financial reporting 101, understanding financial reporting basics and fundamentals

so what is a financial statement it’s not actually rather for documents the primary purpose of those documents is to summarize the financial information of a company and comply with the law by providing an honest and transparent view of the financial situation and performance of that company as a company is a complex thing to summarize it cannot be done on a single document and this is why four documents are needed the balance sheet the income statement the cash flow statement and the statement of changes in equity those four documents serve the objective of looking at the finances of the company from four different angles to give the reader a complete and well-rounded view of the financial situation and performance of the company it is also a mean of facilitating the exchanges between all the stakeholders by providing a common framework to report vital information about the company the balance sheet summarizes what the company owns to judge the value of its properties machinery or any other asset and what he owes or in other words any liability it has to third parties such as loans from the bank for example the income statement which is also commonly called the P&L for profit and loss summarizes the financial performance of the company covering cells expenditures and ultimately the profitability of the company the cash flow statement serves a different purpose focusing on cash sold early and therefore very short-term focused it records how cash enters and exits the bank accounts as we will see further on cash management is what makes or breaks a company it therefore deserves its own document the last document is the statement of changes in equity which records changes in company ownership between shareholders this document is important but not key to understanding financial performance we will therefore not discuss it further at this point it is sufficient for you to know that it exists a very important point to note is that financial statements focus on the past performance of the company sometimes companies can decide to add comments or documents that offer an opinion on future trends or performance those documents are added to the financial statement core financial statement documents find their source soul early in past activity and report what has already happened you so who our financial statements useful to as financial statements give a complete view of the financial situation and performance of the company it is used by many stakeholders as the basis for deciding if they should start stop or continue doing a business with the company the most common stakeholders that have a need for financial statements are banks capital investment firms individual investors company managers customers suppliers and tax authorities let’s talk about banks let’s say for example that you are the owner of an ice cream shop and that you decide to purchase a new ice cream production machine which costs around twenty thousand dollars you decide to ask your bank for a loan your banker is going to be concerned with your solvency in other terms before granting you the loan he would want to confirm that you are going to stay in business long enough in that you can generate enough profits to repay the loan all the elements needed to answer those questions are included in financial statements another example is in the field of capital investment if for say you’re looking to invest in a business or if investors are looking to put money into your company in both cases someone needs to appraise the value of a company to determine how much it is worth financial statements play a big role in such an endeavor to illustrate this just think of it as if you were looking to expand your business by acquiring one of the competing ice cream shops in town looking at its financial statement would enable you to understand how the company has been faring and start evaluating how much it is worth now company managers also have a need in using financial statements whether there are general managers finance sales marketing managers or managers from any other department the use on a regular basis the documents contained in financial statements to take day-to-day decisions even if some of them don’t know that they do as any action that has a financial impact is recorded on one or more of those documents it gives them the ability to analyze past performance to understand if there are areas that are under forming it therefore gives them the ability to put in place corrective actions if we go back to our ice cream shop example we could look into our income statement to see if the company is generating more sales than expenditures and see if it is profitable if it is not the case it gives us the ability to investigate if the issue is coming from insufficient cells or from an excess in spends sales managers for example are usually very interested in income statements as it is the base is used to set their targets and measure their attainments general managers use those documents to answer strategic questions such as our sales growing are we profitable can we be more profitable have we invested too much or not enough are we getting good enough payment terms from our vendors or are we collecting fast enough from our customers in short are we managing well the company and can we do better of course some of our partners such as suppliers and customers will also want to know if we are financially strong enough to work with them suppliers for example we want to know if they can trust us with large quantities of inventory customers on the other hand would want to know if we will be there to support them over the long run in our example we could imagine having to buy large quantities of milk every few days we could ask the milk producer for a 30-day payment term as it is customary for most businesses in essence we would be asking the milk producer to grant us a 30 days loan just as a banker would he would therefore want to verify our solvency before granting us that loan and finally tax authorities also have a need for financial statements in their case they would want to determine if the company has complied to all of its obligations financial statements contain all the information needed for them to make that call financial statements are documents that summarize all the activities of the company that have a financial impact and even small ones the source information of financial statements is the accumulation of all the day-to-day transactions of the company a transaction is a business event such as selling products paying salaries repaying loans and of the more infrequent and significant transactions such as buying an expensive piece of machinery buying property or acquiring a company all those transactions materialize into invoices paychecks loan repayments and so on all the transactions form the accounting journal this journal is the list of all the transaction that occurred over a given period of time you could therefore have a journal for January for February for March and so on you could have a journal for the full year as well which would seem to be the aggregation of the monthly journals then those transactions are categorized based on their nature and the type of money they represent such as revenues costs taxes and so on the transactions are assigned to account where each account covers a single type of transaction account starting with a1 our four assets to our four liabilities three is for equity four is for revenue five is for cogs six for expenses seven for taxes eight for other items those accounts are then summarized in the ledger the ledger is just the summary of all the accounts of the company which in turn summarizes all the transactions of the company each account is specific to one of the financial documents that we will be learning about here balance sheet accounts are the ones starting with 1 2 & 3 & income statement accounts start with 4 5 6 7 & 8 this categorization serves the purpose of giving clarity to what each dollar represents it is very close to you putting money on the side to buy a present well here it’s the same some money is due to the tax authorities some money is due to the shareholders or to suppliers so by keeping each doll in a separate account a business leader can quickly know what is due to whom including to himself to summarize it all starts with a business activity such as selling a product which is a transaction that transaction is recorded in the journal of this month it is then split into its considering elements which are Revenue taxes and cogs which are then reported into separate accounts those accounts are reported in the ledger which is then the source of our financial documents so where can you find phone your statements depending on what you’re trying to achieve financial information such as financial statements will be found in different places if found at all let me explain myself not every company has to publicly share its financial statements actually only public companies do that means that if you’re looking to analyze a public company it should be fairly easy for you to do so the Securities and Exchange Commission the SEC gives free access to its database of financial information published by public companies the database is called Edgar and is accessible online you can simply look it up on Google in the database you should be able to find the latest documents with any number of other documents and information