Accounting 101

A mixed notes of Coursera: Introduction to Financial Accounting and basic term definitions from investopedia.com

Financial Statement

Balance Sheet

  • Financial position (i.e., listing of resources and obligations) on a specific date
  • Assets = Liabilities + Stockholders'Equity
  • This equation must always balance!

Definition of Assets, Liabilities, Stockholders'Equity

Assets - Resources owned by a business that are expected to provide future economic benefits (either provide cash coming in or save the company from having to spend cash in the future)

Liabilities - Claims on assets by "creditors" (non-owners) that represent an obligation to make future payment of cash, goods, or services

Stockholders'Equity - Claims on assets by owners of business - Contributed Capital (arises from sale of shares) - Retained Earnings (arises from operations) - Increased by Revenues - Decreased by Expenses and Dividends

Income Statement

  • Results of operations over a period of time using accrual account (i.e., recognition tied to business activities, not to cash flows)
  • Net income = Revenues - Expenses

Revenue vs Income vs Profit vs Earning

Revenue: Revenue is simply the total amount of cash generated by the sale of products or services associated with the company's primary operations, less any returns or discounts. It can also be thought of as net sales.

E.g.For a grocery store, this includes the sale of anything found in the store, from vegetables to floral arrangements

Income: In a financial context, the term income almost always refers the net income, is a concrete concept. Also referred to as net profit.

Net income accounts for every dime that flows in and out of a company. It includes expenses for product manufacturing, operations, debt payments and other obligations, as well as additional income streams from subsidiary holdings, asset sales, and other considerations.

Income =(often refer to)=> Net Income <==> Net Profit

Read more: What is the difference between revenue and income? - Investopedia

Profit: Profit is the revenue that remains after expenses are paid, and it can refer to a number of figures at a number of levels.

For example, gross profit is revenue less the cost of goods sold. Operating profit is revenue minus the cost of goods sold and operating expenses.

Read more: Is Net Income The Same As Profit? - Video | Investopedia

Earning: A company's earnings are equal to revenue less costs of production over a given period of time. Earnings typically refer to after-tax net income.

A company's earnings are equal to revenue less costs of production over a given period of time. Profit is equal to total revenue less all expenses. In the right context, these could be equal to each other, although that is rare. Big gaps between earnings and profits might be a sign the company spends too much time and money on unproductive activity.

Read more: What is the difference between earnings and profit? | Investopedia

Statement of Cash flows

  • Sources and uses of cash over a period of time
  • Operating activities
    • The provision of goods or services and other normal business activities
  • Investing activities
    • The acquisition or disposal of long-lived productive assets
  • Financing activities
    • Transactions related to owners or creditors

Sources of Financial Statement

  • Company's website
    • I.e. bottom page -> Investor Relations -> Financial -> annual report
  • SEC Edgar website
  • Internet finance site
    • Morningstar
    • Google finance
    • Yahoo finance
    • Reuters
  • Wharton Research Data Science
    • Very expensive

Ratio Analysis

Dupont Analysis

DuPont Analysis Framework

DuPont Analysis Framework

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ROE = ROA * Leverage
ROA = Net Income / Avg. Total Assets

ROE = (ROS * Asset Turnover) * Leverage
ROE = (Profitability * Efficiency) * Leverage

ROE = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity)

De-levered Net Income

ROA would measure operating performance independent of the company’s financing decisions - But, the numerator of ROA, Net Income, includes: Interest Expense - More leverage => higher Interest Expense => lower Net Income - To truly remove all financing effects from ROA, we must de-lever Net Income - ROA = De-Levered Net Income / Avg. Assets - De-levered Net Income = Net Income + (1 - tax rate) x Interest Expense

An example of De-levered Net Income
Company A (No debt) Company B (Some debt)
Pretax, pre-interest income 300 300
Interest expense 0 50
Pretax income 300 250
Taxes (35%) 105 87.5
Net Income 195 162.5
De-levered Net Income 195 195 (162.5 + 50 * (1 - 0.35))

An example of competitor comparison

RatioAnalysis-competitor-comparison

RatioAnalysis-competitor-comparison

A couple things to look at for beginners
  • How does the industry perform?
  • What's the trend of ROE for each company?
  • Who drives ROE in each company? (Who caused the increase/decrease of ROE)
  • Does the company perform good/so so/bad?

