financial statements 101 basics, learning financial statements basics, and fundamentals

0:06 so what is a financial statement it's not actually one document but rather four documents the primary purpose of those documents is to summarize the financial information of a company and comply with the law by providing an honest and transparent view of the financial situation and performance of that company as a company is a complex thing to summarize it cannot be done on a single document and this is why four documents are needed the balance sheet the income statement the cash flow statement and the statement of changes in equity those four documents serve the objective of looking at the finances of the company from four different angles to give the reader a complete and well-rounded view of the financial situation and performance of the company it is also a mean of facilitating the exchanges between all the

0:54 stakeholders by providing a common framework to report Vital Information about the company the balance sheet summarizes what the company owns such as the value of its properties Machinery or any other asset and what it owes or in other words any liability it has to third parties such as loans from the bank for example the income statement which is also commonly called the p&l for profit and loss summarizes the financial performance of the company covering sales expenditures and ultimately the profitability of the company the cash flow statement serves a different purpose focusing on cash solely and therefore very short-term focused it records how cash enters and exits the bank accounts as we will see further on cash management is what makes or

1:45 breaks a company it therefore deserves its own document the last document is the statement of changes in equity which records changes in Company ownership between shareholders this document is important but not key to understanding Financial performance we will therefore not discuss it further at this point it is sufficient for you to know that it exists a very important point to note is that financial statements focus on the past performance of the company sometimes companies can decide to add comments or documents that offer an opinion on future Trends or performance those documents are added to the financial statement but core financial statement documents find their Source solely in past activity and Report what has already happened

2:35 so who are financial statements useful to as financial statements give a complete view of the financial situation and performance of the company it is used by many stakeholders as the basis for deciding if they should start stop or continue doing business with a company the most common stakeholders that have a need for financial statements are banks capital investment firms individual investors company managers customers suppliers and tax authorities let's talk about Banks let's say for example that you are the owner of an ice cream shop and that you decide to purchase a new ice cream production machine which costs around $2,000 you decide to ask your bank for a loan your Banker is going to be concerned with your solvency in other terms before granting

3:25 you the loan he will want to confirm that you are going to stay in business long enough and that you can generate enough profits to repay the loan all the elements needed to answer those questions are included in financial statements another example is in the field of capital investment if for say you're looking to invest in a business or if investors are looking to put money into your company in both cases someone needs to appraise the value of a company to determine how much it is worth financial statements play a big role in such an Endeavor to illust trade this just think of it as if you were looking to expand your business by acquiring one of the competing ice cream shops in town looking at its financial statement would enable you to understand how the company has been

4:12 Fairing and start evaluating how much it is worth now company managers also have a need in using financial statements whether they are general managers Finance sales marketing managers or Managers from any other department they use on a regular basis the documents contained in financial statements to take day-to-day decisions even if some of them don't know that they do as any action that has a financial impact is recorded on one or more of those documents it gives them the ability to analyze past performance to understand if there are areas that are underperforming it therefore gives them the ability to put in place corrective actions if we go back to our ice cream shop example we could look into our income statement to see if the company is

4:59 generating more sales than expenditures and see if it is profitable if it is not the case it gives us the ability to investigate if the issue is coming from insufficient sales or from an excess in spans sales managers for example are usually very interested in income statements as it is the basis used to set their targets and measure their attainments general managers use those documents to answer strategic questions such as are sales growing are we profitable can we be more profitable have we invested too much or not enough are we getting good enough payment terms from our vendors are we collecting fast enough from our customers in short are we managing well the company and can we do better of course some of our partners such as suppliers and customers will

5:47 also want to know if we are financially strong enough to work with them suppliers for example will want to know if they can trust us with large quantities of inventory customers on the other hand will want to know if we will be there to support them over the long run in our example we could imagine having to buy large quantities of milk every few days we could ask the milk producer for a 30-day payment term as it is customary for most businesses in essence we would be asking the milk producer to grant us a 30 days loan just as a banker would he would therefore want to verify our solvency before granting us that loan and finally tax authorities also have a need for financial statements in their case they will want to determine if the company has complied to all

6:34 of its obligations financial statements contain all the information needed for them to make that call financial statements are documents that summarize all the activities of the company that have a financial impact and even small ones The Source information of financial statements is the accumulation of all the day-to-day transactions of the company a transaction is a business event such as selling products paying salaries repaying loans and of the more infrequent and significant transactions such as buying an expensive piece of Machinery buying property or acquiring a company all those transactions materialize into invoices paychecks loan repayments and so on all the transactions form the accounting Journal this journal is the

7:26 list of all the transaction that occurred over a a given period of time you could therefore have a journal for January for February for March and so on you could have a journal for the full year as well which would simply be the aggregation of the monthly journals then those transactions are categorized based on their nature and the type of money they represent such as revenues costs taxes and so on the transactions are assigned to accounts where each account covers a single type of transaction accounts starting with a one are for assets two are for liabilities three is for Equity four is for Revenue five is for cogs six for expenses seven for taxes