for privately held companies it is more difficult as there is no legal obligation to communicate financial documents it then faced three situations either you’re part of that company and therefore can ask the owner or the accountant or the finance team to share with you those documents or your key stakeholders of that company such as a supplier or customer or an investor and can request the financial statements or you’re an individual that does not have a direct contact with the company or its management team and would like to analyze that company to perform for example a research on your competitors or to better understand your market in that case you will have to do intense research to piece together enough information to do that analysis you can also use websites easy to find on Google that provides an aggregation of information about companies and estimates about their financials just remember those are only estimates before we dive into the core content of this course I would like to issue a note of caution on the differences that exist between the accounting roles of countries and regions of the world countries have accounting rules that are specific to them those rules are not better or worse than our accounting rules they’re just different the result is that financial documents from different countries are not comparable an investor cannot take the financial statements of two companies from two different countries and do a line by line compare not only the lines and elements are different but even elements that hold the same name in those documents would not necessarily include the same things this is therefore not possible to compare them the principles don’t remain the same so you would need the help of someone with the local finance expertise to translate the documents into your definition of financial statements or learn by yourself those odds of standards you can understand then the complexity a company needs to go through when it opens offices in more than one country with the development of global companies and international trade there is work undergoing with the objective of finding a common ground on which to prepare financial statements over the past years the international financial reporting standards also called IFRS have been adopted by more than 90 countries for now the u.s. is not part of it so tread carefully with international documents as we briefly saw earlier the balance sheet is one of the three key documents that make up a financial statement every company has the obligation to produce a balance sheet at least once a year this document summarizes everything that the company owns and everything that it owes unlike the other two reports it is a snapshot of the company at a certain point in time meaning that if a balance sheet is prepared on the 31st of December it is reporting the situation for each category as of that day whether that snapshot is completely different from the picture the day before or the day later is inconsequential it is made of two sections called assets and total liabilities and equity the asset section is focusing on what the company owns it is the positive side of the balance sheet and it covers everything that has a tradable value such as cash property machinery or any money that is due to the company such as payments expected from customers if we go back to our ice cream shop example this includes any money that is on the bank account the ice cream production machines the furniture in the store and the store itself if the company was to own it the total liabilities and equity section is the flipside of the assets it is the negative side of the balance sheet and covers two areas the first one called liabilities sums up all the debts of the company for the ice cream shop it is the loan that was contracted to purchase new machinery or your furbish meant of the store or any payment that is due to suppliers the second section is called equity and is summarizing the accounting value of the company which is the accounting value of 100% of the shares of the company the asset section of the balance sheet as we saw previously is containing everything that the company owns it is the plus side or positive side of the balance sheet this includes a variety of elements they all have one thing in common they have a dollar value and can be turned into cash those elements are cash accounts receivable inventory prepaid expenses net fixed assets and other assets those assets are into two subcategories current assets which worked together all the assets that relate directly to the day-to-day activity of the company and fixed an other assets which are investments that have been made to enable such things as production or having office space those are necessary to make the company work but are not necessarily changing every year now let’s look at current assets current assets is a sub categorization of assets which groups to gather all the assets that relate directly to the day-to-day activities of the company any event in the life of the company that influences positively and increases its finances and is short-term in nature is going to be a current asset generally the current assets category encompasses all the assets that serve their purpose within the year let’s start with cash this is a very straightforward category as it is equal to the sum of all cash that is available on the bank account of the company every time a customer makes a payment there is money coming to the bank and the cash of the company increases similarly the cash category of the balance sheet increases accounts receivable is the category for any money that is due to the company but has not been paid yet let’s look at a real-life example let’s imagine that the ice cream shop just received an order to deliver at the end of the month a large quantity of ice cream for a kid’s anniversary the total amount of that order is $500 the customer is requested to pay 30 percent of the order upfront in the remaining 70% on the day of the delivery in other words a hundred and fifty dollars today and three hundred and fifty dollars at the end of the month in our balance sheet we will record one hundred and fifty dollars in the cash category since it is received today and three hundred and fifty dollars in the accounts receivable category because this amount is due to the ice cream shop but has not been paid yet when the end of the month arrives and the three hundred and fifty dollars have been paid then we will subtract three hundred and fifty dollars from the accounts receivable category and add that amount to the cash category the next category is inventory this is everything that has been purchased to be either sold or transformed before it is sold for the ice cream shop any ingredient boat to prepare ice cream would be included in the inventory category such as milk fruits chocolate and much more those are included because once both they will be transformed to form an end product that will then be sold the ice cream shop is selling as well a wide range of soft drinks those are both already in their final form and will not be transformed still when those are purchased they are included in the inventory category so every time a soft drink is purchased by the ice cream shop let’s say for two dollars it is added to the inventory category until it is sold on the day it is sold the two dollars are taken out of the inventory category and added to the cash category if the payment has been received on the day of the sale or it is added to the account receivable category if the payment will occur later now let’s look at prepaid expenses it is a category that covers any service that has already been paid but has not yet been received examples are any deposits paid to companies salary advances to employees or pre payments as you can see current assets are relating to the core activity of the company selling products increasing inventory collecting cash we will speak again of current assets further on what we have learned about current liabilities and the concept of working capital next are categories of assets that are let’s say less current next fixed assets is a category that covers the property’s equipment and more generally anything that is necessary to run the business but does not vary with individual transactions you can find in this category 1 or more offices production equipment computers cars and so on of course to be included in the next fixed assets category any item must be fully owned by the company for example if the ICS is renting its stores it is then not the owner of the store in that case this is just a monthly expense the company and the store value cannot be included in the next fixed assets category we will see further on where it is recorded usually the next fixed assets category is divided into two subcategories the first one is called fixed assets at cost which reports the value of assets at the time of purchase the second is called depreciation the notion of depreciation is complex and important to understand a following video is therefore dedicated to the subject the last category of the asset section is other assets as its name indicates this category covers any asset that cannot be classified in the other categories a good example of other assets is intangible assets intangible assets are assets that do not have a physical presence such as patents copyrights brand names to name a few those assets can have a significant value without which the company would not operate normally or even