MBA ASAP Corporate Finance Fundamentals for Career Success

Excel is a versatile and indispensable tool for finance and investment professionals. Its importance cannot be overstated, as it is used in a wide range of financial tasks, from data analysis to financial modeling and reporting.

1. Financial Analysis and Reporting: Excel enables finance professionals to sort, analyze, and visualize data to identify trends, perform variance analysis, and forecast future financial scenarios. It supports using pivot tables, advanced formulas, and various graphing tools, which are crucial for creating detailed financial reports.

2. Financial Modeling: Excel is widely used for financial modeling, allowing analysts to build models that can predict income, budgeting, cash flow, and other financial projections. Using advanced functions and creating flexible, dynamic models is critical to making informed business decisions.

3. Excel Proficiency is a Game-changer for finance professionals, significantly boosting productivity by saving time. The ability to automate tasks with macros, handle complex calculations with ease, and manage large datasets efficiently are just a few ways Excel streamlines financial tasks.

4. Excel is not just a tool; it's a universal language in the finance industry. Mastery of Excel is often a prerequisite for many finance roles, making it an indispensable skill for job proficiency and career advancement.

5. Decision Making: Excel helps finance professionals in decision-making processes by providing a platform to work through various financial scenarios and analyze potential outcomes. What-if analysis and sensitivity tables are instrumental in this regard.

6. Accuracy and Precision: Excel's precision in handling financial data is critical. A single error can result in significant financial discrepancies; thus, the ability to use Excel to manage and cross-check numbers accurately is vital.

7. Integration and Compatibility: Excel can integrate with many business applications and databases, making it an effective tool for consolidating information from various sources for financial analysis and reporting.

Knowing Excel in finance is not just about understanding the basic features; it involves a deep understanding of its advanced capabilities, which are essential in the sophisticated world of finance.

Excel proficiency is a foundational skill that enables finance professionals to perform their roles effectively and efficiently, whether running regressions, building a discounted cash flow model, or analyzing complex datasets.

Download the MBA ASAP Ultimate Excel Handbook and level up your skill set.

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Bookkeeping and Accounting produce Financial Statements, the cornerstone of Corporate Finance. Therefore, understanding how business transactions aggregate to make financial statements is critical to a foundational understanding of corporate finance. 

Accounting is the procedure of data entry and recording, summarizing, analyzing, and reporting financial data. The end product of accounting is the three financial statements: Income Statement, Balance Sheet, and Cash Flow Statement.

FIVE BASIC ACCOUNTING PRINCIPLES:

1: Revenue Recognition:

→ Revenue is recorded at the time of the transaction.

2: Matching Principle:

→ Expenses are recorded in the same period as the revenues they helped generate

3: Historical Cost:

→ Assets are recorded at their acquisition cost.

4: Full Disclosure:

→ Full disclosure of all relevant info is made available.

5: Objectivity Principle:

→ Information in books should be true, relevant, & accurate.

5 CATEGORIES OF ACCOUNTING:

1: Assets:

→ All Tangible & Intangible items owned by the company.

2: Liabilities:

→ Amounts the company owes to others.

3: Equity:

→ Net Worth of Entity: Assets - Liabilities

4: Expenses:

→ Amount paid purchases made in business.

5: Income:

→ Amount earned by the company from the sale of goods.

JOURNAL VS LEDGER:

→Journal Entries consist of Debits & Credits, the totals of which should be equal

→Journal entries are then transferred to the appropriate Ledger Accounts

FINANCIAL STATEMENTS:

1: Income Statement:

→ Shows profit or loss during the period.

2: Balance Sheet:

→ A company's assets, liabilities, and equity at a point in time.

3: Statement of Cash Flow:

→ Shows the inflow and outflow of cash during the period.

DOUBLE ENTRY SYSTEM

→ Each Accounting Entry will have two sides - Debit and Credit.

THREE FIELDS OF ACCOUNTING:

→ Financial Accounting: Preparing the Financial Statements.

→ Managerial Accounting: Prepare reports for internal use.

→ Cost Accounting: Measure the performance of resources.

The Accounting Cycle

The Accounting Process, Visualized:

Step 1: Identify transactions

→Identify and document all financial transactions that occur within the accounting period.

Step 2: Prepare journal entries:

→Create journal entries to record the details of each transaction, including the accounts affected and the corresponding debits and credits.

Step 3: Record journal entries:

→Enter the journal entries into the general ledger, the central repository for all financial transactions.

Step 4: Prepare trial balance:

→Summarize the balances of all accounts in the general ledger to ensure that the debits equal the credits.

Step 5: Make adjusting entries:

→Make necessary adjustments to the accounts to ensure the accuracy of the financial statements, such as recording accrued expenses or prepaid income.

Step 6: Review adjusted trial balance:

→Verify that the adjusted trial balance reflects the correct account balances after making the adjustments.

Step 7: Produce financial statements:

→Generate financial statements, including the income statement, balance sheet, and cash flow statement, to provide an overview of the company's financial performance and position.

Step 8: Post closing entries:

→Close temporary accounts, such as revenue and expense accounts, to start the next accounting period with zero balances.

Step 9: Review post-closing trial balance:

→Confirm that the post-closing trial balance only includes permanent accounts and that the debits still equal the credits.

Step 10: Prepare journal entries:

→Prepare journal entries for the next accounting period to continue recording new transactions.

Setting Up the Books

When we talk of the "books," we refer to the group of all the accounts of the transactions of an enterprise. This list, or group, makes up the general ledger.

The general ledger collects all asset, liability, equity, revenue, and expense accounts. Transactions are grouped in some related way as accounts, and accounts are grouped and categorized into the General Ledger ("GL").

Transactions are usually related by vendor, customer or type of transaction. For example, your office rent payments would be grouped in an account called "Landlord," "Office Rent," or something similar. Your sales income might be grouped by customer or simply in a general "sales revenue" account; your electric bills and payments would be recorded in an account set up for the utility company.

This list of accounts and vendors is the basic organizing principle of your accounting system. When starting an accounting system for a company, you create a chart of accounts that classifies different groupings of business transactions.

The chart of accounts is a listing of all accounts used in an organization's general ledger. The chart of accounts is simply a laundry list of all the accounts.

Usually, when you begin working for an existing company, the chart of accounts already exists, and as new vendors occur, a new account is added.

The vendor list shows information about the people or companies from whom you buy goods and services, including banks and tax agencies.

The Accounting Cycle

The accounting cycle is a straightforward eight-step procedure for finishing a business' bookkeeping duties. It offers a precise roadmap for the documentation, evaluation, and final reporting of a company's financial operations.

The whole accounting cycle is employed throughout a single reporting period. As a result, maintaining organization throughout the process can be a crucial component that contributes to maintaining overall efficiency. Depending on the necessity for reporting, accounting cycle times will change. Most businesses aim to evaluate their performance monthly. However, some could concentrate more on results on a quarterly or annual basis.

In any case, most bookkeepers are aware of the business's daily financial situation. In general, timing each accounting cycle is essential since it establishes dates for opening and closing. A new cycle starts once an accounting cycle ends, continuing the eight-step accounting procedure.

Understanding the 8-Step Accounting Cycle

The eight-step accounting cycle begins with the individual recording of each business transaction and concludes with a thorough report of the business's actions for the specified cycle duration. In addition, many companies use accounting software to automate the accounting cycle. This automation allows accountants to program cycle dates and receive automated reports.

The eight-step accounting cycle often has to be modified in particular ways for each organization to conform to its own business model and accounting practices.

Double-entry accounting is necessary for businesses to construct the income statement, balance sheet, and cash flow statement.

The 8 Steps of the Accounting Cycle

The following are the eight steps of the accounting cycle:

Step 1: Identify Transactions

The accounting cycle's initial stage is to identify transactions. Business transactions will be numerous throughout the accounting cycle. Each one must be accurately recorded in the business's books.

Recordkeeping is critical for recording all transactions. For example, many companies will use point-of-sale technology linked to their books to record sales transactions. In addition, expenses come in wide varieties.

Step 2: Record Transactions in a Journal

The cycle's second phase is producing journal entries for each transaction. Once more, combining steps one and two with point-of-sale technology is possible, but businesses must also keep track of their costs.

Both must be recorded at the moment of the sale following accrual accounting, which involves matching revenues and costs.

Double-entry bookkeeping requires that two entries be recorded with each transaction to maintain a balance sheet, income statement, and cash flow statement.

Public corporations must prepare their financial accounts according to accrual accounting and generally accepted accounting standards (GAAP).

Each transaction in double-entry accounting has a debit and a credit equal to one another.

Step 3: Posting

A transaction should post to an account in the general ledger after it has been entered as a journal entry. All accounting actions are broken down by account in the general ledger.

This enables a bookkeeper to keep track of account-by-account financial conditions and statuses. For instance, the cash account, which shows how much cash is on hand, is one of the general ledger accounts most frequently referred to.

The ledger was previously considered the gold standard for documenting transactions, but because practically all accounting is now done electronically, the ledger is no longer a significant issue.

Step 4: Unadjusted Trial Balance

The fourth stage of the accounting cycle involves calculating a trial balance at the conclusion of the accounting period. The firm may learn the unadjusted amounts in each account from a trial balance. After testing and analysis in the fourth stage, the unadjusted trial balance is taken on to the fifth step.

Once the accounting period has concluded, and all transactions have been discovered, documented, and posted to the ledger, this is the initial activity that takes place (this is usually done electronically and automatically).

This step is taken to ensure that the overall credit amount and debit balance are identical. If those figures are off, this step can catch a lot of errors.

Step 5: Worksheet

The fifth phase in the cycle involves reviewing a worksheet and locating modifying entries. A worksheet is first made to ensure that debits and credits are equivalent. Again, there will need to be modifications made if there are inconsistencies.

When adopting accrual accounting, correcting entries may also be required to match income and expenses and discover mistakes.

Step 6: Adjusting Journal Entries

A bookkeeper makes corrections in the sixth phase. Adjustments are documented in journal entries.

Step 7: Financial Statements

The seventh phase is when the business prepares its financial statements after completing all adjustment entries. These statements typically consist of an income statement, balance sheet, and cash flow statement for businesses.

Step 8: Closing the Books

In the eighth phase, a business finally completes the accounting cycle by closing its books at the end of the day on the designated closure date. The concluding remarks offer a report for analyzing performance throughout the period.

After closure, a new reporting period is used to restart the accounting cycle. Closing is typically a great time to submit documentation, make plans for the upcoming reporting period, and go through a schedule of the forthcoming activities.

Debits and Credits

Debit and Credit are the two most basic accounting terms to become familiar with. This is because they represent the fundamental concept of bookkeeping. However, the practice of double-entry bookkeeping and the application of debits and credits to accounts is not intuitive and will take some time to get used to. With that in mind, let's discuss the concepts more.

In accounting, there are two sides to every transaction, and they are called debit and Credit. Each journal entry affects at least two accounts; it can affect a group of debits and a group of credits, but they must equal each other. This concept may take a while to get your head around and get used to. But you will. Think of a situation where you lend someone $10.

As Shakespeare said, there are two sides to this IOU-type transaction: the borrower and the lender. You record that you expect the money back (asset), and the other party records that they expect to pay it back (liability). All transactions are two-sided like this example: one account is enhanced, and one is depleted. Or think of a deli counter transaction: you get a sandwich, and the deli receives money. But each side records two entries. From the deli side, they get money, which increases their revenue, and they give up a sandwich, which depletes their inventory. From your side, you get a delicious sandwich, an asset (albeit temporary), and you give up money, which depletes your bank account. Each side records a double-entry transaction. Each side's transaction entry mirrors the other: what you gain, and they give up, and vice versa. Accounting is a zero-sum endeavor.

Debit and Credit can be tricky concepts to understand initially. Here is another attempt at a simple explanation. A Debit increases the enterprise's resources, and a Credit reduces the resources. So, with Asset accounts that are resources, a Debit will increase the account.

With a Liability account, which are obligations of the enterprise, a Debit will decrease that account; because the decrease of a liability, like a loan, means, in essence, increasing the company's resources. Think of this as if you pay off a credit card, you have increased your resources by no longer carrying that debt obligation (and at the same time, you save a ton of interest payments!)

Credits are the mirror image opposite. When you pay a bill, you credit cash (an asset account) because you have reduced your cash amount. If you take out a loan, you credit the loan account (a liability account) because you have increased an obligation of the company.

You may have to refer to this concept of debits and credits several times. Acknowledge that this concept may be challenging, and stay calm. It will become clear with use.

Bank Reconciliation - Manual vs Automated

Automation wasn't even in sight when I started preparing bank reconciliations as a general ledger accountant.

Yes, there was a time when you had to manually reconcile GL transactions and bank statements line by line.

Print them both and knock off reconciled items one by one.

You couldn't even download bank statements as CSV files.

The statements used to be paper-based and received in snail mail.

That also meant difficulty in reconciling bank accounts before the month-end close.

These days, life is much easier!

• Bank portal integration with the accounting software/ERP.

• Downloadable bank statements in the format you need.

• Automated reconciliation software.

You name it, you have it.

When entering transactions in the ERP system, one crucial consideration is that you must accurately tag each transaction so that the reconciliation software can read and compare it with the bank statement.

And tags should be aligned with the data provided by the bank.

Otherwise, reconciliation software is not very useful.

Remember, the review and approval process remains integral to bank reconciliation even after automation.

Here is a comparison of how accounting processes have evolved by leveraging technology.

1- Gathering Data

2- Match Transactions

3- Identify Differences

4- Adjustments

5- Ending Balances

6- Reconciliation

7- Review and Approval

8- Resolve Discrepancies

9- Final Reconciliation

The basics of accounting

This PDF will teach you everything you need to know

Here's what you'll learn:

- Accounting Cycle & Accounting Equation

- List of Accounts and Its Classification

- Accounting Principles

- Journal Entries, Adjusting Entries, & Closing Entries

- Financial Statements

13 Accounting Principles

Accounting is the language of business.

If you want to read financial statements, you MUST understand these 13 principles:

ACCOUNTING PRINCIPLES

→ The rules, benchmarks, and procedures in the accounting field companies should follow while reporting financial statements. In the United States, the common set of accounting standards is GAAP (Generally Accepted Accounting Principles).

ECONOMIC ENTITY

→The Owner & business are two different entities with separate liabilities.

REVENUE RECOGNITION

→ Revenue should be recognized using the accrual basis of accounting.

CONSERVATISM

→When there are two acceptable options for reporting, the less favorable option should be chosen.

CONSISTENCY

→The usage of methods and principles should be consistent until another method proves to be better.

HISTORICAL COST

→Assets should be recorded based on their original purchased value.

FULL DISCLOSURE

→All important information should be disclosed within the financial statements or as a footnote.

GOING CONCERN

→Business is assumed to carry on forever with no intention of liquidation.

MATCHING CONCEPT

→All debits should have a matching credit, and all credits should have a matching debit.

MATERIALITY

→Any information which will have a significant impact should be reported on the financial statements.

MONETARY UNIT

→Transactions that carry a monetary value should be recorded in terms of a monetary currency (Eg, Dollars)

RELIABILITY

→Transactions should only be recorded that can be proven & have significant evidence.

REVENUE TIMING

→ Revenues will be recognized at the time of the transactions regardless of whether payment has been made.

TIME PERIOD

→There should be a standardized time period for the reporting of the financial statements (Ex: Monthly, Quarterly, or Annually)

Do any of these principles need further explanation? If so, let me know in the comments section.

Accruals and Provisions

The Confusing Duo of Accounting. Let's Demystify!

Understanding the difference between accruals and provisions is fundamental for accurate accounting and financial reporting.

It is common for business owners or even us accountants to need clarification on the two.

But it doesn't have to be that way.

Not, at least, after the information I have put together to demystify the confusion.

This is what you will find in the excellent PDF attached:

1- The Confusion

2- The Reason for the Confusion

3- Why Understanding the Difference is Important?

4- Impact of Incorrect Classification?

5- The Concept

6- The Purpose

7- The Recognition

8- The Estimation

9- The Timing

10- The Reversal

11- The Adjustments

12- The Examples

13- The Impact on Cash Flow

14- The Accounting Treatment Process Flow

The General Ledger Closing Checklist

As I write this, I am helping a client streamline their month-end closing and reporting process, including developing and implementing best practices to close each function within the finance department.

Once complete, part of the project is to develop a management and board reporting pack to ensure a seamless record-to-report process.

The accuracy of the General Ledger is critical to achieving accurate and reliable reporting.

Accounting teams cannot avoid the task of closing the books at the end of the month.

It always seems like the next month-end closing is upon us before we close the previous month.

The cycle keeps repeating itself over and over again, like Groundhog Day.

For those days, checklists become handy to ensure we have completed each task necessary to close the month.

I'm a big fan of checklists. Atul Gawande's The Checklist Manifesto is a great book.

One such checklist is the general ledger closing checklist.

Here's something I've created for my client. I am sharing it with the broader audience.

It is helpful to take this and create one based on your processes and dates.

Here's what I have covered in the graphic:

1. Preparation and Planning

2. Review Subsidiary Ledgers

3. Adjusting Entries

4. Revenue Recognition

5. Expense Recognition

6. Depreciation and Amortization

7. Bank Reconciliation

8. Accruals

9. Financial Statement Preparation

10. Review and Approval

11. Documentation & Audit Trail

12. Adjusting Entries

13. Aging Reports

14. Post-Closing Adjustments

15. Final Review

GAAP vs non GAAP

If accounting is the language of business, as we often teach, understanding its high-level concepts is essential.

Yet, when listening to insiders or stock market veterans, they often use industry jargon and alphabet soup acronyms without explaining what each means.

In today’s lesson, we will tackle one of accounting’s most confusing terms, which is crucial to understand when going through a company’s financial statements: GAAP, which stands for generally accepted accounting principles.

GAAP accounting is a commonly accepted set of rules and procedures designed to govern corporate accounting and financial reporting within the United States.

GAAP rules were jointly established by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB).

GAAP rules are applied to profitable corporations (overseen by the FASB) and government and non-profit organizations (regulated by the GASB).

This raises an important question: Why do companies report non-GAAP results if GAAP rules are for corporations?

Non-GAAP refers to accounting practices that do not comply with the GAAP standards. As a result, these metrics aren’t audited and don’t have a standardized reporting format.

Many companies report non-GAAP results to shareholders (in addition to their GAAP results) to add important color and nuance to their numbers that the GAAP standard misses.

However, it’s important to note that non-GAAP numbers can also disguise weaknesses in a company’s results.

Therefore, a discerning investor must carefully comb through the numbers, comparing the GAAP with the non-GAAP results, to see an accurate picture of companies’ finances.

Welcome to the world of Managerial Accounting! As you embark on this journey through the "Principles of Managerial Accounting pages," get ready to unlock the secrets behind the numbers that drive business decisions. This book is not just about crunching numbers; it's about understanding how those numbers tell the story of a business's financial health and guide strategic decisions.

Envision yourself as a pivotal figure in a company, entrusted with making decisions that can steer the course of success or failure. Managerial accounting equips you with the tools to navigate these challenges. From budgeting and cost analysis to financial planning and performance evaluation, you'll acquire the skills to gather, interpret, and utilize financial data, empowering you to make informed decisions that can shape the future of your organization.

Real-world scenarios serve as your guide, illustrating how businesses allocate resources, manage costs, and plan for the future. You'll delve into concepts like job order costing, process costing, and activity-based costing, which provide a clear understanding of the true cost of products and services. Armed with these insights, you'll be better prepared to enhance efficiency, reduce waste, and maximize profitability in any business setting.

Moreover, this book goes beyond traditional accounting. It delves into how accounting information supports managers in planning, directing, and controlling functions. You'll learn to analyze financial statements, develop budgets, and perform variance analysis—all essential skills for any aspiring manager or business leader.

