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What is the Accounting Equation?

The Accounting Equation states that the total value of a company’s Assets must equal the total value of its Liabilities and Equity.

It’s called the Accounting Equation because it sets the foundation of the double-entry accounting system. The double-entry accounting system is a method of accounting where every change to the Assets section must have either (1) an offsetting change in Assets section or (2) a matching change to Liabilities and Equity. The system is the go-to accounting method of the modern day. And Accounting Equation is the premise on which the double-entry accounting system is built. Hence, it’s called the Accounting Equation.

This is also a cornerstone concept that underpins the Balance Sheet. The Balance Sheet shows the value of what the company owns (Assets), owes (Liabilities) and value left to owners (Equity). The Accounting Equation captures the relationship between Assets, Liabilities and Equity through a simple formula. It states that the Assets section must equal the sum of the Liabilities and Equity sections. The value of what a company owns must equal the value of what it owes and value left to owners. For this reason, the Accounting Equation is also known as the Balance Sheet Equation.

Accounting Equation Formula

This is the standard formula. Assets = Liabilities + Equity. When this formula is true, we say that the Balance Sheet “balances”. Based on this formula, we can rearrange the variables to derive its variations:

Assets: Asset is anything that the company controls that has value, anything that benefits the company. Common items in the Assets section include: Cash & Cash Equivalents, Accounts Receivables, Prepaid Expenses, and PP&E.

Liabilities: Liability is anything that has value that the company owes to other parties. Common items under the Liabilities section include: Current Portion of Long-Term Debt, Accounts Payables, Accrued Expenses, Deferred Revenue, Long-Term Debt, and Capital Leases.

Equity: Equity on the Balance Sheet shows the value entitled to the company owners. It’s the value of Assets leftover to the shareholders after covering all Liabilities. Common Equity items include: Common Stock Par Value, Additional Paid-In Capital, Retained Earnings, and Shareholder’s Equity.

Accounting Equation Example

Here’s a real Balance Sheet from Netflix (NASDAQ: NFLX). You can find the company’s Balance Sheet on PDF page 46 of the company’s annual report.

On Netflix’s Balance Sheet, we highlighted total Assets in red and total Liabilities & Equity in green. These two lines must always equal. We can see that the company had $25,974,400,000 in total Assets and $25,974,400,000 in total Liabilities & Equity. The Balance Sheet balances.

How to Use the Accounting Equation

People generally use the Accounting Equation for three purposes. First, we use it as a guide in journal entry. Second, we use it to check that the Balance Sheet balances. And third, we use it to solve missing variables.

Guide in Journal Entry:

Accountants use the Accounting Equation as a guide in their journal entries. It helps them frame how they determine accounts to debit & credit. Every transaction alters the company’s Assets, Liabilities and Equity. It’s the accountants’ responsibilities to keep an accurate journal of these transactions. Every transaction’s impact to Assets must have either offsetting impact to Assets or matching impact to Liabilities and Equity.

For example, a $100 increase in an item under Assets must be met with either a $100 decrease in another Asset item or a $100 increase in Liabilities and Equity. If the accountants keeps accurate records, the Accounting Equation will always “balance”. It should always balance because every business transaction affects at least two of a company’s accounts.

Suppose a company spends $100 to purchase a chair with cash. The company’s PP&E value increases by $100 because it now owns an extra chair worth $100. But its Cash & Cash Equivalents value decreases by $100 because it used $100 to buy the chair. The $100 increase in PP&E is offset by the $100 decrease in Cash & Cash Equivalents. So the total value of Assets is left unchanged. The Accounting Equation balances.

Alternatively, suppose the company decided to borrow $100 to buy the chair as opposed to using its own cash. Then the PP&E will go up by $100, so Assets increase by $100. But Debt will also go up by $100 because the company had borrowed the money. This matching impact increases Liabilities & Equity by $100. The Accounting Equation balances.

Check Balance Sheet:

Remember, the total value of Assets must always equal the total value of Liabilities and Equity. We use the Accounting Equation to check Balance Sheets. Any Balance Sheet whose total Assets value does not equal the sum of its Liabilities and Equity values is wrong.

Step 1: Find the company’s “Total Assets” line on the Balance Sheet.

Step 2: Find the company’s “Total Liabilities & Equity” line on the Balance Sheet. If the company does not have “Total Liabilities & Equity”, add together “Total Liabilities” and “Total Equity”.

Step 3: Compare the values from Step 1 and Step 2 to make sure they are equal. If they are not, the Balance Sheet is wrong.

Total Assets must equal total Liabilities plus total Equity. There are no exceptions. It’s always the case. So simply checking whether the Balance Sheet balance can tell you whether the statement is wrong.

Solve Missing Variables:

Recall that the Accounting Equation is Assets = Liabilities + Equity. Anytime we have two of the three components, we can solve for the third missing variable. For example, if we know a company’s total Asset is $700 and Liabilities is $300, then Equity must equal $400.

Why Assets Must Equal Liabilities Plus Equity

It’s a rule that Assets must always equal Liabilities plus Equity. But why? Why must Assets always equal the sum of Liabilities plus Equity? To answer this question, we need to rearrange the Accounting Equation to as follows:

This formula is a lot easier to understand. If you take the total value of Assets and subtract the total value of Liabilities, then the remainder is value for Equity holders. Said differently, whatever value of the company’s Assets remains after covering its Liabilities belong to the owners. Whatever value is left after the company pays the money it owes to banks, suppliers, and employees belong to the company owners. This is how things work in this world.

The value of your house after paying down mortgage belongs to you. Likewise, whatever value of your car is left after repaying car loans belong to you. Whatever value of your restaurant is left after paying for all the required expenses belong to you. The money in your bank account after you repay outstanding debt (i.e. student loans, mortgage, credit cards) belongs to you.

Suppose you buy a house for $200,000 with $120,000 in mortgage and $80,000 of your own money. The Asset value of the house is $200,000. That’s the value of the house. But you owe $120,000 to the banks. The value of the house after deducting the liability belongs to you, which is $80,000.

You own something after you buy it. And you have to repay what you owe. As long as this is how things work in life, Assets must always equal Liabilities plus Equity.

Limitations of the Accounting Equation

The main limitation of the Accounting Equation is that it doesn’t tell us anything about the company. The formula is more of a principle than a metric that yields significant insight. It tells us how things should be for all companies. It tells us that Assets must equal Liabilities and Equity. Said differently, it states whatever value of Assets left after covering Liabilities is entitled to Equity holders. It doesn’t tell us anything unique about any specific business. It doesn’t tell us how the business is performing, whether its financial health, or how much the company is worth. Investors and analysts have to analyze the financial statements to derive insights into the business performance.

Another limitation of the Accounting Equation is that it can’t tell you if the company’s records are accurately recorded. It can tell you if the records are wrong. If the transactions don’t balance, they’re wrong. But you can’t tell if they’re accurate. A balanced Accounting Equation by itself is insufficient to certify the accuracy of a company’s records. A company’s accounts and Balance Sheet can balance and still for the entries to be wrong. Instead of recording the purchase of the chair for $100, for example, they could record it at $10. So it can tell you if the records are wrong, but it can’t certify if the records are accurate.

What are Accounting Principles?

Accounting Principles are the set of rules and guidelines that govern how companies record and report financial data. They are extremely important because they standardize the way companies present their financials. They standardize and regulate accounting definitions, assumptions, and methods. For example, these principles lay forth the exact criteria under which a company may record revenue. Any well-trained Analyst will understand what a company’s revenue represents because it’s clearly defined with a standardized set of criteria.

You can think of these principles as the grammar behind a language. Just like grammar governs how we use words, these principles govern how companies record financial data. Without grammar, there wouldn’t be a standardized way of constructing sentences and people’s words wouldn’t make any sense. Likewise, without Accounting Principles, companies wouldn’t have a standardized method of recording financials. Different companies’ financial statements would use different methodologies, which will be extremely confusing for Analysts. Companies would also have wide leeway to manipulate financials. That’s why governments all over the world require companies to follow Accounting Principles. It creates a uniform accounting methodology and reduces room for fraud.

Globally, there are three sets of accounting standards that most established companies follow. American companies and those that trade on the American stock exchanges follow the US GAAP, or Generally Accepted Accounting Principles. Chinese companies follow China GAAP. The rest of the world outside of the US and China follow the International Financial Reporting Standards (IFRS). Here’s a map of the countries that adopt IFRS.

American Accounting Principles

American companies follow the US GAAP (Generally Accepted Accounting Principles) when they record their financials. This helps companies across the country prepare financials using a consistent methodology.

In the US, the Securities and Exchange Commission (SEC) has the legal authority to set accounting standards for public companies. However, the SEC looks to a private non-government organization, Financial Accounting Standards Board (FASB), for their technical expertise. As a result, FASB often takes the leadership role in setting and improving the US GAAP.

While FASB has the power to set accounting rules, it does not have the power to enforce. That’s where the SEC comes in. SEC works closely with FASB on the accounting standards and makes sure all the major companies comply.

Small businesses don’t necessarily have to follow this set of rigorous accounting standards. They have leeway because they are usually privately-owned within families. However, large businesses with many investors, especially public companies, usually have to comply with US GAAP.

China Accounting Principles

The Chinese Accounting Standards (CAS), or “China GAAP”, govern accounting and bookkeeping practices in China. All Chinese public companies must follow China GAAP when preparing their financial statements.

Chinese accounting standards and presentation formats were historically very different from that of the western world. However, in April 2010, the Chinese Ministry of Finance issued “Roadmap for Continuing Convergence of Chinese Accounting Standards for Business Enterprises with International Financial Reporting Standards”. It indicated that it will revise and improve China GAAP to converge closer to IFRS that the rest of the world follow. Today, China GAAP is very similar to that of IFRS.

Rest of World Accounting Principles

Outside of the United States and China, most countries follow the IFRS (International Financial Reporting Standards). The IFRS is a set of rules governed by the IFRS Foundation and the International Accounting Standards Board (IASB).

Globally, over 150 countries follow IFRS as their accounting standard. These countries require domestic public companies to follow the IFRS when recording their financials. IFRS is widely popular is because it makes financial statements understandable and comparable across international boundaries. European investors can easily understand African companies and Latin American analysts can easily evaluate Middle Eastern companies. There is a global trend of growing international shareholding and trade. IFRS is progressively replacing many countries’ own national accounting standards to develop a uniform global set of accounting standards.

10 Important Accounting Principles

Across the world, there are a number of key accounting principles. They form the foundation upon which US GAAP, China GAAP and IFRS build their set of rules and guidelines. We lay out the 10 most important ones below.

1. Separate Entity Assumption

   This principle states that accountants should record business transactions separately for each entity. First, this principle requires separation of business transactions and personal transactions. This prevents business owners’ personal transactions from mixing up measurements of business performance. Consequently, the financial statements will reflect purely the business results. Second, this principle requires accountants to avoid intermingling business transactions among different entities. Each business entity should have its own set of transactions.

2. Monetary Unit Principle

   The Monetary Unit Principle states that only accounts measurable with monetary units can be recorded in the company’s financial statements. If a transaction is quantifiable with money, the accountant should record it. If a transaction is not quantifiable with money, then the accountant should not record it. This principle prevents accountants and management teams from recording transactions based on subjective opinions.

3. Time Period Principle

   This principle says that businesses should report their performance for a specific time period. All financial statements must indicate the time period they are for in order to be meaningful. Without specifying time period or consistency, the numbers would be meaningless. Whereas the Income Statement and the Cash Flow Statement report financials over a period of time, the Balance Sheet report financials as of a specific point in time.

4. Materiality Principle

   The Materiality Principle requires accountants to record information that are “material” (significant) when preparing financial statements. Most businesses have sophisticated control systems that record all their transactions. Therefore, the major implication of this principle isn’t about material transactions, but about immaterial (insignificant) transactions.

   This principle allows accountants some liberty in how they treat immaterial transactions. A common usage of this principle is to expense immaterial costs rather than to capitalize them. For example, suppose a company purchased $100 of office supplies. If the $100 is immaterial, the accountant can record the $100 as part of the year’s SG&A expense. However, if the $100 is material, then the accountant will have to follow the standard procedure. They may have to capitalize the office supplies where the $100 adds to PP&E and depreciate over the supplies’ remaining lifespan.

   Materiality is a vague concept without an exact definition. Hence, we often have to rely on accountants’ professional opinion. What is material to one business might be immaterial to another. For example, spending $100 buying office supplies might be material to a local store, but will be immaterial to Amazon.

5. Accrual Principle

   Under the Accrual Principle, companies recognize revenue when they deliver the products and when the collection of payment is reasonably certain. Notice that revenue is not recognized based on when the company receives the cash payments from the sale. In other words, revenue is a measure of the value of products sold as opposed to cash received.

6. Matching Principle

   The Matching Principle requires companies to recognize expenses in the same period as the corresponding Revenue. Companies “match” revenue and related expenses together and record them in the same period. If an expense is directly attributed to revenue (i.e. cause and effect relationship), the company should record it in the same period as the corresponding Revenue. If an expense isn’t directly attributable to Revenue, the company should record the expense in the period that it was used.

7. Cost Principle

   The Cost Principle requires companies to record their Assets, Liabilities and Equity items on the Balance Sheet at their historical cost. The definition of historical cost is the value of money it pays or receives at the time of transaction (“cost basis”). This is an aspect of conservatism within financial accounting. For example, companies often sell their products at a higher price than their cost. However, accountants have to base product values on historical cost rather than what they can sell for. In other words, the value of inventory on the Balance Sheet is based on how much it cost the company to produce these inventory. It’s not based on the value these inventory can sell for.

   Another example is real estate. Suppose a company purchased a building 30 years ago that’s worth 100 times as much today. However, despite the higher valuation, the company must record the value of the building at its historical cost. It has to record the value of the building according to how much it originally cost to acquire the building. Cost Principle injects an aspect of conservatism into financial statements.

8. Continuity Principle (aka “Going Concern Principle”)

   The Continuity Principle allows accountants to assume that a company will continue to exist in the foreseeable future. This transaction underpins various line items on the financial statements, such as D&A, Prepaid Expenses, Deferred Expenses, etc. Without this assumption, companies have to record these expenses right away because the company will cease to exist.

9. Conservatism Principle

   The leading accounting standards generally require accountants to be conservative when preparing financial statements. This principle has two main implications.

   First, it requires accountants to choose the more conservative methodology in situations where there are more than one acceptable methodologies. If there’s an accounting method that yields lower Diluted EPS, then accountants should opt for that method instead.

   Second, it impacts various accounting rules on how companies record income vs. expenses, and assets vs. liabilities. For example, companies must record impairment expense when the fair market value is below the carrying value. However, the opposite is not true. They may not record gains when the fair market value is above the carrying value. Similarly, companies must disclose potential liabilities under Commitments & Contingencies. But the same rules don’t require them to disclose potential income streams.

10. Consistency Principle

    The Consistency Principle requires companies to maintain the same accounting methodology from one period to the next. Companies may not fluctuate between altering methodologies from period to period whenever it suits them. They must stay consistent with their chosen methodology. Those who do change their methodology must fully disclose the change and its implications. The analyst community usually heavily scrutinize changes in methodologies.

These are the 10 main accounting principles. There are many other accounting principles, but the ones above are the most important. They form the foundation of the leading sets of accounting rules and guidelines.

How to Use These Accounting Principles

These accounting principles form the basis on which companies prepare their financial statements. Accountants use these rules as a guide when recording journal entries and preparing statements. Analysts need to keep these rules in mind when they analyze financial statements to understand the context behind the numbers.

In our Lumovest courses, we’ll build upon these principles and walk you through how to analyze financial statements step-by-step. You can watch how it’s done through lesson videos and then practice the analysis through our worksheets. Sign up today for just $30.

What is Accounts Payable?

Accounts Payable is the value of money the company owes to other businesses for goods and services it received. The company has already obtained what it purchased, but it hasn’t paid yet.

When companies order and receive products before paying for them with cash, they are purchasing on account. The companies haven’t paid for these accounts yet, but they’ll eventually pay for them. Hence, these accounts are payable. This is why money owed to suppliers and vendors is known as Accounts Payable.

Accounts Payable arise because large companies, especially those in the B2B space, don’t pay at the time of purchase. There’s often days to weeks of gap in between when they receive the order and when they pay. Whereas regular consumers would pay at the point of purchase, large companies would pay 30-90 days later.

Accounts Payable appears on a company’s Balance Sheet under the Liabilities section. It’s a liability because it represents the money a company owes to suppliers. Companies usually have to settle the payment within a year. Meaning, companies usually have to pay suppliers what they owe within a year. Therefore, Accounts Payable is often considered a Current Liability.

What is Accounts Receivable?

Accounts Receivable is the value of money customers owe the company for goods and services they purchased. Customers had already ordered and received what they purchased, but haven’t paid for them yet. Said differently, it’s the money the company can collect from customers in the future for products it has already provided. If a company has $400 million of Accounts Receivable, it means the company has yet to collect $450 million from customers for products it has already provided.

Accounts Receivable arise because large companies, especially those in the B2B space, don’t pay at the time of purchase. There’s often days to weeks of gap in between when customers receive the order and when they pay for them. Whereas consumers would pay at the point of purchase, large companies would pay 30-90 days later. Some might even extend into the 180 day timeframe. This time lag creates Accounts Receivable.

When customers buy things without paying for them, we say that they’re buying on account. The company hasn’t received cash for these accounts but it’ll eventually receive the cash payments. Hence, the accounts are receivable. Therefore, we call it “Accounts Receivable”.

Accounts Receivable is a Current Asset on the Balance Sheet. It’s an Asset because it represents money the company can collect in the future. Remember, it’s the money customers owe the company. Not the other way around. The customers are the ones who will pay money to the company. Therefore, it’s an Asset to the company. Specifically, it’s a Current Asset because customers usually pay within 30-90 days. Since the company can collect cash payments within a year, it’s a Current Asset.

What are Accrued Expenses?

Accrued Expenses is the value of money the company owes that have accrued over time. It represents the amount of expenses the company has incurred but not yet paid. The word accrued just means accumulated. Naturally, you can think of it as expenses the company accumulated over time but not yet paid.

This is a common line item on the Balance Sheet, under the Liability section. It’s considered a Current Liability because the liability is usually settled with cash payments within one year.

Accrued Expenses vs. Accounts Payable

Accrued Expenses is very similar to Accounts Payable. Both represents money not yet paid for expenses the company has already incurred. However, there’s a subtle difference.

Accounts Payable refers to money owed for expenses that are incurred at a specific point in time. For example, let’s assume a company ordered and received $500 of office supplies but hasn’t paid yet. That $500 is Accounts Payable.

By contrast, Accrued Expenses refers to money owed for expenses that accumulate over time. Common examples are wages, rent and utilities. Take wages for example. The company accrues wage expense everyday but they don’t pay wages until every 2 weeks or every month. The wages that accrue over time but not yet paid is included in this line item. Similar concept goes for rent and utilities expense. Companies use electricity every day. The electricity expense accumulate over time and is only paid at the end of the month. Hence, the money owed for the expense is captured as part of Accrued Expenses as opposed to Accounts Payable.

For many companies, Accounts Payable mostly relate to expenses with suppliers and vendors. It’s money owed to other businesses that sell products to the company. On the other hand, Accrued Expenses primarily consist of employee salary and wages, rent, utilities and interest. There are other expenses that accrue over time, but these are the most common items. Companies that have significant accumulated expenses might break it out by category: Accrued Wages, Accrued Rent, and Accrued Interest.

What is “Accumulated Other Comprehensive Income”?

Accumulated Other Comprehensive Income (AOCI) represents the cumulative total of gains and losses not yet recognized on the Income Statement. We go over this topic in greater detail in our finance curriculum: Course 10 – Lesson 27.

Why can’t companies recognize some gains and losses on the Income Statement? Because in order for companies to record gains and losses on the Income Statement, they must realize them. If they realize the gains and losses, they may record them on the Income Statement. If the gains and losses are unrealized, companies may not record them on the Income Statement.

