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The Holy Equation of Accounting

Assets = Liabilities + Equity

Lightning Round – Financial Accounting   Two types of accounting   1. Managerial Accounting: for internal users   2. Financial accounting: for external decision makers   SEC Act of 1934   10-K: annual report (required & must be audited)   10-Q: quarterly report (not required & no auditing necessary)   8-K: Announce major events such as changes to the management, bankruptcy, major accounting changes, etc.   US: Financial Accounting Standards Board –

Generally Accepted Accounting Principles   International Financial Reporting Standards

Lightning Round – Balance Sheet   Balance sheet shows the company’s position at the point

of time   Assets: any resources that will yield future economic benefit  

Current Assets: Can/will be used in 1 yr.   Cash,

cash equivalents, A/R, Merchandise Inventory, Prepaid Expenses, supplies, etc.


Non-current assts   Long-lived

assets (PPE), Intangibles (patent, trademark, etc.)

  Liabilities: amounts owed by the company    

Current Liabilities: Payables (accounts, taxes, notes, interest, dividends, etc.), Unearned Revenue Non-Current Liabilities: Bonds, Loans

Lightning Round – Balance Sheet   Equity: Owner’s claim on the business assets   Contributed Capital: Preferred & common stock, additional paid in capital (in excess of par), treasury stock   Retained earnings: whatever income/earnings left after drawings/dividends. (cumulative)

Lightning Round – Balance Sheet   Sample Balance Sheet Assets Cash A/R Inventory 150 PPE (Less) Acc. Dep. Total

100 50 500 100 900

Liabilities A/P Expenses Payable N/P Bonds Total

100 50 200 300 650

Owner’s Equity Common Stock Retained Earnings 50 Total

200 250

Lightning Round – Income Statement   Revenue: income that has been “earned”  

Accrual accounting: Revenue is recognized when products are sold or services are performed. Expenses are recognized according to the matching principle (expenses are matched to revenue earned). Does not track cash

  Operating expenses: expenses for day to day

business COGS: cost of goods sold   SG&A: Selling, General, and Administrative   Depreciation: rational and systematic allocation of cost (matching). Just another way of spreading cost.  

  Interest expenses, tax expenses, gains &losses.

Sample Income Statement Revenues Sales


Expenses COGS SG&A Depreciation Operating Income Interest Expense 20 Tax Expense Gain (loss) from sales Net Income

200 100 50 150

39 (20) 71

Lightning Round – Statement of Cash Flow   Does the business have sufficient cash at hand to

operate?   Cash Flows from operations: $ changing hands from everyday business   Cash Flows from investing activities: $ change due to purchase or sales of long term assets (not necessarily like the ones we are doing).   Cash Flows from financing activities: $ change due to raising capital by issuing shares, bonds, getting loans, paying back loans, etc.

Sample Statement of Cash Flows Operating Activities Revenues providing cash Expenses paid with cash Cash Flow from operations

100 90 10

Investing activities Sales of noncurrent assets Purchase of noncurrent assets Cash Flow from Investing activities

0 200 (200)

Financing activities Cash from borrowing 150 Cash from issuing equity Cash used to repay debt Cash used to pay dividends Cash Flow from financing activities

Net change in cash Beginning Balance of Cash Ending Balance of Cash

100 10 0 240

50 100 150

Statement of Owner’s Equity & Notes to financial statements   Statement of Owner’s Equity: refer to the balance

sheet   Notes: the qualitative nature of the numbers in the previous four financial statements

Financial Statement Analysis   Horizontal Analysis: AKA time-series analysis, looks

at trends

Yoy change = (Change this year/last year’s total) x 100%   Absolute $ amount change  

  Vertical Analysis: Common size, what is the

percentage composition of each item?

Balance Sheet: percentage of each item (total asset = 500k, inventory = 100k, or 20%; cash= 400k, or 80%)   Income statement: percentage of sales (sales = 100k, operating expenses = 80k, or 80% of sales)  

Ratios   Liquidity Ratios   Current Ratio: measures company’s ability to pay current liabilities <CurrentRatio = Current assets / current liabilities>  

Quick Ratio: measures company’s ability to pay current liabilities just like current ratio, but this is a much more stringent test QR = Quick Assets / Current Liabilities   Quick

Assets = Cash +Cash equivalents + A/R + Short term investments ( <3 mo )

Ratios   Profitability Ratios   Net Profit Margin: percentage of sales that remain in net income after expenses <Net Income / Net Revenue>  

Gross Profit Margin: NPM tells you the overall profit margin. If there’s an increase or decrease in NPM, is it due to +/- in revenue or is it due to +/- in cost? GPM tells you this <(Net Sales – COGS)/ Net Sales>


Operating profit margin: the two aforementioned ratios may be skewed due to one-time items. This ratio only looks at profitability of usual business <Operating profit / Net Sales>

Ratios   More Probability Ratios   Effective Tax Rate: The company’s stated jurisdictional tax rate may differ from real tax rate due to accounting factors, foreign factors, etc. This rate gives the effective rate. <Effective Tax Rate = Income Tax Expense / Pretax Income>  

Return on Assets: How much income is generated in sales for each dollar invested. <ROA = Net Income / Avg. Total Assets>


Return on Equity: How much is earned as a percentage of each dollar contributed by stockholders and retained in business. <ROE = Net Income / Avg. Stock holder’s equity>

Ratios   More Profitability Ratios    

EPS: < (Net income – preferred dividends) / Avg. number of common shares> P/E: Stock price / EPS

  Solvency Ratio    


Debt to Assets: indicates the proportion of total assets to cover total liabilities <Tot. Liabilities / Tot. Assets> Free Cash Flow: company’s ability to make capital investments and pay dividends from its operating cash flows. <FCF=Net Cash flow from operating activities – purchase of PPE – Dividends paid> Times interest earned: how may times is the company’s interest expense is in terms of operating results (ability to pay interest) <TIE = (net income + interest expense + income tax expense) / Interest expense>

How to use Financial Statements and Ratios to Value Stocks