E145/STS173

Workshop A
Basics of Accounting

Professors Tom Byers and Randy Komisar

Stanford University

With special thanks to:

Roma Jhaveri, Ben Hallen, Filipe Santos, Yosem Companys

Copyright © 2004 by the Board of Trustees of the Leland Stanford Junior University
and Stanford Technology Ventures Program (STVP). This document may be
reproduced for educational purposes only.
 Goals of the Workshop

• Review main accounting documents and financial analysis

• Balance Sheet
• Income Statement (Statement of Operations)
• Statement of Cash Flows

Please refer also to the handout: How to Read a Financial Report

 How Does It All Add Up
When you get paid
for a product or Income Expenses
service… When you buy
something…

Assets Liabilities
often often
generate generate
Assets income Liabilities expenses

The value of
The value of anything you
anything you own… borrow…
 Some Accounting Principles

• Accounting items are classified into “accounts” according

to their nature, translated into monetary units, and
organized in statements

• Basic Accounting formula:

Assets = Liabilities + Equity

What the company owns

How the ownership of assets was financed
(By third parties or by the owners)
 Accounting vs. Market Value
• Equity: Ownership of a company is divided in certificates called
common shares
• Accounting Value (or Book Value) = Equity = Assets – Liabilities

Accounting Value is different from Market Value !!!

• Market Value = Share Price * Number of Common Shares Outstanding

 Income Statement
• Reports the economic results of a company over a time period.
It shows the derivation of earnings or losses.
Income Statement of XXX Corp. – year 2000 $ % Rev.
+ Revenues
- Cost of Revenue (product cost or COGS)
= Gross Margin
- Sales and Marketing
- General and Administrative
- Research & Development
- Depreciation and Amortization
= Operating Income (EBIT)
+ Interest Income(expense) net
= Net Income before Taxes
- Income Tax Provision
- Extraordinary Items
= Net Income
 Income Statement - Analysis

• When does a transaction affect income? - When it changes the

economic value of the company for the owners

• Some Profitability Measures:

ƒ Gross Margin (%) = Gross Profit / Sales
ƒ Operating Margin = Operating Income / Sales
ƒ Return on Sales = Net Income / Sales
ƒ Return on Equity = Net Income / Shareholders’ Equity
• Other Important Measures
ƒ Earnings Per Common Share (EPS) = Net Income / Common Shares
ƒ Price Earnings Ratio (P/E) = Market Price / Earnings Per Share
 Income Statement - Example
From Kimmel et. al. Financial Information For Decision Making

The following information was taken from the 2001 financial

statements of Kellogg Company. Dollar amounts are in millions.

Cost of goods sold $ 4,128.5

Selling & admin. expenses 3,523.6
Interest expense 351.5
Other expense 54.0
Net sales 8,853.3
Income tax expense 322.1
Income Statement - Example
KELLOG COMPANY
Income Statement
For the Year Ended December 31, 2001

Net sales $ 8,853.3

Cost of goods sold 4,128.5
Gross Profit 4,724.8
Selling & admin. expense 3,523.6
Income from Operations 1,201.2
Interest expense 351.5
Other expense 54.0
Net Income Before Taxes 795.7
Income tax expense 322.1
Net Income $ 473.6
 Balance Sheet
• It is a financial snapshot of a company at a given point in time

Balance Sheet of XXX Corp. - 31 December of 2000 (in thousand $)

Cash and Equivalents Accounts Payable

Accounts Receivable Current Liabilities Accrued Expenses
Current Assets (payable in less than a year)
(liquid in less than a year) Inventories Short Term debt
Property, plant and
equipment (minus Long-Term Liabilities (bonds issued, bank loans)
Fixed Assets Depreciation)
Common Stock
Intangibles (minus
depreciation) Shareholders’ Equity Additional Paid-in Capital

Other Assets Investment Securities

Retained Earnings

Total Assets = Total Liabilities + Shareholder’s Equity

 Balance Sheet - Analysis
• Working Capital: measure of the amout of cash available in the short-term;
Also, indication of the funds needed operate within a given business size
= Current Assets – Current Liabilities

• Liquidity ratios: measures of the ability to meet short term financial obligations
ƒ Current Ratio: Current Assets / Current Liabilities
ƒ Acid-test: (Cash + Accounts receivable) / Current Liabilities

• Operational Efficiency Measures

ƒ Inventory Turnover = Cost of Sales per year / Current Inventory
ƒ Accounts Receivable Collection Period = accounts receivable / sales
ƒ Accounts Payable Collection Period = accounts payable / cost of sales
 Balance Sheet - Example
From Kimmel et. al. Financial Information For Decision Making
These financial statement items are for Tweeter Entertainment
Group at year-end on September 30, 2001. (in millions)

Accounts payable $ 38.6

Property, plant & equipment 109.1
Receivables 31.3
Other current liabilities 23.3
Stockholders’ equity 332.4
Cash 3.3
Long-term debt 36.7
Inventories 129.2
Accrued expenses 38.9
Other current assets 7.5
Other liabilities 10.5
Other assets 200.0
 Balance Sheet - Example
TWEETER HOME ENTERTAINMENT GROUP
Balance Sheet (in millions)
September 30, 2001

Assets Liabilities and Stockholders’ Equity

Current assets Current liabilities
Cash $ 3.3 Accounts payable $ 38.6
Receivables 31.3 Accrued expenses 38.9
Inventories 129.2 Other current liabilities 23.3
Other current assets 7.5 Total current liabilities 100.8
Total current assets 171.3 Long-term debt 36.7
Property, plant & equipment 109.1 Other liabilities 10.5
Other assets 200.0 Total liabilities 148.0
Total assets $ 480.4 Stockholders’ equity 332.4
Total liab. & stock. equity $ 480.4
 Statement of Cash Flows
• The Statement of Cash Flows reports cash receipts and payments over a
period, separating operational, investing and financing activities.

Statement of Cash Flows of XXX Corp. – 2000 $

+ Cash Flow from operating activities (reconciled from income statement)
= income
- net changes in working capital (except cash and equivalents)
+ depreciation and amortization
+ Cash Flow from investing activities
+ Cash Flow from financing activities
= Net Change in Cash or Equivalents
+ Cash or Equivalents at beginning of period
= Cash or Equivalents at end of period
Statement of Cash Flows - Analysis
CFIMITYM !!!
(Cash Flow is More Important Than Your Mother!! )
Especially for an entrepreneurial firm...
• How is cash flow different from income?
ƒ Income accrual is not necessarily linked to cash transactions (e.g.,
depreciation, sales by credit)
ƒ Some activities affect cash flows but not income (e.g., investments in
fixed assets, additional capital from shareholders)
• Growth often absorbs cash flow because of a higher need for
working capital and fixed investments (Entrepreneurial firms with
negative income and high growth can have a very fast cash burn rate)
Statement of Cash Flows - Example
From Kimmel et. al. Financial Information For Decision Making

SIERRA CORPORATION
Statement of Cash Flows
For the Month Ended October 31, 2004

Cash flows from operating activities

Cash receipts from operating activities $ 11,200
Cash payments for operating activities (5,500)
Net cash provided by operating activities $ 5,700
Cash flows from investing activities
Purchased office equipment (5,000)
Net cash used by investing activities (5,000)
Cash flows from financing activities
Issuance of common stock 10,000
Issued note payable 5,000
Payment of dividend 500
Net cash provided by financing activities 14,500
Net increase in cash 15,200
Cash at beginning of period 0
Cash at end of period 15,200