In other words, AOCI represents the cumulative unrealized gains or losses from transactions or events not included in Net Income. On the financial statements, AOCI appears as its own line item under the Shareholder’s Equity section.

Examples of items that can impact AOCI include foreign currency translation gains and losses, changes in the fair value of certain financial instruments, and adjustments for certain post-employment benefits.

AOCI is important because it can have a significant impact on a company’s financial statements and overall financial position. For example, if a company has significant unrealized gains in its investments, companies would reflect these gains in AOCI. Over time, these gains would eventually flow into Net Income. This can make the company appear less profitable today than it actually is.

AOCI can also impact a company’s financial ratios and metrics, such as Return on Equity (ROE). This is because Shareholder’s Equity (denominator in EPS) includes AOCI.

Overall, AOCI is an important concept to understand for investors and analysts. By understanding AOCI, investors can gain a better understanding of the impact unrealized gains & losses may have on the company’s financial statements over time.

Here’s how Accumulated Other Comprehensive Income appears on the Balance Sheet for J.M. Smucker.

Accumulated Other Comprehensive Income Examples

So now we understand what AOCI is. Let’s look at some examples of things that go into Accumulated Other Comprehensive Income.

Foreign Currency Translation Gains and Losses: Let’s say a company has operations in several countries with different currencies. This is very common among big corporations. In this case, it will need to translate the financial statements of those operations into the company’s reporting currency. Companies include the resulting foreign currency gains or losses in AOCI.

Unrealized Gains and Losses on Investments: Let’s say a company has investments in securities such as stocks or bonds. Companies include the unrealized gains or losses on those investments in AOCI until they realize these gains or losses.

Pension Liability Adjustments: Changes in the value of a company’s pension plan assets and liabilities can impact AOCI. For example, let’s say a company’s pension plan assets increase in value. The company may include the resulting gain in AOCI until it realizes the gains in some way.

Derivative Financial Instruments: Changes in the fair value of certain derivative financial instruments can impact AOCI until they are settled. Examples of common derivative financial instruments that public companies have include interest rate swaps or commodity futures contracts.

These are some examples of items that go into AOCI.

Accumulated Other Comprehensive Income Formula

Now let’s look at an AOCI example with some numbers. In general, we can calculate AOCI as the sum of Foreign Currency Translation Losses, Changes in Fair Value of Financial Instruments, and Pension Liability Adjustments.

Let’s say a company has the following items that impacted AOCI over time:

Foreign Currency Translation Losses: $(5) million

Unrealized Gains on Available-for-Sale Securities: $10 million

Pension Liability Adjustments: $2 million

Applying the above formula, AOCI equals $10 million – $5 million + $2 million, which equals $7 million. Thus, AOCI for this company is $7 million.

Negative AOCI

It’s called “Accumulated Other Comprehensive Income” if the cumulative number is positive, meaning there’s a net gain. However, if the cumulative number is negative, it means there’s a net loss. In that case, it’s called “Accumulated Other Comprehensive Losses”.

To simplify things, companies often call this line item “Accumulated Other Comprehensive Income & Losses”.

AOCI Accounting Rules

There are several accounting rules that apply to Accumulated Other Comprehensive Income (AOCI). Here are a few key points to keep in mind:

1. AOCI is reported on the Balance sheet, under the Shareholder’s Equity section.
2. Items included in AOCI are typically unrealized non-operating gains and losses. AOCI includes gains and losses that are not part of a company’s core business operations. These items are things such as foreign currency translation gains and losses or unrealized gains and losses on investments.
3. AOCI is subject to reclassification. As companies realize the gains and losses in AOCI, they may reclassify the items from AOCI to Net Income. For example, accounting rules require companies to reclassify gains or losses on available-for-sale securities from AOCI to Net Income when they sell the securities.
4. AOCI is subject to amortization. In some cases, items that companies include in AOCI may be subject to amortization. For example, companies amortize pension liability adjustments over time as they pay off pension obligations.
5. AOCI is a part of Comprehensive Income. Comprehensive Income is a broader measure of a company’s financial performance that includes gains and losses not in Net Income.

These are some accounting rules that apply to AOCI.

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What is “Acquisitions, Net of Cash Acquired”?

“Acquisitions, Net of Cash Acquired” is a common line on the Cash Flow Statement. It measures the net amount of cash a company spent to acquire other companies. For example, suppose a company’s Cash Flow Statement shows $500 million for “Acquisitions, Net of Cash Acquired”. This means the company used $500 million of cash to buy other companies.

Most for-profit companies want to grow. Growth allows the companies to earn more profits and generate greater return for their shareholders. Companies can grow organically by building their own operations or grow inorganically by acquiring other companies. The latter is known as “Mergers & Acquisitions” or M&A for short. M&A is very popular. Each year, thousands of M&A transactions worth trillions of dollars take place around the world. Many companies purchase other companies to become larger and strengthen their competitive position in the industry. In order to make the transactions happen, the buyers have to pay the sellers. In most instances, buyers pay the sellers with cash. How much cash? That’s what the line “Acquisitions, Net of Cash Acquired” measures.

Why does “Net of Cash Acquired” mean?

The first half (“Acquisitions”) of “Acquisitions, Net of Cash Acquired” is very intuitive. It clearly indicates that the cash is being spent on acquisitions. However, what about the second half (“Net of Cash Acquired”)? Why does the name include it and what does that even mean?

Companies have their own business bank accounts. Nike has its bank accounts and Netflix has its own bank accounts. Just like regular people, companies keep their cash in these bank accounts. When Company A acquires Company B, Company A becomes the owner of Company B. Therefore, Company A owns all of Company B’s assets, including the cash in Company B’s bank accounts. Post the acquisition, the cash in Company B’s bank accounts now belongs to Company A. This is “Cash Acquired”. This acquired cash effectively reduced the net amount of cash Company A spent to acquire Company B.

For instance, suppose Company A paid $100 million to acquire Company B. Company B has a bank account with $20 million of cash. After the acquisition, Company A owns Company B, including the $20 million of cash in the bank.  While Company A paid $100 million of cash to buy Company B, it later gained ownership over $20 million. Therefore, Company A effectively only spent $80 million to acquire Company B. The $100 million is “Acquisitions”. The $20 million is “Cash Acquired”. And the $80 million is “Acquisitions, Net of Cash Acquired”.

Companies pay cash upfront to acquire other companies but receives some cash in return. Therefore, accounting requires companies to net out the acquired cash. That’s why the name includes “Net of Cash Acquired”.

Example on the Cash Flow Statement

“Acquisitions, Net of Cash Acquired” is a very common line item on the Cash Flow Statement. It appears under Cash Flow from Investing. Sometimes, this line may appear as “Business Acquisitions”, “Payments Made in Connection with Acquisitions” or other similar variations. Because it represents cash outflow, it usually appears on the statement as a negative number. Here’s an example of Amazon’s Cash Flow Statement.

This line is distinct and separate from “Purchases of Marketable Securities”. “Purchases of Marketable Securities” represents the amount of cash a company invested in liquid securities, such as stocks and bonds. It’s merely investing some of its cash in securities instead of keeping it in the bank to earn better returns. These securities make up a minuscule percentage of other companies. In an acquisition, however, the company spends cash to purchase the entirety or close to entirety of another company.

Financial Implications of “Acquisitions, Net of Cash Acquired”

When the acquiring company buys a target company and gains control, it must consolidate the target company’s financials. Consolidation requires the acquiring company to include the target’s financials in its own financials. For example, suppose the acquiring company has $3 million revenue and the target company has $1 million. Consequently, the acquirer has to consolidate the financial statements and report $4 million in revenue.

As a result, there are important implications of “Acquisitions, Net of Cash Acquired” on the financial statements. The mere existence of this line indicates that the company made acquisitions. This means that the numbers on the financial statements include the numbers from the target company. This could cause significant jumps in values on the Income Statement, Cash Flow Statement and the Balance Sheet. For instance, in the example above, revenue increased from $3 million to $4 million, which represents a 33% increase. Therefore, whenever you see “Acquisitions, Net of Cash Acquired”, know that some of the large jumps are attributable to acquisitions.

Conclusion

In conclusion, “Acquisitions, Net of Cash Acquired” measures the net amount of cash a company spent to acquire other companies. It usually appears on the Cash Flow Statement under Cash Flow from Investing as a negative number.

What is Additional Paid-In Capital (APIC)?

Additional Paid-In Capital (APIC) represents the cumulative money investors paid in excess of stock’s Par Value in a primary market. We cover APIC in our Course 10, Lesson 24.

APIC is reported as a separate line item under the Shareholder’s Equity section of a company’s Balance Sheet. It typically appears alongside other equity line items, such as Retained Earnings and Common Stock Par Value.

APIC can have a significant impact on a company’s financial health and performance. Remember, APIC tracks money shareholders invested into the company. The company can use this cash to fund growth initiatives, such as Research & Development or Capital Expenditures. This, in turn, can help a company increase its market share, generate higher revenues, and improve profitability over time.

How APIC Gets Created

Notice the emphasis on primary market in the definition above. Buying in the primary market means that the investor is buying shares directly from the company. The investor’s money goes into the company’s bank account and the company’s shares goes into the investor’s brokerage account. By contrast, the buying and selling most of us see on the stock market are in the secondary market. Investors are buying from and selling to other investors. The cash does not go into the company’s bank account.

APIC is part of the Shareholder’s Equity section because it represents money that shareholders injected into the company. Emphasis on the word “injected”.

When us regular people buy stocks in the stock market, the money doesn’t go into the company’s bank account. We buy it from other shareholders so our money go to them and their shares come to us. But when investors buy shares directly from the company, they are effectively injecting money into the company.

APIC helps measure how much money investors injected into the company. In other words, when shareholders inject money into the company, it creates APIC.

Additional Paid-In Capital Formula

Here’s how to calculate Additional Paid-In Capital. In every transaction in the primary market, there’s an Offering Price (how much investors pay for each share), Par Value per Share (explained below), and Shares issued (the number of shares the company is selling to investors).

The product of Shares Issued and the difference between the Offering Price and the Par Value per Share equals APIC.

Par Value per Share

The Par Value of common stock is a small made-up number that companies can set discretionarily. It’s a made-up number. Basically, when you set up a corporation, you state will ask you to assign a paper value to each stock. You usually pick some small number, such as $0.01 or $0.00001 per share. For example, the Par Value of Tesla is $0.001. Why? Elon Musk probably liked it better than $0.01 or $0.000001. You can pick $0.0030313 if you want. It’s a made-up number. Well, you might ask, what’s the point then? You can think of this as a stale, ancient, out-of-date practice in today’s age but very inconvenient to change. As a result, the practice of assigning Par Value to each stock still exist today.

Market Price per Share

The Market Price of common stocks is the stock price we see in the stock market. If you open any apps or news and you see the stock price of a stock, that’s the Market Price.

When investors purchase shares of a company’s stock in the primary market, they pay the Offering Price for the shares.  The Offering Price is usually slightly lower than the Market Price.

Additional Paid-In Capital Example

Let’s say Company A issues 1,000 shares of common stock. Offering Price is $5 per share and Par Value is $1 per share.

This means investors injected $5,000 cash into Company A ($5 per share x 1,000 shares). The total par value of the stock is $1,000 (1,000 Shares x $1 Par Value per Share). Therefore, the amount of money investors paid in excess of par value is $4,000 ($5,000 – $1,000).

To record this transaction on the Balance Sheet, Company A would record $1,000 of Common Stock Par Value and $4,000 of Additional Paid-In Capital.

Over time, as Company A continues to issue and sell shares of common stock, APIC would increase. APIC can also be affected by other transactions, such as the issuance of preferred stock or the exercise of stock options.

Tesla Additional Paid-In Capital

Let’s take a look at Tesla’s Additional Paid-In Capital. Here’s Tesla’s 2022 10-K. You can see that it has $3 million Par Value and $32,177 million Additional Paid-In Capital. Therefore, we can calculate investors invested a total of $32,180 million into Tesla.

Difference Between “Additional Paid-In Capital” and “Paid-In Capital”

Long story short, Paid-In Capital = Additional Paid-In Capital + Par Value.

Paid-In Capital (PIC) refers to the total amount of money shareholders invested into a company in a primary market. It includes both the par value of the stock and any additional funds paid above the par value. Balance Sheets usually don’t have a line for PIC. They usually only report Par Value and APIC. However, you can simply calculate this number by adding Par Value and APIC.

On the other hand, Additional Paid-In Capital (APIC) is a subset of PIC. Recall that APIC represents the cumulative money investors paid in excess of stock’s Par Value in a primary market.

Naturally, the sum of Additional Paid-In Capital and Par Value equals Paid-In Capital.

Impact of Stock Price Movements on APIC

Remember that APIC gets created from stock issuances in the primary market? It gets created when investors buy shares directly from the company, thereby putting cash directly into the company. Thereafter, as the stock trades publicly on the stock market, it has nothing to do with APIC. Therefore, stock price movements do not affect APIC.

However, because Offer Price in stock issuances is usually slightly below Market Price, as stock prices change, it will affect the Offer Price at which future shares are issued, and this can affect future APIC.

Learn More About APIC

At Lumovest, we’re building the place where anyone can learn finance and investing in an affordable and easy-to-understand manner. Our courses are far more intuitive, visualized, logical and colloquial than your college professor-taught courses. Our courses are taught by Goldman Sachs investment banker who has worked on transactions worth over $50 billion. We designed our courses to prepare you to succeed in the world of high finance. You’ll learn how to conduct financial analysis exactly like how it’s done on Wall Street’s top firms. Upon completion of the courses, you will receive our Global Financial & Investment Analyst (GFIA) certification. You can sign up here.

What is Adjusted EBITDA?

Adjusted EBITDA is a non-GAAP metric that measures a company’s normalized cash profits. Adjusted EBITDA is essentially EBITDA plus or minus adjustments. These adjustments usually include non-cash items in addition to D&A (i.e. Stock-Based Compensation), non-recurring items, and run-rate adjustments.

This metric is usually used in financial analysis for valuation and debt covenant purposes.

What is Average Revenue per User (ARPU)?

Average Revenue Per User (ARPU) is a financial metric that measures how much revenue on average each user generates. ARPU evaluates the revenue generation performance of companies that provide subscription-based services. We can calculate ARPU by dividing the total revenue by the number of users or subscribers during the same period.

For example, let’s say a streaming service provider has 1 million subscribers and generates $10 million in revenue. To calculate its ARPU, we would divide the $10 million by 1 million, giving us an ARPU of $10. This means that on average, the company earns $10 from each user.

ARPU can be calculated for any type of subscription-based business. Some examples include streaming services, mobile applications, and software-as-a-service (SaaS) providers. It is a valuable metric for investors and analysts because it provides insight into the monetization performance of these businesses.

Why is ARPU Important?

ARPU is an important metric for businesses that offer subscription-based services because it provides insight into the company’s monetization ability. By tracking ARPU over time, companies can assess whether their pricing strategy is effective, and whether they are successfully increasing revenue through the acquisition of new subscribers or the retention of existing ones.

Average Revenue per User can also help companies understand their customer base and identify opportunities for growth. For example, if a company has a high ARPU relative to competitors, it may indicate that its customers are willing to pay more for its products or services. Conversely, if a company has a low ARPU relative to competitors, it may indicate that it’s underpricing its products or for whatever reason, customers aren’t willing to pay more.

Take, for example, Netflix and Disney. In the quarter ended September 2022, Netflix reported $11.85 of ARPU among its global viewers (page 20). In the same period, Disney+ reported only $3.91 of ARPU among global viewers (page 6). This indicates that Disney’s ability to monetize its viewers is weaker than that of Netflix. This could be due to customers not willing to pay the same price for Disney+. It could also be due to Disney undercharging customers. The ARPU metric can help the analyst identify the gap between Netflix and Disney. However, it’s up to the analysts to identify the cause, which will then become part of their investment thesis.

ARPU is also important because it’s a driver of revenue. Mathematically, ARPU times number of users equals total revenue. Naturally, to increase revenue, companies must increase ARPU, number of users, or ideally both. Thus, we can see that ARPU is an essential driver of revenue. As we explain in Course 4 of our curriculum, revenue growth is absolutely critical in investment analysis.

ARPU Formula

How do we calculate ARPU? Here’s the formula.

For example, if a company has $100 million in revenue and 200,000 users, then it has $500 ARPU.

By now, you should understand that ARPU is a very important metric. Perhaps due to its importance and popularity, there are now many variations of this formula.

The first variation is Average Revenue per Paying User. Instead of dividing total revenue by all users, this variation divides total revenue solely by paying users. It completely excludes non-paying users.

The second variation is to calculating Average Recurring Revenue per User. Instead of calculating ARPU off of total revenue, this variation uses the amount of revenue that’s recurring in nature. It excludes non-recurring revenue.

There are many other variations as well, but they’re largely conceptually similar. For example, another variation is to divide total revenue by active users only instead of all users. While some companies present annual ARPU, other companies calculate monthly ARPU.

Regardless the variation, the underlying concept is the same – it measures a company’s monetization ability.

Industries That Use ARPU

ARPU is commonly used in industries that offer subscription-based services. In these industries, customers pay a recurring fee for access to products or services. Some examples of industries that use ARPU are as follows.

• Streaming Services: Streaming services such as Netflix, Hulu, and Disney+ use ARPU to measure the revenue generated from their subscribers.
• Telecommunications: Telecommunication companies such as AT&T and Verizon use ARPU to track revenue generated from mobile phone subscribers.
• Video Games: Video game companies such as Electronic Arts and Activision Blizzard use ARPU to measure the revenue generated by their player base, particularly in games that offer subscription-based services or in-game purchases.
• SaaS Providers: Software-as-a-service (SaaS) providers such as Salesforce and Adobe use ARPU to track the revenue generated by their subscribers. Software subscribers pay for access to cloud-based software products.
• Music Streaming: Music streaming services such as Spotify and Apple Music use ARPU to measure the revenue generated from their subscribers who pay for access to ad-free streaming and other premium features.

Overall, ARPU is a widely used metric that helps businesses and investors understand the revenue model. It helps them understand the company’s monetization and identify opportunities for growth and optimization.

How to Increase ARPU

As explained above, ARPU is particularly important because it’s a driver of revenue. ARPU times number of users equals revenue. Naturally, companies want to increase their ARPU as part of the effort to increase revenue.

But how can companies increase ARPU? Here are some levers companies can pull to increase Average Revenue per User.

First, companies can increase price. Assuming volume doesn’t decline materially, increasing price will increase ARPU. Some companies can simply increase prices because they’re currently underpricing their offerings. As a result, their products appear as a “steal” to users. For other companies, they may need to roll out new features to justify the price increase.

Second, companies can encourage users to buy the more expensive plans instead of the cheaper plans. This changes the revenue mix and the higher priced plans will lift up ARPU. For example, take a look at Adobe’s pricing plans below.

Adobe can try to convince more paying customers to buy the “Creative Cloud All Apps” instead of “Single App”. This will shift revenue mix towards more expensive plans and increase ARPU.

Third, companies can add add-on premium features for purchase. For example, game producers often have items in games that users can purchase. This is in addition to whatever base price that the user is paying (if any).

And lastly, companies can try to attract more affluent users. These customers are less price sensitive and winning over this customer segment can significantly boost revenue.

Learn More

At Lumovest, we’re building the place where anyone can learn finance and investing in an affordable and easy-to-understand manner. Our courses are far more intuitive, visualized, logical and colloquial than your college professor-taught courses. Our courses are taught by Goldman Sachs investment banker who has worked on transactions worth over $50 billion. We designed our courses to prepare you to succeed in the world of high finance. You’ll learn how to conduct financial analysis exactly like how it’s done on Wall Street’s top firms. Upon completion of the courses, you will receive our Global Financial & Investment Analyst (GFIA) certification. You can sign up here.

What is a Balance Sheet?

