E145/STS173
Workshop A
Basics of Accounting
Professors Tom Byers and Randy Komisar
Stanford University
With special thanks to:
Roma Jhaveri, Ben Hallen, Filipe Santos, Yosem Companys
Copyright © 2004 by the Board of Trustees of the Leland Stanford Junior University
and Stanford Technology Ventures Program (STVP). This document may be
reproduced for educational purposes only.
Goals of the Workshop
• Review main accounting documents and financial analysis
• Balance Sheet
• Income Statement (Statement of Operations)
• Statement of Cash Flows
Please refer also to the handout: How to Read a Financial Report
How Does It All Add Up
When you get paid
for a product or
service…
Income
When you buy
something…
Assets
The value of
anything you own…
Expenses
Assets
often
generate
income
Liabilities
Liabilities
often
generate
expenses
The value of
anything you
borrow…
Some Accounting Principles
• Accounting items are classified into “accounts” according
to their nature, translated into monetary units, and
organized in statements
• Basic Accounting formula:
Assets = Liabilities + Equity
What the company owns
How the ownership of assets was financed
(By third parties or by the owners)
Accounting vs. Market Value
• Equity: Ownership of a company is divided in certificates called
common shares
• Accounting Value (or Book Value) = Equity = Assets – Liabilities
Accounting Value is different from Market Value !!!
• Market Value = Share Price * Number of Common Shares Outstanding
Income Statement
•
Reports the economic results of a company over a time period.
It shows the derivation of earnings or losses.
Income Statement of XXX Corp. – year 2000
+ Revenues
- Cost of Revenue (product cost or COGS)
= Gross Margin
- Sales and Marketing
- General and Administrative
- Research & Development
- Depreciation and Amortization
= Operating Income (EBIT)
+ Interest Income(expense) net
= Net Income before Taxes
- Income Tax Provision
- Extraordinary Items
= Net Income
$
% Rev.
Income Statement - Analysis
• When does a transaction affect income? - When it changes the
economic value of the company for the owners
• Some Profitability Measures:




Gross Margin (%) = Gross Profit / Sales
Operating Margin = Operating Income / Sales
Return on Sales = Net Income / Sales
Return on Equity = Net Income / Shareholders’ Equity
• Other Important Measures
 Earnings Per Common Share (EPS) = Net Income / Common Shares
 Price Earnings Ratio (P/E) = Market Price / Earnings Per Share
Income Statement - Example
From Kimmel et. al. Financial Information For Decision Making
The following information was taken from the 2001 financial
statements of Kellogg Company. Dollar amounts are in millions.
Cost of goods sold
Selling & admin. expenses
Interest expense
Other expense
Net sales
Income tax expense
$ 4,128.5
3,523.6
351.5
54.0
8,853.3
322.1
Income Statement - Example
KELLOG COMPANY
Income Statement
For the Year Ended December 31, 2001
Net sales
Cost of goods sold
Gross Profit
Selling & admin. expense
Income from Operations
Interest expense
Other expense
Net Income Before Taxes
Income tax expense
Net Income
$ 8,853.3
4,128.5
4,724.8
3,523.6
1,201.2
351.5
54.0
795.7
322.1
$ 473.6
Balance Sheet
•
It is a financial snapshot of a company at a given point in time
Balance Sheet of XXX Corp. - 31 December of 2000 (in thousand $)
Cash and Equivalents
Current Assets
(liquid in less than a year)
Fixed Assets
Accounts Receivable
Accounts Payable
Current Liabilities
(payable in less than a year)
Inventories
Property, plant and
equipment (minus
Depreciation)
Accrued Expenses
Short Term debt
Long-Term Liabilities (bonds issued, bank loans)
Common Stock
Intangibles (minus
depreciation)
Other Assets
Shareholders’ Equity
Investment Securities
Total Assets
Additional Paid-in Capital
Retained Earnings
= Total Liabilities + Shareholder’s Equity
Balance Sheet - Analysis
•
Working Capital: measure of the amout of cash available in the short-term;
Also, indication of the funds needed operate within a given business size
= Current Assets – Current Liabilities
•
Liquidity ratios: measures of the ability to meet short term financial obligations
 Current Ratio: Current Assets / Current Liabilities
 Acid-test: (Cash + Accounts receivable) / Current Liabilities
•
Operational Efficiency Measures
 Inventory Turnover = Cost of Sales per year / Current Inventory
 Accounts Receivable Collection Period = accounts receivable / sales
 Accounts Payable Collection Period = accounts payable / cost of sales
Balance Sheet - Example
From Kimmel et. al. Financial Information For Decision Making
These financial statement items are for Tweeter Entertainment
Group at year-end on September 30, 2001. (in millions)
Accounts payable
Property, plant & equipment
Receivables
Other current liabilities
Stockholders’ equity
Cash
Long-term debt
Inventories
Accrued expenses
Other current assets
Other liabilities
Other assets
$ 38.6
109.1
31.3
23.3
332.4
3.3
36.7
129.2
38.9
7.5
10.5
200.0
Balance Sheet - Example
TWEETER HOME ENTERTAINMENT GROUP
Balance Sheet (in millions)
September 30, 2001
Assets
Liabilities and Stockholders’ Equity
Current assets
Cash
$ 3.3
Receivables
31.3
Inventories
129.2
Other current assets
7.5
Total current assets
171.3
Property, plant & equipment 109.1
Other assets
200.0
Total assets
$ 480.4
Current liabilities
Accounts payable
Accrued expenses
Other current liabilities
Total current liabilities
Long-term debt
Other liabilities
Total liabilities
Stockholders’ equity
Total liab. & stock. equity
$ 38.6
38.9
23.3
100.8
36.7
10.5
148.0
332.4
$ 480.4
Statement of Cash Flows
•
The Statement of Cash Flows reports cash receipts and payments over a
period, separating operational, investing and financing activities.
Statement of Cash Flows of XXX Corp. – 2000
+ Cash Flow from operating activities (reconciled from income statement)
= income
- net changes in working capital (except cash and equivalents)
+ depreciation and amortization
+ Cash Flow from investing activities
+ Cash Flow from financing activities
= Net Change in Cash or Equivalents
+ Cash or Equivalents at beginning of period
= Cash or Equivalents at end of period
$
Statement of Cash Flows - Analysis
CFIMITYM !!!
(Cash Flow is More Important Than Your Mother!! )
Especially for an entrepreneurial firm...
•
How is cash flow different from income?
 Income accrual is not necessarily linked to cash transactions (e.g.,
depreciation, sales by credit)
 Some activities affect cash flows but not income (e.g., investments in
fixed assets, additional capital from shareholders)
•
Growth often absorbs cash flow because of a higher need for
working capital and fixed investments (Entrepreneurial firms with
negative income and high growth can have a very fast cash burn rate)
Statement of Cash Flows - Example
From Kimmel et. al. Financial Information For Decision Making
SIERRA CORPORATION
Statement of Cash Flows
For the Month Ended October 31, 2004
Cash flows from operating activities
Cash receipts from operating activities
Cash payments for operating activities
Net cash provided by operating activities
Cash flows from investing activities
Purchased office equipment
Net cash used by investing activities
Cash flows from financing activities
Issuance of common stock
Issued note payable
Payment of dividend
Net cash provided by financing activities
Net increase in cash
Cash at beginning of period
Cash at end of period
$ 11,200
(5,500)
$ 5,700
(5,000)
(5,000)
10,000
5,000
500
14,500
15,200
0
15,200