so who our financial statements useful
to as financial statements give a complete view of the financial city
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 a
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 $20,000 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 are 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 cells 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 underperforming it therefore gives them the ability to put in place
corrective actions if we go back to our ice cream tropics
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
sells 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 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 and 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 constituent 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 fun
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 phase 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 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’s not that is completely different from the picture of the day before or
the day later is inconsequential it is made of two sections called
assets and total liabilities in 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 flip side 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 order refurbishment 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 split into two subcategories assets which group together all the
assets that relate directly to the day-to-day activity of the company and
fixed and 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 subcategory zation of assets
which groups together 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 150 dollars today and 350 dollars at the end of the month in our balance
sheet we will record 150 dollars in the cash category since it is received today
and 350 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 amounts to the cash category the next category is inventory
this is everything that has been purchased to be either sold or
transformed before – 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 concepts of working
capital next our categories of assets that are let’s say less current next
fixed assets is a category that covers the properties 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 to 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 is 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 and expense of 100 thousand 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 shit 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 the 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 its 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 debt income
taxes 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 assets 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 services 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 store 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 taxes payable income taxes 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 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 four year loan 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
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 retake 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 have 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 their 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 loan 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 would 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 use
and 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 would 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 accrued 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 and taxes that you paid will then
have to come off the retained earnings category the balance sheet is again in
balance 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
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 a 2012 income statement reports
all the cell’s and expenditures between the 1st of January and the 31st of
December a 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’s 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
tomorrow 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 would 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 accounts 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 and are 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 pay month 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 rendered 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 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 well managed to company
as before because it’s making less money than in the past with no visibility on
the details of whities making less money you could be tempted 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
cost in accounting terms in December 2012 it will mostly be the balance sheet
that would be effected 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
which is sold and increased cash for the payment made by the customer of course
we want to sell our product with a profit which means that the
revenue of the cell 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 ultimately 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 companies 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 already got
while cash in your pocket is reality let’s focus here on the concept 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 sole early 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 two dollars five dollars – $3 if you sell two ice
creams the new revenue is $10 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 $2
by $5 which is equal to 0.4 or 40% if we calculate the margin percent for the two
ice cream salt we divide $4 by $10 and get again 40% and we could sell another
a hundred eyes cream and our margin percent would still be 40% 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 will
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 $10 to $8 but we
generated just as much margin the reason being that we solved this time this
which is a higher margin product the overall result is a higher margin
percent going from 40% to 50% the analysis of margin gives great insights
into the performance of the company outside of showing if 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 spans 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 just as gross margin the
result of a subtraction between revenue and expenditures the major difference
with gross margin 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 show
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 Inc 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 expected 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 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 it’s 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 production 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 self liar’s 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 return 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 the fixed asset at costs of category
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 when 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 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’s nothing more to know than if money is or is not in the
bank you could wonder why turns in 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 it’s 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 received long time after the cell has been made
as a concrete example if you produce your goods one month before selling them
in 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 in 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 will 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 sale 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 a cash flow statement we can be
tempted 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 patents 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 you