Lecture: Keeping Score: Accounting & Financial Statements
Lecture script · about 15–20 minutes spoken · Week 13
Opening
Think about checking your bank app at the end of a month. It shows one number, what's in the account right now. But that number can't tell you whether the month went well. To know that, you'd need more than one view of the same money.
Whether you end up running a coffee cart of your own, reviewing a bike shop's loan request at a bank, sitting on a food bank's board, or keeping the books for a family farm, you'll face that same puzzle. What does a business own and owe? What did it earn over a year? And where did its cash actually go?
Here's where we are. In Week 3, From Idea to Plan, the cart's start-up list and funding plan came to 30,000 dollars. In Week 7, Who Buys and at What Price, we found its break-even of 12,000 drinks a year. Those were forecasts. In this lecture, the cart has finished its first full year, and we read what really happened. Next week, Paying for Growth, reads these same statements to weigh how a second cart could be paid for.
Here's the plan. We'll meet who reads accounting and the steps that produce it. Then we'll read three statements, check that they balance, follow the cash, and finish with four ratios.
1. Who reads the numbers
Picture three people reading about money on the same afternoon. A bank loan officer is deciding whether to lend to a neighborhood bike shop. The board of a community food bank is checking that a year of donations really fed people. And the cart's owner, who's also its manager, is wondering what the cart can afford next.
They want different answers, but they all need the same thing first: honest, organized numbers. That's what accounting provides. 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 five readers brings a question. Owners ask whether the business is worth their money and time. Managers ask what to change next month. Lenders ask whether a loan will be repaid. Investors ask whether to buy a share of the business. Tax authorities ask whether income was reported correctly.
A lot of people think accounting exists only for taxes, because tax season is when they hear the word. But the tax authority is one reader out of five.
Pause and try this. The loan officer reading the bike shop's numbers is which kind of user: an owner, a manager, a lender, an investor, or a tax authority?
Think about what the officer has to decide.
Here's the answer. The officer is a lender, because the decision is whether a loan will be repaid.
Accounting answers a question someone has to decide.
2. The accounting cycle
Picture the cart's very first sale. A customer pays 5 dollars for a latte. That one sale is a tiny piece of the year. Many sales and bills later, the owner needs one clear picture.
The accounting cycle is the five steps that turn a business's activity into usable numbers. You record each sale and each bill. You classify them into groups, like drink sales, rent, and wages. You summarize each group for the period. You report the totals in the financial statements. And you analyze those statements to decide.
The financial statements are the three standard reports a business prepares from its records: the balance sheet, the income statement, and the statement of cash flows.
Follow that latte. The card reader records it. It's classified as a drink sale. At year-end it's summarized with every other drink, 15,000 drinks times 5 dollars, which is 75,000 dollars. That total is reported as revenue. Then the owner analyzes it against the costs.
In this course, you read finished statements and compute from their lines; you don't build them from single sales.
Pause and try this. Which of the five steps is the one where the numbers turn into a decision?
Picture the owner holding the finished report.
Here's the answer. It's analyze, the fifth step, because a report nobody reads changes nothing.
Record, classify, summarize, report, analyze, then decide.
3. The accounting equation
Picture the cart on opening day. You can point at the cart and its equipment, the boxes of cups and beans, and the cash in the account. Now the harder question: who paid for all of it?
Every dollar came from one of two places. Someone outside 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. Owners' equity is the owners' claim on the assets: what they put in, plus profit kept in the business, minus what they took out.
Those three join in one rule. The accounting equation says 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. A balance sheet lists all three as of one date, a snapshot.
On opening day, the cart had 8,000 dollars of cash, 2,000 dollars of inventory, and 20,000 dollars of cart and equipment, for 30,000 dollars of assets. On the other side sat a 10,000-dollar loan and 20,000 dollars of owner's equity, also 30,000 dollars. They match.
Pause and try this. The owner's equity on opening day is 20,000 dollars. Does the owner have 20,000 dollars of cash sitting in the account?
Look back at the cash line.
Here's the answer. No, the cart has only 8,000 dollars of cash, because equity is the owner's claim on all the assets, not a pile of money.
What you own equals who paid for it.
