Accounting

Classification of financial values i.e. Assets, Liabilities and Equity. It looks at measuring values and attributing them to labels according to what we own and what we owe.

It tells us where a company's returns are coming from

Finance expands on

  1. Valuation of our assets and

  2. Funded through:

  • Debt

  • Equity

The understanding of value of what we own as well as the value of what we owe and how we intend to finance our assets.

Where a company's obligations are owed

"A person should not go to sleep at night until the debits equal the credits" - Luca Pacioli

Balance Sheet

Liabilities/debts:

  • Obligations to payback an amount of money that is borrowed

  • Interest payments over the period we have borrowed the money

Loan Terms:

Borrowed amount: $10,000

Interest Rate: 10% per year

Repayment period: 5 years (lump sum)

Amount Returned at end of 5 years: $10,000 + $1000 per years x 5 = $15,000

Required return to shareholders:

The return that shareholders demand from their investment in a given firm or single asset.

Financial Risk:

Risk: The effect of Uncertainty on Objectives. It highlights any deviations from what was expected.

Liability-->Debt holders face Credit Risk.

In case of insolvency, Debt holders are paid first, shareholders are paid second.

Therefore, shareholders demand a higher return than debt holders.

Financial Risk connects the dots (between accounting and finance) by highlighting the returns that debtholders and equity-holders require of an organisation in order to feel adequately compensated for what risk they have respectively taken on.

Capital Gain: When a shareholder makes more money from the sale of shares than what they bought it for.

Dividends are paid to shareholders annually or biannually

Difference between Accounting and Finance

Accounting is historical looking while Finance is future looking

Accountants make different financial statements. Finance use those statements to predict future and based on those assumptions decisions are made on how to spend the case and resources today.

Different Risks:

Accounting: Risk of material misstatement of financial statements.

Finance: Risk of incorrect assumptions about the future.

Financial Statements

A record of financial activity in a business, an overview of financial operations and a record of financial health of a company.

Types of Basic Financial Statements

  1. Income Statement

  2. Balance Sheet

  3. Cash Flow Statement

  4. Statement of Shareholders Equity

Net Income is a part of Owners' Equity.


What Is Financial Statement Analysis?

Financial statement analysis is the process of analysing a company's financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization as well as to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.

Several techniques are commonly used as part of financial statement analysis.

Horizontal analysis compares data horizontally, by analysing values of line items across two or more years.

Vertical analysis looks at the vertical affects line items have on other parts of the business and also the business’s proportions.

Ratio analysis uses important ratio metrics to calculate statistical relationships.

Balance Sheet

The balance sheet is a report of a company's financial worth in terms of book value. It is broken into three parts to include a company’s assets, liabilities, and shareholders' equity.

Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency.

Liabilities include its expense arrangements and the debt capital it is paying off.

Shareholder’s equity includes details on equity capital investments and retained earnings from periodic net income.

The balance sheet must balance with assets minus liabilities equalling shareholder’s equity. The resulting shareholder’s equity is considered a company’s book value. This value is an important performance metric that increases or decreases with the financial activities of a company.

Income Statement

The income statement breaks down the revenue a company earns against the expenses involved in its business to provide a bottom line, net income profit or loss. The income statement is broken into three parts which help to analyse business efficiency at three different points.

It begins with revenue and the direct costs associated with revenue to identify gross profit. It then moves to operating profit which subtracts indirect expenses such as marketing costs, general costs, and depreciation. Finally it ends with net profit which deducts interest and taxes.

Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin, and net profit margin which each divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations.

Cash Flow Statement

The cash flow statement provides an overview of the company's cash flows from operating activities, investing activities, and financing activities. Net income is carried over to the cash flow statement where it is included as the top line item for operating activities. Like its title, investing activities include cash flows involved with firmwide investments. The financing activities section includes cash flow from both debt and equity financing. The bottom line shows how much cash a company has available.

Financial Performance

Ratio analysis can be used to isolate some performance metrics in each statement and also bring together data points across statements collectively.

Balance sheet: asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity

Income statement: gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage

Cash Flow: Cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be shown on a per share basis.

Comprehensive: Return on assets (ROA) and return on equity (ROE). Also DuPont Analysis.

Financial Risk Management helps determining value creation by managing risks.


How does liquidity risk differ from commodity price risk?

Commodity price risk is associated with where that commodity is used in. If that commodity is used as a manufacturing material then the manufacturing cost will be increased hence decreasing the profit margins.

However, liquidity risk is related to how much liquid assets are available to make any payments to suppliers.

Next: Financial Ratios