diyMBA #1: Accounting & Finance
This is my first attempt at writing up a module of my diyMBA (delayed due to general LIFE and getting ready for a BABY!). For each module, I will aim to capture the top things I learnt, explain the basic themes, and outline some more advanced topics.
Intro
A key reason for starting this diyMBA initiative as a whole was to learn understand the different languages of business, of which Accounting & Finance is one of the most impenetrable. I hope investigating this topic will help me understand the basics of the quarterly earnings figures all companies share (here’s my employer Spotify’s Q2 2019 earnings), and therefore the language used to assess and value all companies.
Many MBA courses begin with Accounting & Finance as the first topic as all other topics rest on top, so I started here too. I’m also expecting it to be one of the the most boring, so best get it out of the way.
Top Things I Learnt
- Reading, participating in courses, and condensing my learnings into this overview below did indeed help me begin to learn the language used in this world. There is nothing more valuable than learning the definitions and basic concepts, as it allowed me to start learning the more fundamental lessons. That said…
- … a major breakthrough came when I learnt that some words are used interchangeably, important topics are referred to my multiple names, and though everything looks consistent, its not. Its REALLY annoying. But as soon as I accepted this was still waffly business stuff and not a more specific field like maths or science, I started making progress.
- The most tangible thing I definitely now deeply understand are the concepts I kinda understood before, such as gross vs net profit (above and below the line), COGS and operating income vs non-operating income, or the ways a company can tell a story using its financial statements. This has already had a real impact on my priorities at work.
Basics Themes
It all starts with understanding the Financial Statements. They’re the starting point to understand the health of any company and a key skill if you have aspirations to start your own business.
The Financial Statements: The Balance Sheet
(aka Statement of Financial Position)
What: Shows assets owned by company, liabilities owed, and total investment of its owners.
Time Period: Snapshot at one point in time.
Jargon Defined:
Assets: things a company owns
Liabilities: debts (money) you owe others
Accounts Receivable: money customers owe the company
Liquidity: ease of which assets can be turned into cash
Working capital: liquid assets needed to run the business
Shareholders Equity: money invested by business owners and its shareholders (also called Net Assets)
Key concepts:
- A Balance Sheet must balance, i.e. what you own equals what you owe. If you reduce amounts one side, you must increase on the other.
- Central Formula : Assets (A) = Liabilities (L) + Owners’ Equity (OE)
- When reading a Balance Sheet:
Assets listed first, Liabilities below.
Most liquid assets listed first (i.e “Cash & Cash Equivalents”), less liquid assets below.
Liabilities due first at top, due last below.
What can we learn from the Balance Sheet?
- What is the ‘Cash Position’?
In other words, how much cash is immediately available? Check the “Cash & Cash Equivalents” section.
Too much working capital could mean the business is not running efficiently and should be re-investing or sharing profits with shareholders. Or it could be a good sign to banks of a healthy business with good credit rating.
Too little working capital can run the risk of not meeting immediate demands, or being unable to weather a recession.
2. How has the cash position changed over time?
In other words, did the business make or lose cash in the previous year.
(This years Cash Position / Last years) -1 x 100 = Cash Position % change
3. Whats the ‘Equity Ratio’?
In other words, what % of the company’s assets are financed by shareholders & owners, rather than by liabilities or debts?
= (Total Shareholders Equity / Total assets) x 100
A high/strong equity ratio means there is more equity to borrow against if needed, and therefore is a good credit risk for someone looking to invest. Low/weak equity ratio means the business has already borrowed significantly.
Banks have a low equity ratio, Tech companies have a high ratio.
4. The ‘Return on Assets’ (ROA) or ‘Asset Utilisation’.
In other words, what profit do the assets generate?
Net income / Total Assets x 100 = 8.7%.
For every £100 of assets owned, the company makes £8.70 in sales.
The Financial Statements: The Income Statement
(aka Profit & Loss, P&L, Statement of Earnings, Statement of Operations, and probably even more things)
What: Covers the sources of cash (what a company earns) and uses of cash (what it spends), and therefore calculates how cash was generated (profits).
Time Period: A set period of time (month, quarter, annual).
Jargon Defined:
Cost Of Goods Sold or Cost of Services (aka COGS, COS or Cost of Sales) : direct costs associated with production of good or provision of service (eg materials used).
