Understanding Financial Statements and Their Interconnectedness
Watch the video above to find out how to read your company’s financial statements and how they are interconnected. In order to explain this, I also go over the fundamentals of bookkeeping–which is basically credits and debit–so this is a two-in-one video. In this video, I stick to two of the three primary financial statements–the balance sheet and the income statement. I do not go over the cash flow statement, even though it is also an important statement, because there isn’t enough time for it in this short video.
All of the accounts that you use when keeping your books are listed on either your balance sheet or income statement. The balance sheet has the asset accounts of your company as well as the liabilities and equity accounts. The income statement includes your revenue and expense accounts.
The name “balance sheet” comes from the fact that it is always in balance. There are occasional glitches in bookkeeping systems such as Quickbooks that might cause the balance sheet to not balance as it should, but this is extremely rare. Out of the thousands of financials statements I’ve reviewed I’ve only seen it happen a very few times. Financial software programs like Quickbooks are pretty much dummy proof. If your debits don’t equal your credits it usually won’t let you record the transaction.
The important thing to remember is that debits increase assets and expenses while credits increase liabilities, revenue and equity. So, the assets and expenses. For example, say you have a no payable, that you borrowed money from the bank. You would then have to make monthly payments to pay off the loan. When you make a payment on a liability, you decrease it, so you would debit the liability. On the other hand, the interest on the loan is an expense account, so you can deduct the expenses from your revenue. Say you’re paying $500 for the note and the $500 payment includes $100 of interest expense. In that case you would debit interest by $100 while at the same time decreasing the liability by $400, the principal payment. So you debiting interest and the note payable liability and credit cash for the amount that you paid. Each transaction you put in the system has two sides to the entry, and both sides are always going to be equal.
The end result is an income statement that shows that your net income, that’s your revenue minus your expenses, and a balance sheet that shows all assets, liabilities and equity, where the assets equal the total liabilities and total equity. You might be wondering how the balance sheet will balance if most of the entries you make have a portion of the entry that goes to the income statement. The reason it does is that the net income of the income statement flows through to the equity of the balance sheet.