Income Statements & Balance Sheets Basics

by Pat Samia

While most small entrepreneurs hire accountants to take care of their books —a practice that’s highly recommended—, it doesn’t hurt for the business owner to have a basic understanding of the numbers that go into these books and, ultimately, into the financial statements themselves.

Here, we look into how the two most critical financial statements, the Income Statement and the Balance Sheet, can be constructed from your key facts.

           ILLUSTRATION

You have just started your business. You have a 60-square meter store space, leasehold improvements amounting to PhP200,000, beginning inventory valued at PhP50,000, and two salespeople manning the store. At the end of your opening day, total sales were PhP10,000.  With a mark-up of 40%, this translates to a one-day profit of almost PhP3,000. By month-end, you’ve recorded total sales of PhP200,000.

Let’s start with the balance sheet, which essentially is a report of the resources or assets of the business vis-à-vis the manner of financing these assets (debt and/or equity). To illustrate, when you were setting up your business, you spent for the following:

In addition, you incurred some PhP10,000 for incorporation expenses and business permits and licenses.  An additional PhP5,000 was spent on promotional materials and insurance.  You also bought a desktop computer and printer for PhP30,000.  And finally, you had to have enough cash to cover the first two months of operations.  You estimated this at PhP80,000.  So all told, you disbursed a total of PhP625,000. 

What you had in actual personal savings though amounted to only PhP425,000.  Therefore, you had to borrow PhP200,000 to close the financing gap.  This amount you sourced from a bank (PhP175,000) and from a supplier (PhP25,000).

           These figures are reflected in your beginning balance sheet as follows:

           Consequently, your beginning Balance Sheet will look something like this:

ABC Corporation

Balance Sheet

As of July 31, 2006

           As illustrated, the Balance Sheet follows the fundamental accounting equation: Assets = Liabilities + Owner’s Equity.

           What about the Income Statement?  The Income Statement shows the financial results of operations for a period of time, in this case, a month.  You’ve recorded total monthly gross sales of PhP200,000.  Your expenses, on the other hand, are as follows:
 

           The Income Statement would then be as follows:

ABC Corporation

Income Statement

For the Month Ended August 31, 2006

           Therefore, after one month of operation, your store earned you PhP57,000 in pre-tax income.  Barring any movements in the other balance sheet accounts, this amount will then be added to the Cash account (under Assets), and to the Owner’s Equity account (under Liabilities and Owner’s Equity).  This ensures that your Balance Sheet remains “balanced,” as follows:

ABC Corporation

Balance Sheet

As of August 31, 2006

           Your accountant will most likely make adjustments to these statements to reflect such items as depreciation (an accounting treatment to recognize the decline in the useful value of fixed assets); principal repayments and interest expense (on the long-term debt); and taxes.  Be that as it may, your familiarity with these basic financial statements will also benefit your accountant, as he or she will be able to better explain to you the effect of decisions you make regarding your business.            

In summary, the two basic financial statements are the following:

1.      Income Statement – shows the financial results of operation for a period of time (i.e., “For the Period Ended _______”).  The Income Statement is like a “diary” in that it chronicles what transpired during the period covered.

2.      Balance Sheet – presents the financial position of a business as of a specific date (i.e., “As of ___________”).  Therefore, the Balance Sheet is like a “snapshot,” capturing the state of the business at one point in time.

Entrepreneurs are not always expected to master the financial aspects of their business, since traditionally they are more concerned with the production or delivery of their product or service.  In fact, in the Philippines, finance is one area where most small businesses are weak.  But this shouldn’t deter the business owner from gaining an understanding of the basic finance concepts at the very least. After all, the goal of every small business is to one day be part of the big league. And this can only happen if the entrepreneur continually seeks to expand his knowledge of all aspects of the business.