The Balance Sheet is one of the three main financial statements that we use to analyze a company. It shows a company’s assets (what the company owns), liabilities (what it owes), and equity (value left over for the company owners) as of a specific point in time. The Balance Sheet as a financial report that tells you the company’s net worth at a specific point in time. Logically, a company is made up of all the assets it owns and liabilities it owes. Therefore, the Balance Sheet is a critical component in financial analysis. All of the high paying finance jobs require a solid understanding of the Balance Sheet. Here’s what a Balance Sheet looks like:

Through this article, we’ll develop a strong understanding of Balance Sheet. First, we’ll look at an example of a real Balance Sheet for a real company. Second, we’ll learn how the Balance Sheet is structured and the common line items. Third, we’ll learn the accounting principles that underpin the Balance Sheet. These accounting principles form the basis that determine the values on the Balance Sheet. And finally, we’ll learn about the key insights we can derive from a Balance Sheet. That is, what the Balance Sheet tells you about a company.

Balance Sheet Example

Here’s a real Balance Sheet for Hershey (NYSE: HSY), the maker of the famous Hershey’s chocolate. You can find the Balance Sheet on PDF page 57 of the company’s annual report.

There are a few things to note here.

First, notice that the Balance Sheet is explicitly labeled as “Consolidated” Balance Sheet. This is standard among American companies. Under US GAAP, companies have to report “consolidated” financial statements. To consolidate financials means to combine the financials from all the entities and subsidiaries that the company controls. So “Consolidated” Balance Sheet means the company is including everything that it controls in the financials.

Second, pay attention to the fact that companies clarify the unit metrics for the Balance Sheet at the top. In Hershey’s case, the company is reporting the Balance Sheet values in thousands. The implication is that all the numbers on this statement should be read in thousands. So for example, the value of “Cash and Cash Equivalents” is $587,998. This means it’s $587,998 thousand or $587 million and $998 thousand.

A common mistake among beginners is to read the numbers exactly as stated and neglect the unit metrics. Unit metrics is very common for financial statements of large companies, especially those that are publicly traded. This rounding guides analysts to focus on the important digits. It also makes the Balance Sheet much more appealing to read. Therefore, the first thing you should do anytime you analyze a Balance Sheet is to check the unit metrics. This will enable you to understand the true scale of the numbers.

And third, notice that the Balance Sheet pinpoints the exact date. This brings us to our third point about the Balance Sheet: the time period.

Balance Sheet Time Period

The Balance Sheet differs from the other financial statements in the time period on which it reports the values. Whereas the Income Statement and the Cash Flow Statement shows how the company has performed financially over a period of time, the Balance Sheet shows the financials at a specific point in time. The Income Statement and the Cash Flow Statement might show you the amount of money earned from 1/1 through 12/31. The Balance Sheet, however, will tell you how much assets and liabilities it has on 12/31. For this reason, some people refer to the Balance Sheet as a snapshot of the company’s financial position. That’s why the Balance Sheet is also known as the Statement of Financial Position.

The Balance Sheet enables us to understand the company’s latest financial position at the time we’re performing our analysis. Collectively, the financial statements are saying: given how much money the company made and how much money it spent over last year (Income Statement and Cash Flow Statement), here’s what the company owns and what it owes at the end (Balance Sheet).

The Balance Sheet Equation

The Balance Sheet is structured with three main sections: Assets, Liabilities, and Equity. On Balance Sheets, companies will show the Assets section first, Liabilities second and Equity last.

Assets = Liabilities + Equity

Conceptually, whatever value of assets is left after paying for the value of liabilities belongs to the owners. Therefore, Assets equals the sum of Liabilities and Equity. This is known as the Accounting Equation. The total value of Assets must be the same as the total value of Liabilities and Equity. The two numbers must be the same so that the Balance Sheet “balances”. The Balance Sheet is predicated on this Accounting Equation.

Balance Sheet Format

Within the Assets section, companies will further sub-categorize their various assets by Current Assets and Long-Term Assets. Current Assets are those that can be converted into cash within one year. Long-Term Assets are those that cannot be converted into cash within one year. The ability to convert assets into cash is known as liquidity. The items in the Assets section are ordered based on decreasing liquidity. In other words, the assets that can be most easily converted into cash are listed first. Those that are most difficult to convert into cash are listed last. Naturally, items in the Current Assets section are ordered before Long-Term Assets.

Similar to the Assets section, companies will also further sub-categorize what they owe by Current Liabilities and Long-Term Liabilities. Current Liabilities are those that require cash payments within one year. Long-Term Liabilities are those that do not require cash payments within one year. Current Liabilities are ordered before Long-Term Liabilities.

The Equity section starts with how much money the owners had originally invested into the company. It also includes the gains and losses on those money invested. Then it adjusts for the money investors had gotten back from the company. And lastly, it includes Non-Controlling Interest.

While companies will have minor differences in formatting and labeling, this overall structure is standard across companies. The Assets section comes first, followed by Liabilities and Equity. Within Assets section, items are ordered based on liquidity and sub-categorized into Current Assets and Long-Term Assets. Within Liabilities, items are ordered based on usage of cash and sub-categorized into Current Liabilities and Long-Term Liabilities. Now that we understand how the Balance Sheet is structured, let’s learn about the common line items.

Assets

Conceptually, an asset is anything that the company controls that has value, anything that benefits the company. The common assets that a company has are:

1. Cash & Cash Equivalents

   This is the value of cash the company has on hand. The cash it has in the cash registers, the cash in the bank accounts, CDs, etc. Nothing is more liquid than cash. Therefore, Cash & Cash Equivalents is usually the first line on the Balance Sheet.

2. Short-Term Investments

   This is the value of investments that can be easily sold and converted into cash within a year. They’re usually publicly-traded securities, such as stocks and bonds, that can be easily liquidated.

3. Accounts Receivable

   This is the value of money that the company has yet to collect on goods and services already delivered. Said differently, this is the value of money that customers owe the company but not yet paid.

4. Long-Term Investments

   Long-Term Investments are investments the company has made that cannot be sold and converted into cash within one year. They’re usually investments in privately-held companies. These investments can’t be liquidated without an extended sale process.

5. Property, Plant & Equipment (PP&E)

   Property, Plant & Equipment (PP&E) relate to physical assets the company controls other than its inventory. PP&E includes things like land, factory buildings, machines, computers, desks, chairs, refrigerators, keyboards, telephones, shopping carts, trucks, etc.

6. Intangible Assets

   Intangible Assets are assets that the company controls without a physical substance. Examples are brand, copyrights, patents, licenses, customer relationships, and trade secrets.

There are many other types of assets a company can have, but these are probably the most common ones. Now that we know the common assets a company may have, let’s learn about the common liabilities.

Liabilities

Conceptually, a liability is anything that has value that the company owes to other parties. The common liabilities that a company has are:

1. Current Portion of Long-Term Debt

   This is the amount of money the company owes to lenders that has to be repaid within the year. The company may have borrowed a lot more, but only has to repay a portion of it within one year. Therefore, it’s called “Current Portion” of Long-Term Debt.

2. Accounts Payable

   Accounts Payable represents the value of money the company owes to suppliers and other vendors for goods and services provided. Said differently, the company had purchased things from other companies but not yet paid for them.

3. Deferred Revenue

   Deferred Revenue is the value of goods and services that the company owes to its customers. The customers have already paid the company in advance but the company has not yet delivered what the customers purchased.

4. Long-Term Debt

   Long-Term Debt is the portion of the company’s total borrowings that isn’t due to be repaid within one year. They’ll eventually have to be repaid, just not within the next 12 months.

5. Capital Lease

   Capital Lease represents the present value of future lease payments that the company has to make. It’s the money companies has to pay for whatever asset (i.e. office space, factory building, etc.) the company is leasing.

6. Commitments & Contingencies

   Commitments are obligations of the company to perform something in the future. Example: Company signed a contract to buy $100 million of goods from a supplier. Contingencies are possible obligations that can take place based on uncertain future events. Example: Company is being sued for $20 million and the lawsuit is still pending.

Most companies will have other types of Current Liabilities. We go over detailed list of Current Liabilities in our online courses. Next, let’s go over the common line items that appear under the Equity section.

Equity

Conceptually, the Equity section shows (1) how much money the company’s owners had originally invested into the company, (2) how much gains and losses the company has made for the owners, (3) how much money the company had given back to the owners, and (4) Non-Controlling Interest. Here are the common line items:

1. Common Stock (Par Value) and Additional Paid-In Capital (APIC).

   This is the amount of capital equity holders had invested into the company. Of the total investment, the bare minimum is recorded in Common Stock. Anything in excess of par is included in Additional Paid-In Capital.

2. Retained Earnings

   Retained Earnings is the cumulative profit the company has earned for shareholders that hasn’t been paid through dividends yet. Said differently, Retained Earnings is the company’s cumulative profit that has not yet been distributed to the owners.

3. Accumulated Other Comprehensive Income (AOCI)

   AOCI is the cumulative unrealized gains or losses that the company has earned from investments or other assets. The company has seen the value of its investments increase, but it hasn’t sold them yet. So the gains and losses aren’t realized yet.

4. Treasury Stock

   On the Balance Sheet, this represents the value of money the company had spent to repurchase its stocks. It shows the amount of money the company had given back to the equity holders.

5. Non-Controlling Interest (NCI)

   Non-Controlling Interest represents the value of Assets leftover after Liabilities that is NOT owned by the owners of the company. It’s previously known as Minority Interest.

6. Shareholder’s Equity

   Shareholder’s Equity is the value of the assets the company controls leftover to company’s owners after covering all liabilities. It’s also known as the Book Value of Equity or simply Book Value.

For most companies, those are the only line items they’ll have. In fact, some might have less (i.e. many companies don’t have Non-Controlling Interest).

Balance Sheet Accounting Principles

We learned how the Balance Sheet is structured and the most common line items that appear on it. It’s time to learn about the key accounting principles that underpin the Balance Sheet. These accounting principles form the basis on which the values on the Balance Sheet are recorded. They standardize how companies determine the value of what they own and what they owe.

Monetary Unit Principle:

The first principle underpinning the Balance Sheet is the Monetary Unit Principle. It states that only accounts that can be measured in monetary units can be recorded in the company’s financial statements. If something can’t be measured with money, it can’t be recorded on the Balance Sheet.

Stable Dollar Assumption:

The Stable Dollar Assumption is a premise that the currency used to prepare the financial statements is stable over time. It assumes no impact from inflation or deflation on the currency. Said differently, it assumes that the dollar today has same purchasing power as the dollar 20, 40 years ago.

Cost Principle:

The Cost Principle requires Assets, Liabilities and Equity items on the Balance Sheet to be recorded at their historical cost. Historical cost is defined as the value of money paid or received at the time of transaction (“cost basis”). Financial accounting builds in this aspect of conservatism.

For example, companies often sell their products at a higher price than their cost. However, accountants have to record their values based on historical cost as opposed to what they can sell for. In other words, the value of inventory is based on how much it cost the company to produce these inventory. It’s not based on the value these inventory can sell for. Another example is real estate. A company could have purchased a piece of land 40 years ago that’s worth ten times as much today. However, despite the higher valuation in today’s market, the company would have to record the value of land at cost. It has to record the value of the land based on how much it originally cost to acquire the land. Cost Principle instills an aspect of conservatism into financial statements.

Matching Principle:

The Matching Principle requires revenues and any related expenses be recognized together (“matched”) in the same reporting period. Certain expenses will reduce the value of Assets. For example, recognized Depreciation Expense will reduce the value of PP&E. Bad Debt Expense will reduce the value of Accounts Receivables. Goodwill Impairment will reduce the value of Goodwill. The value of Assets are reduced by associated expenses when they are recognized under the Matching Principle.

Lower of Cost and Market:

Businesses are required to regularly assess the Fair Market Value (“FMV”) of their assets. FMV is what their assets can be sold for in today’s market. Under US accounting rules, companies have to record the lower of historical cost and Fair Market Value. Nothing is done if the FMV is greater than the value of the asset recorded on the Balance Sheet. However, companies have to mark down the value if the FMV is lower than cost.

Continuing with the previous example where a company had purchased a piece of land 40 years ago. If the land is worth more today than what the company had paid for, nothing changes. The company continues to record the land based on historical cost. But if the land is worth less today than original cost, then it’ll have to reduce the value. The company will have to record it at the Fair Market Value because it’s lower than historical cost. This is another aspect of conservatism built into accounting to prevent artificially inflating any company’s value.

Balance Sheet for Investing

By this point of this article, you should now understand what a Balance Sheet is. You should also know what it looks like, its structure, the common line items, and the underlying accounting principles. Naturally, the million-dollar question becomes: so what? What does the Balance Sheet tell you about a company? How can you derive insights from the Balance Sheet for investing?

In short, the Balance Sheet tells you (1) the company’s capital structure, (2) its floor valuation, (3) whether it has any significant assets other than the core business operations, (4) whether the core business is earning a good return and (5) whether it has enough liquidity.

1. Capital Structure

   The Balance Sheet tells us what the company’s capital structure looks like. It’s where we find out how much cash, investments and debt the company has. These are important numbers that we need to bridge between Equity Value and Enterprise Value. If you don’t know how capital structure affects a company’s valuation, you should check out our curriculum on Corporate Valuation. Calculating Equity Value and Enterprise Value is an important step in investment analysis.

2. Balance Sheet as Valuation Reference

   An easy check on valuation is to compare the value of Shareholder’s Equity with Equity Value (aka “Market Capitalization”). For most companies outside of the financial services industry, Shareholder’s Equity is much lower than Equity Value. Therefore, Shareholder’s Equity establishes the floor valuation for the company. If Shareholder’s Equity is somehow higher than Equity Value, it could indicate that there’s something going on with the company. For companies in the financial services industry, such as banks and insurers, Shareholder’s Equity serves as an important valuation metric.

3. Sources of Non-Core Value

   The Balance Sheet tells us whether the company owns any significant investments. Investments are important sources of value separate from the core business, which is measured by Enterprise Value.

   This non-core value is often captured in “Long-Term Investments” or “Investments in Equity Interests”. A real-life example is Yahoo. About a decade ago, Yahoo owned not only its core business (yahoo.com) but also 44% of Alibaba. Yahoo captures its stake in Alibaba in the Investments line on its Balance Sheet under Long-Term Assets. 44% of Alibaba is worth +$200 billion today, but Yahoo’s Balance Sheet only recorded it at $2 billion. At the time, the stock market had priced Yahoo’s stock based only on its core business operations: yahoo.com. This means investors that bought Yahoo stock not only received a stake in yahoo.com but also a piece of Alibaba. They were able to get yahoo.com and a piece of the 44% Alibaba stake for the price of just yahoo.com! Yahoo disclosed information regarding the details of the Alibaba stake in footnotes to the Balance Sheet.

4. Return on Invested Capital (ROIC)

   The Balance Sheet tells us whether the company’s core business operations is earning a good enough return on its investments. Said differently, it tells us whether the company is earning enough money given how much it had to spend. The return a company earns from its business usually go hand-in-hand with the returns investors earn on their investment. In particular, investors want to look for businesses that are earning a ROIC above WACC.

5. Liquidity and Efficiency

   We can calculate Balance Sheet ratios to analyze the company’s liquidity and efficiency. Current Ratio, Quick Ratio and Net Debt (Cash) show whether the company has enough cash to cover its needs. We can also calculate various ratios such as Inventory Turnover, Days Receivable, Days Payable, etc. These ratios partially reflect how efficiently a company is running the various aspects of its business. Frankly, this usually isn’t a significant component of investment thesis. However, it could potentially play a role in an activist investing thesis. Activist investors can push management to improve upon inefficiencies, which will enhance the company’s ability to generate cash flow.

If you know where to look, you can find out a lot about the company from analyzing its Balance Sheet. We’ll go over this in more depth in our courses.

What is Basic EPS?

Basic EPS, or Basic Earnings Per Share, is one of the financial metrics that measure a company’s profitability. Specifically, Basic EPS measures the amount of Net Income a company earns for each of its common stock outstanding.

To calculate Basic EPS, we divide Net Income by the Basic Weighted Average Shares Outstanding (Basic WASO). For example, suppose a company has $1 million Net Income and 1 million Basic WASO. In this case, its Basic EPS is $1.00.

A lot of articles online would tell you that Basic EPS is really important. The logic is that it helps investors and analysts evaluate a company’s per share profitability and value. Afterall, it’s difficult and potentially discrediting to argue it’s anything but that. But the truth is that Basic EPS is not important. While EPS is important, Basic EPS is not. Essentially, EPS has two variations: Basic EPS and Diluted EPS. Basic EPS is the rarely-if-ever-used version of EPS. Diluted EPS, on the other hand, is the nearly-always-used version of EPS. We go over this concept in detail in our curriculum: Course 6, Lessons 11-12.

In fact, Basic EPS is a number that barely gets used among finance professionals. We don’t recall ever basing our analyses on this number during our investment banking work at Goldman Sachs.

The reason Basic EPS is almost never used is because it does not take into account potential dilution. Dilution occurs when a company issues additional shares of common stock. Dilution can decrease the Earnings per Share. Therefore, analysts prefer to use Diluted EPS, which factors in the potential impact of dilution on earnings per share.

Basic EPS is typically reported by companies in on the Income Statement.

Basic EPS Formula

Here’s the formula to calculate Basic EPS.

The formula is actually very simple. We simply take the company’s Net Income and divide it by the Basic Weighted Average Shares Outstanding.

Basic EPS Example

Let’s take a look at Apple. For the 2022 fiscal year (page 29), Apple reported $99.8 billion in Net Income and 16.22 billion Basic WASO. To calculate Basic EPS, we can divide the two numbers.

Basic EPS = Net Income / Basic WASO = $99.8 billion / 16.22 billion Basic WASO.

Basic EPS = $6.15 per share.

So, Apple’s Basic EPS for the 2022 fiscal year was $6.15 per share. This means the company earned $6.15 of profit for each of its shares in 2022.

Most companies’ Basic EPS is as simple as this. However, for a minority set of companies, there can be curveballs. In the next section, we’ll go over different curveballs that might arise when calculating Basic EPS.

Impact of Preferred Stocks

The first curveball that can come up when calculating Basic EPS is when the company in question has Preferred Stocks. The vast majority of companies don’t have Preferred Stocks. They only have Common Stocks. However, a small subset of companies has Preferred Stocks. These Preferred Stocks often have fixed dividends.

Recall that Basic EPS measures the amount of Net Income a company earns for each of its common stock outstanding. Conceptually, it measures the common stocks’ entitlement to profit. Therefore, we have to subtract out the portion of Net Income that the company will pay to preferred shareholders.

Thus, for companies with Preferred Stocks, the formula for Basic EPS becomes as follows.

Formula: Basic EPS = (Net Income – Preferred Dividends) / Basic WASO

Impact of Non-Controlling Interest

The second curveball that can come up when calculating Basic EPS is when the company in question has Non-Controlling Interest (see Course 10, Lesson 28). The vast majority of companies don’t have Non-Controlling Interest (NCI), so this doesn’t come up very often. Luckily, handling NCI in Basic EPS is actually pretty simple.

Starting with Net Income including NCI, we subtract Net Income Attributable to NCI. This gives us the Net Income excluding Non-Controlling Interest, which is what’s attributable to the company’s common shareholders. Then, we divide this Net Income Attributable to Common Stocks by Basic WASO to get Basic EPS.

Formula: Basic EPS = (Net Income – Net Income Attributable to NCI) / Basic WASO

Uber, for example, is a company that has Non-Controlling Interest. Here’s Uber’s Income Statement for 2022 fiscal year (page 74). The Net Income number you should use for Basic EPS is the “Net Income (Loss) Attributable to Uber Technologies, Inc.” That’s the profit metric after deducting the profit attributable to Non-Controlling Interest.

Impact of Non-Recurring Items

The Basic EPS that companies report on the Income Statement are usually GAAP numbers. They usually include one-time, non-recurring items. Ideally, you should adjust the reported Basic EPS to neutralize the impact of these non-recurring items. This way, you get a normalized Basic EPS that more accurately reflects the company’s ongoing earnings potential. Adjusting earnings is a pretty big topic on its own so we won’t dig too deep into it here.

