UNDERSTANDING FINANCIAL STATEMENTS: WHAT DO THEY SAY ABOUT YOUR BUSINESS? (Part 1 of 3)

UNDERSTANDING FINANCIAL STATEMENTS:
WHAT DO THEY SAY ABOUT YOUR BUSINESS?
(Part 1 of 3)
Document #281

Title: UNDERSTANDING FINANCIAL STATEMENTS: WHAT DO THEY SAY
ABOUT YOUR BUSINESS? (Part 1 of 3)
Description: Part 1 – A guide to understanding business financial statements
This workbook is not designed to be your only guide to understanding financial
statements. A much wider range of resources is available to you, and we strongly
recommend you make use of them – everything from books and other publications to
professional organizations and associations to workshops and training sessions.
The Wyoming Small Business Development Center, administered by the University of
Wyoming at Laramie, does not – and cannot – assure that your business will be
successful as a result of implementing the steps outlined in this workbook.
This material is based on work supported by the U.S. Small Business Administration
under Grant Number SB-BD-92006-01. Any opinions, findings, conclusions or
recommendations expressed in this publication are those of the author(s) and do not
necessarily reflect the views of the U.S. Small Business Administration.
Introduction
Do you want to be in financial control of your business?
Do you want to know how your "books" work?
Do you want to understand what your accountant tells you?
Do you want to know where to find answers in your financial statements?
If your answers are yes, you will find helpful information in this booklet.
Owning a small business is the dream of many people in our country. These people have
their own ideas for a product or service to provide to the public or to other businesses.
And many of these business people do a very good job of providing their product or
service, but they do not do a good job of controlling the financial part of their business. It
is simply too easy to devote all of your mental and physical energies to your customers
and then do nothing for yourself.
You must understand that there is no "mystery" to understanding your business's financial
make-up. The same common sense and logic that you apply to your daily operations will
carry you through the steps you need to grasp the financial information. All that is

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necessary is for you to learn a few simple concepts. Master them, and you will no longer
be uncomfortable with your business financial statements.
There are four levels in your business accounting system. They are:
THE FOUNDATION - SOURCE DOCUMENTS AND A FILING SYSTEM
THE INPUT LIST - TRANSACTION JOURNALS
THE CATEGORY LIST - GENERAL LEDGER
THE MANAGEMENT REPORT – FINANCIAL STATEMENTS
The purpose of this book is to help you understand that these four levels of information
contain everything you need to comprehend the financial condition of your business.
Let's consider these four areas one at a time.
Level One
The Foundation – Source Documents and a Filing System
In order to work with your accounting information, you must know what type of
documents create your accounting information and where you can find those documents
in your office. Examples of accounting documents are:
Sales invoices or tickets
Deposit tickets
Paid bills
Bank statements
Canceled checks
Employee earnings records
Monthly, quarterly and annual payroll reports
Monthly sales tax reports (if applicable)
Detailed accounts receivable and accounts payable lists
These documents are the raw materials from which your books and financial statements
are constructed, and they give rise to the first axiom of financial understanding.
Axiom 1
To be able to validate your financial statements, you must be able to verify any items on
them from the applicable source documents.

