/ INVESTING

How to Read Financial Statements

Why Learn How To Read Financial Statements?

Before you can value a company, you have to understand the numbers. This guide is an attempt to be the resource I wish I had when first starting to read financial statements.

This mini-course is not designed to be a fully-fledged accounting course. There are better resources out there if that is your goal; however, if you’re looking to learn how to read financial statements in order to invest using a hands-on approach, you’re at the right place.

This is a living guide and I try to update it monthly. If you notice anything that could be improved, please contact me and let me know.

We’re going to be learning from the perspective of an ambitious entrepreneur starting a fitness center business from scratch. As you follow along, we’ll continuously be flexing our financial statement muscles with consistently harder exercises. Please make sure you’re learning the information by making your best effort at the challenges as they’re designed to help solidify the concepts we just covered.

Please feel free to download the accompanying Excel file detailing all of the financial statements and transactions covered in this free mini-course.

I’m a big believer in learning by doing, so let’s get started.

  1. Funding the Fitness Center
  2. Renting a Location
  3. Purchasing Equipment
  4. Purchasing Insurance
  5. It All Starts with Sales
  6. The Whey of Inventory
  7. The Whey to Sell
  8. The Matching Game
  9. Depreciating our Equipment
  10. Accumulated Depreciation
  11. Cash Flow is NOT Income
  12. Preparing for Opening Day
  13. Opening Day
  14. Purchasing Inventory on Credit
  15. Adding Recurring Expenses
  16. Loans and Interest
  17. Updating our Short-Term Thinking
  18. Loans and Interest
  19. Accruing Interest
  20. Deferred Revenue

01 - Funding the Fitness Center

After months of planning, you’ve estimated that you’ll need $150,000 to open up the perfect fitness center located in your neighborhood. Unfortunately, you only have $50,000 in your bank account from years of saving. Now you understand why they say it takes money to make money! Thankfully, your friend Matt works at Southwest Bank. Southwest is willing to loan you $100,000. This loan is precisely the amount you need! Imagine that!

Now that we have enough money to start our fitness center, we need to track what we own and what we owe. We’ll create a simple table to do this. On the left will be what we own and on the right will be what we owe.

Assets Liabilities 
Cash150,000.00Bank Loan100,000.00
  My Investment50,000.00
Total150,000.00Total150,000.00

If you think about it, both sides will always be equal. What you own has to be purchased by you or purchased from money lent to you. That is why the left side (what you own) will always equal the right side (what you owe). Since it is your business, it might seem strange to think that you “owe” $50,000. Keep in mind that this is the perspective of the company. The business owes you $50,000 and hopefully much more soon!

What the business owns is also called assets, and what it owes is called liabilities. The money left over, in this case after paying back Matt from Southwest Bank, is what you own and is called shareholders equity. Shareholders is just a fancy name for owners. Right now there’s only one hopefully-soon-to-be-rich shareholder, and that’s you.

Again, your assets (left side) will always equal your liabilities plus shareholder’s equity (right side). This balancing leads us to the fundamental equation in accounting:

Assets = Liabilities + Shareholder’s Equity

In accounting, we call this table a balance sheet because both sides are always equal or in balance. The balance sheet shows how your assets, or what you own, were funded. In our case, 1/3rd was funded by the best shareholder of them all, you. And the other 2/3rds was funded by a loan from Matt at the bank. Now if we’re going to exercise, we better find a place to rent and buy some exercise equipment for our members to use. Let’s start on that tomorrow.

02 - Renting a Location

Yesterday, we created a two-column table. We tracked what we own ( assets ) on the left and what we owe ( liabilities & stockholder’s equity ) on the right.

We learned that in accounting this two-column table is called a balance sheet because it must always balance. The fact that the balance sheets must balance makes sense because a balance sheet tells us is how we funded our assets. Did we buy assets with other people’s money that we’ll have to eventually repay or from the owner’s money from operating our fitness center?

Now that we’ve got money in the bank let’s rent that perfect location for our fitness center. The rent is $2,000 a month. How do you think this will change the balance sheet? Remember, the balance sheet must always balance.

Assets Liabilities 
Cash148,000.00Bank Loan100,000.00
  Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,000.00)
  Total Equity48,000.00
Total148,000.00Total Liabilities & Equity148,000.00

Our cash balance went from $150,000 to $148,000 as we used $2,000 in cash to pay rent. Remember, we’ve learned that both sides of the balance sheet must balance because we have to track who owns our assets, and we just gave our landlord $2,000 in our favorite asset: cold, hard cash. Who pays for that?

While it would be nice for us to say to Southwest Bank that we owe them $2,000 less because we had to pay rent, that’s not how it works. As an owner, when the business loses money, it’s your money that’s lost.

I updated our balance sheet to separate both liabilities and stockholder’s equity to make things easier to read. I also created a new category on our balance sheet called earnings to keep track of our original investment compared to how much we earn or (lose) from running our fitness center. You’ll notice instead of listing earnings as -$2,000; I recorded the negative number with parenthesis around it. Using parenthesis to represent negative numbers is conventional in accounting and makes it easier to read. Finally, subtotals have a single underline below them and totals have a double underline. Underlining in this manner is standard practice, but you’ll only see this in the downloadable excel file.

A location without any equipment won’t do us any good. In the next lesson, we’ll purchase some fitness equipment.

03 - Purchasing Equipment

Previously, we updated the balance sheet to help us better track our liabilities and equity. Today, let’s purchase top-notch fitness equipment for our customers to use. We’ve done our research and have decided that we can get the best equipment available, which should help draw members from our competitors, for $25,000. Before moving on, try to think how this would change the balance sheet. Once you’ve got your answer, check to see if you were right below:

Assets Liabilities 
Cash123,000.00Bank Loan100,000.00
Equipment25,000.00Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,000.00)
  Total Equity48,000.00
Total148,000.00Total Liabilities & Equity148,000.00

Our cash balance went from $148,000 to $123,000 because used $25,000 in cash to purchase the exercise equipment. Notice that all we did was trade one asset for another, which is why our total assets didn’t change. We didn’t borrow any more money, so our liabilities stayed the same. If we goofed up and just added $25,000 in exercise equipment without reducing cash, our left column would not have equaled our right column, and we would have quickly realized our mistake.

04 - Purchasing Insurance

Yesterday, we purchased equipment for our fitness center by trading one asset (cash) for another (exercise equipment). Today, let’s get protected from unnecessary risk by buying insurance. It will cost $100 a month to insure our fitness center. The insurance company requires that we pay upfront for the whole year costing us $1,200. Let’s pay our insurance bill and see how it changes our balance sheet. Can you guess?

Assets Liabilities 
Cash121,800.00Bank Loan100,000.00
Prepaid Insurance1,200.00  
Equipment25,000.00Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,000.00)
  Total Equity48,000.00
Total148,000.00Total Liabilities & Equity148,000.00

Our cash balance went from $123,000 to $121,800 due to using $1,200 in cash to buy the insurance. We also have a new asset on our balance sheet called prepaid insurance for the same amount. Wait a minute; how is our insurance expense an asset?

Our insurance protects us for the next 12 months. When we pay for something where we receive a benefit in the future, it becomes an asset and that asset is used up over time. Anything that helps us make money or reduces money going out the door is said to be of economic benefit. Here’s the secret:

  • Any expenditure that has future economic benefit is considered an asset.
  • Any expenditure that only has economic benefit in the present or past, it’s regarded as an expense.

