The Accounting Formula
The most important aspect of accounting, which is the language of business, is understanding the formula that defines the whole logic behind double-entry bookkeeping:
Assets = Liabilities + Equity
The reason why this is the most important formula you will need to know when it comes to understanding accounting is because it follows the laws of motion. These laws imply a certain patterned integrity in how we arrange and account for valued items. Financial accounting, specifically, is the science of studying a company’s bookkeeping. There should be at least three key segments of a company’s financials (whether publicly traded or private) available to those interested in looking at the numbers:
- Income Statement
- Balance Sheet Statement
- Statement of Cash Flows
Also known as the Profit & Loss Statement (i.e. P&L Statement), this should be pretty self-explanatory. It showcases how much revenue or sales were generated for a specified time period (usually by fiscal quarter or year) and takes the difference of that against total operating expenses to net either a profit or a loss for the firm. Generally speaking, it takes about 3–5 years for a company to generate positive gains in profit. Therefore, when reviewing the financials for younger companies (or any companies in general), it’s best to focus on their revenue growth and operating income (total sales net cost of goods sold).
Balance Sheet Statement
This component of a company’s financials reflects a snapshot or a point in time with regards to the formula we introduced at the onset of this article. Whenever a company engages in business or transacts, the balance sheet is constantly affected. Therefore, it is imperative to implement routine analysis at consistent points of time in how the company performs. This will give confidence to vetting comparative metrics on a time horizon or even on a competitor analysis standpoint.
Statement of Cash Flows
Within the Statement of Cash Flows, there are three key segments that infer whether a company is successfully operating by maintaining its cash flow. These three segments are:
- Cash Flow from Operating Activities
- Cash Flow from Investing Activities
- Cash Flow from Financing Activities
The best way to remember the difference between each activities is as follows:
- Operating — think cash collected from customers and other related business activities.
- Investing — think long-term investments in fixed assets, real estate, and equipment.
- Financing — think dividends and stockholder’s equity; cash is paid out for dividends.
Investors like to see capital gains from companies that are able to generate revenue and maintain growth. Most investors prefer to have diversified portfolios filled with stocks that show key fundamental metrics in good measure for investing. More importantly, fundamental investors invest their time in implementing a portfolio management strategy that spreads risk to effectively maximize returns.
Perhaps a more intuitive way of looking at the accounting formula would be to rearrange the variables so that Equity is the net result between Assets and Liabilities — in so few words, subtracting Assets from Liabilities will yield the Equity or ownership of the firm. Assets are fundamental for generating value of a corporate entity, Liabilities are considered financial instruments to also appropriate value but there is no ownership in this category of accounting. Instead, there is an obligation on behalf of the corporate entity to repay all of its debts associated with its Liabilities accounts. This is what ensures investors confidence that their equity dollars aren’t being spent in waste.
Furthermore, the current tax code provides an incentive for companies to allocate their capital structure to add more debt. The interest on debt is tax-deductible, therefore, companies that rely on debt need to keep in mind this aspect. Investors ought to watch for capacity metrics such as debt-equity ratio, working capital, and interest coverage ratios to determine how well a corporate entity is able to maintain its debt schedule and remain solvent.