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Accounting Equation

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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

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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:

[Formula Picture]

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.

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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.

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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.

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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:

[Equity = Assets – Liabilities]

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.

Accounting Principles

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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.

Accounts Payable

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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.

Accounts Receivable

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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.

Accrued Expenses

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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.

Accumulated Other Comprehensive Income

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What is Accumulated Other Comprehensive Income?

Accumulated Other Comprehensive Income (AOCI) is the cumulative unrealized gains or losses that the company has earned from investments or foreign exchange currency fluctuations or other assets.

AOCI is a line item on the Balance Sheet. It’s categorized under the Equity section. It’s an Equity line item because it’s a measurement of gains and losses earned for the company owners.

Acquisitions, Net of Cash Acquired

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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.

Acquisitions, Net of Cash Acquired Example Amazon

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.

Additional Paid-In Capital

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What is Additional Paid-In Capital?

Additional Paid-In Capital (APIC) is the amount of money that equity investors have put into a company above the Par Value. Said different, APIC is a measurement of how much money shareholders have invested into the company.

Additional Paid-In Capital is a line item on the Balance Sheet. It’s categorized under the Equity section. Some companies will break out APIC as its own separate line item. Others will group it together with Par Value into a single line showing the total amount invested into the company. APIC appears under the Equity section because it measures how much money investors had put into the company in the first place.

Adjusted EBITDA

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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.

Average Revenue per User (ARPU)

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What is Average Revenue per User?

Average Revenue per User, or ARPU, measures the average revenue a company generates from each of its users. ARPU is an acronym that can be pronounced as a word: “are-pu”. It’s a non-GAAP metric that allows management and analysts to understand the company’s financials at the per-user level. ARPU is a common metric used by businesses in the technology, media and telecom industries.

Balance Sheet

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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:

Balance Sheet Example Image

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.

Real Balance Sheet Example Image

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

Balance Sheet Assets Layout Image

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.

Balance Sheet Assets + Liabilities Layout Image

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.

Balance Sheet Assets + Liabilities + Equity Layout Image

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.

Balance Sheet Accounting Principles Image

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?

What Balance Sheet Tells You Image

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.

Basic EPS

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What is Basic EPS?

Basic Earnings per Share (EPS) is the amount of profit entitled to each stock based on stocks outstanding. It’s calculated by dividing Net Income by Basic Weighted Average Shares Outstanding (WASO). Whereas Net Income represents the entire pie of profits that shareholders are entitled to, Basic EPS represents the portion of the pie entitled to each share.

Basic EPS is usually reported at the bottom of the Income Statement, after Net Income and Basic WASO. Because Basic EPS is a per-share metric, it’s usually calculated only for publicly-traded companies. That’s because stock market investors focus intently on per share metrics. They care about the stock price per share and the earnings per share Investors can analyze how much profit they get for the price they’re paying. On the other hand, this metric is rarely calculated for privately-held companies. Private companies don’t have stock prices that fluctuate daily and their owners focus instead on the company as a whole. Therefore, private companies often don’t report Basic EPS.

In practice, Financial Analysts rarely use the Basic Earnings per Share number. They prefer to use Diluted Earnings per Share instead.

Beta

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What is Beta?

Beta (β) measures how much an individual security’s price fluctuates in relation to the broader market. Analysts use the Beta Coefficient to determine the volatility and risk of a stock or another security relative to the overall market.

Stocks whose prices move generally in the same direction as the stock market will have positive β. Stocks whose prices move in the opposite direction as the stock market will have negative β. Gold and gold stocks, for example, have a negative Beta Coefficient. Investors view gold as a “safe haven” that stores value. When the stock market declines, investors take money out of stocks and invest in gold. As a result, when stock prices decline, gold prices often increase due to the increased demand.

The stock market has a standard Beta of 1.0. Individual stocks will have Betas higher or lower than 1.0, based on their volatility relative to the stock market as a whole. Stock whose prices move to a greater extent than the stock market have β higher than 1.0. These stocks are more volatile than the overall market. Stocks whose prices move to a lesser extent than the stock market have β lower than 1.0. These stocks are less volatile than the overall market.

In short, Beta can be either positive or negative. It can also be higher or lower than 1.0.

Measure of Risk

Financial analysts use Beta as a measure of a stock’s risk. Volatility indicates risk. The higher the β, the higher the risk. Likewise, the lower the coefficient, the lower the risk. In other words, Beta is a measure of the stock’s risk profile relative to the broader stock market. A β higher than 1.0 is more risky than the stock market. A β lower than 1.0 is less risky than the stock market.

