Have you ever looked at your accounts – a cash flow statement, for instance – and thought you were looking at hieroglyphics? Or thought, “If only there was an English-Accounting dictionary, maybe more of us would have an idea about what’s going on in our financial statements?”

This post tackles the most basic accounting fundamentals. Why do you have to know them? Because accounting is the most important source if information in business.

From the large, multi-national corporation down to the corner beauty salon, every business transaction will have an effect on a company’s financial position. The financial position of a company is measured by the following items:

• Assets (what it owns)
• Liabilities (what it owes to others)
• Owner’s Equity (the difference between assets and liabilities)

The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other. The accounting equation for a sole proprietorship is:

Assets = Liabilities + Owner’s Equity

The balance sheet is one of the three fundamental financial statements and is key to both financial modelling and accounting. The balance sheet displays the company’s total assets, and how these assets are financed, through either debt or equity. It can also be referred to as a statement of net worth, or a statement of financial position. The balance sheet is based on the fundamental equation:

Assets = Liabilities + Equity.

The income statement is a historical record of the trading of a business over a specific period (normally one year). It shows the profit or loss made by the business – which is the difference between the firm’s total income and its total costs. The income statement serves several important purposes:

• Allows shareholders/owners to see how the business has performed and whether it has made an acceptable profit (return)
• Helps identify whether the profit earned by the business is sustainable (“profit quality”)
• Enables comparison with other similar businesses (e.g. competitors) and the industry as a whole
• Allows providers of finance to see whether the business is able to generate sufficient profits to remain viable (in conjunction with the cash flow statement)
• Allows the directors of a company to satisfy their legal requirements to report on the financial record of the business.

A cash flow statement tells you how much cash is entering and leaving your business. Along with balance sheets and income statements, it’s one of the three most important financial statements for managing your small business accounting and making sure you have enough cash to keep operating. The cash flow statement reports the sources and uses of cash by operating activities, investing activities, financing activities, and certain supplemental information for the period specified in the heading of the statement.

Once you’ve created all of these different accounting statements, you have to analyse them. One way of doing that is to learn how to calculate ratios that speak to a company’s financial health.
Financial ratios are relationships determined from a company’s financial information and used for comparison purposes. Examples include such often referred to measures as return on investment (ROI), return on assets (ROA), and debt-to-equity, to name just three. These ratios are the result of dividing one account balance or financial measurement with another. Usually these measurements or account balances are found on one of the company’s financial statements—balance sheet, income statement, cashflow statement, and/or statement of changes in owner’s equity.

You’re almost ready to prepare your financial statement. But first, let’s review the Generally Accepted Accounting Principles which are used by organisations to:

• Properly organise their financial information into accounting records;
• Summarize the accounting records into financial statements; and
• Disclose certain supporting information.

One of the reasons for using GAAP is so that anyone reading the financial statements of multiple companies has a reasonable basis for comparison, since all companies using GAAP have created their financial statements using the same set of rules.

Accounting might seem impenetrable and mysterious, but it follows a simple logic easy to understand. As long as you understand the basic terms, you can read all kinds of financial documents to evaluate a company’s financial health.