Accounting

Basics
Agenda
• Accounting Cycle
• Accounting
Assumptions
• Income Statement
• Balance Sheet
• Cash Flow Statement
• Ratio Analysis
 Accounting Assumptions
• The need for Generally Accepted Accounting Principles arises
from the following needs:
▪ To be logical & consistent
▪ Conform to established practices & procedures

• ICAI lays down the standards and rules, fundamental

assumptions are:
▪ Going Concern
▪ Consistency
▪ Accrual
▪ Business Entity
▪ Matching Principle
Going Concern
• Business will continue to exist and carry on its operations for an
indefinite period (not liquidate in the foreseeable future)

• Hence, the basis of valuation of resources is influenced more

by their future utility than by their current market valuation

• Example: If you recently purchased equipment costing $5,000

that had 5 years of productive life, then under this assumption,
the accountant would only write off one year's value $1,000
(1/5th) this year, leaving
$4,000 to be treated as a fixed asset with future economic
value for the business
Consistency
• Consistency concept states that once a pattern is developed in
accounting, it must be continued
• Uniformity in accounting processes and policies from one
period to another
• Material changes must be disclosed
• Only then, the accounts will be uniform and comparable
• Example: if a company is charging depreciation using the
straight line method, they must stick with the straight line
method
Accrual Basis
• To make a record of all the expenses and incomes relating to the
accounting period whether actual cash has been disbursed or
received or not
• More accurate picture of the company’s current condition but it is
more
complex and expensive to implement
• This is the opposite of cash accounting, which recognizes
transactions only when there is an exchange of cash
• http://www.investopedia.com/video/play/accrual-accounting/
Business Entity Concept
• Business is a different entity from its owners
• The transactions of the business are to be accounted for
separately
from its owners
• Therefore, any personal expenses will not appear in the
income statement of the business entity
• Similarly, if any personal expenses of owners are paid out of the
assets of the entity 🡪 it would be considered as drawings
Matching Principle
• GAAP requires companies to use accrual basis of
accounting
• Matching principle requires that the expenses be matched
with
revenues
• For example, sales commissions expense should be
reported in the period when the sales were made (and not
reported in the period when the commissions were paid)
Income
Statement
 Introduction to Income Statement
• A financial statement that measures a company's financial
performance over a specific accounting period

• It captures two aspects of a business – Revenue & Expenses over

a given period (usually 1 year or 1 accounting period) through both
operating and non-operating activities

• http://www.investopedia.com/video/play/introduction-income-statemen
t/
 Operating v/s Non operating
activities
• Operating activities: All the activities that contribute to generating
revenue from the business’s core operations (manufacturing,
marketing and selling of goods) are clubbed under this head

• Non-operating activities: All activities that are not a part of the

business’s
core operations are called non-operating activities. Items like interest
income, dividend income, foreign exchange gains etc. are the
business’s non- operating activities
 Revenue
• This is income generated by a company from its main business
activities (sales of goods or services) and is also called turnover
or top line

For manufacturing companies 🡪 sale of

goods, For banks 🡪 interest income,
For law firms 🡪 fee from clients

• The Income statement has another head called ‘Other Revenue’.

This is
income generated from its non-operating activities
Cost of Goods Sold & Gross Profit
• All the expenses that lead to adding value to the raw material/semi-
finished goods before the finished product is kept away for storage
or is sent out of
the factory constitute a part of the head ‘Cost of Goods Sold.

• This also includes items like electricity cost at the factory, worker
wages,
carriage-in cost of the raw material etc

• However, the storage costs are the carriage-out costs are not
included under this head

• Therefore, Total Sales – COGS => Gross Profit

 Selling, General &
Administrative Expenses
• This head constitutes all the operating expenses like storage
costs, selling
expenses, employee’s salaries, marketing costs, R&D overheads
etc

• Selling costs include direct selling expenses such as those that

can be directly linked to the sale of a specific unit such as credit,
warranty and advertising expenses

