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All right, our new topic this time is financial statements; basically, it’s accounting.
Now, most people who aren’t accounts probably think well, why do I need to know accounting?
Certainly that was my feeling as a teacher, but then as I started creating my own business I had to learn some of the basics of it.
If you aren’t an accountant you’re going to learn all the accounting terms you need to.
This is not an accounting course.
We’re not going to teach all of those, but I think it would be good to discuss some of the major financial tools that almost every business uses, departments use.
You’re going to come across these terms a lot, you’re going to hear them a lot if you’re in business in any way, so it’s just good to know what they mean and kind of why they’re important to a business.
I think the three big ones that I’m familiar with at least are the balance sheet, the income statement and the cash flow statement.
Would you agree with that?
Absolutely, I think that’s the key.
Any business that you are in, any company that you’re in, you’re going to hear those three terms not only from the accountants, but from the executives, the managers, the owners, whatever level they are or whatever size company.
Those are the score cards, if you will, for a company and each one of them is a little bit different.
Actually, a couple of them are the income expense statement and the cash flow. I look at them more as tracking devices; whereas, the balance sheet is a picture at a certain point in time as to where the company stands.
What the value of the company is no matter what size company it is.
So these are very key statements, the balance sheet being the one that you’re probably going to hear the most about.
That’s the one that assets minus liabilities equal equity.
Bottom line, that’s what that means. Assets are stuff that the company owns. It could be trucks.
It could be machinery. It could be buildings.
Would employees fall into that?
No.
Those are expenses.
No, those actually become liabilities.
Okay, yeah.
Oddly enough.
Stuff. Like physical stuff, software?
Yeah, things that you can put your hands on including software.
Software, certainly as a product, that becomes inventory.
So whatever you make, whether it’s a hard piece of equipment or if it’s software sitting in a warehouse or a closet or somewhere that’s your inventory.
Well, that has a value. That’s an asset to your company.
Okay, got it.
So far nobody seems to be willing to put a value on a person, so that’s not really an asset. So you’ve got your inventory, as I said.
You’ve got all the machinery out in the manufacturing area.
What about furniture or stuff like that, all this equipment?
Absolutely, furniture and fixtures, meaning desks, chairs.
The company may own some company cars, trucks maybe to deliver things.
Could that also be like smaller companies that the company owns?
Would that be an asset too?
Oh, yes.
So a big company owns a little company, the little company is another asset.
Yes, a large company has a subsidiary.
Oh, yeah, subsidiary.
A large company makes computers and they have a subsidiary that makes or supplies the software for those computers that is an asset to the major company.
All right, so things and stuff, a company and stuff like that.
What about liabilities? What’s a liability in accounting terms?
A liability, very basically, what do you owe. What do you owe? Well, there’s a multitude of things here.
Maybe you owe rent on some of your buildings or if you own the buildings you probably still have a mortgage on those buildings.
I guarantee, at least in the United States, you’re going to have taxes on both of those, whether you own them or renting them.
Maybe you financed your equipment. So even though you have an asset of all this equipment on the shop floor, you still owe for it because it’s not paid off.
So it’s basically anything that you owe. Taxes, a tax liability.
So these are all things that are kind of taking money out of the company, out of the bank basically.
Exactly and here’s where you would put in your liability for your people.
Ah, because you have to pay them, payroll.
Payroll, taxes, health insurance, all of the things related to a person here’s where that comes out because you owe that.
That’s a liability that you’re going to have to pay.
I see. Right, got ya.
So that reduces the asset line, if you will, okay?
So what is equity then?
All right.
What’s left after all is said and done between the assets and the liabilities, you just basically take the assets minus liabilities and that’s equity.
Now, equity can come in a lot of forms. The greatest form of course is cash, real money that’s sitting in the bank somewhere.
Another type of equity is investments. The company may have invested.
Maybe something as simple on a small scale for a small company is if they take a certain amount of money out every month and put it into a money market fund.
Well, that’s an investment. It’s not really cash, but it’s still left over so that’s part of the equity.
How is that different than an asset?
That’s different from an asset in that it’s not a hard item that you can grab a hold of and sell.
Oh, it’s not like a thing.
It’s an investment that the company made. How do I explain it? In reality it’s cash.
It could be traded for cash right away.
It could be traded for cash. So bonds and things like that that the company has invested in are looked at similar to cash.
It’s not really cash because you can’t go to the bank and write a check on it, but it’s very, very similar.
So it’s still something if the company needed to they could draw on those investments, turn it immediately into cash
Oh and then use it.
And then use it, so that would be part of the equity.
What about these things like you always see or hear about accountants talking about accounts receivable, accounts payable. It’s kind of confusing sometimes.
Okay, all right.
Is that on a balance sheet also?
Oh, yes. Very definitely, yes.
Accounts receivable is money that your customers owe you. So where do you suppose that is?
