Week 13 · Chapter

Chapter 13 — Keeping Score: Accounting & Financial Statements

Introduction to Business Free sample edition

The module's primary reading · ~45–55 minutes · Objective 7 (read a balance sheet, an income statement, and a statement of cash flows and compute the basic ratios; explain money, banks, deposit insurance, and the Federal Reserve; and compare debt and equity financing and the securities markets for a growth decision), Objective 4 (analyze how a firm creates value through operations, quality management, and information systems, and through marketing — target markets, the marketing mix, the product life cycle, pricing and break-even, distribution, and promotion) · Read it first this week; the lecture, the slides, the tutorial, and the quiz all build on it.

In plain language

Every business tracks how it is doing in money, and accounting (the work of recording, sorting, adding up, reporting, and reading a business's money activity) is how it keeps that record. This week you read the three financial statements (the standard reports a business prepares from its records). One shows what the business owns and owes on a single day, one shows what it earned over a year, and one shows where its cash went. You will check that a statement balances, explain why a profitable business can still be short of cash, and compute four ratios that lenders and owners read. You read the statements here; you never build them from single sales.

Why you already care about this

Think about your own bank app at the end of a month. It tells you how much is in the account right now. It does not tell you whether the month went well, because a paycheck, a rent payment, and a loan to a friend all moved the same balance. To know how the month really went, you would need more than one view of the same money.

A business faces the same puzzle, only with more at stake. The coffee cart has finished its first full year. It sold 15,000 drinks at 5 dollars each. Its owner took money out to live on, paid down part of the equipment loan, and still owes a supplier for beans. Did the cart make money? How much cash does it have? Can it pay what it owes in the coming year? Three statements and four ratios answer those questions, and by the end of this chapter you will be able to read every one.

By the end of this chapter you will be able to:

name who uses accounting and walk the accounting cycle's five steps in plain words;
state the accounting equation and check it on a balance sheet;
read an income statement from revenue down to net income;
connect the income statement to the break-even and the margin on price;
carry net income and owner withdrawals into owners' equity and check that a balance sheet balances;
read the statement of cash flows by its three sections and explain why profit is not cash;
compute the current ratio, debt-to-equity, gross margin, and net profit margin from named lines and say each in words.

Carry this line with you: the balance sheet is a photo; the income statement is a video.

Where we are

Already covered: Week 3, From Idea to Plan, built the cart's start-up list and funding plan; Week 7, Who Buys and at What Price, found the cart's 12,000-drink break-even and its markup and margin; Week 9, Reaching More Customers, set the 3,000-dollar promotion budget; Week 11, Hiring and the Law, priced the helper at 16,000 dollars a year.
This week: what accounting is for, the accounting cycle, the accounting equation, the balance sheet, the income statement, the statement of cash flows, profit versus cash, and four ratios.
How they connect: the plans from earlier weeks were forecasts; this week reads what actually happened in the cart's first year, line by line.
Where we're going next: Week 14, Paying for Growth: Money, Banking & Financial Management, reads these same statements to weigh how a second cart could be paid for.

Several earlier numbers return this week, so here is a quick refresher. In Week 3 the cart needed 30,000 dollars to open: a 20,000-dollar cart and equipment, 2,000 dollars of opening inventory, and an 8,000-dollar cash cushion. The owner put in 20,000 dollars and borrowed 10,000 dollars at 10 percent a year. In Week 7 each drink sold for 5 dollars and used 2 dollars of cups, lids, beans, and milk, so each drink left a per-unit margin of 3 dollars toward fixed costs of 36,000 dollars a year. In Week 9 the promotion budget was 3,000 dollars, and in Week 11 the helper's wages came to 16,000 dollars a year. Every one of those numbers appears on a statement in this chapter.

1. Know who reads the numbers: what accounting is for

Picture three people reading about money on the same afternoon. An illustrative bank loan officer is deciding whether to lend to a neighborhood bike shop. The board of an illustrative community food bank is checking that last year's donations went to feeding people. And the coffee cart's owner, who is also its manager, is wondering whether the cart can afford a second espresso machine.

They need different answers, but all three need the same thing first: honest, organized numbers.

Accounting is the work of recording, classifying, summarizing, reporting, and analyzing a business's money activity so that owners, managers, lenders, investors, and tax authorities can make decisions with it.

