You don’t have to be a CPA to understand basic financial statements. Learn the basic accounting and financial terms and formulas.
All but the smallest businesses prepare financial statements. People inside the business use the statements to analyze their results. How is the business doing? Are there any warning flags that require changes? Is the business growing faster or slower than its competitors? What can it do better?
Investors use financial statements to see whether their money is invested wisely. Are they getting the kind of return that they expected for the money they’ve invested? Would they do better to invest elsewhere? Should they work for a change in management? Is the company a likely target for acquisition?
Vendors use the financial statements to determine whether the company is a good credit risk. Can the business pay its bills? Customers use financial statements to evaluate whether the company is likely to be around to provide services and support in the future.
How can one set of financial statements provide so much information about so many businesses to so many people?
Long ago, authors and theorists broke financial management information into two accounting equations—essential relationships that have been used to describe financial management. These two equations, which provide the basis for the first two financial statements, are:
- ASSETS = LIABILITIES + EQUITY— the basis for the Balance Sheet
- REVENUES – EXPENSES = PROFIT— the basis for the Income Statement
The first of these accounting equations, ASSETS = LIABILITIES + EQUITY, is also referred to by some as the “fundamental accounting equation.”
Using basic algebra, this equation may also be written as:
ASSETS – LIABILITIES = NET WORTH
This equality may be described more simply as:
What you have = What you owe + What you own
What you have – What you owe = What you own
Adapted from Finance and Accounting for Nonfinancial Managers, Third Edition, by Eliot H. Sherman.