Our prepaid insurance will be an asset on the balance sheet until it’s used up over the next 12 months at $100 per month. To think about this another way, imagine if someone wanted to buy our fitness center right now. They wouldn’t have to pay for insurance as we already purchased it. If they bought the business three months from now, we would have used up $300 of our insurance coverage at $100 per month leaving the new buyer with a $900 asset. How do you think our balance sheet will look after we use a month of our prepaid insurance asset?

Assets Liabilities 
Cash121,800.00Bank Loan100,000.00
Prepaid Insurance1,100.00  
Equipment25,000.00Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,100.00)
  Total Equity47,900.00
Total147,900.00Total Liabilities & Equity147,900.00

You can see that our prepaid insurance asset was reduced by $100 and just like with the rent, the owner paid for it. We now have a significant problem, though. When looking at the balance sheet, we can see that we lost $2,100, but we’re not sure how. Where can we find these essential details? For that, we need to put the balance sheet on hold and start discussing the income statement.

05 - It All Starts with Sales

So far we’ve discovered that the balance sheet tracks what our business owns and how we paid for our assets. The balance sheet allows us to answer if our company is in good financial condition and we have enough money in the bank to pay our bills. The balance sheet does not tell us how we made or lost money. For that, we need an income statement.

The income statement describes to us our profit performance, or how we made or lost money over a period of time. Let’s start with a very basic income statement:

Sales Revenue Assets 
Expenses Cash121,800.00
Rent(2,000.00)Prepaid Insurance1,100.00
Insurance(100.00)Equipment25,000.00
Total Expenses(2,100.00)Total Assets147,900.00
Net Loss(2,100.00)  
  Liabilities & Stockholders Equity 
  Bank Loan100,000.00
  Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,100.00)
  Total Equity47,900.00
  Total Liabilities & Equity147,900.00

The income statement starts with sales and subtracts out our expenses to give us net income. Net income is the profit left over after we pay all of our expenses. If we had more expenses than sales and lost money, it’s called net loss instead of net income. It’s vital to have profit because it allows us to reinvest in our business, pay off our loan from Southwest Bank or even put that money back into our owner’s pockets, which in our case is just us! Since we don’t have any sales yet, we lost $2,100.

I’ve listed our latest balance sheet (in vertical format for reading purposes) with the new income statement. Do you see the connection? Earnings on the balance sheet equals our net loss on our income statement; however, both statements tell a very different story.

Again, the balance sheet shows our financial condition. In our case, we’re in good shape (pun intended) and that while a loss of ($2,100) isn’t ideal, we’ll survive because we still have $121,800 cash on hand. The income statement tells us about our profit performance, or how that loss occurred, but does not give us the information we need to decide if we can survive a loss of $2,100.

We’re getting much closer to opening. Let’s stock our shelves with the latest supplements to help our members get in shape that much faster, and along the way, we might learn a little bit about inventory!

06 - The Whey of Inventory

Previously, we reviewed a simple income statement and saw that unlike the balance sheet that only shows us that we lost money, the income statement demonstrated to us how that money was lost.

Today, let’s learn about inventory. We’ll dive right in and buy some Ascent whey protein powder, which is the protein powder I use, for our fitness center. To make things simple, let’s say we buy ten cases of protein powder for a total of $1,000. How would this change the balance sheet? Can you guess?

Income Statement Balance Sheet 
Sales Revenue Assets 
Expenses Cash120,800.00
Rent(2,000.00)Inventory1,000.00
Insurance(100.00)Prepaid Insurance1,100.00
Total Expenses(2,100.00)Equipment25,000.00
Net Loss(2,100.00)Total Assets147,900.00
    
  Liabilities & Stockholders Equity 
  Bank Loan100,000.00
  Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,100.00)
  Total Equity47,900.00
  Total Liabilities & Equity147,900.00

As you can see above, we traded one asset for another. We used $1,000 in cash to buy $1,000 worth of inventory. This inventory is now sitting on our shelves as protein powder. Makes sense, right?

What would our balance sheet look like if we sold some of our protein powder? It just so happens while pondering this very question that your buff friend Sam barges in to see the progress you’ve been making at the fitness center. He can’t wait to join and asks to purchase one case of protein powder for $200 that cost us $100. Perfect timing! (I can hear what you’re saying already. You’re charging your friend? Let’s face it; we have to make money, and it’s still cheaper for Sam to buy from us than elsewhere because we get a substantial “bulk” discount!) How will this change our balance sheet? As always, try to guess what would happen before scrolling down!

Income Statement Balance Sheet 
Sales Revenue Assets 
Expenses Cash121,000.00
Rent(2,000.00)Inventory900.00
Insurance(100.00)Prepaid Insurance1,100.00
Total Expenses(2,100.00)Equipment25,000.00
Net Loss(2,100.00)Total Assets148,000.00
    
  Liabilities & Stockholders Equity 
  Bank Loan100,000.00
  Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,100.00)
  Total Equity47,900.00
  Total Liabilities & Equity147,900.00

We collected $200 in cash from selling protein powder that cost us $100. But wait a minute, there’s a problem. Our balance sheet isn’t balancing!

Welcome to your first challenge. Before scrolling down, try to figure out where we went wrong. Try to take a step back and think about the story an don’t get mired in the numbers. When you’re ready, head to the next lesson.

07 - The Whey to Sell

Previously, we made our very first sale by selling some of our inventory and saw how that affected our balance sheet. After we made the changes, our balance sheet did not balance. I challenged you to think about why that may be the case? Did you figure it out?

The key is that some transactions affect more than just one financial statement. When we make a sale, we need to record it and its cost. We also have to remember that when we make or lose money, it affects our earnings on the balance sheet.

So far we’ve been looking at a simple income statement that shows us how we go from sales to net income by subtracting out expenses. It follows a straightforward formula: sales - expenses = net income

Let’s add yesterday’s protein power transactions to our income statement. As a reminder, we purchased protein powder from Ascent for $1,000. We then sold Sam $200 of protein that cost us $100.

Income Statement Balance Sheet 
Sales Revenue200.00Assets 
Expenses Cash121,000.00
Protein Powder(100.00)Inventory900.00
Rent(2,000.00)Prepaid Insurance1,100.00
Insurance(100.00)Equipment25,000.00
Total Expenses(2,200.00)Total Assets148,000.00
Net Loss(2,000.00)  
  Liabilities & Stockholders Equity 
  Bank Loan100,000.00
  Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,000.00)
  Total Equity48,000.00
  Total Liabilities & Equity148,000.00

Does anything bother you about this income statement? We are combining the cost of what we sell with the expenses we have every month to keep our doors open. What happens if we sold twice as much protein powder or didn’t sell any at all? Our total expenses would fluctuate quite a bit, and it’s challenging to see how much money we made by selling our product.

The above income statement formula works great for service companies, but it’s not as useful for a merchandising business. A merchandising company buys product, stores it as inventory, and then sells it to make a profit, whereas a service company does not or product sales is a very minimal part of the business.

