Accountancy Notes

accountancy finance business management bookkeeping


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The Accounting Equation

Assets = Liabilities + Equity

This is the core accounting equation, and this is shown on the balance sheet, which is one of the core financial statements. Traditionally, these statements were shows with assets on the left, and liabilities and equity on the right; the linear format is more common now.

Assets = What I have
Liabilities = What I owe
Equity = What I own

For example:

I have a car worth £50,000, and it's mine to drive around.
I owe £20,000 on the car loan.
I own £30,000 of equity in the car.

The Finance Principles

Income = Revenue - Cost

What I make is everything I bring in, minus the cost it took to bring that money in.

Revenue = Price x Volume

How much do I charge for my time, and how much do I sell? That's my revenue.

Costs = Fixed + Variable

How does this relate to the accountancy equation? Accountancy is not concerned with performance. Accountancy is an unbiased look back at where the money went. Finance is concerned with the future, being profitable, and knowing why we will be.

Accounting is tracking things.

Finance is using what we are tracking to improve performance (eg. reduced cost, increased revenue, etc.)

The Four Financial Statements

The Balance Sheet

Assets = Liabilities + Equity

This is a snapshot of the company at this moment in time. Any company should be able to print a balance sheet and get an up-to-the moment idea of the status of the business. Hence, they are dated to give context.

Income Statement

Income = Revenue + Cost

The income statement is over a period of time. Generally for quarters and years. What was the income generated by that business in that year? If we take all of the sources of income, and subtract all the sources of costs, we have the remaining profit.

Cash Flow Statement

This tracks our cash, and it's movement. The reporting of income doesn't necessarily match the flow of cash.

Take as an example a retail business which needs to pay VAT. That VAT isnt income, it doesn't belong to the business, it belongs to the state. Nevertheless, the business collects that cash, so it's going to appear on the cashflow statement, but it will not appear in the income statement.

A further example related to depreciation. Lets say the business buys a vehice over a finance period. The cashflow statement would show the outflow of cash to pay for the vehicle, but on the income statement, I'd divide the cost of the vehicle over multiple years.

So: although income in a driver of cash, the income statement and the cash flow statement can differ, sometimes significantly.

Shareholders Equity (also know as Statement of Retained Earnings)

The equity is the ownership of the company. This shows the nature of that equity, the the payment of dividends. In publicly traded companies, there can be many forms of stock (preferred, common, etc.(, and this statement shows us how it changes from period to period.

The Practice of Accounting

Accountancy has rules, but more often they are guidelines. Hence there are different methodologies for preparing financial statements, in the USA there is GAAP (Generally Accepted Accounting Principles), or FASB (Financial Accounting Standards Board), and in the UK there is the ICAEW, ICAS, and CAI.

All the standards bodies generally share come core principles:

Costing

There is much subjectivity to costing; there are many ways to develop a cost:

Process Costing

Standard Costing

For example, pizza. The most expensive ingredient is the cheese, which is a market which varies. The pizzeria uses the standard cost of mozarella, otherwise tracking this price change would be too difficult from unit to unit. The variances go into a variance account.

Job Order Costing

eg. A carpentry firm makes a lot of furniture. The costs are different when making a square stool (which may use cheaper materials, and a less experienced labourer), vs a dining table, which may use more expensive materials, and require a finish from an experienced craftsman.

Cost Allocation

Direct Cost Allocation

Absorption Costing

Full Costing

Break-even analysis

Calculating operational break-even.

Break even example

Selling price == £10 per pizza.

Cost of ingredients == £3.60 per pizza.

Contribution == £6.40 per pizza.

Fixed costs = £4000/month.

Here we are sketching out the pizzeria. My premises and associated fixed costs are £4000 per month. Each pizza which I sell for £10 is costing me £3.60 in ingredients.

Break Even = Fixed Costs / Contribution

    -- or --

Break Even = £4000 / £6.40

      == 625 pizzas sold, or £6250

As soon as we have sold 626 pizzas, everything thereafter is profit.

Pricing

Now we know where the break even point is, depending on the environment and competition, we can set our prices.

For example, when competition is high and business is bad, then understanding the costs we can price at just slightly over the direct costs so we can bring in the money. Or when business is great, then we might have a full pipeline of work, so if we take on new business we may have to pay overtime because we are already at capacity -- so in that instance I might use full costing to make the maximum profit from the extra work.

Ratios

The ratios offer standard quick and easy ways of measuring performance of a business. They're useful to augment a SWOT analysis.

Because they're ratios, they work for businesses large and small.

As ratios are quick, they trade accuracy. Hence, don't look at a single ratio, look at several as a single one wouldn't tell the true story.

Liquidity Ratios

Working Capital Ratio

Working Capital Ratio = Current Assets / Current Liabilities

Quick Ratio (the Acid Test)

Quick Ratio = (current assets - inventories) / current liabilities

Asset Turnover Ratios

Inventory Turnover Ratio

Inventory Turnover Ratio = Sales / Inventory

            - or -

Inventory Turnover Ratio = Costs of Goods Sold / Average Inventory

Accounts Recievable Collection Period

Accounts Recievable Collection Period = Average Accounts Recievable / Average Daily Sales

Profitability Ratios

Return On Equity

ROE = Net Income / Shareholders Equity

Return On Assets

ROA = Net Profile / Total Assets

Return On Investment

ROI = (Gand from Investment - Cost of Investment) / Cost Of Investment

Return On Capital Employed

Debt Ratios

The Debt Ratio

Debt Ratio = Total Debt / Total Assets

Debt Equity Ratio

DER = Total Liabilities / Shareholders Equity

DuPont Pyramid

The DuPont analysis looks at the ROE of a business by breaking it down into three sub-formulas.

Commonly when evaluating a business, after the ROE ratio has been calculated, you can use the DuPont Pyramid to gain further, deeper insight and see what is driving the ROE.

Earnings And Dividends

Earnings Per Sare

EPS = (Net Income - Dividends) / Average Outstanding Shares

Dividends Per Share

DPS = Dividends / Average Outstanding Shares

Price-Earnings Ratio

P/E R = Market Value Per Share / Earnings Per Share.

Valuation

There are three main valuation methods:

Market Valuation / Market Cap

Multiples Method

Discounted Cash Flows

Net Present Value

Internal Rate Of Return

Caveat: If cashflows are positive, and then drop to negative, the IRR equation can be flawed. At this point we would rely on NPV alone.

Discount Rate