My previous post focused on twelve general accounting terms (if you haven’t read it yet, I highly recommend it). The twelve terms explained below deal more specifically with financial reporting. Becoming familiar with these terms will help you to better understand your company’s financial reports and to communicate more effectively with other financial people such as bankers and accountants.
Financial statements – this term refers to a group of financial reports (typically the balance sheet, income statement and a cash flow report) that together provide a complete picture of the financial status of the company. Financial statements can be prepared for any period of time that the company needs (weekly, monthly, quarterly, etc.) and may be required when applying for a loan or line of credit. For those purposes, they should be prepared by a qualified accountant; just printing something from your accounting software may not be enough.
Balance Sheet – is a financial report that provides a summary of all of the assets, liabilities and owner’s equity of a business as of a particular moment in time. The report shows the balance in each of these types of accounts and can be used to determine the net worth of the company. The balance sheet should be viewed in conjunction with the income statement to see the company’s complete financial picture.
Income Statement – also known as a Profit and Loss Statement or P&L, is a financial report that provides an overview of how profitable a company is over a specific period of time; that could be a month, a calendar quarter or a year. This report shows the total of each of the income and expense accounts for the period specified and then shows if the company is experiencing a gain or a loss for the period.
Assets – is a category on the balance sheet that represents all of the accounts with current and future value to the organization. For example cash in bank accounts, accounts receivable, fixed assets like buildings, inventory and machinery, and rent or utility deposits. The assets category is divided into current, fixed and other assets. Current assets are those accounts that are very liquid; meaning they are either cash accounts or can be converted to cash very readily.
Fixed assets are those large dollar items that will have a useful life of more than 12 months or will take longer than 12 months to use up and will be depreciated (e.g. buildings, machinery, and office equipment). Other assets are pretty much anything else that would be categorized as an asset but is neither current nor fixed, like security deposits or notes receivable.
Liabilities – is a category on the balance sheet that represents all of the money that you owe or will need to pay out. For example, credit card debt, a line of credit with the bank, a vehicle loan, payroll taxes, and bills owed to suppliers or vendors. The liabilities category is divided into current and long term liabilities. Current liabilities are those that will be paid within 12 months (e.g. accounts payable and payroll taxes owed). Long term liabilities are those that will take longer than 12 months to pay (e.g. a vehicle loan).
Equity – is a category on the balance sheet that represents the net worth of the company. It is expressed as “assets minus liabilities” which can be translated as ownership in all assets remaining after all debts have been paid. Equity is made up of accounts such as capital contributions, retained earnings, stock, and net income.
Retained Earnings – is an account shown on the balance sheet that represents the net income of the business that is not paid out to the owners or shareholders in the form of a dividend or distribution. It is shown under the equity section of the balance sheet.
Distribution – is a payment (generally in cash but could also be in stock or physical assets) to an owner of the company. Distributions are generally made at specific times of the year and are based on net income or earnings of the company. Distributions reduce an owner’s equity in the company.
Gross Income – also known as gross profit, is expressed as “income minus cost of goods sold.” It is how much a company makes from its product or service that is then available to cover its general operating expenses. This is the figure that is referred to when people ask, “how much do you gross a month?”
Gross income is shown on the income statement and is calculated before net income to let you know if your product or service is profitable. It can be important in determining how efficiently the company is using its labor and materials in the production process. A company’s gross margin is gross income expressed as a percentage of total income.
Operating Income – is the amount of profit left over after subtracting general operating expenses like administrative salaries, office supplies and utilities expenses from gross income. Operating income is shown on the income statement and is calculated before net income to let you know if your normal business operations are profitable. Many companies will not need to calculate this intermediate income figure because they have no other income or expenses not associated with operations.
Net Income – also known as net profit, is the company’s final income after any other income is added to and any other expenses are deducted from operating income. If the number is negative, then the business has experienced a net loss. Net income is often referred to as “the bottom line” because it is shown at the bottom of the income statement. It is an important measure of how profitable the business is over a period of time.
Cost of Goods Sold – are those expenses that are directly related to producing the product that your company sells. Cost of goods sold (COGS) is typically not used for service businesses but it’s ok if you decide to arrange your chart of accounts this way. COGS is shown on the income statement just after revenues and before general and administrative expenses and is used in the calculation of gross income.
Cost of goods sold includes the cost of parts and materials and also labor directly used in building or manufacturing your product. Other costs such as administrative salaries, sales commissions, shop supplies and rent are not part of COGS. For service businesses, COGS might include the wages of individuals who perform the service (e.g. your service techs but not your secretary or bookkeeper), the cost of materials used in performance of the service (e.g. paint purchased to paint a house) or, other services used to facilitate the service you provide (e.g. credit reports ordered by a mortgage company).
So there you have it; enough information to make you sound accounting savvy. I hope you find it helpful. If you have a comment or question, please don’t hesitate to shout it out (or type it out in this case). Thanks for reading.