In order to manage a business effectively from the financial perspective, it is always important to measure: (1) how many assets there are; (2) how much profit is being generated; (3) when the cash is coming in, and (4) how it is being spent.
Accounting is nothing more than the measurement of these processes to reflect what has happened to a business over a relevant period of time. The asset piece is measured by the Balance Sheet, whilst the profit and cash pieces are measured by the Income Statement / Profit and Loss Account and the Cash Flow Statement respectively.
A good financial analyst should be aware of these simple facts, which are essential for any financial modeling exercise. We provide a primer on basic accounting principles in this article. Also read the Glossary of Accounting Terms for a run-down on the key terms and terminology used in accounting.
The Income Statement / Profit and Loss Account
The income statement / profit and loss account measures the sales made and the costs incurred over a particular time period. For external reporting this is usually for a year but internally most businesses will prepare their income statement / profit and loss account on a weekly or a monthly basis.
The income statement / profit and loss account captures a sale when the product or service is delivered to the customer. Cash may or may not change hands at this stage.
Costs are recorded in the income statement / profit and loss account to reflect the costs of making the sales during that time period. This is called the matching or accruals concept. This concept states that the costs recorded must match to the sales made in the relevant time period.
Although the jargon in an income statement / profit and loss account may vary (especially from country to country) the costs are always deducted from sales in order of how closely they relate to the sale itself. The order that cost deduction appears is therefore:
- Cost of product sold
- Sales, general and administration costs
- Interest expense
- Tax expense
After costs are deducted from sales, we are left with the bottom line profit (also known as the net income or profit after tax) which belongs to the shareholders, and consequently is reflected as part of shareholders’ equity on the balance sheet.
The Balance Sheet
The balance sheet shows the position that the business is in at the end of the relevant time period. It shows the assets the business has, its liabilities, and the amount of equity belonging to the shareholders. The reason it is called the balance sheet is because total assets must equal liabilities and shareholders’ equity as illustrated below:
Assets = Liabilities + Shareholders’ Equity
The 2 sides of this equation must always equal or balance.
The liabilities and equity section shows where the business gets its funds and the assets section shows how those funds have been used.
The assets section is generally divided into 2 sub-sections, showing the short term and long term assets. In this context, a long term item is one whose life in the business is expected to be longer than 1 year.
Examples of long term or fixed assets include:
- Plant and machinery
- Financial investments that are to be held for the long term
Short term assets are those whose lives are shorter than 1 year and include:
- Inventories or stock
- Account recievables / debtors (when credit is given to customers)
- Financial investments that are to be held for the short term only (i.e. less than 1 year)
Liabilities are also broken down into short and long term items. Short term liabilities include:
- Accounts payable / creditors (when credit is taken from suppliers)
- Income taxes payable
- Short term borrowings (where the repayment date is within 1 year)
Long term liabilities include borrowings where the repayment date is longer than 1 year from the balance sheet date.
Shareholders’ equity is made up of 2 key pieces. The capital piece represents the shares bought by the investors when the business was set up. This represents the cash that was physically given to the business by the investors, i.e. shareholders. The 2nd (and often more significant) piece is retained earnings / profit and loss reserve. This is the cumulative profit earned that has not been paid to the owners in dividends but has been re-invested in the future growth of the business instead.
The Cash Flow Statement
The final area is the cash flow statement. This shows how cash has been generated and used over the relevant time period. Most cash flow statement styles will present the flows of cash using 3 main categories:
- Operating cash flows
- Investing cash flows
- Financing cash flows
Operating cash flows will include the flows from the core operations of the business and is driven by trading. Investing cash flows deal with any investments in the future of the business. Any new plant and equipment would be included in this section. And finally the financing section deals with any investments made by shareholders and any dividends paid to them. Any new borrowings or any repayments of existing loans would also be shown in this section.