Merchandising companies separate the cost of inventory, which is called cost of goods sold or COGS from the other expenses. A merchandising income statement follows the format: sales - cost of goods sold = gross profit - expenses = net income

Let’s update our income statement to reflect this:

Income Statement Balance Sheet 
Sales Revenue200.00Assets 
Cost of Goods Sold(100.00)Cash121,000.00
Gross Profit100.00Inventory900.00
Expenses Prepaid Insurance1,100.00
Insurance(100.00)Equipment25,000.00
Rent(2,000.00)Total Assets148,000.00
Total Expenses(2,100.00)Liabilities & Stockholders Equity 
Net Loss(2,000.00)Bank Loan100,000.00
  Total Liabilities100,000.00
Gross Margin:50%My Investment50,000.00
  Earnings(2,000.00)
  Total Equity48,000.00
  Total Liabilities & Equity148,000.00

The new version of our income statement has line items for cost of goods sold and gross profit. The cost of goods sold is the cost that goes into our product sales. In our case, it’s the purchase cost of the protein powder. When we subtract cost of goods sold from sales, we get gross profit. Gross profit shows us how much money we made after subtracting out the cost of the products we’re selling. In our case, that’s $200 (sale price) minus $100 (our purchase cost) leaving us with $100 in gross profit.

We can now see how much money we made from selling our protein powder, and our total expenses are far more predictable since it won’t fluctuate from product costs. Adding cost of goods sold and gross profit to our income statement gives us the ability to calculate a ratio that is vital for us to understand: gross margin.

Gross margin shows us how much we make for every dollar of sales expressed as a percentage. We get gross margin by dividing our gross profit by our sales. In our case, our gross margin is 50%. ($100 / $200 = $0.50.) We now know that for every $1 in protein powder we sell, we make $0.50 in gross profit.

Understanding how our costs of merchandise relate to our sales is critical. But what about our $1,000 purchase from Ascent? Should this be added to our income statement? I’ll leave this one with you to think about as it’s a fundamental concept in accounting and we’ll pick up on it next.

08 - The Matching Game

In the last lesson, we discussed cost of goods sold, and how to calculate gross profit and gross margin. I also challenged you to decide if our total inventory purchase should be added to cost of goods sold. What do you think and why?

Let’s change our income statement to expense the $1,000 purchase this month and see what happens. I think the reason why we do not do this for our fitness center will become clear.

Expensing Incorrectly

Income Statement Balance Sheet 
Sales Revenue200.00Assets 
Cost of Goods Sold(1,000.00)Cash121,000.00
Gross Profit(800.00)Inventory900.00
Expenses Prepaid Insurance1,100.00
Insurance(100.00)Equipment25,000.00
Rent(2,000.00)Total Assets148,000.00
Total Expenses(2,100.00)Liabilities & Stockholders Equity 
Net Loss(2,900.00)Bank Loan100,000.00
  Total Liabilities100,000.00
Gross Margin:-400%My Investment50,000.00
  Earnings(2,900.00)
  Total Equity47,100.00
  Total Liabilities & Equity147,100.00

As you can see, our gross profit from sales is ($800), and our gross margin is -400%!. That would mean we lost money selling part of our inventory to Sam. And the “part of our inventory” is the key. We only sold 10% of our stock to Sam, and we have 90% of our protein powder remaining. To make this even worse, next time we made a sale, our gross margin would be 100% because we already expensed 100% of the cost this month.

The above is called a cash-based system of accounting. Cash-based systems record revenues and expenses when the cash is received or paid out. A cash-based system may work for smaller, private companies, but it won’t work for us or any publicly traded company! We will use the accrual method of accounting because it provides a better sense of what’s going on with our business as demonstrated above. The good news is that accrual accounting is simple to understand, and it gives a better picture of what’s going on with our fitness center.

In accrual accounting, the revenue from selling a service or product is recorded in the period where the service was performed, or the product was sold. In keeping with the fitness center, if we received money from a fitness center member this month for a personal training session to occur next month, we wouldn’t record the personal training revenue until next month.

Costs follow the same rule except for one added detail: We always try to match the expenditure to related revenue first. Think about our protein sales example above. Our inventory cost directly corresponds to our protein powder sales revenue.

If there is no corresponding revenue to match with an expense, we expense the expenditure when it’s consumed. To make this more clear, think about our fitness center’s telephone bill. While our revenues may go up when the phone is ringing off the hook, it doesn’t directly correspond with revenue so we would expense the current bill this month.

Expensing Correctly

Income Statement Balance Sheet 
Sales Revenue200.00Assets 
Cost of Goods Sold(100.00)Cash121,000.00
Gross Profit100.00Inventory900.00
Expenses Prepaid Insurance1,100.00
Insurance(100.00)Equipment25,000.00
Rent(2,000.00)Total Assets148,000.00
Total Expenses(2,100.00)Liabilities & Stockholders Equity 
Net Loss(2,000.00)Bank Loan100,000.00
  Total Liabilities100,000.00
Gross Margin:0.50My Investment50,000.00
  Earnings(2,000.00)
  Total Equity48,000.00
  Total Liabilities & Equity148,000.00

09 - Depreciating our Exercise Equipment

In the last lesson, we discussed accrual-based accounting and decided it’s the right choice for our fitness center, and we matched our related inventory expenses as cost of good sold to revenue. Today, we’re going to perform matching once again by allocating the cost of our exercise equipment to its estimated monthly usage.

You may have heard the term depreciation before. Many believe it’s the loss of value of an asset due to usage, such as a car. While this is not entirely wrong, in accounting, depreciation means cost allocation and not necessarily loss of value.

In accounting, we allocate the cost of a long-lived asset over its useful life. “Long-lived” is the accounting terminology for an asset we’re going to use for more than a year, and “useful life” is the accounting way to say how long we’ll be using it as an asset.

Remember in the previous lesson where it made no sense to allocate 100% of the cost of our protein powder when we only used 10% of it? The same goes for our exercise equipment. Let’s look at the wrong way to do it first.

An overly depreciated income statement

Income Statement Balance Sheet 
Sales Revenue200.00Assets 
Cost of Goods Sold(100.00)Cash121,000.00
Gross Profit100.00Inventory900.00
Expenses Prepaid Insurance1,100.00
Insurance(100.00)Equipment25,000.00
Rent(2,000.00)Total Assets148,000.00
Depreciation(25,000.00)  
Total Expenses(27,100.00)Liabilities & Stockholders Equity 
Net Loss(27,000.00)Bank Loan100,000.00
  Total Liabilities100,000.00
Gross Margin:50%My Investment50,000.00
  Earnings(27,000.00)
  Total Equity23,000.00
  Total Liabilities & Equity123,000.00

Just like the previous inventory example, our income statement now tells us we lost a ton of money, but this substantial loss isn’t an accurate representation of what’s going on at our fitness center.

We’ve estimated that our fitness equipment will have a long-lived life of five years before we replace it. We’ve also determined that we can sell or recycle our used equipment after five years for $1,000. This remaining or resale value at the end of an assets useful life is called salvage value. With this knowledge, let’s keep it simple and allocate the non-salvageable cost of $24,000 equally over the next five years, and we’ll deal with the $1,000 at the end of five years. $24,000 / (5 years * 12 months) = $400.00

We’ll allocate $400 in cost per month on our income statement as shown below.

