Financial analysis often involves both using or analyzing historic information and forecasting forward looking financial statements. A thorough understanding of the engineering behind financial statements is essential for a valuation assignment or an M&A transaction.
The balance sheet is the linchpin of the structural integrity of the three key financial statements. It must always balance and the fundamental balance sheet equation, assets equals liabilities plus equity, provides the basis for the recording of all business transactions. Each transaction must be recorded so that the equation is in balance once the processing has taken place.
Accountants use the language of debits and credits to describe the recording of transactions, but it is more important to understand how they impact assets, liabilities and equity. A business may take out a bank loan of 5m, cash will increase by 5m and liabilities will also increase by 5m. Accountants describe this as; debit cash and credit bank debt.
It’s important to understand the definitions of each component in the equation. An asset is a resource, controlled by the business, that is expected to provide benefits in the future. Common examples include inventory, account receivables and PP&E (property, plant and equipment).
Liabilities are obligations as a result of a past transaction. These items provide a source of funding to run the operations of the business. For example, accounts payable are monies owed to suppliers as a result of that supplier delivering goods or services at some time in the past.
Equity is the ownership stake in the business. It too provides a source of funding but is different to a liability because no repayment obligation exists. Retained earnings are all the profits made to date but unpaid to the owners. Because profits are generated for the shareholders, retained earnings are theoretically due to the business owners. However, there is no obligation to pay this amount.
Illustrating the Equation
Let us imagine a business is set up and enters into a series of transactions over the first period. All transactions are recorded by the accounting system and used to produce an income statement, balance sheet and cash flow statement.
Business is set up with an investment by the owners of 50,000
The investment by the shareholders is structured as a share issue of 10,000 shares, issued at 5.00 each. The nominal (or par) value is 1.00, and the accounting rules require the par amount to be reported separately from the additional above par. The additional amount above par is reported in an account called additional paid in capital or share premium.
Property, plant and equipment was purchased for 10,000
This was paid for with cash. The accounting engineering records the new asset and the use of cash.
Inventory was purchased on credit from suppliers for 12,000
The inventory asset is recorded and the obligation to pay the suppliers is reorganized as a liability.
Salaries were paid in cash amounting to 3,000
First the cash account is decreased by the monies spent. However, an asset cannot be recorded because of the uncertainty of future benefit accruing from the salary expenditure. The balancing entry is a reduction in the equity of the shareholders. It is, in fact, an expense and all expenses reduce retained earnings which is part of the shareholder’s equity.
The process of recording these transactions will continue across the period. In reality, a business may have thousands, with each one affecting at least two accounts.
An income statement will also be produced and explains the changes in retained earnings during the period. Net income increases retained earnings balance; dividends decrease it.
Finally, a cash flow statement can be produced for the period and reports the change in cash balances between periods. It is presented into operating, investing and financing flows.
You can download our free excel workout to test your understanding of the accounting equation. See if you can engineer the three financial statements.