With this blog we are going to begin a multi-part series in which we explore, explain, and hopefully enlighten our readers about the often-confusing world of financial statements.  We’ll be looking at the three most common statements—the balance sheet, the income statement, and the statement of cash flows—and trying to give you an understanding of how to interpret them and what they are telling you about your business.

Let’s start with the balance sheet, which presents a snapshot of a company’s financial position at a specific moment in time, often on the last day of the month, the quarter or the year.  The left side of the balance sheet lists a company’s assets (i.e. the things that it owns). The right side lists the liabilities and equity, which represent the financial obligations that the company has to others.  Assets are listed in order of liquidity, or the length of time that it takes to convert them into cash, and liabilities are listed in the order in which they must be paid.

Now let’s take a look at this sample balance sheet from the fictitious ABC Corporation and break down each of the items in a little more detail.

We’ll begin with the asset side before moving on to liabilities and equity.

Cash – This one is pretty easy.  In addition to actual bank notes, cash also includes any money that is immediately available, such as funds in a checking account.  Cash is, by definition, the most liquid of all assets.

Accounts receivable – This represents money that is owed to ABC Corp. by its customers.

Inventory – Inventory is the value of the goods that ABC has in its possession but has not yet sold.

Total current assets – Are all assets that can be easily converted into cash within a year.  In ABC’s case its total current assets are the sum of its cash, accounts receivable, and inventory.

Fixed Assets – Fixed assets include things such as buildings, machinery, and office equipment which are necessary to run the business but which are not expected to be converted into cash.

Total Assets – Equals the sum of all of the assets of ABC Corp., in this case the figure adds up to $50,000 and is comprised of $35,000 in current, or short-term, assets and $15,000 in fixed, or long-term assets.

On the right side of the balance sheet we see the following items:

Accounts payable – The opposite of accounts receivable, this figure represents the money that ABC owes to suppliers, vendors, and other creditors that is due within a year.

Notes payable – Are loans that must be repaid within a year.

Accrued payroll – Is money that is owed to employees. Because ABC, like most companies, does not pay its employees daily it will accrue this liability to its employees between paydays.

Total current liabilities – All liabilities that must be paid within a year, in ABC’s case accounts payable, notes payable, and accrued payroll.

Long-term debt – Is any financial obligation of ABC’s that is due more than one year from the date the balance sheet was prepared.

Total liabilities – Equals total current liabilities plus long-term debt.

Common stock – Represents the value of the stock that has been issued to investors in ABC Corp.

Retained earnings – Are the earnings of ABC that have been reinvested into the business.

Total common equity – Also known as owners’ equity or stockholders’ equity, this figure is the sum of the value of the common stock plus retained earnings.

Total liabilities and equity – Comprises all of the money that ABC owes to others, plus the value of its common stock and retained earnings, in this case $50,000.

While the precise line items on a balance sheet will differ from company to company, the format that we have laid out here will not vary.  And while each company will, of course, have its own unique values for each entry on the balance sheet, one thing that holds true for ABC Corp. holds true for all companies: total assets are equal to total liabilities plus equity.  In our next post we’ll explain why this is so and start a more in-depth explanation of how to read and interpret a balance sheet.

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Back in our inaugural HBS post, we had a look at the way interest rates are set by the Federal Reserve and the effects that rates have on entrepreneurs who need to borrow money to launch or support their businesses.  Now we want to take a look at how rates affect those who are saving to start a new business or to expand an existing one.  In particular, we are going to focus on a very basic yet powerful concept that is available to all entrepreneurs as they attempt to save for the future: compound interest.

Compound interest is simply defined as interest paid on both principal and accrued interest. A quick example can help illustrate what this means to a saver in the real world.  Say you put $10,000 into a bank account earning 5% a year.  At the end of the first year you will have $10,500, as your initial $10,000 deposit grew by $500.  Quick question: at the end of year two, how much money will you have in your account?  If you answered $11,000 (or an additional $500), you are overlooking the magic of compound interest.

Because you will continue to earn interest on your initial deposit of $10,000, as well as on the additional $500 that you earned in year one, your balance at the end of year two will be $11,025. While an extra $25 might not have you worshiping at the altar of compound interest just yet, a look at its effects over the longer term may just make a believer out of you.

Suppose you run a business that regularly requires you to purchase some fairly expensive equipment that has a limited useful life expectancy.  For example, let’s assume that you know you will need to purchase a new $50,000 delivery truck every 10 years. How soon should you start planning, and saving, for this or any other large purchases that your business needs to remain vital? The short answer is: right now.

If you take our advice, you will have to set aside $320 a month in order to be able to purchase that truck when the old one is ready for the junkyard.  If you are like a lot of people though, you probably don’t think too much about purchases that are 10 years off. Maybe you decide to start saving 5 years from now and think that will do the trick.  Well, it might, but you’ll have to set aside $730 a month rather than $320.  Put another way, if you get started right away you’ll need to save a total of $38,400 vs. $43,800 if you wait 5 years. And that means you’ll have $5,400 to put towards other uses, like giving yourself a bonus for being such an astute financial manager.

While this is just one example, the math always reveals the same result: the sooner you start saving, the less you need to set aside each month, no matter the size or the date of your future purchase.  So in order to avoid the financial pain associated with large but necessary purchases, it always pays to start saving as soon as possible for big dollar purchases you’re expecting down the road.