4. The income statement
A year later, the owner wants to know how the year went. A snapshot of one day can't say. So a second statement covers the whole year. An income statement reports revenue, expenses, and net income for a span of time, such as the year ended on a given date.
It reads from the top down. Revenue was 75,000 dollars. Cost of goods sold, the direct cost of the drinks, was 15,000 drinks times 2 dollars, or 30,000 dollars. That leaves gross profit of 45,000 dollars.
Next come operating expenses, the costs of running the cart beyond the drinks themselves: 5,000 dollars for permit and insurance, 7,000 for commissary-kitchen rent, 16,000 for part-time wages, 3,000 for promotion, and 4,000 of depreciation. Depreciation spreads the cart's cost over the years it's used, and recording it pays out no cash. Those add to 35,000 dollars, leaving operating income of 10,000 dollars.
Then interest on the loan, 10,000 times 0.10, or 1,000 dollars. What's left is net income, the bottom line: 9,000 dollars.
Here's a trap. People often think a balance sheet covers a year, because both statements come out at year-end. Read the headings. A balance sheet says "as of" one date. An income statement says "for the year ended" a date.
Pause and try this. A statement is headed "for the year ended" on the cart's first anniversary. Is it a snapshot or a span of time?
Listen to the heading's words.
Here's the answer. It's a span of time, because "for the year ended" covers the whole year, the way an income statement does.
Top line minus costs, line by line, to the bottom line.
5. Tie it to the break-even
Back in Week 7, before the cart sold a drink, its plan forecast a break-even. Now a real year is in. Do the stories agree?
The costs that didn't change with the number of drinks were the operating expenses and the interest: 35,000 plus 1,000, or 36,000 dollars. That's the same total behind the break-even. Each drink left a 3-dollar per-unit margin, so the cart needed 12,000 drinks to cover those costs.
It sold 15,000. That's 3,000 drinks past break-even, each adding 3 dollars. And 3,000 times 3 is 9,000 dollars, the very same net income the statement reports. The plan and the year line up, because the cart sold every drink at one price with one variable cost, the same assumptions the break-even made.
The margin returns too. A 3-dollar gap on a 5-dollar price is a margin on price of 60 percent. You'll meet that 60 percent again as the cart's gross margin.
Pause and try this. Someone says the cart's gross margin should be 150 percent, its markup on cost. What's gone wrong?
Ask what the 3-dollar gap is divided by.
Here's the answer. Markup divides by the 2-dollar cost, but gross margin divides by revenue, so it matches the margin on price, 60 percent.
Past break-even, every drink is profit.
6. The year-end balance sheet
On the first anniversary, the owner takes a new snapshot. Cash is 10,000 dollars, inventory 2,000, and the cart and equipment 16,000, which is 20,000 less 4,000 of depreciation. Total assets: 28,000 dollars.
Two new ideas show up. Accounts payable is money owed to suppliers for goods already received, here 4,000 dollars for beans and cups. And the equipment loan is down to 8,000 dollars, after 2,000 was repaid. So liabilities total 12,000 dollars.
Then the owner's claim. It started at 20,000 dollars. The year's 9,000 of net income raised it. And 13,000 dollars of owner withdrawals, money the owner took out for personal use, lowered it. So owner's equity is 16,000 dollars. The check: 12,000 plus 16,000 is 28,000, equal to total assets.
Two traps live here. One is putting withdrawals on the income statement as an expense. They're the owner taking back part of their own claim, so they reduce equity, not net income. The other is accepting a balance sheet that's "close enough." If it doesn't balance, a line is wrong.
Pause and try this. Should the owner's 13,000 dollars of withdrawals lower the cart's net income?
Think about whose money it is.
Here's the answer. No, withdrawals reduce owner's equity on the balance sheet and never appear as an expense on the income statement.
Net income adds to equity; withdrawals take from it.
7. Follow the cash
Here's a puzzle. The cart earned 9,000 dollars, yet its cash went from 8,000 to only 10,000 dollars. Where did the money go? A statement of cash flows answers that. It reports cash coming in and going out over a span of time, in three groups.
Operating activities are the cash from running the cart. Start with net income, 9,000. Add back the 4,000 of depreciation, since no cash left for it. Add the 4,000 still owed to suppliers, since that cash hasn't gone out yet. That's 17,000 dollars.
