Accountancy Notes

accountancy finance business management bookkeeping

• Accounting deals with tracking the flow of money. How is it used?
• Finance is the usage of the money which you have.

eg.

• In accountancy, you can have -£1000.
• In the real world (finance), you can't have less than zero. I could in fact own £1000, but still have £100 in my pocket.

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:

• Historical Cost Principle: this requires companies to account and report based on acquisition cost at the point of acquisition rather than it's fair market value, for most assets and liabilities. For example, we would report the full value of a vehice, rather than it's value the minute you drove it off the forecourt (when it lost 10% of it's value).

• Revenue Recognition Principle: companies must record revenue when it is earned. This is the essence of accrual basis accounting. The flow of cash does not have any bearing on the recognition of revenue. For example, a sale may be made in January, on 60-day terms. However, I would record that sale in January even though the cash would not be realised until March. Costs are treated the same way.

• The matching principle: expenses have to be matched with revenue. Expenses are recognised when the work actually makes it's contribution to the revenue. For example, a retail business may import stock in bulk. This may be paid for in cash, upfront. So while that will be shown on the cashflow statement, the expense if only recognised when the goods are sold to the end consumer.

• The full disclosure principle: the more time we spend on accounting, the more accuracy we can achieve. But that accuracy costs money to create. So we need to decide based on a trade-off analysis is it's worth providing additional information.

• The materiality principle: The significance of an item reported in the practice of accountancy should be considered at the time it is reported. There is a lot of leeway for accountancy to be honest or corrupt.

• The consistency principle: where guidelines are loose, and whatever accountancy methodology you use, it should be consistent period-to-period.

• The conservatism principle: When choosing between two ways of accounting, the one which has the least favourable outcome to the business should be chosen. The accountancy statements should not give a rose-tinted view of the business.

Costing

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

• Process Costing
• Standard Costing
• Job Order Costing

Process Costing

• Applied with the units produced are very uniform, the same time after time.
• Look at the direct costs incurred when producing the unit (whether paying for materials, or the time for the consultant etc), then take the overhead costs divided by the number of units produced. This gives you a price.

Standard Costing

• Assigning costs using the average or standard costs, rather than the actual direct costs of materials, labour, and overhead.
• The differences between the actual costs and the standard costs are known as variances.

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

• A lot like process costing in that we still apply the direct costs and overheads.
• Used when the products made are sufficiently different from each other.

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.

• Essentially it is costing each unit individually as it is made.

Cost Allocation

Direct Cost Allocation

• Where we only apply the direct costs in making the unit. eg. in the pizzeria, the direct costs are the flour, water, yeast, tomato sauce, cheese etc. However the staff costs are not the direct costs -- you have the pay the chef as long as the restaurant is open, and for lighting and heating, even if there are no customers who come and order the pizza.

Absorption Costing

• Uses direct costs and SOME of the overhead costs.
• eg. in the pizzeria, we find a way to allocate the direct costs into each unit. So for example we could take the average number of pizzas produced per shift, and divide the staffing costs by that amount, and inclue that in the cost.

Full Costing

• note: confusingly some people refer to this as absorption costing :-|
• Uses direct costs and ALL of the overhead costs.
• eg. in the pizzeria, we take the number of pizzas produced in a shift, AND the staffing costs, AND the cost of heating, lighting, rent, etc, and include it all in the unit price.

Break-even analysis

Calculating operational break-even.

• This uses the direct costing approach.
• It requires us to classify costs as either fixed costs, which are not influenced by the volume of units produced, or variable costs, which do vary directly with the volume of units produced.
• This is a subjective analysis!
• eg. in the pizzeria, technically the gas bill for the pizza over in a variable cost. The more pizzas I produce, the more gas I will technically use. However, accounting for this will be a nightmare, so we can make the decision to treat the gas bill as a fixed cost.

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

• Used to determine the companys ability to pay off it's short-term debt obligations.

• the higher value of the ratio, the larger the margin of safety the company has over it's short-term debts.

Working Capital Ratio

Working Capital Ratio = Current Assets / Current Liabilities

• Anything below 1.0 indicated negative working capital.
• Anything above 2.0 means the company is not investing it's excess assets.
• Most people believe a ratio between 1.2 and 2.0 is sufficient.

Quick Ratio (the Acid Test)

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

• Excludes inventory from our current assets, as it may not be easy to turn that ratio into cash.
• Essentially this is measuring the liquid assets available to cover the liabilities.
• The higher the ratio, the better the companys liquidity position.

Asset Turnover Ratios

• Used to indicate the turnover of assets such as inventory and accounts recievable. eg. "How long does it take to collect on my accounts recievable?"

Inventory Turnover Ratio

Inventory Turnover Ratio = Sales / Inventory

            - or -

Inventory Turnover Ratio = Costs of Goods Sold / Average Inventory

• This ratio shows how many times a company's inventory is sold and replaced over a given period.