So, why should you choose to delve into the comprehensive knowledge offered by the "Principles of Managerial Accounting"? Because it will not only equip you with the necessary knowledge but also empower you with the skills to make sound business decisions. Whether you're aspiring for a career in accounting, management, or entrepreneurship, this book serves as your gateway to mastering the language of business and becoming a strategic thinker in the corporate world.

Prepare to be inspired and challenged as you delve into the principles that underpin successful business management. Your journey into the heart of managerial accounting begins now.

Download the Managerial Accounting book.

All the principles you need to know

Chapter 1: Managerial Accounting Concepts

Chapter 2: Job Order Costing

Chapter 3: Process Costing

Chapter 4: Activity-Based Costing

Chapter 5: Cost Volume Profit Analysis

Chapter 6: Variable Costing Analysis

Chapter 7: Budgeting

Chapter 8: Variance Analysis

Chapter 9: Differential Analysis

Source: Christine Jonick, Ed. D

Cost Accounting Formulas

This PDF teaches you everything you need to know

Here's what you'll learn:

- Total Cost (TC)

- Average Cost (AC)

- Marginal Cost (MC)

- Contribution Margin (CM)

- Gross Profit (GP)

- Break-Even Point (BEP)

- Return On Investment (ROI)

- Cost of Goods Sold (COGS)

- Overhead Allocation

- Cost Variance

- Price Variance

- Labor Efficiency Variance

- Predetermined Overhead Rate (POR)

- Economic Order Quantity (EOQ)

- Cost of Quality (COQ)

- Production Volume Variance

- Margin of Safety

- Availability

- Reorder Point

- Takt Time

FP&A Internal Controls and Best Practices

Management and the board rely on your analyses and insights, making decisions based on your TIMELY reports.

A single error can question the accuracy and reliability of the entire report.

How do you achieve accuracy, reliability, and timeliness?

Always remember two things:

1- Accuracy and reliability through internal controls

2- Efficiency and timeliness through process improvement & technology

Here's something to help you achieve just that:

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Establish clear budget procedures and approval processes and monitor performance.

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Implement controls to monitor actual outcomes versus projections and conduct variance analysis.

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Financial data accuracy, completeness, and reliability in FP&A require data validation checks and reviews of data sources and inputs.

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Implement controls to ensure financial analyses, reports, and recommendations are subject to appropriate review and approval.

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Establish segregation of duties within the FP&A function to prevent conflicts of interest and reduce the risk of errors.

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Implement controls to manage changes in processes, models, or methodologies.

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Implement controls to protect sensitive financial information.

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Maintain proper documentation of FP&A activities, including assumptions, models, and calculations.

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Establish controls to ensure compliance with relevant financial regulations, accounting standards, and internal policies.

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Implement controls to monitor the performance and effectiveness of the FP&A function.

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✅ Alignment with Strategy

✅ Collaboration & Communication

✅ Driver-Based Planning

✅ Use of Technology

Provisions in Accounting

Understanding provisions is critical to protecting your business from unexpected financial hits.

Here's a straightforward guide on everything you need to know.

A provision is an amount set aside from a company's profits to cover future liabilities or losses that are probable but uncertain in timing or amount.

It helps businesses prepare for potential financial obligations and ensure their financial statements reflect an accurate and fair view.

What Business Owners Should Know:

-> Provisions enable companies to present a clearer financial picture by accounting for future liabilities in the current period.

-> By setting aside funds for potential future expenses, provisions help businesses manage risks effectively.

-> Proper provisions ensure compliance with accounting standards and regulations, avoiding legal and financial penalties.

Managing provisions accurately is vital for your business's financial health and stability.

Ensure your financial statements reflect an accurate and fair view by properly accounting for future liabilities.

12 Steps Approach to Process Improvement

Improve any process within your organization by following these steps.

With years of corporate experience and a current focus on helping establish and improve processes, I've witnessed the transformative power of streamlining processes.

From enhancing efficiency to boosting productivity, the results speak for themselves.

Here are some of the benefits:

- Enhances quality and consistency.

- Increases efficiency and reduces waste.

- Supports compliance and risk management.

- Facilitates better communication and collaboration.

- Promotes continuous improvement and innovation.

Leveraging my experience, I am helping SMEs document and improve accounting and finance processes and supporting them in doing the same in other departments across the organization.

Here are some examples of processes across the organization:

- Accounting & Finance: Customer Invoicing

- Human Resources: Employee onboarding process

- Operations: Manufacturing workflow optimization

- Customer Service: Customer support ticket resolution

- Information Technology: Software deployment and update process

- Supply Chain Management: Inventory management and replenishment

Here's how you can follow the systematic approach to improve any process within your organization:

1- Understand the Current Process

2- Define the Current Process

3- Identify Pain Points and Bottlenecks

4- Set Objectives

5- Engage Stakeholders

6- Research Best Practices

7- Design the Future State

8- Document the Improved Process

9- Implement Changes Incrementally

10- Provide Training

11- Monitor and Measure

12- Iterate and Refine

Welcome to the first section of this course: understanding financial statements. I promise that these video lessons and the supplemental materials will have life-changing consequences. You will have a better command of your world and deeper insights into its workings.

Financial statements are the end product of accounting. Accounting can seem tedious, but it is the basis of business and investing. Double-entry bookkeeping is 500 years old and is one of the most significant technological inventions ever. The economic development it unleashed fueled the renaissance, the enlightenment, and the modern era.

Johann Wolfgang von Goethe rapturously described accounting this way: “Double-entry bookkeeping is one of the most beautiful discoveries of the human spirit.”

Understanding financial statements are the door to understanding accounting and business.

By the end of this short course, you will understand financial statements and open up a world of potential for your career and life.

You will probably look back over the following years and decades and see this as an inflection point in your destiny. 

Download the book here as a printable pdf or Kindle compatible file.

Let’s get started!

Understanding Financial Statements

Financial statements are essential tools that provide a clear picture of a business's or individual's financial activities. At their core, they serve as a report card detailing how money moves in and out.

Income Statement: Think of this like a monthly budget. It tracks money coming in (revenues) and money going out (expenses). The difference between the two gives the profit or loss. For individuals, it's akin to measuring salary against monthly expenses to determine savings.

Balance Sheet: This offers a snapshot of what a business owns and owes at a specific point in time. On one side, there are assets – everything the business owns that has value, like buildings, equipment, or even cash in hand. On the other side, there are liabilities (what the business owes to others) and equity (the owner's share). The fundamental rule is that assets will always equal the sum of liabilities and equity.

Cash Flow Statement: While the income statement might show a profit, it doesn't necessarily represent cash. This statement bridges the gap. It tracks actual cash moving in and out, divided into three categories: money from doing business (operations), money from buying or selling big items (investing), and money from loans or paying back loans (financing).

Business leaders, investors, and banks use these statements to understand a company's health. They help determine whether a business is growing, if it can pay its bills, and if it might be a good place to invest money. Public companies share these with the government for regulatory reasons, and private companies provide them to the government primarily for tax purposes.

Intro to Financial Statements

• What are financial statements?

• The 3 Financial Statements:

• Income Statement

• Balance Sheet

• Cash Flow

  
  

Understanding Financial Statements   

When you have completed this section of MBA ASAP, you will have a solid understanding of Financial Statements and you will be able to draw meaningful conclusions from their contents.  This knowledge can be highly impactful for the quality of your career, job prospects, and life.   

Financial Statements are the basic language of money and business. Everyone should have a basic understanding of Financial Statements: what they are and what information they provide.  It’s a competency that can open up opportunities and vistas that are closed off otherwise.        

Executives like the CEO, COO, and CFO routinely share and discuss financial data with marketing, operations, and other direct reports and personnel within an organization.  They also compile and share financial information with stakeholders outside the firm such as bankers, investors and the media.    

But how much do you really understand about finance and the numbers? A recent investigation into this question concluded even most managers and employees don’t understand enough to be useful. Check out the quiz in this section to see how you stack up.  I will offer the quiz again at the end of the course so you will be able to gauge how your level of financial competency has improved.    

Three Main Financial Statements   

There are three main financial statements and they are linked together to provide a picture of the financial position and health of an enterprise. They represent the end product of accounting, meaning they are the reports generated by accounting covering all of the transactions of a company.   

The three basic financial statements are the   

• Balance Sheet: which shows firm's assets, liabilities, and net worth on a stated date   

• Income Statement: also called profit & loss statement or simply the P&L: which shows how the net income of the firm is arrived at over a stated period, and    

• Cash Flow Statement: which shows the inflows and outflows of cash due to the firm's activities during a stated period.    

Knowing how to read and understand financial statements is a business skill you can’t ignore. It can help working your way up the corporate ladder by communicating with others in your company and understanding the big picture.  It is also a useful skill in order to understand where your efforts and work can make the most impact.    

When you are thinking about possibly changing jobs and working for a company you can check their financials and make sure they are a healthy organization.  If you are considering starting your own company you will need to have financials prepared by your accountant in order to talk to investors, bankers and vendors.    

If you want to invest wisely in the stock market, analyze the competition or benchmark your performance, you can look up the financials of any publicly traded company at the Securities and Exchange Commission website’s’ EDGAR filings and get an idea of how they are doing.  Check out any public company’s most recent 10K filing there.  A 10K is the Annual Report of the company and its most important business and financial disclosure document.          

Next we will go over each of the financial statements individually and how they are interrelated.  You will find lots more information in the books and other downloadable documents that accompany this course.

The video is a discussion of John Cousins' Financial Statements A$AP! aims to demystify financial literacy, emphasizing its importance for investors, managers, and entrepreneurs. The book explains the fundamental accounting principles and financial statements, including the Balance Sheet, Income Statement, and Cash Flow Statement.

The book is attached as a PDF download. It covers financial statement analysis techniques, such as ratio analysis and DuPont analysis, to assess a company's financial health. Cousins also highlights the role of auditors and the differences between GAAP and IFRS accounting standards.

Additionally, the book includes a glossary of financial terms and addresses common questions related to accounting and financial analysis. The material uses Warren Buffett's investment approach as a benchmark and provides guidance on evaluating financial statements.

The book underscores the value of reading annual reports, even without immediate investment plans, for career advancement and expanded business knowledge.

The Most Important Finance Job

The most important set of tasks that a CFO (Chief Financial Officer) has is the oversight, management, and preparation of financial statements.  Financial reporting with financial statements happens regularly, at least every quarter and once a year for audited financials.  Once you complete a set of financial statements, you are working on the preparation of the next set. 

Becoming intimately familiar with financial statements and how they are interconnected and flow is the critical skill set for corporate finance.   

Financial statements also underlay Discounted Cash Flow analysis, NPV, IRR, and all the valuation techniques of finance.  We will now spend some time thoroughly understanding financial statements.

Imagine being a business owner and not understanding how much your company’s assets are worth.

Or being a CFO who didn’t know the difference between net income and free cash flow.

While these scenarios are nearly unbelievable, it is just as vital for investors to understand how financial statements work as it is for company executives.

Every investor needs to be able to read and analyze the three financial statements companies provide to their shareholders:

1. Income Statement

2. Balance Sheet

3. Cash Flow Statement

Let’s briefly review the purpose of these statements, why they’re essential, and the basic information each reveals.

In this video I discuss that Financial Statements are what accounting produces.  Double entry bookkeeping and accounting helped usher in the modern world. History of Accounting and Commerce

The Fundamental Importance of Understanding Financial Statements

Being able to read and understand financial statements is a fundamental skill to understanding how businesses function. Since financial statements are the end product of accounting, understanding them provides the context for understanding accounting. Mastering this skill will help you become a better manager.    

Being able to read financial statements will also help you make better investment decisions in the stock market because you will be able to get meaningful information out of an Annual Report or a 10K.    

If you are an entrepreneur planning a start up then understanding financial statements is critical for your credibility as you meet with angel investors, bankers, and VCs.    

Financial Statements   

Accounting information is prepared, organized, and conveyed in Financial Statements. Financial statements are reports in which accounting information is organized so users of financial information have a consistent, quick, and thorough means of reading and understanding what is going on in the business.     

There are two basic financial statements: the Balance Sheet and the Income Statement.     

Interested parties need to understand the financial and accounting activities of a business.  The Balance Sheet and Income Statement are a formal record of the financial activities of a business. They are presented in a structured manner and in a form that is consistent and easy to understand once you understand the format.   

Financial Statements provide a high level view of accounting and a summary of how a business is performing. They provide a quick picture that can be easily compared across businesses and industries. Understanding how to read and analyze a Balance Sheet and Income Statement is a great place to start understanding accounting and finance.     

Financial statements are the end product of bookkeeping.  Think of financial statements as the destination or goal of bookkeeping and accounting. When you know where you are going and who the audience is, it is easier to make good bookkeeping decisions.  When you understand the liquidity, solvency and capital structure of a company you can make good financing and investment decisions.    

Financial Statements contain information required to quickly analyze and assess the relative health of a business.  A basic understanding of financial statements also provides the high level perspective on the goals of the bookkeeping work and accounting entries.  The daily operations of a business are measured in the money that comes in as revenues, the money that goes out as expenses, the money that is retained as profit, the money that is invested in operational assets, and the money that is owed.  It’s all about the money. Financial statements let you follow the money.

Revenue = profit per unit sold X number of units sold

Pricing power. Charge more.

Silicon Valley legend Marc Andreessen was asked what he would put on a billboard. Marc said two words: "Raise Prices.

The number one thing – just the theme, and we see it everywhere – the number one theme that our companies have when they get really struggling is they are not charging enough for their product. It has become absolutely conventional wisdom in Silicon Valley that the way to succeed is to price your product as low as possible under the theory that if it's low-priced everybody can buy it and that's how you get the volume. And we just see over and over and over again people failing with that because they get in the problem we call too hungry to eat. They don't charge enough for their product to be able to afford the sales and marketing required to actually get anybody to buy it. And so, they can't afford to hire the sales rep to go sell the product. They can't afford to buy the TV commercial, whatever it is. They cannot afford to go acquire the customers."

The Income Statement

The basic structure and components of the Income Statement are reviewed in this section. The Income Statement is sometimes called the Profit and Loss Statement, or P&L for short.

The components of the Income Statement are:

• Revenue

• Expenses

• Net Income

• Profit

• Earnings

The Income Statement

The daily operations of a business are measured in the money that comes in as revenues, the money that goes out as expenses, the money that is retained as profit, the money that is invested in operational assets, and the money that is owed. It's all about the money. Financial statements follow the money.

The report that measures these daily operations of money in and money out over a period of time is the Income Statement.

Revenues minus Expenses equals Net Income.

The Income Statement can be summarized as Revenues less Expenses equals Net Income. Net Income simply means Income (Revenues) net (less) of Expenses. Net Income is also called Profit or Earnings.

The terms "profits," "earnings" and "net income" all mean the same thing and are used interchangeably. They are synonyms for the bottom line number on the Income Statement. Revenues are often called Sales and are represented on the top line.

You understand the dynamics of this concept intuitively. We always strive to sell things for more than they cost us to make or buy. When you buy a house, you hope it will appreciate in value so you can sell it in the future for more than you paid.

It's also the rule for stocks: buy low, sell high.

The same logic applies to having a sustainable business model in the long run. You can't sell things for less than they cost to make and stay in business for long. So if you own and run a sandwich shop, you had better make sure that you are selling the sandwiches for more than they cost you to make.

Think of the Income Statement in relation to your monthly personal finances. You have your monthly revenues: in most cases the salary from your job. You apply that monthly income to your monthly expenses: rent or mortgage, car loan, food, gas, utilities, clothes, phone, entertainment, etc. Our goal is to have our expenses be less than our income.

There is an old adage: "If you outflow is more than your income, your upkeep is your downfall."

Over time, and with experience, we become better managers of our personal finances and begin to realize that we shouldn't spend more than we make. Instead, we strive to have some money left over at the end of the month that we can set aside and save. In business, what is set aside and saved is called Retained Earnings.

We may invest some of what we set aside with an eye toward future benefits. We may invest in stocks, bonds, mutual funds, or education to expand our future earnings and career prospects. This is the same type of money management discipline that is applied in business. It's just a matter of scale. In business, we buy assets that help the enterprise expand or perform more efficiently. There are a few additional zeros after the numbers on a large company's Income Statement, but the idea is the same.

This concept applies to all businesses. Revenues are usually from Sales of products or services. Expenses are what you spend to support those sales in terms of the operations: Salaries, raw materials, manufacturing processes and equipment, offices and factories, consultants, lawyers, advertising, shipping, utilities etc. What is left over is the Net Income or Profit.

Again: Revenues – Expenses = Net Income.

Net Income is either saved to smooth out future operations and deal with unforeseen events (save for a rainy day); or invested in new facilities, equipment, and technology. Or part of the profits can be paid out to the company owners, called shareholders or stockholders, as a dividend.

The Income Statement is also known as the "profit and loss statement." Business people sometimes use the shorthand term "P&L," which stands for profit and loss statement. A manager is said to have "P&L responsibilities" if they run an autonomous division where they make marketing, sales, staffing, products, expenses, and strategy decisions.

P & L responsibility is one of the most critical responsibilities of any executive position. It involves monitoring the net income after expenses for a department or entire organization, with direct influence on how company resources are allocated and responsibility for performance.

Google the term "income statement," and you will see many examples of formats and presentations. Again, you will see there is variety depending on the industry and nature of the business, but they all follow these basic principles.

Remember: Income (revenue or sales) – Expenses = Net Income or profit

This is a condensed version of the next lecture that hits the main points of the Income Statement without the examples and discussion of public company reporting.  Hearing the basics twice can help make it stick. If you feel relatively familiar with financial statements then you may want to skip this lecture.  Its only three minutes and I have found value in hearing the concepts presented over again. I want to make sure these concepts really sink in. 

The Income Statement

An income statement is one of the three financial statements used for reporting a company’s financial performance over a specific accounting period.

The other two financial statements are the Balance Sheet and the Cash Flow Statement. The income statement focuses on the revenue, expenses, gains, and losses reported by a company during a particular period. It is also known as the Profit and Loss (P&L) statement or the statement of revenue and expense. An Income Statement provides insights into a company’s operations, efficiency of management, underperforming sectors, and performance relative to industry peers.

Learn Income Statements like a pro! With our guide, discover the basics of financial reporting and boost your financial knowledge!

1️⃣ What is an Income Statement?

An income statement, also known as a profit and loss statement (P&L), is a financial report that shows a company's revenues, expenses, and profits (or losses) over a specific period, typically a fiscal quarter or year.

2️⃣ Components of an Income Statement

Revenue (Sales): The total income from selling goods or providing services.

Cost of Goods Sold (COGS): The direct costs of producing the goods or services.

Gross Profit: Revenue minus COGS, representing the initial profit before operating expenses.

Operating Expenses: Costs related to the day-to-day operations of the business (e.g., salaries, rent, utilities).

Operating Income: Gross profit minus operating expenses, indicating the profit from core operations.

Non-Operating Income (Expenses): Additional income or expenses not directly related to core operations.

Net Income (Profit or Loss): The final result indicates the overall profit or loss after all income and expenses.

3️⃣ Analysis of an Income Statement

To evaluate a company's Income Statement, various margins and ratios are used:

Profit Margin

(Net Income / Revenue) x 100

Gross Margin

(Gross Profit / Revenue) x 100

Operating Margin

(Operating Income / Revenue) x 100

EBITDA Margin:

(EBITDA / Revenue) x 100

Revenue Growth Rate:

((Current Period Revenue – Previous Period Revenue) / Previous Period Revenue) x 100

Return on Equity (ROE):

(Net Income / Shareholders' Equity) x 100

Return on Assets (ROA):

(Net Income / Total Assets) x 100

4️⃣ Interpreting an Income Statement

Positive Net Income: The company is profitable, and the amount represents its earnings for the period.

Negative Net Income: The company incurred losses for the period.

Trends: Analyze trends over multiple periods to assess the company's financial health.

Comparisons: Compare the income statement with those of competitors or industry standards for benchmarking.