would not operate at all they therefore need to be reported on the balance sheet as assets their value by the way is very hard to determine and usually the subject of debate a good example of intangible assets is the brand name of well-known companies think about a large soda company which sells millions of drinks thanks to its brand name without that brand name sells would plummet instantly it is therefore of high value and needs to be reported on the balance sheet in the other asset category a concluding note on the order in which cash accounts receivable inventory prepaid expenses next fixed assets and other assets are categorized in the balance sheet at the top you will find the categories that are the easiest to turn into cash there are also called liquid assets liquid means that it is easy to trade the categories are then organized from the most liquid to the least liquid cash of course is the most liquid accounts receivable is cash that should be received soon therefore its liquid but less than cash same goes for inventory the last category net fixed assets is the most difficult to turn into cash and therefore it appears at the bottom of the asset section the purpose of depreciation is to account for fixed assets related expenses in a way that is relevant to its contribution to the business activity and not to evaluate the current value of assets you therefore need to use it as such to understand depreciation we first need to look into how the acquisition of fixed assets is accounted for in a company books when an acquisition is made for a 1 million dollar piece of equipment for example it is treated in two different ways in the company books the two treatments are from a cash standpoint and from a profit standpoint the first treatment is from a cash standpoint if the equipment was purchased with cash then the total cost of that equipment is subtracted from the cash of the company right away that makes sense since the money was spent it needs to be taken out of the bank account and therefore to reduce the cash category of the balance sheet but that same expense is not accounted for the same way when it comes to calculating the profitability of the company as we will see when we will deep dive into the income statement sales or revenue need to be accounted for with these corresponding costs in other words if you need to spend money to make a sale you need to report the revenue from the sale and the corresponding spends at the same time so when you buy a 1 million dollar piece of equipment that is going to be used for 10 years to produce goods the accounting standard requires you to account for that equipment every year during its useful life that’s called depreciation that means that if you use a straight-line depreciation for a 1 million dollar piece of equipment with a useful life of 10 years you will account in the company books an expense of 100,000 dollars every year for 10 years in the balance sheet this will represent the loss of value in the accounting books of the company also called Book value that is recorded over time to be concrete after three years the balance sheet will be showing $1,000,000 in fixed assets at cost since it was the value at which the equipment was purchased and $300,000 in depreciation $100,000 per year the next fixed assets will show a total of seven hundred thousand dollars which is the original value of the asset less the depreciation as said at the beginning of this video the purpose of depreciation is to account for fixed assets related expenses in a way that is relevant to its contribution to the business activity and not to evaluate the current value of assets you therefore need to use it as such while the concept of depreciation is necessary for the evaluation of profitability it is not always a good measure of the value of assets and therefore needs to be used with care some goods such as computers for example lose value over time after one year a computer can lose as much as half of its value therefore accounting in the balance sheet that it loses 1/3 every year for 3 years can be a realistic measure on the other hand some assets have a value that increases over time and in that case next fixed asset value of that asset will not be a good representation of its real value for example a property can see its value increase over time due to increased demand for it its value in the balance sheet will decrease over its 30 years of useful life while it’s real value would increase the liabilities in equity section covers everything that the company owes to banks for example or suppliers employees and so on in other terms this is on the debts that the company has equity is the debt that the company has to its shareholders it is very unique type of debt and therefore has its own section in the balance sheet the equity section contains two categories retained earnings and capital stock the liabilities section covers all the other debts that the company has such as accounts payable accrued expenses current portion of that income tax is payable and long-term debt as for the asset section it is separated into current liabilities and long-term liabilities everything that is affecting the company within the year following the day on which the balance sheet has been prepared is reported in the current liabilities section the rest is considered long-term liabilities are all the debts that a company has whether it is a loan from a bank a payment that is due to a supplier or a salary due to an employee as long as it is some form of a debt it will be recorded as a liability liabilities are reported just as assets in two categories current liabilities and long-term liabilities again just as for assets the current liabilities are the ones affecting and being affected by the daily activity of the company current liabilities include accounts payable accrued expenses current portion of debt and income taxes payable let’s look at those one by one let’s start with accounts payable this category is for any debt that is due to suppliers just as we had an accounts receivable category in the asset section for money due from customers this section is for money that the company owes to its suppliers most companies negotiate payment terms and will receive from their suppliers the possibility of paying a certain number of days after having purchased a good or a service the most common payment terms are prepaid which means the company needs to pay its suppliers before the good is shipped or service is rendered and 30 days net which means the company can pay 30 days after the invoice date during the time between the purchase and the payment the money due to the supplier will have to be put on the side it will be reported in the accounts payable category for example let’s say the ice cream shop decides to purchase on the 15th of April new tables and chairs for its storm to make it nicer for a total value of $3,000 let’s say as well that is supplier a furniture store agrees to give the ice-cream shop a 30 days net payment term that means that even though the order was placed on the 15th of April no payment will be made until the 15th of May on the 15th of April even though the payment is not due for another month the ice cream shop will have to put the money on the side until the payment is made during that time the money will be placed in the accounts payable category now income tax is payable income tax is payable is again a debt but this time to the tax authorities company taxes are paid every three months there is therefore a time difference between the moment that a profit is made and the time the taxes are paid during that time the tax money is put on the side in the income taxes payable category on the day of the payment that amount is taken out of that category since the debt then no longer exists next in line is accrued expenses accrued expenses is reporting any money that is due to stakeholders other than suppliers as we saw earlier suppliers have their own category for that type of debt which is accounts payable for example an employee is one of the stakeholders that can be covered by this category let’s say the ice cream shop has a bonus plan in place to motivate its employees to sell soft drinks and let’s say the bonus is paid only once a year let’s imagine then that John an employee of the ICS has made a terrific job selling soft drinks and by April has already earned $500 worth of bonus as the bonus will be paid only at the end of the year the ice cream shop accountant will have to put those 500 dollars on the side for later payment until the end of the year the $500 will be placed in the accrued expenses category the last category of current liabilities is current portion of debt this category is for the portion of loans that is due within the coming 12 months to be concrete if your company has a year alone in place and he needs to pay $5,000 per month for 48 months we will be reporting only the next 12 months in the current portion of that category in other words 12 times $5,000 the remaining 36 payments will be reported in the long-term debt category only the current portion of debt category will be reported in current liabilities the last liability category is long-term debt which we just saw it’s covering the portion of loans that is beyond the next 12 months equity is a category that covers yet another debt of the company that debt is specific in nature since it is a debt towards the owners of the company also called shareholders I remember that the first time I got