This article was republished from a post on the Invest Before the Street blog

Financial accounting. Who needs it?

Accounting existing for two basic reasons:

caio_triana / Pixabay
  • To track how much money companies make
  • To track what they own (assets)/ what they owe (debt)

Of course it’s much more complicated than that, but let’s kept it simple for now.

A company’s financial statements are divided into three primary segments:

  • Income Statement
  • Cash Flow Statement
  • Balance Sheet

The best way to understand financial accounting? Pretend like you own a business.

Today you are officially the new owner and accountant of a retailer selling sporting goods. It’s the end of the year, so it’s time to put together all the financial statements. There are a few different types of financial accounting methods, IFRS and GAAP being the two big ones, and we are going to use GAAP accounting in this example.

The Income Statement

First off, we begin with our sales, or revenue. This year we sold $1,300 in merchandise, and it cost us $575 to buy that merchandise. Therefore, our Revenue equals $1,300 and our Cost of Goods Sold (COGS) equals $575. If we subtract those two, we see that we earned a Gross Profit of $725 for the year. So far, our Income Statement should look like this:

We did have other costs as well though. We had salaries to pay, administrative costs, etc. These costs all add up to $240, and we call them our Selling, General & Administrative costs (SG&A). We’ve also been spending $50 a year on research and development (R&D) of new products.

Another odd thing happened this year. We decided to buy new carpeting for the store since the previous carpet was getting super old. It cost $50 for the new carpeting. This is an unusual cost though. It’s not like every year the business has to put in a new carpet. This will make our profitability look much lower than it normally does. How can we handle this?

A Quick Lesson on Expensing vs Capitalizing Costs

A company can ‘expense’ its costs or ‘capitalize’ its costs.

Most normal day-to-day costs are ‘expensed’ on the Income Statement like we’ve done so far.

Less frequent larger maintenance or growth related costs can be ‘capitalized’, meaning they are listed as a ‘Capital Expenditure’ on the Cash Flow Statement, instead of an expense on the Income Statement.

Great! Now we can just get rid of that cost on the Income Statement right? Nope, nothing in accounting is that simple.

What if we could spread out the cost of the carpet over the amount of years we expected the carpet to last for? When we capitalize a cost, a line item called Depreciation & Amortization (D&A) is created that does just that. If we think the carpet will last 10 years, we take the $50 cost, and divide that by 10 to get our annual Depreciation & Amortization expense of $5. We list this expense on the Income Statement every year for the next 10 years. This is called ‘depreciating’ or ‘amortizing’. This expense is also referred to as a non-cash expense, because technically we aren’t paying that $5 expense every year. As you’ll see later on, this is added back on our Cash Flow Statement to properly reflect the cash flow of the business for the year.

Let’s take a look at our Income Statement now.

As you can see we’ve now included our SG&A expense, R&D and our Depreciation & Amortization Expense. Now you may ask, “Why is our Depreciation & Amortization expense $65 and not the $5 we just calculated?”. Well, in the past the company must have had other capital expenditures that is also ‘depreciating’ or ‘amortizing’ over time. As you’ll see, Depreciation & Amortization increases by $5 from 2014 to 2015 to reflect our carpet transaction. Now remember, this isn’t actually a real expense. It’s a hypothetical, non-cash expense created by accounting. Later on, I’ll show you how this is added back on the Cash Flow statement to properly reflect the cash flow on this business.

By subtracting our SG&A and D&A from our gross profit, we get our Operating Income, also known as Earnings before Interest & Taxes (EBIT).

So what else is left? Well, really only two things: our Interest Expense and Taxes. Let’s start off with our Interest Expense.

What is Interest Expense? It’s just the interest you have to pay on a loan. Let’s say this retailer borrowed $500 from the bank for 10 years at a 10% interest rate to fund some purchases. This means that every year for 10 years you owe the bank $50 in interest expense ($500 * 10% interest). Since this is a cost that the business has to pay every year, we need to include in on our Income Statement like this:

Subtracting the interest expense from our EBIT gets us our Pretax Income, also known as Earnings Before Taxes (EBT).

Last, but not least, our business has to pay taxes of course. The standard corporate tax rate in the US is 35%. We get taxes based on our Pretax Income. Therefore, our taxes for this year will be $96 ($320 * 35%). Let’s see how our Income Statement looks now:

After we subtract our taxes from our Pretax Income, we get our Net Income, which represents the profit of our business. We earned $224 this year. Not too bad!