Basic vs. Diluted EPS

The difference between Basic EPS and Diluted EPS lies in the number of outstanding shares used to calculate EPS.

Basic EPS divides the company’s Net Income by basic outstanding shares of common stock. This means that the company only takes into account the shares that are currently in existence.

Diluted EPS divides the company’s Net Income by diluted outstanding shares of common stock. This means that the company not only includes the shares that are currently in existence but also shares that will eventually come into existence in the future. In other words, Dilute EPS takes into account the potential impact of dilution on EPS. Dilution occurs when a company issues additional shares of common stock or securities that can be converted into common stock, such as stock options, warrants or units. These additional shares or securities will reduce the shareholders’ true EPS. As a result, most professional analysts use Diluted EPS to measure the company’s profitability on a per share basis. Our curriculum goes over the concept of dilution in detail in Course 3.

To calculate Diluted EPS, the potential dilutive effect of these additional shares or securities is factored in. This is done using the “Treasury Stock Method” or the “If-Converted Method”. The two methods assume that the additional shares or securities are actually exercised or converted into common stock, and the proceeds are used to buy back outstanding shares of common stock.

By factoring in the potential dilutive effect of additional shares or securities, Diluted EPS provides a more conservative estimate of earnings per share than Basic EPS. Diluted EPS is typically lower than Basic EPS.

In summary, Basic EPS assumes that there are no potential dilutive securities outstanding. It only takes into account shares that currently exist. By contrast, Diluted EPS factors in the impact of dilutive securities that can create additional shares in the future. Consequently, Diluted EPS provides a more conservative and truer estimate of earnings per share.

Do You Use Basic or Diluted WASO for EPS?

Companies calculate Basic EPS using Basic WASO. Net Income divided by Basic WASO equals Basic EPS.

Companies calculate Diluted EPS using Diluted WASO. Net Income divided by Diluted WASO equals Diluted EPS.

Should You Use Basic or Diluted EPS?

For valuation analysis, you nearly always use Diluted EPS. You almost never use Basic EPS. We’re using “almost never” instead of a simple “never” to not be absolute. After all, never say never. For example, let’s say you’re trying to calculate a company’s P/E multiple. In this case, you’d use the stock’s current stock price for the numerator and Diluted EPS for the denominator.

How to Increase Basic EPS

From an investor’s perspective, the higher the EPS the better. That’s because a higher EPS means the company is earning more profit for each share. If we own a company’s stocks, we naturally want the company to earn as much profit per share as possible.

So how can companies increase Basic EPS? Well, based on the formula, there’re really two levers that companies can pull. They must either increase Net Income or decrease Basic WASO. To increase Net Income, they must either increase Revenue or decrease Cost. To decrease Basic WASO, they must do share buybacks. That’s how companies can increase Basic EPS.

Learn More

At Lumovest, we’re building the place where anyone can learn finance and investing in an affordable and easy-to-understand manner. Our courses are far more intuitive, visualized, logical and colloquial than your college professor-taught courses. Our courses are taught by Goldman Sachs investment banker who has worked on transactions worth over $50 billion. We designed our courses to prepare you to succeed in the world of high finance. You’ll learn how to conduct financial analysis exactly like how it’s done on Wall Street’s top firms. Upon completion of the courses, you will receive our Global Financial & Investment Analyst (GFIA) certification. You can sign up here.

What is Book Value?

Book Value has two definitions based on the term usage.

First, Book Value is the value of anything appearing on the Balance Sheet. Traditionally, companies record their assets, liabilities and equity in a book. Therefore, the value of these items as recorded in their books is known as “Book Value”. When someone says the “Book Value of XYZ”, it means the value of XYZ on the Balance Sheet. So for example, the “Book Value of Intangible Assets” is the value of Intangible Assets on the Balance Sheet. The “Book Value of PP&E” is the value of PP&E on the Balance Sheet. This definition is based on the usage that specifies a particular item.

Second, Book Value is the value of Shareholder’s Equity on the Balance Sheet. It is one of several metrics that measure the value of the company entitled to equity investors. For reasons we’ll elaborate below, Book Value is a poor way to measure the value entitled to equity investors. When people use the term without specifying any particular item, they’re likely talking about the “Book Value of equity”. As an example, suppose someone says “The book value of the company is $300 million.” They are saying that the value of Shareholder’s Equity on the Balance Sheet is $300 million. This definition is based on the usage that does not specify any particular item.

Either way, Book Value refers to a value on the Balance Sheet. It can refer to any item on the Balance Sheet, or it can refer specifically to Shareholder’s Equity.

Because the first definition is pretty self-explanatory, we’ll focus the explanation of Book Value on the second definition. In other words, when we say “Book Value” in this article, we mean the value of “Shareholder’s Equity”.

Book Value Formula

There are two main ways to calculate Book Value (under the Shareholder’s Equity definition).

The first way uses the Accounting Equation. Recall that there are three sections on the Balance Sheet: Assets, Liabilities and Shareholder’s Equity. The Accounting Equation stipulates that Assets minus Liabilities must equal Shareholder’s Equity. Therefore, if we subtract Liabilities from Assets, it will give us the company’s Book Value.

The second way adds up all the individual components that make up Shareholder’s Equity (Book Value). Recall that Shareholder’s Equity is a section on the Balance Sheet. Within this section, there are individual line items that eventually add up to the section total. Naturally, another way to calculate the Book Value is to add up these individual line items. For most companies, the line items under the Shareholder’s Equity section are Common Stock Par Value, Additional Paid-In Capital, Retained Earnings, Accumulated Other Comprehensive Income and Treasury Stock. When we say you “add up” these numbers, we mean that you use the addition function. However, some of these numbers can appear in negative form. For example, Treasury Stock appears in negative form. By “adding” Treasury Stock, which is a negative number, you’re essentially subtracting it. Likewise, a negative Retained Earnings is known as Accumulated Deficit. By “adding” Accumulated Deficit, which is a negative number, you’re really subtracting it. Add up all these number and that gives us the company’s Book Value.

Book Value Example

Let’s take a look at an example of Book Value using Apple, Inc. Please take a look at its FY2022 Balance Sheet (Page 31).

Using the first way, we see that Apple reported Total Assets of $352,755 million and Total Liabilities of $302,083 million. The difference between the two equals Book Value of $50,672 million.

Using the second way, we see that Apple reported Common Stock Par Value and APIC of $64,849 million, Accumulated Deficit of negative $3,068 million, and Accumulated Other Comprehensive Loss of $11,109 million. The sum of these numbers equals Book Value of $50,672 million.

Frankly, for public companies, this isn’t a number you’ll need to calculate. Why? Because they report the Book Value explicitly on the Balance Sheet. In Apple’s Shareholder’s Equity section, you can see clearly that the company explicitly states that it has a Shareholder’s Equity of $50,672 million.

Book vs. Market

Book Value and Market Value are two different metrics used to measure a company’s value. Book Value is the value of a company’s assets minus its liabilities, as reported on its Balance Sheet. Market Value, on the other hand, is the price at which a company’s stock is currently trading in the stock market.

Book Value provides an estimate of what the company would be worth if all its assets were sold and all its debts were paid off. Book Value is calculated using historical cost accounting methods, which means that the value of the company’s assets is based on the original purchase price, adjusted for depreciation.

Market Value, on the other hand, is a reflection of the current market demand for the company’s stock. It is influenced by a variety of factors such as investor sentiment, industry trends, and the company’s future growth potential. Market Value is determined by the supply and demand for the company’s shares in the stock market, and is constantly changing as investors buy and sell shares.

One major difference between Book Value and Market Value is that market value takes into account future growth potential, while Book Value does not. Market Value reflects the market’s expectations for a company’s future earnings, growth prospects, and other factors that can affect its stock price. Book Value, on the other hand, is based solely on the company’s historical financial statements and does not consider future growth potential.

In general, Market Value is considered a more important metric for investors than Book Value. That’s because the former reflects market demand for the stock and growth potential. However, Book Value can be useful in identifying undervalued companies, and is often used in conjunction with other metrics and analysis to evaluate a company’s overall value and investment potential.

Book vs. Intrinsic

Book Value and Intrinsic Value are also two completely different concepts.

Book Value is the value of a company’s assets minus its liabilities, as reported on its Balance Sheet. It measures the amount of money leftover to equity holders based on historical accounting records.

Intrinsic Value, on the other hand, is an estimate of the true or fair value of the equity, based on the company’s future earnings potential independent of what price (Market Value) the company’s stock is trading at in the stock market. Intrinsic Value takes into account qualitative factors such as the company’s management team, brand strength, and competitive position, as well as quantitative factors such as earnings, cash flow, and financial ratios.

Intrinsic Value is a subjective estimate that can vary depending on the analyst’s assumptions and methodology. It is often calculated using Discounted Cash Flow (DCF) analysis, which estimates the present value of the company’s future cash flows.

While Book Value is based on historical accounting principles, Intrinsic Value is forward-looking and based on future expectations. Intrinsic Value can be higher or lower than Book Value, depending on the company’s growth prospects and other factors.

In general, Intrinsic Value is considered a more important metric for investors than Book Value. That’s because it provides a more complete picture of a company’s potential value and investment potential. However, Book Value can be useful in identifying undervalued companies and as a starting point for further analysis.

Why is It Called “Book Value”?

Back in the day, companies maintained their accounting records by paper and pen. As you can imagine, that results in a heavy stack of papers that appear like books. Therefore, people often refer the practice of keeping accounting records as “keeping books”.

Because Book Value is the amount recorded in these accounting records (“books”), people coined the term “Book Value”.

Can Book Value Be Negative?

Yes, Book Value can be negative. In fact, a lot of companies have negative Book Value. It’s not necessarily a bad thing. Conceptually, Book Value can be negative for two types of companies. Whether negative Book Value is good or bad depends on which type the company is.

The first type of company that has negative Book Value is money-losing companies. These companies have lost so much money that Retained Earnings (Accumulated Deficit) is heavily negative. This causes the overall Shareholder’s Equity to turn negative.

The second type of company that has negative Book Value is companies that returned a lot of capital to shareholders. These companies have used way more cash for dividends and share repurchases that Shareholder’s Equity turns negative.

In short, Book Value can absolutely be negative. And it’s not necessarily a bad thing.

Learn More

At Lumovest, we’re building the place where anyone can learn finance and investing in an affordable and easy-to-understand manner. Our courses are far more intuitive, visualized, logical and colloquial than your college professor-taught courses. Our courses are taught by Goldman Sachs investment banker who has worked on transactions worth over $50 billion. We designed our courses to prepare you to succeed in the world of high finance. You’ll learn how to conduct financial analysis exactly like how it’s done on Wall Street’s top firms. Upon completion of the courses, you will receive our Global Financial & Investment Analyst (GFIA) certification. You can sign up here.

What are Capital Expenditures (CapEx)

Capital Expenditures (CapEx) is the cash a company pays for capital assets that will deliver long-term value to the business. These capital assets usually consist of (1) PP&E and (2) Intangible Assets. PP&E are physical assets, such as buildings, office fixture, cash registers, machinery, etc. Intangible Assets are things like patents and software. Companies makes these spending with the intention of improving or expanding the business, increasing efficiency, or maintaining competitive advantage.

If a company spends $500 buying desks and chairs for its employees, it’d record the $500 as CapEx. Likewise, if a gas station spends $10,000 buying a new gas machine, it’d record the $10,000 as CapEx.

In most instances, companies spend Capital Expenditures mostly on physical assets, such as buildings, machineries, and equipment. A common misconception is that Capital Expenditures only include spending on physical assets. This is not true. Capital Expenditures are expenditures related to capital assets, which are assets that drive the company’s long-term growth. These capital assets may include both PP&E and Intangible Assets. Both PP&E and Intangible Assets enable the business to operate and generate value over the long-term. Therefore, Capital Expenditures include cash spent on both PP&E and Intangible Assets.

However, in practice, many companies spend most of their Capital Expenditures on PP&E. That’s because physical assets often require ongoing maintenance. As a result, in practice, CapEx mostly relate to spending on physical assets.

Capital Expenditures can be categorized into two main types: Growth Capex and Maintenance Capex. Growth CapEx are spendings to expand the business, such as opening new locations, launching new products, or upgrading technology. On the other hand, Maintenance CapEx are investments to maintain the existing business, such as repairing machinery or replacing equipment.

How CapEx Appears on Financial Statements

Capital Expenditures is a line item on the Cash Flow Statement. It usually appears as a cash outflow under Cash Flow from Investing. When companies spend cash to buy capital assets, they are making an investment. They are investing into their core business operations. Therefore, it’s categorized as an investing activity.

Companies that spent all of their CapEx on physical assets will call it “Purchases of Property, Plant and Equipment” or “Purchases of Physical Assets” instead of “Capital Expenditures”. Regardless, the terms are conceptually similar.

Here’s an example from Amazon (10-K page 36).

Remember, CapEx is the cash the company spends on long-term assets. The long-term assets acquired through CapEx recorded on the Balance Sheet, usually in the line item “Property, Plant & Equipment”. These assets depreciate over their useful lives. Useful life is the estimated period of time that the asset will generate benefits for the company. The Depreciation expense is then recorded on the Income Statement and Cash Flow Statement as a non-cash expense.

Capital Expenditures are a key component of a company’s financial management as they can impact the company’s cash flow. Properly managing CapEx is important to ensure the company is investing in the right projects to drive growth and profitability.

Capital Expenditure Examples

Here are some CapEx examples.

Property: A company may invest in real estate to expand its facilities, build new locations, or purchase land.

Equipment: A company may invest in machinery or other equipment to improve production efficiency, increase capacity, or upgrade existing equipment. Examples of equipment include machinery, computers, phones, cash registers, shelves, etc.

Office Furniture & Fixture: A company may invest in things for the office, such as desks, chairs, sofa, conference call technologies, etc.

Technology: A company may invest in software, hardware, or other technology.

The above are some broad examples of CapEx. However, it’s equally important to understand what’s not considered CapEx. Purchase of other businesses is not a form of Capital Expenditure. That’s part of M&A. It’s recorded separately in a different line item on the financial statements.

Growth CapEx

Growth CapEx refers to capital expenditures made by a company to expand or grow its business. These investments are typically focused on increasing revenue, improving market share, or entering new markets. Here’s a real example of Growth CapEx made by Apple.

One of Apple’s recent Growth CapEx initiatives is the development of its own processors for use in its Mac computers. In 2020, Apple announced that it would transition from using Intel processors to its own Apple Silicon processors. The company claimed this would provide better performance and energy efficiency. This initiative required significant investment in R&D equipment, as well as changes to Apple’s supply chain and manufacturing processes.

Apple has also invested heavily in building new retail stores, which have become a significant source of revenue. The spending required to buy the furniture and fixtures required to fill the retail stores is part of Growth CapEx. In recent years, Apple has opened new retail locations in China, India, and other emerging markets. These investments in retail stores have helped Apple to grow its customer base and increase sales of its products.

Maintenance CapEx

Maintenance CapEx refers to capital expenditures made by a company to maintain, repair or replace existing assets. Companies make these spendings to ensure their businesses continue to operate and prevent downtime or failure. These investments are typically focused on maintaining the existing level of operations and are necessary for a company’s long-term success. Here’s a real example of Maintenance CapEx made by United Airlines.

United Airlines is a well-known example of a company that invested heavily in Maintenance CapEx. In 2020, United Airlines announced that it would invest $1 billion in its facilities over the next few years to upgrade and modernize its aircraft fleet.

One of the key initiatives that United Airlines is undertaking as part of this investment is the construction of a new widebody aircraft maintenance facility at its hub in San Francisco. The new facility will be capable of performing maintenance on up to six widebody aircraft at a time. Additionally, it will include state-of-the-art equipment and technology to improve efficiency and reduce downtime.

United Airlines is also investing in the maintenance of its existing aircraft fleet, which is critical to the airline’s operations. In 2020, United Airlines invested $300 million in engine maintenance and overhauls.

Overall, Maintenance CapEx is an essential component of a company’s strategy to maintain its assets and ensure their continued operation. Companies that invest wisely in Maintenance CapEx initiatives can minimize downtime and prevent unexpected failures. Without Maintenance CapEx, equipment’s natural wear and tear can have significant impact on a company’s operations and profitability.

Capital Expenditures vs. Operating Expenses

Capital Expenditures (CapEx) and Operating Expenses (OpEx) are two types of spendings that a company incurs in its day-to-day operations. The main difference between the two is in the nature and timing of the expenses.

Capital Expenditures are investments in long-term assets that are expected to deliver multi-year benefits into the future. Examples include purchasing property or equipment, developing new technologies, or expanding a production facility. Because CapEx delivers multi-year benefits, companies amortize it over the useful life of the asset.

On the other hand, Operating Expenses are the costs incurred by a company to maintain its daily operations. These spending typically provide benefit that last less than a year. For example, common OpEx include rent, salaries, marketing, utilities, and other day-to-day expenses.

Another key difference between CapEx and OpEx is how companies treat them for accounting and tax purposes. CapEx is a capital asset that appears on a company’s Cash Flow Statement and Balance Sheet. OpEx is a cost that appears on a company’s Income Statement. CapEx creates Depreciation or Amortization over its useful life. By contrast, OpEx is fully deductible in the reporting period for tax purposes.

Is Capital Expenditures Tax Deductible?

Yes, CapEx is tax-deductible. While CapEx is typically not fully deductible in the year companies make the spending, it is generally tax-deductible over the useful life of the asset.

For tax purposes, CapEx is typically treated as a capital asset. This means it’s subject to Depreciation or Amortization over its useful life, as determined by the tax code. The IRS established rules for how to calculate the useful life of various types of assets. Companies must use these rules to determine the amount of Depreciation or Amortization to deduct each year.

Therefore, the tax deductions in the form of Depreciation & Amortization for CapEx are spread out over several years. This can help to reduce the company’s taxable income in each of those years. Companies that made significant CapEx can offset Depreciation & Amortization against their taxable income.

However, tax treatment of CapEx can vary depending on the specific circumstances of the investment and each country’s tax code.

CapEx Formulas

Because CapEx is a number that companies report directly on the Cash Flow Statement, you don’t really need to calculate it. However, there are a few formulas related to CapEx you should know.

The first formula captures Capital Expenditures’ relationship with PP&E.

Previous Period PP&E + Current Period Capital Expenditures – Current Period Depreciation = Current Period PP&E.

This formula is used to calculate the total amount of capital expenditures made by a company during a specific period. It takes into account the ending and beginning balances of the company’s net property, plant, and equipment (PPE), as well as the depreciation expense incurred during the period.

The second formula captures Capital Expenditures’ relationship with Revenue.

Capital Expenditures / Revenue = CapEx as a % of Revenue

This formula calculates the percentage of sales that a company is investing in Capital Expenditures. It divides the company’s CapEx by its Revenue and measures the company’s capital intensity.

The third formula captures Capital Expenditures’ relationship with the expected benefits.

Capital Expenditures / Annual Incremental Cash Inflows = Payback Period

This formula calculates the time it takes for a company to recover CapEx through incremental cash flows from the CapEx. The shorter the payback period, the more economically attractive the investment.

How Do You Calculate CapEx?

Notice that none of the above formulas calculate CapEx per se. They all measure CapEx in relation to another metric, but none actually calculates CapEx itself.

That’s because CapEx is usually not a number companies calculate through a formula. It’s really based on however much they spend. For example, if they spent $50 buying an office desk, then CapEx is $50. If they spend $1,000 buying an office computer, then the CapEx is $1,000. A company’s total CapEx is the sum of all these investments in long-term assets.

Want to Learn More?

At Lumovest, we’re building the place where anyone can learn finance and investing in an affordable and easy-to-understand manner. Our courses are far more intuitive, visualized, logical and colloquial than your college professor-taught courses. Our courses are taught by Goldman Sachs investment banker who has worked on transactions worth over $50 billion. We designed our courses to prepare you to succeed in the world of high finance. You’ll learn how to conduct financial analysis exactly like how it’s done on Wall Street’s top firms. Upon completion of the courses, you will receive our Global Financial & Investment Analyst (GFIA) certification. You can sign up here.