This concept of the coefficient is an important component of the Capital Asset Pricing Model (CAPM). CAPM uses this metric to calculate Cost of Equity, which flows into the Discounted Cash Flow analysis.

Book Value

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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. 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’re 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. You’ll have to discern the precise meaning based on each situation’s context.

Capital Expenditures (CapEx)

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What is Capital Expenditures?

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.

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 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.

Capital Lease

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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.

Cash and Cash Equivalent

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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.

Cash Flow from Financing

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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.

Cash Flow Statement

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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 Example

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.

[Beginning Cash + Net Change in Cash = Ending Cash]

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.

Commitments and Contingencies

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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

Current Assets

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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.

Balance Sheet Example

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.

Current Liabilities

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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

Diluted EPS

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What is Diluted EPS?

Diluted Earnings per Share (EPS) is the profit entitled to each stock based on stocks outstanding and dilution effect. The dilution effect accounts for share count increases due to options, warrants, and other dilutive securities. It’s calculated by dividing Net Income by Diluted Weighted Average Shares Outstanding (WASO). Whereas Net Income represents the entire pie of profits that shareholders are entitled to, Diluted EPS represents the portion of the pie entitled to each share.

Diluted EPS is usually reported at the bottom of the Income Statement, after Net Income and Diluted WASO. Companies usually show it next to Basic EPS, which is its sister metric.

Discount Period

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What is Discount Period?

The Discount Period in a DCF is the length of time that we need to discount future cash flow. It’s usually the length of time between the date cash flow occurred and the date we’re trying the value the security as of.

Discount Rate

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What is Discount Rate?

Discount Rate is the rate of return that investors require on an investment. The Discount Rate for stocks is known as Cost of Equity. Similarly, the return required for debt is known as Cost of Debt.

Earnings per Share

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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.

EBIT

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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.

EBITDA

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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).

Effect of Exchange Rate Changes on Cash

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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.

Effect of Exchange Rate Changes on Cash and Cash Equivalents Example

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.

Enterprise Value

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What is Enterprise Value?

Enterprise Value (EV) is the value of a company’s business operations. Enterprise Value is calculated as Equity Value plus Debt Outstanding minus Cash & Cash Equivalents minus Investments. It’s the price to buy the entire business as a whole and is a key valuation metric.

Equity Risk Premium

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What is Equity Risk Premium?

Equity Risk Premium (ERP) is the additional returns investing in the stock market provides, in excess of the Risk-Free Rate.

ERP = Stock Market Return – Risk Free Rate.

Equity Value

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What is Equity Value?

Equity Value is the value of a company available to its owners. The company owners are shareholders. Therefore, Equity Value is the value of the company that belong to shareholders.

Equity Value = Stock Price x Shares Outstanding.

Financial Statements

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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.

Free Cash Flow

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What is Free Cash Flow?

Free Cash Flow (FCF) is the amount of cash generated during a period that can be given back to the company’s investors after all the necessary expenses and investment activities have been paid for. FCF is an extremely important metric in financial analysis. It’s the actual amount of value earned for investors over a period of time. There are two types of FCF: (1) Unlevered and (2) Levered.

GAAP

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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.

Gain on Sale of Asset

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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.

Goodwill Impairment

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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.

Gross Profit

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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.

Impairment Charge

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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.

Income Statement

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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”.

Income Statement Concept Image

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.

Snapchat Income Statement Image

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 Statement Image

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:

Multi-Step Income Statement Image

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.

[Income Statement layout]

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”.

[Income Statement layout – add cost of revenue]

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

[Income Statement layout – OpEx]

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.

[Income Statement layout – Net Income]

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.

Income Tax Expense

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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.

Interest Income

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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.

Inventory

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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.

Investment Banking in China

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Overview of Investment Banking in China

Investment banking in China is a high growth profession, in terms of (i) deal flow, (ii) prestige and (iii) compensation. Driven by its gigantic economy and an increasingly sophisticated financial system, China has developed a thriving investment banking industry.

Similar to the industry elsewhere in the world, the core services of investment banking in China are M&A and financing. China has the world’s second largest M&A market by transaction value, over US$700 billion. In addition, China is home to some of the world’s largest companies, such as Alibaba and Tencent. Naturally, China also has one of the world’s largest financing markets.

List of Top Investment Banks in China

Broadly speaking, there are two types of investment banks in China.

