Principles of Finance with Excel (Основы финансов c Excel)
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PFE, Chapter 7: Accounting principles page 1
CHAPTER 7: AN ACCOUNTING PRIMER
*
this version: October 31, 2003
Chapter contents
Overview......................................................................................................................................... 1
7.1. Three basic accounting statements.......................................................................................... 3
7.2. Starting a firm......................................................................................................................... 8
7.3. The consolidated statement of cash flows ............................................................................ 19
7.4. Computing the free cash flow (FCF).................................................................................... 21
7.5. Stop and think!...................................................................................................................... 25
7.6. The next half year ................................................................................................................. 25
7.7. Computing the free cash flow for the second half year........................................................ 28
7.8. Using the FCF in a valuation exercise.................................................................................. 30
Conclusion .................................................................................................................................... 34
Overview
Accounting is an important component of financial analysis. Although you’ve probably
had an accounting course before taking the principles of finance course for which this book is
*
Notice: This is a preliminary draft of a chapter of Principles of Finance by Simon Benninga
(benninga@wharton.upenn.edu
). Check with the author before distributing this draft (though
you will probably get permission). Make sure the material is updated before distributing it. All
the material is copyright and the rights belong to the author and to MIT Press.
PFE, Chapter 7: Accounting principles page 2
intended, you may have forgotten some basic accounting principles.
1
In this chapter we remind
you of these accounting principles, using a series of simple examples.
One of the things you will notice is that—with the exception of this sentence—we never
refer to debits and credits. This is an accounting chapter for finance students: We write all of
our accounts and information directly onto the balance sheet.
This chapter will help you understand three basic accounting statements: The balance
sheet, the profit and loss statement and the consolidated statement of cash flows. In addition we
will explain in detail the concept of free cash flow, which we introduced in Chapter 6 and which
plays a central role in the valuation of companies.
Accounting concepts discussed
• Balance sheet, profit and loss statement, consolidated statement of cash flows
• Assets, liabilities
• Equity, debt
• Fixed assets, depreciation
• Accounts receivable, accounts payable
• Accrual accounting
Finance concepts discussed
• Free cash flow (FCF)
• Discounting FCFs and residual value to value the firm
1
Without disparaging our accounting colleagues, the introductory accounting courses are often badly taught.
PFE, Chapter 7: Accounting principles page 3
Excel functions used
This chapter uses only the most basic Excel functions.
7.1. Three basic accounting statements
This chapter aims to explain the three basic accounting statements that you need to
understand if you’re to do financial accounting. In this section we summarize these statements;
if you do not understand this summary, skip this section and read on—more explanations will
follow (if you do understand everything, perhaps this section is superfluous for you).
The balance sheet
The balance sheet is a double-columned statement.
• The left-hand column (“Assets”) gives details of what the company owns. It includes
items such as: cash on hand, inventories, and equipment. It also includes items such as
the billings the company has sent out for which it has not received payment (accounts
receivable).
• The right-hand column (“Liabilities and Equity”) gives details of how the company’s
assets are financed—who put up the money to finance the assets. This column includes
items like: borrowing from banks and other debtholders, money raised from shareholders
(equity), bills not yet paid (accounts payable).
PFE, Chapter 7: Accounting principles page 4
BASIC BALANCE SHEET—What assets does the firm own
and how are these assets financed?
Assets: What the company owns Liabilities and equity: Who put up
the money for the assets
Short-term assets—assets with a short life
(generally less than one year, see footnote,
p000)
Cash
Marketable securities
Inventories
Accounts receivable: Customer
billings that are not yet paid
Fixed assets—assets with a longer life
Land
Plant, property and equipment net of
depreciation
Short-term liabilities—financing which the
company will repay in the short term
(generally within one year)
Short-term borrowing from banks
Accounts payable: Bills that the
company must pay
Taxes payable: Taxes that the company
knows it will have to pay in the
short term
Long-term liabilities—debt financing that has
to be repaid over a period of more than one
year
Equity—money provided by shareholders
Stock: Money paid by shareholders to
the company for shares in the
company
Accrued retained earnings: Firm
profits not paid out to
shareholders
TOTAL ASSETS TOTAL LIABILITIES AND EQUITY
NOTE: Total assets and total liabilities-equity are always equal
The profit and loss statement (P&L)
The profit and loss statement (also called an “income statement”) is a statement of how
much the firm has earned over a given period. This period is most often a year, but it can also be
a quarter or a month. The accountant’s aim in the P&L is to provide a statement of earnings that
accurately reflects the underlying economics of the firm’s operations. Many readers of P&L
statements view them as providing a statement of the amount of cash left in the company’s till at
the end of the period. These two aims are not equivalent, and the divergence between them
provides much material for the conflict between accountants and finance professionals. We’ve
PFE, Chapter 7: Accounting principles page 5
already noted this conflict in Chapter 4, where we back the depreciation to the profits when we
derived the cash flow. In section 7.3 of this chapter, we show the accounting profession’s
solution to this problem—the consolidated statement of cash flows. In section 7.4 we discuss the
free cash flow (FCF), which is the finance profession’s answer.
