PRE-READ BASIC ACCOUNTING

Agenda
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Balance sheet Income statement Links across financial statements Cash flow statement Ratio analysis

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Balance sheet overview

Sources and uses of funds Sources and uses of funds Notes Notes

Assets = current + non-current assets Current assets are expected to turn into cash within a

Liabilities Assets Equity

year or used up within a year e.g. cash, accounts receivable, inventories

Non-current assets are expected to be useful for

longer than a year e.g. Property, plant & equipment (PP&E), investments
Liabilities = current + non-current liabilities

Uses of funds

Sources of funds

Current liabilities are due within a year

e.g. accounts payable, loans

Non-current liabilities are obligations that are

expected to last longer than one year e.g. long-term debt

Assets = Liabilities + Equity

Equity has two main elements Paid-in capital Retained earnings

BALANCE SHEET

Assets - major accounts

Driven by i) companys credit management, ii) proportion of credit sales to total sales and iii) selling conditions in the industry Accounts receivable days = account receivable/sales * 365

Accounts receivable

Represents number of days between the sale and receipt of cash Less accounts receivable = fewer assets to fund

Consists of i) raw materials to be used in production process, ii) products in

Inventories

production process that are incomplete and iii) finished products ready for sale
Inventory days = inventory/COGS * 365 Represents number of days for inventory days to move through a business Less inventory = fewer assets to fund

BALANCE SHEET

Assets - major accounts (contd)

PP&E / Fixed assets

Includes buildings, machinery, land, cars, office equipment, etc. PP&E is recorded on the balance sheet at its original cost and is then depreciated Terminology: Gross PP&E = Original cost of assets Net PP&E = Gross PP&E - accumulated depreciation Depreciation records wear and tear on fixed assets in a given year

Different depreciation methods Accumulated depreciation = total value used up so far

BASE analysis: A: Capital expenditure (Capex) refers to the additions to the PP&E account S: Depreciation S: Sale of fixed assets Goodwill refers to the excess of the purchase price over the net assets of the

Intangibles
BALANCE SHEET

target that the Company is acquiring

Other intangibles include: patents, franchises and licenses The depreciation of intangibles is called amortization

Liabilities - major accounts

Bills owed to other people, usually for inventory purchased on credit Typically interest-free -> cheaper source of funding Driven by credit terms the company can get from suppliers Accounts payable days = account payable/COGS * 365

Accounts payable

Represents number of days between the payment to suppliers and receipt of raw materials More accounts payable = cheaper source of funding

Borrowers receive cash when they raise money and pay out cash either as interest

Debt

or principal1 during the life of the loan

Unlike equity, debt funding must be paid back. Companies are legally obliged to

pay the interest and principal due to debt holders

Equity that belongs to the shareholder's! Equal to Total Assets less Total Liabilities Consists of two key pieces: Paid-in capital (also called Common stock) and
BALANCE SHEET

Shareholders equity

Retained Earnings
Paid-in capital is the money invested initially in the business, while retained

earnings is the money re-invested in the business

We will solve an example at the end of this section
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Refers to the money to be paid back when the loan is due. Also known as the face amount of the loan

Other basic concepts

A Balance sheet will always balance! Hence, each transaction must be duly recorded and will impact both the liabilities/equity and

the assets

BALANCE SHEET

Balance sheet concept - Debt

BASE analysis is applicable to Debt as well B: Beginning balance of debt A: (+) Interest accrued and Additional debt taken S: (-) Payments made (Principal and Interest) E: Ending balance

BALANCE SHEET

Agenda
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Balance sheet Income statement Links across financial statements Cash flow statement Ratio analysis

1 9 2 14 3 18 4 24 5

PRE-READ BASIC ACCOUNTING TRAINING

Income statement overview

Sales Costs of goods sold (COGS) Sales, general and administrative costs (SG&A) Other income Other expenses Interest income or expense Tax
INCOME STATEMENT

Sales made in the whole accounting period Production expenses generated by sales Overhead expenses during the whole period Non-operating income for the whole period Non-operating expenses for the whole period Income from cash and investments or the cost of debt for the whole period Tax provision estimated tax amount that have to pay on the periods profit Net income (income after all expenses) generated over the whole period

Net income

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Income statement specifics

COGS tend to fall and rise with the level of sales
Costs of goods sold (COGS)

Represents costs that are directly related to the manufacture of product

or service

Sales, general and administrative costs (SG&A)

SG&A costs tend to remain stable over time Represents costs and expenses that a company incurs to keep the organization

running
Includes other income and expenses that are not part of a companys daily

Other income and expenses

operations
E.g. Gain/loss on the sale of equipment, foreign exchange gains/losses

INCOME STATEMENT

Net income increases equity, not cash

Net income

Net income for a given period is recorded in the balance sheet as an increase

in retained earnings
Net income is not cash income - a company can recognize revenue before it

receives any cash, and it can record expenses before it pays out any cash

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Income statement specifics (contd)

Gross Profit

Gross Profit = Sales - COGS Measures the profitability of the production process

Operating Profit

Operating Profit = Sales - COGS - SG&A Reflects the profitability of the companys ongoing operations

Earnings before interest and taxes (EBIT)

Reflects the profitability of a companys normal on-going operations which excludes one time non-recurring changes, such as restructuring and extraordinary changes

INCOME STATEMENT

EBITDA

EBITDA = EBIT + Depreciation & Amortization (D&A) Excludes non-cash expenses - D&A to get closer to operating cashflow

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The matching concept

The income statement captures a sale when the product or service is delivered to the

customer. Cash may or may not change hands at this stage

Generally Accepted Accounting Principles or GAAP specify when a revenue can be recognized Examples:

Sales on credit? Revenue recognition for long term contracts?

