1. Accounting is an incredible subject. Companies from different sectors and completed unrelated industries can be compared. There are 2 main financial statements: The Profit and Loss account (“P&L”) and the Balance Sheet (“BS”). The third well known statement – The Cash Flow statement – is derived from the P&L and the BS.

2. P&L

Very simply put, P&L shows what profits or losses a company generates in a particular year and the BS shows the economic assets and liabilities of the company. To help understand this, lets compared the financial profile of a company with that of a person.

When comparing the financial profile of a company with that of a person, these statements can be more easily understood.

For a person, the P&L captures the cash inflows (salary, capital gains from investments, etc.) and cash outflows (rent paid, fuel expenses for car, education for children). Subtracting these numbers results in the profit or loss generated in the year.

Similarly, for a company revenues aka sales aka Income captures receipts from sales of goods. Expenses capture costs incurred in the ongoing year. Subtracting these numbers results in the profit or loss generated in the year.

3. Balance Sheet

Balance Sheet is less understood as compared to the P&L. Again, an analogy with a person will be helpful here. An individual’s Balance Sheet comprises of assets (such as a house, car, etc.) and liabilities (home loan, education loan, etc.). The difference between these assets and liabilities is called the individual’s Net worth.

Similarly, a company’s Balance sheet comprises of assets (plant and machinery, inventory, receivables, etc.) and liabilities (Loan taken from banks, payable to vendors). The difference between these two items is called Net worth and in accounting terms is called ‘Shareholders Equity’.

In theory, if all the accounting entries are accurate and reflect values that will be received in the market, if the all assets and liabilities of the company are liquidated then the shareholders will get a value equal to the Shareholders Equity.

Most of the items in financial statements are self-explanatory. However, there are some items that are not as clear.

4. Accrual concept

Accounting stipulates that all activity of a particular year should be accounted for based on accrual concept. Examples include

If an IT services company is paid before it has rendered any services, the cash received is recorded in prepaid revenue (liability side on balance sheet) and not in revenues.

5. Depreciation                                                                

All assets in general are divided in 2 categories: appreciating (such as land, stocks) and depreciating (such as furniture, machinery)

Most companies have some depreciating assets. Accounting norms try to capture the gradual loss in value year by year for each of these depreciating assets. This loss in value is captured in depreciation on the financial statements.

Think of a business that simply built a steel factory but did not manufacture or sell anything for many years after that. In its accounting statements, the P&L will only have depreciation as an expense. This expense be the loss each year. In the Balance Sheet, the assets will initially have the value of the steel plant and the liabilities side will have the shareholders equity having the same amount as the value of the steel plant.

6. Accounting tries to capture Economic values

Accounting statements are built with the objective to put down conservative estimates of accrued profits or losses in the year (through the P&L) as well as the current asset-liability profile (through the Balance Sheet) of the company. When you evaluate any business either as an owner or purchaser you must keep in mind that Accounting tries to capture of economic values of all the items mentioned in the accounting heads. These numbers give you key insights into the value drivers of the business. However, sometimes adjustments have to be made to remove impact of one-time issues in the balance sheet.

 

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