Each of those users asks its own question.

Owners ask whether the business is earning enough to be worth their money and time.
Managers ask where the money is going and what to change next month.
Lenders, like the bank's loan officer, ask whether a loan will be repaid.
Investors ask whether to put money into the business in return for a share of it.
Tax authorities ask whether the business has reported its income correctly.

Worked example — matching readers to questions. The bank, the bike shop, and the food bank are illustrative, and the example uses no figures.

The loan officer and the bike shop: a lender, asking whether the shop can repay.
The food bank's board: the people who oversee a not-for-profit, asking whether the year's money served the mission.
The cart's owner: an owner and a manager at once, asking what the business can afford next.

In words: the same set of numbers serves many readers, and each reader brings a different decision to it.

Misconception check. Students often think accounting exists only to pay taxes, because tax season is when most people hear the word. That is tempting, but the tax authority is only one of five users. The loan officer, the food bank's board, and the cart's owner all read accounting numbers to make decisions. The cure is to ask, of any statement, "who is reading this, and what will they decide?"

Memory hook: accounting answers a question someone has to decide.

2. Walk the cycle: record, classify, summarize, report, analyze

Think about the cart's first morning. A customer pays 5 dollars for a latte. That one sale is a tiny piece of the year's story. Thousands of sales, rent payments, and supply bills later, the owner needs a clear picture of the whole year.

The accounting cycle is the five steps that turn a business's activity into usable numbers:

Record each sale and each bill as it happens.
Classify them into groups, such as drink sales, rent, and wages.
Summarize each group by adding it up for the period.
Report the totals in the financial statements.
Analyze the statements, for example by computing ratios, to make a decision.

The financial statements are the three standard reports a business prepares from its accounting records: the balance sheet, the income statement, and the statement of cash flows.

Worked example — one latte through the cycle. The cart's sale is illustrative.

Record: the card reader logs a 5-dollar drink sale.
Classify: the sale joins the group called drink sales.
Summarize: at year-end, drink sales add up to 15,000 drinks × 5 dollars = 75,000 dollars.
Report: the 75,000 dollars appears as revenue on the income statement.
Analyze: the owner compares that revenue with the costs to judge the year.

In words: one small sale becomes part of a single line on a statement, and that line becomes part of a decision.

This course works at the reader's level. You will read finished statements and compute from their lines. You will not record single transactions or learn bookkeeping mechanics; that belongs to an accounting course.

Misconception check. Students often think the cycle ends when the report is printed. That is tempting, because the report looks like the finished product. But a report nobody reads changes nothing; the fifth step, analyze, is where the numbers turn into a decision. The cure is to finish every statement you read with one sentence about what it means for the business.

Pause and try this. Choose one: (a) pick a purchase you made recently and describe what each of the five steps would look like if a business made it; or (b) explain in two sentences why "analyze" is the step that makes the other four worth doing.

Memory hook: record, classify, summarize, report, analyze — then decide.

3. Balance the start: the accounting equation

On the cart's opening day, the owner could stand beside it and point. There is the cart and its equipment. There are the boxes of cups and beans. There is the cash in the account. Then a harder question: who paid for all of it?

Every dollar of the cart came from one of two places. Either someone outside the business lent it, or the owner put it in.

An asset is something of value a business owns, such as cash, inventory, or equipment.
A liability is a debt a business owes to someone outside it, such as a bank loan or money owed to a supplier.
Owners' equity is the owners' claim on a business's assets: what the owners put in, plus profit kept in the business, minus what the owners took out; on a one-owner business it is written owner's equity.

Those three ideas join in one rule.

The accounting equation is the rule that assets equal liabilities plus owners' equity, because everything a business owns was paid for either by what it owes or by what its owners put in and left in.

assets = liabilities + owners' equity

A balance sheet is a financial statement that lists a business's assets, liabilities, and owners' equity as of one date, a snapshot at a single point in time.

Worked example — the start-up balance sheet, as of opening day. The cart's figures are illustrative, constructed for this course and not real data; money is in dollars.

The table below lists each line once, with assets on the left side of the equation and claims on the right.