They owe you, so that’s an asset?
That’s on the asset side.
Because that’s something that’s adding to.
That’s adding to our assets. We sold them a product, they owe us money.
So that’s an asset on our books. Whatever our accounts receivable bottom line is how much everybody owes us that’s an asset.
Accounts payable that’s money we owe vendors for equipment. Well, probably not for equipment, but for supplies, for services, for cutting the grass, whatever it is.
That’s a liability because we’re going to have to pay that some day.
Ah, so that’s money that’s going to get sucked out.
That’s money going out the door, exactly. So that’s where those two items fall.
The other point, remember I said assets minus liabilities equal equity.
Well, there’s one other item in there. Maybe your cash and your investments don’t come up to that number. That means you’ve got what they call retained earnings.
Now, what’s that? George: Bottom line, that’s profit. That’s the profit we made that we haven’t figured out what we’re going to do with yet.
Are we going to invest it, are we going to put it in the bank, are we going to pay bonuses, whatever, or are we going to carry it forward to the next year and use that to increase the business by buying more equipment or hiring more people or whatever.
So, on a balance sheet where do the retained earnings go?
That’s under the equity. That’s part of the equity.
That’s under equity. Okay, got it.
So basically, you take your assets minus your liabilities and you’ve got a number.
Part of that number is the cash and the investments, but that’s not going to equal the same as assets minus liabilities so what’s left is retained earnings.
That’s your profit.
That’s the profit from the past year that we’re carrying forward on the balance sheet.
So all that together. Assets minus liabilities equal equity and in that number also are going to be your retained earnings if you made it.
Right, retained earnings, investments, all that kind of stuff.
Okay.
So why would you say a balance sheet is important? What does it tell the business when they look at it?
That’s a measure and let me take it on a large scale basis of a very large corporation.
The balance sheet, if you take the assets minus liabilities and you’ve got your equity, in theory, the equity that’s left in the company is “the value” of the company.
That’s what it’s worth.
That’s what the company is really worth.
I see.
That’s their net worth. In fact, that’s the exact term they use. That is their net worth.
Now, if the company is a publicly-traded company, meaning that people buy stock in this company, in theory, that net worth the value of the company divided by the number of shares that are available That should give you the price.
should give you the price of one share.
Theoretically, but of course there’s all kinds of nonsense.
Theoretically. There’s a lot of other dynamics that go into it, but in theory that is the value of the company.
I see.
That’s their net worth.
So that’s really giving you a picture of what this company is worth, the value.
Exactly. If you look at the large companies and you see their net worth, I mean take IBM, GE or some of the really big ones then you’re talking billions of dollars is what the company is worth.
I see.
Okay?
So that’s the balance statement. That’s pretty clear.
Then the income statement, the income and expenses, that’s kind of like the checkbook of the company or the department or the business. Is that fair to say sort of?
Well, no. I would call the cash flow statement the checkbook.
That’s the cash flow statement.
I would say the income and expense statement is kind of like the budget.
I see. Okay.
Okay.
This is where they will keep track of what’s coming in, the income, the revenue, expense is another term.
Then they’ll keep track of the expenses and, of course, the difference is profit or loss sometimes.
Right.
So that’s basically the way, usually on an annual basis, but they certainly break it down on a month-to-month basis.
Some companies I mean it goes all the way down to a weekly basis where they look and see, is our income equal to or greater than our expenses.
That one right there, that statement is the one that will determine, more times that not, whether headcount has to be cut, people have to be released or we have to reduce spending in certain areas.
So they kind of base their budget on that income and expense statement.
On that income and expense statement, exactly.
So that’s a critical one and it’s a budgetary thing because the marketing and sales department will always give you an annual budget on income.
Here’s how much we’re going to sell, here’s how we’re going to make and then every other department in the whole company comes up with an expense that says here’s what I’ve got to have to operate.
Yeah.
Well, hopefully, when you put those two together the income is higher than the expense.
Right.
Sometimes they’re not. If the departments all say we have to have a million dollars to operate and the sales and marketing department say we’re only going to make $800,000 this year well, guess what?
Right at the beginning of the year you’ve got, what’s that, a 20% cut in every department’s expenses.
And then the cash flow statement that’s basically what it says. It’s the actual cash, the actual money coming in and the actual money that’s going out of the bank account.
Right. That’s your checkbook.
Not what’s owed and not what might get paid, but what actually comes into the bank and what actually goes out of the bank.
Right. It has nothing to do with assets, liabilities. Accounts receivable is an asset, but it doesn’t hit the cash flow statement until somebody sends us a check.
Right.
Accounts payable is a liability. It doesn’t hit the cash flow statement until we write a check. So that’s your checkbook.
I see.
How much money we’ve got on day one January 1st and what goes in and out, so how much we’ve got left at the end of the year or the end of the month.
All right, pretty clear I think.
I hope so.
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