Accounting Basics: Agenda
• Introduction to Financial Statements
– Balance Sheet
– Income Statement
– Statement of Cash Flows
• Metrics and Ratios
Balance Sheet
• “Snapshot” of a company’s financial standings
• Details a company’s Assets, Liabilities and
Equity
• Assets: All of the resources of a company
• Liabilities: All of the obligations of the
company
• Stockholders Equity: The equity stake owned
by equity investors. Also referred to as Book
Value because it is the value of the company
after all obligations have been paid, at book
Balance Sheet
• Based on the equation Assets = Liabilities +
Stockholder’s Equity
– In words: The resources of a company must be
equal to all of the capital that is attributed to the
company (i.e. Debt and Equity)
• Important Note: Assets, Liabilities and
Stockholder’s Equity are recorded at historical
cost per GAAP rules, not market value
• Let’s take a look at the left hand of the
equation
• Listed in order of liquidity – how quickly can they be
converted to cash
• Current assets are those that mature in 1 year or less
• Receivables are essentially products or services bought on
account – cash hasn’t changed hands
• Tangible vs. Intangible
• Goodwill is a common intangible assets. It represents the
excess amount paid over the carrying value of a company
acquired, it is impaired not amortized.
• Liabilities are listed in order of time to be repaid
• Accounts payable represents services or products bought on
account – have not yet been paid
• Current portion of long term debt is the portion of long term
debt that must be paid within 1 year
• Minority represents the portion of the company that is not
owned
• Common stock represents the par value of the stock issued by
the company
– Sometimes there will be an account called additional paid-in capital to
account for the surplus over par value
• Retained earnings is the accumulative account that captures
all of the earnings of the company (net income flows into this
account)
• Treasury stock represents the amount of stock repurchased
• Preferred stock is a common type of equity that has higher
claim than common equity, but lower claim than debt.
Generally have regular dividends.
Income Statement
• Income Statement shows the performance of a business over
a given amount of time (i.e. quarter or year)
• By definition income is simply Revenue – Expenses
• Revenue is recognized when it accrues, not when cash trades
hands
– This causes a discrepancy between income and cash flow
• There are also non-cash items on an income statement which
are expenses that don’t actually effect cash flow, but do effect
the amount of taxes paid
– This will be an important concept moving forward
Income Statement
Income Statement
Revenues
- COGS
Gross Profit
- SG&A
- Depreciation and Amortization
EBIT or Operating Income
- Interest Expense
EBT
- Income Taxes
Net Income or Earnings
• Cost of Goods sold includes all of
the cost associated with
producing the product
• SG&A is Selling General &
Administrative Expenses
• Depreciation is how purchases of
fixed assets are expensed – non
cash expense
• Amortization is the depreciation
of intangible assets – non cash
expense
• EBIT stands for Earning Before
Interest and Taxes
Income Statement
Statement of Cash Flows
• Reconciles the amount of money earned (NI) with the actual
cash that the firm generates
– Very important because in Finance we focus on cash over earnings
because earnings can be manipulated and cash cannot
• Breaks cash flows into three separate segments
– Cash from Operating Activities
• Cash provided/used in the normal operations of the business
– Cash from Investing Activities
• Investing activities refer to investments in capital assets (PP&E)
– Cash from Financing Activities
• Refers to any transactions between the firm and holders of capital (debt or equity)
Statement of Cash Flows
Interview Question
• How would a purchase of fixed assets worth
$100 effect the three financial statements?
Assume straight-line depreciation over 10
years.
Answer
• Balance Sheet: Cash decreases by 100, Net PP&E increases by
90, Retained Earnings decreases by 10
• Income Statement: Depreciation increases by $10 and Net
Income decreases by same amount
• Statement of Cash Flows:
– Operating Activities: Net Income decreases by 10, depreciation
increases by 10 – Net Change in cash = $0
– Investing Activities: Capital Expenditure of $100 – Net Change in cash
= $100
Metrics and Ratios
• Solvency:
– Current Ratio: Current Assets/Current Liabilities
– Quick Ratio: Current Assets – Inventory / Current Liabilities
• Leverage:
– Debt-to-Equity Ratio: Total Debt / Total Equity
– Debt Ratio: Total Debt / Total Assets
– Times Interest Earned Ratio (TIE) or EBIT Coverage: EBIT/Int Expense
• Profitability
–
–
–
–
Return on Assets: Net Income / Average Assets
Return on Equity: Net Income / Average Equity
Gross Margin: Gross Profit / Total Revenue
Net Profit Margin: Net Income / Total Revenue
Cash Flows Equations
• Equations that are used for the DCF
• Two Options
– Free Cash Flow to Firm
– Free Cash Flow to Equity
• For our DCF we use FCF to Equity
Components of FCF to Equity
• Net Income + Depreciation – Change in Net Working Capital –
Capital Expenditure + Net New Debt
– Net Income: We start with levered (i.e. after interest) earnings
– Depreciation: We add back Depreciation as it is a non-cash expense
– Net Working Capital: Current Assets – Current Liabilities. Companies
like to maintain a positive net working capital position and a positive
NWC represents an “investment” in NWC
– Capital Expenditure: Change in Net Fixed Assets. We need to invest in
the assets that make our business profitable every year
– Net New Debt: Increasing our debt means we get more cash, which we
add back