In this section we will dive into the financial and managerial side of accounting.
Financial Accounting
Financial accounting is the art of transforming mountains of bookkeeping data into easy-to-understand statements, which you can then use to make decisions, apply for loans, and file taxes. This aspect of accounting is mostly concerned with compiling the big three statements:
- the Income Statement,
- the Balance Sheet,
- the Statement of Cashflows.
In financial accounting these statements are prepared for people external to a company to give them an idea of a business’s health. This may include people such as external stakeholders, lenders, etc. Since these three statements are given to external stakeholders there is a great amount of regulation regarding their preparation. These three statements are prepared under the same set of rules for every company, so an external stakeholder can read these statements for various different companies and compare them fairly.
The set of rules that govern the production of financial statements is known as “accounting principles”. The USGAPP (US Generally Accepted Accounting Principles) is one such set of rules that govern the preparation of these statements. Every country has their own Generally Accepted Accounting Principles (GAAP), which can make things difficult for international companies operating in various different countries. This is the reason why an international set of accounting guidelines was also developed and is accepted by all countries around the world. The International Accounting Standards Board was formed to create these standards which they called the IFRS (International Financial Reporting Standards). Unfortunately, the US still require US GAAP standards to be used for domestic reporting. However, in the future it is expected there will be convergence between the US GAAP and the IRFS standards.
Managerial Accounting
Managerial accounting is for people internal to your company. It is more detailed than financial accounting, and is typically used for people inside your company to make internal daily decisions. Some examples of questions we try to answer with managerial accounting are:
- We are selling women and mens shoes, should we stop selling one kind?
- If we raise our price by $2 on our product will our profits increase or decrease?
We can use the accounting reports we create to answer questions such as these. A good system will show you exactly how much you profit on average per sale, per SKU, and what velocity various SKUs are selling at. You can also view frequently bought together items. Good marketing efforts leverage a good managerial accounting system.
Of course, there are other software that can help with managerial accounting beyond your bookkeeping software. Personally, I use a software called Tripple Whale in my businesses to look at questions such as customer lifetime value, customer affinity for purchasing certain items together, etc. This type of accounting is critical to understanding your audience and market to make informed business decisions.
Now that we know the difference between financial and managerial accounting, let’s dive into the big 3 statements that every business must prepare, and every business owner must know how to read.
The Big Three Statements
The big three statements are:
- the Income Statement,
- the Balance Sheet,
- the Statement of Cashflows.
Each of the three financial statements answers an important question about your business.
The income statement (or profit and loss statement) answers the question: did the company make or lose money in the reporting period?
The balance sheet answers the question: what does the company own and what does it owe?
The cash flow statement answers the question: How much money did the company make during the reporting period?
The Income Statement (or Profit and Loss Statement)
This statement answers the question: did the company make or lose money in the reporting time period? (for new businesses the reporting period is typically 1 year). This statement also allows people to identify trends in revenue or expenses.
Here is the general formula for the income statement:
Revenue – Expenses = Net Income
Revenue is the amount of assets generated in doing business. Different companies create revenue in different ways, by selling software for example, selling consulting services, or selling products. Generally a firm will separate their typical revenue sources from their smaller, more infrequent revenue sources. For example, a company selling on Amazon may make 90% of its revenue through the sale of its products. However, they may make 10% of their revenue on selling marketing services for other Amazon sellers. They may want to report their revenues generated from selling products as “Revenues” on their income statement, and revenues from selling marketing services as “Other Revenues” on the statement to keep them separated.
Expenses are money spent by a business as they are trying to produce a profit. For example, companies purchase inventory, pay rent and pay employees all in the effort of selling products and making profits. The most common expenses an ecommerce company will incur are:
- COGS (Cost of Goods Sold)
- Inventory
- Manufacturing labor
- Fulfillment fees to ship goods to customers
- Advertising fees necessary to sell products
- Selling, General and Administrative Expenses (ie. Operating costs)
- IT
- Accounting
- Salary of people in your company not directly responsible for production of goods
- Utility bills
- Rent
- Depreciation and Amortization
- These are the expenses due to a companies assets losing value over time. Deprecation is the cost associated with the company’s physical properties becoming less valuable over time (like their factories or company vehicles). Amortization is the loss in value of intangible property, like a patent expiring that the company owns, or brand loyalty/good will the company has accumulated. Depreciation and amortization expenses are estimated (with proper justification recorded). In practice there are various different ways to estimate depreciation and amortization expenses.