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You or your bookkeeper should have an organized system of filing these documents.
Some are filed numerically, some chronologically, some alphabetically, but all must be
filed promptly and consistently. The worst enemy in your office is your inability to find
something when you need it. Although the daily responsibility may be a bookkeeper's or
a clerk's, as the owner, you must know where everything is and what it means. Give up
that responsibility and you are inviting a short business career.
Special Discussion – Bank Reconciliation
Bank reconciliation is done monthly after receiving a bank statement and canceled
checks. Reconciling your bank balance verifies the accuracy of your checkbook, but you
must also ensure that the bank balance in your books agrees with the reconciled
checkbook balance. This ensures that your books and your financial statements include
all of your deposits, checks and other charges to your account such as automatic
payments.
If you do not personally do the bank reconciliation, you should physically review it each
month and spot check the reconciliation to the bank statement itself. Always open the
statement and check the ending bank balance with the "balance per bank" amount on the
reconciliation. Also, review the list of outstanding checks, and if any are on the list for
two months or more, find out to whom they were written. Do not make it easy for a
bookkeeper to be dishonest by not checking for yourself. If you have an outside
bookkeeper or accountant reconcile your bank statement, you add another level of
security to your system.
Axiom 2
It is your responsibility to ensure that your bank balance is reconciled each month and
that the bank balance in your books and financial statements agree with the reconciled
balance.
Level Two
The Input List – Transaction Journals
The transaction journal is the entry point into your accounting system. Whether your
system is manual or computerized, your sales, checks, deposits, adjustments, etc. are first
listed in a sequential list showing the transaction date, number, amount, description and
the account name or number to which the transaction has been assigned. Deposits are
usually listed in date sequence, and sales invoices, checks, vouchers, etc. are listed
numerically. Transaction journals are monthly reports, so if you know the date or number
of the transaction, you can find the point at which it entered your accounting system and
where it went.
Your accounting system, whether it is your own internal system or that of a service
bureau or bookkeeping or accounting service, should always include one or more
transaction journals. Some accounting systems group all transactions together into a
single journal, and some have separate journals for each type of transaction, such as sales,

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disbursements, etc. The style is not of primary importance; that its available to you in a
regular, consistent format is.
Axiom 3
To discover where a specific transaction such as a check or a deposit will show in your
books and financial statements, go to the appropriate transaction journal and find the
entry in the sequential list of transactions.
Level Three
The Category List – General Ledger
The general ledger is a cumulative (year-to-date) book (for a manual system) or report
(for a computerized system) that shows the balances in each of your accounts. Your
accounting system is built around a list of account names called a chart of accounts,
organized under the following categories:
Assets
Liabilities
Capital (Owner's Equity)
Income
Cost of Sales (for a business that sells a product)
Operating Expenses
Other Income (Expenses)
It is important to understand these categories. You must know what to find in each
category and understand what order they are listed in to be able to find them in your
general ledger (and later in your financial statements). Consider the following informal
definitions:
Assets – The physical items that your business owns including money, receivables,
investments, buildings, equipment, etc.
Liabilities – Those amounts that your business owes to third parties. They include
payables, notes, mortgages, taxes, owner loans (not owner investments), etc.
Capital – The investments of the owners and the accumulation of profits or losses for the
business since it began.
Income – The sources from which the business earns its money. Income is measured for a
period of time.

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Cost of Sales – The cost of the product sold by a business and the related costs of having
the product available to sell. In some instances service-technician labor is included in cost
of sales along with the product sold. Cost of sales is measured for a period of time.
Operating Expenses – The daily expenses incurred in running your business. They are the
rent, advertising, insurance, etc. Operating expenses are measured for a period of time.
Other Income (Expense) – These are a part of doing business, but are not daily necessities
or a required part of operations. Examples include bad debts recovered, interest income
and expense, discounts earned, insurance on corporate officers, etc. Consult with your
accountant for more information. Other income and expenses are measured for a period
of time.
Your general ledger will have the categories grouped in the order listed above. If your
accounting system is computerized, you should have a "detailed general ledger" in which
every transaction for each category is listed. This is ideal for tracing transactions through
your books. If you do not have a detailed general ledger, or if you have a manual set of
books, there should be an entry in each general ledger account that refers back to one or
more transaction journals. These entries allow you to locate specific transactions that
were classified into the various general ledger accounts. The general ledger is an output-
oriented report. In other words, you analyze the general ledger from the end product (the
category or account name) back to the source transaction. This leads to Axiom 4.
Axiom 4
To analyze your business by questioning what is in a specific account, begin with the
general ledger and trace backwards through the transaction journal until you get to the
source documents.
The general ledger, then, contrasts with the transaction journal, which is an input-oriented
report. To get into the journals you must identify the source transaction. Your question
relates to where in your books the transaction was posted. The output-oriented general
ledger, on the other hand, begins with an account balance, and your question relates to
what items have been posted to a specific account.
Your general ledger and transactions journals are the building blocks upon which your
financial statements are constructed. Many of the answers you seek when you analyze
your financial statements will be found in the journals and ledger. It is crucial that you
understand their role in your accounting system.
Level Four
The Management Report – Financial Statements
We have now arrived at the point that you've been waiting for — how to understand your
financial statements. It is important, however, that you study and understand the material
you have already read, because understanding your financial statements depends on being

