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Welcome to the Finance Storyteller series. I'm here to make business strategy and finance enjoyable and easier to understand. In this video we're going to cover the financial terms EBIT and EBITDA. Let me give you some context so that you know where EBIT and EBITDA fit in. There are three financial statements. The balance sheet and overview of what we own and what we owe at a point in time. The income statement and overview of the profit or income jet you generate during a period. And the cash flow statement and overview of how much cash you generate and where you spend your cash during a period. EBIT and EBITDA are income statement metrics. EBIT is earnings before interest and taxes. EBITDA is earnings before interest, taxes, depreciation and amortization. Earnings is the same as income or profit. The word before suggests that we're excluding certain items from our operational performance metric. Interest is excluded as it depends on your financing structure. How much did you borrow and at what interest rate? Taxes are excluded because it depends on the geographies that you work in. And the arbitration are sometimes excluded because they depend on the historical investment decisions that the company has made. Not the current operating performance. Let me show you an overview of an income statement or profit and loss statement so that you know where EBITDA and EBIT fit in. Revenue minus cost of sales equals gross profit. Gross profit minus SGNA and R&D equals EBITDA. EBITDA minus depreciation and amortization equals EBIT. EBIT minus interest and taxes equals net income. Please be aware that different companies use different terminology. So what you see here might be different from what your company is using. Also, not every company reports both on EBITDA as well as EBITDA. EBITDA is commonly used as a metric in very capital intensive industries like manufacturing, trucking, oil and gas and telecom. Service heavy industries like consultancy wouldn't even bother splitting out the two. What is depreciation and how does that work? Let's assume you want to buy a truck for your company to deliver your products. You spend $100,000 to buy it. What happens on your financial statements is that cash goes down by $100,000. Your fixed assets or plant and equipment go up by $100,000. It would be incorrect to book the full $100,000 straight away as a cost for the current year because you're going to use the truck for multiple years. That's when depreciation comes up. Let's assume that the truck has a useful economic life of five years and has no residual value. If you use straight line depreciation, you book 20,000 per year in depreciation. The value of the asset on the balance sheet goes down by 20,000 per year and in the income statement you charge this 20,000 as an expense. Let's look at an example of using EBITDA and EBITDA in financial reporting. I took the 2015 and a report of the Merch Group, a company headquartered in Denmark and operating globally. They report in US dollars. Their best known business is Merch line, which is the largest container shipping company. They are also active in areas like oil and gas, terminals and drilling. Merch's revenue in 2015 was 15% lower than the year before and the income or net profit was down by 82%. But as net income the most relevant way to measure their profitability performance, Merch gives you the choice to also evaluate profitability at other levels. EBITDA was down 68%, and EBITDA was down 24%. Depreciation and amortization are sometimes referred to as fixed costs. They don't go up and down with the number of units that you sell, but they are driven by the investments that you have made and the number of years that you use those assets. In the case of a company like Merch, which operates in a capital intensive industry, depreciation is a huge number, $8 billion in 2015, almost 20% of revenue. Looking at the EBITDA as well as the EBIT performance gives you more information than looking at EBITDA alone. What a business of finance people use EBITDA for is often mentioned as part of M&A or Merch's and Acquisitions news. The quick and dirty way to calculate the value of a company is by using a multiple of EBITDA. This can help you to get to a ballpark number, but I would advise to always do a more thorough analysis and a more thorough evaluation of a company as there are a lot of ifs connected to using an EBITDA multiple. You are assuming the profitability and the industry doesn't change, you exclude the impact of working capital, which could go up dramatically for a finance growing company, and you exclude the cash that you need for capital expenditures on an ongoing basis for the company. In summary, what is EBITDA? EBITDA is earnings before interest and taxes. EBITDA is earnings before interest, taxes, depreciation and amortization. Both EBITDA and EBITDA are measures of profitability along with terms like gross profit and net income. EBITDA is a meaningful metric for capital intensive industries. I hope you have enjoyed this finance storyteller video. Thank you for watching. Please let me know what you think in the comments section and connect on my blog, LinkedIn, Twitter or YouTube. |
