Accounting works on a double-entry bookkeeping system. Every entry consists of a debit and a credit. On the balance sheet, debits increase assets and reduce liabilities. On the income statement, debits increase expenses and lower revenue. Credits lower assets on the balance sheet and raise liabilities. On the income statement, they increase revenue and lower expenses.
Double-entry bookkeeping requires that debits must equal credits at all times. In accounting parlance, your books must balance. If you are new to accounting, it will, at first, be hard to believe that this system goes back to 1458. As you become proficient, you will understand and appreciate the logic. The benefits are that it is much harder to forget or even hide transactions. A complete set of properly recorded transactions will allow you to create a balance sheet, income statement and statement of cash flows.
Your income statement shows how profitable your business is. Profits are the excess of revenues over expenses. As a small business owner you know you're busy, but you may not know how your business translates into profit. This is what the income statement does. Whether you wish to analyze the income statement to increase profitability or use it to apply for a line of credit, it is something you will be expected to provide.
The Balance Sheet
A balance sheet shows your assets, such as cash and equipment, and your liabilities, such as accounts payable to suppliers and longer-term liabilities such as bank loans. A balance sheet represents the "historical cost" of items, and at first glance you may wonder why it is helpful. Liabilities, for example, always accurately represent the amount you have to pay, but assets represent the amount you paid to acquire the item. Expensive equipment you purchased in the past will not be shown as their market value, but at the price you paid. It is important to remember that there is good reason things are recorded this way. A good accountant will analyze your balance sheet and help you understand the profitability of your past and current decisions.
Statement of Cash Flows
The reality of a business is that if you can't pay your bills, you will be shut down. A statement of cash flows shows you how you've generated cash and how you've used it. It isn't the same as the profit on your income statement. When you're starting out, this can be confusing. To understand why, here's two examples. If you borrow money, you'll generate a lot of cash, but clearly this is not profit from your business activity. If you purchase an asset that is expected to last 10 years, you'll use a lot of cash, but again, this clearly is not an expense you incurred for this year's revenue. As a business owner, your main focus always should be your trade or skill. But a good accountant will help you understand the implications and profitability of your decisions as reflected on your balance sheet, income statement and statement of cash flows.
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