A correctly depreciated income statement

Income Statement Balance Sheet 
Sales Revenue200.00Assets 
Cost of Goods Sold(100.00)Cash121,000.00
Gross Profit100.00Inventory900.00
Expenses Prepaid Insurance1,100.00
Insurance(100.00)Equipment25,000.00
Rent(2,000.00)Total Assets148,000.00
Depreciation400.00  
Total Expenses(1,700.00)Liabilities & Stockholders Equity 
Net Loss(1,600.00)Bank Loan100,000.00
  Total Liabilities100,000.00
Gross Margin:50%My Investment50,000.00
  Earnings(1,600.00)
  Total Equity48,400.00
  Total Liabilities & Equity148,400.00

We’re now allocating the cost of our equipment over how long we’ll be using it. Spreading out the purchase cost of our equipment as our members us it is more representational of what’s going on at our fitness center. If we’re smart, we’ll be saving our monthly depreciation, or $400 a month, to purchase new equipment at the end of the five years.

Unfortunately, we broke our balance sheet again as the assets don’t match the liabilities and equity. We need to update our balance sheet to reflect the $400 in monthly depreciation.

10 - Accumulated Depreciation

We now know what long-lived assets are and how to allocate their cost via depreciation. Today, we’ll finish depreciating our exercise equipment by tracking the depreciation on our balance sheet.

Do you recall when we sold Sam $200 of protein powder that we purchased it for $100? This sale led us to increase our cash by $200, reduce our inventory from $1,000 to $900, and reduce our net loss from ($2,100) to ($2,000).

To make our profit look more representational of what is really occurring at our fitness center, we decided to depreciate our exercise equipment at a rate of $400 per month after we calculated the equipment’s useful life and salvage value. We listed the depreciation expense on our income statement, which reduced our income by the same amount.

In the process, we broke our balance sheet yet again. Let’s think about why. If we spend $400 in cash, it reduces our cash balance, right? The same goes for “spending” useful life on our equipment. We should be reducing the value that is listed on the balance sheet as we’ve used up one month. Let’s fix this now.

An accumulated balance sheet

Income Statement Balance Sheet 
Sales Revenue200.00Assets 
Cost of Goods Sold(100.00)Cash121,000.00
Gross Profit100.00Inventory900.00
Expenses Prepaid Insurance1,100.00
Insurance(100.00)Equipment25,000.00
Rent(2,000.00)Accumulated Depreciation(400.00)
Depreciation(400.00)Total Assets147,600.00
Total Expenses(2,500.00)  
Net Loss(2,400.00)Liabilities & Stockholders Equity 
  Bank Loan100,000.00
Gross Margin:0.50Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,400.00)
  Total Equity47,600.00
  Total Liabilities & Equity147,600.00

As you can see, our earnings is now reflecting the increased loss from depreciation. We’ve done this before, and it makes sense. When our fitness center loses money, it comes out of our pockets.

What may surprise you is that we didn’t reduce our exercise equipment’s value listed on our balance sheet from $25,000 to $24,600. Instead, we add the depreciation to our first contra asset: accumulated depreciation.

A contra asset acts as a reverse asset. We don’t need to understand the technical details of a contra asset here. We just need to remember to subtract contra assets from our assets instead of adding them.

Accumulated depreciation is the most popular contra asset, and it is well named. It carries the balance of all past, present and future depreciation and it never gets set back to zero – it accumulates.

I want to make one last change to our balance sheet before tomorrow. Businesses don’t list their long-lived assets on their balance sheets. Instead, they sum long-lived assets into a single balance sheet line item called property, plant & equipment (PP&E). Most businesses have many fixed assets, and it’s not practical to list them on a balance sheet. Think furniture, computer equipment, buildings, machinery, etc. We listed exercise equipment originally as it made understanding the concepts more straightforward at first, but we’re slowly but surely taking off the training wheels.

A more realistic balance sheet

Income Statement Balance Sheet 
Sales Revenue200.00Assets 
Cost of Goods Sold(100.00)Cash121,000.00
Gross Profit100.00Inventory900.00
Expenses Prepaid Insurance1,100.00
Insurance(100.00)Propery, Plant & Equipment (PP&E)25,000.00
Rent(2,000.00)Accumulated Depreciation(400.00)
Depreciation(400.00)Total Assets147,600.00
Total Expenses(2,500.00)  
Net Loss(2,400.00)Liabilities & Stockholders Equity 
  Bank Loan100,000.00
Gross Margin:0.50Total Liabilities100,000.00
  My Investment50,000.00
  Earnings(2,400.00)
  Total Equity47,600.00
  Total Liabilities & Equity147,600.00

Now that we have a better understanding of depreciation, you may have realized that even though depreciation affects our profit, it doesn’t actually affect our cash balance at the bank. That’s up next.

11 - Cash Flow is NOT Income

Previously, we learned that we don’t directly subtract depreciation from our property, plant and equipment (PP&E) assets. Instead, we add the depreciation to a contra asset called accumulated depreciation. We also touched on the fact that depreciation doesn’t affect our cash. While our profit performance was reduced by $400 due to depreciation, which we’ve determined makes sense as depreciating our assets gives us a better representation of what’s going on with our business, we’re not spending cash on depreciation. Let’s talk a little more about cold hard cash. Cash is the lifeblood of any business. A business with too many cash outflows and not enough cash inflows will soon close its doors. To keep track of our cash, we’re going to add a new statement: The statement of cash flows. The statement of cash flows allows us to keep our finger on the pulse of our business by understanding where our cash is coming from and going to. It’s very similar to a bank statement or ledger where it tracks when money comes in and when money goes out, and it can differ significantly from profit performance represented on the income statement.

While our income statement shows us we lost ($2,400) for the month, our cash balance increased by $121,000! And this example brings me to two essential points:

  1. Cash flows and net income are highly correlated over the long term, but they may diverge significantly in the medium and short-term.
  2. Cash flows only change when we spend or receive cash.

Let’s take a look at the statement of cash flows for our fitness center.

Cash Flow Statement 
Operating Activities 
Net Loss(2,400.00)
Non-Cash Expenses 
Depreciation400.00
Changes in Operating Assets & Liabilities 
Inventory(900.00)
Prepaid Insurance(1,100.00)
Cash Flow from Operations(4,000.00)
  
Investing Activities 
PP&E Expenditures(25,000.00)
Cash Flow from Investing(25,000.00)
  
Financing Activities 
Bank Loan100,000.00
My Investment50,000.00
Cash Flow from Financing150,000.00
  
Cash at Beginning of Month 
Cash at End of Month121,000.00
Increase/(Decrease) in Cash121,000.00
Cash & Cash Equivalents121,000.00

The cash flow statement helps readers understand where the cash is going. We start with net income, we then list our non-cash expenses and adjustments, and then we categorize the rest of the cash inflows and outflows into operating, investing and financing activities.

Operating activities are business activities that generate revenue and related expenses. As we’ll see later, this includes many of the items on our income statement and the current assets of our balance sheet.

Investing activities are business activities that involve acquiring and selling long-lived assets. As a reminder, long-lived assets are assets that have an economic benefit over multiple accounting periods where a period is generally a year.

Financing activities result when we increase, decrease or change our equity or debt levels. It’s time to open the fitness center. Before we do, let’s prepare for the opening day by taking one last look at the current state of the business by looking at our financial statements.

12 - Preparing for Opening Day

Previously, we learned that cash flow and income are very different things. Today, let’s look at the current state of our financial statements to prepare for the new month and opening day.

