Accounting basics for business
Accounting is the language of business. It records, summarises, and reports financial information so owners, managers, and investors can make decisions.
Why accounting matters
Accounting tracks a business's financial activity: what it earns, spends, owns, and owes. Managers use it to plan and control; investors and lenders use it to judge whether to provide money; governments use it for taxes. Financial accounting reports to outsiders; managerial accounting supports internal decisions.
The accounting equation
Every business's finances rest on the accounting equation: assets = liabilities + owners' equity. Assets are what the business owns (cash, inventory, equipment); liabilities are what it owes (loans, unpaid bills); equity is the owners' claim on the remaining assets. Every transaction keeps the equation in balance.
The income statement
The income statement (profit and loss statement) shows performance over a period: revenue minus cost of goods sold gives gross profit; subtracting operating expenses gives operating profit; after interest and taxes comes net profit (net income). It answers: did the business make money?
The balance sheet
The balance sheet shows financial position at a single point in time: assets on one side, liabilities and equity on the other, always balancing. Current assets and liabilities are expected to turn into cash or be paid within a year; non-current ones last longer.
The cash flow statement
The cash flow statement shows cash moving in and out, divided into operating activities (day-to-day business), investing activities (buying or selling equipment and investments), and financing activities (borrowing, repaying, issuing shares, paying dividends). A profitable business can still fail if it runs out of cash.
Accounting standards
To make reports comparable and trustworthy, companies follow standards: Generally Accepted Accounting Principles (GAAP) in the US, set by the Financial Accounting Standards Board, and International Financial Reporting Standards (IFRS), used in over 140 jurisdictions. Public companies' accounts are checked by independent auditors.
Key ratios
Ratios help interpret statements. Profit margin = net profit / revenue shows profitability. The current ratio = current assets / current liabilities shows ability to pay short-term debts; a ratio above 1 is generally reassuring. Return on equity = net profit / equity shows return to owners. Debt-to-equity shows reliance on borrowing.
Worked example
A shop has revenue of 500,000 dollars, cost of goods sold of 300,000, and operating expenses of 150,000. Gross profit is 200,000; operating profit is 50,000. If interest and tax total 10,000, net profit is 40,000, a net profit margin of 40,000 / 500,000 = 8%.
Key takeaways
Accounting records and reports financial information for decisions. Assets = liabilities + equity. The income statement shows profit over a period; the balance sheet shows position at a point in time; the cash flow statement shows cash movements by operating, investing, and financing activities. Profit is not the same as cash. GAAP and IFRS set standards; auditors check accounts. Ratios such as profit margin and the current ratio interpret performance.
Flashcard
Recording and reporting financial information
Check your understanding
A business has assets of 800,000 dollars and liabilities of 500,000 dollars. What is owners' equity?