The coffee cart's start-up balance sheet as of opening day, in dollars (illustrative)
Line	Dollars
Cash	8,000
Inventory	2,000
Cart and equipment	20,000
Total assets	30,000
Equipment loan (liability)	10,000
Owner's equity	20,000
Total liabilities and owner's equity	30,000

Assets: cash 8,000 + inventory 2,000 + cart and equipment 20,000 = 30,000 dollars.
Claims: equipment loan 10,000 + owner's equity 20,000 = 30,000 dollars.
The check: 30,000 = 30,000, so assets = liabilities + owners' equity holds.

In words: on opening day the cart owned 30,000 dollars of things, the bank had a claim on 10,000 dollars of them, and the owner had a claim on the other 20,000 dollars. These are the very numbers from the Week 3 start-up list and funding plan, now arranged as a balance sheet.

Misconception check. Students often think owners' equity is the cash the owners hold. That is tempting, because the owner did hand over 20,000 dollars in cash. But that cash was spent on the cart, the beans, and the cushion. Equity is the owner's claim on all the assets, not a pile of money set aside. The cure is to notice that the cart has only 8,000 dollars of cash on opening day, yet the owner's equity is 20,000 dollars.

Memory hook: what you own equals who paid for it.

4. Read the year: the income statement

A year later, the owner wants to know how the year went. The balance sheet cannot say, because it is a snapshot of one day. The owner needs a statement that covers the whole year.

An income statement is a financial statement that reports a business's revenue, expenses, and net income for a span of time, such as the year ended on a given date.

An income statement reads from the top down. Each line takes something away, until the bottom line is left.

Cost of goods sold is the direct cost of the goods a business sold during a period, such as the cups, lids, beans, and milk in the drinks a coffee cart sold.
Gross profit is revenue minus cost of goods sold: what is left from sales to pay for running the business.
Operating expenses are the costs of running a business beyond the goods it sells, such as rent, wages, insurance, promotion, and depreciation.
Depreciation is the part of a long-lived asset's cost, such as a cart's or a machine's, that is counted as an expense in each year the asset is used; recording it pays out no cash.
Operating income is gross profit minus operating expenses: what the business earns from its main activity before interest.
Interest expense is the interest a business paid or owes on its borrowing during a period, shown on the income statement after operating income.
Net income is revenue minus all expenses for a period, the bottom line of the income statement; when expenses are larger, it is a net loss.

Worked example — the income statement, for the year ended on the cart's first anniversary. The figures are illustrative; money is in dollars and volume in drinks.

The table shows each line in the order an income statement lists them.

The coffee cart's income statement for the year ended on its first anniversary, in dollars (illustrative)
Line	Dollars
Revenue (15,000 drinks at 5 dollars)	75,000
Cost of goods sold (15,000 drinks at 2 dollars)	30,000
Gross profit	45,000
Permit and insurance	5,000
Commissary-kitchen rent	7,000
Part-time wages	16,000
Promotion	3,000
Depreciation	4,000
Total operating expenses	35,000
Operating income	10,000
Interest expense	1,000
Net income	9,000

Revenue: 15,000 drinks × 5 dollars = 75,000 dollars.
Cost of goods sold: 15,000 drinks × 2 dollars = 30,000 dollars.
Gross profit: 75,000 − 30,000 = 45,000 dollars.
Operating expenses: permit and insurance 5,000 + commissary-kitchen rent 7,000 + part-time wages 16,000 + promotion 3,000 + depreciation 4,000 = 35,000 dollars.
Operating income: 45,000 − 35,000 = 10,000 dollars.
Interest expense: 10,000 × 0.10 = 1,000 dollars.
Net income: 10,000 − 1,000 = 9,000 dollars.

In words: from 75,000 dollars of sales, the cart kept 9,000 dollars of net income after paying for the drinks, the cost of running the cart, and the interest on its loan.

Notice one odd line. The cart's 20,000-dollar cart and equipment will last several years, so the cost is spread out. This year's share, 4,000 dollars, is depreciation. It reduces net income, but no cash left the account for it this year; the cash was spent on opening day.

Misconception check. Students often think a balance sheet covers a year, the same way an income statement does. That is tempting, because both are prepared at year-end. But look at the headings. A balance sheet is headed "as of" one date, and it shows a single moment. An income statement is headed "for the year ended" a date, and it covers the whole span. The cure is to read the heading before you read a single number.

Memory hook: top line minus costs, line by line, to the bottom line.

