Business Accounting Series - Part II: Using a Financial Statement

November 02, 2022

Contents

This is a continuation of our Business Accounting Series of articles. Please read Part I - Basic Concepts to understand the basics of business accounting.

The culmination of all this effort to record General Ledger transactions is the financial statement. Understanding financial statements helps a business determine profitability, identify areas of growth, and determine net worth.

3 Determining profitability

Determining profitability is done by reviewing the income statement. The income statement is also commonly known as the Statement of Profit and Loss or P&L Statement. The income statement is organized in a way to assist in understanding profitability of production and overall profitability. The structure is as follows:

• Sales
• Cost of goods sold
• Gross profit
• Overhead expenses
• Other (non-sales) income
• Net profit

The sales minus the cost of goods sold equals the gross profit. The gross profit minus the overhead expenses equals the net profit.

3.1 Sales

Sales include all products, services, and other sellable items that are the business’ focus.

3.2 Cost of goods sold

The cost of goods sold includes all costs directly incurred in producing the sales. This might include buying inventory, paying salaries, equipment rental, and so on.

3.3 Gross profit

The gross profit is simply the total amount of sales minus the total cost of goods sold.²

3.4 Overhead expenses

Overhead expenses constitute all other expenses not directly related to producing sales. This could include rents or leases of buildings, corporate taxes, executive salaries, and so on.

3.5 Net profit

The net profit is the result of all sales minus all expenses. This result is also included on the balance sheet as current earnings.

4 Determining company worth

The total value of a company can be determined by examining the balance sheet. As mentioned previously, the balance sheet always sums to zero. This zero sum highlights a basic accounting principle: you can’t get something for nothing.

This is perhaps best discovered through examples. The examples below look at a business just starting up, a business that is succeeding, and a business that is failing.

4.1 Initial company start up

Imagine starting a company from scratch. Immediately there are expenses related to starting any business. These include business licenses, formation of a product, and salaries. In this simple example we will suppose a sole proprietorship.

Expenses to start operating might include:

• Business license
• Office or store lease or rent
• Materials to create the selling product

There could be many more expenses as well, but these few will suffice. In order to obtain the business license the business must be able to pay for the license. That money could come from the proprietor’s personal funds, from a bank loan (which has some collateral or guarantee on the part of the proprietor), or from outside investors. Any way of initially funding the business results in two things: cash for the business to use and equity on the part of the funding person(s). Both of these are created in equal amounts. You cannot obtain $100.00 in cash without also creating $100.00 of equity.

The cash and the equity have opposite signs and sum to zero. As the cash is used, the equity does not decrease, but rather expenses increase. These expenses are entered on the income statement and therefore included on the balance sheet as current earnings.

At this early stage of business startup the proprietor has used $500.00 of personal funds to start the business. All of those funds have been used to pay for expenses. The balance sheet would have General Ledger accounts that look as follows:

The income statement would be:

Notice that the net income on the income statement becomes current earnings on the balance sheet.

At this point the $500.00 investment by the proprietor has resulted in expenses paid and inventory obtained. Now we sell the inventory:

And the income statement:

Again, take note that sales are negative and expenses are positive.

So how much is this hypothetical business worth? The answer: not much. This business is only worth the initial $500.00 investment. If the business were sold and the proprietor wanted a return on that investment, only the initial $500.00 would be paid. The current earnings account shows that as it stands, this business is not making any money.

4.2 Successful business

In this example we will imagine a successful business. The business has cash in the bank, a real estate asset, some outstanding invoices from vendors, equity, sales, cost of goods sold, and overhead.

Here the business has $1,600,000.00 in assets, a mere $50,000.00 in liabilities, and an investment of $350,000.00 in equity. Also important, the business is making $200,000.00 per fiscal period in current earnings. Notice that this business has kept those earnings year over year in retained earnings.

4.3 Failing business

We will use the successful business example in 4.2 as a starting point.

Notice that the current earnings are positive, meaning that this business is losing $500,000.00 per fiscal period. The retained earnings also show that this business has earned $1,700,000.00 since inception. While the assets and liabilities look good, the current earnings show that this business is now losing money.