Accounting Fundamentals

if you dont understand accounting, there is no way you can understand finance

1. Constructing a Balance Sheet

Financial statements: a record of financial activities of a company

3 key financial statements:

 Balance Sheet / Statement of financial position => shows what a company own (A),
what it is owe (L) and what it is worth (E)
 Income Statement / Statement of Profit or Loss => shows what a company has
earned (R) what it has paid (E) and what the resulting profit or losses in a period of
time
 Statement of cash flows => shows the actual cash movement, how much cash
company brought in and how much it has paid out. Consist of opr, inv, fin.

Balance Sheet

 Assets
o Current Assets
o Non Current Assets => tangible and intangible

 Liabilities
o Current liabilities
o Non current liabilities

 Shareholders’ Equity
What the business is worth after all the liabilities has paid out.
o Common Shares: At the beginning fo a business it is equally to the initial
amount that is invested to the company. In exchange, the investor get
common shares of the company.
o Retained Earnings: Net income flows to company’s equity as retained
earnings. If there is loss, it reduces the retained earning. So, RE is equal to a
running total that shows how much porfit company has made – losses –
dividend

Defining Accounts Receivable and Payables

Accounts receivable : amounts owed by customer to the company

Accounts payable : amounts owed by the company to suppliers
2. Constructing an Income Statement

Revenue/Sales
Direct operating cost (COGS)
Gross Profit
Indirect operating cost (R&D, SG&A)
Operating Income / EBIT
Cost of debt financing (Interest, bank charges)
Tax
Net Income
Income statement only include revenues and expenses that incurr in the running accounting
year.

Accured expense is expense that have been reflected on the income statement but not yet
paid for.
Prepayments is upfront payment relating to a future period

3. Constructing a Cash Flow Statement

Shows sources and use of cash, consist of:
 Operating CF
Includes items found in income statement, such as revenues and operating expense,
only reflect cash payment / receipt that incurr on that period.
 Investing CF
Includes purchasing and selling PPE/asset as well as making investment on
/acquiring/divesting a business
 Financing CF
Includes issuing/repurchasing shares, raising/repaying debt, paying dividend

In theory, it is not necessary to have cash flows statements as all cash items could be
recorded in the balance sheet. However, in practice just the closing cash balance is recorded
on the balance sheet and all the details are shown in the cash flow statement

Profit vs Cash Flows

Accrual concept: recognizes revenues and costs as a business earns or incurs them, not as it
receives or pays money.

Cash flow basis: better to planning daily cash needs / actual cash inflows and outflows
Matching/accrual basis: better to planning daily cost
Depereciation Method

 Straight line method = (Initial cost – Salvage values) / useful life

 Double Declining Balance = (100% x 2 x Beginning period BV) / useful lifes.
 Accelerating depreciation expense, greater in the early period, lower in the
later period. Useful for lower tax bills in the early years by lower taxable
income.
 Unit of production = (number of units produced/ lifetime number of units that
remain to be produced) x (cost – SV)]
 Depreciation expense varies each year since it is based on the output that
the assets produce. This is useful for company which want to match its
depreciation with its actual output

Calculating Operating Cash Flows

1. Direct method
Operating cash inflows – operating cash outflows = Net operating cash flows
>> this method is rarely used in practice

2. Indirect method
Begin with Net Income added or deducted by the movement of working capital
(AP/AR/Inv) then adjusted by depreciation and other non-cash operation item
(unrealised gain/loss, stock-based compensation, etc)

Deriving the complete cash flow statement

Information needed: Last year and current year BS, current year IS

1. Compare the Balance Sheets

Calculate the difference between this year’s figure and last year’s figure, for every
item in the balance sheet.
o If assets increase, this will resulted in a cash outflow, vice versa
o If liabilities increase, this will resulted in a cash inflow, vice versa
2. Classifying the cash flows
o Dealing with PPE
There are usually two reasons why a difference PP&E might have occurred:
 Depreciation, lowering PPE => Operating CF
 Net CAPEX, increasing PPE => Investing CF
Beginning PPE + Net Capex – Depreciation = Ending PP&E
o Dealing with Retained Earnings
 Net Income, increase RE => Operating CF
 Dividend, lowering RE => Financing CF