introduced to the concept of equity being a debt I was really surprised the main reason was that for me if the company was mine there could be no debt between me and myself and in fact it’s not the case to understand the nature of equity it is important to understand that when a company is incorporated a new person is created in the legal sense at least the new person is called a juridical person and has a legal life of its own the company being a juridical person has rights obligations and responsibilities and as such has a life of its own separate from the person who raised it therefore when a company is incorporated it is a different person from yourself which poses the next key question what’s the relationship linking you to your company the link is the following when you erase a company you lend money to your company that new juridical person the company will use those resources to conduct its activities with the objective of generating a profit just as a bank lends you money that you pay back with interest you have landed money to your company that you will get back with interest as well the company owes you the initial investment plus compensation in accounting terms the capital you invested in the company is worth a certain percentage of the company and can go up to 100 percent of the company if you are the sole owner this capital is the equity since the company owes you that money it is indeed a debt towards you the shareholder you might ask what about the compensation well in accounting terms we call those dividends and if the company makes an annual profit you will get a share of it that’s the part of your compensation that relates to your investment that category is divided into two sub categories which are capital stock and retained earnings capital stock or common stock is the total amount that has been invested by the shareholders if three people bring two thousand dollars each to raise a company then capital stock is equal to $6,000 retained earnings is a category that reports the accumulation of all the profits that the company has generated when bills are paid with company money and not new loans the money comes out of the cash category on the assets side and correspondingly reduces the retained earnings category on the liabilities and equity side at the end of the year if there’s any profit left in the retained earnings category it is distributed as dividends to the shareholders if you ever wondered where the name balance sheet comes from the explanation is coming from the fact that the two key sections of the balance sheet assets and liabilities in equity must always be equal to each other or in other words be in balance if that is true it means that all the assets or everything the company owns must be equal to the total amount of what it owes the reason for that is that the company in itself being a Jordy Co person and not a physical person cannot ultimately own anything for itself it therefore does oh whatever it owns to someone else first it owes money to lenders as it has received cash from banks and other lenders a portion of what the company owns belongs to them at least until the loans have been repaid if anything left it is owed to the shareholders the true owners of the company and of its value there’s a formula that summarizes this well and it is assets is equal to liabilities plus equity another way to look at it is to say that if the owners of the company decide to sell all the assets and repay all the debts then any leftover money will belong to them in other words equity is equal to assets minus liabilities let’s take now some live examples to illustrate this important concept the first example if you put your own money into a startup company let’s say $10,000 in cash and make $25,000 out of it then you have more than doubled your money your equity is worth now $25,000 the same as your assets if we look at the asset formula you have now $25,000 of assets which is equal to zero liabilities plus 25,000 dollars of equity if we look at the equity formula $25,000 of equity is equal to 25 thousand dollars of assets minus 0 liabilities for our second example let’s say you borrow $10,000 and make $25,000 out of it then you truly made only $15,000 since ultimately you will have to repay the loan your assets are worth $25,000 your liabilities are worth $10,000 therefore your equity is worth $15,000 from an asset formula standpoint assets equal $25,000 which is equal to $10,000 of liabilities plus 15 thousand dollars of equity from an equity formula standpoint equity is equal to $15,000 which is equal to 25 thousand dollars of assets minus ten thousand dollars of liabilities as a third example let’s say you borrowed $10,000 and spend it all with no return then not only have you lost all the assets of the company but you will also most likely to repay the debt you have no assets left liabilities are $10,000 and therefore your equity becomes a negative $10,000 if we look at it from an asset formula standpoint assets is equal to zero which is equal to $10,000 of liabilities minus ten thousand dollars of equity from an equity formula standpoint equity is equal to minus ten thousand dollars which is equal to zero assets minus ten thousand dollars of liabilities now let’s take a few business situations and see how they impact the balance sheet let’s start with investing so you just decided to start a new company and to invest ten thousand dollars of your own money you put that money on the company bank account which dramatically increases the cash account on the asset side of the balance sheet by ten thousand dollars at the same time the company now owes you ten thousand dollars with therefore increased the capital stock category on the equity side by the same amount you actually need fifteen thousand dollars more to start your operations and ask the bank for a loan the loan is granted and you get fifteen thousand dollars more on your bank account again this gets added to the cash category of the balance sheet totaling now to twenty five thousand dollars you now have a new debt of fifteen thousand dollars and need to add it to the liabilities side the one you have contracted is to be repaid during the next three years you therefore put one third of that loan on the current portion of debt category this is the portion that could be repaid in the first year and the rest goes to the long-term debt category that money is needed to start production you therefore decide to use eight thousand dollars of that money to buy a piece of machinery you therefore paid those eight thousand dollars and reduce the cash category by that amount here you use it to buy an asset you therefore impact only the asset side of things the reduction in cash is here offset by an increase of the net fixed asset category your balance sheet is still in balance let’s get now into production now that you have your piece of machinery you need to buy raw material used another $2,000 on raw material which reduces further your cash if you remember he started with $25,000 and purchased equipment for $8,000 leaving you with $17,000 with that new spend you’re left with $15,000 again on the asset side of the balance sheet you have now $2,000 worth of raw material this raw material is in your inventory which therefore calls for increasing the inventory category by $2,000 with the raw material and machine you transform the material into a finished product ready to be sold this transformation will have no visual impact on the balance sheet but in the details the $2,000 of raw material will be replaced by $2,000 of finished goods let’s get now into selling so you’re now ready to sell goods to customers you sell them for $3,000 the customer requests to pay in 30 days and you accept the term the $2,000 inventory is now sold to the customer in the inventory category therefore goes back to zero the $3,000 are added to the accounts receivable category on the asset side the net impact on the asset section is an increase in $1,000 since you have sold for $3,000 goods that you paid for $2,000 you have increased the value of your assets and therefore the value of your company you can therefore increase retained earnings on the equity side of the balance sheet by $1,000 the balance sheet is again in balance 30 days later the customer pays the $3,000 bill so you can take out $3,000 from the accounts receivable category and increase the cash category by the same amount let’s get now into paying stuff the end of the month is coming did I tell you that you have one employee well you need to pay her or his salary of $1,500 which includes $300 of employee contribution and to which we need to add another $500 of employer taxes to do so we take out $1,200 from the bank account to pay the salary and reduce the cash category by that amount on the liabilities and equity side we increase the accurate expenses category by the $300 of employee contribution as well as the $500 of additional taxes to keep the tax money separate until the payment is made to the authorities the salary in taxes that you paid will then have to come off the retained earnings category the balance sheet is again in balance you the income statement is the second key document of the financial statement its purpose is to report on the business activity of the company to be more precise it focuses on the cells that have been made in the expenditures that have been necessary to fund the daily activities of the company and it concludes with the resulting profit or a loss that has been made