8:11 eight for other items those accounts are then summarized in The Ledger The Ledger is just the summary of all the accounts of the company which in turn summarizes all the transactions of the company each account is specific to one of the financial documents that we will be learning about here year balance sheet accounts are the ones starting with one two and three and income statement accounts start with four five 6 7 and eight this categorization serves the purpose of giving Clarity to what each dollar represents it is very close to you putting money on the side to buy a present well here it's the same some money is due to the tax authorities some money is due to the shareholders or to suppliers so by keeping each Dollar in a separate account a

8:59 business leader can quickly know what is due to whom including to himself to summarize it all starts with a business activity such as selling a product which is a transaction that transaction is recorded in the Journal of this month it is then split into its constituting elements which are Revenue taxes and cogs which are then reported into separate accounts those accounts are reported in The Ledger which is then the source of our financial documents as we briefly saw earlier the balance sheet is one of the three key documents that make up a financial statement every company has the obligation to produce a balance sheet at least once a year this document summarizes everything that the company owns and everything that it owes

9:49 unlike the other two reports it is a snapshot of the company at a certain point in time meaning that if a balance sheet is prepared on the 31st of December it is reporting the situation for each category as of that day whether that snapshot is completely different from the picture the day before or the day later is inconsequential it is made of two sections called assets and total liabilities and Equity the asset section is focusing on what the company owns it is the positive side of the balance sheet and it covers everything that has a tradable value such as cash property Machinery or any money that is due to the company such as payments expect Ed from customers if we go back to our ice cream shop example this includes any money that is on the bank

10:35 account the ice cream production machines the furniture in the store and the store itself if the company was to own it the total liabilities and Equity section is the flip side of the assets it is the negative side of the balance sheet and covers two areas the first one called liabilities sums up all the debts of the company for the ice cream shop it is the loan that was contracted to purchase new Machinery or the refurbishment of the store or any payment that is due to suppliers the second section is called equity and is summarizing the accounting value of the company which is the accounting value of 100% of the shares of the company the asset section of the balance sheet as we saw previously is containing everything that the company owns it is the plus side or

11:24 positive side of the balance sheet this includes a variety of elements they all have one thing in common they have a dollar value and can be turned into Cash those elements are cash accounts receivable inventory prepaid expenses net fixed assets and other assets those assets are split into two subcategories current assets which group together all the assets that relate directly to the day-to-day activity of the company and fixed and other assets which are investments that have been made to enable such things as production or having office space those are necessary to make the company work but are not necessarily changing every year now let's look at current assets current assets is a subcategorization of assets which groups together all the assets that

12:14 relate directly to the day-to-day activities of the company any event in the life of the company that influences positively and increases its finances and it shortterm in nature is going to be a current asset generally the current assets category encompasses all the assets that serve their purpose within the year let's start with cash this is a very straightforward category as it is equal to the sum of all cash that is available on the bank account of the company every time a customer makes a payment there is money coming to the bank and the cash of the company increases similarly the cash category of the balance sheet increases account receivable is the category for any money that is due to the company but has not been paid yet let's look at a

12:59 real life example let's imagine that the ice cream shop just received an order to deliver at the end of the month a large quantity of ice cream for a kids anniversary the total amount of that order is $500 the customer is requested to pay 30% of the order up front and the remaining 70% on the day of the delivery in other words $150 today and $350 at the end of the month in our balance sheet we will record $150 in the cash category since it is received today and $350 in the accounts receivable category because this amount is due to the ice cream shop but has not been paid yet when the end of the month arrives and the $350 have been paid then we will subtract $350 from the accounts

13:48 receivable category and add this amount to the cash category the next category is inventory this is everything that has been purchased to be either sold or transfered form before it is sold for the ice cream shop any ingredient boat to prepare ice cream would be included in the inventory category such as milk fruits chocolate and much more those are included because once bought they will be transformed to form an end product that will then be sold the ice cream shop is selling as well a wide range of soft drinks those are both already in their final form and will not be transformed still when those are purchased they are included in the inventory category so every time a soft

14:33 drink is purchased by the ice cream shop let's say for $2 it is added to the inventory category until it is sold on the day it is sold the $2 are taken out of the inventory category and added to the cash category if the payment has been received on the day of the sale or it is added to the account receivable category if the payment will occur later now let's look at prepaid expenses it is a category that covers any service that has already been paid but has not yet been received examples are any deposits paid to companies salary advances to employees or prepayments as you can see current assets are relating to the core activity of the company selling products

15:19 increasing inventory collecting cash we will speak again of current assets further on once we have learned about current liabilities and the concept of working capital next are categories of assets that are let's say less current next fixed assets is a category that covers the properties equipment and more generally anything that is necessary to run the business but does not vary with individual transactions you can find in this category one or more offices production equipment computers cars and so on of course to be included in the next fixed assets category any item must be fully owned by the company for example if the IC is renting its stores it is then not the owner

16:06 of the store in that case this is just a monthly expense to the company and the store value cannot be included in the next fixed assets category we will see further on where it is recorded usually the next fixed assets category is divided into two subcategories the first one is called fixed assets at cost which reports the value of assets at the time of purchase the second is called depreciation the notion of depreciation is complex and important to understand a following video is therefore dedicated to the subject the last category of the asset section is other assets as its name indicates this category covers any asset that cannot be classified in the other categories