First, there are the global investment banks. These are usually the bulge bracket American and European investment banks. The American investment banks (i.e. Goldman Sachs, Morgan Stanley, J.P. Morgan) are the most prestigious in the Chinese market. Second, there are the native Chinese investment banks. These are domestic banks cultivated in China.

The global investment banks have greater scale, greater resources, and greater brand recognition than the domestic Chinese investment banks. That’s because these global banks operate worldwide and therefore have access to more resources. As a result, prior to the mid-2010s, the global investment banks dominated the Chinese investment banking industry. The global investment banks were and (still are) considered the most prestigious firms. As a result, they historically obtained the most attractive mandates. They win the most deal flow and they also pay their employees the most.

However, by 2021, the Chinese investment banks have made significant progress catching up in their home market. In many cases, the Chinese investment banks surpassed the global investment banks in terms of China deal flow. For example, over 1H’2021, the Chinese investment banks executed more deals in China than their global peers. In China M&A, CICC’s transaction value was more than double that of Goldman Sachs.

Investment Banking in China M&A League Table

In China Equity Capital Markets (ECM), the league table was filled with Chinese investment banks. Among the global investment banks, only Goldman Sachs, Morgan Stanley, Citi and UBS made it to the top 10.

Investment banking in China ECM League Table

In Debt Capital Markets (DCM), none of the global investment banks broke into the top 10. The credit market was dominated by the Chinese investment banks.

Investment banking in china DCM league table

Global Investment Banks

Even though the global investment banks have waning market share in China, their China businesses are still growing. That’s because the Chinese financial markets and economy are growing. Consequently, the global banks are earning more profits from investment banking in China even though their market share is declining. In addition, these global corporations are still considered the most prestigious. Beyond reputation, they also pay the highest compensation.

  • Bank of America (美国银行) (美银)
  • Barclays (巴克莱)
  • Citigroup (花旗)
  • Credit Suisse (瑞士信贷) (瑞信)
  • Deutsche Bank (德意志)
  • Goldman Sachs (高盛)
  • J. P. Morgan (摩根大通) (小摩)
  • Morgan Stanley (摩根士丹利) (大摩)
  • UBS (瑞银集团) (瑞银)

Chinese Investment Banks

The domestic Chinese investment banks significantly increased their capabilities over the past two decades. Not only did they grab market share away from the global investment banks, but they are also expanding overseas.

  • China International Capital Corporation (CICC) (中金)
  • China Securities (中国证券)
  • CITIC Securities (CITIC) (中信)
  • Guotai Junan Securities (GTJA) (国泰君安)
  • Haitong Securities (海通)
  • Huatai Securities (华泰)
  • Industrial and Commerce Bank of China (ICBC) (工商银行)

Salary for Investment Banking in China

Compensation for investment banking in China is pretty straightforward.

The global investment banks have “global pay”. Investment banking analysts in China can expect ~US$100,0000 to US$125,000 as their base salary. Using an USD-RMB exchange rate of 1.0 to 6.4, that’s about ¥640,000 to ¥800,000. In addition to the base salary, the firms also pay year-end bonus, which can be another US$100,000 (¥640,000). In total, a first-year analyst can earn over ¥1 million. Same story for investment banking associates.

By contrast, the Chinese investment banks have “domestic pay”. This pay is significantly lower than that of the global investment banks. That’s because domestically, the Chinese cost of living is much lower. Leadership of the Chinese banks also have to be mindful of the political and social implications. Therefore, the compensation package from the local Chinese investment banks are usually far lower. A first-year investment banking analyst may earn less than ¥500,000. In USD terms, that’s less than US$80,000. Among the domestic banks, CICC and CITIC probably pay the highest.

Hong Kong vs. Mainland

Historically, the global investment banks covered Chinese clients from the Hong Kong office. Some also have an IBD office in Beijing through a joint venture. For example, Goldman Sachs was in a joint venture with Gaohua Securities. The joint venture was known as Goldman Sachs Gaohua (高盛高华) in which Goldman Sachs only owned 51% of the Beijing operations. However, in 2021, the Chinese government granted approval for the global investment banks to acquire full ownership of their Mainland operations. Goldman Sachs, for example, reached agreement to acquire the remaining 49% of Goldman Sachs Gaohua. In addition, the Chinese government is also making it easier for global investment banks to operate in the Mainland. As a result, the global investment banks are now expanding beyond Mainland. They relocated bankers from Hong Kong to Mainland and are increasing their investment banking teams in the Mainland.

By contrast, the Chinese investment banks have always had a sizable presence in both Mainland and Hong Kong.

