Financial accounting includes the preparation of financial statements used by managers, investors, lenders, and other stakeholders to understand the company’s financial position. A company’s financial position includes its profit (or losses) and cash flow generated over a period of time, as well as its assets and liabilities at a point in time.
Financial accounting is relied upon heavily in our Financial Modeling Bootcamp. While we cover these concepts in our classes, attendees should review this guide before class for reinforcement.
Introduction to Financial Statements
A financial report presented according to GAAP (Generally Accepted Accounting Principles) contains:
- Income statement: Profits or losses over a specific period of time
- Balance sheet: Assets, liabilities, and shareholder's equity at a point in time
- Statement of cash flows: Line items that impacted cash over a period of time; broken into three sections: Operations, Investing, and Financing
- Other supporting schedules, or financial statement footnotes
- Annual reports contain more detailed business discussion, risk factors, and management analysis of the business
Where can I find a company's financial reports?
- SEC website (my least favorite alternative)
- BamSEC, an aggregator of financial data (premium subscription required for filings past one year)
- The company's investor relations section of their website (Google search "Apple investor relations")
- Bloomberg Terminal: The premier source for financial data and news, although it costs over $2,000 per month for a subscription. If you have it, use it.
The income statement, also known as the profit and loss statement, includes the company’s revenues and expenses and shows whether the company is making or losing money. An income statement starts with the company’s revenues (i.e.: sales generated from products or services delivered) and subtracts any expenses. Ultimately, the profit and loss statement will show whether the company generated a profit or loss over a specific period of time, whether that is quarterly, annually, or some other time frame.
The main items included on an income statement are:
- Revenues: the sale of products or services
- Cost of goods sold (COGS): The direct cost of the service or good delivered
- For example, the cost of the component parts in a computer as well as any labor costs associated with assembling the product
- Marketing expenses: Advertising or sales initiatives to promote the company’s products or services
- Research & development (R&D): The cost of testing, trialing, creating new products
- Selling, general & administrative (SG&A, or sometimes, G&A): Corporate expenses such as management, salaries, and incentives, corporate offices and other expenses needed to run the company.
- Interest expense: Interest on debt (bonds or loans)
- Interest income: Interest received on cash and investments the company owns
- Income taxes — Federal, state, local, and any international income taxes owed on profits of the business.
- Depreciation and amortization (D&A) — The non-cash expense that represents “spreading out” of larger investments.
- Gross profit is revenue less cost of goods sold, which represents the company’s profit only accounting for the direct cost of the items sold.
- Operating income is revenue less operating expenses (excluding items such as interest expense and interest income) and represents the company’s pre-tax income directly related to its operations (and not including financing considerations like interest).
- Net income is the company’s bottom line profit or loss and represents all revenues less all expenses, including income taxes.
- EBITDA - Earnings before interest taxes depreciation and amortization, and is a common financial profit metric used by financial analysts to measure profitability. (while that doesn’t even begin to cover why EBITDA is important, it's important to understand for the remainder of the article).
Cash vs. Accrual Accounting
Note: Many balance sheet items are derived from accrual accounting
Perhaps the most important concept in financial accounting is the difference between cash-based and accrual accounting. Cash-based accounting is what we would intuitively think of: revenues are generated when we collect money, and expenses are incurred when we pay for them.
Accrual accounting, on the other hand, books revenues when services or goods are delivered (not when they are paid for), and expenses when they are incurred (not when they are paid for). For example, a company delivers a service but has not received payment yet, revenue would still be recorded. The money owed would be booked as accounts receivable as an asset on the company’s balance sheet.
On the flip side, if a company collects cash for a service it has yet to deliver (for example, an airline collects ticket fare three months prior to the travelers’ flight) the collected cash would not hit the company’s revenue (until the date of the customers’ flight). That is known as unearned, or deferred, revenue, which would show up as a liability on the company’s balance sheet because the company owes the service.
Another example of accrual accounting is when suppliers are paid for goods. Very often, companies can pay suppliers 30 days after the goods have been delivered. When the goods are delivered, the company does not record an expense—it only records an expense when the goods are actually sold. Meanwhile, since the company hasn’t paid the supplier yet, it must record this as a liability, known as accounts payable (as discussed earlier, the seller would record this as revenue, even though the cash wasn’t collected, and record an accounts receivable as an asset on its balance sheet.)
When it comes to operating expenses, accrual accounting is once again important. Employees, for example, are typically paid after they have delivered services to the company. Think about your pay cycle, which is likely semi-monthly or every two weeks, covering the previous period. In accrual accounting, even though the company has yet to pay the employee, it must record this as an expense. The expense would hit the income statement, and an accrued expense would show up on the balance sheet as a liability.
