When I was but a young undergraduate student, financial accounting unnerved me. It seemed to be much more arbitrary than a financial system for a company should be. There were so many ways to account for inventory, cash flow, revenue, etc., that it seemed (to me at least) to be a free-form system. Fun fact: it's not! It's much more complicated and bound by formal rules than it first appeared (e.g., Generally Accepted Accounting Principles, or GAAP, as well as numerous Federal laws) to my younger self.
Financial accounting refers to the preparation of the organization's financial statements, including:
the income statement,
the statement of owner's equity,
the balance sheet, and
the statement of cash flows.
As we noted last week, these statements are provided not only to company insiders, but to outside parties, like shareholders, investors and banks.
Managerial accounting, on the other hand, is used strictly within the company. It's a useful system to track inventory as it moves through a manufacturing flow, transitioning from raw materials to finished goods. We won't spend much time on managerial accounting in this class, but you should understand what it is and how it differs from financial accounting. The video (above ) explains it.
As noted above and in last week's lesson, there are several financial statements you must understand because they will be included in your final Business Plan.
The Income Statement
An income statement is a financial statement that measures a company's financial performance over a specific accounting period, such as one calendar year. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. Thing's you'll find on an income statement:
Revenue - Cost of Goods Sold (COGS) = Gross Profit (also called Gross Income)
Expenses include administrative expenses such as salaries and the maintenance of an office or plant. This includes depreciation, the process of spreading the cost of long-term assets over a set period of time.
Net income is the profit or loss after all expenses, including taxes have been deducted from revenue.
Balance Sheet
A balance sheet is a statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period. The name comes from the balance of the Assets - Liabilities = Equity concept
Assets include:
Current assets (i.e., Short-term): cash, temporary investments, accounts receivable
Long-term assets: long-term investments, plant and equipment and organizational funds held for more than one year
Liabilities include:
Current Liabilities: debts owed to short-term creditors (i.e., re-paid within a year or less)
Accounts payable: amounts owed for goods and services
Earned wages and taxes not yet paid (generally falls into accrued expense)
Statement of Cash Flows
This statement shows cash coming in to a business and the cash going out. It's a snapshot in time and it's meant to provide an indicator of overall health. Here's a video that explains it (it's long, but includes the finer points of crafting an accurate statement of cash flows).
Breakeven analysis
How much money do you need to earn each month to avoid losing money? That's your breakeven point. It's valuable for a business to know at how much product it needs to sell to breakeven, that is earn exactly enough to cover all expenses and not lose money.
To determine breakeven, you need to know your business's fixed costs (those that don't change as the quantity of products sold changes, like rent and salaries), and variable costs (costs that vary as the quantity of cost of good sold varies BUT the per unit cost remains constant). Next you must determine your contribution margin per unit: selling price per unit - variable cost per unit. From there you can determine your company's breakeven point in units.
KHAN ACADEMY: INTRO TO THE INCOME STATEMENT
KHAN ACADEMY: INTRO TO THE BALANCE SHEET
STATEMENT OF CASH FLOWS
BREAKEVEN ANALYSIS
TYPES OF STOCK
You have your financial statements. Now what? By using Ratio Analysis, you can get a quick overview of a company's financial health; in fact, this is what the talking heads on CNBC, et.al., do all the time.
Here are the primary ratios you should understand (there are many, many others, but we'll focus on these):
Profit Margin Ratio - the overall percentage of profits earned by the company. The higher the profit margin, the better the cost controls within the company and the higher the return on every dollar of revenue. It's calculated by dividing gross profit by sales: Profit Margin Ratio = GROSS PROFIT/SALES
Net Profit Margin - This is the money the company has after all expenses have been paid. It's calculated by dividing net profit by sales: Net Profit margin = NET PROFIT/ SALES
Return on Assets - Did the company generate a reasonable profit on the assets invested in the company? This ratio will tell you. It's calculated by dividing net income by total assets. With this ratio, it's helpful to know industry averages for your business as what's considered healthy for one industry might be considered bad for another. For example, the Return on Assets average in the retail apparel industry is roughly 13 percent. (These averages can usually be found with a quick Google search.) Return on Assets = NET INCOME/TOTAL ASSETS
Current Ratio - this is a liquidity ratio. This gives you an idea of the company's ability to meet current obligations. Current Ratio = CURRENT ASSETS/CURRENT LIABILITIES
Debt-to-Equity Ratio - this looks as riskiness. That is, the relationship between funds acquired from creditors (e.g., loans and other debt) and funds invested by owners (e.g., equity). Basically, it sheds light on if a company is overextended in terms of debt. Higher ratios can indicate trouble. Debt-to-Equity Ratio = TOTAL LIABILITIES/TOTAL EQUITY
Return on assets - this reflects how much income the firm produces for every dollar invested in assets. Return on Assets = NET INCOME/TOTAL ASSETS
Return on equity - this reflects how much income is generated by $1 the owners have invested in the firm. Stockholders and analsyts use this ratio a lot as a key performance yardstick. Return on equity = NET INCOME/EQUITY
You can finance your business any number of ways. Personal investment and bank loans are common for start-ups, but as a business and its cash needs grow, you will probably have to look elsewhere. Bringing additional owners (and their investments) in is an option as is seeking funds from a private investor (think: Angels and Venture Capitalists). Each of these options carries with it some drawbacks, namely outside investors will want a say in the management of the business and stock in the business.
Once your company gets to a certain size, you may want to go public - that is, to transition from a privately held business to one publicly traded on the stock exchange. But long before you get to that point, you need to understand the three types of stock: Common, which is by far the most prevalent; Preferred, which is grant within a company, but not traded on the stock market; Unlisted can be common or preferred, but it's not traded.