Quick note on finding comparison firms

One approach is to look at standard classification schemes for industries - SICCodes - NAICSCodes

Another approach is to look at who analysts and data services use as comparisons for the company - Analyst reports will often mention competitors - Google Finance give a list of “RelatedCompanies” - Reuters gives Industry and Sector comparisons

Profitability and Turnover Ratios

Profitability

What are the drivers of profitability? Decompose Return on Sales by income statement line item

Gross Margin vs Operating Margin
  • Gross margin (profit) = (revenue - cost of goods) / revenue
    • Revenue <=> Operating Revenue <=> Sales
  • Operating margin (net profit) = (revenue - cost of goods - operating expenses - other expenses - interest - taxes) / revenue
    • A more accurate measure of a company's profitability
    • Examining its net profit margin can help a company gain a much clearer picture of its overall expenses compared to revenue

Read more: What is the difference between gross profit margin and net profit margin? - Investopedia

Profitability-Example

Profitability-Example

Asset Turnover (Efficiency) Ratios

Turnover Ratio in general tells us: How many times per year do we cycle through accounts? Example: Inventory Turnover of 8 means that we build and sell Inventory 8 times per year, on average.

  • Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory
  • Accounts Receivable Turnover = Sales / Average Accounts Receivable
  • Accounts Payable Turnover = Purchases / Average Accounts Payable
    • (Purchases = Ending Inventory + COGS – Beginning Inventory)
  • Fixed Asset Turnover = Sales / Avg. Net PP&E
    • PP&E: Property, plant and equipment

These turnover ratios are hard to interpret

TurnoverRatios

TurnoverRatios

Days Outstanding Ratios are transformable to turnover ratios and more intuitive than turnover ratios.

Days Outstanding Ratios

How many days, on average, are accounts outstanding? Example: Days Inventory of 45 means that it takes 45 days,on average, from the time we start building Inventory until we sell it

  • Days Inventory = 365 * (Average Inventory / Cost of Goods Sold)
  • Days Receivable (Sales) Outstanding = 365 * (Average Accounts Receivable / Sales)
  • Days Payable = 365 * (Average Accounts Payable / Purchases)
  • Net Trade Cycle = Days Receivable + Days Inventory - Days Payable
    • Net Trade Cycle represents the gap between cash outflows and cash inflows that we have to bridge with short-term borrowing
NetTradeCycle

NetTradeCycle

Liquidity Ratios

It tells a company's cash position: e.g., have cash to pay out in short-term, borrowing capacity.

CommonLiquidityRatios

CommonLiquidityRatios

Short-Term Liquidity Ratios

Does the company have enough cash coming in to cover obligations to pay out cash? Ideally,ratios would be over 1.

  • Current Ratio = Current Assets / Current Liabilities
    • Keep in mind some current assets are non-cash pre-paids
    • Keep in mind some liabilities are non-cash unearned revenue
    • Current Ratio is just an approximation, because of it, we have the Quick Ratio
  • Quick Ratio = (Cash + Receivables) / Current Liabilities
  • Cash from Operations(CFO) to Current Liabilities = CFO / Avg. Current Liabilities
    • It tells us did the business generate enough cash during the period to cover its avg. level of current liabilities

Interest Coverage Ratios

Does the company have enough cash coming in from operations to cover interest obligations? Ideally,ratios would be over 1.

  • Interest Coverage = (Operating Income before Depreciation) / Interest Expense
  • Cash Interest Coverage = (Cash from Operations + Cash Interest Paid + Cash Taxes) / Cash Interest Paid
    • more direct measure than Interest Coverage

Long Term Debt Ratios

How does the company finance its growth? Also provide measure of bankruptcy risk and borrowing capacity

  • Debt to Equity = Total Liabilities / Total Stockholders’ Equity
    • Total Assets is sometimes used in the denominator
  • Long-Term-Debt to Equity = Total Long-Term Debt / Total Stockholders’ Equity
  • Long-Term Debt to Tangible Assets = Total Long-Term Debt / (Total Assets - Intangible Assets)

Forecasting

Common Size Financial Statements

Derived from historical financial statements to help forecasting the trends

  • Common Size Balance Sheet
    • Express all numbers as a percent of Total Assets
  • Common Size Income Statement
    • Express all numbers as a percent of Sales
  • Cash Flow Statement
    • Typically not common sized
Benefits
  • Remove effects of growth to help spot trends in the financial statements
    • Growth in Assets and Sales drive trends in all of the line items
    • Are certain line items growing more or less than would be expected given the growth in assets or sales?
  • Facilitate preparation of forecasted future financial statements
    • Combine historical common size statements with growth forecasts to get future statements
Forecasting Financial Statements

To be continued if needed ...

Accounting-based Valuation

To be continued if needed ...


References

A gentle and practical introduction to value investing

Accounting Analytics (Coursera Course)