• General and administrative expenses include salaries of non-sales

personnel, rent, heat and lights

• Therefore, Total Gross Profit – SG&A => EBITDA

 Depreciation &
Amortization
• Depreciation is used in accounting to try to match the expense of an asset
to the income that the asset helps the company earn
• For example, if a company buys a piece of equipment for $1 million and expects it to
have a useful life of 10 years, it will be depreciated over 10 years. Every accounting
year, the company will expense $100,000 (assuming straight-line depreciation), which
will be matched with the money that the equipment helps to make each year

• Amortization is similar to depreciation as a concept except that it is applied to only

intangible assets. For example, suppose XYZ Biotech spent
$30 million dollars on a piece of medical equipment and that the patent on
the equipment lasts 15 years, this would mean that $2 million would be
recorded each year as an amortization expense
• Therefore, EBITDA – DA => EBIT (Operating Profit)
Other Revenue &
Expenses
Other Revenue: This includes interest income, dividend income,
profit from sale of assets etc.

Other Expenses: This includes any non-operating expense or loss.

Video
s
Accounting Basics:
http://www.youtube.com/watch?v=YzRrTWjQRgA
Balance
Sheet
http://www.investopedia.com/video/play/introduction-balance-she
et/
Accounting Equation
Assets
=
Liabilities
+
Owner’s Equity
 Balance
•Sheet
A Balance Sheet is a financial statement that summarizes a
company's assets, liabilities and shareholders' equity at a
specific point in time
• These three balance sheet segments give investors an idea as
to what the company owns and owes, as well as the amount
invested by the shareholders
• The balance sheet must follow the following formula:
Assets = Liabilities + Shareholders' Equity
• It's called a balance sheet because the two sides balance out
• A company has to pay for all the things it has
(assets) by either borrowing money (liabilities) or
getting it from shareholders (shareholders' equity)
 What is an
Asset?
• Definition: An asset is anything of value that can be converted into
cash. Assets are owned by individuals, businesses and
governments.
• Think of assets as that which is source of funds/ cash for a firm
• Examples of assets include
▪ Cash
▪ Cash equivalents: certificates of deposit, checking and savings
accounts, money market accounts, physical cash, Treasury bills
▪ Real property: land and any structure that is permanently attached
to it
▪ Personal property: everything that you own that is not real property
such
as boats, collectibles, household furnishings, jewelry, vehicles
▪ Investments: annuities, bonds, cash value of life insurance
policies, mutual funds, pensions, stocks and other
investments
 Assets
•
Continued
Assets can be broadly divided into 2 categories:
• Current Assets: All assets that are reasonably expected to be converted
into cash within one year in the normal course of business
• Example: Cash, accounts receivable, inventory, prepaid expenses
• Importance: Current assets are important to businesses because they are
the assets
that are used to fund day-to-day operations and pay ongoing expenses
• Non Current Assets: Assets that are expected to be converted into cash in
a time
frame greater than a year, anything that isn’t a current asset
• Example:
▪ Property, plant and equipment
▪ Intellectual Property
▪ Goodwill
 What are Liabilities ?
• Definition: A company's legal debts or obligations that arise
during the course of business operations, think of liabilities as
an outflow of funds
• Alternatively, think of it as any money or service that is owed to
another party
• Examples
▪ Loans, accounts payable, mortgages, accrued expenses

• Current liabilities are debts payable within one year, while

long-term liabilities are debts payable over a longer period
 What is Owner’s Equity?
• Definition: The portion of the balance sheet that represents the
capital received from investors in exchange for stock (paid-in
capital), donated capital and retained earnings.
• Stockholders' equity represents the equity stake currently held on the
books by a firm's equity investors
• Owner’s Equity = Share Capital + Retained Earnings
• Owner’s Equity = Total Assets – Total Liabilities
• Stockholders' equity is often referred to as the book value of the
company, and it comes from two main sources
• Original source is the money that was originally invested in the
company, along with any additional investments made thereafter
• The second comes from retained earnings that the company is
able to
accumulate over time through its operations
Possible changes in a Balance
Sheet: Example Assets Liabilities and
Equity

Purchase a tractor via a loan

Paying off the tractor loan via

cash

Purchase a tractor via cash

Taking a new loan to pay the

tractor loan
Possible changes in a Balance
Sheet: Example Assets Liabilities and Equity

