E145/STS173E145/STS173

Workshop AWorkshop ABasics of AccountingBasics of Accounting

Professors Tom Byers and Randy KomisarStanford University

With special thanks to:Roma Jhaveri, Ben Hallen, Filipe Santos, Yosem Companys

Copyright © 2004 by the Board of Trustees of the Leland Stanford Junior University and Stanford Technology Ventures Program (STVP). This document may be

reproduced for educational purposes only.

Goals of the WorkshopGoals of the Workshop

• Review main accounting documents and financial analysis• Balance Sheet• Income Statement (Statement of Operations)• Statement of Cash Flows

Please refer also to the handout: How to Read a Financial Report

How Does It All Add UpHow Does It All Add UpIncome Expenses

Assets Liabilities

When you buy something…

When you get paid for a product or service…

The value of anything you own…

The value of anything you borrow…

Assets often generate income

Liabilities often generate expenses

Some Accounting PrinciplesSome Accounting Principles

• Accounting items are classified into “accounts” according to their nature, translated into monetary units, and organized in statements

• Basic Accounting formula:

Assets = Liabilities + Equity

What the company ownsHow the ownership of assets was financed (By third parties or by the owners)

Accounting vs. Market ValueAccounting vs. Market Value

• Equity: Ownership of a company is divided in certificates called common shares

• Accounting Value (or Book Value) = Equity = Assets – Liabilities

Accounting Value is different from Market Value !!!

• Market Value = Share Price * Number of Common Shares Outstanding

Income StatementIncome Statement• Reports the economic results of a company over a time period.

It shows the derivation of earnings or losses.

+ Revenues - Cost of Revenue (product cost or COGS)

= Gross Margin- Sales and Marketing- General and Administrative- Research & Development- Depreciation and Amortization

= Operating Income (EBIT) + Interest Income(expense) net

= Net Income before Taxes - Income Tax Provision - Extraordinary Items

= Net Income

Income Statement of XXX Corp. – year 2000 $ % Rev.

Income Statement - AnalysisIncome Statement - Analysis

• When does a transaction affect income? - When it changes the economic value of the company for the owners

• Some Profitability Measures: Gross Margin (%) = Gross Profit / Sales Operating Margin = Operating Income / Sales Return on Sales = Net Income / Sales Return on Equity = Net Income / Shareholders’ Equity

• Other Important Measures Earnings Per Common Share (EPS) = Net Income / Common Shares Price Earnings Ratio (P/E) = Market Price / Earnings Per Share

Income Statement - ExampleIncome Statement - Example

The following information was taken from the 2001 financial statements of Kellogg Company. Dollar amounts are in millions.

Cost of goods sold $ 4,128.5

Selling & admin. expenses 3,523.6Interest expense 351.5Other expense 54.0Net sales 8,853.3Income tax expense 322.1

From Kimmel et. al. Financial Information For Decision Making

Income Statement - ExampleIncome Statement - Example

KELLOG COMPANYIncome Statement

For the Year Ended December 31, 2001

Net sales $ 8,853.3Cost of goods sold 4,128.5Gross Profit 4,724.8Selling & admin. expense 3,523.6Income from Operations 1,201.2Interest expense 351.5Other expense 54.0Net Income Before Taxes 795.7Income tax expense 322.1Net Income $ 473.6

Balance SheetBalance Sheet

• It is a financial snapshot of a company at a given point in time

Current Assets (liquid in less than a year)

Fixed Assets

Other Assets

Current Liabilities(payable in less than a year)

Long-Term Liabilities (bonds issued, bank loans)

Shareholders’ Equity

Cash and Equivalents

Accounts Receivable

Inventories

Property, plant and equipment (minus Depreciation)

Intangibles (minus depreciation)

Investment Securities

Total Assets =

Accounts Payable

Accrued Expenses

Short Term debt

Common Stock

Additional Paid-in Capital

Retained Earnings

Total Liabilities + Shareholder’s Equity

Balance Sheet of XXX Corp. - 31 December of 2000 (in thousand $)

Balance Sheet - AnalysisBalance Sheet - Analysis

• Working Capital: measure of the amout of cash available in the short-term;

Also, indication of the funds needed operate within a given business size

= Current Assets – Current Liabilities

• Liquidity ratios: measures of the ability to meet short term financial obligations Current Ratio: Current Assets / Current Liabilities Acid-test: (Cash + Accounts receivable) / Current Liabilities

• Operational Efficiency Measures Inventory Turnover = Cost of Sales per year / Current Inventory Accounts Receivable Collection Period = accounts receivable / sales Accounts Payable Collection Period = accounts payable / cost of sales

Balance Sheet - ExampleBalance Sheet - Example

These financial statement items are for Tweeter Entertainment Group at year-end on September 30, 2001. (in millions)

Accounts payable $ 38.6Property, plant & equipment 109.1Receivables 31.3Other current liabilities 23.3Stockholders’ equity 332.4Cash 3.3Long-term debt 36.7Inventories 129.2Accrued expenses 38.9Other current assets 7.5Other liabilities 10.5Other assets 200.0

From Kimmel et. al. Financial Information For Decision Making

Balance Sheet - ExampleBalance Sheet - Example

Assets

Current assets Cash $ 3.3 Receivables 31.3 Inventories 129.2 Other current assets 7.5 Total current assets 171.3Property, plant & equipment 109.1Other assets 200.0Total assets $ 480.4

Liabilities and Stockholders’ Equity

Current liabilities Accounts payable $ 38.6 Accrued expenses 38.9 Other current liabilities 23.3 Total current liabilities 100.8Long-term debt 36.7Other liabilities 10.5 Total liabilities 148.0Stockholders’ equity 332.4Total liab. & stock. equity $ 480.4

TWEETER HOME ENTERTAINMENT GROUPBalance Sheet (in millions)

September 30, 2001

Statement of Cash FlowsStatement of Cash Flows

• The Statement of Cash Flows reports cash receipts and payments over a period, separating operational, investing and financing activities.

+ Cash Flow from operating activities (reconciled from income statement)

= income

- net changes in working capital (except cash and equivalents)

+ depreciation and amortization

+ Cash Flow from investing activities

+ Cash Flow from financing activities

= Net Change in Cash or Equivalents

+ Cash or Equivalents at beginning of period

= Cash or Equivalents at end of period

Statement of Cash Flows of XXX Corp. – 2000 $

Statement of Cash Flows - AnalysisStatement of Cash Flows - Analysis

CFIMITYM !!!

(Cash Flow is More Important Than Your Mother!! )

Especially for an entrepreneurial firm...

• How is cash flow different from income? Income accrual is not necessarily linked to cash transactions (e.g.,

depreciation, sales by credit) Some activities affect cash flows but not income (e.g., investments in

fixed assets, additional capital from shareholders)

• Growth often absorbs cash flow because of a higher need for working capital and fixed investments (Entrepreneurial firms with negative income and high growth can have a very fast cash burn rate)

Statement of Cash Flows - ExampleStatement of Cash Flows - Example

SIERRA CORPORATIONStatement of Cash Flows

For the Month Ended October 31, 2004

Cash flows from operating activities Cash receipts from operating activities $ 11,200 Cash payments for operating activities (5,500) Net cash provided by operating activities $ 5,700Cash flows from investing activities Purchased office equipment (5,000) Net cash used by investing activities (5,000)Cash flows from financing activities Issuance of common stock 10,000 Issued note payable 5,000 Payment of dividend 500 Net cash provided by financing activities 14,500Net increase in cash 15,200Cash at beginning of period 0Cash at end of period 15,200

From Kimmel et. al. Financial Information For Decision Making