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Understanding Your Financial Statements

financial statements and your small business.

As an accountant for over 10 years, I have found that many of my clients have had one universal issue: Understanding their financial statements and their relevance. The purpose of this article is to not only educate and empower you to understand your financial statements, but also their importance when making decisions in your small business.

Why are the important?

They help you make better decisions.

Financial statements are crucial when it comes to making decisions in business as they give you a clear, accurate account as to how your business is actually performing. With this information you can then track your business’s financial fitness and make any necessary adjustments to your spend, invest, or borrow if needed. They also play a crucial role in helping you determine how much cash is available for business use. This information is exactly what you need when making growth/ management decisions.

a requirement for Tax returns.

Ensuring your bookkeeping is up-to-date – and having financial statements prepared based thereon – will ensure that you have all the information you need for tax season. This data is the information that is used to prepare and submit your income tax return, and the financial statements are generally the supporting documents requested by SARS should you be selected for verification/ an audit.

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they are Proof of your success.

They provide historical records of how well your business has performed. This will assist when making not only the crucial business decisions we spoke of earlier, but will also be used should you ever need to secure funding.

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certain laws require you to prepare them.

Laws such as the Companies Act of 2008 and Tax Administration Act (falling under record keeping), require businesses to have financial statements prepared within a certain period of time after their financial year has ended.

As of 1 September 2018, the Companies and Intellectual Properties Commission (CIPC) announced that submitting annual financial statements (AFS), or a financial accountability supplement (FAS), will be a mandatory requirement when submitting your CIPC Annual Returns.

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What are they?

To help you understand the financial statements that your accountant prepares for you, we will cover 2 of the 3 core reports that are used to evaluate a business, namely the Statement of Financial Position (Balance Sheet) and Profit and Loss (Income) Statement.

The Statement of Financial Position (balance sheet).

Per Investopedia, a statement of financial position, or balance sheet, is a financial statement that reports a company’s assets, liabilities, and shareholder equity. It provides a snapshot of a company’s finances (what it owns and owes) as of the date of publication.

I will go over these in a bit of details below:

Assets.

These are what the business owns that will bring it benefits in the future. Some examples of assets include your customer accounts, vehicles, bank accounts, and investments.

 

Liabilities.

Liabilities are the debts of the business. They are everything that the business owes to another entity/ individual. Liabilities can include items such as supplier accounts, loans, credit cards, bank overdraft and your company’s tax bill.

 

Equity.

This sums the net worth of your small business once you have totaled everything that your business owns (assets) and have deducted everything owed to creditors (liabilities).

For a sole proprietorship/ partnership, equity is referred to as “owners’ equity” whereas in a corporation, it is referred to as “shareholders’ equity”.

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The Profit and Loss (Income) Statement.

Per Investopedia, an income statement is one of the three major financial statements that reports a company’s financial performance over a specific accounting period.

Revenue/ Turnover.

Revenue is the money that is made by your business from its various activities. This could be from sale of goods/ services to your customers. It could further include fees earned, interest revenue, and interest income. If the income is earned as a result of a main business activity, it is an operating revenue, whereas if it is accumulated as a result of a secondary activity (such as passive income), it is known as non-operating revenues/ other income.⁠

Cost of Sales.

These are the direct costs associated with the production of the company’s goods/ services. The amounts included in cost of sales could range from materials used to produce goods, direct labour costs paid to staff assigned to make the goods/ carry out the services, and commission associated with sales.

Gross Profit/ Loss.

Gross profit/ loss is the difference between your revenue and cost of sales. It reflects the money that your business has left over once all the direct costs associated with producing and selling its products/ services (cost of sales) has been deducted from its turnover (sales).

Gross Profit = Sales – Cost of Sales

Should your financial report indicate a gross profit situation, this would mean that your turnover was higher than your cost of sales (surplus). If it reflect a gross loss, this would mean that your cost of sales was higher than your sales/ turnover and you had a deficit.

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Other income.

This is income derived from sources that don’t relate to your core activities. This could be interest on investments, royalties or any other fees collected such as commission.

Expenses/ Operating Expenses.

These are the costs incurred when running your company. Examples of these include bank charges, interest expense, rent and utilities, payroll costs, depreciation, and telecommunications.

Net Profit/ Loss.

The net profit/ loss of a company is the amount after other income has been added and expenses/ operating expenses have been deducted from your gross profit/ loss. It can also be referred to as net earnings or net income.

Net Profit = Total Income – Total Expenses

Income tax expense.

This is the business’s calculation on how much tax it is responsible for paying in the current financial year.

Annual Financial Statements (AFS) are formed by the general grouping of the line items of the above elements. Assets, liabilities and equity will form the Statement of Financial Position, while revenue, cost of sales, other income, expenses and your income tax expense will group to form the Profit and Loss Statement. The changes in these elements will form the Cash Flow Statement. Notes to Financial Statements are also a part of your Annual Financial Statements. These help explain specific items in your reports by providing a clearer picture as to what they are and how they have been treated by your accountant.

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