The Cash Flow Statement

The Income Statement helped us identify how much profit our business generated this year.

The Cash Flow Statement will help us identify how much cash went in and out the door this year.

Let’s get started. We always begin with our Net Income. From there we take our non-cash expenses, like Depreciation and Amortization and add them back since we actually didn’t pay those expenses. We can pull these numbers right from the Income Statement.

Now there is a big quirk with the Cash Flow Statement. Let’s say you sold something to one of your friends. Ever have them pay you online with something like PayPal or Venmo? You know how it can take a few days for that money to get into your bank account? If this were for a business, this could cause some issues.

Imagine if you sold something to someone on December 31st 2014 who paid with a credit card, but the money didn’t actually get into your bank until January 5th 2015 because it had to ‘process’. You can book the revenue for 2014, but you really didn’t get paid until 2015.

On the other hand, you could have purchased some supplies from a supplier on December 31st, but your money wasn’t taken from your bank account until January 5th. You can book the cost for 2014, but you didn’t actually pay for anything until 2015.

When you do your financial accounting for 2014, how do you handle this? You technically had both the sale and purchase of supplies happen on the December 31st, but the movement of the cash didn’t happen until January 5th.

To fix this issue, a line item called Change in Working Capital is created on the Cash Flow Statement to account for these cash flow discrepancies. You’ll see later on in the Balance Sheet section how this is reflected there.

So after we identify our Change in Working Capital for year, here’s what our Cash Flow Statement will look like:

Once we account for the Change in Working Capital, we have our Cash Flow from Operations (CFO). This is the true amount of cash flow generated by the business this year. You’ll notice CFO is actually greater than net income because we add back all our non-cash expenses.

This next section of the Cash Flow Statement is called Cash Flow from Investing Activities. This section accounts for any investing related cash flows, such as acquisitions of other companies, sales of equipment, and our old friend, Capital Expenditures. Remember that $50 carpeting purchase we mentioned earlier? This is where we put that charge. Let’s take a look:

You can see we added the $50 carpeting charge in the Capital Expenditures line. It looks like the company had similar Capital Expenditures the last two years as well.

The last part of the Cash Flow Statement is called Cash Flow from Financing Activities. This section accounts for financing related things, like paydowns/increases in debt, dividends to shareholders, and share repurchases.

So what did our business do this year? Well, we paid off $10 of debt.

Dividends? We paid $50 in dividends to our shareholders this year. A dividend is a cash payment that publicly traded companies pay their shareholders for being holders of the stock. For example, a company can pay a 5 cent dividend on every share outstanding. If you owned 100 shares, you would receive a $5.00 dividend.

Share Repurchases? We paid $30 to repurchase shares this year. What’s the point of a share repurchase? When a company buys back its own stock, there are less publicly traded shares in the market, and current shareholders end up owning a larger piece of the company. For example, let’s say our company had 100 million shares outstanding and this one shareholder owned 20 million shares, or 20% of the company (20mm shares / 100mm shares outstanding). If the company decided to buy back 10 million shares, there would only be 90 million shares outstanding now. Therefore, that one shareholder would own 22% of the company after the buyback (20mm shares / 90mm shares outstanding).

So after this, what would our Cash Flow Statement look like now?

If we add up all three sections of the Cash Flow Statement: CF from Operating Activities, CF from Investing Activities, and CF from Financing Activities, we can determine our total change in cash for the year. This year we netted $139 in cash after all expenditures and costs. That’s pretty good!

The Balance Sheet

Last, but not least, is our final financial statement, the Balance Sheet. The Balance Sheet is comprised of three main parts:

Assets (what we own), Liabilities (what we owe to others), Equity (what our stock is worth).

Let’s start off with our Assets. These are broken down into two sections: Current Assets & Non-Current Assets. Our Current Assets include more liquid assets like cash, inventory, accounts receivable (I’ll explain this in a bit). Our Non-Current Assets include less liquid assets like property & equipment.

Well, we know our business had $404.50 in cash at the end of the year, according to our cash flow statement. Separately, we know we had about $90 worth of inventory at the end of the year. Lastly, we need to figure out our Accounts Receivable.