We’ve covered everything that’s here already so if you don’t understand it, please go back and brush up on what you’re missing. As you review, try to see how the three financial statements connect and ask yourself the “why” behind the connection.

There’s a reason why I inserted the cash flow statement between the balance sheet and the income statement on the associated Excel file. If you think about it, we make sales and pay expenses, and these transactions drive our cash flows, and those cash flows update our balances. As you can see, each item on the cash flow statement has a corresponding balance sheet line item.

For instance, our net loss of ($2,400) shows up on the bottom line of our income statement, it is the starting point for our statement of cash flows and ends up on our balance sheet under earnings. Logically, this makes sense. Our owners lost money this month because our business lost money.

Income Statement 
Sales Revenue200.00
Cost of Goods Sold(100.00)
Gross Profit100.00
Expenses 
Insurance(100.00)
Rent(2,000.00)
Depreciation(400.00)
Total Expenses(2,500.00)
Net Loss(2,400.00)
  
Gross Margin:0.50
Cash Flow Statement 
Operating Activities 
Net Loss(2,400.00)
Non-Cash Expenses 
Depreciation400.00
Changes in Operating Assets & Liabilities 
Inventory(900.00)
Prepaid Insurance(1,100.00)
Cash Flow from Operations(4,000.00)
  
Investing Activities 
PP&E Expenditures(25,000.00)
Cash Flow from Investing(25,000.00)
  
Financing Activities 
Bank Loan100,000.00
My Investment50,000.00
Cash Flow from Financing150,000.00
  
Cash at Beginning of Month-
Cash at End of Month121,000.00
Increase/(Decrease) in Cash121,000.00
Cash & Cash Equivalents121,000.00
Balance Sheet 
Assets 
Cash121,000.00
Inventory900.00
Prepaid Insurance1,100.00
Propery, Plant & Equipment (PP&E)25,000.00
Accumulated Depreciation(400.00)
Total Assets147,600.00
  
Liabilities & Stockholders Equity 
Bank Loan100,000.00
Total Liabilities100,000.00
My Investment50,000.00
Earnings(2,400.00)
Total Equity47,600.00
Total Liabilities & Equity147,600.00

In the next lesson, we’ll start the new month tomorrow by finally opening our fitness center!

13 - Opening Day

In the previous lesson, we took time to review what we’ve learned so far and prepared for opening day. Today was opening day. How did we do?”

The day turned out better than expected! We kicked off the start of the month with fifty fitness enthusiasts signing up for a monthly membership at $50 per month paid in cash. Also, Sam stopped by again and purchased $600 worth of protein powder that cost us $300. Since it was a bulk order, we allowed Sam to buy on credit. Wait, what is credit?

When we let someone purchase something on credit, we give them the product or service in advance of payment. In this case, we gave Sam an invoice stating he had to pay within 30 days, or net 30 for short. The rules around how Sam has to pay us back are called the payment terms or just terms for short. How do we keep track of the mini-loan we gave Sam and other customers? We create a new asset account called accounts receivable.

Accounts receivable, or A/R for short, is just a bucket for all the money we’ve loaned to customers to purchase our products and services in advance of payment. How do our financial statements change from the above transactions? Keep in mind this is the start of a new month. As always, take some time to think about your answers vs. going right to the solution!

Income Statement 
Sales Revenue 
Membership Revenue2,500.00
Product Revenue600.00
Total Sales Revenue3,100.00
Cost of Goods Sold(300.00)
Gross Profit2,800.00
Expenses 
Insurance-
Rent-
Depreciation-
Total Expenses-
Net Income2,800.00
  
Gross Margin:0.90
Cash Flow Statement 
Operating Activities 
Net Loss2,800.00
Non-Cash Expenses 
Depreciation-
Changes in Operating Assets & Liabilities 
Accounts Receivable(600.00)
Inventory300.00
Prepaid Insurance 
Cash Flow from Operations2,500.00
  
Investing Activities 
PP&E Expenditures-
Cash Flow from Investing-
  
Financing Activities 
Bank Loan-
My Investment-
Cash Flow from Financing-
  
Increase/(Decrease) in Cash2,500.00
Cash at Beginning of Month121,000.00
Cash at End of Month123,500.00
Balance Sheet 
Assets 
Cash123,500.00
Accounts Receivable600.00
Inventory600.00
Prepaid Insurance1,100.00
Propery, Plant & Equipment (PP&E)25,000.00
Accumulated Depreciation(400.00)
Total Assets150,400.00
  
Liabilities & Stockholders Equity 
Bank Loan100,000.00
Total Liabilities100,000.00
My Investment50,000.00
Retained Earnings400.00
Total Equity50,400.00
Total Liabilities & Equity150,400.00

Notice that because we started a new month, the income and cash flow statement values were set back to zero, and the balance sheet accounts were not. You may remember that the income and cash flow statements look at changes over time, and the balance sheet looks at a single point in time.

For instance, when we ask ourselves profit performance questions like “how much money did we make this month?”, we shouldn’t have last month’s sales numbers affecting this month’s sales. The same goes for cash flow. But when we ask financial position questions like “how much money do we have in the bank?”, our bank balance better carry over from month to month! To highlight this, I’ve renamed the balance sheet earnings account to retained earnings. Retained earnings are the earnings we’ve accumulated over time. If in total we lost money since starting the business, we wouldn’t call it retained earnings because we didn’t earn any money. Instead, it is called accumulated deficit, which is just a fancy name for the amount of money we’ve lost since starting the business.

Okay, back to the original question on how the new members and Sam’s purchase affected our financial statements.

The membership enrollment is easy. Our membership revenue, collected in cash, increased by $2,500 and consequently our cash flow increased by the same amount. This makes sense, right? If we collect $2,500 in cash, our cash flow will go up by the same amount, which will then cause our cash balance at the bank and balance sheet to increase by the same amount.

The purchase of protein powder by Sam was a little more challenging. Remember the accrual accounting matching principle? We have to allocate both the revenue and the cost of that revenue anytime we sell inventory:

  1. The sale of protein powder on credit caused our product revenue, and accounts receivable to both go up by $600.
  2. The transaction cost us $300 in inventory, which is our protein powder purchase price for the protein we sold to Sam.

Sam’s purchase did not affect cash, but it did show up on the income statement. How do we have the correct cash balance of $2,500 showing up as the increase to cash so far for the month? Take time to think about it.

The ending point on our income statement is the starting point for our cash flow statement. We then reverse anything on the income statement that affected profit but didn’t affect cash. In our case, we have two items:

  1. Accounts Receivable
  2. Inventory

Let’s consider Sam’s purchase using store credit. While the sale increased our profit by $600, we didn’t collect the cash yet, so we need to subtract that amount from our profit to get to cash. How about inventory? When Sam purchased the protein powder, the cost of the protein powder showed up as the cost of goods sold (COGS) and lowered our profit by $300; however, we didn’t spend any cash on inventory as we purchased our stock earlier in bulk. Accordingly, we have to add $300 to our profit to get to cash.

When we take our profit and add back the transactions that didn’t affect cash, we get to the increase in cash for the month: $2,800 - 600 + 300 = $2,500, which then is added to our bank account, or in our case, the balance sheet.

