Assets = Liabilities + Owner’s Equity
Assets: All the property (tangible, intangible) owned by the company.
Liabilities: All the debts the company currently has outstanding to lenders.
Example: Lisa owns a $300,000 home. To pay for the home, she took out a mortgage on which she still owes $230,000. Lisa would be said to have $70,000 equity in home. Applying the Accounting Equation to Lisa’s situation would give us this:
Assets = Liabilities + Owner’s Equity
$300,000 = $230,000 + $70,000
My Asset is your Liability
One concept that can trip up accounting invoices is the idea that liability for one person is in fact an asset for somebody else
Example: If you take out a loan with your bank, the loan is clearly a liability for you but an asset for the bank.
Balance Sheet
A company’s balance sheet shows its financial situation at a given point in time. It’s a formal presentation of the Accounting Equation.
Current Assets and Long-term Assets
Current assets are assets that expected to be converted into cash within 12 months or less, such as Accounts Receivable, Cash and Inventory.
Everything that’s not a current asset is a long-term asset. Long-term assets can be property, plant and equipment.
Current liabilities and Long-term Liabilities
Current liabilities are liabilities that need to be settled in 12 months or less, such as Accounts Payable. Notes Payable that are paid off over a period of time are split up on the balance sheet so that the next 12 months’ payments are shown as a current liability while the remainder of the note is shown as a long-term liability.
Income Statement
A company’s income statement shows the company’s financial performance over a period of time (usually one year). This is in contrast to the balance sheet which shows financial position at a point in time.
Gross Profit
Gross profit = Revenues – COGS
Net profit = Gross profit – SG&A (Overhead Expenses)
Example: Laura runs a small business selling T-shirts. At the beginning of the month, Laura ordered 100 T-shirts for $3 each. By the end of the month, she had sold all T-shirts for a total of $800. For the month, Laura’s Cost of Goods Sold (COGS) is $300, leaving her Gross Profit $500.
Operating Expenses and Non-operating Expenses
Operating expenses are expenses related to normal operation of the business and are likely to be incurred in future periods as well, such as rents, insurance premiums, employees’ wages.
Non-operating expenses are expenses not related to the normal operation of the business, and as a result are unlikely to be incurred again in the following year, such as lawsuits.
Operating Income and Net Income
Operating income = Gross profit – Operating expenses
Operating net income = operating income – non-operating expenses
Many companies try to classify as many expenses as possible as non-operating to make their operating income look more impressive to investors.
Retained Earnings
Retained earnings is the sum of all a company’s undistributed profits over the entire existence of the company. In other words, they are not profiting that have been distributed to company shareholders in the form of dividend payments.
The statement of retained earnings is a very brief financial statement which has only one purpose, to detail the changes in a company’s retained earnings over a period of time.
Dividends are not an expense.
Unlike many other cash payments, however, dividends are simply a distribution of profits (as opposed to expenses which reduce profits). Because they’re not a part of the calculation of net income, dividend payments don’t’ show up on the income statement. Instead they appear on the statement of retained earnings.
Retained earnings are not the same as cash.
Just because a company hasn’t distributed its profits to owners doesn’t mean it hasn’t already used them for something else. For instance, profits are frequently reinvested in growing the company by purchasing more inventory for sale or purchasing more equipment for production.
The statement of retained earnings acts as a bridge between the income statement and the balance sheet. It takes information from the income statement, and it provides information to the balance sheet.
Cash Flow Statement
Cash flow statement is exactly what it sounds like. It reports a company’s cash inflows and outflows over an accounting period. At first it seems to serve the same purpose as income statement. But there are differences in the timing the transactions are recorded.
Example: In September, XYZ consulting performs marketing services for a customer who does not pay until the beginning of October. In September, this sale would be recorded as an increase in both Sales and Accounts Receivable (and the sale would show up on a September income statement). The cash however isn’t received until October, so the activity wouldn’t appear on September cash flow statement.
The second major difference is cash flow statement includes several types of transactions that are not included in the income statement.