A Quick Lesson on Accounts Receivable, Accrual Basis Accounting & Working Capital

But, what is Accounts Receivable? Remember earlier on when we were talking about the Change in Working Capital on the Cash Flow Statement, and how that’s driven by timing issues? Well, Accounts Receivable is one of the line items created by this. If we sold something for $10, but haven’t actually received that money in our bank account, an Accounts Receivable asset is created that shows we eventually are supposed to receive $10 for that item.

Think about it like this. When we sell an item, we want to be able to book the revenue on our Income Statement the day we make the sale. We don’t want to have to wait until we receive the money in our bank account. The problem with this is that if we want to book the revenue on our Income Statement the day we made the sale, we won’t actually have any cash flow yet because the money from the purchase isn’t in our possession yet.

To fix this, someone came up with the concept of ‘Accrual Basis Accounting’ and ‘Working Capital’. Under ‘Accrual Basis Accounting’ we can book revenue on the day we make the sale, even if we actually haven’t received the cash flow yet. That Change in Working Capital line item we saw on the Cash Flow Statement just corrects those timing differentials that arise. So, if we sold something for $10 but haven’t received the cash flow yet, we can book the $10 in revenue on the Income Statement, but we’d have a $10 Change in Working Capital OUTFLOW to offset it on the Cash Flow Statement. We’d also create a $10 Accounts Receivable asset on the Balance Sheet to show that we expect to receive the $10 eventually.

Working Capital represents the differential between these ‘Accrual Basis Accounting’ assets, such as Accounts Receivable (what we are owed) and Inventory and ‘Accrual Basis Accounting’ liabilities, such as Accounts Payable/Accrued Expenses (what we owe to others).

In this case, we can say Working Capital equals our ‘Accrual Basis’ Current Assets (Accounts Receivable & Inventory) minus our ‘Accrual Basis’ Current Liabilities (Accounts Payable/Accrued Expenses), which we’ll talk about in a bit.

You may be wondering, “What does inventory have to do with this? Isn’t that just a straightforward expense?”. Not exactly. The problem with inventory is that you buy it way in advance, and those expenses are often big and lumpy. Wall Street hates inconsistency. They like it when things are predictable. To fix this, inventory became part of Working Capital. When a large purchase is needed to buy inventory like t-shirts in our case, it’s accounted for as a cash outflow on the Change in Working Capital line, instead of as an expense on the Income Statement. To smooth out earnings and expenses, the cost of inventory expense is recognized on the Income Statement when we sell the t-shirt in our store. Therefore, it is tied together with the sale of the t-shirt at the exact same time, making the numbers on the Income Statement look much more smooth.

Now let’s get back to our Balance Sheet.

So after all this talk on Accounts Receivable, Working Capital, and ‘Accrual Basis Accounting’, we determine that we should have about $170 in Accounts Receivable this year. How does our Balance Sheet look so far?

So far so good. We got our cash, AR, and inventory comprising our Current Assets.

How about our Non-Current Assets? Well, we of course have our Property & Equipment. But what value would we put on the Balance Sheet? We know what we paid for it, but some stuff is definitely old and not worth as much anymore. How should we handle this?

Remember when we talked about Depreciation & Amortization earlier on? The whole concept of depreciation and amortization is to ‘depreciate’ or ‘amortize’ an asset over its life expectancy, so at the end of its life expectancy, its value on the Balance Sheet will be $0. As something depreciates or amortizes, that depreciation or amortization builds up and creates a ‘Contra-Asset’ called Accumulated Depreciation & Amortization.

By the way, depreciation & amortization are basically the same thing. You use the word depreciation when your referring to physical assets like a house, and you use amortization when you’re referring to an intangible asset like a brand.

Let’s say that it would equal $650 if we were to add up what we paid for all the property, equipment, carpeting, etc that we’ve ever bought. That would be our Gross Property, Plant, & Equipment value.

Then we want to identify the sum of all of our depreciation & amortization expenses over time to calculate our Accumulated Depreciation. We figure out that this is about $230 for us.

Since Accumulated Depreciation is a ‘Contra-Asset’ we want to subtract our $230 of Accumulated Depreciation from our $650 of Gross Property, Plant & Equipment. This will get us our Net Property, Plant & Equipment of $420, which is the value we will use on the Balance Sheet. Let’s take a look:

Here’s two quick things to notice:

  • Gross PP&E goes up by $50 from 2014 to 2015 because of our Capital Expenditures in 2015, which were $50
  • Accumulated depreciation goes up by $65, which was our Depreciation & Amortization expense for 2015

Other big Non-Current Assets that we see often are Intangibles and Goodwill.