But these issues are for later! In the meantime here’s a typical profit and loss statement:
PROFIT AND LOSS—how much money did the firm make?
Sales
Subtract costs of goods sold (COGS)—the direct cost of producing the sales
Subtract selling, general, and administrative expenses (SG&A)—the overheads involved in
producing the sales
Subtract depreciation—the cost of using the firm’s fixed assets
Subtract interest expenses—the cost of the firm’s borrowings
Add interest income and other income from cash and marketable securities
Profits before taxes (PBT)
Subtract taxes
Profits after taxes (PAT)
Subtract Dividends paid to shareholders
Retained earnings—firm profits not paid to shareholders.
These are added to the “accrued retained earnings” item on the Liabilities and Equity side
of the balance sheet
PFE, Chapter 7: Accounting principles page 6
A basic misunderstanding—the corner grocery store versus IBM
or: Accrual versus Cash Accounting
“My grandparents operated a corner grocery store. Gramps gave no credit and paid all his bills
in cash. At the end of every day he walked to the bank and deposited whatever he had in the cash
register drawer (“the till”). This was his profit for the day. I don’t understand all this b.s. about the
profit and loss not reflecting the cash realities of a business. Why can’t everyone be like Gramps?”
If you have a simple business, you can still be like Gramps. You can do your accounting using
the cash accounting method—whatever remains in the till (or in your bank account) is your profit over
a given period. But most business use the accrual accounting method discussed in this chapter. In
this method, certain non-cash items count as either income or as expenses. The system applies
economic logic to make the income/expense determination. Here are some examples which even
Gramps would agree with:
• On January 15, 1953, Gramps took in $1000 and paid out bills of $600. But when writing down
the profit at the end of the day, he saw that Mrs. Smith, one of his best and most reliable clients,
had promised to pay him her $25 grocery bill tomorrow. By the logic of cash accounting,
Gramps had made $400 for the day, but by any other logic, his actual profits for the day were
$425.
• On the next day, the milk man came by before the store opened and left $50 of dairy products on
the stoop. Gramps will pay him a day later. By economic logic, the unpaid bill of $50 should be
attributed to today (and lower today’s profits), even if only paid the next day.
These examples can be multiplied, until even Gramps would agree that accrual accounting,
though more complicated than cash accounting, is a more logical way to determine his profits.
PFE, Chapter 7: Accounting principles page 7
The consolidated statement of cash flows
The firm’s consolidated statement of cash flows explains where the money came from
and where it went. Because the profit and loss statement does not necessarily reflect the realities
of how cash flows into and out of the firm as a result of its activies, the cash flow statement is
necessary to close the loop.
CONSOLIDATED STATEMENT OF CASH FLOWS
Where did the cash come from and where did it go?
Operating cash flows—cash implications of the firm’s activities
Profits after taxes
Add back depreciation (this is an expense on the P&L, but doesn’t cost cash)
Subtract increases in inventories, accounts receivable, etc. (these don’t appear on the
P&L, but they require cash)
Add increases in accounts payable, taxes payable, etc. (these appear on the P&L as
expenses but they weren’t actually paid, and so they supply cash)
Investment cash flows—cash implications of the firm’s investment activities
Subtract out purchases of equipment
Subtract purchases of subsidiaries, other companies, etc.
Add back sales of equipment, subsidiaries, etc.
Add or subtract sales or purchases of financial investments (such as securities) by the
firm
Financing cash flows—cash implications of the firm’s financing activities
Add new debt financing
Subtract repayment of debts
Add sales of new shares (and subtract repurchases of shares by the firm)
Subtract dividends paid to shareholders
Adding all these items together should give the change in the firm’s cash balances over the
accounting period
In the following sections, we show how to construct these three statements for Anytown
Travel Services (ATS), a new company which is just being started in Anytown, U.S.A.