What is Capital Lease?

A Capital Lease is a lease arrangement where the lessee has ownership characteristics. Another name for this is Finance Lease. US GAAP calls it Capital Lease and IFRS calls it Finance Lease.

A lessee, or a tenant, is the party that rents an asset from another party. By contrast, a lessor is the owner of the asset that rents it to another party. Lessor is essentially the landlord.

In a lease arrangement, the lessee rents the asset from the lessor. For example, a company can rent an office from the building landlord. If you rent an apartment, then you have a lease arrangement with the apartment landlord. This is very common. Almost every large company has a lease of some kind.

In the corporate world, large businesses rent assets (i.e. office, vehicles) for many years and for large amounts of money. Sometimes, the company leasing the asset will lease it for most of the asset’s lifespan. As a result, their lease arrangements can often contain “ownership characteristics”. The company might be technically “leasing” the asset, but their arrangement with the lessor may contain characteristics that essentially makes the lessee the owner. These lease arrangements that contain ownership characteristics are known as Capital Leases. By contrast, lease arrangements that don’t have ownership characteristics are just regular leases, or Operating Leases.

Capital Lease Accounting

With a normal Operating Lease, companies don’t record the leased assets on the Balance Sheet because they don’t own it. They’ll just record a rent expense on the Income Statement and track cash payments on the Cash Flow Statement.

With a Capital Lease, companies have to record the leased assets on the Balance Sheet, as if they own it. They will include the value of the leased assets in the Assets section. On the Liabilities section, they’ll record Capital Lease of an equal value. As a result, the Balance Sheet will balance. And then on the Income Statement, they’ll record Depreciation Expense. On the Cash Flow Statement, they’ll add back D&A and track cash payments for the rent.

It’s important to emphasize that under a Capital Lease, companies are still renting the assets. They don’t legally own the assets. The distinction of Capital vs. Operating lease is merely one of whether the arrangement has ownership characteristics. The implication of Capital versus Operating Lease is just how companies present their numbers on the financial statements.

Capital Lease Criteria

Under the US GAAP, a company must capitalize the lease if the arrangement meets any of the following criteria.

1. Lease Term Test

   The term of the lease is greater than 75% of the asset’s estimated economic life.

2. Purchase Option Test

   The lease includes an option to purchase the asset for less than fair market value.

3. Ownership Test

   The lessor transfers ownership of the asset to the lessee at the end of the lease term.

4. Present Value Test

   The present value of the lease payments exceed 90% of the asset’s fair market value.

The above is the tests that US companies have to hold themselves to under US accounting standards. Internationally, European companies following IFRS face similar tests. Under IFRS, a company should capitalize the lease if the arrangement meets any of the following criteria.

1. Lease Term Test

   The lease term is for the major part of the economic life of the asset, even if title is not transferred.

2. Purchase Option Test

   The lessee has the option to purchase the asset at a price sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised.

3. Ownership Test

   The lease transfers ownership of the asset to the lessee by the end of the lease term.

4. Present Value Test

   At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.

5. Specialization Test

   The leased assets are of a specialized nature such that only the lessee can use them without major modifications being made.

What is Cash & Cash Equivalent?

Cash and Cash Equivalent is the value of cash and assets that can be easily converted into cash. There are two components: (1) Cash and (2) Cash Equivalent. Let’s go over what each of these entail.

Cash includes physical coins and paper bills, money in checking and savings accounts, money orders, etc. By comparison, Cash Equivalents are assets that can liquidate into cash within 90 days. They are assets such as Certificate of Deposit, Treasury Bills, Commercial Paper, Money Market Funds, etc. Hence, these items are highly liquid and can easily convert into cash within 90 days.

Companies usually group the two together and show them as a single line item. Together, Cash and Cash Equivalent measures the amount of money a company has at its disposal. Financial analysts uses this number often to determine the company’s valuation and to evaluate a company’s spending power.

This is an Asset on the Balance Sheet. Recall that the Balance Sheet orders the Assets section by liquidity. By definition, cash is the most liquid asset any company has. Therefore, it usually appears as the first line on the Balance Sheet, under Current Assets.

What is Cash Flow from Financing?

Cash Flow from Financing is the movement of cash between the company and its investors, both equity investors and credit investors as well as the cost to facilitate these movements.

What is Cash Flow from Investing?

Cash Flow from Investing is the cash flow a company uses to reinvest into the company and the cash it receives from divesting portions of the company.

What is Cash Flow from Operations?

Cash Flow from Operations represents the cash flow a company generates from its business operations.

What is a Cash Flow Statement?

Cash flow means movement of cash. Therefore, Cash Flow Statement is a report that shows the company’s movement of cash over a period of time. It tracks the amount of actual cash coming into and going out of the company’s pockets. These cash can be physical cash that we can touch, like dollar bills and coins. It can also be digital cash like deposits in the banks. Both are cash. The Cash Flow Statement tracks where these cash is coming from and where they’re going.

Along with the Income Statement and Balance Sheet, Cash Flow Statement is one of the three main financial statements. In fact, it’s arguably the most important among the three because cash flow is the key driver of valuation. Ultimately, how much a company is worth is based on how much cash it’ll generate. Cash is also what the company uses to pay for its operations and the key determinant of financial health. If we can only have one financial statement to evaluate a company, we would pick the Cash Flow Statement. You must understand cash flow if you want to get one of the high paying finance jobs.

You can think of the Cash Flow Statement as a financial report that tracks all the cash movements. It adds up all the cash inflows and subtracts all the cash outflows. What we have at the end is the overall net change in cash and the ending cash balance.

Cash Flow Statement Purpose

Different people use Cash Flow Statement for different purposes. Senior management uses it to gauge whether there’s enough cash to pay expenses (i.e. suppliers, employees, etc). Investors use it to analyze the company’s free cash flow profile and value the company. Specifically, credit investors focus on whether the company has enough cash to repay debt with interest. Meanwhile, equity investors focus on the ability for the cash to grow over time. Both groups of investors would also want to use the cash flow to estimate the company’s valuation. Competitors might use it to gain insights into the business and compare the performance with their own.

Cash Flow Statement Example

Here’s a real Cash Flow Statement example for Amazon (NASDAQ:AMZN). You can find the Cash Flow Statement on PDF page 44 of Amazon’s annual report.

Cash Flow Statement is also commonly known as the “Statement of Cash Flows”. Large companies would often call it “Statement of Cash Flows” on official documents, especially in company reports.

Cash Flow Statement Format

The Cash Flow Statement has 3 sections: Cash Flow from Operations, Cash Flow from Investing, and Cash Flow from Financing. It’s nearly always presented in this exact order. At the end, it adds up all the cash flows to show the overall Net Change in Cash.

Cash Flow from Operations represents the cash flow generated from and used for running the business operations. It includes cash received from customers, cash paid to suppliers, cash paid for taxes, etc.

Cash Flow from Investing represents the cash flow generated from and used for investments. The cash the company use to reinvest into the business to fund expansions, for example, is captured here. Examples include cash used to build new factories, open new stores, buying other businesses and buying stocks and bonds.

Cash Flow from Financing represents the cash flow generated from and returned to investors. The cash the company raises from investors by issuing stocks and borrowing debt are the two primary cash inflows. Conversely, the cash the company uses to pay dividends, repurchase shares, and repay debt are the three primary cash outflows.

The statement breaks out all the key line items within each section. Cash inflows are presented as positive numbers. Cash outflows are presented as negative numbers in parenthesis format. This way, readers can easily distinguish between cash inflows and cash outflows. If you see a number in parenthesis () on the Cash Flow Statement, it means it’s a cash outflow.

At the end, it sums up all the cash flows in these sections to calculate the Net Change in Cash. This represents how much the company’s cash balance has changed over the period of the Cash Flow Statement. Adding the Net Change in Cash to the beginning cash balance would give us the ending cash balance.

Cash Flow from Operations

Let’s go over the common line items under Cash Flow from Operations. There’ll be variations among companies. Some companies will have more lines, while others will have less. However, the lines below are often the main ones.

1. Net Income

   Under US GAAP, Cash Flow from Operations start with Net Income. Net Income is the first line under Cash Flow from Operations and comes from the Income Statement. It represents the overall profit of the entire company. It adds up all the incomes (Revenue, interest income, other incomes) and subtracts all expenses (operating expenses, interest, taxes). This is the ultimate amount of profit that the company earned for shareholders during the period.

2. Depreciation & Amortization (D&A)

   Depreciation & Amortization is an expense that reflects the usage of the company’s assets. As the company’s assets are used over time, they experience natural wear and tear. D&A is an expense that captures this natural wear and tear. The Income Statement subtracts D&A expense to calculate Net Income. However, there’s no cash payment required for D&A. No cash is paid for ongoing wear and tear. D&A is merely a reflection of reduction in asset value as assets are used up over time. Therefore, D&A is a non-cash expense. Because it’s deducted in Net Income, we need to add it back here to neutralize the impact of the non-cash expense.

3. Stock-Based Compensation (SBC)

   Stock-Based Compensation is an expense that reflects the portion of the company’s compensation expense paid with stocks as opposed to cash. SBC is part of the total compensation expense, which is usually part of the SG&A expense. The Income Statement subtracts the entire SG&A expense to calculate Net Income, which means it also subtracts SBC. However, SBC is a non-cash expense. No cash was paid because the company paid with stocks instead. Therefore, it’s a non-cash expense and we need to add it back.

4. Changes in Accounts Receivables

   When Accounts Receivables decrease, it means the company has collected a portion of the outstanding payments from its customers. Therefore, it’s a cash inflow. When Accounts Receivables increase, it means the company hasn’t collected payment on a portion of the period’s revenue. As a result, the amount of increase in Accounts Receivables must be deducted from Net Income because that’s not cash. That’s why Changes in Accounts Receivables impact Cash Flow from Operations.

5. Changes in Inventory

   When Inventory decrease, the difference adds to the company’s cash flow. When inventory increase, the change decreases the company’s cash flow.

6. Changes in Accrued Expenses

   Accrued Expenses are unpaid expenses that the company has accumulated over time. When Accrued Expenses increase, it means there are more unpaid expenses. This means a portion of the expenses deducted in the period’s Net Income hasn’t been paid with cash yet. However, Net Income had subtracted the entire expense regardless of whether it’s paid or not. To give credit to these unpaid expenses that were subtracted, we add increases in Accrued Expenses to cash flow.

   Likewise, when Accrued Expenses decrease, it means the company used cash to pay off the accumulated unpaid expenses. That’s a use of cash. Cash is moving out of the company. Therefore, we subtract the decrease in Accrued Expenses from Net Income to calculate Cash Flow from Operations.

7. Changes in Prepaid Expenses

   Prepaid Expenses is the value of the cash payment made in advance for expenses, before they are incurred. It’s the amount of cash the company has paid upfront for future expenses. For example, suppose a company pays $10,000 in advance for next year’s insurance. The $10,000 is a Prepaid Expense. Logically, an increase in Prepaid Expenses means the company has spent more cash. It’s a cash outflow, so we need to subtract it from Net Income.

   Likewise, a decrease in Prepaid Expenses means the company had incurred expenses that it had already paid for. These expenses are subtracted in this period’s Net Income. But because these expenses had already been paid for, they don’t require cash payments in the period they are incurred. In other words, there were no cash outflow associated with these expenses incurred during the period. Therefore, we add decreases in Prepaid Expenses to Net Income to give credit to these prepaid expenses.

Cash Flow from Investing

As a reminder, Cash Flow from Investing represents the cash flow generated from and used for investment activities. Generally speaking, there are three types of investments. The first is physical assets, known as Property, Plant & Equipment or PP&E for short. It includes things like factories, office buildings, chairs, tables, refrigerators, computers, etc. The second type is businesses. If a company were to spend cash to acquire another business, the cash being spent is an investment. And the third type is securities, like treasuries, stocks and bonds. Securities are investments the company makes to earn some extra cash on the side.

1. Capital Expenditures

   Capital Expenditures (CapEx) is the cash spent on Property, Plant & Equipment (PP&E). You can think of CapEx as the cash used to purchase physical assets. If a company were to spend $20,000 buying a new machinery for its factory, that $20,000 is a CapEx. CapEx is a cash outflow. It’s a usage of cash that usually brings Cash Flow from Investing down to the negative territory.

2. Proceeds from Sale of PP&E

   Proceeds from Sale of PP&E is the cash received from selling the company’s physical assets. It’s exactly what the name sounds like. This line is the polar opposite of Capital Expenditures. Whereas CapEx represents cash spent on buying physical assets, this line represents the cash received from selling existing physical assets. This is a positive number on the statement because it’s a cash inflow.

3. Acquisitions, Net of Cash Acquired

   This is the amount of cash spent acquiring other businesses, net of the cash that comes with the acquired business. Whereas CapEx is purchases of physical assets (i.e. chairs), Acquisitions refer to the purchase of entire companies (i.e. LLC, corporations). This is cash being spent, so it’s a cash outflow.

4. Purchases and Sale of Marketable Securities

   Marketable Securities are investment instruments that can be easily bought or sold. Examples are treasuries, stocks and bonds. Purchases of Marketable Securities are cash used to buy these securities. Companies may have a lot of cash in the bank. They want to put these cash to good use and earn some extra money on the side. Purchases are cash outflows, so they show up as negative numbers.

   In contrast, Sale of Marketable Securities refers to the cash received from selling the investment instruments the company owns. It’s the cash proceeds received from selling the company’s investment portfolio of treasuries, stocks and bonds. The cash proceeds received are cash inflows, so they show up as positive numbers.

Cash Flow from Financing

Cash Flow from Financing captures the cash movements between the company and its investors. Inflows are cash the company receive from investors whereas outflows are cash the company returns to investors. Credit and equity investors are the two main types of investors in a company. Therefore, the financing line items mainly relate to cash movements between the company and its debt and equity investors.

1. Proceeds from Debt Issuance

   Proceeds from Debt Issuance are cash received from borrowing debt. The company is raising money to fund its operations by issuing debt. “Issuing debt” is just a fancy term for borrowing debt. The company is receiving cash from lenders. Therefore, it’s a cash inflow and shown as a positive number on the statement.

2. Repayment of Debt

   Repayment of Debt is the cash used to repay debt. The company is taking money out of its bank accounts and paying back the debt it had borrowed. However, note that the value in this line only refers to the repayment of debt principal. It does not include Interest Expense, which is included in Net Income under US GAAP. It’s a cash outflow and shown as a negative number on the statement.

3. Proceeds from Stock Issuance

   Proceeds from Stock Issuance are cash received from issuing additional shares to investors. The company is raising money by giving a piece of the company to investors who provide cash. In other words, it dilutes existing shareholders’ ownership stakes in the company. After the stock issuance, the company has more cash but the existing owners own a smaller proportion of the company. It’s a cash inflow and shown as a positive number on the statement.

4. Dividend Payments

   Dividend Payments are the cash returned to shareholders from the profits the company has earned. The company is taking cash out of its bank accounts and giving these cash back to its investors. Hence, it’s a cash outflow and shown as a negative number.

5. Share Repurchase

   Share Repurchase is the amount of cash the company spent to repurchase shares. Buying back shares is a common method of returning capital to equity investors. It’s often more tax-efficient than dividend payments. The company is using cash to buy its stocks back from stockholders. Therefore, it’s giving cash back to investors and a cash outflow.

Foreign Currency Effect

The Cash Flow Statements of large, multi-national companies often have an additional line at the bottom called Foreign Currency Effect. What is this line and why do companies have it?

To understand this line, we need to understand the cash holdings of large multi-national companies. These companies operate in many different countries with different currencies and bank accounts. They’ll have some cash in each country denominated in the local currency. Logically, they need to have cash in local currency in order to fund their local operations. For example, they need to pay employees in Europe with Euros and employees in Japan with Yen. Therefore, multi-national companies spread their cash balance across many different currencies. However, for the purpose of the financial statements, companies have to present their total cash balance in a single currency. They have to account for the cash held in many different currencies in a single currency. Therefore, they have to convert different currencies into a single currency to get the total value of the cash balance.

Unfortunately, the foreign exchange rates among currencies don’t stay the same. They fluctuate daily. When foreign exchange rates fluctuate, it impacts the value of the company’s overall cash balance. Therefore, the value of the company’s cash balance would change every day even without any cash flow activities. To capture the impact on cash balance from foreign exchange rate fluctuations, companies have a line called “Foreign Currency Effect”. It captures the impact on cash balance due to foreign exchange rate fluctuations during the period.

Net Change in Cash

At the bottom of the Cash Flow Statement, it shows the Net Change in Cash. Net Change in Cash is the overall change in value between the company’s cash balance at the beginning of the period and its cash balance at the end. We can calculate Net Change in Cash by adding up all the company’s cash flows and the Foreign Currency Effect on Cash.

Income Statement vs. Cash Flow Statement

Why do we need the Cash Flow Statement when we already have the Income Statement? Doesn’t the Income Statement already tell us how much money the company is making?

Recall that while the Income Statement measures the profitability of the company, it does not measure cash flow. Profits and cash flow are two completely different things. Income Statement measures profits. The Cash Flow Statement measures cash flow.

To illustrate how profits and cash flow differ, let’s review how companies record the values on the Income Statement. Companies record the values on the Income Statement under Accrual Principle and Matching Principle.

Accrual Principle requires companies to recognize revenue when products are provided, without regards to whether cash is received. For example, if a business had delivered goods to a customer before getting paid, it has to record revenue nonetheless. Likewise, if a customer has already paid but the business has yet to provide the product, then the company can’t record the transaction as revenue. Therefore, revenue is the value of goods and services delivered to customers. It’s not cash received.

Similarly, companies recognize expenses under the Accrual Principle and the Matching Principle. Those expenses that have a direct relationship with revenue are recorded when their corresponding revenue is recorded. For example, the cost to produce a product is recognized when the revenue from that product is recognized. Expenses that do not have a direct relationship with revenue are recognized in the period they are used. Pay attention to the criteria here. At no point is the expense recognized based on when cash is paid.

Because of these accounting principles, the values on the Income Statement do not represent cash flow. Cash Flow Statement, on the other hand, measures cash movements purely based on cash received and cash paid.

What Does the Cash Flow Statement Tell You?

To financial analysts, the Cash Flow Statement is arguably the most important among the three financial reports. But why? What does the Cash Flow Statement tell you? Here, we’ll lay out some of the most important insights we can get from this statement.

Free Cash Flow Profile

We need the company’s Cash Flow Statement to calculate its free cash flow metrics. Specifically, we care about Levered Free Cash Flow (LFCF) and Unlevered Free Cash Flow (UFCF). Levered Free Cash Flow and Unlevered Free Cash Flow are two highly important metrics in investing. We won’t be able to calculate them without Cash Flow Statement. The amount of free cash flow the company generates drive its valuation. These free cash flow metrics also enable us to determine the company’s ability to spend on certain items. For example, they enable to estimate how much debt a company can repay or how many shares it can repurchase.

Capital Intensity

The Cash Flow Statement tells us the capital intensity of the business. Said differently, it tells us how much capital the business needs to run its operations or expand its footprint. Specifically, we can look at the Capital Expenditures history. Does the business require a lot of CapEx to keep its business up and running? A capital intensive business would require a lot of CapEx. A non-capital intensive business would have very little CapEx.

Acquisition History

You can get a sense of the company’s acquisition history from the line Acquisitions, Net of Cash Acquired. You can see how much the company spent to buy other businesses and when. There are situations where you’ll need to derive the price the company paid to acquire another business. If the company’s press releases don’t disclose the purchase price, then you can get an estimate from the Cash Flow Statement.

You can also triangulate price paid with valuation multiples to back-solve for the target company’s operating metrics. Once you have the operating metrics, you can potentially back them out of the company’s overall operating metrics. This will allow you evaluate the business’s organic performance independent of acquired financials.