16:56 a good example of other assets is in intangible assets intangible assets are assets that do not have a physical presence such as patents copyrights brand names to name a few those assets can have a significant value without which the company would not operate normally or even would not operate at all they therefore need to be reported on the balance sheet as assets their value by the way is very hard to determine and is usually the subject of debates a good example of intangible assets is the brand name of well-known companies think about a large soda company which sells millions of drinks thanks to its brand name without that brand name sales would plummet instantly it is therefore of high value and needs to be reported on the balance sheet in the other

17:45 asset category a concluding note on the order in which cash accounts receivable inventory prepaid expenses next fixed assets and other assets are categorized in the balance sheet at the top you will find the categories that are the easiest to turn into Cash they are also called liquid assets liquid means that it is easy to trade the categories are then organized from the most liquid to the least liquid cash of course is the most Liquid account receivable is cash that should be received soon therefore it's liquid but less than cash same goes for inventory the last category net fixed assets is the most difficult to turn into Cash and therefore it appears at the bottom of

18:31 the asset section the purpose of depreciation is to account for fixed assets related expenses in a way that is relevant to its contribution to the business activity and not to evaluate the current value of assets you therefore need to use it as such to understand appreciation we first need to look into how the acquisition of fixed assets is accounted for in a company books when an acquisition is made for a $1 million piece of equipment for example it is treated in two different ways in the company books the two treatments are from a cash standpoint and from a profit standpoint the first treatment is from a cash standpoint if the equipment was purchased

19:16 with cash then the total cost of that equipment is subtracted from the cash of the company right away that makes sense since the money was spent it needs to be taken out of the bank account and therefore to reduce the cash category of the balance sheet but that same expense is not accounted for the same way when it comes to calculating the profitability of the company as we will see when we will Deep dive into the income statement sales or Revenue need to be accounted for with its corresponding costs in other words if you need to spend money to make a sale you need to report the revenue from the sale and the corresponding spend at the same time so when you buy a $1 million piece of equipment that is going to be used for 10 years to produce Goods the

20:03 accounting standard requires you to account for that equipment every year during its useful life that's called depreciation that means that if you use a straight line depreciation for $1 million piece of equipment with a useful life of 10 years you will account in the company books an expense of $100,000 every year for 10 years in the balance sheet this will represent the loss of value in the accounting books of the company also called Book value that is recorded over time to be concrete after 3 years the balance sheet will be showing $1 million in fixed assets at Cost since it was the value at which the equipment was purchased and $300,000 in depreciation $100,000 per year the

20:53 next fixed assets will show a total of $700,000 which is the original value of the asset less the depreciation as said at the beginning of this video the purpose of depreciation is to account for fixed assets related expenses in a way that is relevant to its contribution to the business activity and not to evaluate the current value of assets you therefore need to use it as such while the concept of depreciation is necessary for the evaluation of profitability it is not always a good measure of the value of assets and therefore needs to be used with care some Goods such as computers for example lose value over time after one year a computer can lose as much as half

21:41 of its value therefore Accounting in the balance sheet that it loses a third every year for three years can be a realistic measure on the other hand some assets have a value that increases over time and in that case the next fixed asset value of that asset will not be a good representation of its real value for example a property can see its value increase over time due to increase demand for it its value in the balance sheet will decrease over its 30 years of useful life while its real value would increase the liabilities and Equity section covers everything that the company owes to Banks for example or suppliers employees and so on in other terms this is all

22:28 the debts that the company has Equity is the debt that the company has to its shareholders it is a very unique type of debt and therefore has its own section in the balance sheet the equity section contains two categories retained earnings and Capital stock the liabilities section covers all the other debts that the company has such as accounts payable acred expenses current portion of debt income taxes payable and long-term debt as for the asset section it is separated into current liabilities and long-term liabilities everything that is affecting the company within the year following the day on which the balance sheet has been prepared is

23:14 reported in the current liabilities section the rest is considered long-term liabilities are all the debts that a company has whether it is a loan from A bank a payment that is due to a supplier or a salary due to an employee as long as it is some form of a debt it will be recorded as a liability liabilities are reported just as Assets in two categories current liabilities and long-term liabilities again just as for assets the current liabilities are the ones affecting and being affected by the daily activity of the company current liabilities include accounts payable acred expenses current portion of debt and income taxes payable let's look at those

24:02 one by one let's start with accounts payable this category is for any debt that is due to suppliers just as we had an accounts receivable category in the assets section for money due from customers this section is for money that the company owes to its suppliers most companies negotiate payment terms and will receive from their suppliers the possibility of paying a certain number number of days after having purchased a good or a service the most common payment terms are prepaid which means the company needs to pay its suppliers before the good is shipped or service is rendered and 30 days net which means the company can pay 30 days after the invoice date during the time

24:48 between the purchase and the payment the money due to the supplier will have to be put on the side it will be reported in the accounts payable category for example let's say the ice cream shop decides to purchase on the 15th of April new tables and chairs for its store to make it nicer for a total value of $3,000 let's say as well that its supplier a furniture store agrees to give the ice cream shop a 30 days net payment term that means that even though the order was placed on the 15th of April no payment will be made until the 15th of May on the 15th of April even though the payment p is not due for another month the ice cream shop will have to put the money on the side until