The location distinction between Mainland and Hong Kong has important implications on compensation for investment banking in China. First, the pre-tax compensation package is generally higher in Hong Kong than that in Mainland. In other words, for the exact same role, the pay is higher in Hong Kong than it is in Mainland. That’s partially because Hong Kong has a much higher cost of living. Second, the personal income tax rate is much higher in Mainland (up to 45%) than it is in Hong Kong (up to 20%).

Breaking into the Industry

Similar to the situation in other investment banking markets, it is very competitive to break into investment banking in China. Statistically, recruiting is even more difficult than in the United States just because China has a much larger population.

To break into investment banking in China at a top firm, you should try to attend a feeder school. That’s the standard and the most common way to enter into the industry.

However, there’s a separate way to break into the industry. The culture in China is very connection-driven. A large part of a candidate’s success is based on who the candidate knows or who the candidate’s parents know. If you have strong connections, you have a huge leg up in the recruiting process. If you don’t have strong connections, the best way is to attend a feeder school.

Feeder Schools

There are three types of feeder schools to break into China investment banking. The first type of feeder are top schools in the United States, United Kingdom, and Canada. Highly ranked public universities, such as Harvard and Stanford, as well as public universities, such as the University of Michigan and UC Berkeley are very prestigious in China. The second type of feeder are top schools in the Mainland, specifically 985 and 211 universities. Among these universities, Tsinghua, Peking, Fudan and Shanghai Jiao Tong (清北复交) have an outsized representation. The third type of feeder are top schools in Hong Kong. They are the University of Hong Kong (HKU), Chinese University in Hong Kong (CUHK) and to a lesser extent, Hong Kong University of Science & Technology (HKUST).

Investment Banking Course

In addition to attending a feeder school or having the right connections, candidates also need to know financial analysis. Our courses are taught by Goldman Sachs investment banker. We designed our courses to prepare you for investment banking. We teach you how to conduct financial analysis like how it’s done on Wall Street.

Upon completion of the courses, you will receive our Global Financial & Investment Analyst (GFIA) certification. You can sign up here.

Investment Banking in India

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Background of Investment Banking in India

Banking services have long existed in India since the ancient times. By 1990, there were several thousand bankers in India.

In 1990, the country set up its own self-regulatory organization called the Association of Merchant Bankers of India (AMBI). In the early 2000s, the global investment banks expanded their operations into India. Recognizing the vast market potential of India, Goldman Sachs, Morgan Stanley, and others quickly built up their presence in the country. Subsequently, in 2010, AMBI changed its name to Association of Investment Bankers of India (AIBI). AIBI serves as the industry governing and self-regulatory body of the investment banking industry in India. All major investment banks are members of the AIBI.

Today, India is a high growth country with a vibrant financial market. All leading global investment banks have a regional presence in India. In addition, the country has successfully nurtured several of its own highly reputable domestic investment banks.

List of Investment Banks in India

Broadly speaking, there are two types of investment banks in India. First, there are the global investment banks. These are usually American and European investment banks with a regional presence in India, covering the Indian market. Second, there are the domestic Indian investment banks. These are local native banks founded in India. The global investment banks have greater scale, greater resources, and greater brand recognition than the native Indian investment banks. That’s because these global banks have presence around the world. However, the native Indian investment banks often have strong local relationships. They can win new mandates through their local connections and local know-how. Here’s a list of the top investment banks in India.

Global Investment Banks

Bank of America

Bank of America is an American multinational universal bank and financial services holding company headquartered in Charlotte, North Carolina. BofA Securities India Ltd is the subsidiary entity providing investment banking services for the Indian market. BofA Securities provides capital raising solutions, M&A advisory, securities research, and sales and trading capabilities.

Website (India): https://www.bofa-india.com/aboutus.html

Website: https://business.bofa.com/

Barclays

Barclays plc is a British multinational universal bank, headquartered in London, England. Founded more than 300 years ago in 1690, the company is listed on the New York Stock Exchange and the London Stock Exchange.

Website: https://home.barclays/

Citigroup

Citigroup is an American multinational universal bank, headquartered in New York City, New York. The investment banking services is provided through Citi’s Institutional Clients Group. Besides its investment banking services, Citi also offers retail banking services in India.

