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Demystifying Financial Statements for Designers
Save the red for your designs. Learn how to prepare accurate financial statements that will help keep your business in the black.
by Shel Perkins
July 11, 2006
It's important for every design business to produce accurate financial statements at the end of every month. These include a balance sheet and a profit and loss statement (P&L). They should be prepared as soon as possible after the month has ended. If someone else prepares the financial statements for you, it's vital to spend time reading and analyzing the information. Get comfortable with the formats. Know where all of the numbers come from and how they've been calculated. You need to be able to use the statements as the basis for sound business decisions.
The P&L (also called an income statement) is an operational view of your design business over a span of time, such as a month, a quarter, or a year. Within that specific time period, it shows how income compared to expenses and whether or not a net profit was produced.
The balance sheet, in contrast, does not represent a span of time. It shows the strength of the company at one particular moment. It's an itemized statement of assets and liabilities in order to show the net worth of the business at that one moment. It's called a balance sheet because it's based on the "accounting equation," a mathematical expression that describes the relationship of the items included. The formula is this: assets = (liabilities + owner's equity). Looked at in another way, the total assets of the business minus its total liabilities will equal owners' equity, which can also be called the net worth or book value of the company.
For internal management purposes, it's preferable for your statements to be accrual-based. In accrual-based accounting, all income is counted when it is earned and all expenses are counted when they are incurred, regardless of when the actual cash is received or paid. This means that on your financial statements, you'll be recognizing project activity in the month where the work itself took place. Your invoices to clients are recorded as sales and then tracked as open accounts receivable. Your purchases from vendors are recorded as expenses and then tracked as open accounts payable. This is in contrast to cash-basis accounting, where income and expenses are not counted until the actual cash changes hands. Cash payments tend to happen long after the fact, which can distort your view of monthly activity and indicate ups and downs that are quite misleading. For this reason, accrual-based financial statements present a more accurate picture.
Also in an accrual-based accounting system, adjusting entries are made when the books are closed at the end of each month in order to update your accounts for items such as depreciation that have not been recorded as part of your normal daily transactions. In design firms, depreciation expenses for computers and equipment can be significant.
Lastly, the P&L and balance sheet are interrelated. At the end of each year, the final net profit (or loss) shown on the P&L is moved into the retained earnings account on the balance sheet. This allows the P&L to start again at zero for the following year.
Shel Perkins is a designer, educator and consultant to creative firms. His book 'Talent Is Not Enough: Business Secrets For Designers' is now available from New Riders/Peachpit Press. To contact Shel with questions and comments, please e-mail us at email@example.com.