this is the reason it is usually called the P&L where the P stands for profit and the L stands for loss the income statement reports on the business activity over a certain period of time which means that it will report all the cells and expenditures activity between a start date and an end date as an example the 2012 income statement reports all the sales and expenditures between the 1st of January and the 31st of December 2013 first quarter income statement could report the activity between the 1st of January and the 31st of March I’m saying could report as some companies have a fiscal year that starts at a different time than the 1st of January and their quarters are therefore not the same as the calendar year quarters the income statement has a set of categories that we will be reviewing individually those categories are revenue costs gross margin operating expenses operating income non operating income and expenses and net income now let talk about revenue so revenue or income or sales are all words that describe the same thing when a company wins new business it goes through a set of actions to fulfill the request of the customer and it results with an obligation for the customer to pay for the good or the services provided by the company revenue can have different names such as turnover or top-line that last name top-line comes from its position within the income statement as it is the first line of the income statement it’s the top line to understand what exactly revenue is it is important to understand the complete cycle of a sale the usual steps are an initial discussion between the company and the customer the company issues a quote to the customer with the price requested to render the service or provide the good negotiation between the customer and the company happens the final quote is sent to the customer the customer approves the quote the company sends an invoice to the customer the company ships goods or renders a service and the customer pays the invoice the last three steps sometimes happen in a different order depending on the situation the reason it is so important to understand the cycle of a sale is because that cell becomes revenue only when the invoice is issued before that time it’s just a discussion between the customer and there is no true commitment once the invoice is issued there’s a formal agreement between the company and the customer which would be followed by a payment in the shipment of goods or rendering of service in the example of the ice cream shop most of the steps happen even if they do in a very short period of time a customer enters the shop he checks out the ice cream prices on a board or on a menu he could ask for a discount but for a simple ice cream you might not accept to offer a discount and will confirm to the customer that the price will remain unchanged the customer can choose to accept that price in that case you will first prepare and provide the ice cream the customer will pay and you will give him a bill in the case of the ice cream shop you will have to wait until the last steps to account that cell in your revenue to link this back to what we have learned on the balance sheet once the invoice is issued and therefore the sale is made the customer either pays right away and the cash category increases or the customer is due to pay in the near future and in that case it’s the account receivable category that will be increased if it’s a good that has been shipped then the inventory category will decrease as soon as the good will come out of the inventory to be shipped to the customer so what’s the difference between revenue and cash the income statement reports revenue while the cash flow statement reports cash the big difference between the two is the payment as we have seen previously the generation of revenue occurs when the invoice is sent and until the payment is made a debt exists between the customer and supplier when you eat at a restaurant for example at the end of the meal the cheque is brought to you in accounting terms the restaurant gives you an invoice during the five minutes between receiving the cheque and paying it you actually owe money to the restaurant during those five minutes the restaurant has generated revenue equal to the amount of the check but no cash since you have not paid in accounting terms again the revenue is recorded right away on the income statement as revenue and in the balance sheet as accounts receivable if you remember this is the category for money owed by customers to the company at the end of those five minutes you pay the bill an hour longer indebted to the restaurant there is no change to the income statement but in the balance sheet the amount of the check is removed from the accounts receivable since your death has been repaid and that same amount is moved to the cash category the restaurant has now earned cash of course in this example it all happens in five minutes and in the company books it will be reported as having happened at the same time but companies have access to a large variety of payment terms which create a significant time difference between the invoice date and the payment date payment terms start with prepayment which require the customer to pay on the invoice date it can also have many forms such as Peyman 30 days after the invoice date called 30 days net 60 days after the invoice date called 60 days net at the end of the month called end of month on the 15th of the following month called end of month the 15 and so on there’s no limit to the creativity of companies when it comes to payment terms and it can go as high as 120 days after the invoice date in some countries this means that if your company has offered a 30 days net payment term to a customer you will have to deliver the good or render the service and wait 30 days after the invoice date to collect the money the money as we have seen is due to you on the invoice date but the customer owes you the money during those 30 days in essence you’re lending money to your customer for 30 days that also means that during those 30 days you will not be able to pay your bills with that money even though you earned it until it is paid to you in the income statement all the expenditures of the company are divided into two categories costs and expenses a company needs to spend money in order to operate on day to day basis does expenditures enable a wide variety of activities ranging from the fulfilment of customer orders to paying salaries furniture rent utilities and many more in the income statement the expenditures are divided into two categories to give the reader the ability to differentiate between the costs of products from the rest of the expenditures let me explain why with an example let’s imagine that the ice cream shop has been making good money for some time now and that the owner wants to stop renting its shop and buy it the ice cream shop owner will speak to its banker and because it is a well-managed company making good profits it will get a loan to buy that shop once the shop is purchased the ice cream shop will start repaying the loan on a monthly basis each month it will therefore be making less money since it has new expenditure to pay but if you step back and analyze the financial health of the ice cream shop would you say it’s not as we’ll manage the company as before because it’s making less money than in the past with no visibility on the details of white is making less money you could be tented to just conclude that the income statement has therefore a category for product related costs so that you can make the difference between how the business is run and how the company in general is run for our ice cream shop example you would therefore see that the money made from selling ice creams and other products is still the same and the company is as well-managed as it was in the past it’s making now less money than in the past due to an increase in expenditures that are not related to the business activity cost is the name of those expenditures that are related to products it is usually also called cost of goods sold or cogs for short what we mean by that is that to sell a product to a customer you need to put that product together there’s the raw material the machinery the salaries of workers in other words everything that we need to prepare that product for the ice cream shop this is the milk sugar eggs and many more ingredients it’s the cups in which you hand the ice cream to the customer is the paper napkins and anything that comes into the fulfillment of the orders of your customers as explained in a previous video the income statement is reporting the activity for a given period of time therefore the question of when to record the costs becomes important do you record the cost of producing goods at the time of production or do you do it at the time of the sale if you have produced a hundred pounds of ice cream in December 2012 do you record it in 2012 or do record in 2013 when the ice cream was actually sold the answer is an ambiguous it’s at the time of the sale in accounting we like to have our revenues and our costs reported together it’s interesting to note that you have produced that ice cream in December 2012 you have therefore already spent the money to buy all the ingredients and so forth but while you have spent the cash it is not yet the time to record the costs in a chanting terms in December 2012 it would mostly be the balance sheet that would be affected as cash would be spent to prepare an inventory