Preparing the Cash Flow Statement

In November 1987, the Financial Accounting Standards Board (FASB) issued a "Statement of
Financial Accounting Standards" which required businesses to issue a statement of cash flow rather
than a statement of changes in financial position. There are two methods for preparing and
presenting this statement, the direct method and the indirect method. The FASB encourages, but
does not require, the use of the direct method for reporting. The two methods of reporting affect
the presentation of the operating section only. The investing and financing sections are presented in
the same way regardless of presentation methods.
Direct Method

The direct method, also called the income statement method, reports major classes of operating
cash receipts and payments. Using this method of preparing a cash statement starts with money
received and then subtracts money spent, to calculate net cash flow. Depreciation is excluded
altogether because, although it is an expense that affects net profits, it is not money spent or
received.

Indirect Method

This method, also called the reconciliation method, focuses on net income and the net cash flow
from operations. Using this method one starts with net income, adds back depreciation, then
calculates changes in balance sheet items. The end result is the same net cash flow produced by the
direct method. The indirect method adds depreciation into the equation because it started with net
profits, from which depreciation was subtracted as an expense. Regardless of whether the direct or
the indirect method is used, the operating section of the cash flow statement ends with net cash
provided (used) by operating activities. This is the most important line item on the cash flow
statement. A company has to generate enough cash from operations to sustain its business activity.
If a company continually needs to borrow or obtain additional investor capitalization to survive, the
company's long-term existence is in jeopardy.

ONLINE CASH FLOW WORKSHEETS

Achieving a positive cash flow does not come by chance. You have to work at it. You need to analyze
and manage your cash flow to more effectively control the inflow and outflow of cash. The U.S. Small
Business Administration recommends undertaking cash flow analysis to make sure you have enough
cash each month to cover your obligations in the coming month. The SBA has a free cash flow
worksheet you can use. In addition, most accounting software packages geared to small or mid-sized
businesses – such as Quickbooks will help you produce a cash flow statement. There are also other
websites offering free templates, including Winsmark Business Solutions and Office Depot.

FINANCING AND INVESTING SECTIONS

The cash flows, in and out, resulting from financing and investing activities are listed in the same way
whether the direct or indirect method of presentation is employed.

Cash Flows from Investing

The major line items in this section of the cash flow statement are as follows:

Capital Expenditures. This figure represents money spent on items that last a long time such as
property, plant, and equipment. When capital spending increases, it often means the company is
expanding.

Investment Proceeds. Companies will often take some of their excess cash and invest it in an effort
to get a better return than they could in a savings account or money market fund. This figure shows
how much the company has made or lost on these investments.
Purchases or Sales of Businesses. This figure includes any money the company made from buying or
selling subsidiary businesses and will sometimes appear in the cash flows from operating activities
section, rather than here. Cash Flows from Financing The major line items in this section of the cash
flow statement include such things as:

Dividends Paid. This figure is the total dollar amount the company paid out in dividends over the
specified time period.

Issuance/Purchase of Common Stock. This is an important number because it indicates how a

company is financing its activities. New, rapidly growing companies will often issue new stock and
dilutes the value of existing shares in so doing. This practice does, however, give a company cash for
expansion. Later, when the company is more established it will be in a position to buy back its own
stock and in this way increase the value of existing shares.

Issuance/Repayments of Debt. This number tells you whether the company has borrowed money
during the period or repaid money it previously borrowed. Borrowing is the main alternative to
issuing stock as a way for companies to raise capital.

The cash flow statement is the newest of the three fundamental financial statements prepared by
most companies and required to be filed with the Securities and Exchange Commission by all publicly
traded companies. Most of the components it presents are also reported, although often in a
different format, in one of the other statements, either the Income Statement or the Balance Sheet.
Nonetheless, it offers the manager, investor, lender, and supplier of a company a view into how it is
doing in meeting its short-term obligations, regardless of whether or not the company is generating
income.