Accounts Recievable Collection Period

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

• This ratio shows how efficient we are at collecting the money owed to us.

Profitability Ratios

• Used to assess the bottom line of the business.
• Having a higher value relative to a competitors ratio is favourable.
• Maintaining the same ratio period-to-period indicates the company is doing well.
• These ratios require background knowledge of the business to make good quality comparisons.

Return On Equity

ROE = Net Income / Shareholders Equity

• The amount of net income returns as a percentage of shareholders equity.

• Measures the companys profitibaility by revealing how much profit the company generates with the money the shareholders invested.

Return On Assets

ROA = Net Profile / Total Assets

• Indicates how profitable a company is relative to it's total assets.
• Gives a good idea of how the management is using it's assets to generate earnings.
• Tells you what earnings were generated from invested capital.

Return On Investment

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

• Used to evaluate the gain from an investment. What money did you put in and what money did you get out?
• In an investment does not have a positive ROI, or there are other opportunities with a higher ROI, then the investor should look elsewhere.

Return On Capital Employed

• Measured the company profitability and the efficienct of the capital which is deployed.

  ROCE = EBIT / (Assets - Current Liabilities)

Debt Ratios

• Give an idea of the company's overall debt load.
• Helpful to determine the overall level of financial risk to the comany and it's shareholders.
• The greater debt, the greater risk of bankruptcy.
• Also known as 'leverage'.

The Debt Ratio

Debt Ratio = Total Debt / Total Assets

• Interpreted as the proportion of the assets which are financed by debt.
• The higher the ratio the greater the financial risk.
• However, debt ratio averages can vary widely across industries.

Debt Equity Ratio

DER = Total Liabilities / Shareholders Equity

• Compares a companys total liabilities to it's total equity.
• Answers the question "Who are we turning to for money, investory or creditors?"
• Similar to ROE, but with a debt perspective.
• Measures how much suppliers, lenders, creditors have committed to the company vs. what the shareholders have committed.
• A lower percentage means the company is using less leverage and has a stronger equity position.
• 2:1 is considered the acceptable level. For example, for a company £200,000 is debt, it's expected the shareholders have committed £100,000.

DuPont Pyramid

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

• Profit Margin (PM = Profit / SaleS). This shows us operating efficiency. How efficiently is it producing it's profit?
• Total Asset Turnover (TAT = Sales / Assets). This shows us how efficiently a business is using it's assets.
• Equity Multiplier (EM = Assets / Equity). This tells us how financially leveraged the business is.

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

• Ratios used by investors to understand the value of a potential or existing investment.
• These simplify the evaluation process by comparing relevent data to get the estimated value.

Earnings Per Sare

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

• The companys profit is distributed among all the shares which are available. This shows the performance of each share.

Dividends Per Share

DPS = Dividends / Average Outstanding Shares

• As above, this values the total dividend paid per share.

Price-Earnings Ratio

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

• this is a valuation of the company's current share price vs it's per-share earnings.
• reflects confidence in the performance of the business. You'll pay more for a share if you believe it will earn more.

Valuation

There are three main valuation methods:

• Market valuation
• Multiples method
• Discounted Cash Flow Analysis

Market Valuation / Market Cap

• The simplest way to value a publicly traded company.

  Value = Price of A Share X Number of Shares.

• This is the quickest, easiest way to value, but we sacrifice accuracy.

• The market cap is rarely considered to uncover the true value.
• It is driven by traders/investors; the market is largely driven by the crowds and doesn't have true insight.
• This can be used to determine if a stock is over/under valued.

Multiples Method

• This is a medium difficulty method of valuation.
• This is useful for comparing companies in the same sector/industry.
• All sectors have a multiple which is commonly used for valuation. But it changes from industry to industry.

• Examples of multiple valuations:

  • Price/Earning ratios
  • EBITDA (Earnings Before Interest Taxes Depreciation and Amortization)

• Take an average across the industry for P/E, EBITDA, Market Cap. These can then be multiplies into the company we are examining to get a rough valuation.

Discounted Cash Flows

• The most thorough method.
• Uses the free cash flows and a 'discount rate' to calcular NPV (Net Present Value).
• It can also be used to calculate the IRR (Internal Rate Of Return).

Net Present Value

• Uses the time value of money; tells us what the future cash flows are worth in todays money.
• Takes into account the companys current cost of capital (in the form of a weighted average cost of capital [or WACC])
• NPV discounts future cash flows at the rate of WACC to arrive at a present value. If this is greater than zero, then the investment is profitable.

Internal Rate Of Return

• IRR is the yield of the investment as a percentage
• If the IRR is greater than the WACC, it's a good investment.

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

• A monetization of the risk associated with a venture.
• Cash flows are discounted by this rate to determine the present value "net of risk".
• At the lowest, we use inflation.
• At the highest, we use speculated risk.
• For existing businesses, we can use the WACC.