Investing activities cover long-lived assets like equipment. The cart bought none, so that's 0.
Financing activities are cash to and from lenders and owners. The loan repayment of 2,000 and the withdrawals of 13,000 total 15,000 dollars going out. Accountants show a negative amount in parentheses, so that line is written with the 15,000 inside parentheses.
So the net change in cash is 17,000 minus 15,000, or 2,000 dollars. And 8,000 plus 2,000 is 10,000, the same cash on the year-end balance sheet.
Pause and try this. On which of the three sections do the owner's withdrawals appear?
Ask whether the money went to a lender, an owner, or equipment.
Here's the answer. They appear under financing activities, because the withdrawals are cash paid to the owner.
Operating runs it, investing builds it, financing funds it.
8. Profit is not cash
Picture a family farm in early spring. Last year it earned a solid profit. Yet right now it's buying seed and paying workers, and the harvest won't sell for months. It's profitable over the year and short of cash this week.
The cart shows the same lesson in numbers. Net income was 9,000 dollars. Cash rose 2,000 dollars. The gap is 7,000 dollars. Profit counts revenue and expenses when they're earned and used. Cash counts money when it moves.
Some items took cash without touching net income: the owner's 13,000 dollars of withdrawals and the 2,000 dollars of loan repayment. Others cut net income without taking cash this year: the 4,000 of depreciation and the 4,000 still owed to suppliers. Put those together and you land on the 2,000-dollar rise in cash.
This gap is mostly the owner's choice to withdraw money, but the lesson holds for any business.
Pause and try this. A friend says the cart "has 9,000 dollars" because its net income was 9,000 dollars. Is that right?
Compare net income with the rise in cash.
Here's the answer. No, cash rose only 2,000 dollars, because profit measures earning and the cash went to withdrawals and repayment.
Profit is earned; cash is counted.
9. Four ratios
A loan officer with a stack of statements wants a few comparisons that show health at a glance. Ratios do that job.
Two ideas first. Current assets are cash and other assets a business expects to use up or turn into cash within a year. For the cart that's 10,000 plus 2,000, or 12,000 dollars. Current liabilities are debts due within a year: the 4,000 payable plus the 2,000 of the loan due in the coming year, or 6,000 dollars.
The current ratio is current assets divided by current liabilities: 12,000 divided by 6,000 is 2.0. The cart holds 2 dollars of near-term assets for each dollar due within the year. Debt-to-equity is total liabilities divided by owners' equity: 12,000 divided by 16,000 is 0.75, so the cart owes 75 cents for each dollar of the owner's claim.
Gross margin is gross profit divided by revenue, times 100: 45,000 divided by 75,000, times 100, is 60 percent. Net profit margin is net income divided by revenue, times 100: 9,000 divided by 75,000, times 100, is 12 percent. So 12 cents of each sales dollar is left as profit.
A ratio is a fact from two named lines. Whether 2.0 is enough for a lender is a judgment. Label it as one, and treat none of this as investment or tax advice.
Pause and try this. Someone divides 6,000 by 12,000 and calls the 0.5 the cart's current ratio. What did they do?
Say the formula in words, then check which line went on top.
Here's the answer. They flipped it, putting current liabilities on top, when current assets belong on top, so the current ratio is 2.0.
Name the two lines, then divide.
Closing
Let's pull it together. Accounting records, classifies, summarizes, reports, and analyzes money activity for five kinds of readers. Every balance sheet obeys one rule: assets equal liabilities plus owners' equity, to the dollar.
The cart opened with 30,000 dollars of assets. Its first year brought 75,000 dollars of revenue and 9,000 dollars of net income, exactly what 3,000 drinks past break-even predict. At year-end, 12,000 plus 16,000 made 28,000 dollars, and the sheet balanced. Withdrawals lowered equity, never net income.
The cash statement showed why profit isn't cash: cash rose only 2,000 dollars. And four ratios summed up the year: a current ratio of 2.0, debt-to-equity of 0.75, a gross margin of 60 percent, and a net profit margin of 12 percent.
Next in this module come the slide deck, the Readings & Resources page, the lecture tutorial, the practice set, the quiz, the discussion, and the assignment. Next week, Paying for Growth: Money, Banking & Financial Management, reads these statements to weigh how a second cart could be paid for.
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