5. Tie it to the break-even: fixed costs and the margin on price

In Week 7, before the cart had sold a single drink, its plan forecast a break-even. Now a year of real numbers is in. Do the two stories agree?

Start with the costs that did not change with the number of drinks. On the income statement, those are the operating expenses and the interest.

Worked example — the break-even check. The figures are illustrative; money is in dollars and volume in drinks.

Fixed costs: 35,000 + 1,000 = 36,000 dollars, the same total behind the break-even.
Break-even: 36,000 ÷ (5 − 2) = 12,000 drinks a year.
Drinks past break-even: 15,000 − 12,000 = 3,000 drinks.
Profit from those drinks: (15,000 − 12,000) × 3 = 9,000 dollars.

In words: the first 12,000 drinks paid the cart's fixed costs, and each of the 3,000 drinks after that added 3 dollars of profit, which is exactly the 9,000 dollars of net income on the income statement.

Two more lines connect to earlier weeks. The 16,000 dollars of part-time wages is the Week 11 hiring plan, and the 3,000 dollars of promotion is the Week 9 budget. The income statement is where those plans show up as real costs.

The margin you met in Week 7 returns as well. Each drink's 3-dollar gap over its 5-dollar price is a margin on price of 3 ÷ 5 × 100 = 60 percent. You will meet that same 60 percent again in section 9 as the cart's gross margin, because gross profit is the drinks' 3-dollar gaps added up across the year.

Caveat: the check works this neatly because the cart sold every drink at one price with one variable cost, the same assumptions the break-even made. A real business with many prices would not tie out to the dollar.

Misconception check. Students often think markup and margin are the same percentage, so the cart's gross margin "should be 150 percent." That is tempting, because both describe the same 3-dollar gap. But markup on cost divides by the 2-dollar cost, while margin on price divides by the 5-dollar price. Gross margin divides gross profit by revenue, so it matches the margin on price, 60 percent. The cure is to ask what the gap is divided by.

Memory hook: past break-even, every drink is profit.

6. Check the year-end balance: carry the year into equity

Back to the snapshot. On the cart's first anniversary, the owner takes a new photo of what the cart owns and owes. A lot has changed since opening day.

Two new ideas appear on this balance sheet.

Accounts payable is money a business owes to its suppliers for goods or services it has already received but not yet paid for.
Owner withdrawals are money an owner takes out of the business for personal use; withdrawals reduce owners' equity and are never an expense on the income statement.

Worked example — the year-end balance sheet, as of the first anniversary. The figures are illustrative; money is in dollars.

The table lists the year-end lines in the same order as the start-up balance sheet.

The coffee cart's year-end balance sheet as of its first anniversary, in dollars (illustrative)
Line	Dollars
Cash	10,000
Inventory	2,000
Cart and equipment, after 4,000 of depreciation	16,000
Total assets	28,000
Accounts payable	4,000
Equipment loan	8,000
Total liabilities	12,000
Owner's equity	16,000
Total liabilities and owner's equity	28,000

Cart and equipment: 20,000 − 4,000 = 16,000 dollars.
Total assets: cash 10,000 + inventory 2,000 + cart and equipment 16,000 = 28,000 dollars.
Equipment loan: 10,000 − 2,000 repaid = 8,000 dollars, with 2,000 of it due within the coming year.
Total liabilities: accounts payable 4,000 + equipment loan 8,000 = 12,000 dollars.
Owner's equity: 20,000 + 9,000 of net income − 13,000 of owner withdrawals = 16,000 dollars.
The check: 12,000 + 16,000 = 28,000 dollars, equal to total assets of 28,000.

In words: a year in, the cart owns 28,000 dollars of things, owes 12,000 dollars to its supplier and the bank, and the owner's claim is 16,000 dollars. The year's 9,000 dollars of net income raised the owner's claim, and the 13,000 dollars the owner withdrew lowered it.

Misconception check. Students often put owner withdrawals on the income statement as an expense, or accept a balance sheet that is "close enough." Both are tempting: withdrawals feel like money going out, and a small gap looks harmless. But withdrawals are the owner taking back part of their own claim, so they reduce equity, not net income. And a balance sheet that does not balance means a line is wrong somewhere. The cure is to write out the check, liabilities + owners' equity = assets, to the dollar.