The matching concept implies that the costs incurred to make sales for a particular period should

be reflected in that period itself

Example: If a retailer sold 20mm units in a quarter, the cost of the 20mm units, the rent for his

shop for that quarter and the salaries of store employees for that period should all be reflected in the income statement for that quarter

INCOME STATEMENT

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Agenda
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Balance sheet Income statement Links across financial statements Cash flow statement Ratio analysis

1 9 2 14 3 18 4 24 5

PRE-READ BASIC ACCOUNTING TRAINING

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Links - summary

Net income

Retained earnings

Revenue
LINKS ACROSS FINANCIAL STATEMENTS

Current assets

COGS

Inventories

Interest

Balance sheet

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Links - details
Net income <-> Retained earnings Net income <-> Retained earnings Revenues <-> Current assets Revenues <-> Current assets

Net income

Revenues

L A
LINKS ACROSS FINANCIAL STATEMENTS

L Current assets

Retained earnings

Base analysis B: Beginning balance (Retained earnings of

When customers pay on the spot, cash goes up When the company gives credit, accounts

previous period)
A: Additions during the period (Net income) S: Subtraction (Dividends) E: Ending balance (Retained earnings)

receivable (A/R) goes up

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Links - details (contd)

COGS <-> Inventories COGS <-> Inventories Interest <-> Balance sheet Interest <-> Balance sheet

COGS

Interest income and expense

L Inventories
LINKS ACROSS FINANCIAL STATEMENTS

Debt Cash and investments

When raw materials are purchased, they register as

The larger a companys outstanding loans, the

inventories
Inventories are used up (decreases) as the raw

larger its interest expense1

Conversely, the larger a companys interest-bearing

materials are converted to final products

In other words, as inventories decrease, COGS are

assets, the larger its interest income1

incurred (increase)

Assuming interest rates stay constant

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Agenda
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Balance sheet Income statement Links across financial statements Cash flow statement Ratio analysis

1 9 2 14 3 18 4 24 5

PRE-READ BASIC ACCOUNTING TRAINING

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Cashflow statement overview

Cashflow statement

Liabilities Assets

Operating activities

Cash

Equity

Investing activities Cashflow statements are important to financial analysts for two main reasons:
Companies can manipulate net income by changing their

Financing activities

accounting policies but they cannot manipulate cash flows

CASH FLOW STATEMENT

Financial analysts use cashflows in valuation and to measure

liquidity when assessing a companys credit risk

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Cashflow statement details

Operating activities

Anything that helps a company carry out its day-to-day activities, such as

making sales, purchasing supplies, paying bills to suppliers and paying salaries
Calculations Start with net income Add non-cash expenses like depreciation and amortization Subtract non-cash income Find changes in B/S accounts driven by operating activities e.g. A/R,

inventories, A/P, accrued expenses

Investing activities

Cash inflows: Sales of PP&E, sale of investments Cash outflows: Capex, purchase of investments

CASH FLOW STATEMENT

Financing activities

Cash inflows: Issuance of new debt, issuance of new stock Cash outflows: Repayment of existing debt, purchase of treasury stock, payment

of dividends

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Sample cash flows from operating activities

CASH FLOW STATEMENT

Class discussion: What does each item above imply? --- Increase in asset is use of cash, while increase in liabilities is source of cash.

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Sample cash flows from investing and financing activities (Nike Inc, contd)

CASH FLOW STATEMENT

Again remember, Increase in asset is use of cash, while increase in liabilities is source of cash Decrease in asset is source of cash, while decrease in liabilities is use of cash

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Checking net cashflow results

Calculate net change in cash from the balance sheet

Ending cash - Beginning cash Net change in cash

This years ending cash balance Last years ending cash balance

Check net change in cash from the balance sheet against net change in cash from the cash flow statement
Balance sheet Net change in cash must equal Cash flow statement Net change in cash

CASH FLOW STATEMENT

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Agenda
Page

Balance sheet Income statement Links across financial statements Cash flow statement Ratio analysis

1 9 2 14 3 18 4 24 5

PRE-READ BASIC ACCOUNTING TRAINING

24

Ratio analysis
Profitability ratios Profitability ratios Leverage ratios Leverage ratios

Gross Profit margin = Gross Profit / Sales EBIT margin = EBIT / Sales EBITDA margin = EBITDA / Sales Net margin = Net income (NI) / Sales Return on Assets (RoA) = NI / Total assets Return on Equity (RoE) = NI / Shareholders

Total debt / EBITDA Total debt / (EBITDA - capex) Total debt / Shareholders equity Total debt / Total capitalization1

equity
Efficiency ratios Efficiency ratios Coverage ratios Coverage ratios

Accounts receivable days (AR / Sales * 365) Inventory days (Inventory / COGS * 365) Accounts payable days (AP / COGS * 365)
RATIO ANALYSIS

EBIT / interest EBITDA / interest (EBITDA - capex) / interest

Total capitalization = Total debt + shareholders equity

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