To appreciate bookkeeping and accounting, you need to understand why you are doing what you're doing with these numbers, and what knowledge your results will give you. The result you are working toward is good information that which will be available to you from your financial statements. There are a wide variety of financial statements you can generate with the most common ones being a balance sheet and an income statement. These each take a different view on what is essentially the same information.
The Income Statement (also called a profit and loss statement) simply shows income and expenses for a given time period. It gives you a picture of you are making money or losing money over that time interval.
The Balance Sheet looks at the bigger picture of your business comparing all your assets to all your liabilities. It tells you if you closed the business and sold everything today, how much money would you have (or how much would you owe). The reason this is called a Balance Sheet is that Assets need to balance (equal) the Liabilities. The amount you would have if everything were liquidated today is called Net Worth and is listed under Liabilities. If have more Liabilities than Assets, the Net Worth is negative.
Although some business owners want to see the income statement and may ignore the balance sheet, you need to use both together to see the total picture of what is happening in your business. What makes accounting useful is the relationship between the numbers on the financial statements, and the things you can learn when you understand them.
Here are some other financial statements that are useful to have:
A budget projects sales and expenses for each month of a year to estimate the flow of cash. This helps you predict times that you may have cash shortfalls and prepare for them. It also allows you to compare over the year how you are performing in relation to your projections.
Cash Flow Statement
This may be one of the most critical and least understood documents you can prepare. Some of the information that can be gained from this statement is:
Are the operating activities generating cash? It is not critical if they are not, but it is a good sign if they are.
Which working capital components have large uses of cash? What might be happening to cause this? This helps you understand how the cash got used.
How much cash is provided for or used in investing activities? Compare this year's capital expenditures to last year's capital expenditures. Were there any significant increases or decreases? A reduction in capital expenditures may indicate a cash flow problem.
What cash is provided by or used in financing activities? This will tell you how much debt has been paid (or borrowed.) It will indicate if you are using more debt or have paid down your credit line in the past year. It will also tell you if there were other unusual financing activities which were not highlighted elsewhere in the analysis.
Ratios and Quality Indicators
Financial ratios look at relationships between various numbers generated by your financial statements. The ratios allow you to analyze how different aspects of your business are functioning. If there are problems, they help you locate what is causing the problems. The ratios give you a deeper look into specific parts of your business so that you can see what is working and what is not.
Let's take a look at what is needed to develop a set of financial statements.