Chapter 9: Understanding Accoutning

Accounting

The process of measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision-makers.

Management Accounting (Managerial Accounting)

Provides financial information to internal decision-makers (like managers) to help plan, control, and operate the business efficiently.

Focus: Inside the company

Reports: flexible, detailed, and used for day-to-day decisions

Financial Accounting

Prepares financial statements (income statement, balance sheet, statement of cash flows, etc.) for external users to evaluate the company's financial performance.

Focus: Outside the company

Must follow International Financial Reporting Standards (IFRS) for accuracy and comparability

IFRS (International Financial Reporting Standards)

Global accounting rules ensuring financial statements are prepared consistently and can be compared across companies.

Financial Statements

Financial reports that summarize the financial condition and operations of a business.

Income Statement

Shows sales, expenses, and whether or not a profit was made.

Balance Sheets

Show assets and liabilities, the amount invested in the business.

Statement of Cash Flows

Show how much cash is coming in and going out.

Assets

The resources from which it expects to gain some future benefit.

Liabilities

The debts that it owes to outside individuals or organizations

Owners Equity

The investment in the business.

Accounting Equation

Assets = Liabilities + Owner's Equity

A statement of cash flow will report cash in three distinct areas of business:

Cash from Operations

Cash from Investing

Cash from Financing

Trend Analysis

Examines financial data across multiple periods to identify growth or decline patterns.

Horizontal Analysis

Compares financial results (like sales or profit) from one period to another to measure changes over time.

✔ Shows growth, decline, trends

✔ Uses increase or decrease in percentage from one year to the next.

Vertical Analysis

Expresses each item on a financial statement as a percentage of a one category (e.g., net income as % of sales) to show proportion and efficiency.

✔ Everything on the income statement is shown as a % of sales

✔ Everything on the balance sheet is shown as a % of total assets

✔ Shows structure, proportions, where the money is going

Ratio Analysis

Evaluates a company's financial performance by examining relationships between different figures on its statements.

Profitability Ratios

Show how much profit a company makes relative to sales.

Earnings per Share (EPS)

Return on Equity (ROE) = Net income ÷ Total shareholder equity

➝ "Out of every $1 the company earns in sales, how much becomes actual PROFIT (before interest + taxes)?"

Return on Sales (ROS)

Return on Sales (ROS) = Operating profit (EBIT) ÷ Net sales

➝ "If the company's profit was split across all its shares, how much would each share get?"

Solvency Ratios

Measures of the ability of the company to survive over a long period of time.

Current Ratio

Current Ratio = Current assets ÷ Current liabilities

➝ "Do we have enough short-term assets (cash, inventory, receivables) to cover our short-term bills?

If >1: we can pay our bills

If <1: we're struggling"

Equity to Ratio

Debt to Equity = Total liabilities ÷ Total shareholder equity

➝ "How much debt vs. owner investment?

High ratio = risky

Low ratio = safer"

Working Capital

Working Capital = Current assets - Current liabilities

➝ "Leftover short-term money.

Positive = good

Negative = yikes"

Activity Ratios

These measure how efficiently the company uses assets.

Inventory Turnover

Inventory Turnover = (Cost of Goods Sold) COGS ÷ Inventory

➝ "How fast we sell our inventory.

High = inventory sells fast

Low = inventory sits on shelves"

Asset Turnover

Asset Turnover = Sales ÷ Total assets

➝ "How efficiently we use assets to generate sales.

High = company uses assets well

Low = assets are wasted"

Receivables Turnover

Receivables Turnover = Sales ÷ Accounts receivable

➝ "How often customers pay us.

High = customers pay quickly

Low = customers owe us for too long"

Efficiency (Effectiveness) Ratios

Show how efficiently assets are used to generate sales or profit.