Accounting 101 – Not your best subject.
But, if you intend to invest in a private company, spend a few minutes on these crib notes. They may save you a bundle down the road.
You may remember, from your freshman year accounting class, that there are three main financial statements that any Company needs to maintain: the “Balance Sheet,” the “Income Statement,” and the “Cash Flow Statement.”
We’ll try to reduce each to its essentials and show how they interact with each other.
What is a Balance Sheet?
The Balance Sheet is a snapshot taken on a particular date of a Company’s ”Assets,” ”Liabilities” and Shareholder’s Equity – what is left after deducting a Company’s Liabilities from its Assets. This shows an interested party what the Company owns, what it owes, and what is left. A fundamental element is that the Balance Sheet “balances”: the amount of Assets always equals the sum of Liabilities plus Equity.
Elements of a Balance Sheet
No surprise. A Company’s Assets are what the Company owns. These will be listed in order of liquidity, with “Short-Term Assets” listed above “Long-Term Assets.” Short-Term Assets include ”Current Assets,” such as cash, “Inventory,”and “Accounts Receivable” (payments customers owe the business) and Long-Term Assets include Assets with a longer life such as investments, “Property, Plant and Equipment (‘PP&E’),” ”Intangible Assets” and others. Some of these may have a corresponding liability in the next section.
A Company may have purchased its building with a commercial mortgage from a local bank, or it may have taken a loan against its Accounts Receivable (amounts the Company is owed from its customers). For that matter, it may have ”Accounts Payable” – invoices from its vendors for inventory it purchased or other assets. Expect to find ”Current Liabilities” (e.g. payroll or accounts payable) above Long-Term Liabilities (e.g. mortgages, ”Notes Payable” and the like).
Shareholder or Owners’ Equity
From an accounting perspective, Shareholder Equity represents the ”Net Equity” the owner has in the business Assets. It is the initial ”Paid-in Capital” (funds put into the business as an equity investment) plus or minus the Net Income over the life of the firm. In regard to a liquidation, it is the residual value of the firm after Assets are liquidated and all “Creditors” are satisfied. How does each of these interrelate?
Let’s take an example. A Company needs cosmetic supplies to fill the shelves before Valentine’s Day, but it doesn’t have the cash to do so.
So, it takes a short-term $1 Million loan from the local lender, increasing its Liabilities. However, the Company’s cash Assets increase by the same amount until the Inventory is purchased, when the cash is reduced on the Balance Sheet and Inventory rises by that amount. At the outset, the owner’s equity doesn’t change. Over time, one hopes, the loan is paid back (reducing the Liabilities) by selling the inventory as ”Finished Goods” (thus reducing the Assets), with the hope that Shareholder’s Equity has risen because the sales have produced bottom line profits.
Now, imagine the Company sells $500,000 to a store, but the store will not pay the invoice for 30 days. The Company’s Inventory (Assets) goes down, but the Accounts Receivable (also an Asset) rise correspondingly.
What would happen if you made a $50,000 equity investment in the Company? The Company’s Assets would increase (cash), as would Shareholder’s Equity.
There are several common terms relating to financial statements found in the Investment Terms that will be helpful to know. Please click here to find their definitions:
”Retained Earnings”: Retained Earnings are the profits that a Company has earned to date, less any ”Dividends” (or ”Distributions” if an LLC) paid to investors. A large Retained Earnings balance implies a financially healthy organization.
“Additional Paid-in Capital,” or ”Capital Surplus” the amount that Shareholders have paid for stock that exceeds the “par value” of the stock, no matter whether common or preferred.
As mentioned above, there are two other primary statements with which an investor should be familiar.
While a Balance Sheet provides a picture of a Company’s status at a point, the Income Statement shows how a Company is performing over a specified period, generally one full year, or for a quarter or a month. It shows the amount of “Revenues” (sales) generated less all expenses incurred by the Company over the same period. And, most importantly, it identifies what’s left, whether or not the Company made a profit.
Cash Flow Statement
A Company’s Cash Flow Statement captures the amount of cash generated and used during a specific period. Unlike the Income Statement, it shows the cash in and cash out during the period. The main difference between Cash Flow Statements and Income Statements is that Income Statements include “non-cash” expenses (such as ”Depreciation” and ”Amortization”), whereas Cash Flow Statements address true cash flow (cash in/cash out) of the business.