5️⃣ Importance of the Income Statement

• Investor Insight

• Management Tool

• Creditworthiness

• Strategic Planning

• Legal Compliance

• Transparency and Trust

• Benchmarking

Income Statements don't have a universal look or layout.

That's because management teams have complete control over the terms & layout of their financial statements.

Here are the other words that management teams can use when creating their Income Statement:

INCOME STATEMENT SYNONYMS:

→Revenue Statement

→Earnings Statement

→Operating Statement

→Statement of Earnings

→Statement of Operations

→Profit and Loss Statement (P&L)

REVENUE SYNONYMS:

→Sales

→Income

→Top Line

→Receipts

→Turnover

→Gross Sales

→Gross Income

COST OF GOODS SOLD SYNONYMS:

→Goods Cost

→Direct Costs

→Cost of Sales

→Cost of Revenue

→Cost of Products Sold

GROSS PROFIT SYNONYMS:

→Sales Profit

→Gross Margin

→Gross Income

→Gross Earnings

OPERATING EXPENSES SYNONYMS:

→Overhead

→Operating Costs

→Operating Outgo

→Sales & Marketing

→Business Expenses

→Operational Expenses

→General & Administrative

→Research & Development

→Selling, General, and Administrative Expenses (SG&A)

OPERATING INCOME SYNONYMS:

→Operating Profit

→Business Income

→Operating Margin

→Operating Earnings

→Operating Cash Flow

→Earnings Before Interest and Taxes (EBIT)

PRE-TAX PROFIT SYNONYMS:

→ Pretax Profit

→ Pretax Earnings

→Income Before Tax

→Profit Before Tax (PBT)

→Earnings Before Tax (EBT)

→Operating Profit Before Tax

→Earnings Before Income Taxes (EBIT)

INCOME TAX SYNONYMS:

→Direct Tax

→Revenue Tax

→Earnings Tax

→Tax on Income

→Corporate Income Tax

→Fiscal Charge on Income

EARNINGS SYNONYMS:

→Profits

→Income

→Earnings

→Net Profit

→Bottom Line

→Net Earnings

→Profit After Tax (PAT)

→Net Income After Taxes

→Earnings After Tax (EAT)

→Net Income Before Extraordinary Items

SHARES OUTSTANDING SYNONYMS:

→Issued Shares

→Outstanding Stock

→Outstanding Equity

→Basic Shares Outsanding

→Diluted Shares Outstanding

→Outstanding Shares of Stock

→Fully Diluted Shares Outstanding

EARNINGS PER SHARE SYNONYMS:

→EPS

→Profit Per Share

→Net Income Per Share

3 Easy Steps to Analyze Business Profitability.

Most business problems fall into one of 3 main areas:

Profitability: How effectively your business generates profit in relation to its expenses.

Cash Flow: The management of the inflow and outflow of cash, ensuring that your business can meet its financial obligations.

Growth: The ability of your business to expand sustainably and profitably.

Financial analysis is a key tool in identifying and addressing these three critical business issues.

Here's how to solve profitability issues:

1️⃣ Gross Profit Margin: (Gross Profit / Revenue) x 100

>> This tells you how efficiently you use raw materials and labor.

>> Drops could be due to increased costs or ineffective pricing.

>> If this margin is dropping, look to renegotiate contracts, trim waste in production, or tweak prices

2️⃣ Operating Profit Margin: (Operating Income / Revenue) x 100

>> This shows how much of each dollar of revenues is left after considering COGS and OPEX (operating expenses).

>> If this margin is dropping, your indirect costs may need to be reviewed because you lack operating flexibility.

3️⃣ Net Profit Margin: (Net Income / Revenue) x 100.

>> Net Profit is what's left of revenues after all expenses and taxes are paid.

>> If this margin is dropping but your other margins are fine, consider tax and debt cost optimization.

>> If this margin drops alongside your other margins, your business model and capital structure may need an overhaul.

EBITDA Explained

What is EBITDA, and what is your take on this metric?

EBITDA stands for:

• Earnings

• Before:

• Interest

• Taxes

• Depreciation

• Amortization

It's a financial metric that shows how much money a company makes before accounting for non-operational expenses like interest and taxes and non-cash expenses like Depreciation and Amortization.

Why is EBITDA important for Businesses?

EBITDA is important because it gives businesses an idea of how much money they generate from their operations.

This is useful for investors and lenders who want to know how profitable a company is.

It's like a scorecard to know how much money a company is making.

How is EBITDA calculated?

To calculate EBITDA, start with a company's revenue and subtract its cost of goods sold.

Then, you subtract its operating expenses (like salaries and rent).

Another way to calculate it:

Net Income

+ Interest Expense

+ Taxes

+ Depreciation

+ Amortization

EBITDA vs. Net Income

EBITDA:

In EBITDA, you don't consider these expenses: Depreciation, Taxes, and Interest.

Net Income:

However, net income is what remains as actual profit after Depreciation, interest, and taxes are taken into account.

The P&L Statement, Visualized

If you're in business, you MUST understand how a Profit & Loss Statement works.

P&L has many different names, including:

• Income Statement

• Revenue Statement

• Earnings Statement

• Operating Statement

• Statement of Earnings

• Statement of Operations

The P&L shows a company's profitability at multiple levels over a period of time using accrual accounting.

Its purpose is to track a company's revenue, expenses, and profits.

Main sections:

? REVENUE: Total Sales

➖ COST OF GOODS SOLD: The cost to deliver the product or service

? GROSS PROFIT: Revenue - Cost of Goods Sold

➖ R&D EXPENSES: All expenses related to developing products & services

➖ SG&A EXPENSES: All other overhead expenses

? OPERATING INCOME: Gross Profit - Operating Expenses

➖ INTEREST EXPENSE: Interest paid to bondholders & banks

? PRE-TAX INCOME: Operating Income - Interest Expense

➖ INCOME TAX: Taxes paid to Governments

? NET INCOME: Pre-Tax Income - Income Tax

To analyze a P&L quickly, focus on changes in margins.

GROSS MARGIN

Gross margin is a profitability metric that indicates the percentage of revenue after subtracting the cost of goods sold (COGS).

Calculation

Gross Margin = Gross Profit / Revenue

Gross Profit = Revenue - COGS

OPERATING MARGIN

Operating margin, or operating profit margin, measures the percentage of operating income (profit after operating expenses) relative to total revenue.

Calculation

Operating Margin = Operating Income / Revenue

NET MARGIN

Net margin, also referred to as net profit margin or simply profit margin, represents the percentage of net income (profit after all expenses, including interest and taxes) relative to total revenue.

Calculation

Net Margin = Net Income / Revenue

Here is a bonus lecture on the Income Statement.  This is from a classroom lecture going over the Income Statement concepts.  Sometimes hearing things a second or third time presented in a little different way can help make the concepts stick. If you feel comfortable with the Income Statement ideas, then by all means skip ahead.  One way to check if you really understand the concepts is to teach it to someone or rehearse teaching it to yourself. Give it a try and see where you might get stuck. Then focus on the parts that are still less than crystal clear.

The Income Statement

The basic structure and components of the Income Statement are reviewed in this lecture.  The Income Statement is sometimes called the Profit and Loss Statement or P&L for short. 

The components of the Income Statement are:

• Revenue

• Expenses

• Net Income

• Profit

• Earnings

  
  

The Income Statement    

The daily operations of a business are measured in the money that comes in as revenues, the money that goes out as expenses, the money that is retained as profit, the money that is invested in operational assets, and the money that is owed.  It’s all about the money. Financial statements follow the money.    

The report that measures these daily operations, of money in and money out over a period of time, is the Income Statement.    

Revenues minus Expenses equals Net Income   

The Income Statement can be summarized as: Revenues less Expenses equals Net Income.  The term Net Income simply means Income (Revenues) net (less) of Expenses.  Net Income is also called Profit or Earnings.  The terms "profits," "earnings" and "net income" all mean the same thing and are used interchangeably. They are synonyms for the bottom line number on the Income Statement. Revenues are often called Sales and are represented on the top line.    

You understand the dynamics of this concept intuitively.  We always strive to sell things for more than they cost us to make or buy. When you buy a house you hope that it will appreciate in value so you can sell it in the future for more than you paid for it. It’s also the rule for stocks: buy low, sell high. In order to have a sustainable business model in the long run, the same logic applies.  You can’t sell things for less than they cost to make and stay in business for long. If you own run a sandwich shop you had better make sure that you are selling the sandwiches for more than they cost you to make.    

Think of the Income Statement in relation to your monthly personal finances.  You have your monthly revenues: in most cases the salary from your job.  You apply that monthly income to your monthly expenses: rent or mortgage, car loan, food, gas, utilities, clothes, phone, entertainment, etc.    Our goal is to have our expenses be less than our income.     

There is an old adage: “If you outflow is more than your income, your upkeep is your downfall.”   

Over time, and with experience, we become better managers of our personal finances and begin to realize that we shouldn’t spend more that we make.  We strive to have some money left over at the end of the month that we can set aside and save.  In business, what is set aside and saved is called Retained Earnings.      

Some of what we set aside we may invest with an eye toward future benefits.  We may invest in stocks and bonds or mutual funds, or we may invest in education to expand our future earning and career prospects.  This is the same type of money management discipline that is applied in business.  It’s just a matter of scale. In business we buy assets that help the enterprise expand or perform more efficiently. There are a few additional zeros after the numbers on a large company’s Income Statement but the idea is the same.    

This concept applies to all businesses.   Revenues are usually from Sales of products or services.  Expenses are what you spend to support those sales in terms of the operations: Salaries, raw materials, manufacturing processes and equipment, offices and factories, consultants, lawyers, advertising, shipping, utilities etc.   What is left over is the Net Income or Profit.   Again: Revenues – Expenses = Net Income.    

Net income is either saved in order to smooth out future operations and deal with unforeseen events (save for a rainy day); or invested in new facilities, equipment, and technology. Or part of the profits can be paid out to the company owners, called shareholders or stockholders, as a dividend.     

The Income Statement is also known as the "profit and loss statement". Business people sometimes use the shorthand term "P&L," which stands for profit and loss statement.  A manager is said to have “P&L responsibilities” if they run an autonomous division where they make the decisions about marketing, sales, staffing, products, expenses, and strategy. P & L responsibility is one of the most important responsibilities of any executive position and involves monitoring the net income after expenses for a department or entire organization, with direct influence on how company resources are allocated and responsibility for performance.     

Google the term “income statement” and you will see lots of examples of formats and presentations. You will see there is variety depending on the industry and nature of the business but they all follow these basic principles.    

Remember:  Income (revenue or sales) – Expenses = Net Income or profit   

The top line of the Income Statement: Revenue

This section goes over the economic concept of Supply and Demand and ties Supply and Demand to Revenue, which is the top line of the Income Statement. Revenue is Price times Quantity, and Price and Quantity are the axes of the Supply/Demand relationship graph.

Definition of Supply and Demand: the amount of goods and services available for people to buy compared to the amount of goods and services people want.

If less of a product than the public wants is produced, the law of Supply and Demand says that more can be charged for the product.

The four basic laws of Supply and Demand:

1) If the Supply increases and Demand stays the same, the price will go down.

2) If the Supply decreases and Demand stays the same, the price will go up.

3) If the Supply stays the same and Demand increases, the price will go up.

4) If the Supply stays the same and Demand decreases, the price will go down.

Basics of Microeconomics

Supply and Demand

Let’s break the concept of graphing Supply and demand down by thinking about any product you buy regularly and are familiar with. How about pizza?

Demand is a function of how many people or customers are interested in purchasing a particular product or service.

Many dimensions affect your decision to buy a pizza: quality, delivery, timeliness, taste, etc. But the one we will be concerned about (and plot on a graph) is probably dear to your heart (and purse): price.

Consider your purchasing decision: if a pizza costs $30, you probably will not buy too many of them. If it costs $1.50, you may eat nothing but pizza until you really fatigue from it.

Most everyone else thinks about the pizza purchase decision the same way. Therefore, the Demand graph is the sum of everybody’s decisions to purchase based on price.

We graph Supply and Demand on two axes: the horizontal axis is Quantity: which is how many pizzas get purchased in aggregate at each Price; Price is the vertical axis.

The Demand curve (even though it is usually represented as a line, we call it a curve) has a downward slope, which means that at high prices, less Quantity is sold, and at low prices, more is sold.

The Supply curve is the amount providers will make at a certain price. The curve is the sum of what happens to Quantity at all these different price points.

The way to think about Supply is: if pizzas are selling at $30 a piece, lots of folks will think about getting into the pizza business because they feel they can make lots of money; and if pizzas are selling at $1.50 many pizza makers will abandon the business because they are losing money.

So more Quantity is supplied to the market at higher prices and less at lower prices.

These two lines, Supply and Demand, make an X on the graph. Where they intersect is where the market balances and enough are sold at that price to satisfy both the Demand for pizza and the Supply of pizza. That is the market equilibrium and determines the Quantity and the price at which the market clears.

Elasticity of Demand

Elasticity of Demand measures the slope of the demand curve and helps locate the point where total Revenue is maximized. Total Revenue is price times quantity.

Revenue is calculated as Price times Quantity Sold. Prices are determined through Supply and Demand.

Price is determined by where the Demand for a good or service meets the Supply.

Revenue is the Price times the Quantity sold. Revenue is the top line of the Income Statement. So this section reviews the dynamics and components of how that Revenue number is derived.

This lecture analyzes the top line of the Income Statement: Revenue.  Revenue is calculated as Price X Quantity Sold.  I go into detail as to how prices are determined through supply and demand. 

This Lecture goes over the concept of Supply and Demand and ties it to price, sales and revenue. Price is determined by where the Demand for a good or service meets the Supply. Revenue is the Price times the Quantity sold. Revenue is the top line of the Income Statement. So this lecture reviews the dynamics and components of how that Revenue number is derived.

Expenses

Salaries are usually a company's most significant Expense.

Opex vs. Capex.

Opex is short for Operating Expense, and Capex is short for Capital Expense. For example, salaries are an operating expense, and automation or robotics is a capital expense that offsets salaries by reducing the number of employees necessary to run a business.

Capital expenses appear as an asset on the balance sheet and are depreciated in the Income Statement.

COGS cost of goods sold.

Cost of goods sold (COGS) is the direct cost of making a company's products. It is an important line on your income statement that can tell you a lot about your financial performance, efficiency, and profitability.

SG&A

SG&A is an initialism used in accounting to refer to Selling, General, and Administrative Expenses, which is a significant non-production cost presented in an income statement.

Fixed costs

A fixed cost is an expense that a firm incurs that remains the same regardless of how many goods and services are produced or sold. Fixed costs are frequently associated with ongoing expenditures like rent, interest payments, and insurance that are not directly tied to production.

Variable costs

A variable cost is an expense for the firm that varies according to how much is produced or sold. Depending on a company's production or sales volume, variable costs grow or fall. They climb as output rises and reduce as production declines.

A manufacturing company's raw material and packaging costs, credit card transaction fees, or shipping charges, which increase or decrease with sales, are examples of variable costs.

Fixed costs and variable costs can be compared and analyzed.

Break even with revenue.

When determining when you will break even financially, a break-even analysis compares the expenses of a new business, service, or product against the unit sale price. In other words, it indicates when you will have generated enough revenue to pay for all your expenses, both fixed and variable.

Non-cash expenses: AP, depreciation, and amortization

The second most significant Expense in business is usually Taxes.

14 Types of Costs You Should Know

Net income. Profit. Earnings

Net income, Earnings, and Profits are synonyms.

In business, as in life, it’s not what you make (revenue). It’s how much you keep (profit). Two ways to achieve more net income: increase revenue or decrease expenses.

EBIT earnings before interest and taxes

EBITDA. Cash flow. Remove distortions of non-cash expenses.

How do we analyze companies?

Start with the income statement.

It can show us the revenues, expenses, and profits over a specific period.

The income statement can give us insights into whether the company is growing or shrinking.

Here is the breakdown of an income statement in its most common form:

???????: This includes all income from sales, services, or other primary business activities.

???? ?? ????? ???? (????): Direct costs attributable to the production of goods sold by a company.

????? ??????: Calculated as Revenue minus Cost of Goods Sold. It represents a company's profit after deducting the costs associated with making and selling its products.

????????? ????????:

???????, ???????, ??? ?????????????? ???????? (??&?): Expenses related to selling products and managing the business.

???????? ??? ??????????? (?&?): Costs of developing new products or services.

????????? ?????? is Earnings Before Interest and Taxes (EBIT), which is calculated by subtracting operating expenses from gross profit.

???????? ???????: The cost incurred by an entity for borrowed funds.

????? ??????/????????: Non-operational revenue or costs, such as gains or losses from investments or foreign exchange.

???-??? ??????: Income before income taxes are deducted.

Income Tax Expense: The amount of tax owed based on pre-tax income.

??? ??????: The final bottom line of the income statement, calculated as Pre-tax Income minus Income Taxes. This figure represents the total earnings attributable to shareholders after deducting all expenses.

Also crucial to analyzing an income statement is margins:

• Gross margin = Gross profit/revenues

• Operating margin = Operating profit/revenues

• Net Income margin = Net Income profit/revenues

Ideally, we want stable or growing margins.

The bottom line is that we want a growing, profitable company that can lead to further digging.

4 Types of Income Statement Analysis

1. Vertical Analysis:

Vertical analysis dissects the income statement vertically, showcasing each line item as a percentage of total revenue.

This method offers a snapshot of the proportion of expenses, making it easier to identify trends and assess cost structures.

2. Horizontal Analysis:

By comparing income statements across multiple periods, horizontal analysis unveils the evolution of financial performance over time.

Understanding year-over-year changes aids in identifying growth patterns, potential areas of concern, and overall business stability.

3. Ratio Analysis:

Ratios derived from income statement figures provide a deeper understanding of a company's financial health.

Key ratios like the profit margin, return on assets, and earnings per share offer valuable insights into profitability, efficiency, and overall operational effectiveness.

4. Common Size Analysis:

This analysis involves expressing each line item as a percentage of total revenue.

It provides a standardized view of the income statement, facilitating comparisons across different companies or industries.

Common size analysis helps investors and analysts evaluate the relative importance of each expense category.

Embracing these diverse analytical approaches empowers financial professionals to make informed decisions, assess risk, and strategize for sustained business success.

Income Statement - Revenue to Net Profit Movement

What causes the change from the revenue to EBITDA to Net Profit?

Observing the movement on the chart below will help you understand the cause of change.

Below are the explanations and calculations for each step depicted on the chart:

Revenue
• Revenue, also known as sales or turnover, is the total amount of money a company generates from its primary business activities.

COGS
• COGS refers to the direct costs associated with producing or manufacturing the goods or services that a company sells.

Gross Profit
• Gross Profit is the amount of money a company has left after subtracting the direct costs of producing its goods or services (COGS) from its total revenue.
• GP = Revenue – GOGS

OPEX
• OPEX are a company’s ongoing costs to operate its business. Include items such as rent, utilities, salaries, and marketing expenses.

Other Income
• Other Income refers to revenue generated by a company that is not directly related to its core business operations. This can include income from investments, interest, or other sources outside the company's primary activities.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
• EBITDA is a measure of a company's operating performance. It excludes interest, taxes, and non-cash expenses like depreciation and amortization.
• EBITDA = GP – OPEX + Other Income

EBIT (Earnings Before Interest & Taxes)
• Depreciation and amortization are non-cash expenses that represent the allocation of the cost of tangible and intangible assets over time.
• EBIT = EBITDA – Depreciation

EBT (Earnings Before Taxes)
• Interest expenses represent the cost of borrowed funds. Subtract interest from the Adjusted EBITDA.
• EBT = EBIT – Interest Expense

Net Profit
• Subtract taxes from Earnings Before Taxes to arrive at Net Profit.
• Net Profit = Earnings Before Taxes - Taxes

I use this video as a promo but it is an effective intro or refresher on The Balance Sheet.

