Income Statements & Balance Sheets 101

While most small entrepreneurs hire accountants to take care of their books–a practice that’s highly recommended–, it doesn’t hurt for the business owner to have a basic understanding of the numbers that go into these books and, ultimately, into the financial statements themselves.


Here, we look into how the two most critical financial statements, the Income Statement, and the Balance Sheet, can be constructed from your key facts.

Illustration:

You have just started your business. You have a 60-square meter store space, leasehold improvements amounting to PhP200,000, beginning inventory valued at PhP50,000, and two salespeople manning the store. At the end of your opening day, total sales were PhP10,000. With a mark-up of 40%, this translates to a one-day profit of almost PhP3,000. By month-end, you’ve recorded total sales of PhP200,000.

The Balance Sheet

Let’s start with the balance sheet, which essentially is a report of the resources or assets of the business vis-a-vis the manner of financing these assets (debt and/or equity).

To illustrate, when you were setting up your business, you spent for the following:

[Item: Cost]

• Inventories: PhP50,000
• Leasehold improvements (all expenses related to sprucing up the store): PhP200,000
• Delivery van (bought second-hand): PhP250,000

In addition, you incurred some PhP10,000 for incorporation expenses and business permits and licenses. An additional PhP5,000 was spent on promotional materials and insurance. You also bought a desktop computer and printer for PhP30,000. And finally, you had to have enough cash to cover the first two months of operations. You estimated this at PhP80,000. So all told, you disbursed a total of PhP625,000.

What you had in actual personal savings though amounted to only PhP425,000. Therefore, you had to borrow PhP200,000 to close the financing gap. This amount you sourced from a bank (PhP175,000) and from a supplier (PhP25,000).

These figures are reflected in your beginning balance sheet as follows:

Item	Amount (PhP)	Classification	Explanation
Cash	80,000.00	Current Asset	Minimum cash requirement
Inventories	50,000.00	Current Asset	Beginning inventories for sale; also represents the minimum inventory amount you have on hand at all times
Prepaid Expenses	15,000.00	Current Asset	Expenses paid in advance
Office Equipment	30,000.00	Non-Current Asset or Fixed Asset	Represent assets used in the business and not intended for sale
Leasehold Improvements	200,000.00	Non-Current Asset or Fixed Asset	Represent assets used in the business and not intended for sale
Delivery Van	250,000.00	Non-Current Asset or Fixed Asset	Represent assets used in the business and not intended for sale
Accounts Payable	25,000.00	Current Liabilities	Amount owed to supplier
Loans	175,000.00	Long-term Liabilities	Money owed to a bank or other lender
Owner’s Equity	425,000.00	Owner’s Equity	Residual interest of the owner in the business

Consequently, your beginning Balance Sheet will look something like this:

ABC Corporation
BALANCE SHEET
As of July 31, 2006
ASSETS
Current Assets
Cash	80,000.00
Inventories	50,000.00
Prepaid Expenses	15,000.00
Total Current Assets	145,000.00
Non-Current Assets	480,000.00
Total Non-Current Assets	480,000.00
TOTAL ASSETS	625,000.00
LIABILITIES AND STOCKHOLDER'S EQUITY
LIABILITIES
Current Liabilities
Accounts Payable	25,000.00
Total Current Liabilities	25,000.00
Long Term Liabilties	175,000.00
TOTAL LIABILITIES	200,000.00
Stockholder's Equity	425,000.00
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY	625,000.00

As illustrated, the Balance Sheet follows the fundamental accounting equation:

Assets = Liabilities + Owner’s Equity.

The Income Statement

What about the Income Statement? The Income Statement shows the financial results of operations for a period of time, in this case, a month. You’ve recorded total monthly gross sales of PhP200,000. Your expenses, on the other hand, are as follows: [Item: Cost]

Purchase cost of merchandise: PhP100,000
Rent: PhP24,000
Salaries: PhP16,000
Other Operating Expenses: PhP3,000

The Income Statement would then be as follows:

INCOME STATEMENT
For the Period Ended August 31, 2006
Sales	200,000.00
Less: Cost of Sales	100,000.00
Gross Profit	100,000.00
Less: Operating Expenses
Salaries	16,000.00
Rent Expenses	24,000.00
Others	3,000.00
Total Expenses	43,000.00
Net Income Before Tax	57,000.00

Therefore, after one month of operation, your store earned you PhP57,000 in pre-tax income. Barring any movements in the other balance sheet accounts, this amount will then be added to the Cash account (under Assets), and to the Owner’s Equity account (under Liabilities and Owner’s Equity).

This ensures that your Balance Sheet remains “balanced,” as follows:

ABC Corporation
BALANCE SHEET
As of August 31, 2006
ASSETS
Current Assets
Cash	137,000.00
Inventories	50,000.00
Prepaid Expenses	15,000.00
Total Current Assets	202,000.00
Non-Current Assets	480,000.00
Total Non-Current Assets	480,000.00
TOTAL ASSETS	682,000.00
LIABILITIES AND STOCKHOLDER'S EQUITY
LIABILITIES
Current Liabilities
Accounts Payable	25,000.00
Total Current Liabilities	25,000.00
Long Term Liabilties	175,000.00
TOTAL LIABILITIES	200,000.00
Stockholder's Equity	482,000.00
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY	682,000.00

Your accountant will most likely make adjustments to these statements to reflect such items as depreciation (an accounting treatment to recognize the decline in the useful value of fixed assets); principal repayments and interest expense (on the long-term debt); and taxes. Be that as it may, your familiarity with these basic financial statements will also benefit your accountant, as he or she will be able to better explain to you the effect of decisions you make regarding your business.

In summary, the two basic financial statements are the following:

1. Income Statement – shows the financial results of operation for a period of time (i.e., “For the Period Ended _______”). The Income Statement is like a “diary” in that it chronicles what transpired during the period covered.

2. Balance Sheet – presents the financial position of a business as of a specific date (i.e., “As of ___________”). Therefore, the Balance Sheet is like a “snapshot,” capturing the state of the business at one point in time.

Entrepreneurs are not always expected to master the financial aspects of their business, since traditionally they are more concerned with the production or delivery of their product or service. In fact, in the Philippines, finance is one area where most small businesses are weak. But this shouldn’t deter the business owner from gaining an understanding of the basic finance concepts at the very least. After all, the goal of every small business is to one day be part of the big league. And this can only happen if the entrepreneur continually seeks to expand his knowledge of all aspects of the business.

About the Author: Pat Samia is actively involved with the financial development of the SME community. Among others, she has been a member of Entrepinoy Volunteers Foundation, Inc. and has been a financial consultant to various SMEs.

This article originally came out in the September-October 2006 issue of SME Insight Magazine published by Hinge Inquirer Publications, the Philippines’ leading niche publications company and magazine arm of the Philippine Daily Inquirer. photo from ww.freedigitalphotos.net