As you may recall from the previous lesson, all of the cash flow changes for the month are added to the balance sheet balances. This makes logical sense, right? The balance sheet contains the balances of all of our accounts up until last month, and then the changes in cash for this month are added to the balances to get the most up-to-date numbers.

Whew! That was a lot. If you understood all of that, congratulations! You’re well on your way to becoming a financial statement ninja. If not, hang in there with me, and we’ll get you to kung fu status, too.

14 - Purchasing Inventory on Credit

Previously, we had a successful opening day. We had a bunch of new members and sold our buff friend Sam protein powder on credit. The sale created an asset on our books called accounts receivable as we expect to receive the money within 30 days.

Today, we’re in Sam’s seat. Since we’re starting to get low on protein powder, we decided to purchase $2,000 worth of Ascent protein powder on credit instead of paying cash. We’ll receive the protein powder today and pay Ascent back in 30 days. To keep track of this, Ascent will create an accounts receivable on their books, and we’ll create an accounts payable on ours. How do you think our financial statements will change?

Income Statement 
Sales Revenue 
Membership Revenue2,500.00
Product Revenue600.00
Total Sales Revenue3,100.00
Cost of Goods Sold(300.00)
Gross Profit2,800.00
Expenses 
Insurance-
Rent-
Depreciation-
Total Expenses-
Net Income2,800.00
  
Gross Margin:0.90
Cash Flow Statement 
Operating Activities 
Net Loss2,800.00
Non-Cash Expenses 
Depreciation-
Changes in Operating Assets & Liabilities 
Accounts Receivable(600.00)
Inventory(1,700.00)
Prepaid Insurance-
Accounts Payable2,000.00
Cash Flow from Operations2,500.00
  
Investing Activities 
PP&E Expenditures-
Cash Flow from Investing-
  
Financing Activities 
Bank Loan-
My Investment-
Cash Flow from Financing-
  
Increase/(Decrease) in Cash2,500.00
Cash at Beginning of Month121,000.00
Cash at End of Month123,500.00
Balance Sheet 
Assets 
Cash123,500.00
Accounts Receivable600.00
Inventory2,600.00
Prepaid Insurance1,100.00
Propery, Plant & Equipment (PP&E)25,000.00
Accumulated Depreciation(400.00)
Total Assets152,400.00
  
Liabilities & Stockholders Equity 
Bank Loan100,000.00
Accounts Payable2,000.00
Total Liabilities102,000.00
My Investment50,000.00
Retained Earnings400.00
Total Equity50,400.00
Total Liabilities & Equity152,400.00

Our income statement didn’t change because we didn’t sell anything. Even though we added accounts payable to our cash flow statement, our cash flow didn’t change because we purchased on credit.

Our balance sheet was affected as we now have $2,000 more worth of protein powder inventory on our shelves for which we still owe our vendor. We created an account called accounts payable to track this transaction and future liabilities created when we receive a product or service in advance of payment.

Logically this all makes sense because no cash changed hands. The balance at the bank would remained unchanged as very simply: cash flow only changes when we use cash.

Ascent did give us a more significant discount on this purchase. Each case cost us $100 on our previous purchase and $80 on this one. Do you think we need to account for this?

15 - Assigning Cost to Inventory

Previously, we created an accounts payable to keep track of our purchase on credit for additional inventory. I also pointed out that we paid two different prices for our inventory. Do we need to account for this, and if so, how? Welcome to today’s lesson.

With our first purchase of protein powder, we acquired 10 cases for $1,000. On Friday, we received a more substantial volume discount and stocked our shelves with 25 cases for $2,000. The cost of each case with our first purchase is $100 and $80 for our second. When Sam comes in to order more protein, what is the cost of our protein powder? Do we track each one individually; or is our cost $100, perhaps it is $80 or is it somewhere in-between?

If we were selling something expensive such as cars or airplanes, specific identification, or tracking the cost of each item sold, would make sense. For protein powder, we don’t need that level of detail.

We could use a first-in, first-out (FIFO) cost flow assumption. This method associates cost in the order inventory was purchased meaning that the first 10 cases will cost us $100 and the next 25 cases will cost us $80. We could use a last-in, first-out (LIFO) cost flow assumption causing the next 25 cases to cost us $80 and then the remaining cases to cost us $100 each.

Instead, let’s use a weighted average approach. We purchased 10 cases at $100 and 25 cases at $80. This would give us a weighted average of: ($1,000 + $2,000) / 35 = $85.71.

Why is this important? It affects our gross profit margins. We sell each case for $200. In the FIFO approach, our next case would cost $100 giving us a gross margin of 50% and a gross profit of $100. With the LIFO approach, our next case would cost $80 giving us a gross margin of 60% and a gross profit of $120. Since we’re using a weighted average, the next case sold would cost us $85.71 giving us a gross margin of 57% and a gross profit of $114.29. 10% of profit margin from just changing our inventory accounting method is substantial. So why would companies choose different methods? There are two:

  1. Reporting
  2. Taxes

From a reporting perspective, managers are incentivized to do their best as bonuses, and other perks are often tied to company profitability. From a tax perspective, managers are incentivized to report lower profits because lower profits lead to lower taxes having to be paid, saving the company money. Even though it’s permitted in the U.S., there are some standards (IFRS) that prohibit the use of LIFO because it can distort profits in more than just the ways stated above. For now, we’re happy using the weighted average approach at our fitness center as we believe it gives us the best representation of our true profitability.

16 - Adding Recurring Expenses

Now that we understand inventory costing methods. Let’s get back to work and update our financial statements by filling in our recurring operating expenses. Before entering our expenses, our latest income statement shows a profit of $2,800! Financial statements can give us a false sense of what’s going on if all of the transactions for that period have not been entered. Let’s get a better representation of how this month is going by filling in our recurring expenses, which will be an exercise for you.

Update our financial statements with this month’s rent ($2,000), insurance ($100) and depreciation ($400) expenses. This exercise should be more straightforward as we’ve seen all of these transactions before:

  1. Paying rent reduces our net income, cash, and cash flow by $2,000.
  2. Paying insurance reduces our net income, but it does not affect cash at all because we prepaid this earlier, so we add it back on the cash flow statement causing it to drop by the same amount on the balance sheet.
  3. Our depreciation expense reduces our net income, but it’s a non-cash expense, so we add it back on our cash flow statement. This increases our accumulated depreciation contra asset.
Income Statement 
Sales Revenue 
Membership Revenue2,500.00
Product Revenue600.00
Total Sales Revenue3,100.00
Cost of Goods Sold(300.00)
Gross Profit2,800.00
Expenses 
Insurance(100.00)
Rent(2,000.00)
Depreciation(400.00)
Total Expenses(2,500.00)
Net Income300.00
  
Gross Margin:0.90
Cash Flow Statement 
Operating Activities 
Net Loss300.00
Non-Cash Expenses 
Depreciation400.00
Changes in Operating Assets & Liabilities 
Accounts Receivable(600.00)
Inventory(1,700.00)
Prepaid Insurance100.00
Accounts Payable2,000.00
Cash Flow from Operations500.00
  
Investing Activities 
PP&E Expenditures-
Cash Flow from Investing-
  
Financing Activities 
Bank Loan-
My Investment-
Cash Flow from Financing-
  
Increase/(Decrease) in Cash500.00
Cash at Beginning of Month121,000.00
Cash at End of Month121,500.00
  
Cash Balances:Yes
Balance Sheet 
Assets 
Current Assets 
Cash121,500.00
Accounts Receivable600.00
Inventory2,600.00
Prepaid Insurance1,000.00
Total Current Assets125,700.00
  
Long-Term Assets 
Propery, Plant & Equipment (PP&E)25,000.00
Accumulated Depreciation(800.00)
Total Long-Term Assets24,200.00
Total Assets149,900.00
  
Liabilities & Stockholders Equity 
Current Liabilities 
Accounts Payable2,000.00
Total Current Liabilities2,000.00
  
Long-Term Liabilities 
Bank Loan100,000.00
Total Long-Term Liabilities100,000.00
  
Total Liabilities102,000.00
  
Equity 
My Investment50,000.00
Retained Earnings(2,100.00)
Total Equity47,900.00
Total Liabilities & Equity149,900.00

Did you figure it out successfully? If so, you’re well on your way. If not, that’s okay, too. We’ll get more practice as we continue with our fitness center.