25:34 the payment is made during that time the money will be placed in the accounts payable category now income taxes payable income taxes payable is again a debt but this time to the tax authorities company taxes are paid every 3 months there is therefore a time difference between the moment that a profit is made and the time that taxes are paid during that time the tax money is put on the side in the income taxes payable category on the day of the payment that amount is taken out of that category since the debt then no longer exists next in line is acred expenses acrude expenses is reporting any money that is due to stakeholders other than suppliers as we saw earlier suppliers

26:23 have their own category for that type of debt which is Accounts Payable for example an employee is one of the stakeholders that can be covered by this category let's say the ice cream shop has a bonus plan in place to motivate its employees to sell soft drinks and let's say the bonus is paid only once a year let's imagine then that John an employee of the IC has made a terrific job selling soft drinks and by April has already earned $500 worth of bonus as the bonus will be paid only at the end of the year the ice cream shop accountant will have to put those 500 $0000 on the side for later payment until the end of the year the $500 will be placed in the acur expenses category the last category of current liabilities is current portion of debt this category is for the portion

27:13 of loans that is due within the coming 12 months to be concrete if your company has a 4-year Loan in place and it needs to pay $5,000 per month for 48 months we will be reporting only the next 12 months in the current portion of debt category in other words 12 * $55,000 the remaining 36 payments will be reported in the long-term debt category only the current portion of debt category will be reported in current liabilities the last liability category is long-term debt which we just saw it's covering the portion of loans that is beyond the next 12 months Equity is a category that covers yet another another debt of the company that debt is specific in nature since it is a debt towards

28:03 the owners of the company also called shareholders I remember that the first time I got introduced to the concept of equity being a debt I was really surprised the main reason was that for me if the company was mine there could be no debt between me and myself and in fact it's not the case to understand the nature of equity it is important to understand that when a company is incorporated a new person is created in the legal sense at least the new person is called a Jal person and has a legal life of its own the company being a judical person has rights obligations and responsibilities and as such has a life of its own separate from the person who raised it

28:49 therefore when a company is incorporated it is a different person from yourself which poses the next key question what's the relation ship linking you to your company the link is the following when you raise a company you lend money to your company that new judical person the company will use those resources to conduct its activities with the objective of generating a profit just as a bank lends you money that you pay back with interest you have lended money to your company that you will get back with interest as well the company owes you the initial investment Plus compensation in accounting terms the capital you invested in the company is worth a certain percentage of the

29:34 company and can go up to 100% of the company if you are the sole owner this capital is the equity since the company owes you that money it is indeed a debt towards you the shareholder you might ask what about the compensation well in accounting terms we call those dividends and if the company makes an annual profit you will get a share of it that's the part of your compensation that relates to your investment that category is divided into two subcategories which are Capital stock and retained earnings Capital stock or common stock is the total amount that has been invested by the shareholders if three people bring $2,000 each to raise a company then Capital stock is

30:21 equal to $6,000 retain earnings is a category that reports the accumulation of all the profits that the company has generated when bills are paid with company money and not new loans the money comes out of the cash category on the assets side and correspondingly reduces the retained earnings category on the liabilities and Equity side at the end of the year if there's any profit left in the retained earnings category it is distributed as dividends to the shareholders if you ever wondered where the name balance sheet comes from the explanation is coming from the fact that the two key sections of the balance sheet assets and liabilities and Equity must always be equal to

31:06 each other or in other words be in Balance if that is true it means that all the assets or everything the company owns must be equal to the total amount of what it owes the reason for that is that the company in itself being a Jal person and not a physical person cannot ultimately own anything for itself it therefore does owe whatever it owns to someone else first it owes money to lenders as it has receiv received cash from Banks and other lenders a portion of what the company owns belongs to them at least until the loans have been repaid if there's anything left it is owed to the shareholders the true owners of the company and of its value there's a formula that

31:52 summarizes this well and it is assets is equal to liabilities plus Equity another way to look at it is to say that if the owners of the company decide to sell all the assets and repay all the debts then any leftover money will belong to them in other words Equity is equal to assets minus liabilities let's take now some live examples to illustrate this important concept now first example if you put your own money into a startup company let's say $10,000 in cash and make $25,000 out of it then you have more than doubled your money your Equity is worth now $25,000 the same

32:39 as your assets if we look at the asset formula you have now $225,000 of assets which is equal to zero liabilities plus $25,000 of equity if we look at the equity formula $25,000 of equity is equal to $25,000 of assets minus zero liabilities for a second example let's say you borrow $10,000 and make $25,000 out of it then you truly made only $115,000 since ultimately you will have to repay the loan your assets are worth $225,000 your liabilities are worth $10,000 Therefore your Equity is worth $115,000 from an asset formula standpoint assets equal $25,000 which is equal

33:30 to $10,000 of liabilities plus $115,000 of equity from an equity formula standpoint Equity is equal to $115,000 which is equal to $25,000 of assets minus $10,000 of liabilities as a third example let's say you borrow $10,000 and spend it all with no return then not only have you lost all the assets of the company but you will also most likely have to repay the debt you have no assets left liabilities are $10,000 and therefore your Equity becomes a negative $110,000 if we look at it from an asset formula standpoint assets is equal to zero which is equal to $10,000 of liabilities minus $10,000 of equity from an equity formula standpoint Equity is equal