An Intangible Asset is something like the value of a brand, or the value of movie rights, like Toy Story.

Goodwill is normally related to acquisitions. If we decided to purchase another retailer, we would end up owning all of its assets. The problem that arises here is that sometimes we end up paying more than the value of the other company’s assets. If we acquired the other retailer for $500, but it only had $400 of tangible and intangible assets, then the other $100 we can’t identify would go to Goodwill. Let’s see what this looks like on our Balance Sheet:

Looks like our Goodwill & Intangibles have remained pretty consistent over the years. Now a business can have many more different kinds of assets, but these are some of the biggest ones you’ll see on a company’s financial statement.

Now let’s try and identify our business’ liabilities.

Just like our assets, liabilities are broken down into Current Liabilities and Non-Current Liabilities. Current Liabilities include things like Short-Term Debt, the Current Portion of Long Term Debt, and Accounts Payable/Accrued Expenses.

Remember our previous conversation on ‘Accrual Basis Accounting’ and Accounts Receivable? Well, Accounts Payable/Accrued Expenses arise when we receive a certain service, but the cash flow hasn’t left our bank account yet to pay for the service. So, when we pay the electric bill, we are receiving the service (electricity) upfront, but oftentimes the cash flow doesn’t leave our bank accounts on the day we are billed by the electric company. This results in the creation of an Accounts Payable/Accrued Expenses liability.

Let’s say our electric bill was $10. On the Income Statement we book the expense the day we are billed, but on the Cash Flow Statement we have a $10 cash INFLOW on the Change in Working Capital line since we haven’t actually paid the bill yet. The Accounts Payable/Accrued Expenses liability that is created on the Balance Sheet basically shows that we owe that money to someone else, and expect to pay it out soon.

After looking through our business’ numbers, we come to the conclusion that we have about a $150 Accounts Payable/Accrued Expenses liability.

How about our Short-Term Debt? If we have debt outstanding on a credit card, we could classify this as Short-Term Debt. We see that we currently have no Short-Term Debt.

How about the Current Portion of Long-Term Debt? If we have a long-term loan outstanding, we might have to make a small principal payment every year. What does that mean? Well, we might be required to pay $10 in principal every year on our $500 loan. Don’t confuse this with Interest Expense. We still have our normal interest expense payment on our Income Statement. The word ‘principal’ just refers to paying down the actual balance of the loan. So, if we pay our $10 principal payment on our $500 loan, our outstanding balance on the loan would drop to $490. That $10 required principal payment is labeled as the Current Portion of Long-Term Debt on the Balance Sheet because it is due within a year. Let’s take a look at our Balance Sheet so far:

Here we see our $10 principal payment listed every year, as well our Accounts Payable & Accrued Expenses.

How about our Non-Current Liabilities? This is primarily comprised of any Long-Term Debt our business may have. In our case, it looks like we have about $480 of Long-Term Debt outstanding. Let’s see how this all looks on our Balance Sheet:

That’s it for liabilities! Now a business can have many more different kinds of liabilities, but these are some of the biggest ones you’ll see on a company’s financial statement.

Last, but not least, we have our last section of the Balance Sheet, our business’ Equity. I don’t find this section particularly useful, but it’s important to understand how it works. The Equity section is meant to try and the value the business’ outstanding equity. Although, this is a bad proxy to use to actually value a company’s outstanding stock. Instead, we’ll focus on how it interacts with the other two financial statements.

First off, we have our Common Shares, which is a basically useless line item. Then was have Paid-In Capital, which tracks movements in the repurchases, issuances of stock, and dividends.

Next, we have Retained Earnings, which is essentially the sum of our business’ Net Income throughout its existence. Let’s take a look at how it looks for our company:

Here’s a few things to notice:

  • The value of Paid-in Capital goes down by $80 each year because of our $30 in share repurchases we are making, and $50 in dividends, as you saw previously on the Cash Flow Statement
  • Retained Earnings went up by $224 from 2014 to 2015 because we made $224 in Net Income.
  • On every Balance Sheet, Assets always equal Liabilities + Equity, as you’ll see that they do here.

That’s it for our introduction on the three financial statements! Over the next few lessons, we’ll go much more in depth on each of them to make sure you have a solid understanding on each, as well as go through some real life examples.