Capital Return Programs

Capital return is an important factor for some investors. We can see whether the company is returning capital to shareholders under Cash Flow from Financing. If the company pays dividends, then it’ll show Dividend Payments. If it has a share buyback program, then it’ll show the amount of cash spent on repurchasing shares. Companies that are not returning capital to investors will not have either of these two lines.

What is Changes in Working Capital?

Changes in Working Capital measures the difference in a company’s Net Operating Working Capital between two periods of time.

What is Commitments and Contingencies?

Commitments and Contingencies is a type of liability. Commitments are obligations to perform something in the future while Contingencies are possible obligations that can take place based on uncertain future events

What is Cost of Goods Sold?

Cost of Goods Sold (COGS) is the cost to produce and deliver the company’s products. These are the direct costs attributable to the sale of each product.

What are Current Assets?

Current Assets are cash and other assets that can be converted into cash within one year. For this reason, it’s also known as Short-Term Assets. We’ll use the two terms interchangeably. This is usually the standard definition for Current Assets because most companies have an operating cycle shorter than a year.

However, for companies whose operating cycle is longer than one year, any Asset expected to be converted into cash within the operating cycle can classified as a Current Asset. An operating cycle is the average period of time it takes for the company to produce the goods, sell them, and receive cash from customers.

Generally speaking, most companies have an operating cycle shorter than a year. Therefore, most companies measure their Short-Term Assets based on the criteria of whether they can be liquidated into cash within one year.

Companies disclose the Current Assets they own and their values on the Balance Sheet. The one year period criteria is measured as 12 months from the date of the Balance Sheet.

Current Assets List

Here’s a list of Current Assets that often appear on companies’ Balance Sheets:

• Cash & Cash Equivalents: Paper bills, coins, bank deposits, money orders, commercial papers, Certificate of Deposits, etc.
• Short-Term Investments: US Treasuries, stocks, bonds, crypto-currencies, funds, etc. Companies can easily liquidate these investments, often immediately at the click of a button. It’s also known as Marketable Securities.
• Accounts Receivables: Expected future payment from customers for products already provided. These are payments that customers owe the company for products that they already received. Customers usually pay within 30-90 days. Therefore, Accounts Receivables is a Short-Term Asset.
• Inventory: Merchandises the company has not yet sold. Inventory is part of the list because businesses can generally sell most Inventory within one year.
• Prepaid Expenses: Value of expenses the company has paid upfront and not yet incurred.
• Deferred Tax Asset: Asset that allows the company to reduce its future taxable income and pay less taxes.

Different companies will have different lists of Short-Term Assets. Some might have more in addition to the above list. Others might have less. It varies from one company to another because it’s dependent on the business model.

Current Assets Example

Here’s a real Balance Sheet showing the Short-Term Assets of Hershey (NYSE: HSY). You can find the Balance Sheet on PDF page 57 of the company’s annual report.

The Balance Sheet has three main sections: Assets, Liabilities and Equity. Current Assets is a sub-section within Assets.

The Assets section structures line items by order of liquidity. Liquidity is the ease of conversion into cash. The Assets section orders the most liquid line items first and the lease liquid item last. Therefore, the Balance Sheet orders the Current Assets above Non-Current Assets. Within the Current Assets section, nothing is more liquid than Cash & Cash Equivalents. Therefore, Cash & Cash Equivalents is almost always the first line on the Balance Sheet.

Current Assets Formula

To get the most from analyzing Current Assets, you shouldn’t look at them based solely on their absolute values. You should also use Current Assets to calculate various ratios that can yield insights into the operating performance. Here are some formulas that will help you when dealing with Short-Term Assets.

1. Current Assets = Sum of All Items Listed under Current Assets

   To calculate the total value of Current Assets, we should add up all the items categorized under that section. In the Hershey example, we can just add up Cash & Cash Equivalents, Accounts Receivable, Inventories and Prepaid Expenses. Different companies will have different Short-Term Assets so there isn’t a single formula. Anyone giving you a formula of x+y is ignoring this variability among companies. Therefore, you have to just add up all the items categorized under Current Assets.

2. Net Working Capital = Current Assets – Current Liabilities

   Net Working Capital (NWC) is the difference between Current Assets and Current Liabilities. You can think of it as the difference between the cash a business will receive and the cash it’ll use in the next 12 months. Whether NWC is positive or negative depends on the business model. Some companies will have positive NWC while others will have consistently negative NWC. Both are normal. What should raise eyebrows, though, is if the business deviates from the historical norm. An example would be a business having negative NWC in one year when it had positive NWC in historical years. So NWC is a metric we need to analyze in relation to a company’s historical performance.

3. Current Ratio = Current Assets ÷ Current Liabilities

   Current Ratio tells us the percentage of the company’s near-term liabilities that it can repay with liquid assets. The higher the Current Ratio, the safer the company is liquidity-wise. Businesses with high Current Ratio has plenty of cash to cover its operating needs. Companies with Current Ratios <1 could potentially face a liquidity crunch where they don’t have enough cash to fund operations.

4. Quick Ratio = (Cash & Cash Equivalents + Short-Term Investments + Accounts Receivables) ÷ Current Liabilities

   Quick Ratio is a variation of the Current Ratio, but only based on the most liquid Current Assets. It only includes Cash & Cash Equivalents, Short-Term Investments or Marketable Securities, and Accounts Receivables. Quick Ratio excludes all other Current Assets. This is also a measure of liquidity. A Quick Ratio greater than 1 indicates healthy liquidity.

To learn more about Current Assets, check out our online courses. We’ll go over all the major line items one by one.

What is Current Liabilities?

Current Liabilities are liabilities the company owes that require the usage of cash within one year. Because these obligations require near-term cash payments, they’re also known as Short-Term Liabilities. This is usually the standard definition for Current Liabilities because most companies have an operating cycle shorter than a year.

An operating cycle is the average period of time between producing the goods and receiving cash from customers. For companies whose operating cycle is longer than one year, any Liability expected to be settled with cash payments within the operating cycle can classified as a Current Liability.

In most instances, companies have operating cycles shorter than one year. Therefore, most companies’ Current Liabilities are obligations that require cash settlement within one year.

Companies disclose the Current Liabilities they owe and their values on the Balance Sheet. The one year period criteria is measured as 12 months from the date of the Balance Sheet

What is Deferred Revenue?

Deferred Revenue is the value of money company received from customers in advance for goods and services not yet provided.

What is Depreciation Expense?

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Difference Between Depreciation and Amortization

Depreciation is used for tangible physical assets (PP&E) while Amortization is used for Intangible Assets (i.e. patents, copyrights, etc).

What is Diluted EPS?

Diluted EPS, or Diluted Earnings Per Share, is one of the financial metrics that measure a company’s profitability. Specifically, Diluted EPS measures the amount of Net Income a company earns for each of its common stock outstanding and common stock that will get created in the future. We go over the topic of Diluted EPS in greater detail in our curriculum: Course 6, Lesson 11.

To calculate Diluted EPS, we divide Net Income by the Diluted Weighted Average Shares Outstanding (Diluted WASO). For example, suppose a company has $3 million Net Income and 2 million Diluted WASO. In this case, its Diluted EPS is $1.50.

In general, Earnings per Share (EPS) is an extremely important number. It comes in two forms: Basic EPS and Diluted EPS. Basic EPS is almost never used while Diluted EPS is almost always used in financial analysis. This makes Diluted EPS an absolutely essential number in finance.

During our time working in investment banking at Goldman Sachs and in private equity, we used Diluted EPS whenever we had to reference per share earnings. The implication is that as you read about “EPS” online, or in books, or in the news, you should know that chances are they’re referring to Diluted EPS when they say “EPS”. They are not referring to Basic EPS. We go over how to use EPS in financial analysis in our curriculum. Specifically, Course 3 covers calculating Diluted EPS step-by-step; Course 6 covers how to think about EPS; and Course 9 covers using EPS in valuation.

The reason Diluted EPS is the more commonly used form of EPS is because it factors into account potential dilution. Dilution occurs when a company issues additional shares of common stock. Dilution can decrease each share’s earnings. Therefore, analysts prefer to use Diluted EPS, which includes the potential impact of dilution.

Basic EPS is typically reported by companies in on the Income Statement.

Diluted EPS Formula

Here’s the formula to calculate Diluted EPS.

The formula is actually very simple. We simply take the company’s Net Income and divide it by the Diluted Weighted Average Shares Outstanding.

Diluted EPS Example

Let’s take a look at Apple. For the 2022 fiscal year (page 29), Apple reported $99.8 billion in Net Income and 16.33 billion Diluted WASO. To calculate Diluted EPS, we can divide the two numbers.

Diluted EPS = Net Income / Diluted WASO = $99.8 billion / 16.33 billion Diluted WASO.

Diluted EPS = $6.11 per share.

So, Apple’s Diluted EPS for the 2022 fiscal year was $6.11 per share. This means the company earned $6.11 of profit in 2022 for every share.

Most companies’ Diluted EPS is as simple as this. However, for a minority set of companies, there can be curveballs. In the next section, we’ll go over different curveballs that might arise when calculating Diluted EPS.

Impact of Preferred Stocks

The first curveball that can come up when calculating Diluted EPS is when the company in question has Preferred Stocks. The vast majority of companies don’t have Preferred Stocks. They only have Common Stocks. However, a small subset of companies has Preferred Stocks. These Preferred Stocks often have fixed dividends.

Recall that Diluted EPS measures the amount of Net Income a company earns for each of its common stock outstanding and common stock that will get created in the future. Conceptually, it measures the common stocks’ entitlement to profit. The common stockholders are not entitled to the portion of Net Income paid to preferred stockholders through dividends. Therefore, we have to subtract out the portion of Net Income that the company will pay to preferred shareholders.

Consequently, for companies with Preferred Stocks, the formula for Diluted EPS becomes as follows.

Diluted EPS = (Net Income – Preferred Dividends) / Diluted WASO

Impact of Non-Controlling Interest

The second curveball that can come up when calculating Diluted EPS is when the company in question has Non-Controlling Interest (see Course 10, Lesson 28). The vast majority of companies don’t have Non-Controlling Interest (NCI), so this doesn’t come up very often. Luckily, handling NCI in Diluted EPS is actually pretty simple.

Starting with Net Income including NCI, we subtract Net Income Attributable to NCI. This gives us the Net Income excluding Non-Controlling Interest, which is what’s attributable to the company’s common shareholders. Then, we divide this Net Income Attributable to Common Stocks by Diluted WASO to get Diluted EPS.

Diluted EPS = (Net Income – Net Income Attributable to NCI) / Diluted WASO

Verizon, for example, is a company that has Non-Controlling Interest. Here’s Verizon’s 2022 fiscal year Income Statement (page 54). The number you should use for Diluted EPS is the “Net Income Attributable to Verizon”, which was $21.256 billion. That’s the profit metric after deducting the earnings attributable to Non-Controlling Interest. Dividing $21.256 by 4.204 billion Diluted WASO equals $5.06 Diluted EPS.

Impact of Non-Recurring Items

The Diluted EPS that companies report on the Income Statement are usually GAAP numbers. They usually include one-time, non-recurring items. Ideally, you should adjust the reported Diluted EPS to neutralize the impact of these non-recurring items. This way, you get a normalized Diluted EPS that more accurately reflects the company’s ongoing earnings potential. Adjusting earnings is a pretty big topic on its own so we won’t dig too deep into it here.

Basic vs. Diluted EPS

The difference between Basic EPS and Diluted EPS lies in the number of outstanding shares used to calculate EPS.

Basic EPS divides the company’s Net Income by basic outstanding shares of common stock. This means that the company only takes into account the shares that are currently in existence.

Diluted EPS divides the company’s Net Income by diluted outstanding shares of common stock. This means that the company not only includes the shares that are currently in existence but also shares that will eventually come into existence in the future. In other words, Dilute EPS takes into account the potential impact of dilution on EPS. Dilution occurs when a company issues additional shares of common stock or securities that can be converted into common stock, such as stock options, warrants or units. These additional shares or securities will reduce the shareholders’ true EPS. As a result, most professional analysts use Diluted EPS to measure the company’s profitability on a per share basis. Our curriculum goes over the concept of dilution and how to calculate it in detail in Course 3.

To calculate Diluted EPS, the potential dilutive effect of these additional shares or securities is factored in. This is done using the “Treasury Stock Method” or the “If-Converted Method”. The two methods assume that the additional shares or securities are actually exercised or converted into common stock, and the proceeds are used to buy back outstanding shares of common stock.

By factoring in the potential dilutive effect of additional shares or securities, Diluted EPS provides a more conservative estimate of earnings per share than Basic EPS. Diluted EPS is typically lower than Basic EPS.

In summary, Basic EPS assumes that there are no potential dilutive securities outstanding. It only takes into account shares that currently exist. By contrast, Diluted EPS factors in the impact of dilutive securities that can create additional shares in the future. Consequently, Diluted EPS provides a more conservative and truer estimate of earnings per share.

Do You Use Basic or Diluted WASO for EPS?

Companies calculate Basic EPS using Basic WASO. Net Income divided by Basic WASO equals Basic EPS.

Companies calculate Diluted EPS using Diluted WASO. Net Income divided by Diluted WASO equals Diluted EPS.

Should You Use Basic or Diluted EPS?

For valuation analysis, you nearly always use Diluted EPS. You almost never use Basic EPS. We’re using “almost never” instead of a simple “never” to not be absolute. After all, never say never.

For example, let’s say you’re trying to calculate a company’s P/E multiple. In this case, you’d use the stock’s current stock price for the numerator and Diluted EPS for the denominator.

Using Basic EPS in the denominator would be a rookie mistake. Don’t do it.

How to Increase Diluted EPS

From an investor’s perspective, the higher the Diluted EPS the better. That’s because a higher EPS means the company is earning more profit for each share. If we own a company’s stocks, we naturally want the company to earn as much profit per share as possible.

So how can companies increase Diluted EPS? Well, based on the formula, there’re really two levers that companies can pull. They must either increase Net Income or decrease Diluted WASO.

To increase Net Income, they must either increase Revenue or decrease Cost. To increase Revenue, they must either sell more product units or raise pricing. To decrease cost, they must reduce at least one of Cost of Goods Sold, Operating Expenses, Interest Expense, or Taxes.

To decrease Diluted WASO, they must do share buybacks. Alternatively, companies can also find ways to let dilutive securities expire without causing dilution. Such methods could potentially be painful and so it’s debatable whether they’re beneficial.

These are the different ways companies can increase Diluted EPS.

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What is Earnings per Share?

Earnings per Share (EPS) is the company’s profit entitled to each stock. It measures the profits the company earned for each share in a given period.

There are two types of EPS. Basic EPS and Diluted EPS.

What is EBIT?

EBIT is a metric that measures the profit generated by the business operations. It‘s an acronym that stands for Earnings Before Interest and Taxes. This profit metric accounts for all of the company’s income and expenses, except non-operating items, interest, and taxes. What we have at the end, is therefore a profit metric that measures solely the earnings from the core business operations.

Another name for EBIT is “Operating Income”. Companies often label Operating Income as opposed EBIT on the Income Statement.

What is EBITDA?

EBITDA is a non-GAAP metric that measures the cash profit generated by the business operations. It stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It’s calculated as EBIT plus Depreciation and Amortization (D&A).

What is “Effect of Exchange Rate Changes on Cash”?

“Effect of Exchange Rate Changes on Cash” refers to the changes in the value of a company’s cash balance due to fluctuations in foreign currency exchange rates. It’s a common line item on the Cash Flow Statement. Companies that operate 100% domestically with no foreign commercial activities are unlikely to have this line item. On the contrary, companies that conduct business abroad will likely possess this line item. Since many publicly-traded companies are multi-national corporations, many public companies report this line on the Cash Flow Statement.

Reporting Currency

Every company reports their financial statements in a particular currency. Companies in the United States usually report their financial statements in the US Dollar. Likewise, companies in Europe often report their financial statements in Euro or the British Pound. Similarly, companies in China report their financial statements in the Chinese Yuan. The Reporting Currency is the currency in which the company prepares its financial statements.

Functional Currency

By contrast, large multi-national companies often conduct business beyond their home country. Due to their overseas presence, they often deal with the foreign currencies of whichever country their operations are located. Each country will have its own official currency. Functional Currency is the currency of the primary economic environment in which an entity operates.

“Effect of Exchange Rate Changes on Cash” Example

For example, Tesla is an American company with significant overseas presence in China. Tesla’s US entity sells the vehicles to American consumers in US Dollars. Its US bank account will store its cash in US Dollars. Therefore, the Functional Currency of the Tesla US entity is US Dollar. However, the Tesla China entity sells vehicles to Chinese consumers in Yuan. Its China bank account will store its cash in the Yuan. Therefore, the Functional Currency of Tesla’s China entity is the Yuan. Similar concept applies to Tesla’s UK entity. The UK entity sells Tesla vehicles to British consumers in the Pound. Tesla’s UK bank account will store its cash in the Pound. Consequently, the Functional Currency of Tesla’s UK entity is the Pound.

Because of Tesla’s presence in many difference countries, it has many different Functional Currencies. However, when Tesla reports its financial statements, it has to report the numbers in the US Dollar. In other words, Tesla’s Reporting Currency is the US Dollar. On the Balance Sheet, the company must report its Cash & Cash Equivalents balance in US Dollar. This requires the company to convert each Functional Currency into the Reporting Currency.

Similar to stock prices, foreign currency exchange rates change every minute. Therefore, the value the Functional Currencies converts into the Reporting Currency will vary based on the exchange rates. Companies can have no changes to their bank account for an entire year and the value of the Cash & Cash Equivalents balance in the Reporting Currency will still change because of the constant fluctuations in foreign currency exchange rates.

Impact on the Cash Flow Statement

“Effect of Exchange Rate Changes on Cash” is important because it changes companies’ cash balance in the Reporting Currency. It is usually situated at the bottom of the Cash Flow Statement, immediately after Cash Flow from Financing. Most times, it will either increase or decrease the companies’ cash balance in the Reporting Currency. Rarely does it have neutral impact because rarely do currency exchange rates remain exactly the same.

For example, here’s the “Effect of Exchange Rate Changes on Cash” from McDonald’s Cash Flow Statement. McDonald’s is an American company with US Dollar as its Reporting Currency. However, it operates throughout the world with many different Functional Currencies. It’s no surprise then that foreign currency exchange rates can significantly affect the company’s cash balance.

Conclusion

“Effect of Exchange Rate Changes on Cash” refers to the changes in the value of a company’s cash balance due to fluctuations in foreign currency exchange rates. It exists because companies’ Functional Currencies may differ from their Reporting Currencies. It appears towards the bottom of the Cash Flow Statement.

What are Financial Statements?

Financial Statements are reports showing a company’s financial performance over a period of time. There are five types of financial statements.

1. Income Statement
2. Cash Flow Statement
3. Balance Sheet
4. Statement of Comprehensive Income
5. Statement of Changes in Equity

While there are five statements, not all of them are created equal. The Income Statement, Cash Flow Statement and Balance Sheet are by far the most important. They often shed the most relevant insight into the company. Therefore, these three are the major financial statements and are indispensable to investment analysis.

Independent accounting firms often audit these reports to certify that the numbers are fair and in compliance with accounting principles.

What is GAAP?

GAAP stands for Generally Accepted Accounting Principles. It’s a set of accounting principles and procedures that companies must follow when preparing their financial statements. The US GAAP governs American companies while the IFRS governs European companies.

What is Gain on Sale of Asset?

Gain on Sale of Asset is the gain achieved from selling an asset at a higher price than the Balance Sheet book value. The amount of gain is the difference between the cash proceeds from the sale and the Balance Sheet book value. Companies record this gain as an income on the Income Statement.

What is Goodwill?

Goodwill is the unidentifiable intangible assets within a company.

What is Goodwill Impairment?

Goodwill Impairment is an expense that reflects a reduction in the value of Goodwill on the Balance Sheet. The impairment occurs if the carrying value exceeds fair market value.

What is Gross Profit?

Gross Profit is the profit generated from goods and services sold. It measures the profitability of products. It’s the difference between revenue from these products and the cost to provide these products. Gross Profit = Revenue – Cost of Goods Sold.