of ice cream in other words the cash category of the balance sheet will decrease by the amount spent and that amount would be moved into the inventory category and to stay there until the ice cream inventory is sold when an ice cream is then sold we will record in the income statement the revenue and the cost associated with that sale if we go a step further in that logic the consequence on the balance sheet will be to decrease inventory for that ice cream we just sold an increase cash for the payment made by the customer of course we want to sell our products with a profit which means that the revenue of the sale needs to be greater than the cost of it if you follow me that means that the cash increase in the balance sheet will be greater than the decrease in inventory the net effect of that is that overall assets will be increased if you think about it it’s quite logical each time you make a profit your assets increase and the value of your company increases as well let’s make a pause here in the review of the income statement to define one of the most important concepts in Finance and maybe the most important for our discussion here profitability profitability is the difference between the money that comes into the company from sales and other money generating activities and the money that comes out of the company as expenditures in other terms to ask about the profitability of a company is the same as to ask if the company is making money is my company profitable is it making money if yes meaning if you generate more money from your business activities than you spend and you have money left in your pocket or rather in the company’s pocket then yes your company is profitable if not that means your company spends more money than it earns and it is therefore not profitable it is generating a loss this is a dire situation for a company to be in which requires immediate action to avoid bankruptcy in the income statement we calculate different types of profitability even though ultimate there is only one form of profitability which is the one that includes all revenues whatsoever and all expenditures whatsoever for us to understand the workings of a company and take actions that will help the company to progress positively there is a need to calculate other forms of profitability such as the profitability from production activities or the profitability from business activities and ultimately the overall profitability of the company the profitability from production activities is measured by the gross margin and focuses on your products or services the profitability from business activities is a bit wider in definition it is measured with the operating income it includes the gross margin plus operating expenses the last one and true profitability of the company is measured by the net income and is the one including all the elements above plus any remaining revenues or expenditures that are not related to the operations of the company we will be reviewing each one of those in the chapter ahead there’s a famous saying that goes like this revenue is vanity margin is sanity and cash is reality what it means is that however big the revenue of a company’s it gives no insight whatsoever on its financial health of course it’s impressive to be able to generate millions or billions of dollars in revenue but focusing only on that element is a dangerous game if the cost of running your business is as great as your revenue then the company generates no profit and the owners of the company the shareholders get no return for their investment even worse if there is a downturn in the economy as we’ve experienced in the recent years the company will then be the first one to be at risk of defaulting so this is why margin is sanity making sure you generate a profit is the guarantee that you’re not just working to pay the bills you actually generate extra money that can be used as a compensation for your investment such as dividends or reinvested in the development of your company as I’m sure you’re already got while cash in your pocket is reality let’s focus here on the cept of margin and more specifically cross margin gross margin is the result of the simple subtraction revenue minus costs so to have any gross margin you need to generate more revenue selling your products than you spend making them when you look at your revenue so lowly you can see if you’re progressing with sales increasing month over month or if you have a decrease and need to work on changing the trend but costs on their own are not necessarily a good measure either of how good your performance is costs could be increasing for many reasons such as increasing the cost of materials for the ice cream shop example that could be your milk increasing or simply because sales have gone up and you therefore have more ice cream out of your inventory this is our gross margin comes into play as gross margin is the combination of revenue and cost it gives you the ability to estimate if your overall business performance is good enough if an ice cream is sold for five dollars and if it costs three dollars to produce the near margin is $2 $5 – three dollars if you sell to ice cream the new revenue is ten dollars your costs six dollars and your margin four dollars in other words if each of your sales are generating margin than an increase in sales results in an increase in gross margin in our example when sales double margin doubles as well gross margin is usually displayed in two forms its dollar value as we’ve just seen in our example and as a percentage of revenue in this example the margin percent on an ice cream is calculated by dividing two dollars by five dollars which is equal to zero point four or forty percent if we calculate the margin percent for the two ice cream salt we divide four dollars by $10 and get again 40 percent and we could sell another a hundred I scream in our margin percent would still be 40 percent the benefit of tracking margin percent becomes obvious when complexity increases in a company in our example things are maybe too simple businesses have usually more than one product high margin products low margin products and sometimes cost of production increases because the price of ingredients increase or decrease because the company is now using more efficient machinery all those elements and actually many more will have an influence on the evolution of revenue and the evolution of costs and they will all be summarized in the gross margin percent if for example you sell an ice cream for five dollars with a soda for three dollars then your total sale would be eight dollars if the cost of making the ice cream is still three dollars and the cost of the soda is one dollar then the margin on your ice cream would be two dollars and on the soda would be two dollars as well the resulting total margin for the order would be four dollars in percentage terms the margin of the ice cream is still 40 percent when the margin of the soda is 67 percent the resulting margin is 50 percent if we compare that to our previous example we have generated less revenue going from ten dollars to eight dollars but we generated just as much margin the reason being that we sold this time to soda which is a higher margin product the overall result is a higher margin percent going from 40 percent to 50 percent the analysis of margin gives great insights into the performance of the company outside of showing of the company is making profits its evolution can be explained by a large number of factors that are affecting both revenue and costs it is by investigating those factors that we get a good understanding of what is working and what’s not working in the business performance of the company operating expenses also called up X are that second kind of expenditures those expenditures are key to the operations of the company but are not specific to products they include compensation and benefits for non product related staff marketing spends communication spends travel rent utility bills and so on added together with costs they form the expenditures of the company that are related to running the business operating income called as well up Inc is dressed as gross margin the result of a subtraction between revenue and expenditures the major difference with gross more is that it includes more expenditures as we have seen earlier gross margin is the difference between revenue and costs and is specific to the activities around selling products or services it is the production in a wide sense related profitability operating income is a wider type of profitability as it includes as well all the operating expenses it is therefore the profitability of running the business in a general term you can calculate it using one of the following formulas operating income is equal to revenue minus costs minus operating expenses or operating income is equal to gross margin minus operating expenses your production could be profitable but not your business for example setting ice cream could be profitable but not enough to cover all of the expenses of your business you could be selling ice cream for a higher amount of money than it cost you to produce it which would make it profitable from a production standpoint but you could have a reign that is too expensive or too many employees for a business of your size the result would be that your operating expenses would be using up all the profits generated with your production of ice cream and leaving your company with the loss in such a case you