With this post, we kick-start the series on “Accounting Basic for Startups” with TaxmantraA startup needs to understand the importance of preparing financial statements from a long term perspective. If you are thinking of executing a sustainable profitable business model, then financial statements serve as an indicator for investors, government authorities, stake-holders and other agencies in deciding whether they should do business with you or not.
The purpose of financial statements is to communicate the state of affairs of your business. The three most common and important financial statements for a startup or for that matter any businesses are balance sheet, an income statement (profit & loss account) and a cash flow statement.
Balance Sheet (Statement of Assets and Liabilities)
Balance Sheet is considered as a popular tool in the business building process and involves crystal clear classification and segregation of assets and liabilities that the entity owns and owes. Moreover it facilitates in calculation of key financial ratios like current ratio, quick ratio, working capital Ratio, debt equity ratio and many more.
Say for example, current assets include cash, stocks and bonds, accounts receivable, inventory details, prepaid expenses and other items which can be converted into cash within one year or during the normal course of business. In addition to this, inventories should be further segregated into closing stock of raw materials, finished goods and work – in – progress. Briefly, work – in – progress implies partially completed products that will be available for sale upon completion. Hence it indicates the working capital required and the operating cycle the product will consume in generating profit. This helps in judging the liquidity of the entity. The same concept is used to determine the short term and the long term debt of the business.
Profit & Loss Statement or Statement of Operational Efficiency
Understanding Profit & Loss statement (also can be termed as operational efficiency statement) is indispensable for good management of financials. Startups generally incur losses in the initial year of their business. However, a business cannot continue to operate indefinitely with a loss because debt owners expect loans to be paid.
Decisive interpretation of the statement requires complete accounting of income, direct and indirect expenses, manufacturing expenses and other costs associated with operations of businesses, so as to determine the correct profitability. This will help in calculating the operational income of the business and derive the net profit of the firm. It is always advisable to account all transactions on chronological basis and the income statement should be prepared on monthly, quarterly and on an annual basis. This will help in assessing the financial implication of your strategies on the business.
Cash Flow Statement
Cash Flow Statement is different from Income Statement in the sense that a business may be making profit but still the cash flows can show a negative sign, which implies cash crunch. For example, when a company makes a sale on credit this will be reflected as revenue in the profit and loss statement but the actual cash on that would be collected later. Thus, it will not be reflected in the cash flow statement.
It is always advisable that cash statement should be prepared on a monthly basis to check the cash position at the end of each month for adequacy to meet the cash requirements for the following month.
Cash Flow Statement can be considered as a yardstick which helps to avoid redundant expenses. It is definitely most important for startups because it represents how much cash a company is generating from its core operations.
It is generally prepared in three segments namely, (i) Income from Operating Activities, (ii), Income from Financing Activities and (iii) Income from Investing Activities.
Also, it is important to note that, it accounts for incomes and gains (from income statement), as well as any working capital changes in the current assets and current liabilities. It blends operating activities (shown in the income statement) with changes in balance sheet accounts to show how the business’s cash is “flowing out of business.”
Regular maintenance of these financial statements facilitates in financial planning, budgeting, and checking financial deviations which ultimately play paramount role in success of your business.
Startups and other businesses feel free to visit Taxmantra.com for comprehensive accounting and taxation assistance.