What is Impairment Charge?

Impairment Charge is an expense that reflects a reduction in the carrying value of an asset on the Balance Sheet. The impairment occurs when the carrying value of a particular asset on the Balance Sheet exceeds its fair market value. While any asset can suffer impairment, the most commonly impaired assets are inventory, PP&E, intangible assets and goodwill.

What is an Income Statement?

The Income Statement shows the company’s revenue, cost and profits over a period of time. Along with the Cash Flow Statement and Balance Sheet, it’s one of the three main financial statements. You can think of it as a financial report that tells you how much money the company made during the period. Pretty much all of the highest paying finance jobs would require a strong understanding of this financial statement.

The Income Statement adds up all the sources of income and subtracts all expenses. What it has at the end, is profit, also known as “the Bottom Line”.

The Bottom Line

A key takeaway from an Income Statement is how much profit the company earned during the reporting period. This financial statement starts with revenue, which is often the biggest source of income, adds other incomes and subtracts expenses.

If the company generated more income than cost during the period, it’ll record a profit. This is known as Net Income or Net Profit. But if the company incurred greater cost than what it generated in income, it’ll record a loss. This is known as Net Loss. Either way, the Net Profit / Loss number is often show at the bottom of the report. For this reason, it’s also known as the “Bottom Line”.

The Net Income / Net Loss number is the key takeaway from the Income Statement. That’s why the Income Statement is known as “Statement of Profit & Losses” or “Statement of P&L”. P&L is just an abbreviation for Profit & Losses. So the next time someone talks about P&L, you should know that they’re referring to the Income Statement. And because P&L is the key financial metric that characterizes a business operations, the Income Statement is sometimes also called the “Statement of Operations”.

Underneath Net Income, publicly-traded companies will also show Net Income per Share. This represents the profit earned for each share given how many shares the company has outstanding. Whereas Net Income represents the total profit for the entire company, Net Income per Share represents the piece of the profit entitled by each share. This is also known as Earnings per Share or EPS.

Essentially, the Income Statement shows how the money made from selling products is transformed into profits and profit per share.

Income Statement Example

Here’s a real Income Statement example for Snapchat (NYSE:SNAP). You can find this example on PDF page 68 of Snap’s annual report.

As you can see, this financial report starts with Revenue, and then subtracts expenses and adds other sources of income. In this case, the total expense is greater than total income, so the company is incurring a Net Loss.

First, notice that Snap’s Income Statement is called “Consolidated Statements of Operations”. This is common. Publicly-traded companies will usually call it “Statements of Operations” in official documents as opposed to “Income Statement”. That’s because “Statement of Operations” sounds more official than “Income Statement”. However, content-wise, it’s the same as Income Statement. Therefore, if you’re looking for Income Statements of publicly-traded companies, you should search for “Statement of Operations” instead.

Second, notice that the numbers are presented “in thousands, except per share amounts”. This means that data related to financials per share are presented as-is. In other words, $2.95 of net loss per share means exactly $2.95. Not $2,950. However, all other numbers are shown in thousands. In Snapchat’s Income Statement, that means all the numbers between Revenue and Net Loss are shown in thousands. Same thing goes for “weighted average shares used in computation of net loss per share”.

And third, notice that the Income Statement often shows several years of data. It’s standard for companies to show several years of data across the columns. They do this so readers can easily see how the company performed over time. Setting consecutive years’ data side-by-side makes it easy for analysts to identify patterns. On a related note, notice that the periods are clearly labeled. “Year Ended December 31” to let readers know that the numbers reflect performance over a one year period.

Income Statement Format

Now we know what the Income Statement is and what it looks like. It’s time to learn the Income Statement format and how it’s structured. Broadly speaking, there are two types of Income Statement formats: Single-Step Income Statement and Multi-Step Income Statement.

Single-Step Income Statement:

The Single-Step Income Statement is a format showing the calculation to Net Income / Net Loss through a single step. It simply subtracts total expenses from total income (Revenue and other incomes). Here’s what a Single-Step Income Statement would look like.

Single-Step Income Statements are generally used by small to medium sized and privately-held companies. Large-sized, publicly-traded companies rarely use the Single-Step Income Statement format. Instead, most public-traded companies adopt the Multi-Step Income Statement format.

Multi-Step Income Statement:

The Multi-Step Income Statement is a format that shows the calculation to Net Income / Net Loss through multiple steps. It calculates other profit metrics along the way, before arriving at Net Income / Net Loss. Instead of calculating the bottom line through a single step, the Income Statement makes multiple calculations. It makes a few stops along the way before arriving at Net Income / Net Loss. Here’s the same Income Statement that we used for Single-Step laid out in Multi-Step format:

Most large-sized, publicly-traded companies adopt the Multi-Step Income Statement format. They do this because it highlights the company’s various profit metrics. You can think of this as the standard Income Statement format for most large companies. Let’s dig deeper to understand how a standard Income Statement (Multi-Step) is structured.

The Income Statement always begins with Revenue. Revenue is always the first line on the report. It’s always at the top. For this reason, it’s also known as “the top line”. This stands in direct contrast to Net Income / Net Loss, which is known as “bottom line”.

From Revenue, we subtract Cost of Revenue to calculate Gross Profit. Gross Profit measures the amount of profit purely from what the company sells.

And then from Gross Profit, we add other incomes and subtract all expenses related to the core business operations. Collectively, this gets us to Operating Income. It measures the amount of profit the company generated from its core business operations.

And then from Operating Income, we add and subtract non-operating related income and expenses. This gets us to the Net Income / Net Loss number, which is the bottom line.

See? It takes multiple steps along the way to go from Revenue to Net Income / Net Loss. Hence the name, Multi-Step Income Statement.

The Accounting Principles

Four accounting principles underpin how revenue and expense amounts are recognized. They guide the companies in determining the amount of revenue and expenses to record.

Monetary Unit Principle:

The first principle underpinning the Income Statement is the Monetary Unit Principle. The Monetary Unit Principle states that only transactions measurable in monetary units may be recorded in the company’s financial statements. If something can’t be measured with money, it can’t be recorded on the Income Statement.

Stable Dollar Assumption:

The Stable Dollar Assumption is an assumption that the currency used to prepare the financial statements (U.S. Dollar for American companies) is stable over time, without being affected by inflation or deflation.

Accrual Principle:

The Accrual Principle requires companies to recognize revenue based on when it’s earned rather than when payment is received. For example, suppose a company has delivered goods to a customer who has not yet paid. Under the Accrual Principle, the company should record this Revenue on the Income Statement.

Likewise, the Accrual Principle also requires companies to recognize expenses based on the Matching Principle and when it’s incurred as opposed to when cash payments are made. For example, companies would have to record the month’s utility expense even if they haven’t paid yet.

Small, mom and pop stores are likely to ignore the Accrual Principle. They tend to prepare their financial statements on a cash basis, based on when cash is received and paid. It’s a lot easier for them to track cash movements than it is to track accrued revenue and expenses. However, all publicly-traded companies in the US and Europe will observe the Accrual Principle and prepare their Income Statement accordingly.

Matching Principle:

The Matching Principle requires companies to record expenses on the Income Statement in the same period as the related Revenue. Revenue and related expenses are “matched” together and recorded in the same period. If an expense is directly related to revenue (i.e. cause and effect relationship), it should be recorded in the same period as the corresponding Revenue. If an expense isn’t directly-related to Revenue, the expense should be recorded in the period that it was used.

Income Statement Line Items

Let’s go over the common Income Statement line items. There may be some variations among companies, but the gist is the same. Below, we lay out these common line items in the order they usually appear.

1. Revenue

   Revenue is the value of goods and services that the business has sold. Companies generally provide their revenue recognition guidelines to explain the criteria they follow to determine whether a transaction is eligible to be recorded as Revenue.

2. Cost of Goods Sold (COGS)

   Cost of Goods Sold is the cost to provide the goods and services that the business has sold. Companies that sell physical products would call it “Cost of Goods Sold” but companies that sell services or a mix of product and services would call it “Cost of Service” or “Cost of Revenue”.

3. Gross Profit

   Gross Profit represents the profit generated purely from the goods and services that the business has sold. It’s the difference between Revenue and Cost of Goods Sold. Put another way, it’s the money company sold its products for less the cost of these products.

4. Research & Development (R&D)

   Research & Development are expenses related to improving existing products or developing new products. They help the business stay competitive and enable the company to launch new products in the future. Not all businesses will have this R&D expense. Hotels and restaurants, for example, won’t have R&D expense. R&D is more common among science and technology-based companies.

5. Selling, General and Administrative (SG&A)

   SG&A are expenses the company incur to (1) create demand for the business and (2) administer the business. The former is mostly sales and marketing expenses. Costs the company incurred to convince customers to buy its products. It includes items such as advertising fees, marketing team wages, sales commissions, public relations, etc. The latter is mostly expenses to administrate the company. It includes things like corporate office rent and payroll for the corporate staff, such as management, legal, finance, HR, etc. Sometimes companies would break SG&A into two separate lines on the Income Statement. One for Sales & Marketing and another for General & Administrative. However, in many instances, companies lump them together and call it Selling, General and Administrative.

6. Operating Income

   Operating Income represents the profit generated from running the business operations. It’s the difference between Revenue and all business operating expenses. Think of this as the profit a company earns just from running the business. It doesn’t include income from other sources, such as interest on the cash deposited in the bank. On the Income Statement, companies would often call this “Operating Income” or “Income from Operations” or “EBIT”.

7. Interest and Taxes

   After recording the P&L for the business operations, the Income Statement accounts for income and expenses aside from the business. These mainly relate to interest income from cash deposited in the bank, and interest expense on debt borrowed. And then after accounting for interest, we subtract Income Taxes.

8. Net Income

   Net Income is the bottom line on the Income Statement and represents the overall profit of the entire company. It adds up all the incomes (Revenue, interest income, other incomes) and subtracts all expenses (operating expenses, interest, taxes). This is the ultimate amount of profit that the company earned for shareholders during the period.

9. Weighted Average Shares Outstanding (WASO)

   Weighted Average Shares Outstanding is the average number of shares the company has outstanding during the period. The number of shares outstanding changes over time because companies can issue additional shares or repurchase existing shares.

10. Earnings per Share (EPS)

    Earnings per Share represents the Net Income the company has earned for each share. It represents the profit each share is entitled to. For this reason, it’s also known as “Net Income per Share”. We can calculate EPS simply by dividing the company’s Net Income by WASO. Whereas Net Income represents what the company earned in total, EPS represents what the company earned for each stock.

Are you starting to see the flow behind the Income Statement? It starts with Revenue. From here, it subtracts Cost of Goods Sold to get Gross Profit, which is the profit of the products sold. Then, it subtracts other operating expenses to get Operating Income. This is the profit of the entire business operations. Then, it accounts for other income and expenses outside of the business, like interest and taxes to calculate Net Income. And finally, it divides the Net Income by the Weighted Average Shares Outstanding to calculate Earnings per Share. What we have at the end is the total profit for all shareholders and the profit entitled to each share.

Income Statement Formula

Now that we know the common line items, let’s learn about the important Income Statement formulas. We’ll lay out the formulas we use to compute (1) certain line items and (2) ratios.

1. Gross Profit = Revenue – Cost of Goods Sold

   Note that synonyms for Revenue is Sales. And synonyms for Cost of Goods Sold is Cost of Service, Cost of Revenue, and Cost of Sales. Different companies might label things differently, so you can still plug them into this formula. The greater the Gross Profit, the more money the company has left to pay for other operating expenses.

2. Operating Income = Revenue – All Operating Expenses

   Most publicly-traded companies would explicitly calculate Operating Income on the Income Statement. The calculation is very simple. Simply subtract all of the company’s operating expenses from Revenue and that’s the Operating Income. The greater the operating income means the more profitable the company’s business is.

3. Net Income = Operating Income + Interest Income – Interest Expense – Taxes

   To calculate Net Income, we can start with Operating Income, add Interest Income, and subtract Interest Expense and Income Taxes. Alternatively, we can start with Revenue, add other sources of income and subtract all expenses.

4. Earnings per Share = Net Income / Weighted Average Shares Outstanding

   EPS can be calculated by dividing Net Income by WASO. EPS is probably one of the most important line items for a public company. How much EPS a company generates directly affects its stock price.

5. Growth Rate = (Current Year Metric / Prior Year Metric) – 1

   We use growth rates to analyze the company’s performance trajectory. Healthy businesses grow over time. All else equal, it’s far better to invest in a growing business than a declining business. Similarly, the greater the growth rate, the better. Analysts usually calculate growth rates on Revenue and profit metrics.

   As an example, suppose a company generated $500 of Revenue in Year 1 and $700 in Year 2. Then the growth rate from Year 1 to Year 2 is ($700 / $500) – 1, or 40%.

6. Profit Margin = Profit Metric / Revenue

   We can calculate profit margin for all the profit metrics by dividing them by the matching Revenue. Divide Gross Profit by Revenue and we have Gross Margin. Similarly, divide Operating Income by Revenue and we have Operating Margin. Margins are usually presented in percentage format.

   As an example, suppose a company generated $180 of Operating Income on $500 of Revenue in Year 1. This means it has an Operating Margin of ($180 / $500), or 36%.

Income Statement Limitations

While the Income Statement can tell us a lot about the company’s profitability, it has 2 major limitations. It doesn’t measure cash flow and it doesn’t paint the full picture of the company’s earnings power.

Does Not Measure Cash Flow:

Revenue and expenses on the Income Statement are recorded on an accrual basis. Recall that we learned about the Accrual Principle and Matching Principle earlier in this article.

Revenue is recognized when goods and services are delivered to customers. Notice that Revenue is not recognized based on when cash is received, but based on when products are provided. For many large businesses, cash is rarely received at the exact same time when goods and services are delivered. Similarly, expense is recognized based on when they are incurred and matched with the corresponding revenue. It’s not recorded based on when they are paid for with cash. That’s why there’re accounts receivables and accounts payables.

Because the Income Statement doesn’t track when cash is received or paid, it doesn’t measure cash flow. Ultimately, the value of a company is based on how much cash flow it’ll generate. For that, we have to turn to the Cash Flow Statement.

Does Not Paint the Full Picture of Earnings Power:

The Income Statement under US GAAP records all income and expenses incurred, regardless of circumstances. This could create a misleading representation of the company’s true earnings power. For example, an Income Statement might show a significant increase in Revenue and profits relative to the prior year. This would give the impression that the business is on a great trajectory. However, this increase could be due to a recent acquisition as opposed to natural organic growth. It’s up to analysts to dissect the numbers and understand the story behind the numbers. Another common issue is that companies could’ve incurred certain one-time expenses. These expenses might’ve been incurred due to unusual events that won’t occur again. As a result, these non-recurring expenses could make the company’s earnings lower than what it’s normally capable of.

Because of these limitations, analysts can’t rely their opinion of a company solely based on the Income Statement. We have to evaluate the company in conjunction with the Cash Flow Statement and the Balance Sheet. We should also make manual adjustments to the GAAP metrics to assess the true underlying earnings power of the business.

Non-GAAP Adjustments

To overcome the limitations of the Income Statement under GAAP, analysts often make adjustments to the earnings metrics. These adjustments are outside of GAAP, so they’re called non-GAAP adjustments. We’ll talk about non-GAAP adjustments in greater detail in a separate article.

What is Income Tax Expense?

Income Tax Expense is the tax expense a company recognizes based on its corporate income and the government tax rate. Income Tax Expense = Pre-Tax Income (x) Effective Tax Rate.

What is Income Tax Payable?

Income Tax Payable is the amount of taxes that the company owes the government but not yet paid with cash.

What is Intangible Assets?

Intangible Assets are non-financial assets that lack a physical substance.

What is Interest Expense?

Interest Expense is the cost accrued from borrowing debt. When companies borrow debt, they have to repay it along with interest expense.

What is Interest Income?

Interest Income is the amount of interest a company earns, usually on the cash it has in the banks. When a company deposits cash in a bank, the bank has to pay interest on the cash. Just like how we earn interest in our bank accounts, companies earn interest on their deposits as well. That interest is a source of income for companies.

Whereas Interest Expense is the cost a company accrues for borrowing other parties’ cash, Interest Income is what the company earns for letting other parties (banks) use its cash.

What is Inventory?

Inventory is a company’s products waiting to be sold. In the context of the Balance Sheet, Inventory represents the value of all these unsold merchandises.

What are Long-Term Assets?

Long-Term Assets are assets that the company doesn’t intend or is unable to convert into cash within one year. This stands in contrast versus Current Assets which the company can convert into cash within one year.

The one year cutoff is usually the standard definition for Long-Term Assets. That’s because most companies have an operating cycle shorter than a year. However, for companies whose operating cycle is longer than one year, any Asset that the company doesn’t intend or is unable to convert into cash within the operating cycle should be classified as a Long-Term Asset. An operating cycle is the average period of time it takes for the company to produce the goods, sell them, and receive cash from customers. Any asset that isn’t a Current Asset must be a Long-Term Asset. For this reason, Long-Term Assets are also known as “Non-Current Assets”. We will use these two terms interchangeably.

Generally speaking, most companies have an operating cycle shorter than a year. Therefore, most companies use one year as the threshold for Current vs. Non-Current Assets.

Companies disclose all the Long-Term Assets they own and their values on the Balance Sheet. The one year period criteria is measured as 12 months from the date of the Balance Sheet.

Long-Term Assets List

Below is a list of Non-Current Assets that frequently appear on corporate Balance Sheets.

• Long-Term Investments: Stocks, bonds and other securities the company intend to hold for more than one year. Companies may also own equity in private companies that would require an extended sale process to liquidate into cash.
• Property, Plant & Equipment (PP&E): Land, buildings, buildings, machinery, equipment, furniture & fixtures, etc. Essentially, PP&E captures all the physical assets the company owns aside from inventory.
• Identifiable Intangible Assets: Patents, copyright, trademark, brand identity & logo, trade secret, customer relationships, etc.
• Goodwill: Unidentifiable intangible assets. Goodwill arises from buying another company at a price above the acquired company’s net asset value.
• Other Long-Term Assets: No uniform standard here and varies from company to company.

It’s important to note that not all companies will have all the above assets. Some might own other Non-Current Assets, in addition to the above. Others might own less. It varies from company to company.

Long-Term Assets Example

Here’s a real example of Long-Term Assets from Nordstrom’s Balance Sheet. We highlighted them with the red box. You can find Nordstrom’s Balance Sheet on page 37 of its annual report here.

Notice that whereas Current Assets is explicitly labeled and has its own subtotal, Non-Current Assets aren’t specifically labeled as such. Instead, companies just list Non-Current Assets underneath the Current Assets section. The Balance Sheet implies that any asset outside of the Current Assets section must be a Long-Term Asset. This is usually the case for most public companies’ Balance Sheets.

Fixed Assets

Long-Term Assets are often confused with Fixed Assets. Long-Term Assets refer to assets that the company doesn’t intend or is unable to convert into cash within one year. By contrast, Fixed Assets refer to tangible physical assets with a useful life longer than one year. Fixed Assets is also known as Property, Plant & Equipment, or PP&E. Fixed Assets is just one of several Long-Term Assets. So while Long-Term Assets include Fixed Assets, the two are not synonymous.

LT Assets Impact on Business Quality

Non-Current Assets such as PP&E and Intangible Assets form the backbone of every company. These assets, such as computers, office furniture & fixtures, trademarks, and patents, enable businesses to sell their products. Companies that have significant Long-Term Assets driven by PP&E or intangible assets are generally capital-intensive. That’s because it takes lots of capital to acquire or these assets. A PP&E of $100mm on the Balance Sheet means the company had spent $100mm or more to acquire it. This means the business needs to spend a lot of money in order to make sales and generate profits. All else equal, businesses that can generate the same earnings with less Long-Term Assets are superior. They are run more efficiently and can earn profits with less capital investments. Therefore, all else equal, investors prefer to invest in non-capital intensive businesses.