would have to consider either to increase prices generate more margin or share reduce your expenditures whether it be by negotiating with your supplier for lower prices on ingredients or through moving to a smaller shop operating income is therefore a tool that you can use to review if your business is healthy and if its operational activities are profitable again as for gross margin the operating income of a company is usually measured in both dollar value and percentage of revenue as it is as important to ensure the value is at least positive and to ensure that the operating income of the company is relevant to the amount of revenue generated if last year for example he generated $5 of operating income for each $100 of revenue or in other terms 5% of up ink and this year you generate $7 of upping for $200 of revenue or 3.5% then you’re indeed making $2 more profit compared to last year but in percentages or relative terms you’re making less upping than last year this in itself is not necessarily a bad sign but it requires further investigation in order to understand the source of it it could be that this year one of your lower margin products just picked up in sales and that it overall reduces your relative upping to revenue up to now we have seen all the aspects of the income statement which relate to the operations of the company but some of its income and expenditures can have their source outside of the operations of the company such elements could be for example taxes paid the relevant authorities this is an expense that’s not done with the purpose of generating business or maintaining business but rather to fulfilling a legal obligation it is therefore reported below the operating income line you can find as well their interests paid on loans or interests received on money left on a saving account in general terms this section will cover the inflow or outflow of money that is due to non operational activities you can also find here any element that is not related to the normal activities of the company for example you will find their transactions that are significantly more important in dollar terms than your normal activities such as acquiring a company or selling part of your company or the consequences of events that are out of the ordinary such as the impact of an earthquake for example on your business financials net income is the last line of the income statement and as such it earned the name of the bottom line it is indeed the bottom line of your company and where you can see if you’re making any money some money or good money it is one of the most important aspects of your business and definitely the most important one of the income statement it is the element of the income statement that needs to perform well in which you need to focus on by analyzing its underlying elements such as revenue expenditures whether operational or non operational to get it to the third level net income is how much money the company is making over a certain period of time and it is very different from cash net income is money earned but not yet paid and crew money made is money in the bank to go back to the expression revenue is vanity margin is sanity and cash is reality only cash is reality we will deep dive into that topic in the next chapter now let’s take a few business situations and see how they impact the income statement let’s start with selling products as you sell a new product you invoice the customer by giving or sending him a paper or electronic invoice this triggers automatically the addition of the revenue and costs associated with that order to the income statement the revenue is added to the revenue line and the cost to the cost line now let’s take this example a step further and consider the impacts on both balance sheet and income statement as you invoice your customer the revenue side of the invoice is impacting the income statement by increasing the revenue line on the balance sheet its impacted first on the asset side by the increase of the cash category as soon as the payment is made on the liabilities and equity side the seller you just made will impact retained earnings and income taxes payable on the cost side the same sale will impact the income statement by increasing the cost line by the cost associated with that sell on the balance sheet in the asset section the same cost will be deducted from the inventory category as you sell a good you take it out of the inventory and give it to the customer so in the same way it’s taken out of the inventory category of the balance sheet on the liabilities and equity side of the balance sheet it will reduce retained earnings also note that at this point the balance sheet remains in balance now let’s look at paying bills as you pay your bills it can either be for production purposes or other general expenditures or even for buying fixed assets we have seen in the previous example how in expenditures are handled let’s see now the cases of general expenditures and fixed asset purchases for general expenditures let’s say that you need to pay for sell flyers as you will receive the invoice from the manufacturer you will send him the money by writing a check by cash or by wire transfer in any case the amount will have to be added in the income statement to the expenses category in the balance sheet that same amount would be deducted from the cash category on the asset side and will reduce returned earnings on the liabilities and equity side for fixed asset purchases you need to recall what we learned about depreciation in the balance sheet chapter as a fixed asset is purchased it’s accounted for differently from a cash standpoint and from a profit standpoint from a cash standpoint on the day of the purchase the total amount of the purchase is deducted from the cash category of the balance sheet and the same amount increases the net fixed asset category and within the net fixed asset category it is entered in the fixed asset at Cost subcategory once that is done every year the asset will get depreciated by a portion of its value this year’s depreciation will be added to the accumulated depreciation subcategory in total the net fixed asset category will decrease by the newly depreciated amount on the income statement side that depreciation for the year will be taken into consideration if you remember when the asset was first purchased there was no impact to the income statement and of course it needs to impact at some point the profitability of the company well that’s what it does once the asset is depreciated that depreciation amount is included in the income statement as an expense it therefore reduces the income or profits of the company by that same depreciated amount you the cash flow statement is the last document of the financial statement and is the one that is the most grounded in reality here there is nothing more to know than if money is or is not in the bank you could wonder why Tirzah need to have such a document when you already have a bank statement a balance sheet in an income statement well first of all the income statement does not report cash it reports revenue it reports income but not cash for the bank statement and the balance sheet which do report cash it is done in a way that does not give a sufficient level of detail to enable a good understanding of the key levers the company needs to use to ensure its success and sometimes its survival in the cash flow statement cash is reported over a period of time a year for example and you can follow its evolution between a starting date and an end date just as the first of January up to the 31st of December in a cash flow statement the main categories are the beginning balance cash from operations fixed asset purchase net borrowing income tax paid sale of stock and the ending balance the biggest reason for having a cash flow statement is that there’s a big difference between the accounting view of the company and its cash reality both views are correct and useful to managing the company and both show the company through different lenses which complete each other the profitability of the company is as we’ve seen the difference between its revenue and its expenditures in the income statement we always assume that they both happen at the same time to ensure we can review the profitability of each of our actions but when it comes to spending money or collecting it the timing of it can be and usually is very different from that income statement view to sell your products you need to purchase material and produce goods well in advance which therefore implies that you have actually spent the money well before it is accounted for in the income statement and as we have already seen revenue is very different from cash which can be receive a long time after the cell has been made as a concrete example if you produce your goods one month before selling them and your receive payment one month after selling them you can end up with two full months between the time you invest the company’s money and the time you get the return during that time you need to be able to continue to fund the operations of the company either with money that has been saved or with a loan and the bigger the orders you receive and the more this situation creates pressure for the company if you think of it this is critical for successful companies that can receive increasing orders as they become more successful and need to find a way to fund the gap that exists between production and payment this is why it is sometimes