What is accounting? How does it work? What are its benefits?
Accounting is the practice of recording transactions and events in order to track financial information. This helps businesses manage their finances better and makes them accountable for their actions.
Accounting is a vital part of every business. Without it, you won’t know whether or not you’re profitable. You also won’t be able to make informed decisions that will help your company grow.
1) Why accounting is important?
2) Financial Statements – they include accounts receivable, accounts payable, equity, income, assets, liabilities, owner’s equity, profit & loss account (P&L), cash flow, capitalization, balance sheet, statement of changes in equity, statements of cash flows, and statement of cash flows. We also discuss free cash flow, return on investment and payback period. All these terms play an important role at each stage of the business.
3) Earnings per share (EPS) – this shows how much money shareholders have made with their shares. It gives us insight as to what kind of investments worked out well and what didn’t.
4) Revenues and expenses – revenues are anything that come into a business while the cost of doing business is called Expenses. The difference between the two is the operating revenue which is the amount generated by sales after subtracting costs.
5) Balance Sheet – this includes all the different items needed for a business to function like name plates, computers, furniture, fixtures, machinery, vehicles, etc… The total value of all these things is called net worth. Total assets equal to the sum of current assets plus non-current assets. Current assets are those that don’t last long so they’re easily converted into cash. Examples are inventory, prepaid items, trade notes, bills paid off within one year, etc… Non-current assets are considered to be very valuable resources. They can be used to generate a steady stream of earnings. Non-current assets may take longer than one year to convert into cash. Examples are buildings, land, equipment, etc… Liquidity measures how readily something can be turned into cash. An asset with a short life is less liquid than an asset with a long life. Equity is the residual amount left over from assets and liabilities. Owners’ equity is everything owned by the owners of a company including the amount of stockholders’ equity, preferred stock, treasury shares, par value of common shares, etc… Liabilities are debts owed by the entity. These include accounts payable, accrued salaries, interest payable, etc… Profit and Loss Statement (also known as Income Statement) shows the bottom line of any business. It tells us how much profit was earned during a particular time interval. It also tells us how many losses were incurred during that same period. Cash Flow Statement shows us where our cash came from and where it went. A positive number means we had more incoming cash than outgoing cash. A negative number indicates the opposite.
6) Free Cash Flow – this is the amount of cash generated by operations after deducting depreciation expense. Depreciation refers to the process of writing down the value of an asset. For example, if you buy a new car then your depreciation will be $2000 because the car has a depreciated value of $2000. This concept applies to both tangible and intangible assets. Tangible assets include property, plant and equipment while intangible assets include goodwill, trademarks, patents, customer relationships, brand recognition, domain names, copyright, software code, training materials, etc… Return On Investment (ROI) is the percentage increase or decrease in the value of an investment compared to its initial purchase price. Payback Period is the length of time it takes to break even when investing in a project. If you invest $1000 today and get back $1500 in 3 years, your payback period would be 3 years.
7) Shareholder Value – this is the overall return on investments made by shareholders. It’s calculated by dividing the book value of the firm by the market capitalization of the firm. Book value is the value of the firm’s assets minus its liabilities. Market capitalization is the total value of the firm’s outstanding shares times their respective prices. So, if the book value of a firm is $100 million and the market cap is $200 million, then the shareholder value would be $100 million / $200 million 50%.
8) Net Present Value (NPV) – NPV is the discounted future cash flow. Basically, it’s the present value of a series of payments. To calculate NPV, first determine the discount rate. Then multiply each cash flow by the appropriate discount factor. Finally, add up all the values. Discount factors are usually expressed as percentages. For example, if the discount rate is 10% and the first payment comes due in 2 years, the discount factor would be 0.1. In other words, the 1st payment gets 10% of its face value now instead of later. When calculating NPV, make sure the cash flows have already been adjusted for inflation. For example, if a $10,000 payment is due in 2 years but inflation causes the actual dollar amount to be $12,000, then use only $10,000 in the calculation.
9) Debt Ratio – this is the ratio of debt to equity. It’s calculated by taking the sum of liabilities divided by the sum of shareholders’ equity. The higher the debt ratio, the more riskier the company is perceived to be. Companies with high debt ratios are often viewed as having poor management practices. Conversely, companies with low debt ratios are thought to be better managed.
10) Leverage Ratio – this is the relationship between debt and equity. It’s calculated using the following formula: Debt Long Term Debt + Short Term Debt x Leverage Ratio. Leverage ratio is calculated by dividing the sum of debt by the sum of shareholders equity. The higher the leverage ratio, the greater the potential risk to investors.
11) Margin of Safety – this is the difference between the cost of borrowing money and the expected rate of return on that loan. A margin of safety should always exist. You can never borrow 100% of what you’re trying to invest in. Even Warren Buffett doesn’t try to do that. He uses borrowed funds to round out his portfolio.
12) Liquidity – liquidity measures how easily something can be converted into cash. Liquidity affects valuation. Valuation is the estimated current worth of a business. It’s based on the assumption that buyers will pay fair market value for a company. However, there may not be enough demand for a particular stock at any given point in time. In such cases, a buyer might be willing to wait until the stock becomes more liquid before buying it. Liquidity also helps determine whether a company is overvalued or undervalued because it makes it easier to sell a stock than buy one.
13) Return On Equity (ROE): ROE represents the average earnings available after interest expense and taxes per share compared to the total number of outstanding shares. This figure shows whether a company is earning dividends or selling off parts of itself for growth. Dividend payout ratio dividend/shareholders’ equity.
14) Sales Growth Rate – sales growth rate shows how fast a company’s revenue has increased during a certain period of time. Higher sales growth rates indicate faster-growing companies.
15) Earnings Per Share (EPS): EPS shows how much profit a company earned relative to the total number of shares outstanding. Earnings per share gives an indication of whether the company is making money. Earnings per share also provides information regarding a company’s profitability.
16) Assets Turnover: assets turnover indicates how quickly a company turns its assets into cash. High assets turnovers result in higher profits.
17) Return On Assets (ROA): ROA is used to measure efficiency of operations. It calculates net income as a percentage of total assets owned.
18) Current Ratio: the current ratio measures whether a firm is able to meet short term obligations like bills payable. If the current ratio is too high, it means that the company owes more than it has in cash and must wait to collect debts. If the current ratio isn’t high enough, the company may go bankrupt.
The above are some basic accounting terms that you need to know if you want to get started investing. I hope that you found this video helpful.