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Burning Spurshare or EPS? How do I calculate EPS? Is EPS the same as dividend per share? These are the questions we will look at in this final storyteller video. Let's take an example of EPS from a very well known company. Do you know of any company that had 216 billion in revenue in 2016 and 46 billion in income? You guessed it right, Apple. How do we calculate Apple's EPS? The formula for the earnings per share is to take the net income and divide it by the number of shares. EPS is there for the proportional part of total profits that is attributable to you if you own one unit of a company's stock. Apple's net income was 45.7 billion, but how many shares did Apple have on average in 2016? There are two numbers at the bottom of the page, the basic number of shares and the diluted number of shares. What is the difference between these two? The word diluted gives you the way. If you have ever taken a science class, you probably have worked on diluting the active ingredient in a fluid to make its effect weaker. That's pretty much the same as what is happening when you look at diluted EPS. The effect of dilution has been taken into account. The basic number of shares is the number that currently exists. The number below it is the number that could exist if all convertible securities were exercised at the earliest point in time. Things like stock options, convertible debt and warrants. So let's calculate basic EPS first. Take the 45.7 billion of net income and divide by 5.47 billion shares to get to $8.35 per share. Next we calculate diluted EPS. We once again take the 45.7 billion of net income in the numerator, but this time we divide by 5.5 billion of what is often called common stock and common stock equivalence. We get to $8.31 of diluted EPS. Is EPS the same as dividend per share? No it is not. EPS is the proportional part of total profits that is attributable to you if you own one unit of a company's stock. Dividend per share is what is actually paid out by the company. As you see in this chart, Apple has a dividend payout of 26% of its profit. The rest of the cash is kept inside the company for future use, but that's the topic of another video. On the Finance Storyteller YouTube channel, you can find lots of well-researched videos explaining business, finance and accounting topics. Please subscribe to the Finance Storyteller channel and take the time to like the video and comment below. On average I post one new video per week. If you subscribe to the channel, you will be the first to see it. |
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Welcome to the Finance Storyteller series. In this video we are going to cover a key term for the world of corporate finance, free cash flow. We will take an in-depth look at common and alternative definitions of free cash flow, compare the profit view and the cash flow view of looking at the company's performance, and we will analyze the free cash flow numbers published by companies like ExxonMobil, Facebook, General Electric and General Motors. Let's get started. The first thing to be aware of is that free cash flow is a non-gap metric. This means it is not covered by generally accepted accounting principles, and to a certain extent companies have some creative liberty in defining the term. If you want to learn more about Gap versus non-gap metrics, then please watch my video on that topic. I will link to it on the end screen of this video, as well as in the description below. Let me give you some context so you know where free cash flow fits in. There are three financial statements, the balance sheet, an overview of what we own and what we owe at a point in time, the income statement, an overview of the profit or income that you generated during a period, and the cash flow statement, an overview of how much cash you generate and where you spend your cash during a period. Free cash flow, as his name suggests, is a cash flow metric. If you look through annual reports or finance textbooks looking for a definition of free cash flow, you will often find something along the following lines. Free cash flow is that part of the total cash flow that is not required for operations or reinvestment. Free cash flow is the part of cash flow that is available for distribution among all the securities holders, debt or equity of an organization. In other words, that part of the cash flow you could take out of the company to pay down debt or pay a dividend to shareholders without hurting its ongoing operational capability to pay the bills and without hurting the investment plan. To calculate free cash flow, you take the most comparable gap metric, cash from operating activities or CFOA and deduct capital expenditures. You can find these numbers in the cash flow statement that the company publishes in its annual report or quarterly earnings release, so you can always calculate free cash flow yourself by looking up those numbers. Some companies explicitly mention and calculate free cash flow for you. About half of the annual reports that are reviewed in preparing for this video