Balance Sheet

Assets reflect a firm’s investment decisions and liabilities plus shareholder’s equity reflect a firm’s financing decisions.

Assets = Liabilities + Shareholder’s Equity

Or

Investing = Financing

In general, firms attempt to balance the term structure of their financing with the term structure of their investments.

When analyzing a balance sheet, one looks for a reasonable balance between the term structure of assets and the term structure of liabilities pls shareholder’s equity. The proportion of short versus long term financing should bear some relation to the proportion of current versus noncurrent assets.

The Balance Sheet Explained Simply

The master equation: Assets = Liabilities + Shareholder Equity

TIME: The Balance Sheet records a Point in Time

ACCOUNTING METHOD: Accrual

3 Main Sections:

ASSETS: What the company Owns

LIABILITIES: What the company Owes to creditors

EQUITY: The net value of the owner's claim

ASSETS

They are listed in order of liquidity (how quickly it can be turned into cash).

CURRENT ASSETS: Expected to be used in <1 year

→Cash

→Marketable Securities

→Accounts Receivable

→Inventory

→Other Current Assets

LONG-TERM ASSETS: Expected to be last >1 year

→Long-Term Investments

→Fixed Assets

→Goodwill

→Other Long-Term Assets

LIABILITIES

Listed in order of when they are expected to be paid off.

CURRENT LIABILITIES: Expected to be paid in <1 year

→Payables & Accrued Expenses

→Short-Term Debt

→Other Current Liabilities

LONG-TERM LIABILITIES: Expected to be paid in >1 year

→Long-Term Debt

→Other Long-Term Liabilities

SHAREHOLDER'S EQUITY

CAPITAL RAISED FROM INVESTORS

→Preferred Stock

→Common Stock & Additional Paid-In Capital

PROFITS RETAINED BY THE COMPANY

→Retained Earnings

→Treasury Stock

Balance Sheet Basics

The Balance Sheet is a condensed statement that shows the financial position of an entity on a specified date, usually the last day of an accounting period.

Among other items of information, a balance sheet states

• What Assets does the entity own,

• How it paid for them,

• What it owes (its Liabilities), and

• What is the amount left after satisfying the liabilities (its Equity)

Balance sheet data is based on what is known as the

Accounting Equation: Assets = Liabilities + Owners' Equity.

Think of a Balance Sheet in terms related to everyday life. For example, homeownership, when you have a mortgage, is represented as a Balance sheet. Your home ownership has the three components of Asset, Liability, and Equity.

The Asset is the value of the house. An appraisal determines this. An appraisal considers recent sales of homes in the area and compensates for differences like the number of bath or bedrooms, the size of the lot, etc.

The Liability is the mortgage. This debt is how much you owe against the house.

Equity is the difference between the asset's value and the Liability amount. For example, if your home is worth $200,000 and you have a remaining mortgage balance of $150,000, then you have $50,000 in Equity. We sometimes call this homeowner's Equity.

If your mortgage balance is more than the value of the home, then you are considered "upside down" or "underwater." The same principle applies to a business: if the value of its Liabilities is more than the value of the Assets, then the enterprise is insolvent and probably headed for bankruptcy.

A Balance Sheet is organized under subheadings such as current assets, fixed assets, current liabilities, Long-term Liabilities, and Equity.

The Balance Sheet, along with the income and cash flow statements, comprises the financial statements, a set of documents indispensable for running a business.

What does the Balance Sheet balance?

The balance sheet is structured to show the amount and type of assets an enterprise owns and how those assets are funded. One side of the balance sheet shows what you have (assets), and the other side shows how you paid for it (Debt and Equity).

Assets can be purchased and paid for in two ways: with debt or with Equity (or a combination of the two). What a company owes, the obligations or loans, are called Liabilities; what a company owns is the Equity or Stock.

The Liabilities and Equity are equal to the Assets. Therefore, they are two sides of the same coin and must balance, hence the term Balance Sheet.

This balancing is a fundamental principle of Accounting called the Accounting Equation. Assets = Liabilities + Equity.

Balance Sheet Format

A Balance Sheet is typically organized in two columns, with the Assets on the left and the Liabilities and Equity on the right. It is divided into subcategories, with the most current types on top and the more long-term varieties towards the bottom.

Current Assets are ones like cash that can be used on short notice, and Long term Assets are things like factories that would take longer to convert to cash—current means short-term, stuff that needs to be addressed within one year. Long-term means stuff longer than the next year.

Bills that need to be paid within the month are considered Current Liabilities, and loans that are paid back over years are regarded as Long term Liabilities.

Equity is what the owners actually own. Equity is basically Assets less Liabilities and is shown as accounts below the Liabilities on the left-hand side. Equity is shown below the Liabilities because debt has senior claims on the assets.

In the event of liquidation like bankruptcy, the debt holders get paid from the sale of assets first, and then anything left over goes to the equity holders.

Here is an example Balance Sheet to get and idea of the format; notice that the Total Assets equals the Total Liabilities plus Equity.

Here's how you can be a financial expert by analyzing balance sheets:

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==============

Grasp the fundamental concepts of assets, liabilities, and equity. Familiarize yourself with the balance sheet equation: Assets = Liabilities + Equity.

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==========================

Assess the company's ability to convert its assets into cash within a year. Evaluate the value of long-term assets like property, plant, and equipment.

?????????? ???????????:

============

Evaluate the company's short-term and long-term obligations. Understand how these obligations impact the company's financial flexibility.

??????? ?????? ???????????:

==================

Analyze the company's common stock and retained earnings. Assess the ownership structure and the company's ability to generate profits over time.

?????? ??? ??????:

============

Utilize ratios like the current ratio, debt-to-equity ratio, and debt-to-asset ratio to gain insights into the company's financial strength and efficiency.

???????? ????????? ???? ?????:

=================

Be vigilant about red flags like increasing accounts receivable, rising inventory, and high debt levels. These signals could indicate potential financial risks.

????????? ??? ???????:

================

Benchmark the company's balance sheet ratios against industry peers to assess its relative financial position.

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====================

Financial analysis is not an exact science. To enhance your expertise, stay informed about financial trends, accounting standards, and industry developments.

What is Working Capital?

Here's a simple way to understand this confusing finance term.

Working capital -- aka Net Working Capital -- is the difference between a company's current assets (expected to be used/consumed/converted into cash <1 year) and current liabilities (debts that are expected to be paid off in <1 year).

Why is working capital important?

Working Capital is a quick way to assess a company's liquidity, which is its ability to meet its short-term obligations.

It serves as an indicator of a company's financial health.

If working capital is positive, it indicates that a company has sufficient resources to cover its short-term financial needs.

If working capital is negative, it indicates that a company may face financial difficulties.

There are three ways to calculate working capital:

THE SIMPLE METHOD

Current Assets - Current Liabilities

This is the most common method and easiest to calculate.

THE NARROW METHOD

(Current Assets - Cash) - (Current Liabilities - Debt)

This method excludes cash & debt, which can help compare companies with different capital structures.

THE SPECIFIC METHOD:

Accounts Receivable + Inventory - Accounts Payable:

This method focuses on the cash conversion cycle of a business, which is the time it takes to convert inventory into cash.

Balance Sheet

Reports | Reconciliations | Analyses | KPIs | Ratios

We prepare and review different month-end balance sheet reports, reconciliations, analyses, and ratios.

Consolidating these reports and reconciliations in one place would be beneficial.

I know only some reports are for everyone or may be required.

However, having them all in one place makes it easier to see what is relevant to us and applicable to the business.

I have covered the main balance sheet accounts. Based on your accounting practices and needs, you may have some other accounts.

Take this as a guide and prepare the reports/reconciliations that apply to you.

I have included the following wherever they were applicable:

1- Reports

2- Reconciliations

3- Analyses

4- KPIs

5- Ratios

The overall balance sheet reconciliation is one periodic report that sits on top of all these.

No matter what business you are in and what your accounting practices are, they apply to all of us.

I'll teach you How to Read a Balance Sheet in 7 minutes.

I've spent 30+ years studying Finance, with 15 as a public company CFO.

This post is a "cheat sheet" ebook on how to read a Balance Sheet in 7 minutes:

• What does the balance sheet tell you?

• What is the structure of the balance sheet?

• What are Assets?

• What are Liabilities?

• What is Equity?

• How do you analyze a balance sheet?

Here is a bonus lecture on the Balance Sheet.  This is from a classroom lecture going over the Balance Sheet concepts.  Sometimes hearing things a second or third time presented in a little different way can help make the concepts stick. If you feel comfortable with the Balance Sheet ideas, then by all means skip ahead.  One way to check if you really understand the concepts is to teach it to someone or rehearse teaching it to yourself. Give it a try and see where you might get stuck. Then focus on the parts that are still less than crystal clear.

Balance Sheet Basics 

  The Balance Sheet is a condensed statement that shows the financial position of an entity on a specified date, usually the last day of an accounting period.         

Among other items of information, a balance sheet states

• What Assets the entity owns,    

• How it paid for them,   

• What it owes (its Liabilities), and    

• What is the amount left after satisfying the liabilities (its Equity)   

Balance sheet data is based on what is known as the 

Accounting Equation: Assets = Liabilities + Owners' Equity.   

Think of a Balance Sheet in terms related to everyday life.  Home ownership, when you have a mortgage, is represented as a Balance sheet. Your home ownership basically has the three components of Asset, Liability and Equity. The Asset is the value of the house. This is determined by an appraisal. An appraisal takes into account recent sales of homes in the area and compensates for differences like the number of bath or bedrooms, the size of the lot, etc.    

The Liability is the mortgage. This is how much you owe against the house. The Equity is the difference between the value of the Asset and the amount of the Liability. If your home is worth $200,000 and you have a remaining mortgage balance of $150,000, then you have $50,000 in Equity. We sometimes call this homeowner’s equity.    

If your mortgage balance is more than the value of the home, then you are considered “upside down” or “under water”. The same principle applies to a business: if the value of its Liabilities is more than the value of the Assets then the enterprise is insolvent and probably headed for bankruptcy.     

    A Balance Sheet is organized under subheadings such as current assets, fixed assets, current liabilities, Long-term Liabilities, and Equity With income statement and cash flow statement, it comprises the financial statements; a set of documents indispensable in running a business.     

What does the Balance Sheet balance?   

The balance sheet is structured to show the amount and type of assets an enterprise owns and how those assets are funded.  One side of the balance sheet shows what you have (assets) and the other side shows how you paid for it (debt and equity).    

Assets can be purchased and paid for in two ways: with debt or with equity (or a combination of the two).  What a company owes, the debts or loans, are called Liabilities; what a company owns is the Equity or Stock.    

The Liabilities and Equity are equal to the Assets.  They are two sides of the same coin and they must balance; hence the term Balance Sheet. This is a fundamental principal of Accounting called the Accounting Equation.  Assets = Liabilities + Equity.     

Balance Sheet Format   

A Balance Sheet is typically organized in two columns with the Assets on the left and the Liabilities and Equity on the right. It is divided into subcategories with the most current types on top and the more long-term varieties towards the bottom.     

Current Assets are ones like cash that can be used on short notice and Long term Assets are things like factories that would take longer to convert to cash.  Current means short term; stuff that needs to be addressed within one year. Long-term means stuff longer than the next year.    

Bills that need to be paid within the month are considered Current Liabilities and loans that are paid back over years are considered Long term Liabilities.    

Equity is what the owners actually own.  Equity is basically Assets less the Liabilities and is shown as accounts below the Liabilities on the left hand side.  Equity is shown below the Liabilities because debt has senior claims on the assets. In the event of liquidation like a bankruptcy, the debt holders get paid from the sale of assets first and then anything left over goes to the equity holders.    

Here is an example Balance Sheet to get and idea of the format; notice that the Total Assets equals the Total Liabilities plus Equity.

Here is another bonus lecture on the Balance Sheet.  This is from a classroom lecture going over the Balance Sheet concepts.  Sometimes hearing things a second or third time presented in a little different way can help make the concepts stick. If you feel comfortable with the Balance Sheet ideas, then by all means skip ahead.  One way to check if you really understand the concepts is to teach it to someone or rehearse teaching it to yourself. Give it a try and see where you might get stuck. Then focus on the parts that are still less than crystal clear.

The Balance Sheet

Assets = Liabilities + Equity

Here is a quick analysis of the balance sheet:

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Calculate the working capital (current assets - current liabilities) to assess the company's liquidity.

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calculate cash to short-term liabilities to review any potential liquidity issues in the very short term.

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Calculate dso to see how quickly the company collects cash.

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Calculate dio to see how the company is efficient in converting inventories into cash

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Check the efficiency with fixed asset turnover evaluation.

Evaluate fair value, especially for intangibles.

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Calculate the current ratio and quick ratio to assess liquidity.

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Calculate Days Payable Outstanding (DPO) to track how quickly a company pays a bill and tends to prolong terms.

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The top priority in payment. Make sure the company is able to meet its immediate financial obligations.

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Evaluate debt-to-asset ratio to determine solvency.

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Calculate the equity ratio (equity / total assets) to understand stability

ROE (net income/equity) to understand the profitability

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1. understand the meaning of the ratio

2. result interpretation

3. compare with last period, budget and industry peers

4. action plan

What Is an Asset?

The fundamental bet of a new business is that a founder can use the capital from investors to purchase a variety of assets, uniquely combine those assets, and create more value than those assets could produce on their own.

Return on Invested Capital (ROIC) measures the success of this effort and strategy.

Let's say I wanted to raise money for a crypto company: I don't know how it will work, but considerations will involve stuff like ownership, community, and software. I first need to raise capital from investors. My investors hope I will use this capital to build the business, and I will use the money to buy assets of some sort.

If you asked a startup founder what excited them about their new venture, none would say "responsible stewardship of assets." It's all about building products! Building teams! Few people get into entrepreneurship to carefully manage spreadsheets.

However, understanding how to communicate in assets allows technology leaders to relate with their management team; it means founders no longer glaze over when their accountant speaks; it means understanding investors' incentives.

Knowing finance is power.

The most fundamental atomic unit of business is the asset. Understanding what an asset is, why it matters, and what excites investors is critical to career success. This is the way I wish I had been taught finance!

What is An Asset, and Why Do They Matter

Assets are a concept where the outline is clear, but the details are blurry. When you use the word "asset" at a meeting, everyone will vigorously nod their heads in accord while also conjuring up completely different definitions. A wise company builder can only realistically resolve this conundrum by comprehending what asset implies in relation to other factors.

On the outline level, an asset is any resource with an economic value. That's it! However, there is a big difference between your boss calling you an asset and your accounting team deciding what number to put next to "assets" on the balance sheet.

In a company, assets produce income. They are called income-producing assets. An asset can increase sales and revenue or help reduce costs. Both ways add to improving the bottom line (net income).

Let's take a step back and ask why we need to keep track of this stuff. First, the point of GAAP (generally accepted accounting practices) is to enforce a standard quantifiable version of a story that a business tells about itself. This standard is critical so that investors can look at the company's information and have reasonable trust that it corresponds to something specific in the real world.

So, if standard transparent information for owners (or potential owners) is generally the reason for accounting classifications, what is the need for an "asset" specifically? It's to give you some idea of the value of a company.

In business, assets break down into four broad categories. They are:

Current Assets

Current Assets are easy to liquidate; Cash and one step removed from cash assets. These are what a company uses when it needs Cash quickly. When things get tight, you want current assets readily available. Interestingly, there is no universal rule on what level of disclosure is required, so you'll often see different companies emphasize different things depending on their type of business.

The second thing an asset can be is:

Fixed Assets

Assets lasting longer than a year are called fixed assets. These are also called Tangible Assets. In corporate meetings, you will hear it called "PP&E": property, plants, and equipment. Financial judgments are made in calculating and depreciating the asset for an expense. Depending on which country a company is headquartered in and what accounting standard they adhere to, depreciation can occur over the "useful life" of the asset or on a more accelerated timeline.

Treating your assets and claiming depreciation expenses can result in huge swings in valuations.

Financial investments

Say you are a successful company like Apple. One of the best parts about being a great company is making lots of Cash. A company can, and probably should, return it to shareholders, but sometimes they choose to keep it. But when inflation strikes, you want only some of that sitting in a bank account. You want it out in the market, making a return or keeping up with inflation. Cash management is where you'll see some companies deploy their excess Cash in various ways.

Microstrategy put their excess Cash in Bitcoin. It worked incredibly well until it didn't. Tesla also took a position with its Cash in Bitcoin, but then Elon thought better of it and decided to sell that position and be safer. Most companies put their Cash in marketable securities. Marketable Securities is the Asset line on the Balance sheet just below Cash for most companies.

Intangible assets

The last type of thing an asset can be is intangible. Intangible assets are the best example to highlight the difference between accounting and finance. Finance is about long-term power: it deals with the strategic use and investment of capital. Accounting is tracking the day-to-day flows of value and is concerned with painting a hyper-accurate current picture of reality.

For intangible assets, there is often strong disagreement between the two functions. For example, when trying to value a brand or a patent, accountants have to use the principle of conservatism.

This point is significant because most technology companies' competitive advantages are intangible assets. Ask yourself this: what value would you ascribe to the network effects of LinkedIn? How valuable is the data housed therein? When Microsoft bought them for $26.2B in 2016, the company had a book value of assets worth roughly $7B. The $19.2B difference comprised future expectations of cash flows AND the other assets that hadn't been valued up to the point of acquisition.

The difference between finance and accounting is minute compared to the difference between executives and accounting. Perhaps the most crucial assets of all, a talented workforce and productive culture, aren't considered assets by accountants. They're an expense. There is a vast difference between how financial statements portray the world and reality.

How To Think About Technology Companies in the Pursuit of Assets

Many of the most successful companies have as few assets as possible. They can wring more economic value out of the minimal amount of assets. The more assets required to make your economic engine work, the more capital you must raise, and the lower the return on invested capital. Asset-light companies have a better return on assets.

There are notable exceptions, with some of the most highly valued companies today (Walmart and Tesla) taking an asset-heavy approach, but they are the exception. Vertical integration is a risky strategy. Hard tech, like building factories and producing complicated things like computer chips or batteries, can act as moats and barriers to entry—this approach limits threats of competition.

It's simple. The more a company can offload its unprofitable assets onto suppliers, the better return it can generate.

An investment round into a project is about purchasing returns-driving assets. Sometimes asset means the accountant definition, sometimes the CEO one. The game of finance is knowing when and how you should appeal to the right audience.

Fixed Assets

Life Cycle Management System

I have spent most of my career managing fixed assets in various capacities. Regardless of my position, fixed assets management found its way to me.

Fixed assets are a tedious and cumbersome area of accounting, especially if you have an extensive database of fixed assets like mine.

It takes time and effort to keep your fixed asset register clean and reconciled, and it also requires continuous physical effort to conduct physical verifications and tagging projects.

Nevertheless, to manage your fixed assets well, you need a sound system that enables you to reconcile your fixed assets register (FAR) and prevent errors.

I included the system functionalities and equipment you need to manage fixed assets life cycle and conduct physical verification and tagging exercises:

You'll find:

1- Must-Have System Functionalities

2- Mandatory Fields

3- Reports that you must be able to generate

4- Must Have Options

5- Nice to Have Options

6- Equipment for Physical Verification & Tagging

Two options:

a) Barcode Tagging

b) RFID Tagging

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This used to confuse me.

There's an easy way to distinguish them.

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Here are some other noteworthy differences:

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- Tangible assets are depreciated over their useful life.

- Intangible assets are amortized over their useful life.

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- Valuation of tangible assets is generally based on cost or market value.

- Intangible assets valuation often relies on the income approach or market comparables.

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- Tangible assets typically have a finite lifespan.

- Intangible assets can have an indefinite lifespan, depending on the asset type.

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- Tangible assets are more risky due to physical deterioration or technological advancements.