Website: https://icg.citi.com/icghome/what-we-do/bcma

Credit Suisse

Credit Suisse Group AG is a global investment bank and financial services firm founded and based in Switzerland. Founded in 1856, Credit Suisse also has a major focus on wealth management for the super wealthy. Credit Suisse established its presence in India in 1997. Today, the firm has offices in Mumbai, Pune and Gurgaon, with vendor offices in Bangalore, Hyderabad and Kolkata. India is the second-​largest footprint for Credit Suisse outside of Switzerland, which demonstrates the importance of the country.

Website: https://www.credit-suisse.com/

Credit Suisse Pune Office

Credit Suisse Pune Office

Deutsche Bank

Deutsche Bank AG is a German multinational investment bank and financial services company headquartered in Frankfurt, Germany. Founded in 1870, the company is dual-listed today on the Frankfurt Stock Exchange and the New York Stock Exchange. While DB doesn’t offer retail banking services in many other big countries, DB does offer it in India.

Website: https://www.db.com/

Goldman Sachs

Goldman Sachs is an American multinational investment bank and financial services company headquartered in New York City. It is arguably the most prestigious investment bank in the world. It offers services in investment management, securities, asset management, prime brokerage, and securities underwriting. Goldman Sachs opened its Bengaluru office in 2004, Mumbai office in 2006 and Hyderabad office in 2021.

Website: https://www.goldmansachs.com/

HSBC

HSBC, officially known as The Hongkong and Shanghai Banking Corporation Limited, is a British universal bank. It operates branches and offices throughout the Indo-Pacific region, and in other countries around the world.

Website: https://www.hsbc.com/

J.P. Morgan

JPMorgan Chase & Co. is an American multinational universal bank and financial services holding company headquartered in New York City. JPM entered into the India market in 1922. Today, it has offices across Bengaluru, Hyderabad, and Mumbai.

Website: https://www.jpmorgan.com/

Jefferies

Jefferies Group LLC is an American multinational independent investment bank and financial services company headquartered in New York City. The firm provides clients with capital markets and financial advisory services, institutional brokerage, securities research, and asset management. It was founded in 1962.

Website: https://jefferies.com/

Morgan Stanley

Morgan Stanley is an American multinational investment bank and financial services company headquartered in New York City. MS has been operating in India for over 26 years, providing a variety of services to domestic and international clients. It has five offices in India: four in Mumbai and one in Bengaluru.

Website: https://www.morganstanley.com/

Nomura

Nomura is a Japanese multinational universal bank with an integrated network spanning over 30 countries. Founded in 1925, it employs nearly 30,000 customers across the world. Nomura set up its Indian operations in Mumbai in 2005. Today, Nomura India employs staff across Investment Banking, Global Markets, and Corporate Infrastructure divisions.

Website: https://www.nomura.com/

UBS Investment Bank

UBS is a Swiss multinational investment bank founded and based in Switzerland. Co-headquartered in Zürich and Basel, UBS operates in all major financial centers around the world. UBS Securities India Private Limited is the company’s subsidiary entity providing investment banking services in India.

Website: https://www.ubs.com/

Indian Investment Banks

Many domestic Indian investment banks have very good deal flow in India. The following firms have the most deal flow according to data compiled on Indian M&A and financing transactions.

  • AK Capital Services
  • Avendus Capital
  • Axis Bank
  • Bajaj Capital
  • Derivium Capital
  • Edelweiss Financial Services Ltd
  • HDFC Bank
  • ICICI Bank
  • ICICI Securities Primary Dealership Limited:
  • Indusind Bank Ltd
  • JM Financial Ltd
  • Karvey Consultants Ltd
  • Kotak Mahindra Bank Ltd
  • LKP Securities
  • L&T Financial Services
  • Punjab National Bank (India)
  • RBSA Advisors
  • Real Growth Securities Pvt Ltd
  • SPA Capital Advisors Ltd
  • State Bank of India (SBI)
  • Tipsons Consultancy Services
  • Trust Group
  • Yes Bank

Services for the Indian Market

In the preceding section, we talked about the two types of investment banks in India. The global investment banks with a regional office in India and the domestic Indian banks specializing in India. There’s a pretty clear divergence in the type of services the two types of investment banks offer.

The global investment banks focus on (i) Mergers & Acquisitions (M&A) and (ii) Capital Markets (Financing). M&A refers to the buying and selling of companies. Capital Markets refers to raising capital from debt and equity investors. M&A and financing are the heart and soul of the global investment banks. These firms generate most of their investment banking revenue from M&A advisory fees and underwriting fees.

By contrast, the domestic Indian investment banks offer a wide range of investment banking services. Similar to the global banks, the domestic Indian investment banks also provide M&A and financing advisory services. However, in addition to these two core services, the native firms also offer a wide range of ancillary services.