34:22 to minus $10,000 which is equal to zero assets minus $10,000 of liabilities now let's take a few business situations and see how they impact the balance sheet let's start with investing so you just decided to start a new company and to invest $10,000 of your own money you put that money on the company bank account which automatically increases the cash account on the asset side of the balance sheet by $10,000 at the same time the company now owes you $10,000 we therefore increase the Capital stock category on the Equity side by the same amount you actually need $15,000 more to start your operations and ask the bank for a loan the loan is granted and you get $115,000 more on

35:08 your bank account again this gets added to the cash category of the balance sheet totaling now to $25,000 you now have a new debt of $115,000 and need to add it to the liability side the loan you have contracted is to be repaid during the next 3 years you therefore put one third of that loan on the current portion of Deb category this is the portion that would be repaid in the first year and the rest goes to the long-term debt category that money is needed to start production you therefore decide to use $8,000 of that money to buy a piece of Machinery you therefore paid those $88,000 and reduce the cash category by that amount here you use it to buy an asset you therefore impact only

35:54 the asset side of things the reduction in cash is here offset by an increase of the net fixed asset category your balance sheet is still in Balance let's get now into production now that you have your piece of Machinery you need to buy raw material you spend another $2,000 on raw material which reduces further your cash if you remember you started with $225,000 and purchased equipment for $8,000 leaving you with $117,000 with that new spend you're left with $155,000 again on the asset side of the balance sheet you have now $2,000 worth of raw material this raw material is in your inventory which therefore calls for increasing the inventory category by $2,000 with the raw

36:43 material and machine you transform the material into a finished product ready to be sold this transformation will have no visual impact on the balance sheet but in the details the $2,000 of raw material will be replaced by $2,000 of finished goods let's get now into selling so you're now ready to sell Goods to customers you sell them for $3,000 the customer requests to pay in 30 days and you accept the term the $2,000 inventory is now sold to the customer and the inventory category therefore goes back to zero the $3,000 are added to the accounts receivable category on the asset side the net impact on the asset section is an increase in $1,000 since you have sold for $3,000

37:32 Goods that you paid for $2,000 you have increased the value of your assets and therefore the value of your company you can therefore increase retain earnings on the equity side of the balance sheet by $1,000 the balance sheet is again in balance 30 days later the customer pays the $3,000 bill so you can take out $3,000 from the account's receivable category and and increase the cash category by the same amount let's get now into paying stuff the end of the month is coming did I tell you that you have one employee well you need to pay her or his salary of $1,500 which includes $300 of employee contribution and to which we need to add another $500 of employer taxes to do so we take out $1,200 from the bank account to pay the salary and reduce the cash

38:24 category by that amount on the liabilities and Equity side we increase the accured expenses category by the $300 of employee contribution as well as the $500 of additional taxes to keep that tax money separate until the payment is made to the authorities the salary and taxes that you paid will then have to come off the retain earnings category the balance sheet is again in Balance the income statement is the second key document of the financial statement it's purpose purpose is to report on the business activity of the company to be more precise it focuses on the sales that have been made and the expenditures that have been necessary to fund the daily activities of the company and it concludes with the resulting profit or loss that has been made

39:14 this is the reason it is usually called the p&l where the P stands for profit and the L stands for loss the income statement reports on the business activity over a certain period of time which means that it will report all the sales and expenditures activity between a start date and an end date as an example a 2012 income statement reports all the sales and expenditures between the 1st of January and the 31st of December a 2013 first quarter income statement could report the activity between the 1st of January and the 31st of March I'm saying could report as some companies have a fiscal year that starts at a different time than the 1 of January and their quarters are therefore not the same as the calendar year quarters the income statement has

40:03 a set of categories that we will be reviewing individually those categories are Revenue costs gross margin operating expenses operating income non-operating income and expenses and net income now let's talk about Revenue so revenue or income or sales are all words that describe the same thing when when a company wins new business it goes through a set of actions to fulfill the request of the customer and it results with an obligation for the customer to pay for the good or the services provided by the company Revenue can have different names such as turnover or topl line that last name Top Line comes from its position within the income statement as it is the first

40:50 line of the income statement it's the top line to understand what exactly revenue is it is important to understand the complete cycle of a sale the usual steps are an initial discussion between the company and the customer the company issues a quote to the customer with the price requested to render the service or provide the good negotiation between the customer and the company happens the final quote is sent to the customer the customer approves the quote the company sends an invoice to the customer the company ships Goods or renders a service and the customer pays the invoice the last three steps sometimes happen in a different order depending on the situation the reason it is so important to understand the cycle of a sale is because that sale becomes Revenue only when

41:38 the invoice is issued before that time it's just a discussion between the customer and there is no true commitment once the invoice is issued there's a formal agreement between the company and the customer which will be followed by a payment and the shipment of goods or rendering of service in the example of the ice cream shop most of the steps happen even if they do in a very short period of time a customer enters the shop he checks out the Ice Cream prices on a board or on a menu he could ask for a discount but for a simple ice cream you might not accept to offer a discount and will confirm to the customer that the price will remain unchanged the customer can choose to accept that price in that case you will first prepare and provide the ice cream

