Liquidity ratios are probably the most commonly used of all the business ratios. Your creditors may often be particularly interested in these because they show the ability of your business to quickly generate the cash needed to pay your bills. This information should also be highly interesting to you, since the inability to meet your short-term debts would be a problem that deserves your immediate attention.

This type of financial statement is used to bridge the gap between the amount of equity the owners have in the business at the beginning of the accounting period and the amount of their equity at the end of the period. The income statement summarizes the revenues and expenses during the accounting period. The statement of changes in financial position is used to show the condition of accounts at the end of a particular period. The statement of changes in owners' equity does a bit of each.

The creation of your financial statements is largely a mechanical exercise. The numbers to be used are found in your accounting records after the books are closed at the end of the period; to draw up the statements, you, your accountant, or your accounting software simply look up the numbers and plug them into the statement.

An easy way to spot trends in your balance sheet and income statement data from a number of years, or to compare your information with that of another company or industry group, is to use "common size" financial statements.

You don't have to be an accountant to make effective use of the data on your balance sheet. Use balance sheet data to monitor your company's financial health by monitoring the following:

While the balance sheet is a financial snapshot, giving you a picture of the business's assets and liabilities on a single day at the end of the accounting period, the income statement shows you a summary of the flow of transactions your business has had over the entire accounting period. In other words, the income statement shows you what happened during the period between balance sheets.

The statement of changes in financial position provides data that are not explicitly present in the balance sheet or the income statement. This statement helps to explain how your company acquired its money and how it was spent. This statement can also help to identify financing needs, to identify cash drains, and to identify holes in the cash budgeting process. Use the statement of changes in financial position as a tool to analyze cash inflows and outflows. Also, use it as a starting point to forecast future cash flows and financing requirements.

The balance sheet is a statement of your company's relative wealth or financial position at a given point in time. It's often referred to as a "snapshot" because it gives you a fairly clear picture of the business at that moment, but does not in itself reveal how the business arrived there or where it's going next. That's one reason why the balance sheet is not the whole story — you must also look at the information from each of the other financial statements (and at historical information as well) to get the most benefit from the data.

After you've gotten the basics of financial recordkeeping down pat, and you have a good handle on your company's cash flow and other day-to-day issues, you may want to take a longer and deeper look at the financial state of your company. In some cases, you may need to undertake a fairly detailed financial analysis because you are looking for additional capital in the form of loans or investors.

If you want a clear understand of how your business is doing financially, and you want to be able to predict and plan for the future, a fairly thorough understanding of your financial statements is essential. A sound understanding of financial statements will help you:

Before we launch into a discussion of the nuances of financial statements, you need to accept the fact that there are rules to putting these statements together. How much you need to worry about the rules, however, depends on what you want to do with the statements. If you are intending to show them to third parties such as lenders, creditors, or investors, you need to be more careful than if they are intended for your eyes only.

Once you've decided that a particular major purchase or project is right for your business, the issue becomes, what's the best way to implement your decision?

Don't fall for expensive service contracts. Service contracts that are pitched to you when you buy a piece of business equipment are often a good deal for the supplier — but not for you. In most cases, the amounts you'd spend on a service contract is wasted money. This is especially true in the case of generic equipment that normally carries a warranty anyway — if something is going to go wrong, it will generally do so in the first 30 to 60 days, when your warranty should cover the problem.

If the major purchase you're considering is a car, truck, or some fairly standard office equipment, you may want to consider leasing your equipment rather than buying it. Leases for standard equipment are easy to arrange with suppliers and, in fact, there's a great deal of competition in that business, so you may be able to whittle down the costs even further. However, be aware that leasing will frequently cost you more in the long run.

Of the four methods of analyzing a major purchase, which one is the best? While the payback period method and the accounting rate of return method are the easiest to compute, most accountants would prefer to look at the net present value and the internal rate of return. These methods take into consideration the greatest number of factors, and in particular, they are designed to allow for the time value of money. If the net present value is negative, or if the internal rate of return is less than the cost of borrowing, the project should be rejected as not financially feasible (unless the project is one that's required by law, such as a safety upgrade).

The internal rate of return (IRR) method of analyzing a major purchase or project allows you to consider the time value of money. Essentially, it allows you to find the interest rate that is equivalent to the dollar returns you expect from your project. Once you know the rate, you can compare it to the rates you could earn by investing your money in other projects or investments.

How can you quickly estimate your cost of borrowing, which is used as the "discount rate," for purposes of analyzing a major purchase decision?

The net present value method (NPV) of evaluating a major project allows you to consider the time value of money. Essentially, it helps you find the present value in "today's dollars" of the future net cash flow of a project. Then, you can compare that amount with the amount of money needed to implement the project.

A fairly simple way of gauging your return on an investment in a major project or purchase is the accounting rate of return (ARR). The formula is:

The payback method is the simplest way of looking at one or more major project ideas. It tells you how long it will take to earn back the money you'll spend on the project. The formula is:

Once you've identified what your major purchase or project should accomplish for you and fleshed out your requirements for the project, the next step is to evaluate the costs. In doing so, you'll also be making more decisions about what features you absolutely need, and which you can live without, in view of their respective price tags.

If you want to finance your major purchase or project with a bank loan, your lender is likely to want to see a cash flow budget showing the effect of the project on your revenues, and proving that you can make the anticipated loan payments.

From time to time, every business owner wrestles with the question of whether it's time to make a major purchase, or to undertake an expensive, lengthy project. Depending on the size and type of business you own, you might have to decide things like whether to purchase a new car or truck, upgrade your computer system, hire a new employee, redecorate your retail store, undertake a major expansion, or even buy another related or unrelated business.

First of all, what do we mean by a "major purchase?" Among financial types (like your banker or accountant), the main consideration is usually that the item or project will have a service period of more than a year. If so, you'd want to spend at least some time studying the issue, and doing what is known as "capital budgeting." If the item will last for less than a year, it's probably not worth a detailed analysis — you might decide to just "get it if you need it."