Accounting is a vast domain, as it looks at a firm or individual performance and offers hints for future financial performance. Accounting understanding and correct use is a basic requirement for conducting successful business and for managing our business or personal money and assets.
Business Knowledge Inc. strategic business approach relies heavily on conveying to our customers the importance of accounting as a fundamental business domain supporting our business sustainable success. Our forefront scope is to ensure that our customers understand how a firm or individual generates income, pay their dues and collect their cash, use it for investments and track the cash flow as premises of financial success.
Accounting covers all money related information that is emerging from any activity in our lives. Accounting is meant to provide a snapshot in time of our financial status and it offers tools for assessing the personal or business financial outcome on the past financial activities.
We offer bellow a definition of accounting, a brief review of financial statements and a quick reference on the financial ratios. Specific articles are available under the White Papers section.
1. Definition of Accounting
Without understanding itself, a business is heading for low performance or even failure. The core activities are about what value adding activities a business is going to conduct, and how is it going to conduct them. Accounting is meant to provide information for helping leaders making decisions. Accounting provides information regarding resources such as labor, material, various services, buildings and equipment, including the way these are financed and the results achieved through their use.
2. Financial Statements
The accounting backbone of any business is a set of reports produced as the end result of Financial Accounting. These reports are meant to provide appropriate information to company management helping with the decision making process. The financial evaluation of the past, assessment of the present and the projection of the future of the business is done through the use of financial ratios.
These reports are called financial statements and they are:
The Balance Sheet (The Statement of Financial Position)
The Income Statement
The Cash Flow Statement
The Balance Sheet
The balance sheet it is a snapshot of the financial position of the company at any point in time.
On the left side there are the Assets and at the right the Liabilities and the Owners’ Equity
The fundamental equation of accounting defines the balance sheet:
Assets = Liabilities + Owner’s Equity
Assets are represented by the cash, equipment and other resources necessary for the business to operate. The assets are owned by the business.
Liabilities and Owners’ Equity are the sources that provide the business assets.
Liabilities are obligations of the business to outside parties who have provided resources.
Owners’ Equity is the other source that the business uses to acquire its assets.
There are two sources of equity funds:
1. The amount provided directly by equity investors
2. The amount retained from the profits (or earnings) that is called Retained Earnings
The Income Statement
The amount added to Retained Earnings as result of profitable operations during a period is the income of the period.
The basic income statement equation is
Revenue – Expenses = Net Income
A business must be selling product, that is called Sales Revenue and for that it has associated costs, called Cost of Sales.
The difference between Sales Revenue and Cost of Sales is called gross margin:
Revenue Sales – Cost of Sales = Gross Margin
The final item (bottom line) on the income statement is called net income if positive or net loss if negative.
The Cash Flow Statement
The purpose of the cash flow statement is to provide information about the use of cash by the business for a given period. The cash flow has three major components: cash flow from operations, investment activities and financing activities.
The activities associated with the cash flow can be classified as sources of cash, that being activities that generate cash, and uses of cash, that being activities that involve spending of cash.
Cash flow statements help answers the following questions:
1. How much cash has been provided by normal operations?
2. In what other ways was cash generated?
3. Is the company investing enough in plant and equipment to replace old facilities such that it maintains appropriate levels of efficiency?
4. Is the company reinvesting the excessive cash?
5. Are company investments financed by internally generated cash or by external borrowing?
6. Is the external financing cash obtained as debt or sold equity, and in what proportion?
3. Financial Ratios
Financial ratios are a quick firm barometer.
With information available in the financial statements, the financial ratios can be used to figure out very fast the overall performance of the company, profitability, the way the resources are managed, company financial condition and the dividend policy, if any.
Examples of financial ratios:
Overall performance measure:
Return on equity, return on invested capital
Gross margin, expense ratio, cash realization
Day’s cash, day’s inventory, current ratio
Financial leverage, debt to equity
Dividend yield, dividend payout