17 - Updating Our Short-Term Thinking

Now that our financial statements are reflecting our recurring operating expenses, we have a picture of what’s going on with our fitness center. Today, we’re going to update how we think about our balance sheet.

The balance sheet seeks to help us answer financial positions questions such as:

  1. Can pay our debts (solvency)?
  2. How quickly can we turn our assets into cash without affecting the asset’s price (liquidity)?
  3. How does our company finance its long-term operations and growth (capital structure)?

By classifying our assets and liabilities into short-term and long-term, we can more easily answer the above questions. Short-term, also known as current, is the term given to any asset or liability that will be used or paid within one year. As we discussed when purchasing our exercise equipment, anything that provides us with an economic benefit over multiple years is considered long-term.

Our assets and liabilities are now listed in order of liquidity and categorized into current (short-term) and long-term. This balance sheet format helps us perform ratio analysis. Ratio analysis is the fancy term for when we divide one number by another to evaluate a relationship between two areas of our business. For instance, the current ratio helps us determine if we’re going to be able to pay this year’s bills by taking all of the current assets and dividing them by all of the current liabilities. Remember, current liabilities are liabilities due this year. Our fitness center’s current ratio is: $125,700 / $2,000 = 62.85 The current ratio for our fitness center tells us we are in virtually no danger of not being able to pay this year’s bills. In fact, we could pay them 62.85 times! We’ll get more into ratio analysis later. For now, just know that we’re going to stay in business.

Now that we’re separating assets and liabilities into long and short-term, that reminds us that we need to worry about that loan from Southwest.

18 - Loans and Interest

Previously, we categorized current and long-term assets and liabilities. We also introduced ratio analysis to see how likely we would be able to pay this year’s bills by reviewing our fitness center’s current ratio. Today, we’re going to discuss interest.

When negotiating with Southwest Bank, we agreed to pay our loan quarterly or every three months. That’s the end of next month! As they say, time flies when you’re having fun! Let’s refresh the bank loan details.

The principal amount, which is just a fancy name for the amount we borrowed, is $100,000. We borrowed $100,000 at a 3.68345% interest rate paid quarterly over ten years. Our loan terms conveniently equate to a quarterly payment of $3,000 for the life of the loan according to this loan payment calculator.

Interest is probably a term you’ve heard of before. It’s the charge for borrowed money. The interest rate is stated as an annual percentage of the principal amount even though loans can be longer or shorter than a year. Percent means “per hundred” so a 1% interest rate means one dollar for every hundred dollars borrowed.

Loans are paid using blended payments. A blended payment is the term used when the payment amount includes both interest and some of the principal. Do you think our loan from Southwest Bank is a long-term or a short-term liability?

Sorry for the trick question. It’s both, and congrats if you got that one right! The loan period is ten years but the payments that are due within one year of the balance sheet date is considered current.

Separating what’s current and what’s due in future years helps us better understand our fitness center’s financial obligations. Our current ratio doesn’t do us any good if we don’t have everything we owe this year factored in!

In year one, we will pay $8,435.53 in principal and $3,564.47 in interest. Let’s update our balance sheet to reflect the current portion of the loan.

Balance Sheet 
Assets 
Current Assets 
Cash121,500.00
Accounts Receivable600.00
Inventory2,600.00
Prepaid Insurance1,000.00
Total Current Assets125,700.00
  
Long-Term Assets 
Propery, Plant & Equipment (PP&E)25,000.00
Accumulated Depreciation(800.00)
Total Long-Term Assets24,200.00
Total Assets149,900.00
  
Liabilities & Stockholders Equity 
Current Liabilities 
Accounts Payable2,000.00
Current Portion of Bank Loan8,435.53
Total Current Liabilities10,435.53
  
Long-Term Liabilities 
Bank Loan91,564.47
Total Long-Term Liabilities91,564.47
  
Total Liabilities102,000.00
  
Equity 
My Investment50,000.00
Retained Earnings(2,100.00)
Total Equity47,900.00
Total Liabilities & Equity149,900.00

We can now easily see the $8,435.53 of principal that is due in the next twelve months. We can check our work by adding our short-term loan balance to the long-term portion: $8,435.53 + $91,564.47 = $100,000, which was our original loan amount. But what about the $3,564.47 in interest that is also due this year? Believe it or not, the balance sheet does not list future interest payments. The only interest recorded on the balance sheet is interest that is due but not yet paid called accrued interest payable. Accrued is the accounting term used for recording something before paying it. Accruing liabilities gives us a more accurate financial picture. Just because we haven’t paid something doesn’t mean we don’t owe it.

To make this more concrete, think about a sales commission. Many sales reps earn a commission on sales. The company owes the sales reps money even though it may not pay the commission for a few months. It’s in the best interest of the company to track this liability for planning purposes and to make sure they can pay their star sales reps the commission they deserve.

Now it’s exercise time. Here’s your challenge.

Our fitness center is in its second month of operation. We said earlier that we’re being charged interest daily. While we won’t update our accrued interest liability every day, as that wouldn’t be a good use of our time, we will update it each month. With this in mind, and knowing we’ve borrowed Southwest Bank’s money for one month so far, how does this affect our financial statements? We won’t worry about this month’s borrowing just yet as we’re only halfway through. Just worry about last month’s statements. Good luck!

19 - Accruing Interest On Our Loan

In the last lesson, we discussed current and long-term loan obligations, and how to accrue interest. I also asked you to flex your financial statement muscles with an exercise challenge. How did you do?

To solve the challenge, you needed to open up the amortization calculator, enter the details of our loan, and click the create amortization schedule.

The amortization schedule shows us that our first quarterly payment of $3,000 includes $2,080 in principal and $920 of interest. Since only one month has passed and not one quarter, we divide the amounts by three. This division gives us a payment amount of $1,000 including $693.33 of principal and $306.67 in interest. With this information, we can update our financial statements.

The trick to solving this problem is to remember that last month’s net income would be lower due to interest expense, which would affect our retained earnings, and that no cash was paid out.