Relationship with Other Financial Statements

Income Statement and Cash Flow Statement impact Long-Term Assets. Some examples of how they’re connected are:

• Purchases or Sales of Securities (Cash Flow Statement) can increase or decrease the value of Long-Term Investments.
• Capital Expenditures (Cash Flow Statement) and Depreciation (Cash Flow Statement) drive PP&E.
• Divestitures (Cash Flow Statement) and Gain / Loss on Sale of Asset (Income Statement) also affect PP&E.
• Amortization (Cash Flow Statement) impacts the value of Intangible Assets on the Balance Sheet.
• Acquisitions, Net of Cash Acquired (Cash Flow Statement) can increase PP&E, Intangible Assets and Goodwill.

What are Long-Term Liabilities?

Long-Term Liabilities are obligations that do not require cash payments within 12 months from the date of the Balance Sheet. This stands in contrast versus Short-Term Liabilities, which the company has to settle with cash payment within one year. Any liability that isn’t a Short-Term Liability must be a Long-Term Liability. Because Long-Term Liabilities are not due in the near future, this item is also known as “Non-Current Liabilities”. We will use these two terms interchangeably in this article.

The one year cutoff is usually the standard definition for Long-Term Liabilities (Non-Current Liabilities). That’s because most companies have an operating cycle shorter than one year. However, the classification is slightly different for companies whose operating cycles are longer than one year. An operating cycle is the average period of time it takes for the company to produce the goods, sell them, and receive cash from customers. For companies with operating cycles longer than a year, Long-Term Liabilities is defined as obligations due beyond the operating cycle. In general, most companies have an operating cycle shorter than a year. Therefore, most companies use the one year mark as the standard definition for Short-Term vs. Long-Term Liabilities.

Companies disclose all the Non-Current Liabilities they owe and their values on the Balance Sheet. The one year mark is measured as 12 months from the date of the Balance Sheet.

Long-Term Liabilities List

Below is a list of Long-Term Liabilities that commonly appear on a company’s Balance Sheets.

• Long-Term Debt. These are debt the company borrows from lenders but don’t have to repay within one year. Public companies often don’t break out “Long-Term Debt” by tranches on the Balance Sheet.
• Operating Lease. These are lease arrangements that last longer than one year. For example, a company may lease an office space or a machinery.
• Deferred Revenue (Long-Term). These are payments the company received from customers for products and services the company won’t provide within one year.
• Deferred Income Taxes (Long-Term). These are taxes that the company owes. However, the company does not expect to pay these taxes within one year. Instead it’ll pay these taxes in the future, beyond the one year mark.
• Other Long-Term Liabilities. Companies may have miscellaneous obligations that they must report but are not large enough to have their own lines. Consequently, companies group them together into “Other Long-Term Liabilities”.

Not all companies will have all the liabilities we list above. Some companies might possess some obligations and not the rest. Others might owe other obligations in addition to the above. It varies from company to company.

Financial Liabilities vs. Operating Liabilities

There are two types of Long-Term Liabilities: financial liabilities and operating liabilities. Financial liabilities are obligations related to the capital structure. Debt is the most common financial liability that companies have. In addition, some companies may also have other financial liabilities. By contrast, operating liabilities are obligations related to the business operations. Examples of operating liabilities include operating leases, pension obligations, deferred revenue, and deferred income taxes.

Long-Term Liabilities Example

Here’s a real example of Non-Current Liabilities from Bight Horizons Family Solutions’ Balance Sheet. We emphasized them in yellow highlight. You can find Bright Horizons Family Solutions’ Balance Sheet on page 54 of its annual report here.

Notice that Current Liabilities is explicitly labeled and has its own subtotal. On the contrary, Non-Current Liabilities are not explicitly labeled. There are no heading that inform readers that line items in a particular section are Non-Current Liabilities. Instead, companies merely list individual Long-Term Liabilities underneath the Current Liabilities section. The industry expects readers to know that any liabilities outside of the Current Liabilities section must be a Non-Current Liability. This is how most public companies usually present Long-Term Liabilities on the Balance Sheet.

Impact on Corporate Financial Health

Long-Term Liabilities are very common in business, especially among large corporations. Nearly all publicly-traded companies have Long-Term Liabilities of some sort. That’s because these obligations enable companies to reap immediate benefit now and pay later. For example, by borrowing debt that are due in 5-10 years, companies immediately receive the debt proceeds. They can use the proceeds to expand and grow their business. They don’t have to repay the debt until 5-10 years later.

While these obligations enable companies to accomplish their near-term objective, they do create long-term concerns. Companies eventually need to settle all liabilities with real payments. If the obligations accumulate into an overly large amount, companies risk potentially being unable to pay the obligations. This is especially the case if the future obligations are due within a short time span of one another. This could create a liquidity crisis where there’s not enough cash to pay all maturing obligations simultaneously.

Having some Non-Current Liabilities is a good thing. It allows management to optimize the company’s finances to grow faster and deliver greater returns to the shareholders. However, too much Non-Current Liabilities will have the opposite effect. It strains the company’s cash flow and compromises the long-term corporate financial health.

Relationship with Other Financial Statements

Long-Term Liabilities appears on the Balance Sheet. The Balance Sheet integrally links with the Income Statement and the Cash Flow Statement. Therefore, changes on the Income Statement and the Cash Flow Statement will trickle over to the Balance Sheet. Some examples of how the Income Statement and the Cash Flow Statement can affect long term obligations are listed below.

• Recognizing revenue (Income Statement) can decrease the value of long-term Deferred Revenue. On the other hand, receiving additional upfront payments from customers (Cash Flow Statement) for future delivery of products / services can increase long-term Deferred Revenue.
• Borrowings and repayment of debt (Cash Flow Statement) can alter the value of Long-Term Debt.
• Payment of income taxes (Cash Flow Statement) can decrease the value of long-term Deferred Income Taxes.

Conclusion

Long-Term Liabilities are obligations that do not require cash payments within 12 months from the date of the Balance Sheet. Another name for this is “Non-Current Liabilities”. Long-Term Liabilities are shown on the Balance Sheet.

What is Minority Interest?

Minority Interest is the value of the minority equity in a subsidiary that the parent company does not own. So if a company owns 60% of a subsidiary and another company owns the remaining 40%, Minority Interest is the value of the 40%. Minority Interest appears on the Balance Sheet under the Liabilities section.

What is Multi-Step Income Statement?

Multi-Step Income Statement is an Income Statement presentation that shows the calculation from Revenue to Net Income through multiple steps.

What is Net Income?

Net Income is the amount of profit after deducting all expenses. A company’s Net Income is the profit remaining after paying for all operating and non-operating costs.

What is Net Interest Expense?

Net Interest Expense is a company’s interest expense net of interest income. It’s a company’s cost from borrowing debt after being offset by the company’s earnings from the interest on its cash. Net Interest Expense = Interest Expense – Interest Income. It’s called Net Interest Income if Interest Income exceeds Interest Expense.

What is Non-Controlling Interest?

Non-Controlling Interest (NCI) is the portion of equity in a parent-controlled subsidiary that the parent does not own.

What is Paid-In Capital?

Paid-In Capital is the total amount of money equity investors have invested into the company during stock issuances. Said differently, it’s the total amount of cash a company has raised from investors through stock issuances.

It’s called “Paid-In Capital” because it’s the total amount of money investors “paid in” during stock issuances. Common other names are “Contributed Capital”, “Contributed Surplus”, and “Share Capital”.

What is Par Value of Common Stock?

Par Value of Common Stocks is the minimum price that a company may sell each share of its common stock.

What are Prepaid Expenses?

Prepaid Expenses are expenses the company has paid in advance, before they are incurred.

What is Property, Plant & Equipment?

Property, Plant & Equipment (PP&E) is the physical assets a company owns, aside from inventory and cash.

What is Research & Development Cost?

Research & Development Cost (R&D) is expenses a company incur to create new products or improve upon existing products.

What is Restructuring Charge?

Restructuring Charge is expenses a company incurs to make significant changes to how it conducts business.

What is Retained Earnings?

Retained Earnings is the cumulative profit a company has earned that it hasn’t returned to shareholders through dividends yet. Said differently, it’s the cumulative amount of profit a company has retained within the company after paying dividends. Therefore, it’s called “Retained Earnings”.

What is Revenue?

Revenue is the value of products a company sells to customers.

What is Revenue Recognition?

Revenue recognition is the accounting principle that governs how and when companies can record revenue. It’s a set of rules that standardize the way companies around the world measure revenue. It lays out the clear process and conditions that companies must follow in order to recognize any revenue.

Revenue is one of the most important metrics on the financial statements. It’s the first line on the Income Statement and influences all the lines that follow. How much revenue a company generates influences profit, cash flow and even valuation. Therefore, revenue is an essential metric in analyzing a company’s financial health and future prospects.

At a conceptual high level, companies recognize revenue when the following conditions are met.

• The company has transferred the goods / services to the customer.
• The collection of payment for the goods / services is reasonably certain.

In accounting language, we say that the collection of payment is probable and the company has satisfied the performance obligations. If you’re short on time, these two conditions are the key takeaways. The rest of this article will go over the revenue recognition standards in greater details.

For many businesses, revenue transactions are simple and straightforward. At a supermarket, customers take the product home and pay at the checkout counter. At a restaurant, customers consume the meal and pay on site. These companies provided the goods to the customer and the collection of payment was reasonably certain. However, there are also many other businesses with more complicated revenue transactions. These businesses rely on revenue recognition standards to guide them on when and how to record revenue.

Accounting Standards for Revenue Recognition

Sizable companies can’t just record revenue however they want. They must follow the revenue recognition rules set in the accounting standards. In the United States, companies follow the US GAAP maintained by the Financial Accounting Standards Board (FASB). For most of the rest of the world, companies follow the IFRS maintained by the International Accounting Standards Board (IASB).

Revenue Recognition Before May 2014

Prior to May 2014, revenue recognition policies were very problematic in both US GAAP and IFRS. The US GAAP was way too detailed. It had complex and disparate revenue recognition requirements for specific transactions and industries, such as software, real estate, and construction. As a result, different industries followed different accounting rules for economically similar transactions. By contrast, the IFRS was too lacking in details. It provided limited guidance and companies found the guidance difficult to apply. As a result, the FASB and the IASB worked together on a joint initiative to create a new set of revenue recognition accounting standards.

Revenue Recognition After May 2014

In May 2014, the FASB issued Topic 606, Revenue from Contracts with Customers. In the same month, the IASB issued IFRS 15, Revenue from Contracts with Customers. Along with other consequential amendments, these documents stipulate the new revenue recognition standards that companies around the world follow. The new standards also largely converged the US GAAP and IFRS revenue recognition requirements and eliminated most previous differences.

As previously explained in the first section, many businesses have very simple and straightforward revenue transactions. However, many other businesses have complicated revenue transactions. Examples include real estate construction arrangements, intellectual property licenses, and services with milestone payments. These might make it difficult to determine what the company has committed to deliver, the revenue amount and when revenue should be recorded.

Due to the convoluted nature of these transactions, companies and customers would enter into contracts. That’s why both the US GAAP and IFRS documentations reference “contracts with customers”. The new standards use these contracts with the customers as the basis for recording revenue.

The 5-Step Revenue Recognition Process

Under the new standards, both the US GAAP and the IFRS adopted a 5-step process to recognize revenue.

1. Identify the contract with a customer.
2. Identify the performance obligations (promise) in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the reporting organization satisfies a performance obligation.

Companies must believe that the collection of payment is reasonably certain (“probable”) before they commence the 5-step process.

Step 1: Identify the Contract

The first step in applying the new revenue recognition standard is to identify the contract with a customer. This is very straightforward. The key here is that the counterparty to the contract must be a customer. Contracts that are not with customers are outside the scope of the revenue recognition standard.

For example, Company A signs contract with Company B to jointly build a mall whereby Company B will control the mall and pay a fixed amount of money to Company A. Should Company A recognize the money it receives from Company B as revenue? It depends. If Company A and Company B are acting as partners, then Company A can’t recognize the payments as revenue. Company A might have to categorize the payments as dividend payments or investment income. If Company B is a customer receiving service from Company A, then Company A may recognize the payment as revenue.

Step 2: Identify the Performance Obligations

The second step in applying the new revenue recognition standard is to identify the performance obligations in the contract. Under the new standards, performance obligations are the unit of account. Therefore, performance obligations serve as the basis for how and when to recognize revenue. Management needs to evaluate whether to categorize multiple promised goods / services separately or as a single obligation.

In many businesses, the performance obligation is very straightforward. For example, in a restaurant, the performance obligation is likely the service of meals to the customer. The following are other examples of performance obligations.

• Netflix granting access to its shows and movies for a monthly subscription.
• Apple delivering iPhone that customer ordered on its website.
• Citibank safeguarding the money that customers deposited.

Step 3: Determine the Transaction Price

The third step in applying the new revenue recognition standard is to determine the transaction price. The transaction price is the amount a company expects to be entitled in exchange for goods or services transferred. Management should take into account both fixed and variable considerations of the transaction price.

A common question people have is whether companies record sales taxes in revenue. The new standards state that amounts collected on behalf of third parties should be excluded. Companies collect sales taxes on behalf of the government. Therefore, companies may not include sales taxes in revenue.

Step 4: Allocate the Transaction Price

The fourth step in applying the new revenue recognition standard is to allocate the transaction price. The objective is to allocate the transaction price to each performance obligation. The amount allocated should depict the amount the company expects to be entitled for fulfilling that obligation.

Here’s a key concept. The transaction price should be allocated to each performance obligation based on the relative standalone selling prices of the goods or services being provided to the customer. For example, let’s take a look at Microsoft. Suppose Microsoft sells its Surface laptop for $1,000 and Office 365 for $500. If a customer were to purchase the laptop on its own, then the standalone selling price is $1,000. And if the customer were to purchase bot the laptop and Office 365 separately, the total price is $1,500. But what if Microsoft sells the Surface laptop with Office 365 to a customer as a bundle for $1,300? How should Microsoft recognize revenue from the sale of laptop versus from the sale of Office 365?

Using the standalone selling prices, Microsoft should calculate the laptop revenue as ($1,000 / $1,500) x $1,300. Similarly, Microsoft should calculate Office 365 revenue as ($500 / $1,500) x $1,300. Therefore, Microsoft should allocate $866.67 of revenue to the laptop and $433.33 of revenue to Office 365.

Step 5: Recognize Revenue

The fifth and final step in applying the new revenue recognition standard is to recognize the revenue. The accounting standards require companies to recognize revenue when performance obligations are satisfied. A performance obligation is satisfied when the “control” of the promised good or service is transferred to the customer.

Remember that companies must determine that the collection of payment is probable before they even commence the 5-step process. Therefore, the two conditions to recognize revenue are what we stated in the beginning.

• The collection of payment for the goods / services is reasonably certain.
• The company has transferred the goods / services to the customer.

Conclusion

Revenue recognition is a set of accounting rules that govern how and when companies may record revenue. It used to be very complicated with different rules for different industries and major discrepancies between US GAAP and IFRS. After 2014, the FASB and the IASB introduced a 5-step process that standardizes how companies recognize revenue. Companies recognize revenue when the collection of payment is probable and performance obligation is satisfied.

SG&A Expense, or SG&A for short, stands for Selling, General & Administrative Expense. SG&A is a major line on the Income Statement. It represents the expenses a company incurs related to marketing and administering the company. All companies incur at least some amount of SG&A Expense. That’s because all businesses need to promote their products and services and all businesses need to have some administrative functions. Therefore, all companies will have SG&A though they might not necessarily use that exact name on the financial statements.

Breaking Down SG&A Expense

As a reminder, SG&A stands for Selling, General & Administrative. To better understand this line item, it helps to disaggregate SG&A into two parts. First, we’ll look at what “Selling” typically includes. Then, we’ll go over what’s included in “General & Administrative”.

Selling (S)

The first part of SG&A Expense are selling expenses. These are expenses a company incurs to “make the sale”. In order to make the sale, a company will need to promote itself and its products and services. Examples of selling expenses include salary and commission to the company’s sales people. Other examples include paying advertisements and organizing promotional events. These activities create demand for the company’s business and broadly categorized as “selling”. Therefore, the expenses a company incurs due to these selling activities are included in the SG&A Expense.

It is unlikely a successful business can sell its products and services without any selling activities. That’s because businesses need to inform customers of their existence and educate the customers about their products. In addition, most businesses have competition that target the same customers for the same products. To attract the customers, businesses must promote and market themselves.

General & Administrative (G&A)

The second part of SG&A Expense are general & administrative expenses. Companies incur these expenses in order to keep their business running. Every company, no matter how efficient, will incur at least some sort of administrative expense. For example, general & administrative expenses include the salary and bonus to the company’s management team. It also includes the compensation to the company’s personnel in administrative functions, such as finance, legal, and human resources. Aside from personnel cost, a company will also need to pay office rent, buy office supplies and pay utilities. These are expenditures a company must incur in order to keep it running on a day-to-day basis.

Similar to selling, it’s extremely unlikely that a successful business can scale and grow without any administrative activities. That’s because businesses can’t operate automatically. Humans must manage the businesses in order for them to function, which creates administrative expenses.

SG&A Expense on the Income Statement

SG&A is usually reported on the Income Statement as an operating expense. This means that SG&A is reported after total sales (revenue) but before operating income. SG&A is one of the expenses subtracted from total sales (revenue) in order to calculate operating income.

Most companies group record SG&A as a single line on the Income Statement. For example, here’s a snapshot of Apple’s Income Statement. Apple groups selling, general and administrative activities together into a single expense line.

Other companies prefer to break SG&A into two parts. These companies usually report a line for Sales & Marketing and a separate line for General & Administrative. Here’s an example of Facebook’s Income Statement. Facebook prefers to break SG&A into two parts: “Marketing and Sales” and “General and Administrative”.

How to Forecast SG&A Expense

While it’s important to know a company’s historical SG&A Expense, it’s also helpful to forecast future SG&A Expense. So, how do financial analysts forecast SG&A? Broadly speaking, there are three ways to forecast SG&A.

The first way to forecast SG&A Expense is by growing it by a certain rate year after year. For example, let’s say a company incurred $1,000 of SG&A Expense this year. If we forecast it to grow by 5%, then that means we’re estimating $1,050 of SG&A Expense next year.

The second way to forecast SG&A Expense is by projecting it as a percentage of revenue. In practice, many large corporations budget their SG&A expenditures based on how much revenue the company will generate. For example, let’s say a company will generate $5,000 of revenue next year. If the company spends 20% of revenue on SG&A, then that implies $1,000 of SG&A Expense next year.

The third way to forecast SG&A Expense is by projecting the components that make up SG&A and adding them up. Imagine a company will spend $300 on advertising, $400 on office rent, and $500 on manager salary next year. Assuming that these are all the company spends on SG&A, then we can add them up, which totals $1,200. This method is less common than the other two methods because detailed breakdown of SG&A is not usually publicly available.

Conclusion

SG&A stands for Selling, General & Administrative. It captures the costs incurred to market and administer a company. SG&A is a common line item on the Income Statement. Analysts can forecast SG&A with a growth rate, as a percentage of revenue, or through the sum of its components.

What is Share Capital?

Share Capital is the total sum of money investors have invested into the company through share issuances. Said differently, it’s the total amount of money a company raised from investors by issuing shares.

It’s called “Share Capital” because it’s the capital obtained by selling shares in the company. It has other names, such as “Paid-In Capital”, “Contributed Surplus”, and “Contributed Capital”.

What is Shareholder’s Equity?

Shareholder’s Equity is the value of a company’s assets that belong to the shareholders after deducting all its liabilities. It’s also called “Book Value”.

What is Single-Step Income Statement?

Single-Step Income Statement is an Income Statement format that shows the calculation from Revenue to Net Income through a single step.

What is Treasury Stock?

Treasury Stock is stock that a company has repurchased from shareholders.

What is Weighted Average Shares Outstanding?

Weighted Average Shares Outstanding (WASO) is a company’s average shares outstanding during a specific period, weighted by duration.