PFE, Chapter 7: Accounting principles page 8
7.2. Starting a firm
Brother and Sister live in Anytown, U.S.A.. They’ve just graduated from college, and
have decided to start a taxi service. There’s no taxi company in Anytown, and they think it will
be a great success. They’ve got $25,000 in cash with which to start the business.
It’s 2 January 2003. Brother and sister:
• Go to a lawyer and incorporate themselves as Anytown Travel Services (ATS).
• They open a bank account and deposit $25,000.
At this point their balance sheet looks like this:
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ABCDE
1-Jan-03
Assets Liabilities and equity
Cash 25,000 Equity 25,000
Total assets 25,000 Total liabilities and equity 25,000
ANYTOWN TRAVEL SERVICES (ATS), Inc.
Now they need a taxi, so they go to a local used car dealer and pick out a nice car. Along
with the taxi sign on top of the car, some minor repairs, and a tank of gas, the car costs $18,000.
They pay for the car in cash. Here’s their new balance sheet:
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ABCDE
1-Jan-03
Assets Liabilities and equity
Cash 7,000 Equity 25,000
Taxi 18,000
Total assets 25,000 Total liabilities and equity 25,000
ANYTOWN TRAVEL SERVICES (ATS), Inc.
31 January 2003
During January 2003, their first month of operation, brother and sister have:
• Collected $12,000 in taxi fares
• Paid $4,000 in gasoline and other costs
PFE, Chapter 7: Accounting principles page 9
• Paid themselves $1,000 each as a salary.
2
This means that the balance sheet on 31 January 2003 looks like:
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25
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ABCDE
31-Jan-03
Assets Liabilities and equity
Cash Equity 25,000
Cash at beginning of month 7,000
Fares 12,000
Gas, etc. -4,000
Salaries -2,000
Cash at end of month 13,000
Taxi 18,000
Total assets 31,000 Total liabilities and equity 25,000
ANYTOWN TRAVEL SERVICES (ATS), Inc.
Unfortunately, this balance sheet doesn’t balance—the total assets don’t equal the total
liabilities and equity. This is probably the worst transgression you can make in an accounting
framework! In this case the solution to this problem is easy—ATS has actually made $6,000
during the month ($12,000 in receipts minus $6,000 in costs). This profit is added to the initial
equity of the firm as retained earnings (meaning: profits not paid out):
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43
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ABCDEFGHI
31-Jan-03
Assets Liabilities and equity Profit and loss for the period
Cash Sales 12,000 <-- =B38
Cash at beginning of month 7,000 Owner salaries -2,000 <-- =B40
Fares 12,000 Fuel -4,000 <-- -
Gas, etc. -4,000 Equity Profit 6,000 <-- =SUM(H36:H38)
Salaries -2,000 Initial stock 25,000 Dividends 0
Cash at end of month 13,000 Accumulated retained earnings 6,000 Retained earnings 6,000 <-- =H39+H40
Taxi 18,000
Total assets 31,000 Total liabilities and equity 31,000
ANYTOWN TRAVEL SERVICES (ATS), Inc.
The retained earnings from the profit and loss—that part of the profits that ATS doesn’t pay out
as dividends—ends up on the balance sheet in “accumulated retained earnings.” This means that
we’ve now got 2 equity accounts—“Initial stock” is the amount of money brother-sister initially
2
Do Anytown residents give tips? Yes, but Brother and Sister decided that whoever’s driving can keep the tips
she/he gets.
PFE, Chapter 7: Accounting principles page 10
put into the firm, and “accumulated retained earnings” is that part of profits they’ve decided not
to pay out.
A Note on Terminology
Almost every accounting item in our example has another (equally valid) name. For
example:
• Profit is also called Income and a Profit and Loss statement is often called an Income
Statement.
• Initial Stock is also called “Stock issued at par” or sometimes “Stock issued at par and
additional premium” or “Paid-in capital” (in this book we often use just “Stock”)
We’ll try to be consistent in this book, but we can’t always keep our promise!
28 February 2003
Receipts, costs and salaries during the month were the same as those in January. On the
last day of February, however, ATS underwent a dramatic expansion: Brother and Sister bought
another taxi. Like the first, this one cost $18,000. They paid for this taxi by using $10,000 of
their cash and borrowing $8,000 from the bank. The loan has to be paid off over the next 10
months ($800 per month) and ATS has to pay 1% interest per month on the outstanding loan
balance. Because the loan has to be paid back in the short-term, it is classified as a current
liability—an obligation of the firm that has to be paid back within a year.
Here’s what the balance sheet looks like: