What is Accounting? • Accounting is the process of: - Systematically recording - Summarizing - Analyzing - Reporting financial transactions in the business • It is the language of the business • Accounting helps provide transparent and reliable data and information to make important business decisions.
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Why is Accounting required? Understand the cash flows and returns on investment generated by the Company To access the performance and determine competitive strategy To determine if the company has complied with the regulations and paid appropriate taxes on profits
Analysts Manage-ment
Investors
Competitors
Interested
For planning, budgeting and making important business decisions
Employees
To understand the business performance
Parties
Banks
Government
To determine the credit worthiness of the Company for purpose of extending credit
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To access the current performance and forecast future cash flows
Suppliers
Customers
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Access the balance sheet strength and ability to pay interest on loan
To access the business continuity
Types of Financial Statements Type of Financial Statements
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Income statement
Statement of Revenue, Expenses and Net profit
Balance sheet
Statement of Financial position (Assets and Liabilities)
Cash flow statement
Statement of Cash inflows and outflows
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What is an income statement? • Income statement or profit and loss statement shows the entities incomes and expenses during a period. • It shows how the revenues (top line) of the company has translated into net income (bottom line) during the period.
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Revenues Less: Cost of goods sold Less: Selling and marketing exp Less: Depreciation Earnings before interest and Tax Less: Interest Less: Taxes Net income
Income statement - Example John has started a business of selling dress material with $1,000 on 1st January 2020. He purchases 100 meters of the material from his suppliers for $9 each. He sells this material for $20 each. At the end of the month, John has no material left. Apart from the material purchase, he incurred an additional expense of $100 in marketing his material. You are required to prepare the Profit and loss account for John. Income statement of John for the period 01st Jan to 31st Jan 2020 • • • • • •
Revenue is the amount received on sale of goods. In our example, John sold 100 meters of dress material @ $20 per meter. Hence, his total revenue is $2,000. Cost of goods sold (COGS) is the price paid for acquiring goods. John purchased 100 meters of dress material @ $9 per meter. Hence his total Cost of goods sold is $900. Marketing Spend is a spend associated with sales of products and services. In the above example, John incurred a marketing spend of $100.
Net income is the profit generated by a Company after accounting for all expenses.
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What is a Balance sheet? •
Assets
Balance sheet is the statement of Assets, liabilities and equity of a company as at a given date.
Current Assets (Cash, Inventory, AR) Non-Current Assets (PPE, Goodwill)
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It is a statement showing what an entity owns (Assets), what it owes to others (Liabilities) and what its owners have invested in the business (Equity).
Liabilities Current Liabilities (Accounts payable) Non-Current Liabilities (LT Debt)
Assets = Liabilities + Equity
Equity
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Balance sheet – Example (1/3) Continuing with our previous example, lets assume that John had invested $1000/- equity in his business. On the day of investment his balance sheet would look like this. Balance sheet of John as on 1st Jan 2020
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Current assets are those assets which can be converted into cash within one year. They include: Cash and cash equivalent, Trade receivable, Inventory, prepaid expenses etc.
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Non-current Assets include assets such as Property plant and equipment, Long term investments etc. which cannot be converted into cash (during the normal course of operations) within one year.
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Current Liabilities are liabilities which are expected to be paid within one year. These liabilities include: Trade payables/ creditors, Short term outstanding expenses, Short term debt etc.
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Non-current liabilities are those liabilities which are expected to be paid after one year. It includes Long term debt, Pension, Post-retirement benefit liabilities etc.
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Equity is the amount invested in the business by its owners.
John had invested $1,000 in the business. His balance sheet will look as shown above. Equity will be $1,000 and Assets will be $1,000 cash.
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Balance sheet – Example (2/3) When John buys the dress material for $900 his balance sheet will look as under. Balance sheet of John as on 1st Jan 2020
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$1,000 cash gets reduced to $100, as he paid $900 for the dress material.
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The dress material purchased becomes his inventory of $900 in the balance sheet.
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There is no change in the equity investment
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Balance sheet – Example (3/3) In the next one month, John sells off all the inventory and earns a net profit of $1000. His balance sheet on 31st January will look like this. Balance sheet of John as on 31st Jan 2020
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His inventory gets converted to revenues of $2,000. Out of which he pays $100 for marketing spend. That means his cash balance would increase by $1,900. Closing cash balance for John would be $100 + $2,000 - $100 = $2,000
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Inventory gets reduced to NIL as all the material has been sold.
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Equity increases by $1,000 which is the net profit earned during the period. Closing Equity = Opening Equity + Net profit Closing Equity = $1,000 + $1000 = $2,000
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What is a Cash flow statement? •
Cash flow statement shows how efficiently a company manages its cash.
Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities
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It shows how much cash a company has generated from its operations and how much of it was expensed and retained during a period.
Net cash inflow/ outflow Cash balance at the beginning of the period Cash at the end of the period
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Cash flow statement – Example (1/3) Continuing with our previous example. Let’s look at the cash flow statement of John on 01st Jan 2020 before he purchases the dress material. Cash flow statement for John
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There is no cash flow from Operating and Investing Activities. John has financed his business with $1000 equity. Hence cash flows from Financing Activities would be positive $1000.
Opening cash is NIL and closing cash is $1,000 funded in the business.
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Cash flow statement – Example (2/3) When John purchases the dress material, his cash flow statement would look like this. Cash flow statement for John
$900 used in purchasing dress material is a cash outflow for John from Operating Activity.
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Closing cash left in the business is $100.
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Cash flow statement – Example (3/3) At the end of the month, John’s cash flow statement would look like this. Cash flow statement for John for the period 1st Jan – 31st Jan 2020
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$1000 earned in the business or net income is a cash inflow from operating activity. The inventory during this period reduced to NIL (see balance sheet above). This decrease is a cash inflow of $900 for the business. Summing these two give the cash flow from operations, which is $1,900. When we add the net cash flows generated to the opening cash balance, we get the closing cash balance for John’s business: i.e. $2000/-. This balance matches with what we have in the balance sheet
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