42:24 the customer will pay and you will give him a bill in the case of the ice cream shop you will have to wait until the last steps to account that sell in your Revenue to link this back to what we have learned on the balance sheet once the invoice is issued and therefore the sale is made the customer either pays right away and the cash category increases or the customer is due to pay in the near future and in that case it's the account receivable category that will be increased if it's a good that has been shipped then the inventory category will decrease as soon as the good will come out of the inventory to be shipped to the customer so what's the difference between revenue and cash the income statement reports Revenue while the cash flow statement reports cash the big difference between the two is the payment as we have seen

43:15 previously the generation of Revenue occurs when the invoice is sent and until a payment is made a debt exists between the customer and supplier when you eat at a restaurant for example at the end of the the meal the check is brought to you in accounting terms the restaurant gave you an invoice during the 5 minutes between receiving the check and paying it you actually owe money to the restaurant during those five minutes the restaurant has generated Revenue equal to the amount of the check but no cash since you have not paid in accounting terms again the revenue is recorded right away on the income statement as revenue and in the balance sheet as accounts receivable if you remember this is the categ for money owed by customers to the company at the end

44:01 of those 5 minutes you pay the bill and are longer indebted to the restaurant there is no change to the income statement but in the balance sheet the amount of the check is removed from the accounts receivable since your debt has been repaid and that same amount is moved to the cash category the restaurant has now earned cash of course in this example it all happens in 5 minutes and in the company books it will be reported as having happened at at the same time but companies have access to a large variety of payment terms which create a significant time difference between the invoice date and the payment date payment terms start with prepayment which require the customer to pay on the invoice date it can also have many forms such as payment 30 days after the invoice

44:48 date called 30 days net 60 days after the invoice date called 60 days net at the end of the month called end of month on the 15th of the following month called end of month the 15 and so on there's no limit to the creativity of companies when it comes to payment terms and it can go as high as 120 days after the invoice date in some countries this means that if your company has offered a 30 days net payment term to a customer you will have to deliver the good or render the service and wait 30 days after the invoice date to collect the money the money as we have seen is due to to you on the invoice date but the customer owes you the money during those 30 days in essence you're lending money to your customer for 30 days that also means that during those 30 days you will not

45:39 be able to pay your bills with that money even though you earned it until it is paid to you in the income statement all the expenditures of the company are divided into two categories costs and expenses a company needs to spend money in order to operate on day-to-day basis those expenditures enable a wide variety of activities ranging from the Fulfillment of customer orders to paying salaries furniture rent utilities and many more in the income statement the expenditures are divided into two categories to give the reader the ability to differentiate between the costs of products from the rest of the expenditures let me explain why with an example let's imagine that

46:25 the ice cream shop has been making good money for some time now and that the owner wants to stop renting its shop and buy it the ice cream shop owner will speak to its banker and because it is a well-managed company making good profits it will get a loan to buy that shop once the shop is purchased the ice cream shop will start repaying the loan on a monthly basis each month it will therefore be making less money since it has new expenditure to pay but if you step back and analyze the Financial Health of the ice cream shop would you say it's not as well managed the company as before because it's making less money than in the past with no visibility on the details of why it is making less money you could be tempted to just conclude that the income statement has

47:12 therefore a category for product related costs so that you can make the difference between how the business is run and how the company in general is run for our ice cream shop example you would therefore see that the money made from selling ice creams and other product is still the same and the company is as well managed as it was in the past it's making now less money than in the past due to an increase in expenditures that are not related to the business activity cost is the name of those expenditures that are related to products it is usually also called cost of goods sold or cogs for short what we mean by that is that to sell a product to a customer you need to put that product together there's the raw material the Machinery the salaries of workers in

48:01 other words everything that we need to prepare that product for the ice cream shop this is the milk sugar eggs and many more ingredients it's the cups in which you hand the ice cream to the customer is the paper napkins and anything that comes into the Fulfillment of the orders of your customers as explained in a previous video the income statement is reporting the activity for a given period of time therefore the question of when to record the costs becomes important do you record the cost of producing Goods at the time of production or do you do it at the time of the sale if you have produced 100 pound of ice cream in December 2012 do you record it in 2012 or do you record it in 2013 when the ice cream was actually sold the answer is an ambiguous it's

48:50 at the time of the sale in accounting we like to have our revenues and our costs reported to together it's interesting to note that you have produced that ice cream in December 2012 you have therefore already spent the money to buy all the ingredients and so forth but while you have spent the cash it is not yet the time to record the cost in accounting terms in December 2012 it will mostly be the balance sheet that will be affected as cash will be spent to prepare an inventory of ice cream in other words the cash category of the balance sheet will decrease by the amount spent and that amount will be moved into the inventory category it will stay there until the ice cream inventory is sold when an ice cream is then sold we will record in the income statement the revenue

49:38 and the cost associated with that sale if we go a step further in that logic the consequence on the balance sheet will be to decrease inventory for that ice cream which just sold and increase cash for the payment made by the customer of course we want to sell our products with a profit which means that the revenue of the sale needs to be greater than the cost of it if you follow me that means that the cash increase in the balance sheet will be greater than the decrease in inventory the net effect of that is that overall assets will be increased if you think about it it's quite logical each time you make a profit your assets increase and the value of your company increases as well let's make a pause here in the review of the income statement to Define one of the most