- Intangible assets face lower physical obsolescence risks but can be affected by changes in law, market demand, or technology.

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- Tangible assets are often used as collateral for loans due to their physical value.

- Intangible assets are less commonly used as collateral due to difficulty in valuation.

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- Tangible assets are acquired or constructed physically.

- Intangible assets are created through legal or intellectual effort.

In this lecture I review the Balance Sheet and Income Statement and how they are connected and the flow of money through them.  This is a summary and preparation for discussing the Cash Flow Statement. 

In this lecture I talk about Accrual Accounting and the Matching Principle and why they are so important.  Then I discuss the impact of these concepts on the Balance Sheet and Income Statement.  Then I talk about Liquidity Ratios and the Current Ratio and the Quick Ratio. 

So this lecture starts to tie together Accounting, Financial Statements, Corporate Finance, and Financial Analysis.

DEPRECIATION

DEPRECIATION is an accounting method used to allocate the cost of tangible assets (such as buildings, machinery, and vehicles) over their useful lives. It represents the systematic reduction in an asset's value due to wear and tear, obsolescence, or other factors.

Depreciation happens to TANGIBLE Assets (you CAN touch them)

Examples:

• Car

• Equipment

• Buildings

3 DEPRECIATION METHODS

STRAIGHT - LINE

The most common and easiest method to calculate depreciation. To use this depreciation method, you need to divide the cost of an asset by the useful life of an asset (in years).

FORMULA: Cost / Useful Life

DECLINING BALANCE

Used to calculate large depreciation expenses or assets that quickly lose value. Multiply the opening book value by the depreciation rate.

FORMULA: Opening book value x (100% / Useful Life of asset)

SUM OF THE YEARS DIGITS

An accelerated depreciation method increases the expense in the early years and lowers it in the latter years. Multiply the cost of an asset by its useful life over the sum of the years digits.

FORMULA: Cost x ( Useful life / Sum of the Years digits)

See the infographic for examples!

Depreciation is the last concept I present in preparation of discussing the Cash Flow Statement.  Depreciation is an accrual concept that creates an asset on the Balance Sheet and a non-cash expense during the asset's useful life.  Depreciation then gets reconciled with cash in the Cash Flow Statement.  You are really starting to become a savvy business person!

Cash Flow

The cash flow statement is a financial document that provides detailed data regarding all cash inflows a company receives from its ongoing operations and external investment sources and all cash outflows that pay for business activities and investments during a given period. It is one of the three fundamental financial statements used to assess a company's performance and financial health; the other two are the income statement and the balance sheet.

Here are the key components of a cash flow statement:

1. Operating Activities: This section shows the cash flow from day-to-day business operations. It starts with net income and then reconciles all non-cash items to cash items involving operational activities. This includes adjustments for depreciation, changes in accounts receivable and payable, and changes in inventory.

2. Investing Activities: This section reports cash flow from all investing activities. It includes purchases of physical assets, investments in securities, or the sale of securities or assets. Negative cash flow here could indicate that the company is investing in its future growth.

3. Financing Activities: This section reflects the cash flow from financing activities like issuing stock, paying dividends, and borrowing. It explains how a company finances its operations and growth through debt, equity, and dividend policies.

4. Net Increase or Decrease in Cash: This section shows the net change in the company's cash position over the period. If the closing balance of cash and cash equivalents is higher than the opening balance, the company has a net increase in cash.

5. Beginning and Ending Cash Balance: The statement starts with the amount of cash on hand at the beginning of the period and ends with the amount of cash at the end of the period.

The cash flow statement is essential for understanding a company's liquidity, solvency, and overall financial health. It shows how well a company manages its cash position, indicating whether it can generate enough cash to meet its debt obligations and fund its operating expenses. Unlike the income statement, it's immune to accounting assumptions and is a good indicator of a company's financial strength and ability to generate cash to fund operations.

Suppliers who allow a firm to pay later for goods and services received now are in effect supplying the firm with cash.

Creditors who permit a firm to increase amounts owed are in effect providing cash.

Cash Flow Statements do not have a universal look or layout.

That's because management teams control the terms and categories of their financial statements.

Here are the other words that management teams can use when creating their Cash Flow Statement:

CASH FLOW STATEMENT SYNONYMS:

→Cash Statement

→Statement of Cash Flow

→Financial Flow Statement

→Statement of Financial Flows

→Statement of Cash Operations

NET INCOME SYNONYMS:

→Profits

→Income

→Earnings

→Profit After Tax

→Earnings After Tax

NON-CASH CHARGES

→Depreciation

→Amortization

→Write-downs

→Deferred Taxes

→Impairment Charges

→Stock-based Compensation

→Unrealized Gains and Losses

CHANGES IN WORKING CAPITAL

→Credits

→Accruals

→Payables

→Provisions

→Inventories

→Receivables

→Prepayments

OPERATING CASH FLOW

→Cash Profit

→Cash Income

→Operating Cash

→Cash from Operations

→Cash Generated from Operations

→Net Cash from Operating Activities

CAPITAL EXPENDITURES:

→Capex

→PPE Spend

→Plant Outlay

→Property Spend

→Facilities Spend

→Equipment Spend

→Infrastructure Spend

→Property, Plant, and Equipment

ACQUISITIONS:

→Merger

→Takeover

→Asset Buy

→Consolidation

→Company Purchase

→Corporate Acquisition

PROCEEDS FROM SALE OF INVESTMENTS

→Sale Gain

→Disposal

→Asset Sale

→Divestiture

→Liquidation

→Sale Proceeds

→Disposal of Investments

→Proceeds from Sales of Assets

→Proceeds from Disposition of Investments

NET CASH FROM INVESTING ACTIVITIES

→Investing Cash

→Investment Flow

→Investment Outlay

→Cash from Investing

→Investing Cash Flows

→Cash Used in Investing

→Cash Flow from Investments

→Net Cash Used in Investing Activities

BORROW / REPAY DEBT:

→Debt Raised

→Loan Issuance

→Bond Issuance

→Debt Refinance

→Issuance of Bonds

→Borrowing Activities

→Repayment of Loans

→Debt Financing Activities

→Payments on Borrowings

→Debt Issuance/Repayment

→Proceeds from Issuance of Debt

ISSUE / REPURCHASE STOCK:

→Stock Sale

→Equity Issue

→Issuing Shares

→Equity Buyback

→Share Buyback

→Stock Issuance

→Equity Offering

→Stock Redemption

→Equity Repurchase

→Repayment of Share Capital

→Issuance of Equity Interests

→Repurchase of Equity Interests

PAY DIVIDENDS:

→Payouts

→Dividend Outlay

→Profit Distribution

→Dividend Allocation

→Distribute Earnings

→Dividend Remittance

→Dividend Distribution

→Dividend Disbursement

→Shareholder Dividends

→Cash Dividend Payment

NET CASH FROM FINANCING ACTIVITIES:

→Finance Cash

→Funding Cash

→Financing Flow

→Fund Injections

→Funding Activities

→Cash from Financing

→Cash from Financial Activities

→Net Cash Provided by Financing Activities

I've spent 35 years studying Finance, with 15 as a CFO, and

I'll teach you everything you need to know about the Statement of Cash Flows (SCF) in the next 7 minutes:

• What does the SCF tell you?

• What are the different types of cash flows?

• What are operating activities?

• What are investing activities?

• What are financing activities?

• How do you analyze the SCF?

How to Analyze a Cash Flow Statement

Earnings are an opinion; cash flow is a fact.

The Cash Flow Statement is by far the most important Financial Statement.

I'll teach you everything here.

1️⃣What is a Cash Flow Statement?

- A cash flow statement shows you how much cash goes in and out of a company over a certain period

- The purpose of this statement is to track how much cash is moving through a business

- You want to invest in companies that generate cash and manage their cash position well

2️⃣Structure of a Cash Flow Statement

Every cash flow statement consists of 3 parts:

• Cash Flow from Operating Activities

• Cash Flow from Investing Activities

• Cash Flow from Financing Activities

3️⃣Cash Flow from Operations

- This section shows all cash the company generated from its normal business activities

- It shows you all the cash a company earned from selling its normal products and services

- The cash flow from operating activities is comparable to net income, but it filters out a few income and expense posts that didn't cause actual cash to enter or exit the company

- Cash Flow from operating activities = net income + non-cash charges +/- changes in working capital

4️⃣Cash Flow from Investing Activities

The Cash Flow from Investing Activities gives you an overview of the company's investment-related income and expenditures.

- The Cash Flow from Investing Activities consists of 3 major parts:

o Capital expenditures (CAPEX)

o Mergers & Acquisitions

o Marketable securities

- Cash flow from investing activities = Sale of marketable securities + divestments - CAPEX - Mergers & Acquisitions - purchase of marketable securities

5️⃣Cash Flow from Financing Activities

- Measures the cash movements between a company and its owners (shareholders) and its debtors (bondholders)

- This section gives you an insight into how the company is financing its business activities

- Cash Flow from Financing Activities = Debt issuance + issuance of new stocks - dividends - debt repayments - share buybacks

6️⃣Changes in cash balance

- Finally, you can calculate the total changes in the cash balance

- Cash at the end of the year = Cash at the beginning of the year + CF from operating activities + CF from investing activities + CF from financing activities

Cash is King!

And the CFO is the king-maker.

Here are 19 ways you can improve your cash flow:

1. VOLUME - More volume from existing customers

2. VOLUME - Bring in new customers

3. VOLUME - Get referrals from existing customers

4. VOLUME - Run marketing campaigns for new leads

5. VOLUME - Launch new products and categories

6. PRICE - Launch higher-priced new items

7. PRICE - Raise prices on existing items

8. COGS - Get better deals with your suppliers

9. COGS - Automate processes and production

10. COGS - Manager better and learn from returns

11. SG&A - Cut the marketing budget

12. SG&A - Optimize the payroll

13. SG&A - Cut other spending like travel and consultants

14. SG&A - Find new ways to run your logistics

15. PP&E - Increase return on assets

16. PP&E - Develop proprietary technology

17. INVENTORY - Increase inventory turns

18. INVENTORY - Better inventory management

19. INVENTORY - Increase your buying efficiency

This is a partial list.

There are so many ways you can optimize cash flow.

You must identify through an analysis where the most considerable potential is.

Then, bring the right people around the table to discuss actions to take.

Decide what to do and follow up if you get the desired results.

If yes, push for more.

If not, find out why and execute better or do something different.

That's the WHAT and HOW of increasing cash flow.

The Cash Conversion Cycle - Visualized

What is it? Why is it important?

The Cash Conversion Cycle (CCC) is not just a theoretical concept but a practical tool that measures how efficiently a company manages its working capital. Understanding CCC can help you identify areas for improvement in your business operations.

It is the time period between when a company purchases inventory from its suppliers and when it collects the cash from customers.

A shorter CCC is a sign of efficient business operations. This means the company can quickly convert its investments into cash, available for other business needs. This improves the company's liquidity and allows it to respond more effectively to market changes and opportunities.

The CCC is measured in days.

The formula for CCC is straightforward: it's the sum of the Days Inventory Outstanding (DIO), the Days Sales Outstanding (DSO), minus the Days Payable Outstanding (DPO).

DIO = Days Inventory Outstanding = (Average Inventory/COGS) × 365

DSO = Days Sales Outstanding = (Average AR/ Credit Sales) x 365

DPO = Days Payable Outstanding = (Average AP/ COGS) x 365

AR = Accounts Receivable

AP = Accounts Payable

COGS = Cost of Goods Sold

A bad CCC is 90+ days.

An average CCC is between 30 and 90 days.

A good CCC is <30 days.

A GREAT CCC is <0, which means the company collects cash from customers before it pays its suppliers.

Free Cash Flow

Download the PDF; it teaches you everything you need to know.

1️⃣ What is free cash flow?

A company's free cash flow is equal to all the cash that enters it minus all the cash that leaves it over a certain period.

You can calculate it as follows:

Free cash flow = operating cash flow - CAPEX

The operating cash flow measures the cash generated by a company's regular business operations.

Capital expenditures (CAPEX) show how much money a company has used to maintain or buy physical assets.

2️⃣ What can a company do with its FCF?

The company can do different things with its free cash flow:

▪️ Reinvest for organic growth

▪️ Pay down debt

▪️ Acquisitions and takeovers (M&A)

▪️ Paying out dividends

▪️ Buying back shares

3️⃣ FCF Margin

This metric indicates how much cash a company generates per dollar in sales.

FCF margin = (free cash flow/sales)

Visa, for example, has a free cash flow margin of 60.2%.

For every $100 in sales, Visa generates $60.2 in pure cash.

4️⃣ FCF > Net Income

Earnings are an opinion; cash is a fact.

While earnings are an accounting metric, free cash flow looks at the money that actually entered and left the firm over a certain period.

5️⃣ FCF Conversion

The more earnings are translated into. FCF, the better.

FCF Conversion = (free cash flow / net earnings)

Seek companies with an FCF conversion of at least 85%.

6️⃣ Free cash flow yield

The free cash flow yield (FCF Yield) of a company is a great way to assess its valuation.

Free cash flow yield = (Free cash flow per share/ stock price)

The higher this ratio, the cheaper the stock.

Revenue and Income are NOT the same things!

Costs and Expenses are NOT the same things!

Net Income and Free Cash Flow are NOT the same things.

Confused? Let me break it down for you:

Sales and revenue mean the same things.

Both are the money that comes in from customer payments.

They both refer to the "top line" of the income statement.

Orders and sales are NOT the same things.

Orders are when a customer places a request for the future delivery of a product or service.

Orders become sales when the product is actually shipped or the service is performed.

Costs are different from expenses.

Costs are money spent on making a product or delivering a service (hence "cost of goods sold")

Expenses are money spent on developing, selling, accounting for, and managing the product or service.

Costs and expenses both become expenditures when money is actually sent to the vendors to pay the bills.

Profits, earnings, and net income all mean the same thing.

They are the "bottom line" of the income statement.

They all represent what is left over after all of the costs & expenses are subtracted from the revenue.

Net income and free cash flow are NOT the same things!

Net income measures profitability on the income statement using accrual accounting.

Free cash flow measures cash flow available to shareholders on the cash flow statement using cash accounting.

Accrual accounting and cash accounting are not the same things.

Accrual accounting: revenue or expenses are recorded when they occur, not when payment is received or made

Cash accounting: transactions are recorded only when money goes in or out of an account.

Here is a bonus lecture on the Cash Flow Statement.  This is from a classroom lecture going over the Cash Flow Statement concepts.  Sometimes hearing things a second or third time presented in a little different way can help make the concepts stick. The Cash Flow Statement can be a little tricky to understand at first so going over the material can be helpful. If you fell bored by this lecture then good! It means you understand the concepts.

If you feel comfortable with the Cash Flow Statement ideas, then by all means skip ahead.  One way to check if you really understand the concepts is to teach it to someone or rehearse teaching it to yourself. Give it a try and see where you might get stuck. Then focus on the parts that are still less than crystal clear.

Cash Flow is King

What is free cash flow yield, and why is it important?

In running a business, nothing beats real cash on hand.

In the investment world, cash flow, especially free cash flow, is essential to understand a company's stability and capital strength.

The Power of Free Cash Flow

Free cash flow is the money left after a company pays its expenses, taxes, interests, and capital expenditures. In addition, dividends, debt payments, stock buyback, and growth investments come from free cash flow.

When a company earns a positive free cash flow, it generates more cash than it needs to operate its business and can invest in growth.

Free cash flow (FCF) = Operating cash flow minus capital expenditure.

A company's cash flow statement is where operating cash flow and capital expenditure items are found.

Free cash flow is not net income because net income does not measure a company's actual cash position. For example, if a company increases revenue in the form of accounts receivable to be collected next year, the company has yet to receive the cash. So, an increase in accounts receivables will reduce cash flow even though the revenue is reported in the net income number.

Therefore, free cash flow (FCF) is better than net income for measuring a company's performance and how much cash is available to distribute to shareholders and invest for future growth.

Companies can manipulate their Net Income number but cannot mess around with free cash flow.

What is Free Cash Flow Yield?

Free Cash Flow Yield is calculated by comparing a company's free cash flow per share to its stock price per share.

Free cash flow yield (FCFY) = Free Cash Flow per Share/Price per Share

The higher the free cash flow yield, the more valuable the company is because of its stronger ability to pay off debt, distribute cash to shareholders, and invest for its benefit and growth.

Warren Buffett likes to look at cash flow rather than earnings multiples to determine whether an investment is a value.

"I wouldn't look for a single metric like relative P/Es to determine what — how — to invest money. You really want to look for things you understand, and where you think you can see out for a good many years, in a general way, as to the cash that can be generated from the business. And then, if you can buy it at a cheap enough price compared to that cash, it doesn't make any difference what the name attached to the cash is. "

Warren Buffett

What to Look For When Screening Investments

You have probably heard of "value" and "growth" stocks and wondered how to tell them apart and the benefits of one versus the other. Unfortunately, the two terms are arbitrary to a degree.

We want a screening tool that is less vague and subjective and more quantitative and objective.

Rather than looking for a value or growth stock, a better way to screen investments is to look at the free cash flow yield to understand the company's business strength compared to its market value.

In a risk-off environment, investors care for quality and cash flow.

A persistent negative free cash flow may signify a company is becoming illiquid and cannot sustain its operations.

A negative free cash flow yield is not always bad. For example, if the company is investing for the future and is expecting a higher investment return than the cash paid, like in a high-growth company, the temporary negative free cash flow yield needs to be investigated against the company's business needs and potential.

When measuring investment options, cash is King.

You can't control your Profit if you can't control your Costs.

There are main Cost Drivers you should control to drive your profitability.

Some are within your control (internal) or outside your control (external).

Your internal cost drivers are within your business's control, and you can influence them through your operations and management practices.

Prioritize these drivers to improve your cost structure and competitiveness.

Internal cost drivers include volume, efficiency, process improvements, and quality.

External cost drivers are outside your business's direct control and are influenced by external market conditions, such as supply and demand, commodity prices, and regulatory requirements.

Monitor these drivers and adapt your strategy to respond to market conditions.

External cost drivers include material costs, labor costs, and overhead costs.

Here's how you can use each of these seven drivers to impact your Costs positively:

1️⃣ Volume

• Increase production volumes to take advantage of economies of scale

• Implement a just-in-time (JIT) inventory system to reduce inventory costs

• Consolidate your production facilities to reduce fixed costs

2️⃣ Efficiency

• Reduce your cycle time by implementing lean manufacturing

• Automate manual processes to increase productivity

• Improve product design to reduce waste and scrap

3️⃣ Process improvements

• Streamline workflows and eliminate non-value-added activities

• Invest in technology to automate manual processes

• Implement kaizen programs to drive process improvements

4️⃣ Quality

• Implement quality control procedures to reduce your defects and scrap

• Invest in employee training and development to improve your product quality and performance

5️⃣ Material costs

• Optimize your material usage through better inventory management and production planning

• Explore alternative materials or substitutes to reduce costs

6️⃣ Labor costs

• Cross-train employees to improve flexibility and reduce overtime costs

• Improve employee retention and engagement to reduce your turnover costs

• Use temporary or contract labor to supplement permanent staff

7️⃣ Overhead costs

• Outsource your non-core functions to reduce fixed overhead costs

• Implement a telecommuting program to reduce your office space costs

Cash Flow Ratios

The Cash Flow Statement shows a company's profitability at multiple levels over a period of time using cash accounting.

3 Main sections:

OPERATING ACTIVITIES

Shows cash inflows & outflows from normal operations

INVESTING ACTIVITIES

Shows cash outflows from capital expansion & long-term investments

FINANCING ACTIVITIES

Shows cash changes to the company's capital structure

6 Cash Flow Ratios to watch

LIQUIDITY RATIOS

Cash Ratio = Cash Balance ➗ Current Liabilities

Current Ratio = Current Assets ➗ Current Liabilities

COVERAGE RATIOS

Cash Coverage Ratio = Cash Balance ➗ Interest Expense

Debt To OCF = Total Debt➗ Operating Cash Flow

VALUATION RATIOS

Price to CFFO = Share Price ➗ Cash Flow From Operations Per Share

Price to FCF = Share Price ➗ Free Cash Flow Per Share

In this lecture I tie together the financial statement interconnection and flow and then review the Balance Sheet and Income Statement.