necessary to find financial partners to help you go through that high-pressure time and not turn down orders it is therefore critical for a company to be able to manage its cash and have a thorough understanding of its inflows and outflows of money gaining that understanding enables the company leaders to understand what its venerable ities are and to take appropriate actions well in advance of their occurrence now let’s look at the cash flow statement in detail compared to the balance sheet and the income statement the cash flow statement is quite simple it is reporting the inflows and outflows of cash from the company by breaking it down into big categories it’s starting from the beginning balance and ending with the ending balance the beginning balance is the cash position at the start of the reported period the cash position is a fancy name for the balance on your bank account at a shortened date if you are looking at a cash flow statement for the past year then it is the cash position as of the 1st of January of that year and need the same logic the ending balance is the cash position at the end of the 31st of December the beginning balance is always equal to the ending balance of the previous period these years beginning balance is therefore equal to the ending balance of last year to walk from the beginning balance to the ending balance we start with the first category which is the cash from operations cash from operations is the cash that comes from running the business it is the cash from sales the cash from purchasing material paying salaries rent paying anything that is related to running the business then comes fixed asset purchases a time will come when you will need to invest in new assets such as replacing machinery or buying property even though that is a key element to running a company it is not a day-to-day activity and is therefore reported in a different category that is dedicated to purchasing new assets to do that you will sometimes have to take loans which will inject cash into your company that cash is not generated by your activity but will help you go through tough times and make an investment that would otherwise have required you to save money for years before making it the cash coming from those loans are reported under the net borrowing category next is taxes paid this one is very straightforward it is the amount of taxes that the company paid the last element is sale of stock this is another mean to bring cash into the company selling stock to new investors is a way to bring new funds which most of the time will be used to develop the company further that cash is reported under the sale of stock category the cash flow statement ends with the ending balance which is the beginning balance plus all the money that came in – all the money that came out in other words beginning balance plus or minus cash from operations plus or minus fixed asset purchases plus or minus net borrowing plus or minus taxes paid plus or minus sales of stock equals ending balance it could seem surprising to have both plus and minus for all those items but you need to remember that each of those categories can report a vast number of situations for example if the amount of debt that you’re paying back is bigger than the money that you borrow then you could have a negative amount for a net borrowing the same goes for purchasing or selling assets selling or buying stock or having a tax refund yes it does happen I’m sure we will all agree that more cash is better and when we read the cash flow statement we can be tented to view a negative cash flow as bad news we need to be careful not to make hasty conclusions as we have already seen the cash flow of a company is made up of many inflows and outflows of cash when a company invests in its future by purchasing machinery property patterns or even other companies it can be spending a lot of cash to do so this will therefore reduce the cash position of the company and could create a negative cash flow in that case it’s clear that it is negative cash today due to an investment that is expected to bring more cash in the future than if the investment was not made in this case a negative cash flow is far from being bad news it’s therefore very important to look in the tail into the cash flow statement categories to understand the source of a reduction or of a negative cash flow if it is due to the operations of the business then it could be critical to the survival of the company if it is due to more investments or the repayment of loans then it could be a positive sign in the previous chapters we have learned about each of the financial documents that make up a financial statement as you have seen a single transaction or business event will be reflected in more than one document and may be in all of them whether you consider the balance sheet the income statement or the cash flow statement each of those documents provide a unique angle on the financials of the company with these unique benefits and limitations take the balance sheet for example its unique angle is to show you what the company owns owes and the accounting value of the company I’m saying accounting value because one of its limitations is that the value of the equity of the company does not take well into consideration elements such as the future potential of the company it does not take into good consideration either the competitive edge it has thanks to a unique technology for example or the strength of its customer base the balance sheet looks at assets cash debt but a growing number of companies are providing services and have their biggest asset being their intellectual property or some other less tangible assets that are not well represented in the balance sheet the income statement for example gives a lot more answers on those intangible assets by providing a view of the business performance a company that is growing fast that makes good profit gives you a dynamic view of the path it is on by combining the analysis of the balance sheet and the income statement you can gain a new level of understanding you can see if the company is growing fast and heavily indebted and if it has a low level of debt significant assets but is unprofitable in short you have a much deeper understanding of the situation of the company and by the way in the two examples I quoted there’s no way of saying if those are desirable situations or not the same goes for the cash flow statements understanding the cash situation of the company is yet another angle in a new set of information a company can have good assets it can be growing it be profitable but do a poor job of turning all of those into the reality of cash if that happens no payment can be made neither to suppliers to employees or to invest in future growth it creates an uncertainty that needs to be managed and can prove lethal to the company combining financial documents is a key step to having a well rounded picture of the company to understand its past performance where it stands today and if it has the means to be more successful in the future financial documents are best analyzed over time let’s take for example the concept of growth if a company grows it can mean for example that it is generating more revenue this year than it did last year by looking at financial information over time you are in essence looking at the trajectory on which the company is each financial element whether it is in the balance sheet income statement or cash flow statement can be analyzed over time it is always very interesting to compare two previous quarter’s or years and understand if the performance is heading in the expected direction reviewing information over time also provides the ability of identifying exceptional changes in the performance of the company such as the acquisition of a new business or on the opposite side the selling of a division of the company such analysis can be performed on virtually any element of the company some interesting metrics are revenue evolution profit evolution expenditure evolution asset evolution that evolution can shave Ellucian and many more we’ve been talking about numbers for some time now which makes good sense given this is a finance course but any business leader will tell you that numbers can tell only part of the story having a good management team awesome products or be the first to open a new market our element that will have a huge impact on the success of your company but cannot be grasped by looking at financial statements only any experienced finance professional will tell you that those in turn and external factories are what gives meaning to the numbers when revenue is growing year-over-year how can you tell if this is due to a higher customer demand better products good sales people or any other factor answering such questions is key to understanding what you’re doing right and what you are doing wrong and lead you to taking actions that will improve your business situation the answer of such questions is in the analysis of the context of your company it is done through the analysis of contextual elements such as your target market your competitors your suppliers the management team the location of your stores and many more it’s in the light of those elements that you can truly conclude if the figures within the financial statements are indicating a good performance a good strategy or not so remember that context is just as important as the numbers themselves you

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