Operating income or expenses are incurred from regular business operations, eg wages, research & development, marketing
Non-operating income or expenses are incurred from outside the regular business operations, such as dividends, currency exchange
Depreciation: the amount a tangible asset (eg equipment, vehicles) decreases in value over a period of time
Amortisation: the amount an intangible asset (eg patent, trademark) decreases in value over a period of time
Gross Profit: revenue minus COGS, shown as a ££ amount.
Gross Profit Margin: (revenue minus COGS) divided by revenue. Percentage of revenue that exceeds the COGS, shown as %.
Net Profit: gross profit minus all other expenses, shown as a ££ amount.
Net Profit Margin: (revenue minus COGS and all other expenses) divided by revenue, shown as %.
“The Line”: “Above the line” is a phrase used for costs above the Gross Profit line on the income statement, typically Sales and COGS. “Below the line” are operating expenses, interest and taxes. Items above the line often fluctuate more on the short term and can have a greater impact on sales, and so get more attention from the management team. Items below the line fluctuate less and have less of a direct impact, and so get less attention.
Key concepts:
- Revenues (earned income) is not the same as receipts (cash received or paid out). The latter lives on the Balance Sheet.
- Net Income is calculated each year, then set to zero for the new year. The difference is retained as earnings or losses on the balance sheet.
The top line of the income statement is the company’s operating revenues. Costs are then deducted one by one, in order of their proximity to the core business operations.
1. Costs of Goods Sold are removed first, showing the Gross Profit.
2. Operating expenses are removed next, showing the Operating Income.
3. Non-Operating expenses are removed next, showing the Net Income.
4. The bottom line shows the Net Income (aka Net Profit) and the Earnings Per Share (read more below).
Two other important concepts are:
EBIT (Earnings Before Interest & Taxes)
= Net Income + Interest expenses + Tax Expenses
By adding Interest and Tax back in to the Net Income figure, we get a closer look at how the core business is performing.
EBITDA (Earnings before Interest, Taxes, Depreciation, Amortisation)
= Net Income + Interest + Taxes + Depreciation + Amortisation
By also adding in Depreciation and Amortisation along with Tax and Interest back into the Net Income figure, we get an even closer look at the core business performance.
What can you learn from the Income Statement?
An income statement provides valuable insights into a company’s operations, the efficiency of its management, under-performing sectors and its performance relative to industry peers. For example:
1. Revenue Growth: Is it increasing at a faster rate than previous years?
Revenue Growth = (this year revenue / last year revenue -1) x 100
2. How profitable is the company based on only its core operating activities?
Gross profit and Gross margin show this. Track the change over time and learn why it’s changing. If things aren’t going well, should Overhead costs (rent, utilities, salaries of central teams) be reduced, whilst keeping R&D and Marketing well funded to drive sales?
Focus too on EBITDA which strips away extraneous factors, to look deep into the core of the business for a better indicator of profitability than is shown by the net income.
3. How profitable is the company compared to others?
Earnings per Share (EPS) allows for comparisons across industries, and shows the profit generated by each share of outstanding stock.
Calculated through Net Income / Avg number of outstanding shares.
Basic EPS is all outstanding common stock. Diluted EPS also includes stock not yet exercised (eg by staff, investors). Most analysts use Diluted EPS as standard.
The Financial Statements: Cash Flow Statement
What: Covers the sources and uses of cash, showing how well cash is generated to pay its debts and fund its operating expenses.
Time Period: A set period of time, such as a month, quarter or a year. Historical figures from prior periods are often shown alongside.
Jargon Defined:
Cash Flow: the cash and cash equivalents flowing in and out of the company
Cash Balance: the cash available on hand, also shown on the balance sheet
Cash Equivalents: anything that can be quickly converted into cash, such as bank deposits, short-term investments, overdrafts.
Key concepts:
- When reading the statement positive numbers mean a source of cash, and negative numbers mean cash was used.
Statement is divided into 3 sections:
1. Operating Activities — cash flow from the regular business operations, eg selling goods sold or services
2. Investing Activities — cash flow from the acquisition or disposal of a long term asset or investment
3. Financing Activities — cash flow from borrowing or raising money eg bonds, stock, dividends.
What can you learn from the Cash Flow Statement?