Most Confusing Finance Terms Explained

FIXED COSTS VS. VARIABLE COSTS

• Fixed Costs: Costs that do not change with production or sales volume (e.g., rent).

• Variable Costs: Costs that vary with production or sales volume (e.g., materials, direct labor).

EBITDA VS. NET INCOME

• EBITDA: Earnings before interest, taxes, depreciation, and amortization.

• Net Income: Total profit after all expenses, including interest, taxes, depreciation, and amortization.

PROFIT VS. REVENUE

• Profit: Net earnings after deducting all expenses.

• Revenue: Total Income generated from sales or services before deducting expenses.

CAPEX VS. OPEX

• CapEx: Funds used by a company to acquire, upgrade, and maintain physical assets (PPE, buildings, or intangibles)

• OpEx: Day-to-day business expenses (e.g., rent, utilities).

ACCRUAL VS. CASH ACCOUNTING

• Accrual Accounting: Recording revenues and expenses when they are incurred, regardless of when cash is exchanged.

• Cash Accounting: Recording revenues and expenses only when cash is exchanged.

MARKET CAP VS. ENTERPRISE VALUE

• Market Cap: Total value of a company's outstanding shares.

• Enterprise Value: Total value of a company, including debt and excluding cash

WHO DOES WHAT TOWARD FINANCIAL STATEMENTS

✅ CFO

? Pivotal role in the FS creation  and interpretation

? Ensures that FS complies with standards

? Uses FS as a tool for strategic planning

? Presenting key results to the stakeholders

? FS and budget approvals

✅ Accountant

? Involved in the nitty-gritty details

? Ensures that FS are aligned with GAAP

? Provides data on cost structures

✅ Controller

? Supervision of the overall accounting process

? Internal controls setup to ensure the quality of FS

? Ensures that financial reports are accurate

✅ Tax Specialist

? Analyses whether costs are deductible

? Calculates deferred tax assets and liabilities

? Reconciliation of tax account to ensure FS quality

? Tax provision calculation

? Involved in FS projection as a part of tax planning

✅ Auditor

? Testing internal controls that ensure FS quality

? Assess general and specific audit risks

? Make testing of presented figures

? Issue the opinion of conducted audit toward FS

✅ Acquirer

? Due Diligence of FS

? Quality of earning based on FS

? Net debt and Net working capital analysis

? EBITDA adjustments

✅ FP&A specialist

? Reads and interprets FS to gauge the financial health

? FS long-term projections

? Cash flow planning

? KPI and management reporting

? Budget variance analysis

? Ratio and Scenario analysis

✅ Investment Analyst

? Compare FS with other companies in the industry

? Identifies financial trends

? CAPEX analysis

? ROCE analysis

? ROIC analysis

? Gross and net margin analysis

? Use projected FS to make a valuation

? Various risk assessments

✅ Banker

? Uses FS to assess the creditworthiness

? Solvency, liquidity, and profitability analysis

? Recommends suitable loan amounts and structure

Financial statements aren't just for accountants or finance teams.

They are a guidebook for various stakeholders, from investors to competitors.

Each user has a unique perspective and focuses on different aspects of these statements.

Grasping the diverse uses of financial statements can provide a significant competitive edge, empowering you as a business or finance professional in strategic decision-making and relationship-building.

DEPRECIATION

DEPRECIATION is an accounting method used to allocate the cost of tangible assets (such as buildings, machinery, and vehicles) over their useful lives. It represents the systematic reduction in an asset's value due to wear and tear, obsolescence, or other factors.

Depreciation happens to TANGIBLE Assets (you CAN touch them)

Examples:

• Car

• Equipment

• Buildings

3 DEPRECIATION METHODS

STRAIGHT - LINE

The most common and easiest method to calculate depreciation. To use this depreciation method, you need to divide the cost of an asset by the useful life of an asset (in years).

FORMULA: Cost / Useful Life

DECLINING BALANCE

Used to calculate large depreciation expenses or assets that quickly lose value. Multiply the opening book value by the depreciation rate.

FORMULA: Opening book value x (100% / Useful Life of asset)

SUM OF THE YEARS DIGITS

An accelerated depreciation method increases the expense in the early years and lowers it in the latter years. Multiply the cost of an asset by its useful life over the sum of the years digits.

FORMULA: Cost x ( Useful life / Sum of the Years digits)

See the infographic for examples!

The Most Important Financial Ratios

Including:

1️⃣ Liquidity Ratios

2️⃣ Profitability Ratios

3️⃣ Efficiency Ratios

4️⃣ Solvency Ratios

5️⃣ Valuation Ratios

6️⃣ Return Ratios

7️⃣ Coverage Ratios

8️⃣ Growth Ratios

9️⃣ Market Ratios

? Payout Ratios

The DuPont Analysis is a comprehensive framework that breaks down the various factors contributing to a company's Return on Equity (ROE). By dissecting ROE into its fundamental components, investors and analysts can gain deeper insights into a company's financial performance and pinpoint specific areas of strength and weakness. This detailed approach thoroughly examines profitability, asset utilization, and financial leverage, providing a clearer picture of what drives a company's financial success.

The model was developed by F. Donaldson Brown, an employee of the DuPont Corporation, in 1914. 

The attached graphic visually simplifies the DuPont analysis to highlight its key elements. The analysis begins with revenues, adjusted for costs and expenses to determine net profit. When divided by revenues, this net profit yields the profit rate, a crucial indicator of profitability. Additionally, the analysis considers current and fixed assets to calculate asset turnover, another vital component that measures how effectively a company utilizes its assets to generate sales.

The culmination of these factors—profit rate and asset turnover—combined with the equity multiplier, leads to the calculation of Return on Equity. By using this structured approach, the DuPont Analysis equips investors and analysts with the tools to delve into the underlying reasons behind the variations in ROE, whether it is due to the company's profitability, asset efficiency, or leverage. This powerful tool provides a nuanced understanding that goes beyond the surface-level financial metrics, enabling better investment decisions and strategic financial planning.

Margin shows how much of a product's sales price or revenue you got to keep.

Markup shows how much over cost you've sold your product(s) for.

Let's dig deeper into each of these.

Margin (or Gross Profit Margin in this case) is the proportion of a product’s Sales Price that exceeds the Product Cost.

Margin = (Product Sales Price - Product Cost)/ Product Sales Price

Margin = Gross Profit per Product / Product Sales Price x 100

Note that the Margin is calculated as a percentage.

Meanwhile, Gross Profit is calculated as an amount.

Markup is the proportion by which you increase the Product Cost to arrive at the Sales Price.

Markup = (Product Sales Price - Product Cost)/ Product Cost

Markup = Gross Profit per Product / Product Cost x 100

Markup can be calculated based on a product's variable cost or based on its total (absorption) cost.

Marking up the variable cost could result in under-costing and underpricing the product, which may increase revenues at the expense of reduced profitability and cash flows.

Use Cost-Volume-Profit analysis to determine the number of units you need to sell to break even.

Marking up the absorption cost could result in over-costing and overpricing, which in turn could reduce revenues also at the expense of reduced profitability and cash flows.

Be careful with the fixed manufacturing depreciation expense which gets included in the full/absorption cost of a product.

To calculate your margin if you know your markup: Margin = Markup /(1+Markup)

To calculate your markup if you know your margin: Markup = Margin / (1-Margin)

How to use Margin and Markup:

Both Margin and Markup calculate the difference between price and cost.

Margin relates that difference to Price or Revenue.

Markup relates that difference to Cost.

If you know the Product Cost, use Markup to determine an appropriate selling Price.

If you know the Product Gross Profit, use it to determine the Gross Profit Margin and track profitability over time.

Learn the basics of Working Capital (WC) and Invested Capital (IC).

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WC is the difference between a company's current assets (short-term resources) and current liabilities (short-term obligations).

Working Capital is like a financial safety net, measuring a company's liquidity and its ability to handle day-to-day operations. It's your company's financial superhero, providing a buffer against unexpected cash flow disruptions.

Working Capital management involves optimizing current assets and liabilities to improve liquidity.

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IC is the total amount of money invested in a company or project.

IC can include equity from shareholders, debt from lenders, and retained earnings. It represents the total Capital employed to generate returns.

It provides a buffer against unexpected cash flow disruptions. It is used in metrics like return on invested Capital (ROIC) to evaluate profitability and efficiency.

? Red Flags in Financial Statements ?

• Declining profit margins

• Creative accounting practices

• Excessive debt levels

• Inconsistent Cash Flow

• Frequent changes in auditors

• Overstated revenue or assets

• Integrity concerns

• Unusual inventory levels

• Declining market share

• Unexplained changes in accounting policies

Equity and Cap Tables — Who Owns What and Why It's Everything

HERE IS A story that plays out in Silicon Valley and startup ecosystems everywhere with depressing regularity.

Two founders start a company. They are friends, they are excited, they are moving fast. Someone asks about equity and they say they'll figure it out later. They are too busy building to worry about ownership percentages. That conversation can wait.

It cannot wait.

Two years later, the company is doing well. There are investors, employees, and real money on the table. And suddenly the question of who owns what — the question they deferred because they were too busy building — becomes the only question that matters. Friendships end. Lawyers get involved. Companies that should have thrived get torn apart from the inside by a dispute that could have been resolved in an afternoon with a whiteboard and an honest conversation.

The cap table is not paperwork. It is the constitution of your company. It determines who gets rich when things go right, who controls the company's direction when there is disagreement, and who gets paid when things go wrong. Understanding it from day one is not optional. It is one of the most important things you will ever do as a founder.

WHAT A CAP TABLE IS

Cap table is short for capitalization table. It is a document — often, in early stages, a simple spreadsheet — that records who owns what percentage of your company, in what form, and at what price.

At its most basic, a cap table answers three questions:

Who are the owners? Founders, investors, employees with options, advisors with equity — every person or entity with an ownership stake in the company appears on the cap table.

What do they own? Shares of stock, options to purchase shares, warrants, convertible notes — the form of ownership matters because different instruments carry different rights.

How much is their stake worth? At a given valuation, what is each owner's piece worth? This number changes every time you raise money, grant options, or issue new shares.

In the early days, your cap table might fit on a napkin. Two founders, fifty-fifty split, a hundred shares each. Clean and simple.

It will not stay that way. Every time you bring in an investor, every time you issue options to an employee, every time you take on a convertible note, the cap table changes. By the time you reach Series A, it is a complex document with multiple share classes, multiple investors, and an option pool that has been negotiated, adjusted, and re-negotiated. By the time you reach exit, it may be one of the most scrutinized documents in the deal.

Start understanding it now, while it is still simple.

FOUNDER EQUITY SPLITS: GETTING IT RIGHT BEFORE IT GETS UGLY

The first entry on your cap table is the founder split — how ownership is divided among the people who started the company. This is the conversation most founding teams avoid because it feels awkward and because everyone wants to preserve the harmony of the early days.

Have the conversation anyway. Have it early. Have it in full.

Here are the questions that need to be answered honestly:

Who came up with the idea? Ideas matter, but they matter less than you think. An idea without execution is worth very little. Weight this factor accordingly.

Who has been working on this the longest? Time invested before the company was formally founded is a real contribution. It should be reflected in the split.

Who is taking the biggest risk? If one founder is leaving a high-paying job and another is keeping theirs while working on the startup part-time, that asymmetry in commitment should show up in the equity.

What does each founder bring? Skills, relationships, capital, domain expertise — the contributions that will actually build the company deserve weight.

What will each founder do going forward? Past contribution matters, but so does future role. The person who will be CEO, running the company day to day, typically carries more responsibility and more risk than a technical co-founder who will be heads-down on product.

There is no formula that spits out the right answer. What there is is an honest conversation that either produces agreement or reveals misalignment you need to know about before you go further.

One strong piece of advice: equal splits are almost never right, but they are extremely common because they feel fair and avoid conflict. They are the path of least resistance in the short term and the source of enormous conflict in the long term. If two founders split the company fifty-fifty and later disagree on a major decision, there is no tiebreaker. The company is deadlocked. Equal splits require unanimous agreement to function. That works fine when everything is going well. It fails catastrophically when it doesn't.

Think hard about whether equal is actually right, or whether it just feels easier than having the real conversation.

VESTING: THE MECHANISM THAT PROTECTS EVERYONE

Once you have agreed on the equity split, the next question is how that equity is earned. The answer, for virtually every startup, is vesting.

Vesting means that founders earn their equity over time rather than owning it all immediately. A typical founder vesting schedule is four years with a one-year cliff. Here is what that means:

Four years is the total period over which you earn your equity. If you own 40% of the company with a four-year vesting period, you earn that 40% gradually over 48 months.

The one-year cliff means you earn nothing for the first year, and on your one-year anniversary, you receive credit for the entire first year at once — typically 25% of your total grant. After the cliff, vesting continues monthly or quarterly for the remaining three years.

Why does this matter? Because startups fail or change direction, and co-founders sometimes leave. Without vesting, a co-founder who leaves after six months walks away with the same equity stake they would have earned by staying for four years. With vesting, they leave with whatever they have earned up to that point. The unvested portion remains with the company and is reissued to whoever performs the work going forward.

Vesting protects everyone. It protects the company and the remaining founders from a departing co-founder taking a significant equity stake for minimal contribution. And paradoxically, it protects the departing founder too — because any investor will demand vesting as a condition of their investment, and it is far better to negotiate it among yourselves on friendly terms than to have it imposed later by a term sheet.

Vest your equity. All of it. Including the CEO's. Including yours.

DILUTION: HOW IT WORKS AND HOW TO THINK ABOUT IT

Every time your company issues new shares — to investors, to employees, to advisors — your percentage ownership decreases. This is dilution. It is not inherently bad. In fact, dilution is the mechanism by which startups grow. But founders who don't understand it often feel blindsided when they realize that the 60% they owned at founding has become 15% by the time the company exits.

Here is a simple illustration of how dilution works:

You and your co-founder each own 50% of the company. You decide to raise a seed round, selling 20% of the company to investors. After the round, the investors own 20%, and you and your co-founder each own 40%. You have been diluted — your percentage has decreased — but the company is now worth more. If the investors paid a fair price, your 40% stake in a more valuable company is worth more than your 50% stake in a less valuable one.

This is the essential insight about dilution: the percentage matters less than the value of what the percentage represents. Being diluted from 50% to 15% feels like losing. But if the company has grown from a $2 million valuation to a $200 million valuation in the process, your stake has gone from $1 million to $30 million. That is not losing. That is the point.

The danger is not dilution itself — it is dilution without value creation. Every round of financing should increase the value of the company enough to more than offset the dilution. When it doesn't, founders and early investors are giving away ownership without receiving adequate compensation. Watch out for this pattern.

THE OPTION POOL: WHAT YOU'RE GIVING AWAY WHEN YOU CREATE ONE

A stock option gives an employee the right to purchase shares of the company at a fixed price — called the exercise price or strike price — at some point in the future. Options are one of the primary ways startups attract and retain talent when they cannot compete with large company salaries. The promise is simple: help us build this thing, and if we succeed, you will share in the upside.

The option pool is the block of shares set aside for this purpose. Most early-stage startups create an option pool equal to 10% to 20% of the fully diluted shares outstanding. Investors will often require you to establish or expand the option pool before they invest.

Here is the part founders miss: the option pool comes out of the founders' equity, not the investors'. When an investor requires you to create a 15% option pool as part of your seed round, that 15% dilutes the founders before the investor's money comes in. The investor's ownership percentage is calculated after the option pool is created, meaning the investor suffers less dilution from the pool than the founders do.

This is not a conspiracy. It is standard practice. But understanding it changes how you negotiate. You can push back on the size of the option pool. You can ask the investor to model out how many options you actually expect to grant before the next round and size the pool accordingly, rather than using a round number. Sophisticated founders negotiate this. Founders who don't understand cap tables accept whatever number is in the term sheet.

Know what you are agreeing to.

PREFERRED VS. COMMON STOCK: THE INVESTOR'S ADVANTAGE EXPLAINED

When investors put money into your company, they almost never buy the same kind of stock that founders hold. Founders hold common stock. Investors hold preferred stock. The difference is significant and often poorly understood by founders until it is too late to matter.

Common stock is the basic form of equity. It has no special rights or privileges beyond a proportional claim on the company's assets and earnings. Founders, employees, and advisors typically hold common stock or options to purchase common stock.

Preferred stock comes with a set of contractual rights that common stock does not have. These rights vary from deal to deal, but typically include:

Liquidation preference — in a sale or wind-down, preferred stockholders get paid before common stockholders. We will cover this in detail in a moment.

Anti-dilution protection — if the company later raises money at a lower valuation than the preferred stockholders paid, their shares are adjusted to protect them from the full impact of the down round.

Pro-rata rights — the right to participate in future financing rounds to maintain their ownership percentage.

Information rights — the right to receive regular financial reports and other information about the company.

Board representation — preferred stockholders, particularly lead investors, often receive the right to appoint one or more directors to the board.

None of these rights are inherently unreasonable. Investors are taking real risks, and preferred stock rights are how they manage that risk. But founders need to understand exactly what rights they are granting in each round, because those rights accumulate. By the time you reach Series B or C, the preferred stockholders may have rights that significantly constrain your ability to run the company or sell it on your own terms.

LIQUIDATION PREFERENCES: WHO GETS PAID FIRST

The liquidation preference is one of the most consequential terms in any investment agreement and one of the least understood by first-time founders. Understanding it is essential.

Here is the basic concept: when a company is sold or liquidated, preferred stockholders have the right to receive their investment back — plus any agreed-upon return — before common stockholders receive anything.

In its simplest form, a 1x non-participating liquidation preference means that if investors put in $5 million, they get the first $5 million out of any sale proceeds. Whatever is left goes to the common stockholders — founders, employees, and others — in proportion to their ownership.

This seems reasonable. Investors get their money back first. Founders get whatever is left. If the company sells for significantly more than was invested, everyone does well.

The complication is participating preferred stock. With participating preferred, investors get their liquidation preference back first, and then they also participate in the remaining proceeds alongside the common stockholders, as if they had converted to common stock. This is called double-dipping, and it significantly reduces what founders and employees receive in a sale.

Here is a simplified example. Say investors put in $10 million for 40% of the company on participating preferred with a 1x preference. The company sells for $30 million.

With non-participating preferred: investors take their $10 million preference, leaving $20 million for common stockholders.

With participating preferred: investors take their $10 million preference, then take 40% of the remaining $20 million — another $8 million — for a total of $18 million. Common stockholders share $12 million instead of $20 million.

The difference is $8 million. Coming out of the founders' pockets.

Participating preferred is a term worth pushing back on. Many founders accept it without realizing what it means. Now you know.

CONVERTIBLE NOTES AND SAFES: SEED STAGE FINANCING INSTRUMENTS

Before we leave the topic of cap tables, it is worth briefly addressing two instruments that are common in early-stage financing and that affect your cap table in ways that are not always immediately obvious.

Convertible notes are short-term debt instruments that convert into equity at a future financing round. Instead of pricing your company's valuation at the seed stage — which is genuinely difficult when the company is very early — investors lend money that converts into shares when you raise a priced round later.

Convertible notes typically include a discount rate — the noteholder converts at a lower price than the Series A investors pay, as compensation for taking earlier risk — and a valuation cap, which sets the maximum valuation at which the note will convert. The valuation cap is the term that matters most. If you set it too low, the note converts into a much larger percentage of your company than you expected.

