Accounting Made Simple summary

As we’ve just learned, the accounting equation is fundamental. But it serves a more important role as well. It forms the basis for your balance sheet.

Your balance sheet is your core financial statement. Building on the accounting equation, it uses assets, liabilities and owner’s equity to show your firm’s financial position at any given point in time.

We’ve mastered accounting equations and balance sheets. Next up: the income statement. Unlike a balance sheet, which shows financial accounts at any given moment, the income statement tracks your company’s financial performance over a specified period of time – the course of a year, for instance.  

This document is organized in a straightforward way: you take what you’ve earned (revenue) and subtract what you’ve spent (expenses). Now you see why it’s often called a profit and loss (P&L) statement.

You’ve surely heard this term before: The cash flow statement. But what is it? Well, it’s a simple accounting document that records inflows and outflows of cash. It’s important to have one of these statements in addition to an income statement, since there’s often a lapse between when an income or expense item is recorded and when the cash actually moves in or out of the firm’s accounts.

Imagine your company performs a marketing service in September, but the client doesn’t pay until the beginning of October. That sale would appear in both your P&L statement and your balance sheet as early as September, but since the actual payment won’t arrive in your bank account until October, you wouldn’t include it on September’s cash flow statement.

Once you’ve created all of these different accounting statements, you have to analyze them. One way of doing that is to learn how to calculate ratios that speak to a company’s financial health.

Liquidity ratios are the first to consider, because these indicate how easily a company can meet its short-term financial obligations. A rule of thumb: the higher the ratio, the better.

You’re almost ready to prepare your financial statement. But first, let’s review the Generally Accepted Accounting Principles (GAAP), a set of best practices that are followed by many countries, including the United States.

The single most important aspect of GAAP probably has to do with double-entry accounting and its accompanying system of debits and credits.