3 categories of cash flows
- Operating cash flows – activities directly related to normal business operations (i.e. things that will likely be repeated year after year, e.g.: receipts from sales, payments made to suppliers, payments made to employees, tax payments)
- Investing cash flows – investments in financial securities (e.g. stocks, bonds…) and cash spent/received on/from capital assets
- Financing cash flows – inflows/outflows to owners and creditors (e.g. dividend payments to shareholders, paying back loans).
Liquidity Ratio
Liquidity ratios are used to determine how easily a company will be able to meet its short-term financial obligations. The higher the better. The most frequently used liquidity ration is known as the current ratio:
Current ratio = Current Assets / Current Liabilities
Return on Assets
A company’s return on assets shows a company’s profitability in comparison to that company’s size (as measured by total assets). In other words, it answers ‘how efficiently is this company using its assets to generate profits?’
Return on Assets = Net Income / Total Assets
By using return on assets or return on equity, you can make meaningful comparisons between the profitability of two companies, even if they are drastically different sizes across multiple industries.
Return on Equity
A company’s return on equity is the same as return on assets, except shareholders’ equity replace assets. It answers, ‘how efficiently is this company using its investors’ money to generate profits?’
Return on Equity = Net Income / Shareholders’ Equity
Gross Profit Margin
Gross profit margin shows what percentage of sales remains after covering the cost of inventory sold.
Groff profit margin = Sales – COGS / Sales
Gross profit margin comparisons across different industries can be rather meaningless. For instance, a grocery store has a lower profit margin than a software company, regardless of which company is run in a more cost-effective manner.
Debt ratio
A company’s debt ratio shows what portion of a company’s assets has been financed with debt.
Debt ratio = Liabilities / Assets
Debt-to-Equity Ratio
A company’s debt-to-equity ratio shows the ratio of financing via debt to financing via capital from investors.
Debt to Equity ratio = Liabilities / Owner’s Equity
Pros and Cons of Financial Leverage
It’s obviously risks for a company to be very highly leveraged (that is financed largely with debt). However, the more leveraged a company is, the greater its return on equity will be.
Example: XYZ software has $200 million of assets, $100 million of liabilities and $100 million of owners’ equity. XYZ’s net income for the year is $15 million, giving them a return on equity of 15%. If, however, XYZ software capital structure was more debt-dependent such that they had $150 million of laities and only $50 million of equity – their return on equity will now be much greater (30%), thereby offering the shareholders twice as great a return on their money.
Inventory Turnover
Inventory turnover shows how many times a company’s inventory is sold and replaced over the course of a period.
Inventory turnover = COGS / Average Inventory
Average inventory = Beg. Inventory + Ending Inventory / 2
Inventory Period
Inventory Period shows how long, on average, inventory is on hand before it’s sold
Inventory period = 365 / Inventory Turnover
A higher turnover (thus a lower inventory period) shows the company’s inventory is selling quickly and is indicative that management is doing a good job of stocking products that are in demand.
Receivables Turnover
Receivables turnover shows how quickly the company is collecting upon its Accounts Receivable.
Receivable Turnover = Credit Sales / Avg. Accounts Receivable
Average Collection Period
Average collection period is exactly what it sounds like: the average length of time that a receivable from a customer is outstanding prior to collection.
Average Collection Period = 365 / Receivables Turnover
Obviously, higher receivables turnover and lower average collection period is generally the goal.
Generally Accepted Accounting Principles (GAAP)
In the US, GAAP is the framework of accounting rules used when preparing financial statements. The goal of GAAP is to make it so that potential investors can compare financial statements of various companies in order to determine which ones they want to invest in, without having to worry one company appears more profitable on paper simply because it’s using different accounting rules.
Securities and Exchange Commons (SEC) requires all publicly traded companies adhere by GAAP when preparing their financial statements.
Double-Entry Accounting
Debit everything that’s coming in. Credit everything that’s going out.