Sometimes, expenses are paid before they are incurred. For example, tenants typically pay rent before the start of a month. The rent, in that case, would not be recorded as an expense (yet), and a prepaid expense would show up as an asset on the company’s balance sheet.
As mentioned earlier, depreciation represents the “spreading out” of some larger investment. Let’s say a company spends $1 million on a new production plant. In cash-based accounting, that $1 million would be recorded as an expense. However, economically, the cost of that plant should be spread out over its useful life, so as to not skew financial results. Suppose the useful life of the plant is 5 years. Instead of recording a $1 million expense when the asset is purchased, we would record $200,000 of depreciation each year for five years. Therefore, income would only be reduced by $200,000 in the first year. This, you would agree, is a much more accurate representation of the company’s financial position. Meanwhile, the company’s capital purchase would show up on the balance sheet as an asset in Plant, Property & Equipment (PP&E). Over time, the value of that PP&E would be reduced to zero ($200,000 per year for five years).
When it comes to income taxes, an expense is recorded based on when the income is earned, and not when the taxes are actually paid. For example, if a company owes a tax bill for the previous year, but has yet to pay it, the taxes would still show up on the income statement, and an accrued expense for taxes would show up as a liability on the balance sheet. If a company chooses to pre-pay taxes for the year (to get a discount or perk), then it would show up as a pre-paid expense.
A company’s balance sheet is one of the three main financial statements and it shows the company’s assets, liabilities, and shareholders’ equity at a specific time (as opposed to an income statement, which shows company’s profitability over a period of time).
The three sections of the balance sheet are:
- Assets: Anything of value that the company owns, including cash, investments, PP&E, intangible assets, goodwill, accounts receivable, prepaid expenses
- Liabilities: anything the company owes, including debt (short and long-term), accounts payable, accrued expenses, etc.
- Shareholders’ equity: capital paid in by owners whether through equity contributions or keeping the profits of the business in the business (retained earnings)
Assets = Liabilities + Shareholders’ Equity
This accounting identity, which must always hold true: Assets = Liabilities + Shareholders’ Equity.
Think of a balance sheet as follows: a company has a bunch of assets, how did the company get the money to pay for those assets? It paid for them using some combination of liabilities and shareholders’ equity.
For example, you own a printing business and need to purchase machinery for $100,000. Here are a few ways (examples to illustrate the identity) you can purchase that asset (which would be recorded as PP&E in the assets section on the balance sheet).
- The business has made a lot of money over the years (profit) and you kept that money in the company’s bank account (i.e. you didn’t distribute the capital to the shareholders). In this case, you are using the company’s retained earnings to finance the investment.
- Imagine this is a new business, and therefore the company does not have any retained earnings. We can go to the bank and take out a loan. The loan would show up as debt (either short or long-term depending on the maturity of the loan) in the liability section of the balance sheet.
- Alternatively, the owner of the business (or, in a larger company, the investors or stockholders) can contribute capital. That would show up as paid in capital in the shareholders’ equity section of the balance sheet.
All of a company’s assets since its inception must have been paid for from a combination of liabilities and the shareholder's equity. Every transaction must maintain that identity. This leads to the concept of dual-entry journal accounting, which we’ll discuss in another article.
Statement of Cash Flows
As discussed earlier, due to accrual accounting, a company’s profit is not necessarily its net cash flow. To reiterate, it may have sold products but have yet to receive the cash (accounts receivable). Therefore, there is a need for another financial statement that clearly shows the actual cash inflows and outflows.
The statement of cash flows is broken into three sections:
- Cash flow from operations
- Cash flow from investments
- Cash flow from financing
It is easier to explain what is included in cash flow from operations by showing what is not included. Cash flow from operations includes everything except for activities related to investments and financing.
Cash flow from investments includes cash flows from capital expenditures, acquisition of businesses and other assets not in the ordinary course of business, and purchase or sale of investment securities (for example, a company may invest its cash in short-term bonds to earn some additional interest on cash it is not currently using).
Cash flows from financing include transactions with equity and debt holders: capital raises, distributions to shareholders, repurchases of shares (the opposite of issuing shares), and borrowing or repaying debt.
Now, we can circle back to cash flows from operations. Once again, the net income of a company does not represent its net cash for that period, for many reasons that we’ll now elaborate on.
The cash flow from operation section typically begins with the company’s net income and adds or subtracts any items that would impact its actual cash flow. For example, D&A is added back to net income since that is a non-cash expense. Other non-cash expenses, such as stock-based compensation (when employees or executives are paid in stock instead of cash) is also added back. Other non-cash charges include asset impairments.
Additionally, the cash flow from operations must adjust for all those working capital items, which include accounts receivable, prepaid expenses, accounts payable, accrued expenses, and income taxes payable. Essentially, the cash flow from operations section readjusts the income statement to reflect the actual cash flow for the period.
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