Accounting is the language of business. Unless you are keeping track of how your company is doing, you won’t know how to improve it. Everything in this course revolves around these three financial statements.
You are the new CEO of a lemonade stand. You need a loan of $50 (liability) to buy some assets. You purchase a stand for $20 and have $30 left over.
OK. So at any given point in time you have Assets, Liabilities, and Equity. The secret is, Assets = Liabilities + Equity. That’s called the “Accounting Equation.” Your loan was $50 (Liability), you used it to buy a stand for $20 (Asset), and have $30 cash (Asset). You have $50 debt (Liability) and $50 of assets. A = L + E.
BAM! You just sold $90 worth of lemonade. Nicely done. Your balance sheet looks something like this now.
A balance sheet is a snapshot in time and is a good indicator of your net worth as a business. Now let’s jump into your income statement.
Sure. You sold $90 but the cups, sugar, and lemons cost $20. Your gross profit is $70. You also had to pay for some administrative overhead. That left you with $67 operating income or EBIT (Earnings Before Interest & Taxes). You then need to take out interest and taxes, which leaves you with a net profit of $64.
COMMON SIZED financial statements are a great way to figure out how you are doing over time, or to compare one company in a similar industry with another. All you do is divide everything by sales to see where any differences are.
Pro forma is just a fancy way of saying “what the future could look like.” It is forecasting based on an increase in sales. Look at your financial statement and everything on it that is dependent on sales. In this case, let’s say COST OF GOODS SOLD (COGS) and ADMINISTRATIVE expenses both increase with sales.
If sales increased by 20%, what would our net profit be? Look at the previous page and see that COGS was 22% of sales, and your administrative expense was 3%. When increasing $90 by 20% ($108), you then figure out what 22% and 3% (COGS and administrative, respectively) of $108 are.
FINANCIAL RATIOS
Financial ratios are a great way to compare how you are doing over time, to diagnose any issues, or to see how one company in a similar industry stacks up against another. Here are some of the most common.
Financial leverage: How much debt is used to finance your assets.
Liquidity: Your company’s ability to pay back short-term obligations. The higher the ratio, the higher the capability.
Profit generated with money invested by shareholders.
Efficiency at cost control in converting revenue into profit. The higher the number, the better.
This is a combo-equation that shows some of the strengths and weaknesses of the company and how they affect the return on equity.
How Shares Work
When starting your lemonade stand you established that there would be 100 shares. You took on a business partner and now each of you owns 20 shares. Where the business stands, you now both own 20% of the business. Your company is worth $204 now, so how much is each share worth?