had companies publishing their version of free cash flow. Unfortunately, the definitions that companies use are not always the same. Some stay very close to what you see here, but we will also see some alternative definitions along the way in this video. Fortunately, you have come to the right place, the Finance Storytale channel, to learn how to make sense of this. If you look up free cash flow in an annual report, you will see that companies provide you with some context to their definition and disclaimers as to what you should be aware of when analyzing free cash flow numbers. The following sentences are part of Facebook's annual report discussion of free cash flow. We define and we have chosen, clearly indicate that this is a non-gab metric, that is not part of generally accepted accounting principles, but something that a company can choose to define in a certain way. The last sentence shown here about other companies possibly presenting similarly titled measures differently is part of a well-worded paragraph, starting with the words free cash flow has limitations as an analytical tool and you should not consider it an isolation or as a substitute for analysis of other gap financial measures. I encourage you to look up the full text in the latest Facebook annual report. It's time to dive into the numbers and review Facebook's free cash flow over the past couple of years. Like many other companies, Facebook puts the older years on the right and the latest years on the left. If you go from 2011 on the right to 2015 on the left, you see the net cash provided by operating activities growing very quickly, especially in the 2013 to 2015 timeframe. The cash outflow for property and equipment also goes up significantly, especially in 2014 and 2015 as Facebook expands its capacity. 2015 has been a record year in free cash flow for Facebook, $6.1 billion. At the moment of putting together this video, I only have Facebook's numbers for the first three quarters of 2016, but those nine months are already higher on each of the line items than the 12 months of 2015, so Facebook should have another record free cash flow year in 2016. Later on in this video, we will look at the free cash flow of companies in very different industries, General Motors, ExxonMobil and General Electric. So does a company that is very profitable always have a very high free cash flow? That's not necessarily the case. The reason for that is that the way you measure profitability is different from the way you measure cash flow. In the profit view of a company, the matching principle is very important, matching the revenue and expenses to the period in which they occur. In the cash flow view of a company, the moment when cash is flowing in and cash is flowing out of the company is key. Let me illustrate this with some transactions. Let's assume we run a small factory that produces widgets. If we purchase raw material and we pay the supplier for it, we book a debit to inventory and a credit to cash. This transaction does not impact profitability, but it does impact cash flow. If you use the machines in the factory to produce, you book a depreciation charge in the income statement. For cash flow, depreciation is not relevant, as you do not pay depreciation to anyone, hence there is no cash outflow. If you want more explanation on how depreciation works and how it is calculated, watch the final storyteller video on depreciation. If you sell goods to a customer on credit, you book the revenue and cost of goods sold of that sale when the goods are delivered and you meet all the revenue recognition criteria. The difference between the revenue and the cost of goods sold is your margin. For cash flow, this transaction does not do anything. Because no cash is coming into the company yet until the customer actually pays you. If you sell goods to a customer with a cash payment, both profit and COVOA are impacted. It's only a small step from COVOA to free cash flow. Deduct the part of the cash flow that needs to stay in the company to fund new investments or replacements of existing machines. This is called CAPEX or Capital Expanded Juice. It's time to start comparing some companies under free cash flow performance. Don't jump to conclusions that the company is doing well when the free cash flow is high. They could get there by taking short term measures like limiting their CAPEX spending, which puts their longer term financial health at risk. Analyze the numbers, see the context and only then draw conclusions. Here's the free cash flow picture for car company general motors. Paying cash flow in 2015 is slightly higher than that of Facebook. But due to the capital intensive nature of the car industry, CAPEX is way higher. And therefore free cash flow is far lower for GM than it is for Facebook. Now let's look at one company that is a descendant of a corporation started in 1870 and another one that was founded in 1892. Action mobile and general electric. Both companies are large multinationals that in recent years have gone through large transformations of their business portfolio. The free cash flow definitions that they use reflect those strategic paths. Once again, words