i'm writing this as i learn it so some of it may be wrong. In theory someday i would come back and revise it once i am more sure, but i probably won't.
The very basics
- assets, liabilities: An assets is something that you own, or something owed to you. A liability is something that you owe. Assets have positive value, and and liabilities have negative value. An assets could be something owed to you; e.g. if someone else has promised to pay you $10 a month from now, that promise is an asset (its market value is worth somewhat less than $10; however in accounting, in certain cases i think its book value be worth the entire $10, not sure about this though).
- capital: Something that will help you produce value in the future. For example, a factory.
- finance: Let's say you want to start a manufactoring business and you need to buy a factory first. You think that the manufactoring business will make much more money than the factory costs, that is, you think that the money spent on the factory will be a good investment. But you aren't rich enough to buy a factory. Since you expect the manufactoring business to be a good investment, it would make sense for a rich person (or, more commonly, a large group of ordinary people, e.g. a pension fund) to agree to pay for it now, and then after the business is successful, you'll give them more money back later. These sorts of arrangements are called finance.
- There are two main classes of finance arrangements, debt and equity. Debt is when you say, 'You give me this much money now, and i promise to give it back to you, plus this much interest, at this time'. Equity is when you say, 'Let's go into business together. Both of us will be owners of the company. When we make a profit, we'll split it.'. Roughly speaking, debt is when the amount of money that the investor gets back later is not dependent on how much profit your business makes, and equity is when it does depend on the business's profit, but this is not precisely true, as debt can have whatever weird contractual terms you wants, and equity is most fundamentally defined not in terms of what sort of contract you have, but rather as whether you have ownership, although ownership is a fuzzy notion.
Four financial statements
- balance sheet: what you own
- income statement: what you earned and what you spent, but with various prescribed adjustments to make it less bumpy and more diagnostic of how well you are doing (e.g. if you buy capital equipment, the full price of the equipment is not taken as a charge all at once, but rather is smoothed over a long time after you buy it; this is called depreciation. And when you purchase inventory to sell, this doesn't count against your income because you have less cash but now you have $700 worth of inventory instead, so you're not losing money)
- cash flow statement: how much raw cash you earned and how much you spent, without the above mentioned adjustments
- Statement of changes in equity: this keeps track of changes like when the owners put more money into the business, or take money out of the business
Notes
It's possible to be making a profit according to the income statement but to simultaneously have negative cash flow (according to both the cash flow statement, and to your bank account).
For example, a fast growing manufactoring business is constantly spending money buying more capital equipment and more parts to make more stuff, and it has to spend this money before it sells the things that the new equipment and parts create. The income statement doesn't immediately reflect all of the spending on capital equipment (these expenses will trickle into future income statements via depreciation) and doesn't reflect the spending on inventory.
A negative cash flow situation could continue for a long time if you have lots of cash, but otherwise you must either seek financing or reduce your rate of growth.
So even if the income statement says you're doing well, you have to watch out for cash flow. "Cash is king" as they say.
The income statement
The income statement is (for the most part) a journey that starts with the money that customers give you, takes out various expenses, and eventually tells you how much profit is left over.
- sales: how much money your customers gave you. See 'net sales' in the notes below.
- gross profit: sales - cost of goods sold
- cost of goods sold (cogs): what you paid for merchandise you sold, including labor costs if you made or improved them yourself, and the cost of moving them around. Service businesses use an analogous quantity, sometimes called 'cost of services delivered' or something similar; sometimes this quantity is called "cost of revenue" to be generic. How do you decide whether a cost goes under cost of revenue or under operational expenses? If the cost is incurred only in proportion to the number of items you sell (or the number of items you buy so that you can sell them later) then it's a cost of revenue. Otherwise, it's an operational expense, even if your capacity varies proportionally with it. For example, if you have a consulting firm and you pay sales commissions, this varies according to how much is sold; but your office rent does not (even though if you grow too much you'll have to move to a bigger office, so in the long term rent might be proportional to how many consultants your firm employs).
- operating proft: gross profit - operating expenses
- operating expenses include Selling, General and Administrative, Depreciation and Amortization, Research and Development
- Selling, General and Administrative ("SGA" or "SG&A") includes paying salespeople and marketers, paying management, advertising, office rent. These are sometimes called "overhead", although this is not a technical term and often other things are called overhead instead (e.g. i think there is also a term called "manufactoring overhead" which are costs other than SGA which can't be directly traced to a product, in the sense that there is no product such that if the company decided to stop making the product, the cost which still be incurred). Often broken into "selling" and "G&A".
- Depreciation and Amortization: if you buy capital equipment, the full price of the equipment is not taken as a charge all at once, but rather is smoothed over a long time after you buy it; this is called depreciation. Each period, a small portion of the price of each past capital equipment purchase will shows up in the depreciation section. Amortization is similar but depreciation is for tangible assets, amortization is for intangible assets
- Research and Development: Note that market research is not counted as R&D. Software development per se does not count as R&D, but "if a software company improves the efficiency of its product as a result of investment in research activities", that's R&D ( http://www.cbsnews.com/8301-505125_162-51066521/understanding-research-and-development-accounting/ ). The rules for where to book software development costs seem very confusing to me, see http://www.christophertechnology.com/docs/SOP%2098-1%20+%20EITF%2000-2%20Application.pdf
Notes
- gross sales: the sum of the nominal prices of everything you sold, without accounting for discounts or returned goods. "sales" usually refers to "net sales" not "gross sales".
- revenue: money coming in
- revenue includes all money coming in, not just money from sales: "Revenues from a business's primary activities are reported as net sales" but other sources of money (e.g. interest on the cash in the company's bank account) are also added to revenue separately.
- net sales: gross sales - (deduction for returns, discounts)
- run rate: extrapolating a rate from part of a year to an annulal figure. If spoken without further specification, usually refers to sales run rate. E.g. if a company sold $100 in the first quarter, it has a $400 run rate.
- run rate is very deceptive for highly seasonal industries
- gross margin as ratio: (sale price - cost per unit) / (sale price)
- markup as ratio: (sale price - cost per unit) / cost
- note that gross margin and markup are just two ways of measuring how much more the sale price is than the cost, as a ratio; they differ only in which of those is in the denominator
- A typical ratio of R&D to revenues for a high technology company is 7%, according to https://www.boundless.com/accounting/controlling-and-reporting-of-intangible-assets/research-development-cost/accounting-for-r-d-activity/
- Some principals for deciding when costs are capitalized (e.g. their cost trickles into the income statement over a long period of time) a and when they are expensed (e.g. the cost is charged to the income statement when it actually occurs) are:
Alternate waystations from sales to profit
Other basics
double entry accounting
cash vs. accrual accounting
operating income
Valuation
- book value
- market capitalization
- enterprise value
Valuation metrics
P/E (price/earnings) ratio (reciprocal of earnings multiple) P/S (price/sales) ratio (reciprocal of sales multiple)
links
more specialized topics
todo
accounting terms folder in my bookmarks
key industry metrics from
http://www.bloomberg.com/visual-data/industries/rank/name:market-share
see also/copy over from Self:notes-business-startups
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