50:25 important Concepts in finance and maybe the most important for our discussion here profitability profitability is the difference between the money that comes into the company from sales and other money generating activities and the money that comes out of the company as expenditures in other terms to ask about the profitability of a company is the same as to ask if the company is making money is my company profitable is it making money if yes meaning if you generate more money from your business activities than you spend and you have money left in your pocket or rather in the company's pocket then yes your company is profitable if not that means your company spends more money than it earns and it is therefore not profitable it is generating a loss this is

51:14 a dire situation for a company to be in which requires immediate action to avoid bankruptcy in the income statement we calculate different types of profitability even though ultimately there is only one form of profitability which is the one that includes all revenues whatsoever and all expenditures whatsoever for us to understand the workings of a company and take actions that will help the company to progress positively there's a need to calculate other forms of profitability such as the profitability from production activities or the profitability from business activities and ultimately the overall profitability of the company the profitability from production activities is measured by the gross margin and focuses on your products or Services the profitability from business activities is a bit wider in definition it is

52:05 measured with the operating income it includes the gross margin plus operating expenses the last one and true profitability of the company is measured by the net income and is the one including all the elements above plus any remaining revenues or expenditures that are not related to the operations of the company we will be reviewing each one of those in the chapter ahead there's a famous saying that goes like this revenue is Vanity margin is sanity and cash is reality what it means is that however big the revenue of a company is it gives no Insight whatsoever on its Financial Health of course it's impressive to be able to generate millions or billions of dollars

52:50 in Revenue but focusing only on that element is a dangerous game if the cost of running business is as great as your Revenue then the company generates no profit and the owners of the company the shareholders get no return for their investment even worse if there's a downturn in the economy as we've experienced in the recent years the company will then be the first one to be at risk of defaulting so this is why margin is sanity making sure you generate a profit is the guarantee that you're not just working to pay the bills you actually generate extra money that can can be used as a compensation for your investment such as dividends or reinvested in the development of your company as I'm sure you already got why cash in your pocket is reality let's focus here on the

53:39 concept of margin and more specifically gross margin gross margin is the result of a simple subtraction Revenue minus costs so to have any gross margin you need to generate more Revenue selling your products than you spend making them when you look at your Revenue Solly you can see if you're progressing with sales increasing month over month or if you have a decrease and need to work on changing the trend but costs on their own are not necessarily A good measure either of how good your performance is costs could be increasing for many reasons such as increasing the cost of materials for the ice cream shop example that could be your milk increasing or simply because sales have gone up and you therefore have more ice cream out of your inventory this is where

54:25 gross margin comes into to play as gross margin is the combination of Revenue and cost it gives you the ability to estimate if your overall business performance is good enough if an ice cream is sold for $5 and if it costs $3 to produce then your margin is $2 $5 minus $3 if you sell two ice creams then your revenue is $10 your costs $6 and your margin $4 in other words if each of your sales are generating margin then an increase in sales results in an increase in gross margin in our example when sales double margin doubles as well gross margin is usually displayed in two forms its dollar value as we've just seen in our example and as a percentage of Revenue

55:14 in this example the margin percent on an ice cream is calculated by dividing $2 by $5 which is equal to 0.4 or 40% if we calculate the margin % for the two ice cream sold we divide $4 by $10 and get again 40% and we could sell another 100 ice cream and our margin percent would still be 40% the benefit of tracking margin percent becomes obvious when complexity increases in a company in our example things are maybe too simple businesses have usually more than one product high margin products low margin products and sometimes cost of production increases because the price of ingredients increase or decrease because the company is now using more efficient

56:00 Machinery all those elements and actually many more will have an influence on the evolution of Revenue and the evolution of costs and they will all be summarized in the gross margin percent if for example you sell an ice cream for $5 with a soda for $3 then your total sale would be $8 if the cost of making the ice cream is still $3 and the cost of the soda is $1 then the margin on your ice cream will be $2 and on the soda will be $2 as well the resulting total margin for the order will be $4 in percentage terms the margin of the ice cream is still 40% when the margin of the soda is 67% the resulting margin is 50% if we compare that to our previous example we have generated

56:49 less Revenue going from $10 to $8 but we generated just as much margin the reason being that we sold this time the soda which is a higher margin product the overall result is a higher margin percent going from 40% to 50% the analysis of margin gives great insights into the performance of the company outside of showing if the company is making profits its Evolution can be explained by a large number of factors that are affecting both revenue and costs It Is by investigating those factors that we get a good understanding of what is working and what's not working in the business performance of the company operating expenses also called Opex are that second kind of expenditures those expenditures are key to the operations of the company but are not specific to

57:38 products they include compensation and benefits for non-product related stuff marketing spans communication spans travel rent utility bills and so on added together with costs they form the expenditures of the company that are related to running the business operating income called as well upping is just as gross margin the result of a subtraction between revenue and expenditures the major difference with gross margin is that it includes more expenditures as we have seen earlier gross margin is the difference between revenue and costs and is specific to the activities around selling products or Services it is the production in a wide sense related profitability operating

58:24 income is a wider type type of profitability as it includes as well all the operating expenses it is therefore the profitability of running the business in a general term you can calculate it using one of the following formulas operating income is equal to revenue minus costs minus operating expenses or operating income is equal to gross margin minus operating expenses your production could be profitable but not your business for example selling ice cream could be profitable but not enough to cover all of the expenses of your business you could be selling ice cream for a higher amount of money than it cost you to produce it which would make it profitable from a production standpoint but you could have a rent that is too expensive or too many employees