Purchase a tractor via a loan Increase Increase

Paying off the tractor loan via

cash

Purchase a tractor via cash

Taking a new loan to pay the

tractor loan
Possible changes in a Balance
Sheet:
Example Assets Liabilities and Equity

Purchase a tractor via a loan Increase Increase

Paying off the tractor loan via Decrease Decrease

cash

Purchase a tractor via cash

Taking a new loan to pay the

tractor loan
Possible changes in a Balance
Sheet: Example Assets Liabilities and Equity

Purchase a tractor via a loan Increase Increase

Paying off the tractor loan via Decrease Decrease

cash

Purchase a tractor via cash Inc&Dec No Change

Taking a new loan to pay the

tractor loan
Possible changes in a Balance
Sheet: Example Assets Liabilities and Equity

Purchase a tractor via a loan Increase Increase

Paying off the tractor loan via Decrease Decrease

cash

Purchase a tractor via cash Inc&Dec No Change

Taking a new loan to pay the

No Change Inc&Dec
tractor loan
Cash Flow
Statement
Cash Flow Statements- Video
http://www.investopedia.com/video/play/what-is-ca
sh- flow/
 More about Cash Flows
(1/2)
• The income statement is a description of how the assets
and liabilities were utilized in the stated accounting period
• The cash flow statement explains cash inflows and outflows,
and will ultimately reveal the amount of cash the company
has on hand
• It is calculated by adding noncash charges (such as depreciation) to net
income
after taxes
• It can be used as an indication of a company's financial strength
• Cash inflows usually arise from one of three activities –
• Cash Flow from Financing
• Cash Flow from Operations
• Cash Flow from Investing

• Cash outflows result from expenses or investments

 More about Cash Flows
(2/2)
Cash Flow 🡪 Shows the cash on hand; which will ensure that
creditors, employees and others can be paid on time.
If a business does not have enough cash to support its operations, it is
said to be insolvent, and a likely candidate for bankruptcy should the
insolvency continue
Think of it as a compressed version of the company's check book that
includes a few other items that affect cash, like the financing section,
which shows how much the company spent or collected from the
repurchase or sale of stock, the amount of issuance or retirement of
debt and the amount the company paid out in dividends

http://www.youtube.com/watch?v=GkGdlgX3xYI
 Cash Flow
Computations`
• The statement of cash flow can be presented by means of two ways:
• The Indirect method
• The Direct method
• The Indirect Method is preferred by most firms because is shows
a reconciliation from reported net income to cash provided by
operations.
• The Direct Method presents cash flows from activities through a
summary of cash outflows and inflows. However, this is not the
method preferred by most firms as it requires more information to
prepare.
http://www.investopedia.com/exam-guide/cfa-level-1/financial- stat
ements/cash-flow-direct.asp
Cash Flow from Operating ie
Activit
•It refers to money generated by a company's core business s
activities🡪 revenues and cash operating expenses- net of taxes
• Cash inflow (+)
• Cash Received from sale of goods and services
• Interest earned from debt instruments of other entities
• Dividends earned from equity investments

• Cash outflow (-)

• Payments to suppliers
• Payments to employees
• Payments to government
• Payments to lenders
• Payments for other expenses
• http://www.investopedia.com/exam-guide/cfa-level-1/financ
ial- statements/cash-flow-statement-basics.asp
Cash Flow from Investing e
Activiti s
• CFI is cash flow that arises from investment activities such as the
acquisition or disposition of current and fixed assets
• Cash inflow (+)
• Sale of property, plant and equipment
• Sale of debt or equity securities (other entities)
• Collection of principal on loans to other entities
• Cash outflow (-)
• Purchase of property, plant and equipment
• Purchase of debt or equity securities (other entities)
• Lending to other entities
• http://www.investopedia.com/articles/financial-theory/11/cash-flo
w-
from-investing.asp
 Cash Flow from Financing e
•Activiti
CFF is cash flow that arises from raising (or decreasing)s
cash
through the issuance (or retraction) of additional shares, short-term
or long-term debt for the company's operations
• Cash inflow (+)
• Sale of equity securities
• Issuance of debt securities
• Cash outflow (-)
• Dividends to shareholders
• Redemption of long-term debt
• Redemption of capital stock
Ratio
Analysis
 Ratio
Analysis
Broadly speaking 5 types of ratios :