- Cash generated from operating activities is often compared to net income to determine the “quality” of earnings — if it’s higher than net income it’s classed of “high quality”.
- Investing Activities shows us how much value is being re-invested back into the company. A negative number here is not necessarily a bad thing, as it shows a company who are confident of future opportunities and are investing now so they can realise them later.
- A positive figure means stock is being issued of money is being borrowed. A negative figure means the company is using its cash to reduce its outstanding debt or give value back to shareholders through dividends. Financing activities can help show if a company is funding losses from its core operating activities by raising more money from elsewhere.
Advanced Themes
More on Financial Statements. I’ve obviously barely scratched the surface here, and I’m sure you can see quite how dense this subject gets. It’s great to understand the basics and to know what kind of things others can see, but it’s important to know that there are huge details buried beneath these statements if you have the advanced skills to find them. Best consult with the experts to understand these details, rather than spending time learning the more advanced stuff.
Ratios. The Financial Statements show the raw figures, but we need ratios to compare companies. Again, these are very advanced and I won’t be spending time learning them, but I believe it’s important to know they exist and what they can show us. It’s worth noting that usually financial ratios are only used to compare companies in the same industry.
Liquidity Measures: How much can be converted to cash?
1. Current Ratio = Current assets / current liabilities
Can bills be paid? >1 shows liquidity
Capitalisation Measures : How’s it funded?
2. Financial Leverage = (Total Liabilities + Owners Equity) / Owners Equity
A Leveraged company assumes more debt than invested by owners. >2 shows extensive use of debt.
3. Long-term debt to capital = Long term Debt / (Liabilities + OE)
Debt is paid before dividends to investors, therefore debt level shows ‘riskiness’. >50% is risky (though OK in stable industries)
Activity Measures: How are assets being deployed?
4. Assets turnover per Period = Sales / Total assets
How actively does the firm use its assets / what sales are produced from assets? Ratio is industry specific, eg grocery is high, antiques store is low.
5. Inventory Turns per period = COGS / Av. inventory held during period
6. Days Sales in inventory = Ending Inventory / (COGS / 365)
5. and 6. show how actively a companies inventory is being deployed. Is stock collecting dust?
Profitability Measures: Profit compared to assets & sales
7. Return on Sales (ROS) = Net income / Sales
8. Return on Equity (ROE) = Net Income / OE
Two of many ‘Return’ ratios, used to define return on many aspects of the balance sheet (eg assets).
In Conclusion
Just peeking through the window of this topic and understanding some of it made me realise just how detailed this shit is and how I should definitely listen to any accounting or finance person who genuinely understands it all. I am in awe of people who can read these statements like books, quickly zooming in on the pertinent facts that tell the inside story of a business, and using ratios to compare one company with another.
Ultimately, a business must find some way to make money. Companies must tell the story of how they make money today, or will in the future, in order to attract staff, investment, or even customers. There are many ways to tell this story — press, branding, marketing — but the financial statements and associated analysis tell the most accurate version of that story, which is why the investing community place such attention on them (or at least should… never underestimate the power of a positive press story!).
Knowing the levels of detail others are scrutinising your company’s financials also makes us consider how decisions are made internally that will impact these figures. For example, do you work in a department that is “above the line” or “below the line”? The answer could impact your request for a wage increase or an extra headcount in your team, as these changes will either effect Gross Profit or be hidden elsewhere depending on how your department ultimately impacts sales. Whether you want to be “above” or “below” the line will depend on the story your company wants to tell that quarter.
Yes I started this overview my saying this topic is boring, but having written this up I almost wanna take that back (but not quite). It may be a little dry, but that’s part of its innate charm.
Scratch under the surface and we start to see the power of these numbers and the stories they tell. All we’ve got to do is learn the language that brings them to life.
Reading / Courses
“Building Business Acumen”. Paid for 10 hour course funded by my employer, covering the Financial Statements and surrounding topics using a range of learning techniques and tests.
Books included Ten Day MBA by Steven Silbiger and ‘Accounting Made Simple’ by Mike Piper (albeit the Blinkist version!)
… topped up by lots of Investopedia and university articles like this one from Harvard Business School when summarising my learnings.