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able to move comfortably from your source documents through your journals and
ledgers.
Every time you have statements prepared, whether monthly, quarterly or annually, you
should receive the following two primary financial statements:
Income Statement
The income statement will tell you if you made a profit or a loss for a specific accounting
period (month, quarter, year, etc.)
The income statement is the one you always look at first. Its purpose is to show you if
you made a profit or a loss. The income statement is designed to give you information
about the accounts in your accounting system that fall in the categories of income, cost of
sales, operating expenses and other income (expense). The income statement measures
results for a period of time.
Balance Sheet
The balance sheet will tell you how you have managed the assets and liabilities of your
business. It will show if you are a good steward with your money.
The balance sheet is the statement you seldom look at because you may not understand
what it is telling you. The purpose of the balance sheet is to show you what the business
owns, what it owes, and what the difference – or its capital – is. It is designed to give you
information about the accounts in your accounting system that fall in the categories of
assets, liabilities and capital (owner's equity). The balance sheet describes a specific date
in time.
You will find examples of balance sheets and income statements in Appendix A. Turn
now to A2 - A5 and look at them. We will talk next about where to look to find answers
to your specific questions. Later we will review some specific techniques to emphasize
relationships within the two statements.
The Secret of Understanding Financial Statements
When reading your financial statements is new to you, most of what you see is strange. If
you are unable to find something that makes sense quickly, you are likely to lose interest
and turn to something that you like or understand better. But the positive financial impact
that a thorough review of your statements will have on your business is crucial. This
leads to Axiom 5.
Axiom 5
When looking at financial statements, ask questions that will eliminate 50 percent of your
alternatives first, thus, reducing your confusion and reducing the time it takes to address
your concerns.

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The first thing you must do when you are unfamiliar with analyzing financial statements
is to ask the following question:
Q: Is the item I am asking about part of the profit or loss of my business, or is it part of
what it owns and what it owes?
A: If your question is about profit or loss like income, cost of sales, operating expenses or
other income (expense), you want the income statement.
OR A: If your question is about assets, liabilities, or capital (owners' equity), you want
the balance sheet. Now that you have eliminated 50 percent of your financial statement
alternatives, let's look at the composition of each statement so that we can further limit
our alternatives.
Income Statements
Income statements will be organized like this:
Income
Cost of Sales
Gross Profit (a total of income less cost of sales)
Operating Expenses
Net Operating Income (a total of gross profit less operating expenses)
Other Income (Expense)
Net Income (a total of net operating income plus or minus other income)
Look at the categories that have the dots beside them. They are from your general ledger.
By classifying your question under one of those four areas, you can effectively eliminate
75 percent of the income statement. Now you can set about finding the answer to your
question.
Example
Say you had a question about an advertising expense, what would you do? Your thought
process would be something like this:
1. My question is about advertising. Is that part of profit and loss or part of what I own
and what I owe (assets and liabilities)?
Advertising is about profit and loss. Set the balance sheet aside.
2. Is advertising part of income, cost of sales, operating expenses or other income and
expense?

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It is not income. It is not cost of my product sold. It is not other income (expense),
because it is a normal part of operations. Therefore I can ignore the other three parts of
the income statement and concentrate on operating expenses.
With two simple questions you can narrow your search down to a single part of a
financial statement. Now, if you wanted to know what was in advertising expense, using
what you learned earlier in this booklet, you would go to the general ledger and through
the transaction journal and possibly all the way back to your filed source documents to
find a paid bill for a specific advertising expense.
The first part of analyzing your own financial statements is being able to decide quickly
where to look, and then to be able to work backwards through the general ledger to
identify any income or expense item about which you have a question.
Now look again at the income statement in Appendix A and review the individual
account names. Compare them against your own financial statements. If necessary, visit
with your own accountant and learn how each account is used and what you can expect to
find in it. Your responsibility is to become familiar with your own income statement and
learn what to expect as you read and study it.

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