What is Financial Accounting?
Financial accounting includes the preparation of financial statements to understand a company's financial position. The company's position includes profitability, cash flows, and assets and liabilities.
Understanding financial accounting is essential for understanding, valuing, or investing in a business.
Before we get into the key financial statements, let cover a core accounting concept that underlies the financial statements, cash vs accrual accounting. This relates to when we record items in our books. For example, if we sell a product online, should we count revenue as when the person places the order and pays, or when the product is actually delivered to the customer?
Cash-based accounting is a little more simple and intuitive than accrual accounting and it is dictated by the change of cash. When we get paid we record the revenue, and when we pay we record the expense.
Accrual accounting, the GAAP standard used by all US public companies, records items when goods or services are delivered and when expenses are incurred. If a company delivers a service but has not been paid yet, it would still be able to count that as revenue.
Why is this important?
You might be asking, “why is this important? Who cares?” Well, let’s put ourselves in the shoes of a small business owner to see when this might impact us. We run a cool sneaker store in Brooklyn. It’s January 1st and we realize we are running low on inventory so we decide to make a big order of the newest shoes. We decide to order 2,000 pairs of shoes to last us about 5 months. Each shoe costs us about $50 from our supplier and we resell them for $100. We purchase our inventory and owe our supplier $100,000 (2,000 x $50).
Let’s say we pay this in January and we sell 400 pairs of shoes over the course of January, which is exactly what we expected. If we were doing things according to cash accounting, we would have generated $40,000 in revenue in January but lost $100,000 to inventory. We would technically be losing $60,000 in January. We bought the inventory expecting to sell it over the course of 5 months and we sold exactly what we expected, so does it make sense that we recorded a big loss in January? Well, accrual accounting would argue not.
With accrual accounting, the cost of inventory would be accrued as the goods were sold. In this example, if we sold 400 pairs of shoes in January our Cost of Goods would be $20,000 (400 * $50) and our revenue would be $40,000 so we would have made a profit of $20,000. As you can tell from this example, the method of accounting we use can make a big difference in the story we tell at the end of the month. In one case we actually lost money while in the other we made $20K in profit. That is why it is important to understand the difference between cash and accrual accounting when running a business or analyzing another business.
The Financial Statements
There are three key financial statements that you'll learn about in financial accounting.
- Income Statement
- Balance Sheet
- Statement of Cash Flows
The income statement, or profit and loss statement, is a report of a company’s revenues and expenses over a certain time frame. At the top of the income statement are the revenue items and then those are followed by expenses. At the end of the income statement, you’ll see the total profit or loss which is the revenue - expenses. Some of the key items on the income statement are:
Revenues: sales generated from a product or service
COGS: cost of goods sold, the direct cost of the service or good delivered
Marketing Expenses: advertising or sales initiatives towards selling the products or services
R&D: research and development
SG&A: selling, general, and administrative expenses including salaries, office rent, and other expenses needed to run the company
Interest Expense: any interest paid on debt (loans or bonds)
Income Taxes: any income taxes owed on profits from the business
Depreciation & Amortization: non-cash expense that represents the “spreading out” of larger investments (ex: machinery, equipment, etc.)
When we talk about profitability we generally refer to net income which is the bottom-line profit of a company (revenue - expenses) but there are some other profit metrics we might consider looking at as well:
Gross Profit: revenue minus COGS, which can provide insight into the profitability of the direct sale of products or services
Operating Income: revenue minus operating expenses, which represents pre-tax income directly related to operating the business
EBITDA: earnings before interest, taxes, depreciation, and amortization, which is commonly used by analysts to assess profitability
The balance sheet tells us the assets, liabilities, and shareholders’ equity of a company at a specific point in time.
Assets include anything of value that the company owns including cash, equipment, goodwill, receivables, and prepaid expenses.
Liabilities include anything the company owes including debt, accounts payable, and accrued expenses.
Shareholders’ equity refers to the capital paid in by owners through equity contributions or retaining earnings.
The accounting identity, which shows the relationship between these three items must always hold true.
Assets = Liabilities + Shareholders’ Equity
Basically, a company has assets and those assets must have been paid for with liabilities or shareholders’ equity. What do we mean by that?
Say we run a sneaker store and we need to purchase inventory. There are a couple of ways we can pay for this.
This business has made money and has cash on hand - this would be considered retained earnings because it is earnings that was kept in the business
We can take a loan which would be a liability (debt).
We as the owner of the business can pay for it out of our pocket which would be considered paid capital in the shareholders’ equity of the balance sheet
Statement of Cash Flows
As we discussed earlier, accrual accounting and cash accounting can result in pretty different outcomes. Since most large businesses use accrual accounting, it can be hard to understand the movement of cash using the income statement or balance sheet. That’s where the statement of cash flows comes in handy. The statement of cash flows tells us the cash inflows and outflows broken out in three sections.
Cash flow from operations - everything except for activities related to investing and financing
Cash flow from investments - cash flows from capital expenditures, asset purchases not in the ordinary course of business, and purchase or sale of investment securities
Cash flow from financing - cash flows from transactions with equity and debt holders including capital raises, distributions, share repurchases, and the borrowing or repayment of debt