Pause and try this. Choose one: (a) explain to a friend, in two sentences, why the owner's 13,000 dollars of withdrawals do not change the cart's net income; or (b) describe what you would look for first if a balance sheet you were handed came out 500 dollars short.

Memory hook: net income adds to equity; withdrawals take from it.

7. Follow the cash: the statement of cash flows

The cart earned 9,000 dollars of net income, yet its cash went from 8,000 to only 10,000 dollars. Where did the money go? A third statement answers that question.

A statement of cash flows is a financial statement that reports the cash coming into and going out of a business over a span of time, grouped as operating, investing, and financing activities.

Operating activities are the section of the statement of cash flows that shows the cash coming in and going out from running the business day to day.
Investing activities are the section that shows cash spent on or received from long-lived assets, such as buying or selling equipment.
Financing activities are the section that shows cash received from or paid to lenders and owners, such as repaying a loan or an owner's withdrawal.
The net change in cash is the total of the three sections, which equals the year-end cash minus the cash at the start of the year.

Accountants show a negative amount in parentheses, so (15,000) means 15,000 dollars of cash paid out.

Worked example — the statement of cash flows, for the year ended on the first anniversary. The figures are illustrative; money is in dollars.

The coffee cart's statement of cash flows for the year ended on its first anniversary, in dollars (illustrative)
Line	Dollars
Net income	9,000
Add back depreciation, which used no cash	4,000
Add the increase in what is owed to suppliers	4,000
Operating activities	17,000
Investing activities	0
Loan principal repaid	(2,000)
Owner withdrawals	(13,000)
Financing activities	(15,000)
Net change in cash	2,000

Operating activities: 9,000 + 4,000 + 4,000 = 17,000 dollars.
Investing activities: 0 dollars, because the cart bought no new equipment.
Financing activities: (2,000) + (13,000) = (15,000) dollars.
Net change in cash: 17,000 − 15,000 = 2,000 dollars.
Year-end cash: 8,000 + 2,000 = 10,000 dollars, the same 10,000 on the year-end balance sheet.

In words: running the cart brought in 17,000 dollars of cash, the owner and the bank took 15,000 dollars of it back out, and the cash in the account rose by 2,000 dollars.

Why add depreciation back? It cut net income by 4,000 dollars, but no cash left this year. And why add the 4,000 dollars owed to suppliers? The cart used beans and cups it had not yet paid for, so the cash was still in the account at year-end.

Misconception check. Students often think the statement of cash flows repeats the income statement. That is tempting, because both cover the same year and the cash-flow statement opens with the income statement's net income. But the income statement asks "did the cart earn money?" and the cash-flow statement asks "where did the cash go?" The 13,000 dollars of withdrawals appears on the cash-flow statement and never on the income statement. The cure is to ask which question a statement answers.

Memory hook: operating runs it, investing builds it, financing funds it.

8. Separate profit from cash

Picture an illustrative family farm in early spring. Last year it earned a solid profit. Yet right now it is buying seed, paying workers, and fixing a tractor, and its harvest will not sell for months. The farm is profitable over the year and short of cash this week.

The coffee cart shows the same lesson in numbers. Profit counts revenue and expenses when they are earned and used. Cash counts money when it actually moves.

Worked example — the 7,000-dollar gap. The cart's figures are illustrative; money is in dollars.

The gap: net income 9,000 − the rise in cash 2,000 = 7,000 dollars.
Items that took cash without touching net income: the owner's 13,000 dollars of withdrawals and the 2,000 dollars of loan repayment.
Items that cut net income or added costs without taking cash: the 4,000 dollars of depreciation and the 4,000 dollars still owed to suppliers.
Putting it together: 9,000 + 4,000 + 4,000 − 2,000 − 13,000 = 2,000 dollars, the rise in cash.

In words: the cart earned 9,000 dollars, but cash rose only 2,000 dollars, mostly because the owner withdrew 13,000 dollars to live on.

Honesty note: the cart's gap is mostly the owner's own choice. On another business the gap could come from unpaid customer bills or a big equipment purchase instead. The lesson is general: a profit on the income statement does not promise cash in the account.