• Liquidity ratios: measure of whether the firm would be able to pay off
imminent
liabilities using the existing “liquidifiable” assets

• Profitability ratios: measure of performance and operational efficiency in

terms of
profits and returns

•Turnover ratios: measure of efficient utilization of resources for boosting

topline and bottomline of the firm

• Solvency ratios: measure of how optimum and sustainable the capital

structure is
to support the operations

•Valuation ratios: to value a company based on fundamentals as well as

market perception
 Liquidity
ratios
1. Current ratio: company's ability to pay back its short-term es (debt
liabiliti payables) with its short-term assets (cash, and
inventory, receivables)

The higher the current ratio, the more capable the company is of paying
its obligations but at the same time a very high value could lead to high
opportunity costs as well (too much investments in current assets)

2. Quick ratio / Acid Test ratio: company’s ability to meet its short-term
obligations with its most liquid assets

Hence we exclude assets such as inventory and prepaid expenses which

cannot be
converted into cash quickly
Session
LIABILITES ASSETS
Exercise
Capital 180 Net Fixed Assets 400
Reserves 20 Inventories 150
Term Loan 300 Cash 50
Bank Overdraft 200 Receivables 150
Trade Creditors 50 Goodwill 50
Provisions 50
800 800

Calculate Net Working Capital (Current Assets – Current Liabilities),

Current
Ratio and Quick Ratio
 Profitability ratios

Other indicators include:

• Return on Capital Employed: company's ability to generate returns

from its
available capital base

• Return on Equity: how much the shareholders earned for their

investment in
the company
 Turnover ratios
1. Receivables Turnover ratio: firm's effectiveness in dit as well
extending cre collecting debts as

Days Sales Outstanding (DSO): average number of days that a

company takes to collect revenue after a sale has been made

2. Inventory Turnover ratio: how many times a company's inventory is

sold and
replaced over a period

Days Inventory Outstanding (DIO): how long it takes to turn its inventory
(including goods that are work in progress, if applicable) into sales
Calculat (i) Inventory Turnover (ii) Receivables Collection Period SO) (iii)
e
Creditors’ (D
payment period Average
(DPO)
C.Assets
Sales 1500 Inventories 125
Cost of sales 1000 Debtors 250
Gross profit 500 C.Cash 225
Trade Liabilitie
Creditors s 200
(i) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times
(ii) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 =
61 days
(iii) Average Creditors’ payment period : (Trade Creditors/Cost of sales) x 365
(200/100) x 365 = 73 days
 Solvency
ratios
1. Debt Equity ratio: relationship between the capital y creditors
contributed b the capital contributed by shareholders; shows and
the extent to which
shareholders' equity can fulfill a company's obligations to creditors in the
event
of a liquidation

2. Interest Coverage ratio: how easily a company can pay interest

expenses on outstanding debt; the lower the ratio, the more the
company is burdened by debt expense

3. Debt Service Coverage ratio: amount of cash flow available to

meet annual
interest and principal payments on debt
The amount of Term Loan installment is Rs.10000/ per month,
monthly average interest on TL is Rs.5000/-. If the amount of
Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What
would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment

= (270000 + 30000 + 60000 ) / 60000 + 120000
= 360000 / 180000 = 2
 Valuation
ratios
1. Price/Earnings Multiple: gives you an idea of what the market is to pay
willing
the company’s earnings. The higher the P/E the more the market
for is
willing to pay for the company’s earnings

2. Dividend Yield: dividend paid by the company in relation to its market

price Income investors value a dividend-paying stock, while growth
investors have little interest in dividends, preferring to capture large
capital gains, hence becomes important for income investors

3. EV Multiples: allows investors to assess a company on the same basis

as that of an acquirer; serves as a proxy for how long it would take for
an acquisition to earn enough to pay off its costs (in detail later)
Thank
You!