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Keep your record keeping system simple—you really need to follow only four steps.

Step #1: Record daily expenses in a notebook.

Step #2: Make a monthly summary of your income and out-of-pocket expenses in your ledger or on your computer spreadsheet.

Step #3: Summarize all this information into a profit and loss statement. A large number of business owners retain an accountant on a quarterly basis to summarize financial information from income and expense ledgers. If preparing your profit and loss statement seems like an unbearable chore, let your accountant take over.

Step #4: Use the information that has been gathered to prepare other analyses.

STEP #1: Recording Income and Expenses.

You'll need to write down your revenues or income, as well as all your business-related expenses—the cash you spend, the purchases put on a credit card and the bills you pay by check.

Record your expenses right away in a notebook that you keep at your office. In addition to jotting down the dollar amounts as you spend them, include the date and purpose for each expenditure. Use the expense checklist as a guideline. Make sure you expand the categories as you incur any expenses not listed. It is better to be too detailed than to leave anything out.

Hot tip: Attach a large envelope to your expense notebook with a paper clip or rubber band. Put all receipts for cash and credit card purchases in this envelope. You will need this supporting documentation for your tax return.

STEP #2: Monthly Summary

To track your income and expenses on a monthly basis, transfer the information from your notebook to a ledger—actually to two ledgers, one for income and one for expenses. A ledger is nothing more than a sheet of lined paper with columns for entering income and expenses by category. You can purchase ledger pads in your stationery store. Of course, all of this can be accomplished using a computer.

Put all your sales slips, credit card receipts, invoices, and other business papers in a fireproof file box, arranged by month. Have a category for bank deposit slips and bank statements with canceled checks. Put your file box or filing cabinet in a safe place.

STEP #3: Drawing Up Your Profit and Loss Statement

Your books and records contain facts and figures which make up a picture of your business. In order to see the picture, you have to arrange the records into various documents, including a balance sheet, profit and loss statement, and statement of cash flows. Most important, a profit and loss statement (P&L)—sometimes called an income statement or operating statement—will determine how much net profit or loss you had in a given year. It is a summary of your income and expenses. You'll find it is easiest if you do a P&L at the end of each month and then total all twelve at the end of the year. Drawing up this statement each month will highlight how your business is doing.

When the bottom line shows a loss, you're operating "in the red," a figure of speech left over from the days when losses were written in red ink as a warning sign. Operating at a loss typically occurs in the initial stages of a business when a large amount of cash is spent for purchasing equipment, space, and other start-up items. One of the main goals of a business should be profitability. In fact, you want to be operating in the black as soon as possible. Many businesses operate "in the black" for cash-flow purposes, but for tax purposes they operate "in the red." This is because some non-cash expenses are tax-deductible, such as depreciation.

You can use the Profit and Loss Statement from the next section to use this as a model.

NOTE: When numbers are negative, that is, when there's a loss, they are surrounded by parentheses or brackets. Also, remember, even if you don't actually incur certain types of expenses each month, you should set aside some money each month, or anticipate these costs, because you know eventually you will need new equipment, and maintenance is inevitable.

STEP #4: Preparing Other Financial Analyses

In addition to preparing a P&L, the information that has been gathered can be used to prepare other financial analyses such as determining what each aspect of your business costs and to break down your profit/loss by source.