Debit = Inflow
Credit = Outflow
Asset = Liabilities + Owner’s Equity
So, debits increase an asset account and decrease liability/owner’s equity account. Credits decrease asset account and increase liability/owner’s equity account.
Example: You purchase a $600 workstation for your startup.
- Workstation (Asset) $600
- Accounts Payable (Liability) $600
You debit your workstation account because value is flowing into it. In double-entry accounting, every debit (inflow) always has a corresponding credit (outflow). An accountant would say we’re crediting the bank account $600 and debiting the workstation account $600.
Example: Chris’s construction takes out $50,000 loan with a local bank.
- Cash (Asset) $50,000
- Notes Payable (Liability) $50,000
Example: Chris’s construction purchased $10,000 worth of building supplies, using credit to do so.
- Building Supplies (Asset) $10,000
- Accounts Payable (Liability) $10,000
General Ledger
A general ledger is a place where all a company’s journal entries get recorded. Of course, hardly anybody uses an actual paper document for a general ledger anymore. Instead journal entries are entered into a company’s accounting software, whether it’s high-end customized program or Excel spreadsheet.
General ledger is a company’s most important financial document, as it’s from the general ledger’s information that a company’s financial statements are created.
Cash Accounting and Accrual Accounting
Under cash accounting, sales are recorded when cash is received, and expenses are recorded when cash is paid. It’s straightforward and intuitive. The problem with the cash method however is that it doesn’t always reflect the economic reality of a situation.
Example: Pam runs a retail ice cream store. Her lease requires her to prepare her rent for the next 3 months at the beginning of every quarter. For example, in April she’s required to pay her rent for April, May and June.
If Pam uses cash accounting, her net income in April will be substantially lower than that of May and June, even if her sales and other expenses are the same. If a potential creditor was to look at her financial statements, the lender would get the impression that Pam’s profitability is subject to wild fluctuations. This is of course a distortion of the reality.
Under accrual accounting, revenue is recorded as soon as services are provided or goods are delivered, regardless of when cash is received (note therefore we use AR account). Similarly, expenses are recognized as soon as the company receives goods or services regardless of when it pays for them (note therefore we use AP account). Accrual accounting fix the major shortcoming of cash method: distortions of economic reality due to frequent time lag between a service being performed and the service being paid for.
Depreciation
When a company buys asset that probably last for more than one year, the cost of that asset isn’t counted as immediate expense. Rather the cost is spread out over many years through a process known as depreciation.
The most basic form of depreciation is straight-line depreciation where the cost of the asset is spread out evenly over the expected life of the asset.
Example: Daniel spends $5,000 on a laptop. He expects the laptop to last for 5 years by which point it will likely be of no substantial value. Each year, $1,000 of the laptop cost will be counted as an expense.
Salvage (Residual) Value
What if a business plans to use an asset for few years then sell it before it becomes entirely worthless? Salvage value (also known as residual value) is the value that asset is expected to have after the planned number of years of use.
Example: Lynda spends $10,00 on office furniture which she plans to use for next 10 years. After that she believes it will have a value of approximately $2,000. Depreciable cost in this case is $8,000.
Immaterial Asset Purchases
Consider the case of $20 wastebasket. Wastebasket is almost certain to last for several years but in terms of the impact on company’s financial statement is clearly negligible. The benefit of additional accounting accuracy is far outweighed by the hassle involved in making insignificant depreciation. As a result, assets of this nature are generally expensed immediately upon purchase, rather than depreciated over many years.
Amortization
Amortization is very analogous to depreciation which an intangible asset’s cost is spread out over the asset’s life. Generally intangible assets are amortized using the straight-line method over the shorter of: the asset’s expected useful life or the asset’s legal life.
Example: Kurt runs a business making components for wireless routers. In 2011, he spends $60,000 obtaining a patent for a new production method he developed. The patent will expire in 2031.
Even though the patent’s legal life is 20 years, its useful life is likely to be much shorter given the rapid rate of innovation. As such, Kurt will amortize the patent over which he projects to be its useful life: 4 years.