59:10 for a business of your size the result would be that your operating expenses would be using up all the profits generated with your production of ice cream and leaving your company with the loss in such a case you would have to consider either to increase prices to generate more margin or to reduce your expenditures whether it be by negotiating with your supplier for lower prices on ingredients or through moving to a smaller shop operating income is therefore a tool that you can use to review if your business is healthy and if its operational activities are profitable again as for gross margin the operating income of a company is usually measured in both dollar value and percentage of Revenue as it is as important to ensure the value is at least positive and to

59:55 ensure sure that the operating income of the company is relevant to the amount of revenue generated if last year for example you generated $5 of operating income for each $100 of Revenue or in other terms 5% of upping and this year you generate $7 of upping for $200 of Revenue or 3.5% then you're indeed making $2 more profit compared to last year but in percentages or relative terms you're making less oping than last year this in itself is not necessarily a bad sign but it requires further investigation in order to understand the source of it it could be that this year one of your lower margin products just picked up in sales and that it overall

1:00:43 reduces your relative oping to revenue up to now we have seen all the aspects of the income statement which relate to the operations of the company but some of its income and expenditures can have their Source outside of the operations of the company such elements could be for example taxes paid to the relevant authorities this is an expense that's not done with the purpose of generating business or maintaining business but rather to fulfilling a legal obligation it is therefore reported below the operating income line you can find as well their interests paid on loans or interests received on money left on a saving account in general terms this section will cover the inflow or outflow of money that is due to non-operational activities

1:01:32 you can also find here any element that is not related to the normal activities of the company for example you will find there transactions that are significantly more important in dollar terms than your normal activities such as acquiring a company or selling part of your company or the consequences of events that are out of the ordinary such as the impact of an earthquake for example on your business financials net income is the last line of the income statement and as such it earned the name of the bottom line it is indeed the bottom line of your company and where you can see if you're making any money some money or good money it is one of the most important aspects of your business and definitely the most important one of the income statement it is the element of

1:02:21 the income statement that needs to perform well in which you need to focus on by analyzing its underlying elements such as Revenue expenditures whether operational or non-operational to get it to the expected level net income is how much money the company is making over a certain period of time and it is very different from cash net income is money earned but not yet paid and true money made is Money in the Bank to go back to the expression revenue is Vanity margin is sanity and cash cash is reality only cash is reality we will deep dive into that topic in the next chapter now let's take a few business situations and see how they impact the income statement let's start with

1:03:09 selling products as you sell a new product you invoice the customer by giving or sending him a paper or electronic invoice this triggers automatically the addition of the revenue and costs associated with that order to the income statement the revenue is added to the revenue line and the cost to the cost line now let's take this example a step further and consider the impacts on both balance sheet and income statement as you invoice your customer the revenue side of the invoice is impacting the income statement by increasing the revenue line on the balance sheet it's impacted first on the asset side by the increase of the cash category as soon as the payment is made on the liabilities and Equity side the sale you just made will impact retained

1:03:56 earnings and income taxes payable on the cost side the same sale will impact the income statement by increasing the cost line by the cost associated with that sell on the balance sheet in the asset section the same cost will be deducted from the inventory category as you sell a good you take it out of the inventory and give it to the customer so in the same way it's taken out of the inventory category of the balance sheet on the liabilities and Equity side of the balance bance sheet it will reduce retained earnings also note that at this point the balance sheet remains in Balance now let's look at paying bills as you pay your bills it can either be for production purposes or other General expenditures or even for buying fixed assets we have seen in the previous example

1:04:47 how production expenditures are handled let's see now the cases of General expenditures and fixed asset purchases for General expenditures let's say that you need to pay for Sal liers as you will receive the invoice from the manufacturer you will send him the money by writing a check by cash or by wire transfer in any case the amount will have to be added in the income statement to the expenses category in the balance sheet that same amount would be deducted from the cash category on the asset side and will reduce return earnings on the liabilities and Equity side for fixed asset purchases you need to recall what we learned about depreciation in the balance sheet chapter as a fixed asset is purchased it's accounted for differently from a cash standpoint and from

1:05:36 a profit standpoint from a cash standpoint on the day of the purchase the total amount of the purchase is deducted from the cash category of the balance sheet and the same amount increases the net fixed asset category and within the net fixed asset category it is entered in the fixed asset at Cost sub category one once that is done every year the asset will get depreciated by a portion of its value this year's depreciation will be added to the accumulated depreciation subcategory in total the net fixed asset category will decrease by the newly depreciated amount on the income statement side that depreciation for the year will be taken into consideration if you remember when the asset was first purchased there was no impact to the income statement and of course it needs to

1:06:25 impact at some point the profitability of the company well that's when it does once the asset is depreciated that depreciation amount is included in the income statement as an expense it therefore reduces the income or profits of the company by that same depreciated amount the cash flow statement is the last document of the financial statement and is the one that is the most grounded in reality here there's nothing more to Know Than if money is or is not in the bank you could wonder why there's a need to have such a document when you already have

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