Misconception check. Students often think profit is cash in the bank, so a business with 9,000 dollars of net income "has 9,000 dollars." That is tempting, because in everyday life "making money" and "having money" sound the same. But the cart's cash rose only 2,000 dollars that year. The cure is to read net income from the income statement and cash from the balance sheet, and to use the cash-flow statement to connect them.

Pause and try this. Choose one: (a) describe one way a profitable business you know of could run short of cash in a busy season; or (b) explain in two sentences why a lender might care more about cash than about net income.

Memory hook: profit is earned; cash is counted.

9. Compute four ratios: read the statements in a line each

A loan officer reading a stack of statements does not want forty numbers. The officer wants a few comparisons that show health at a glance. Ratios do that job.

Two more ideas set up the first ratio.

Current assets are cash and other assets a business expects to use up or turn into cash within a year, such as inventory.
Current liabilities are debts a business must pay within a year, such as accounts payable and the part of a loan due in the coming year.

Now the four ratios, each built from two named lines.

The current ratio is current assets divided by current liabilities, written as a plain decimal; it shows how many dollars of near-term assets a business holds for each dollar it owes within the year.
Debt-to-equity is total liabilities divided by owners' equity, written as a plain decimal; it shows how many dollars a business owes for each dollar of the owners' claim.
Gross margin is gross profit divided by revenue, times 100: the percent of each sales dollar left after paying for the goods sold.
Net profit margin is net income divided by revenue, times 100: the percent of each sales dollar left as profit after every expense.

Worked example — the cart's ratio set. The figures are illustrative and come from the year-end balance sheet and the income statement; money is in dollars.

Current assets: cash 10,000 + inventory 2,000 = 12,000 dollars.
Current liabilities: accounts payable 4,000 + the 2,000 of the loan due within the year = 6,000 dollars.
Current ratio: (10,000 + 2,000) ÷ (4,000 + 2,000) = 12,000 ÷ 6,000 = 2.0.
Debt-to-equity: 12,000 ÷ 16,000 = 0.75.
Gross margin: 45,000 ÷ 75,000 × 100 = 60 percent.
Net profit margin: 9,000 ÷ 75,000 × 100 = 12 percent.

In words: the cart holds 2 dollars of near-term assets for each dollar due within the year, owes 75 cents for each dollar of the owner's claim, keeps 60 cents of each sales dollar after paying for the drinks, and keeps 12 cents of each sales dollar as profit.

In practice (your tools). You can compute the ratio set in any free spreadsheet, such as Google Sheets. Type 10000 in cell B2 for cash, 2000 in cell B3 for inventory, 4000 in cell B4 for accounts payable, and 2000 in cell B5 for the loan due within the year. In cell B6 type =(B2+B3)/(B4+B5) for the current ratio. Type 12000 in cell B7 for total liabilities and 16000 in cell B8 for owner's equity, then type =B7/B8 in cell B9 for debt-to-equity. For the margins, type 75000 in cell B10, 45000 in cell B11, and 9000 in cell B12, then type =B11/B10*100 and =B12/B10*100.

A ratio is a fact computed from two named lines. Whether 2.0 is "enough" for a lender, or 0.75 is "too much" debt, is a judgment, and a careful reader labels it as one. Nothing here is investment or tax advice for a real business.

Misconception check. Students often flip a ratio's lines, dividing current liabilities by current assets. That is tempting, because both lines sit near each other on the balance sheet. But 6,000 ÷ 12,000 = 0.5 is not the current ratio; it would wrongly suggest the cart owes twice what it can cover. The cure is to say the formula in words first, "current assets divided by current liabilities," and then put the first-named line on top.

Pause and try this. Choose one: (a) write one sentence a loan officer might say about the cart's current ratio, and label which part is fact and which is judgment; or (b) explain why the gross margin and the net profit margin differ by so much on the same 75,000 dollars of revenue.

Memory hook: name the two lines, then divide.