- Interest expenses
- Cost a company bears due to interest expenses on their financing, such as loans they took.
- Taxes
- Income taxes, which are taken as a percentage of profits generated from a company by the government body.
Here is an example of an income statement:
Source: https://www.investopedia.com/terms/i/incomestatement.asp
The Balance Sheet
A balance sheet will show a list of a company’s assets, liabilities and shareholder’s equity (sometimes referred to as ‘net worth’). The general formula of a balance sheet is assets minus liabilities equals shareholder’s equity. The shareholder’s equity is the book value of the business to it’s owners and investors. The shareholder’s equity of a business factors in the total amount invested into the corporation by it’s owners, and any surplus earnings left in the business from the past (called "retained earnings").
A timesheet is not time specific (as was the case for an income statement). A timesheet has no specific reporting period. So the income statement tells you how much money the business makes in a given period. And the balance sheet gives you a list of the company’s assets at a snapshot in time.
The reason it is called a balance sheet is because at any given time the total assets equals total liabilities plus total shareholder’s equity. Or, in short: assets = liabilities + shareholder’s equity. This is known as the Accounting Equation.
This makes sense when you think about it. Assets are what the firm owns (ie. what it purchased with the money it has). Liabilities and Equity are the firms sources of financing. Liabilities are the external financing taken on my a firm (like a bank loan), and equity is internal financing taken on (like a shareholder investment). So, it makes sense that assets should be equal to liabilities + shareholder’s equity.
Some of the most common Assets you will see in a balance sheet include:
- Cash and cash equivalents – Cash in the companies’ bank account.
- Inventory – Value of raw materials or finished inventory that is ready to be shipped to customers but not yet sold.
- Accounts Receivable – Amount of money owed by customers for goods purchased in the past.
- Property, plant and equipment – This can include things like factories, machinery, computer systems, office equipment, etc.
Note that inventory and accounts receivables are both assets that can be converted to cash quickly, whereas property, plant and equipment are assets that cannot be converted to cash quickly. It is important to make note of this distinction as these two groups are usually separated on a balance sheet. On the balance sheet the inventory and accounts receivable assets would be classified as “current”, and the property, plant and equipment as “non-current”.
Here is an example balance sheet:
Source: https://www.investopedia.com/terms/b/balancesheet.asp
Some of the most common Liabilities you will see in a balance sheet include:
- Accounts Payable – Money owed to suppliers of the company for things such as inventory in production.
- Financial Liabilities – Bank loans for example.
- Tax Liabilities – Sales taxes we owe governments or states for selling products in their jurisdiction.
- Non-current Liabilities – Such as pension benefits or other retirement expenses due.
Equity is the capital that shareholders have invested into the company. The shareholder’s will not get paid back the money they invested directly, rather they will reap the benefits of the company as the company succeeds. The value of their shares will increase as the company succeeds, and they may also reap the benefits of regular cash payouts in the form of dividends if the company chooses to do so.
The Equity rows in a balance sheet will include:
- Paid in Capital – This is the money invested into the company by the shareholders.
- Retained Earnings – The profits of the firm that were not distributed back to the shareholders, but held inside the firm to fuel growth.
- Net Income – The profit the firm made in the given period. This number is taken from the bottom of the income statement.
The Statement of Cash Flows
The cash flow statement shows what cash enters and exits a business, over a certain period of time. We separate cash flows into 3 different groups:
- Operating – Things that a business does everyday (collecting payments from customers, paying for inventory, paying employees, etc.). If all is well here the businesses operating activities is generating more cash than its spending.
- Investing – Investing in assets, such as buying manufacturing machines, buying warehouses, etc.
- Financing – Borrowing money via loans, getting cash from investors, paying dividends, etc.
The cash flow statement is prepared based on the information from the income statement and balance sheet.
This statement is very important, especially for investors as it tells you how much liquidity or free cash flow a company is generating. Ultimately, a businesses goal is to put money in the bank, not record theoretical profit on an excel sheet, and the cash flow statement is the place to see how much money is going into the bank.
Here is an example cash flow statement:
