Q: I purchased an accounting software program to handle my finances. But when I run the reports, I'm more confused than ever. My income statement says I made a profit of $40,000, but my checking account is empty. Help!
A: Darn it! It's always disappointing when your profit doesn't necessarily mean more cash in the bank-especially when you realize you have to pay taxes on that profit! Go ahead. Cry a little. Now, I'll help you understand how this can happen.
Your income statement (aka profit and loss statement, or P&L) is a handy financial report. It shows money in (income, revenues, sales) and money out (expenses, costs.) More money in than money out creates a profit. More money out than money in creates a loss. Profit is better than loss. So far, this is pretty clear-cut, right?
Now, profit is also reflected in another financial report: the balance sheet. Think of the balance sheet as the ultimate scorecard for your business. The balance sheet is based on this equation: Assets = Liabilities + Equity. Here are the simplified definitions of these accounting terms:
- Assets: The stuff. The goods. What you have. Assets include cash, accounts receivable, inventory, tools, vehicles, buildings, real estate and so on.
- Liability and equity: Who has dibs on the stuff. A liability is what you owe. Equity is what you own.
What you own is recorded in the equity accounts. Claims on the assets by someone other than you are recorded in liability accounts.
The income statement is a report that shows changes in the equity section of the balance sheet as a result of business operations. (Hang with me--I know this gets a bit confusing.) Think of your income statement as a magnifying glass on the equity section of the balance sheet. It shows you the details--money in, money out and what's left over. What's left over is profit, and the profit is reflected in the equity section of the balance sheet. Pull out your own financial reports. Notice that the current earnings line of the equity section matches the profit line on the income statement.
A profit increases the equity in your company. Cool! Because there will be an equal increase on the asset side of the balance sheet. Very cool! Remember, the balance sheet has to balance. So profit creates an increase in equity and assets. That's the fun part.
Now, remember there are different kinds of assets: cash, accounts receivable, inventory, tools, vehicles, buildings and real estate. You have $40,000 in profit. Great! Your balance sheet will show an increase in your equity of $40,000. (Check the current earnings account.) The total increase on the asset side of the balance sheet will be $40,000. But that $40,000 can be in cash, accounts receivable, inventory, tools, vehicles, buildings or real estate. Where it falls depends on if you collected on the sales in the first place (accounts receivable), or maybe you spent the cash on more inventory, tools or a new truck.
And that's why the profit amount isn't the amount in your checking account.
Promise me you'll run a balance sheet, income statement and cash flow report every week. No more surprises. Have your accountant check your accounting work until you're certain the reports are accurate. Keep your chin up. You're getting smarter by the minute!
|Use the income statement to measure business revenues vs. expenses. Check out "Income Statement."|
Author Ellen Rohr nearly starved in her family's small contracting business-until she learned how to manage money. "Do what you love, certainly," she says, "but the money won't just take care of itself." Ellen's pricey college education didn't prepare her for real-world business. "Financial business basics aren't that difficult.but where do you learn them? Unfortunately, business literacy isn't taught in school. I teach the basics and take the mystery out of making money." Ellen's mission as an author, columnist and seminar leader is to help people make a living doing what they love.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.