Key terms

accounting — The work of recording, classifying, summarizing, reporting, and analyzing a business's money activity so that owners, managers, lenders, investors, and tax authorities can make decisions with it. (first used: 1. Know who reads the numbers: what accounting is for)
accounting cycle — The five steps that turn a business's activity into usable numbers: record each sale and bill, classify them into groups, summarize each group for the period, report the totals in the financial statements, and analyze the statements to decide. (first used: 2. Walk the cycle: record, classify, summarize, report, analyze)
financial statements — The three standard reports a business prepares from its accounting records: the balance sheet, the income statement, and the statement of cash flows. (first used: 2. Walk the cycle: record, classify, summarize, report, analyze)
asset — Something of value a business owns, such as cash, inventory, or equipment. (first used: 3. Balance the start: the accounting equation)
liability — A debt a business owes to someone outside it, such as a bank loan or money owed to a supplier. (first used: 3. Balance the start: the accounting equation)
owners' equity — The owners' claim on a business's assets: what the owners put in, plus profit kept in the business, minus what the owners took out; on a one-owner business it is written owner's equity. (first used: 3. Balance the start: the accounting equation)
accounting equation — The rule that assets equal liabilities plus owners' equity, because everything a business owns was paid for either by what it owes or by what its owners put in and left in. (first used: 3. Balance the start: the accounting equation)
balance sheet — A financial statement that lists a business's assets, liabilities, and owners' equity as of one date, a snapshot at a single point in time. (first used: 3. Balance the start: the accounting equation)
income statement — A financial statement that reports a business's revenue, expenses, and net income for a span of time, such as the year ended on a given date. (first used: 4. Read the year: the income statement)
cost of goods sold — The direct cost of the goods a business sold during a period, such as the cups, lids, beans, and milk in the drinks a coffee cart sold. (first used: 4. Read the year: the income statement)
gross profit — Revenue minus cost of goods sold: what is left from sales to pay for running the business. (first used: 4. Read the year: the income statement)
operating expenses — The costs of running a business beyond the goods it sells, such as rent, wages, insurance, promotion, and depreciation. (first used: 4. Read the year: the income statement)
depreciation — The part of a long-lived asset's cost, such as a cart's or a machine's, that is counted as an expense in each year the asset is used; recording it pays out no cash. (first used: 4. Read the year: the income statement)
operating income — Gross profit minus operating expenses: what the business earns from its main activity before interest. (first used: 4. Read the year: the income statement)
interest expense — The interest a business paid or owes on its borrowing during a period, shown on the income statement after operating income. (first used: 4. Read the year: the income statement)
net income — Revenue minus all expenses for a period, the bottom line of the income statement; when expenses are larger, it is a net loss. (first used: 4. Read the year: the income statement)
accounts payable — Money a business owes to its suppliers for goods or services it has already received but not yet paid for. (first used: 6. Check the year-end balance: carry the year into equity)
owner withdrawals — Money an owner takes out of the business for personal use; withdrawals reduce owners' equity and are never an expense on the income statement. (first used: 6. Check the year-end balance: carry the year into equity)
statement of cash flows — A financial statement that reports the cash coming into and going out of a business over a span of time, grouped as operating, investing, and financing activities. (first used: 7. Follow the cash: the statement of cash flows)
operating activities — The section of the statement of cash flows that shows the cash coming in and going out from running the business day to day. (first used: 7. Follow the cash: the statement of cash flows)
investing activities — The section of the statement of cash flows that shows cash spent on or received from long-lived assets, such as buying or selling equipment. (first used: 7. Follow the cash: the statement of cash flows)
financing activities — The section of the statement of cash flows that shows cash received from or paid to lenders and owners, such as repaying a loan or an owner's withdrawal. (first used: 7. Follow the cash: the statement of cash flows)
net change in cash — The total of the operating, investing, and financing sections of the statement of cash flows, which equals the year-end cash minus the cash at the start of the year. (first used: 7. Follow the cash: the statement of cash flows)
current assets — Cash and other assets a business expects to use up or turn into cash within a year, such as inventory. (first used: 9. Compute four ratios: read the statements in a line each)
current liabilities — Debts a business must pay within a year, such as accounts payable and the part of a loan due in the coming year. (first used: 9. Compute four ratios: read the statements in a line each)
current ratio — Current assets divided by current liabilities, written as a plain decimal; it shows how many dollars of near-term assets a business holds for each dollar it owes within the year. (first used: 9. Compute four ratios: read the statements in a line each)
debt-to-equity — Total liabilities divided by owners' equity, written as a plain decimal; it shows how many dollars a business owes for each dollar of the owners' claim. (first used: 9. Compute four ratios: read the statements in a line each)
gross margin — Gross profit divided by revenue, times 100: the percent of each sales dollar left after paying for the goods sold. (first used: 9. Compute four ratios: read the statements in a line each)
net profit margin — Net income divided by revenue, times 100: the percent of each sales dollar left as profit after every expense. (first used: 9. Compute four ratios: read the statements in a line each)

