taxable income. Accumulated depreciation is the cumulative sum of depreciation for physical assets such as property and equipment.
Intangible assets are assets other than real or tangible property and have no physical existence. They may or may not be reported on the balance sheet. Intangible assets can be and usually are amortized over time.
Liabilities
Liabilities are usually presented in order of their due date and divided in two main sections: current liabilities and long-term liabilities.
Current liabilities are generally due within 1 year, with most items usually having a cycle shorter than 12 months. Several of the items in this category are associated with day-to-day operating expenses and are usually paid within 30 to 180 days depending on the country and culture. Current liabilities may consist of the following:
1 Accounts payable (payments due to other parties)
2 Wages and salaries (payments due to employees)
3 Current portion of long-term debt
4 Short-term loans (from banks or other sources)
Long-term liabilities are obligations that are due beyond 1 year. These can include the following:
1 Notes payable and bonds
2 Mortgages and capital leases
3 Deferred taxes (taxes that may have to be paid in the future)
Shareholders' Equity
Equity represents the shareholders’ stake in the firm. The book value of equity known as shareholders’ equity or stockholders’ equity is the portion of firm capital provided by its investors. This amount is the cumulative amount shareholders have invested in the venture, plus or minus cumulative earnings or losses, minus distributions to owners. This section of the balance sheet is composed of the following:
1 Par value (nominal amount per share of stock or stated value if the stock has no par value)
2 Capital surplus (amount paid for shares of stock by investors in excess of par or stated value)
3 Retained earnings (prior and current periods’ earnings and losses minus dividend payment)
4 Accumulated other comprehensive income or losses (accumulated unrealized gains and unrealized losses such as foreign currency hedges or unrealized pension costs)
Reaching a Balance
The basic accounting equation must always be maintained; total assets must equal total liabilities plus total shareholders’ equity. With some effort and interpretation, assets, liabilities, and equity can be used to generate a picture of the company's health at a particular moment in time. In the real world, the venture's balance sheet will undoubtedly be composed of more items than have been described here, but the format of the balance sheet will be similar to the one presented.
All entrepreneurs need to develop a clear understanding of accounting principles. The first accounting concept should be the balance sheet. The balance sheet represents a view of the firm at a particular point in time.
In Chapter 4, we will explore the balance sheet using ratio analysis. Analysis of the balance sheet can be very helpful in generating insights into management's capabilities, trends in the firm's performance over time, and the firm's performance vis-à-vis peer groups at a point in time.
The Income Statement
The income statement describes the results of a company's operations over a specific interval of time. This interval could be a month, quarter, or year. The purpose of the income statement is to describe how much revenue was generated and what the associated level of expenses was. With these two pieces of information, we can determine whether the company is making a profit or not (see Table 3.2). The basic formula for the income (i.e., profit and loss) statement is simple:
A second use of the income statement is to provide the basis for calculating various measures of profit and cash flow. Various measurements of profit and cash flow include pretax net profit, net income (NI), and earnings before interest, taxes, depreciation, and amortization.
Pretax operating income is the primary measurement of the total earnings generated by the firm without regard to taxes and net interest income (expense). This measurement is an intermediate measure of firm performance that helps describe the firm's economic results over a period of time (see Table 3.2).
Table 3.2
Net income is the primary measurement of the after-tax total earnings of the firm. This measurement takes into account the firm's tax liability (see Table 3.2).
Earnings before interests, taxes, depreciation, and amortization (EBITDA) represent the profit generated after all expenses related to operations are paid. EBITDA is useful for comparison and valuation purposes as it paints a basic picture of the venture's operating capability as well as its ability to cover nonoperating payments such as taxes, interest payments, and principal (see Table 3.3).
Cash versus Accrual Accounting
Two main methods used in accounting are the cash accounting method and accrual accounting method. The cash accounting method records revenues when received and expenses when paid. The results can be difficult to understand and get a clear picture of the company as expenses may be registered several months before or after the associated revenue is made (see Table 3.4). Because of this poor matchup between revenue and expenses, this method is not good for larger, more complex firms with large inventories, but it is perfectly appropriate for small businesses with limited or no inventory.
Table 3.3
Table 3.4
The accrual accounting method registers revenues billed but not necessarily when the actual cash is received; similarly, this method registers expenses as incurred (accrued) but not necessarily as they are paid. The advantage of this method is that it provides a clear picture of a venture with respect to relating costs and revenues. On the other hand, this method does not give a precise picture of how the company is doing in terms of liquidity. To be more specific, it does not show whether the venture is about to run out of cash.
Revenues
