introduction-to-financial-statements

Introduction to financial statements

Introduction to Financial Statements

Finance is one of the most crucial topics that one must know before starting a business. This blog covers the basics of a subtopic of finance; the financial statements.

Introduction

Finance refers to the management of large amounts of money, especially by governments or large companies. Individuals also manage their own finances, but there is a huge difference between personal finance and the financing of a company. Starting a company requires tremendous knowledge of multiple topics such as marketing, stocks, economics, and much more.


 There are three types of financial statements:
  • Profit and Loss statement(P&L)
  • Balance sheet
  • Cash flow statement

To practically understand these statements, assume that a small lemonade stand company, called Josh’s Lemonade is set up. What would its financial statements look like?

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Profit and Loss statement

The income statement includes the revenue or turnover, the expenses and the net profits. So, suppose Josh sets up one lemon stand down the street, and after a year of starting his business, writes down his P&L statement:

 

Josh’s Lemonade

Income statement

Lemonade stands:                                1
Cups sold per stand: 800
Cups sold: 800
   
Price per cup: $1.00
Revenue: $800
Less: COGS 200(Cost of inventory)
Less: Depreciation 60(Assumes 5-year useful life for the stand)
Less: Labor expense $530
EBIT $10
Profit Margin 1.3%
   
Less: Interest 25(10% of 250)
Pretax earnings $15
   
Less: Taxes 5(35% of EBIT)
Net Income: $10
Per share $0.01

COGS: Costs of Goods sold refers to the selling price of the product; basically, the money needed to serve customers

EBIT (Earnings before Interest and Taxes): It is basically the revenue generated from a business, including the cost of goods sold.

Per share: There are multiple shares of each public company. Individuals or other companies may own these shares and expect them to grow in value. These shares may be bought by others, who see the potential of the company and those who bid on the shares’ value to plummet, sell them.

One book that I would recommend to anyone who wants to learn more about Financial Statements is:

Warren Buffett Accounting Book: Reading Financial Statements for Value Investing

 

The Balance Sheet

A balance sheet shows the assets, the liabilities and the net worth or shareholders’ equity of the company in a tabular form. These three categories constitute what is known as the accounting equation:

Assets= Liabilities + Equity  

The balance sheet of Josh’s lemonade stand is as follows:

Josh’s Lemonade

Balance Sheet

Assets
Cash $750
Fixed assets $300
Inventory $200
Goodwill $1000
Total Assets: $1,750
   
Liabilities
Debt $250
Total liabilities $250
   
Shareholder’s Equity: $1500
Josh’s Lemonade

Balance Sheet

Assets
Cash $750
Fixed assets $300
Inventory $200
Goodwill $1000
Total Assets: $1,750
   
Liabilities
Debt $250
Total liabilities $250
   
Shareholder’s Equity: $1500
Per Share $1.00

Current Assets: An item of property owned by a person or company, regarded as having value and available to meet debts, commitments, or legacies. Assets can be in the form of liquid cash, deposit accounts, money orders or short-term investments.

Fixed Assets: Assets that are purchased for long-term use and are not likely to be converted quickly into cash. Fixed assets include Property plants, equipment/tools, machinery and furniture. These assets wear out over time, and sometimes even require maintenance.

Liabilities: Things for which someone is responsible, especially the amount of money owed. Liabilities are in the form of debt, such as rental payment or loans.

Goodwill: The established reputation of a business regarded as a quantifiable asset and calculated as part of its value when it is sold.

 

Cash flow statement

Josh’s Lemonade

Cash flow statement

Cash Flow from operations:  
Net Income $10
Plus: Depreciation 60
CFO $50
   
Cash Flow from Investing:  
Capex (Capital expenditure): 300
CFI $300
   
Cash Flow from Financing:  
Debt issued 250
Equity issued 500
CFF $750
   
Beginning cash
Change in cash 500
Ending cash $500

 

CFO: Cash flow from operating activities indicates the amount of money a company makes from ongoing activities such as manufacturing or selling of goods and services.

CFF: ‘Cash flow from’ shows the net flow of cash that are used to fund a company.

 

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