Balance Sheet 
Assets 
Current Assets 
Cash121,500.00
Accounts Receivable600.00
Inventory2,600.00
Prepaid Insurance1,000.00
Total Current Assets125,700.00
  
Long-Term Assets 
Propery, Plant & Equipment (PP&E)25,000.00
Accumulated Depreciation(800.00)
Total Long-Term Assets24,200.00
Total Assets149,900.00
  
Liabilities & Stockholders Equity 
Current Liabilities 
Accounts Payable2,000.00
Accrued Interest306.67
Current Portion of Bank Loan8,435.53
Total Current Liabilities10,742.20
  
Long-Term Liabilities 
Bank Loan91,564.47
Total Long-Term Liabilities91,564.47
  
Total Liabilities102,306.67
  
Equity 
My Investment50,000.00
Accumulated Deficit(2,406.67)
Total Equity47,593.33
Total Liabilities & Equity149,900.00

Instead of recreating last month’s income statement, I just updated the accounts that would have been affected instead. I reduced the accumulated deficit by last month’s interest expense amount of $306.67, and because we didn’t pay out anything in cash, I created an accrued interest category under the short-term liabilities section to record the amount until we pay it out in cash to Southwest Bank.

When thinking about how statements would be affected, I start at the top of the income statement, then think about cash flows, and finally tally the results on the balance sheet.

In this instance, I would start by thinking we would have an interest expense on the income statement that would reduce our net income. Because no cash was spent and to simplify things, we can skip the cash flow statement and go directly to the balance sheet. Our interest expense needs to be paid, but we won’t pay that out until the end of next month so we’ll create an account to hold the amount and reduce our retained earnings by that amount. Finally, we’ll check to see if the balance sheet is in balance. If you follow these steps and use a pen, paper, or Excel, it makes these problems much more manageable.

20 - Deferred Revenue

Many of our members want to ramp up their progress by getting expert help. Sam, who is a certified personal trainer and an avid consumer of protein shake, has expressed interest in setting up shop at our gym. After discussions with Sam, we’ve come to an agreement that we’ll let him use our gym for his professional training practice and split the profits 60/40. Sam charges $50 per session, which means he’ll make $30 and pay us $20 to use our gym and equipment.

We introduce Sam to many of our members and ten of them sign up for a two-month package, which is 20 sessions or 10 sessions per month. The first 10 sessions will happen this month and the second set of sessions will occur next month. They pay Sam $1,000 for the full two months upfront, and Sam then pays us our share of $400.

We’re going to have to update our financial statements to reflect the new source of income, but before we do, how should we record it?

When we receive money in advance of performing the related service, it’s considered deferred revenue. Deferred revenue is a liability. Imagine if Sam had a customer cancel on him. Would we charge Sam for using the facility even though he didn’t use it? No. We wouldn’t. Technically, we should only recognize revenue when Sam uses our gym for the personal training, but to keep it simple, we’ll recognize this month’s now and the rest will be deferred revenue, which we’ll recognize next month.

With that bit of information, we can now update our financial statements.

Income Statement 
Sales Revenue 
Membership Revenue2,500.00
Product Revenue600.00
Rental Revenue200.00
Total Sales Revenue3,300.00
Cost of Goods Sold(300.00)
Gross Profit3,000.00
Expenses 
Insurance(100.00)
Rent(2,000.00)
Depreciation(400.00)
Total Expenses(2,500.00)
Net Income500.00
  
Gross Margin:0.91
Cash Flow Statement 
Operating Activities 
Net Income500.00
Non-Cash Expenses 
Depreciation400.00
Changes in Operating Assets & Liabilities 
Accounts Receivable(600.00)
Inventory(1,700.00)
Prepaid Insurance100.00
Accounts Payable2,000.00
Deferred Revenue200.00
Cash Flow from Operations900.00
  
Investing Activities 
PP&E Expenditures-
Cash Flow from Investing-
  
Financing Activities 
Bank Loan-
My Investment-
Cash Flow from Financing-
  
Increase/(Decrease) in Cash900.00
Cash at Beginning of Month121,000.00
Cash at End of Month121,900.00
Balance Sheet 
Assets 
Current Assets 
Cash121,900.00
Accounts Receivable600.00
Inventory2,600.00
Prepaid Insurance1,000.00
Total Current Assets126,100.00
  
Long-Term Assets 
Propery, Plant & Equipment (PP&E)25,000.00
Accumulated Depreciation(800.00)
Total Long-Term Assets24,200.00
Total Assets150,300.00
  
Liabilities & Stockholders Equity 
Current Liabilities 
Accounts Payable2,000.00
Deferred Revenue200
Accrued Interest306.67
Current Portion of Bank Loan8,435.53
Total Current Liabilities10,942.20
  
Long-Term Liabilities 
Bank Loan91,564.47
Total Long-Term Liabilities91,564.47
  
Total Liabilities102,506.67
  
Equity 
My Investment50,000.00
Accumulated Deficit(2,206.67)
Total Equity47,793.33
Total Liabilities & Equity150,300.00

We’ll follow the process I outlined in the previous lesson.

We add rental revenue to our income statement increasing our net income by $200. This additional net income flows through to the top line of the cash flow statement increasing it by $200.

We received $400 in cash so our cash flow will change by $400. The remaining $200 of the cash, which didn’t flow through from the income statement, is captured in deferred revenue causing our increase in cash at the bottom of the cash flow statement to equal $400, which is exactly what we expected.

The bottom of our cash flow statement flows to the top of our balance sheet. Our balance sheet’s cash position has increased by $400 causing our total assets to increase by $400. We know that the $400 increase needs to be matched on the liabilities and equities side in order for the balance sheet to stay in balance. The $200 in deferred revenue from the cash flow statement is added to an equivalent liability, and the $200 in net income reduces our accumulated deficit causing our total liabilities and equities to be increased by $400, putting our balance sheet in balance.

21 - Gross Income, Operating Income, EBIT, EBT, and Net Income

When looking at a business, there’s many levels of income that helps us understand how profitable our business is at different “stages”. I’ll list them in order and then discuss each:

  1. Gross income
  2. Operating income
  3. Earnings before interest & taxes (EBIT)
  4. Earnings before taxes (EBT)
  5. Net Income

Gross income is something we already understand as we’ve covered it previously. It’s revenues - cost of goods sold = gross income. It tells us how much we’ve made before operating and non-operating expenses.

Operating income is money left over after all ordinary business expenses. It’s revenue - cost of goods sold - operating expenses = operating income. Operating income is nice as it allows you to compare the income of companies in a more apples-to-apples way and we’ll use it extensively when learning how to value companies.

Earnings before interest and taxes, while very closely related to operating income, includes non-operating income and expenses. Non-operating income and expenses are the gain or loss from activities that are not part of every day operations. It’s revenue - cost of goods sold - operating expenses - non-operating expenses + non-operating income = EBIT.

Earnings before taxes is EBIT minus interest expense. Interest expenses are not considered an operating expense as two identical companies could adjust its debt structure and not Interest Expense isn’t considered an operating expense. Subtracting interest from earnings before interest and taxes gives us, you guessed it, EBT or earnings before taxes.

ET, the least alien of all of the income measures, otherwise known as net income, net earnings, net profit and the bottom line, is found by subtracting taxes from EBT. It’s revenues - cost of goods sold - operating expenses - non-operating expenses + operating expenses - interest expenses + interest income - taxes = net income.

To date, we’ve only been discussing net income; however, we’re near the end of month two of running our fitness center so let’s update our accrued interest to Southwest.

To be continued…

leo

Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.