Start-Up Advisory

Domestic banks can advise start-ups through early stage fundraising. Similarly, they can also help venture capital firms with finding attractive investment opportunities.

Partner Search / Joint Venture

As multinational corporations do in many places in Asia, they often form joint venture partnerships with local domestic companies. The domestic banks can advise them through this process and helping them find the right local partner.

Restructuring

After India passed the Insolvency and Bankruptcy Code, 2016 (IBC 2016), the country possesses a legal framework for restructuring and reorganization. The local domestic banks provide this service to work with creditors and debtors through the IBC 2016.

Due Diligence

Domestic banks can also conduct due diligence for their clients. This is not something that the global investment banks offer as a standalone service. The global banks will usually conduct due diligence as part of M&A or financing advisory. However, the domestic banks differentiate themselves by offering this service to clients in silo.

Investment Banking in India Salaries

Here are some of the salary information for an entry-level investment banking analyst position at the global investment banks. Please note that this is just the salary. Investment banking compensation includes a mixture of (i) salary, (ii) bonus, and on some rare occasions (iii) stock-based compensation. Therefore, total all-in compensation is likely higher than the figures below.

Investment Banking in India Salaries

GFIA Certification for Investment Banking in India

Because investment banking is a very high paying job, it’s very competitive. To successfully break into the industry, candidates should demonstrate (i) a track record of excellence and (ii) mastery of financial analysis.

You can demonstrate a track record of excellence through academics, extracurriculars and work experience. Academically, you can demonstrate this by attending some of the top universities such as University of Delhi and IIT. In addition, grades and test scores also matter. Extracurricular-wise, if you’ve won certain competitions in your hobbies, that would also add points. And work experience wise, you can strengthen your candidacy by working at big companies and through investment banking internships.

You can demonstrate mastery of financial analysis through our GFIA Certification program. We offer a full suite of financial analysis courses to prepare you for a career in investment banking. Upon successful completion of our program, you’ll receive our Global Financial & Investment Analyst (GFIA) certification. You can sign up here.

Levered Free Cash Flow

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What is Levered Free Cash Flow?

Conceptually, Levered Free Cash Flow (LFCF) is the cash flow generated in a period that is free to be given to shareholders.

It’s the amount of cash flow leftover after paying for all expenses (including interest) and investing activities. All the mandatory and necessary cash payments to keep the business running have been paid for. All expenses and relevant investing-related cash outflows have been deducted. LFCF is what’s left that the company can use to fund financing activities. It can use the cash to pay shareholders dividends, repurchase shares, repay debt outstanding, or keep it in the bank.

Long-Term Assets

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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.

Long Term Assets Image

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.

Long-Term Liabilities

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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.

Long-Term Liabilities Example

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.

Margin of Safety

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What is Margin of Safety?

Margin of Safety is the cushion investors get on investments against potential risks. This cushion represents the extent to which negative events can damage the intrinsic value without compromising investors’ required investment returns.

Market Capitalization

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What is Market Capitalization?

Market Capitalization (Market Cap) is the value of the company entitled to the shareholders based on the market price. Shareholders are the owners of the company. Therefore, Market Capitalization represents the total value that belong to the company owners.  Market Cap is calculated by multiplying the company’s total shares outstanding by the stock price.

Mid-Year Convention

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What is Mid-Year Convention?

Mid-Year Convention is the practice of discounting future cash flow assuming receipt of cash flow evenly throughout the year. Mid-Year Convention is used in DCF analysis to better reflect the timing of cash flow.

Minority Interest

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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.

Net Income

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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.

Net Interest Expense

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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.

Paid-In Capital

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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”.

Present Value

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What is Present Value?

Present Value is the value of an asset today. It represents what an asset is worth “at present”. Therefore, it’s called “Present Value”.

Present Value is commonly used in DCF analysis to describe what a future amount of money is worth today.

Retained-Earnings

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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”.

Revenue Recognition

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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

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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.

Apple SG&A

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”.

Facebook SG&A

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.

Share Capital

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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”.

Testing

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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.

Valuation Methods

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What are Valuation Methods?

Valuation Methods are ways to determine how much an asset is truly worth. There are 3 main valuation methods to determine how much a company or a stock is worth.

Valuation Multiples

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What are Valuation Multiples?

Valuation Multiples are ratios that you can use to determine how much a company or is worth. The main valuation multiples are EV/Sales, EV/EBITDA, and P/E.

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