The income statement is the one we all tend to focus our attention on because it provides the proverbial “bottom line”— the company’s profit or loss. It’s usually done on a quarterly basis.
As you look at the basic income statement you’ll notice that it seems a lot like the cash flow statement. You start with your revenues less commissions. From that, you subtract direct labor (drafters and architects, for instance, for an architectural firm) and materials.
The result is a subtotal that gives you your gross profit or loss. (The percentage of gross profit to revenues can be a very useful number. It’s your gross margin and can help you compare yourself with others in your industry—it tells you immediately whether your labor or other costs are way out of line.)
From your gross profit, you subtract indirect labor (nonbillable time, for instance), administrative labor, and expenses (general and administrative), along with any depreciation. The result is another subtotal that is your pretax net profit or loss.
From that, you subtract a provision for taxes, and the result, at long last, is your net income, or the net increase (or decrease) in retained earnings.
Once again, keep in mind that for smaller businesses, the income statement is less important than the cash flow statement, since it’s possible for a business to run out of cash early in a quarter, even though it’s heading toward profits at the end of the quarter. The primary difference between the cash flow and income statements, then, is timing.
The Balance Sheet: A Statement of Business Health
The balance sheet is more esoteric. It shows the state of the company’s assets and liabilities at a particular point in time. As a statement of the company’s resources, it is important in determining basic business health.
On one side of the balance sheet are the company’s assets— current assets such as cash and accounts receivable and fixed assets like furniture and computers.
On the other side of the balance sheet are the liabilities—the current liabilities like accounts payable and notes payable and long-term liabilities such as equity.
The assets and liabilities must add up to the same number and be balanced. That’s why it’s called the balance sheet.
Balance sheets are very useful for measuring the health of manufacturing, wholesaling, and other product-oriented businesses in which assets can be measured in terms of equipment and inventory. The balance sheet is less useful for evaluating service businesses. Indeed, the balance sheet can be misleading for an architectural or personnel placement business since their primary assets are their people.
Unfortunately, bankers tend to rely heavily on the balance sheet, using ratios of various assets and liabilities. As the economy becomes service oriented, however, bankers are gradually changing their attitudes, so it pays to shop around if you encounter resistance from some bankers.
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