SAFEs — Simple Agreements for Future Equity — were developed by Y Combinator as a simpler alternative to convertible notes. They are not debt and they do not accrue interest. Like convertible notes, they convert into equity at a future round. They have become the dominant instrument for pre-seed and seed financing in the startup ecosystem.

The key point about both instruments is that they represent future dilution that does not appear on your cap table until they convert. Founders who have issued several convertible notes or SAFEs sometimes discover at their Series A that the actual dilution from conversion is significantly larger than they anticipated. Model it out before you issue these instruments. Understand what your cap table will look like post-conversion at various valuation scenarios.

READING AND MANAGING YOUR CAP TABLE THROUGH THE STAGES

Your cap table is a living document. It changes every time you issue shares, grant options, raise money, or have an employee exercise their options. Managing it actively is not optional.

At [S1] — Idea Stage: Your cap table should be simple. Founders and their vesting schedules. Nothing else. Set it up correctly from day one. Use a spreadsheet or a dedicated cap table management tool. Keep it current.

At [S2] — Launch Stage: You may have issued some advisor equity and perhaps a convertible note or SAFE. Make sure you understand the dilution implications of these instruments at various valuation scenarios. Run the numbers before you issue anything.

At [S3] — Scale Stage: Your cap table is now complex. Multiple investors, multiple share classes, an option pool with grants at various strike prices, and possibly convertible instruments that have not yet converted. This is the stage at which dedicated cap table software — Carta is the industry standard — becomes essential. Human error in a spreadsheet at this stage is genuinely dangerous. Invest in the right tools.

At [S4] — Exit Stage: The cap table determines who gets paid what in a sale. Every preference, every conversion right, every anti-dilution provision comes into play. Your attorney and your investors' attorneys will model dozens of scenarios. You should be able to read and understand every line before you sign anything.

A$AP ACTION [S1] → [S3]

1. Have the founder equity conversation this week. If you have a co-founder and you haven't formally agreed on equity split and vesting, stop everything and have that conversation today. Write it down. Have your attorney document it in a founders' agreement. The discomfort of the conversation now is nothing compared to the cost of the conflict later.

2. Build your cap table from day one. Even if it is just two founders with equal shares, create a cap table document today. Use a spreadsheet or sign up for Carta's free tier. Get in the habit of keeping it current. Every equity grant, every option, every convertible instrument goes on the table the day it is issued.

3. Model your dilution before your next round. Before you issue any convertible notes, SAFEs, or new equity, build a simple model showing what your cap table looks like post-conversion or post-close at two or three different valuation scenarios. Know what you are agreeing to before you agree to it.

* * *

The 10 Key Types of Equity Everyone Should Understand.

Master them to refine your capital structure,

To drive optimal financing strategies,

To seize growth opportunities,

To increase profitability.

1️⃣ Angel Investors

• Gain funding from wealthy individuals looking to invest in promising startups.

• Offer equity in exchange for capital in early-stage companies

• It also provides mentorship and industry connections

2️⃣ Venture Capital

• Secure funding from venture capital firms focusing on high-growth potential businesses

• Involves significant equity given away, often in multiple funding rounds

• Provides extensive resources and guidance, but requires sharing control

3️⃣ Seed Funding

• Obtain initial capital to start or expand the business, often from family, friends, or early investors.

• Typically, smaller amounts that help prove a concept before seeking more significant investments

• Often structured as convertible notes or equity stakes

4️⃣ Crowdfunding

• Raise small amounts of money from many people

• Can offer rewards, equity, or debt based on the type of crowdfunding

• Enables validation of business concepts through market interest

5️⃣ Private Equity

• Access capital from private equity firms

• Involves significant investment in exchange for substantial equity stakes

• Firms actively engage in managing and growing the business

6️⃣ Initial Public Offering (IPO)

• Offer shares to the public in a new stock issuance, providing capital for expansion

• Increases scrutiny as public companies must adhere to strict regulatory standards

7️⃣ Corporate Venture Capital

• Receive investment from a corporation looking to fund startups with strategic alignment

8️⃣ Convertible Debt

• Borrow money under the condition that the debt will convert into equity

• Protects investors with the security of debt instruments

• Useful for startups in early stages when valuation is challenging

9️⃣ Equity Crowdfunding

• Raise capital by selling small amounts of equity to a large number of investors via crowdfunding platforms

• Allows investors from various backgrounds to invest in startups they believe in

• Provides startups with a broad investor base and potential brand advocates

? Employee Stock Ownership Plans (ESOPs)

• Provide company shares to employees as part of compensation

• It helps align employee interests with those of shareholders

What would you add?

Debt vs Equity

Debt vs Equity: does Debt to Equity tell the whole picture?

We must measure how well a company invests to grow.

Companies have two options beyond internal (free cash flow).

Debt or Equity.

Understanding these options can significantly influence a company's financial structure and growth trajectory.

???? involves borrowing money that must be repaid over time, with interest.

It includes instruments like bank loans, bonds, debenture, and credit lines.

Debt financing is advantageous because interest payments are tax-deductible, and it doesn't dilute ownership.

However, it requires regular repayments that can strain cash flow, and excessive debt can lead to an increased risk of bankruptcy.

?????? represents ownership in a company acquired through instruments like stocks.

Equity financing allows companies to raise capital without incurring debt.

The main advantages include no obligation for repayment and no interest expenses, which is beneficial during cash flow downturns.

However, issuing Equity can dilute current shareholders' stakes and might lead to conflicting interests among investors.

????? ?? ????:

1. ??????? ????: Backed by collateral, offering lower risk and interest rates. Think bonds or bank loans

2. ????????? ????: Based on creditworthiness, typically carrying higher interest rates. Think lines of credit or commercial paper.

????? ?? ??????:

1. ?????? ??????: Provides voting rights and dividends, subject to business performance.

2. ????????? ??????: Often carries no voting rights but provides fixed dividends.

????????? ????:

1. ????-??-?????? ?????: Indicates the proportion of debt to shareholder equity, look for ratios < 1.0

2. ???????? ???????? ?????: Shows how easily a company can pay interest on its outstanding. Ideal > 3x

????????? ??????:

1. ?????? ?? ?????? (???): Measures how well a company leverages its Equity to grow profits. Look for > 15%.

2. ?????-??-???????? ????? (?/?): Helps evaluate if a stock price accurately reflects the company's earnings prospects. The higher, the better.

So, to summarize:

Don't let some ratio decide whether a company has too much debt.

Reason from first principles.

What's the ???? created by all this debt? Is this risk comfortably manageable given the company's cash-generating power? Or is Equity a better option for the company?

I am excited to share a guide on Debt Financing. I address the essential aspects of the topic to provide insight into how strategic borrowing can rocket a business to new heights. Jump in and enhance your financial strategy today.

What This Guide Will Cover

1️⃣ Overview of Debt Financing.

2️⃣ Purpose, Importance & Key players involved.

3️⃣ Types of Debt Financing.

3️⃣ Debt Term Length & Security.

4️⃣ Impact on Financial Statements.

5️⃣ Key Considerations Before Borrowing.

6️⃣ Leading Debt Financing Options Globally and their reason.

7️⃣ Pros and Cons of Debt Financing.

8️⃣ Summary.

Financial statements – primarily the Balance Sheet, Income Statement, and Cash Flow Statement – are intricately linked and provide a comprehensive picture of a company's financial health. Understanding how they interconnect is crucial for analyzing a company's performance and financial position.

The Balance Sheet: This statement provides a snapshot of a company's financial position at a specific point in time. It lists the company's assets (what it owns), liabilities (what it owes), and equity (the owner's share). The fundamental equation of the balance sheet is Assets = Liabilities + Equity.

The Income Statement: Also known as the Profit and Loss Statement, it shows the company's revenues and expenses over a period (e.g., a quarter or a year). It starts with sales revenue and subtracts various costs to arrive at the net income or loss. The bottom line of the income statement, 'Net Income,' links directly to both the balance sheet and the cash flow statement.

• • Link to the Balance Sheet: The net income contributes to a company’s equity as Retained Earnings. Retained Earnings are a part of the shareholder's equity on the balance sheet and represent the accumulated amount of net income that has been retained (not paid out as dividends) within the company.

  • Link to the Cash Flow Statement: The net income is the starting point for the cash flow statement's 'Operating Activities' section.

The Cash Flow Statement: This statement shows the actual inflows and outflows of cash and cash equivalents over a period. It helps stakeholders understand how the company generates and uses its cash. It is divided into three sections: Operating Activities, Investing Activities, and Financing Activities.

• • Operating Activities: This section starts with the net income from the income statement and adjusts for non-cash items and changes in working capital.

  • Investing Activities: These include cash flows from the purchase and sale of assets, like property and equipment, which are reflected in the balance sheet's asset section.

  • Financing Activities: These are cash flows related to borrowing and repaying debt, issuing equity, and paying dividends, which affect the liabilities and equity sections of the balance sheet.

  • Net Increase/Decrease in Cash: This figure is added to/subtracted from the previous period's cash balance on the balance sheet.

Feedback Loop and Continual Flow: After adjusting for cash flows, the ending cash balance from the cash flow statement is carried over to the balance sheet as the cash amount for the new period. Simultaneously, the net income affects both the equity section of the balance sheet and the beginning of the cash flow statement. This cycle repeats each reporting period, demonstrating the interconnected nature of these statements.

In summary, the income statement provides a view of profitability over a period, the balance sheet shows financial position at a point in time, and the cash flow statement reconciles the two by showing how money is generated and spent. Together, these statements provide a holistic view of a company's financial health and are invaluable for investors, managers, and other stakeholders.

How Financial Statements Interconnect and Link

Understanding how the three financial statements connect is critical to gaining financial fluency.

INCOME STATEMENT

Shows a company's revenue, expenses, and net income over a period of time (month, quarter, year) using accrual accounting.

BALANCE SHEET

Shows a snapshot of a company's assets, liabilities, and equity at a point in time using accrual accounting.

CASH FLOW STATEMENT

Shows a company's cash movements over a period of time (month, quarter, year) using cash accounting.

Many connections between financial statements bridge the gap between cash accounting & accrual accounting.

Note: This visual doesn't show all the connections, just the major ones.

The Big Picture of Financial Statements

The three Financial Statements: Balance Sheet, Income Statement, and Cash Flow Statement, are interconnected, and the accounting numbers flow through them. They are the measure of a company's performance and health.

The basic interconnection starts with a Balance Sheet showing the financial position at the beginning of the period (usually a year); next, you have the Income Statement that shows the operations during the year, and then a balance Sheet at the end of the year.

The Cash Flow is necessary to reconcile the cash position starting from the Net Income number at the bottom of the Income Statement. The cash number calculated from the Cash Flow Statement is added to the cash reported on the beginning Balance Sheet. This number needs to match the actual money in the bank at the end of the period and is used as the Cash account balance at the top right (Asset column) of the end-of-year (EOY) Balance Sheet.

The Net Income number from the Income Statement is then added to the Retained Earnings number in the Equity section (lower left-hand side) of the end-of-year (EOY) Balance Sheet.

Changes in non-cash accounts like Accounts Receivable and Accounts Payable and Depreciation and Amortization will make up the difference between the Cash Flow number added on the right side of the Balance Sheet and the Net Income number added on the left-hand side.

When this is done correctly, all the numbers should reconcile. The Assets will equal the Liabilities and Equity (remember the Accounting Equation A = L + E) of the EOY Balance Sheet.

Financial Statement Interconnections and Flow

Think of it as a system of two Balance Sheets acting as bookends for the Income Statement. And the Cash Flow Statement is used to reconcile the Net Income (or Loss) at the bottom of the Income Statement with the amount of cash in the bank.

This process accounts for every penny that has come in, gone through, and gone out of a company during the period.

Understanding these three financial statements and how they knit together will allow you to assess any company's financial health, viability, and prospects and help you make rational, fact-based investment decisions. This is how Warren Buffett does it.

This section ties together the functionality of the financial statements. I hope this might be an "aha" moment for you. It was for me when I finally realized how this all fit and worked together. This understanding of financial statements is the basis of Financial Literacy and Capitalism. Understanding this big conceptual accounting picture will provide a context to keep you from getting lost in the details.

Now its time to test your new knowledge.

Here is a quiz to test your new knowledge of financial statements and how they interconnect and flow together. Download the spreadsheet and fill in the yellow squares numbered 1-22. The only number you need to know is at the top where it says that Accounts Receivable AR increased by $75.  This AR increase number is just a random change that I picked to illustrate that with just one given number, we can calculate all the other numbers with just addition and subtraction.

The following video will go over the quiz and the answers. Don't peak! : )

Understanding the Interconnectivity of Financial Statements

Financial statements are interwoven documents that tell the entire fiscal story of a business. The interplay among the Balance Sheet, Income Statement, and Cash Flow Statement is essential for a comprehensive understanding of a company's financial standing.

The Balance Sheet, a snapshot of the company's financial status at a specific point in time, reflects information derived from the Income Statement.

In turn, the Income Statement, which details the company's revenues and expenses over a period, draws upon data concerning the company's assets, liabilities, and equity as depicted in the Balance Sheet.

Meanwhile, the Cash Flow Statement serves as the connecting thread, demonstrating how the business's operations generate and use cash, thus linking the operational results with the company's financial position.

To construct a dynamic financial model, one begins by channeling Net Income from the Income Statement to the Balance Sheet, contributing to Retained Earnings, and then to the Cash Flow Statement as a part of Operating Cash Flow.

The adjustments made in Current Assets and Current Liabilities on the Balance Sheet are totaled to reflect the Changes in Operating Assets and Liabilities within the Cash Flow Statement.

Adding back the Depreciation Expense, a non-cash charge, into the Cash Flow Statement under Operating Cash Flow is a crucial step. This amount is then reconciled in the Investing Cash Flow section by adjusting the beginning Fixed Assets balance and any acquisitions or disposals to arrive at the net cash used or provided by investing activities.

The reconciliation of Long-Term Debt involves subtracting the opening balance from the ending balance, which determines the cash flows related to financing activities. Similarly, Equity adjustments are made by adding the period's Net Income to the opening balance and subtracting the ending balance to finalize the Financing Cash Flows.

The sum of the previous period's ending cash balance and the current period's flows from operations, investing, and financing activities cumulatively determine the new closing cash balance on the Balance Sheet.

It's crucial to remember that crafting a Cash Flow Statement requires just two Balance Sheets—one from the start and one from the end of the period—and an Income Statement that covers the interim. This setup is instrumental in tracking the cash's journey through the business, providing key insights into the company's vitality and risk exposure.

However, avoiding jumping to conclusions based on cash flow figures is essential. Positive cash flows may not always signal financial health, just as negative cash flows don't inherently spell trouble. The context in which these cash flows occur is vital for accurate interpretation and analysis.

Download the attached PDF with the answers to the quiz and follow along with the spreadsheet lecture.

Here is another look and review of the Financial Statement Flow Quiz.  This one is from a classroom and the video isn't as clear as the one above, but hearing another take on the analysis will help the concepts sink in. You can Download the attached PDF with the answers to the quiz, if you haven't already, and follow along with the video lecture.

Four Fundamental Steps to Gauge a Business's Fiscal Well-Being

Whether you're delving into the financial world as an expert or navigating it from another professional angle, grasping the financial vitality of a business is crucial.

Here's how these insights apply across different roles:

These steps are vital for accountants or financial experts in pinpointing and steering the essential factors influencing financial outcomes.

For those in management, such understanding sharpens awareness of how capital is distributed within the company, allowing for synergy between individual and collective ambitions and ultimately boosting overall efficiency.

For employees, it clarifies the company's financial focus and the mechanisms that drive success, enabling smarter, career-enhancing choices.

For investors, it provides:

• A clearer view of the risks inherent in managerial choices.

• The robustness and continuity of cash flow.

• The congruence with personal investment strategies.

For business owners, it equips them with the knowledge to make educated decisions and optimize the distribution of their business's resources.

Now, let's delve into the four recommended steps for evaluating a company's financial robustness:

Scrutinize the Balance Sheet

Purpose: To inspect the company's immediate financial standing and long-term viability, measure how efficiently assets are being utilized, and understand the company's debt-to-equity dynamics.

Examine the Income Statement

Purpose: To assess the company's revenue-generating capabilities and operational efficiency, ensuring it can pay off its expenses and thrive financially during economic downturns.

Evaluate the Cash Flow Statement

Purpose: To understand the company's cash generation efficacy, which is indicative of its ability to maintain and expand operations and meet its financial obligations.

Conduct a Comprehensive Ratio Analysis

Purpose: By integrating horizontal and vertical analyses, ratio analysis reveals a company's financial health, offering insights into its profitability, liquidity, solvency, operational efficiency, and capacity to generate cash flow in alignment with its strategic goals.

The Altman Z-Score is a formula developed by Edward Altman in the 1960s. It is used to predict the likelihood of a company going bankrupt within two years.

The Z-Score uses five different financial ratios to develop a single number that measures the company's financial health.

Altman Z-Score breaks down into five major components:

• ??????? ??????? ?? ????? ?????? - A measure of ?????????

• ???????? ???????? ?? ????? ?????? - A measure of ?????????????

• ???????? ?????? ???????? ??? ????? ?? ????? ?????? - A measure of ????????? ??????????

• ?????? ????? ?? ?????? ?? ????? ??????????? - A measure of ????????

• ????? ?? ????? ?????? - A measure of ????? ????????

With these components, you can understand if a company's risk of bankruptcy is due to issues with liquidity, profitability, operating efficiency, solvency, or asset utilization.

????'? ? ????????? ?? ??? ???????:

(1.2 × Working Capital/Total Assets)

+

(1.4 × Retained Earnings/Total Assets)

-

(3.3 × EBIT/Total Assets)

+

(0.6 × Market Value Equity/Total Liabilities)

-

(1.0 x Sales/Total Assets)

=

Altman Z-Score

Altman Z-Score RESULTS:

0.0 - 1.8 = Distress Zone

1.8 - 3.0 = Grey Zone

3.0 - 4.0+ = Safe Zone

Example:

Working Capital = $2,000

Total Assets = $10,000

??????? ??????? ?? ????? ?????? = ??%

Retained Earnings = $3,000

???????? ???????? ?? ????? ?????? = ??%

EBIT = $2,500

???? ?? ????? ?????? = ??%

Market Value of Equity = $12,000

Total Liabilities = $5,000

?????? ????? ?????? ?? ????? ??????????? = ?.?

Sales = $20,000

????? ?? ????? ?????? = ???%

?????? ?-????? = (1.2 × 20%) + (1.4 × 30%) + (3.3 × 25%) + (0.6 × 2.4) + (200%) = 4.925

4.925 = SAFE ZONE

Invested Capital vs Working Capital

Invested capital includes the assets Microsoft uses to grow.

Working capital is the lifeblood Microsoft uses to function daily.

Invested Capital

1. ??????????: Total capital invested in a company's operations.

2. ??? ??????????: Includes equity, debt, and retained earnings.

3. ???????: Used to fund a company's growth and operations.

4. ???????????: Sum of debt and equity minus non-operating assets.

5. ?????: Measures the company's use of funds for generating returns.

Working Capital

1. ??????????: Difference between current assets and current liabilities.

2. ??? ??????????: Includes cash, receivables, and inventories minus payables.

3. ???????: Manages day-to-day operational expenses.

4. ???????????: Current assets minus current liabilities.

5. ?????: Indicates short-term financial health and liquidity.

??? ???????????

1. Invested capital represents total funds used for growth; working capital focuses on daily operational liquidity.

2. Invested capital includes long-term debt and equity; working capital covers short-term assets minus liabilities.

3. Invested capital is for overall company investment; working capital ensures smooth day-to-day operations.

Understanding invested and working capital is crucial for evaluating a company's long-term investments and short-term financial health.

