What is Accounting?
When people use the term ‘accounting’, they are generally referring to the process of systematically recording, analyzing, and interpreting a business’s financial information. Accounting is important because all financial analyses are built upon a solid understanding of a company’s financials.
There are three financial statements that you use to evaluate the performance and financial health of a company: The Income Statement, Cash Flow Statement, and Balance Sheet. These statements are published in periodic and annual filings for companies, and are often accompanied with financial footnotes and management discussion & analysis (MDA) to help investors better understand the specific compositions of the various numbers.
The Three Financial Statements
The Income Statement
The Income Statement illustrates the profitability of the company over a period of time by recording its revenues, expenses, and taxes, with its post-tax profit at the very bottom. For a line item to appear on the income statement, it must firstly, correspond to the period shown on the Income Statement and secondly, affect the company’s taxes by increasing or reducing the company’s taxable income. Common Income Statement line items include:
Revenue: Revenue represents the value of the products and/or services that a company sells. It is recorded when the transaction is processed – even though the cash may not be received at the time of the transaction (more on this later). It is often referred to as the “top line.”
Cost of Goods Sold (COGS): COGS represents the expenses that are linked directly to the sale of those products and/or services (e.g. COGS for a store that sells burgers would be the cost of the ingredients of the burger).
Operating Expenses: Operating Expenses are items that are not directly linked to product sales. Examples include employee salaries, rent, marketing costs, research and development costs, as well as non-cash expenses such as Depreciation.
Interest Expense: Interest Expense represents expenses related to paying debt holders periodic payments
Net Income: Net Income is the after-tax profits available to common shareholders after debt payments have been made. Broadly speaking, Net Income = Revenue - Expenses - Taxes. It is the last line of the Income Statement and is thus commonly referred to as the “bottom line.”
It is worth pointing out that not all the line items on a company’s Income Statement need to be cash expenses (e.g. Depreciation is a non-cash expense accounting for the deterioration of plant, property, and equipment over time), nor do all items need to be related to the company’s operational activities (e.g. Interest Expense, Gains/Losses on the sale of assets etc. are considered non-operational since they are not directly related to providing the company’s goods and/or services to the market).
The Balance Sheet
The Balance Sheet is a snapshot of the company’s Assets and Liabilities & Equity at a specific point in time. A company’s assets are essentially its economic resources while a company’s Liabilities & Equity are its funding or means of acquiring these resources. The Balance Sheet is governed by the fundamental accounting equation: Assets = Liabilities + Equity.
The easiest way to intuitively understand the significance of a balance sheet is to think of a personal Balance Sheet. Assume you have $10K in cash savings from your job and own a house that is worth $30K. Both the cash and the house are your Assets so you have a total of $10K + $30K = $40K on the Assets side of your Balance Sheet. Let’s now assume that you took out a mortgage (loan to buy property or land) of $10K to pay for your house. This $10K has to be paid back eventually so it is an obligation (Liability) on your end. What is your Equity then? Your Equity is everything you have left after paying off your $10K mortgage, in this case: $40K - $10K = $30K. It is no coincidence that your Liabilities + Equity ($10K + $30K) is exactly equal to your Assets ($40K), since balance sheets must always remain in balance!
For companies, Assets are the resources the company uses to operate its business, including Cash, Inventory, and Plant Property & Equipment (PP&E), etc., while Liabilities are items that represent the company’s obligations (usually to external parties, such as suppliers or debtors) and are used to fund the business. Common Liabilities include Accounts Payable (expenses a company has yet to pay) and Long-Term Debt (debt that is due in over a year’s time) etc. Equity refers to the value of the business that is available to shareholders after all Liabilities have been paid off, hence the equation: Equity = Assets - Liabilities. Common Equity line items include Common Stock & Additional Paid-In Capital (APIC), which represents the market value of shares at the time those shares were issued b the company and Retained Earnings, which represents the company’s after-tax profits (Net Income) less any dividends paid out to investors. The Balance Sheet PDF will cover specific line items in more detail.
It is worth noting that while both Liabilities and Equity represent sources of funding for the company’s Assets, Liabilities take priority over Equity. This means that if the company were to go bankrupt, the debt holders of the company would be paid first (in interest) with the remaining cash. Unlike debt holders, Equity holders or shareholders of the company are not promised contractual payments so they could end up losing their entire investment. However, when a company increases in value, it is the Equity holders and not the Debt holders who realize the gain. The debt investors only receive their contractual payments. Thus, Equity investments involve more risk but also promise higher returns.
The Cash Flow Statement
As mentioned previously, there are many cases when a transaction is recorded on the Income Statement but there is no actual inflow or outflow of cash. For example, assume a customer purchases a product but instead of paying on the spot, promises to send payment 30 days later. The transaction would be recorded as a sale (hence an increase in Revenue) on the Income Statement, but the actual amount of cash the company has would not increase until 30 days later. This method of accounting (recording a sale when the transaction occurs, regardless of when cash is received) is known as accrual accounting. It is also the reason why we cannot simply rely on the Income Statement and need a Cash Flow Statement to reflect the company’s cash inflows and outflows over a period of time.
The Cash Flow Statement can be divided into 3 main sections:
Cash Flow from Operations (CFO): This section starts with your Net Income and includes the cash effects of transactions involved in calculating Net Income. In other words, your CFO reconciles your Net Income to the amount of cash your company generated from operating its business over the specified period of time. Common items include Depreciation, Stock-based Compensation, Accounts Receivable, Accounts Payable, etc.
Cash Flow from Investing (CFI): This section includes cash activities related to the company’s investments, acquisitions or sales of assets/businesses. Since investments or purchases result in cash outflows for the company, they are negative. Sales, which result in cash inflows for the company, are positive.
Cash Flow from Financing (CFF): This section includes cash activities related to capital raising (either via the issuance of debt or common stock) as well as the payment of dividends. Just as in the other sections, a cash inflow (e.g. the company issues debt) results in a positive number while a cash outflow (e.g. the company pays dividends) results in a negative number.
At the very end of the Cash Flow Statement, you find Net Change in Cash, which, as its name suggests, is simply the change in the company’s cash over the specified period. The Net Change in Cash is the sum of the company's CFO, CFI, and CFF.
Linking the Three Financial Statements
While the Income Statement, Balance Sheet, and Cash Flow Statement are 3 separate financial statements, they are closely linked to one another. In fact, changing one line item in one sheet will very often result in corresponding changes in the other two as well.
Net Income, the “bottom line” of the Income Statement is the first line of the Cash Flow Statement. This means that increasing or decreasing Net Income would correspondingly increase or decrease cash flows. Net Change in Cash over the period, the last line of the Cash Flow Statement, links directly to the ‘Cash’ line on the Assets side of the Balance Sheet. Specifically, a positive Net Change in Cash would result in an increase in Cash while a negative Net Change in Cash would result in a decrease. On the Liabilities & Equity side of the Balance Sheet, the line item Retained Earnings is equal to Net Income - Dividends. Once again, this means that increasing or decreasing Net Income would correspondingly increase or decrease Retained Earnings. While there is no need to go into specifics at this point, note that each CFO, CFI, and CFF item on the Cash Flow Statement is linked to another item on the Balance Sheet. For example, an increase in the non-cash expense depreciation, which is reflected in the Income Statement and the Cash Flow Statement, translates to a decrease in PP&E on the Balance Sheet.
To learn more about the three financial statements, check out our downloadable cheat sheets below:
Cash Flow Statement
Test your accounting understanding: