3 Important Financial Statements Every Business Owner Should Know
Small businesses must be well informed to survive in a competitive environment and one of the vital competency they must develop is to read and understand important financial statements. Understanding essential financial statements such as ‘Trial Balance’, ‘Balance Sheet’, and ‘Profit and Loss’ statements is paramount as these are very important reports for small businesses to ensure their competitiveness in the market.
Running a business without understanding these financial reports is like driving a car without a dashboard. Let’s look into each of these financial reports in detail..
Businesses engaged in financial activities need constant information on a variety of parameters such as market demand, market share, price, competitive activity, cost of production, investment, cost of capital, and statutory levies. Of these, one of the most vital one is financial information such as revenues, costs, capital, salaries, loans and investments. If you take an example of a household, information on items such as salary earned by the principal wage earner, expenses incurred on running the household, school fees and price of vegetables would be some of the information required on a regular basis and this would constitute financial information.
One of the methods of collecting and storing financial information is the double entry method where for every amount of money transacted there will be a debit entry in one account and a credit entry in another account. All the accounts will either have a credit balance or a debit balance.
In order to ensure that the data recorded is correctly done and stored, accountants use a tool known as the trial balance. The trial balance will allow the accountant to prepare the information that can later be utilised for generating important financial statements such as the balance sheet and the profit and loss statement (also known as the income statement).
These two statements are considered to be the most important financial statements for a variety of people interested in any company or organisation. For instance, one could be an investor wanting to invest in the company. One could be a supplier wanting to supply goods and services. One could be a lender who has leant money to the company and wants to know if the company is doing well enough to repay the loan taken.
The balance sheet is the financial state of affairs of a company on any given day, usually the last day of the financial year (typically March 31 each year in case of India). It gives an accurate picture of the company on that particular day in financial terms represented by assets, liabilities and equity. In the household example, the family can take stock of the year gone by and plan to balance the accounts either by borrowing if there is a shortage or by saving if there is an excess.
The profit and loss statement is the financial state of affairs of a company for a given period usually a financial year encapsulated in the form of either a profit or loss for the company. Typically, companies make a profit and loss statement for a quarter or even a month to help the company assess its performance vis-à-vis objectives set. In the household example, the family tends to make a profit and loss statement every month coinciding with the receipt of salary for the month.
Based on the important financial statements of the company people can come to conclusions about the financial health of the company and take steps to engage with that company. Similarly, these statements are among the more important reports for small businesses to project themselves in the market.
What is Trial Balance
In an accounting system based on the double entry method, any expenses incurred would be posted as a debit in one account and a credit in another account. Similarly, any money received will also receive the same treatment. Once the period is over and all entries made, a trial balance will be prepared. This will be the summation of all general ledger accounts.
At the end of the period (one year) for which the trial balance is generated, all accounts will show a credit balance or a debit balance depending on the number of transactions posted to each account. When the balances are listed out it will indicate whether the total of all debits is equal to the total of all credits. If they don’t tally then an investigation could reveal an error and the same can be rectified (that is why it is called a trial balance). The trial balance will also help tracing any arithmetical errors or wrong entries.
After rectifying the errors in such a way that the credits and debits are equal the trial balance will be used to prepare important financial statements, more specifically the balance sheet and the profit and loss statement.