This attached text is from the investment bank Merrill Lynch.  It serves as a comprehensive guide to understanding financial statements, focusing on the core components of an annual report: the Balance Sheet, Income Statement, Statement of Changes in Shareholders' Equity, and Statement of Cash Flows. It explains key accounting concepts like Assets, Liabilities, Shareholders' Equity, Revenue, and Expenses, using a fictional company, Typical Manufacturing, as an illustration. The material also discusses significant ratios for analyzing financial health, such as the Current Ratio, Debt-to-Equity Ratio, and Earnings per Common Share, and emphasizes the importance of Footnotes and independent Audit reports for a complete financial picture. Ultimately, the goal is to equip readers with the knowledge to analyze a company's financial performance and position for investment or employment purposes.

The deep dive explains and discusses the text.

Here’s what you’ll learn:

• The Letter to Shareholders

• The Business Review

• The Financial Review

• The Balance Sheet

• The Income Statement

• The Statement of Changes in Shareholders’ Equity

• The Statement of Cash Flows

• The Footnotes

Source: Merrill Lynch

Financial statement ratio analysis involves evaluating relationships between figures in the financial statements (Balance Sheet, Income Statement, and Cash Flow Statement) to assess a company's performance, financial health, and underlying value. These ratios provide insights into various aspects like profitability, liquidity, efficiency, and solvency. Here's a breakdown of key categories of financial ratios:

Profitability Ratios: These ratios measure a company's ability to generate profit relative to its revenue, operating costs, balance sheet assets, and shareholders' equity.

• • Net Profit Margin: (Net Income / Revenue) * 100. It shows the percentage of revenue that turns into profit after all expenses.

  • Return on Assets (ROA): Net Income / Total Assets. This indicates how effectively a company uses its assets to generate profit.

  • Return on Equity (ROE): Net Income / Shareholders' Equity. It measures the return generated on the shareholders' investment in the company.

Liquidity Ratios: These assess a company's ability to meet its short-term obligations and thus remain solvent.

• • Current Ratio: Current Assets / Current Liabilities. A ratio above 1 indicates that the company has more current assets than current liabilities.

  • Quick Ratio (Acid-Test Ratio): (Current Assets - Inventories) / Current Liabilities. It's a more stringent measure than the current ratio, excluding inventory from current assets.

Efficiency Ratios: These ratios evaluate how well a company uses its assets and liabilities internally.

• • Asset Turnover Ratio: Revenue / Average Total Assets. This measures the efficiency of a company's use of its assets in generating sales revenue.

  • Inventory Turnover: Cost of Goods Sold / Average Inventory. It shows how quickly a company sells and replaces its inventory.

Leverage (Solvency) Ratios: These ratios provide insight into a company's use of debt for funding its operations.

• • Debt-to-Equity Ratio: Total Liabilities / Shareholders' Equity. It indicates the proportion of equity and debt the company uses to finance its assets.

  • Interest Coverage Ratio: EBIT (Earnings Before Interest and Taxes) / Interest Expense. This shows how easily a company can pay interest on its outstanding debt.

Valuation Ratios: These are used to assess the attractiveness of a company's investment potential.

• • Price-to-Earnings (P/E) Ratio: Market Price per Share / Earnings per Share. It shows how much investors are willing to pay per dollar of earnings.

  • Price-to-Book (P/B) Ratio: Market Price per Share / Book Value per Share. It compares a company's market value to its book value.

Each of these ratios provides different insights and should be used in conjunction with others for a comprehensive analysis. It's also important to compare these ratios to industry averages, historical data, and competitor data to get a clear picture of a company's performance. Ratio analysis is a fundamental aspect of fundamental analysis and is widely used by investors, analysts, and finance professionals.

Welcome to "How to Analyze Financial Statements Fast," a concise guide to help you quickly understand and interpret a company's key financial documents. This resource is for those who need to grasp the essentials of financial statements without diving into overwhelming detail.

Every company produces three primary financial statements, each serving a distinct purpose:

• Balance Sheet: Provides a snapshot of a company's net worth at a specific point in time.

• Income Statement: Reveals whether the company is profitable over a particular period.

• Cash Flow Statement: Shows the movement of cash in and out of the business over time.

In this guide, we break down each statement into its core components and highlight the critical elements to focus on for a rapid assessment:

1. Balance Sheet

   • Cash & Equivalents: Assess liquidity.

   • Debt: Compare against cash holdings.

   • Goodwill: Check for significant amounts.

   • Retained Earnings: Ensure they are positive and growing.

   • Receivables & Inventory: Monitor their levels.

2. Income Statement

   • Revenue: Track trends.

   • Gross Profit: Observe changes.

   • Earnings Per Share: Check profitability.

   • Shares Outstanding: Note any fluctuations.

   • Operating Expenses: Evaluate stability.

3. Cash Flow Statement

   • Operating Cash Flow (OCF): Determine positivity and growth.

   • Capital Expenditures (CapEx): Compare with OCF.

   • Non-Cash Charges (NCC): Look for stock-based compensation.

   • Stock Transactions: Identify buybacks or issuances.

   • Debt Management: Check borrowing and repayment activities.

With less than five minutes of analysis per statement, this guide will help you swiftly identify a company's strengths and weaknesses, providing a solid foundation for more in-depth financial decision-making.

Download the MBA ASAP Financial Ratios Handbook for the Most Important Financial Ratios with their Formulas. Here is what you will find:

Liquidity Ratios:

- Current Ratio: Current Assets / Current Liabilities

- Quick Ratio: (Current Assets - Inventory) / Current Liabilities

- Cash Ratio: Cash and Cash Equivalents / Current Liabilities

Profitability Ratios:

-Net Profit Margin: Net Profit / Revenue

-Gross Profit Margin: (Revenue - Cost of Goods Sold) / Revenue

-Return on Assets (ROA): Net Income / Average Total Assets

Efficiency Ratios:

-Inventory Turnover: Cost of Goods Sold / Average Inventory

-Receivables Turnover: Revenue / Average Accounts Receivable

-Asset Turnover: Revenue / Average Total Assets

Solvency Ratios:

-Debt to Equity Ratio: Total Debt / Shareholders' Equity

-Interest Coverage Ratio: Earnings Before Interest and Taxes (EBIT) / Interest Expense

-Debt Ratio: Total Debt / Total Assets

Valuation Ratios:

-Price-to-Earnings (P/E) Ratio: Market Price per Share / Earnings per Share (EPS)

-Price-to-Book (P/B) Ratio: Market Price per Share / Book Value per Share

-Dividend Yield: Dividends per Share / Market Price per Share

Return Ratios:

-Return on Equity (ROE): Net Income / Average Shareholders' Equity

-Return on Investment (ROI): Net Profit / Investment Cost

-Return on Capital Employed (ROCE): Earnings Before Interest and Taxes (EBIT) / Capital Employed

Coverage Ratios:

-Fixed Charge Coverage Ratio: (EBIT + Lease Payments) / (Interest + Lease Payments)

-Debt Service Coverage Ratio: Net Operating Income / Debt Service

Growth Ratios:

-Earnings Growth Rate: (Current Year EPS - Last Year EPS) / Last Year EPS

-Sales Growth Rate: (Current Year Sales - Last Year Sales) / Last Year Sales

-Dividend Growth Rate: (Current Year Dividends - Last Year Dividends) / Last Year Dividends

Market Ratios:

-Market Capitalization: Number of Shares Outstanding * Market Price per Share

-Earnings per Share (EPS): Net Income / Weighted Average Shares Outstanding

-Dividends per Share: Total Dividends Paid / Number of Shares Outstanding

Payout Ratios:

-Dividend Payout Ratio: Dividends per Share / Earnings per Share

-Retention Ratio: (Net Income - Dividends) / Net Income

Learning and understanding these ratios can empower financial professionals like you to make informed decisions and optimize business performance.

Two basic techniques are used in Corporate Finance.

One is the ratio analysis of financial statements, and the other is calculating the present value of future cash flows.

Bankers, investors, financiers, CFOs, and entrepreneurs use these tools and techniques to value assets and make decisions. 

This section will look at using financial ratios as a capital budgeting, analysis, and allocation tool. There are lots of different accounting ratios that get used inside a firm.   

By ratio analysis, I mean taking two numbers from financial statements and dividing one by the other. So we are taking two pieces of accounting data, putting one over the other, forming a ratio.

We are taking two pieces of data and creating a performance metric. Ratios are presented as a percentage or a number depending on whether the usual case is bigger or less than one. 

Ratios are a performance analysis tool. Ratios allow us to compare different companies or a company over time.

Ratios are great tools to make this comparison because they enable us to “normalize” the numbers. A ratio eliminates size differences and allows for pure comparison to compare apples to apples. 

Financial ratios are derived from accounting information and rely on understanding financial statements.

Financial Ratios Handbook

This compilation includes:

Profitability Ratio

A. Return

Return on Equity

Return on Assets

Return on Capital Employed

B. Margin

Gross Margin Ratio

Operating Profit Margin

Net Profit Margin

Leverage Ratio

Debt-to-Equity Ratio

Equity Ratio

Debt Ratio

Efficiency Ratio

Accounts Receivable Turnover Ratio

Accounts Receivable Days

Asset Turnover Ratio

Inventory Turnover Ratio

Inventory Turnover Days

Liquidity Ratio

A. Asset

Current Ratio

Quick Ratio

Cash Ratio

Defensive Interval Ratio

B. Earnings

Times Interest Earned Ratio

C. Cash Flow

Times Interest Earned (Cash Basis) Ratio

CAPEX to Operating Cash Ratio

Operating Cash Flow Ratio

Valuation Ratio

A. Price

Price-to-Earnings Ratio

B. Enterprise Value

EV/EBITDA Ratio

EV/EBIT Ratio

EV/Revenue Ratio

Financial Statement Analysis and Ratios

Accounting and Finance overlap in this area.  The launching place for Corporate Finance is the ability to read and understand Financial Statements. The analysis of financial statements and subsequent assumptions and projections based on that analysis is the next step. 

Financial Statement Analysis is the process of analyzing a company's financial statements and comparing the analysis across companies and industries in order to make better operating and investing decisions. This analysis method involves specific techniques for evaluating and quantifying risk, performance, financial health, and the future prospects of an enterprise. 

We can look at the performance of a particular company over time such as year to year results.  This is called Horizontal Analysis. 

And we can look at various performance characteristics within a single time period. This is called Vertical Analysis. 

We can create metrics across an industry segment as an average value to compare our company against.  This is called Benchmarking.  We can also aggregate up different industry groups and see how they perform relative to each other.  This type of analysis can be helpful in gauging where to allocate investment dollars in a portfolio.  It can also be used to see how a management team is performing relative to its competition.    

Financial Ratio Analysis

A complete guide

Here's what you will learn:

- Introduction to Financial Analysis

- Different types of Financial Ratios

- Using Financial Ratios for Analysis

- Limitations of Financial Ratios

- Advanced Financial Analysis

- Pitfalls of Financial Ratios

And much more!

Key Financial Ratios

Here's everything you need to know:

Balance Sheet Ratios

You want to invest in companies that are in good financial shape.

• Interest Coverage

• Net Debt/Free Cash Flow

• Goodwill/Assets

Capital intensity

The lower the capital intensity, the better

• CAPEX/Sales

• CAPEX/Cash from Operations

Capital Allocation

Capital allocation skills are the most critical task of management.

• Return On Equity (ROE)

• Return On Invested Capital (ROIC)

• Return On Capital Employed

Profitability

The higher the profitability, the better

• Gross Margin

• EBIT Margin

• Free Cash Flow Margin

Dividend

You want a company's dividend to be gradually increasing and robust.

• Dividend yield

• Payout ratio

Valuation

The cheaper you can buy a company, the higher your margin of safety

• Price-to-earnings ratio

• Free Cash Flow Yield

How to analyze a business, FAST:

Study these 12 accounting ratios.

PROFITABILITY RATIOS

→ Gross Profit Margin = Gross Profit ➗ Sales

→ Operating Margin = Operating Profit ➗ Sales

→ EBITDA Margin = EBITDA ➗ Sales

→ Net Profit Margin = Net Income ➗ Sales

RETURN ON CAPITAL RATIOS

→ Return on Equity = Net Income ➗ Total Equity

→ Return on Assets = Net Income ➗ Total Assets

→ Return on Capital Employed = EBIT ➗ (Total Assets - Current Liabilities)

→ Return on Invested Capital = NOPAT ➗ Invested Capital

LIQUIDITY RATIOS

→ Current Ratio = Current Assets ➗ Current Liabilities

→ Cash Ratio = Cash & Cash Equivalents ➗ Current Liabilities

FINANCIAL LEVERAGE RATIOS

→ Debt Ratio = Total Debt ➗ Total Assets

→ Debt To Equity Ratio = Total Liabilities ➗ Total Equity

DIVIDEND POLICY RATIOS

→ Payout Ratio = Dividend Per Share ➗ Earnings Per Share

→ Dividend Yield = Dividend Per Share ➗ Share Price

Notes:

EBT = Earnings Before Tax

EBIT = Earnings Before Interest & Taxes

EBITDA = Earnings Before Interest, Taxes, Depreciation & Amortization

NOPAT = Net Operating Profit After Tax

What ratios do you look at the most?

Vertical and Horizontal Analysis

Vertical and horizontal analysis are techniques used in financial statement analysis to assess

• a company's performance,

• financial health, and

• to compare it with other companies or

• its historical performance.

Here's a detailed breakdown of their professional differences:

Definition:

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It involves expressing each item on a particular financial statement as a percentage of a base figure.

For example, each line item (like Cost of Goods Sold or Operating Expenses) can be presented as a percentage of total revenue on an income statement.

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Evaluates changes in financial statement numbers across multiple periods.

It looks at the amount and percentage change from one period to the next.

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Provides insights into the structure of assets, liabilities, and equity OR the composition of revenues and expenses.

It helps in understanding the relative proportion of each component.

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It helps to identify trends over time.

Aids in determining if certain financial metrics are improving or deteriorating over time.

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Each item is compared to a single item within the same period. For instance, on a balance sheet, all accounts might be represented as a percentage of total assets.

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Items are compared to the same item from a previous period.

In this lecture I show you a spreadsheet with Financial Statements and we calculate and discuss financial ratios.   Download the spreadsheet in order to get better insight into the calculations and how financial statements interconnect and flow.

Horizontal and Vertical Analysis

Horizontal analysis compares financial information over time, typically from past financial statements such as the income statement. When comparing this past information we look for variations of particular line items such as higher or lower earnings, sales revenues, or particular expenses. Horizontal analysis is used to look for trends that can be extrapolated in order to predict future performance.

Vertical analysis is a proportional analysis performed on financial statements. It is ratio analysis. Line items of interest on the financial statement are listed as a percentage of another line item. For example, on an income statement each line item will be listed as a percentage of Sales.  

Financial Ratios

Financial ratios are powerful tools used to assess company upside, downside, and risk. There are four main categories of ratios: liquidity ratios, profitability ratios, activity ratios and leverage ratios. These are typically analyzed over time and across competitors in an industry. Using ratios “normalizes” the numbers so you can compare companies in apples-to-apples terms.

Liquidity and Solvency

Solvency and liquidity are both refer to a company’s financial health and viability. Solvency refers to an enterprise's capacity to meet its long-term financial commitments. Liquidity refers to an enterprise’s ability to pay short-term obligations. Liquidity is also a measure of how quickly assets can be sold to raise cash.

A solvent company is one that owns more than it owes. It has a positive net worth and is carrying a manageable debt load. A company with adequate liquidity may have enough cash available to pay its bills, but may still be heading for financial disaster down the road. In this case a company meets liquidity standards but is not solvent. Healthy companies are both solvent and possess adequate liquidity.

Liquidity ratios are used to determine whether a company has enough current asset capacity to pay its bills and meet its obligations in the foreseeable future (current liabilities).  Solvency ratios are a measure of how quickly a company can turn its assets into cash if it experiences financial difficulties or is threatened with bankruptcy. Both measure different aspects of if, and how long, a company can pay its bills and remain in business.

The current ratio and the quick ratio are two common liquidity ratios. The current ratio is current assets/current liabilities and measures how much liquidity (cash) is available to address current liabilities (bills and other obligations).  The quick ratio is (current assets – inventories) / current liabilities.  The quick ratio measures a company’s ability to meet its short-term obligations based on its most liquid assets, and therefore excludes inventories from its current assets. It is also known as the “acid-test ratio.”

The solvency ratio is used to examine the ability of a business to meet its long-term obligations. Lenders and bankers most commonly use the solvency ratio because they are most concerned about their ability to get paid back any money they lend. The ratio compares cash flows to liabilities. The solvency ratio calculation involves the following steps:

All non-cash expenses are added back to after-tax net income. This approximates the amount of cash flow generated by the business. You can find the numbers to add back in the Operations section of the Cash Flow Statement.

Add together all short-term and long-term obligations.  This is the Total Liabilities number on the Balance Sheet. Then divide the estimated cash flow figure by the liabilities total.

The formula for the ratio is:

(Net after-tax income + Non-cash expenses)/(Short-term liabilities + Long-term liabilities)

A higher percentage indicates an increased ability to support the liabilities of a business over the long-term. Acceptable solvency ratios vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. 

Remember that estimations made over a long term are inherently inaccurate. There are many variables that can impact the ability to pay over the long term. Using any ratio to estimate solvency needs to be taken with a grain of salt.

Return on Invested Capital  ROIC

Return on invested capital (ROIC) measures a firm's profit over the typical cost of the debt and equity capital it uses.

The value of other businesses can be determined using the return on invested capital as a benchmark.

The efficiency with which a company directs the funds under its control toward successful investments or projects is measured by its return on invested capital (ROIC). The ROIC ratio demonstrates how effectively a business generates returns from its capital (equity and debt). Investors determine the effectiveness of a company's use of invested capital by contrasting its return on invested capital with its weighted average cost of capital (WACC).

Calculate ROIC as EBIT/(debt + equity)

ROIC stands for Return on Invested Capital. ROA stands for Return on Assets. ROA tells us how efficiently a business uses its existing assets to generate profits. ROIC tells us how effective a business is in re-investing in itself.

ROCE Explained Simply

ROCE = Return on Capital Employed

It's a ratio that measures how efficiently a company uses its equity and debt to generate profits.

ROCE Formula:

EBIT / Capital Employed

Capital Employed = Average Total Assets - Average Current Liabilities

This represents the long-term funds used in the business by both creditors and owners.

When to Use ROCE?

Utilize ROCE when evaluating the efficiency of companies within the same industry.

It's particularly useful in capital-intensive sectors like manufacturing or utilities.

Pros of ROCE:

• A broader measure of capital efficiency.

• Simple to calculate and understand.

• Useful for capital-intensive industries.

Cons of ROCE:

• Can be skewed by high debt levels.

• Neglects timing of cash flow.

• Not reliable when comparing companies in different industries.

Things to Be Aware Of:

• Inconsistencies in definition

• Sensitivity to short-term fluctuations

• High debt levels distorting results

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ROE measures how much profit a company generates with shareholders' invested money. It's a key indicator of financial health and shareholder value.

???????: ROE = Net Profit / Shareholders' Equity

Details:

• ????????? ??? ?????? ?? ??? (?????? ????? ???): Reflects the actual profit earned by the company after all expenses and taxes.

• ??????? ??? ?????? ????????????: Individuals or entities that own shares in the company, representing their stake.

• ???????: Effective management of equity financing is crucial to fund operations and grow the company.

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ROCE measures how efficiently a company can generate profits from its capital employed, providing insight into the profitability and efficiency of capital use.

???????: ROCE = EBIT / Total Capital Employed

Details:

• ????????? ????????? ?????? ?? ???? (???????? ?????? ???????? & ?????): Earnings from the company's core business operations.

• ??????? ??? ???????????? (?????? + ????): Includes both shareholders and debt holders who have provided capital to the company. –

• ???????: Efficient utilization of total capital mirrors the company's long-term asset management effectiveness.

??? ?????????: ROE and ROCE are crucial metrics for assessing a company's ability to generate returns.