Summary

Accounting records, classifies, summarizes, reports, and analyzes money activity for owners, managers, lenders, investors, and tax authorities.
The accounting equation: assets = liabilities + owners' equity, on every balance sheet, to the dollar.
The cart opened with 30,000 dollars of assets: a 10,000-dollar loan plus 20,000 dollars of owner's equity.
A balance sheet is "as of" one date; an income statement and a statement of cash flows are "for the year ended" a date.
The cart's year: revenue 75,000, gross profit 45,000, operating income 10,000, net income 9,000 dollars.
The break-even check: (15,000 − 12,000) × 3 = 9,000 dollars, the same net income.
Net income adds to owners' equity; owner withdrawals reduce it and are never an expense.
The year-end balance sheet: 12,000 + 16,000 = 28,000 dollars of total assets.
Cash flows: operating 17,000, investing 0, financing (15,000), net change 2,000 dollars.
Profit is not cash: net income was 9,000 dollars, but cash rose only 2,000 dollars.
The ratios: current ratio 2.0, debt-to-equity 0.75, gross margin 60 percent, net profit margin 12 percent.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

An illustrative neighborhood bike shop, as of the last day of its year, has cash of 6,000 dollars, inventory of 9,000 dollars, and repair tools and equipment of 19,000 dollars. It owes a parts supplier 3,000 dollars and has a bank loan of 12,000 dollars. Find total assets, total liabilities, and owners' equity, and write out the check.
An illustrative campus print shop had revenue of 48,000 dollars for its year, cost of goods sold (paper and toner) of 14,000 dollars, operating expenses of 23,000 dollars, and interest expense of 500 dollars. Its owner also withdrew 7,500 dollars. Find gross profit, operating income, and net income, and say where the 7,500 dollars belongs.
An illustrative family farm has current assets of 21,000 dollars, current liabilities of 14,000 dollars, total liabilities of 35,000 dollars, and owners' equity of 50,000 dollars. Find the current ratio and debt-to-equity, and say each in words.
An illustrative landscaping business had net income of 13,000 dollars and depreciation of 2,500 dollars, with no change in what it owed suppliers. It bought a new mower for 5,500 dollars, and its owner withdrew 14,000 dollars. Find each section of its statement of cash flows and the net change in cash, and explain the result.

Answers (worked reasoning — read after attempting)

Total assets: 6,000 + 9,000 + 19,000 = 34,000 dollars. Total liabilities: 3,000 + 12,000 = 15,000 dollars. Owners' equity is what is left of the assets after the liabilities: 34,000 − 15,000 = 19,000 dollars. The check: 15,000 + 19,000 = 34,000 dollars, equal to total assets. The trap this item catches is reading the 6,000 dollars of cash as the owner's equity; the owner's claim is 19,000 dollars, on all the assets.
Gross profit: 48,000 − 14,000 = 34,000 dollars. Operating income: 34,000 − 23,000 = 11,000 dollars. Net income: 11,000 − 500 = 10,500 dollars. The 7,500-dollar withdrawal is not an expense, so it does not appear on the income statement; it reduces owners' equity on the balance sheet and appears as cash paid out under financing activities.
Current ratio: 21,000 ÷ 14,000 = 1.5, so the farm holds 1.5 dollars of near-term assets for each dollar due within the year. Debt-to-equity: 35,000 ÷ 50,000 = 0.7, so the farm owes 70 cents for each dollar of the owners' claim. Flipping the first ratio (14,000 ÷ 21,000) would put the wrong line on top.
Operating activities: 13,000 + 2,500 = 15,500 dollars, because depreciation used no cash. Investing activities: (5,500) dollars for the mower. Financing activities: (14,000) dollars for the owner's withdrawal. Net change in cash: 15,500 − 5,500 − 14,000 = (4,000) dollars. The business earned 13,000 dollars of profit, yet its cash fell 4,000 dollars, because the owner's withdrawal and the mower took more cash than the year brought in; profit is not cash.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the cart's statements become the evidence for a financing decision, as money, banks, and the debt-versus-equity choice take the stage.

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