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Understanding Financial Statements

Types of Accounting

Accounting

Financial

Financial accounting deals with historical data. Users of this data include investors, creditors, owners government bodies - i.e. IRS and, if public, competitors, potential employees and potential future investors

Financial

Managerial

Managerial

Managerial accounting relates to accounting information prepared to help managers make decisions for the business. Examples include GP analysis, unit costs, departmental costs, prices, etc.

Accounting Equation

Accounting Equation

Assets = Liabilities + Owner's Equity

Assets

Assets are resources owned by an entity. Assets include receivables, pre-paid expenses, inventory, land, patents, equipment, copyrights

Assets

Liabilities

Liabilities are amounts owed to others.

Liabilities include Payables, wages, notes, taxes, loans, etc.

Liabilities

Owner's Equity

Owner's equity, also known as stockholder's equity, net assets, and book value of the company.

The OE is when what the company owns is deducted from what is owed for an ownership balance

Owner's Equity

Income Statement

Income Statement

Definition

The income statement tells the reader how a company has performed - that is, its income or loss for a period of time.

Also called a P&L. (Profit and Loss Statement)

Definition

Detail

Revenues and Expenses

  • The income statement is the first statement prepared
  • It represents a period of time
  • Answers the question - did the company make money?
  • There are only two categories on the income statement - revenues and expenses
  • Revenues are created when the entity sells a product or service and receives cash or creates a receivable
  • Expenses are outflows of cash or using up of assets or incurring a liability for services or goods received. Expenses may also be recognized to reflect an allocation of cost to the period - i.e. depreciation

Where do we see EBITDA?

Gross Profit

  • Gross profit is the difference between sales and COGS (Cost of Goods Sold)
  • This metric helps to measure whether a company is generating enough profit margin to cover OPEX (Operating expenses) and provide NI (Net income) to the company

Gross Profit

Balance Sheet

The balance sheet is created second and records the assets, liabilities and equity of a company at a point in time. It is a snapshot.

Balance Sheet

Working Capital

Working capital refers to the difference between current assets and current liabilities. It is the lifeblood or a company. Working capital planning is an important part of every business - particularly when seasonal and other factors may make these changes sudden, variable or unpredictable

Working Capital

Liquidity

Liquidity is having enough cash on hand to meet cash flow needs

Liquidity

Cash

  • Cash is the liquid monetary asset a company has on hand or in checking and savings accounts.
  • Cash equivalents are short term investments that mature within 90 days or less
  • Receivables are recorded as revenue on the income statement but may impact the cash flows if the terms are adverse to the business operations and the payables

Assets

Inventory Considerations

Inventory

  • Inventory is merchandise held by a company to be sold to customers and is a significant asset
  • Inventories consist of raw materials, WIP (Work in progress), and finished goods
  • Inventories are recorded as an asset until sold
  • Once sold, the inventory account is reduced and the expenses account COGS is increased. THis is how we achieve "balance" in the balance sheet

Inventory Methods

Inventory Management

There are three commons ways to manage inventory:

  • FIFO (first in first out) - assumes that the oldest costs in inventory are moved to COGS first the result is that ending inventory consists of the most recent costs
  • LIFO (last in first out) - assumes that the newest costs in inventory are the first ones moved to COGS resulting in the oldest costs remaining on the balance sheet
  • Average Cost Model - the average cost of all the purchases is used to determine which method is the most appropriate for the business

LIFO Benefits

If a company that sells products (retailer, manufacturer, etc.) finds the cost of its items increasing, the use of LIFO will result in less taxable income and less income tax payments than FIFO. Over a long period of time, or when costs increase dramatically, the lower income tax payments will be significant.

LIFO

Definition

Liabilities - the claims of creditors to the assets of a company usually arise due to an expense or the purchase of an asset

Liabilities

Cash Flows

Cash does not equal revenue

Cash Flows

Key Difference

Cash vs. Revenue

  • A Statement of Cash Flows tracks the sources and uses of cash in the company
  • Revenue is booked to the P&L at the time of sale, not when cash is received... for a small business that is most likely operating on a cash basis, managing cash flows AND revenues/expenses will be critical
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