create worlds. The words used in defining strategy impact the world of financial metrics. If you look at the free cash flow definition of action mobile, you see that they start 12 like everyone else with a line called net cash provided by operating activities. Even though this is significantly lower in 2015 than in 2014, in absolute terms, it is still very big at 30 billion dollars. Additions to property plants and equipment are usually between 30 and 35 billion per year, but were cut to 26 billion in 2015. The next line is one that we have not seen before in the definitions used by other companies, proceeds from sales of subsidiaries, property plant and equipment, and sales and returns of investments. This is a line that consistently reflects the cash inflow for the past 5 years, but should be treated with caution as you cannot keep selling part of your business portfolio forever. You would end up with no company assets at all. Another unusual part of action mobile's definition of free cash flow, first data of other companies, is the line of additional investments and advances and the one below of collection of advances. Over time, these seem to largely offset each other. If you look at the free cash flow numbers per action mobile's definition at the bottom, you see how dramatically the picture had changed from the 2011-2012 timeframe of having more than 30 billion in free cash flow per year to about 20% of that level in 2015 at $6.5 billion. That's the difference between oil being at $100 per barrel for your $30. Last example is General Electric. Their free cash flow has gone up in recent years, just like action mobile, in their definition GE has chosen to add cash inflows from selling property, plant and equipment, as well as cash inflows from business dispositions. For GE, the bottom line in terms of free cash flow is the total of free cash flow plus dispositions. It's time to zoom out from definitions and numerical examples to the big question. Why is free cash flow such a big deal in the first place? The reason for that is that free cash flow is a key variable for analysts and investors that try to estimate the value of a firm. The value of a company today can be seen as the cash that they currently have plus the estimates of future free cash flows discounted back using the weighted average cost of capital to their present value. At the time of writing and producing this video, the market capitalization of Facebook is bigger than that of action mobile or General Electric. A very large part of that is driven by the large potential for growth in free cash flow for Facebook. A lot of assumptions go into the valuation calculation, as estimating the future free cash flow of a company requires you not only to have an understanding of its historical performance, but also of its vision, mission and strategy going forward. Its competitive landscape and the impact of all these on the free cash flow estimates. The further out into the future you go, the tougher it becomes to make a solid estimate. Not an easy task, and possibly an impossible one, in a world that is volatile, uncertain, complex and ambiguous. In summary, free cash flow is a useful non-gap metric to look at the performance of a company, that we were of the variation in definitions that exist. Free cash flow does not come for free, as in dollar bills just dropping from the air. Companies have to work very hard to generate free cash flow. The best way to think of it is a cash flow that wants to have freedom. On the Finance Storyteller YouTube channel, you can find lots of well-researched videos, explaining business, finance and accounting topics. Please subscribe to the Finance Storyteller channel and take the time to like the video and comment below. On average, I post one new video per week. If you subscribe to the channel, you will be the first to see it. |
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Welcome to the final storyteller series. In this video I'm going to discuss depreciation every later topics. Here's an overview of the terminology we're going to cover. Let me take you through the underlying concept first and then address some of the specific questions you might have about the topic. What is depreciation? How does that work? Let's assume you want to buy a truck for your company. You spend $100,000 to buy it. We usually call that an investment in fixed assets. You could also call it capital expenditure, capax in short. What happens on your balance sheet, the overview of what you own and what you own, is that cash goes down by $100,000. Your fixed assets or plant an equipment go up by $100,000. It would be incorrect to book the full $100,000 straight away as a cost for the current year in your income statement because you're going to use the truck for multiple years. Once you put the asset into productive use, depreciation has to be recorded. Let's assume that the truck has a useful economic life of five years and has no residual value. If you use straight line depreciation, you book $20,000 per year in depreciation. The value of the asset on the balance sheet goes down by $20,000 per year and in the income statement you charge this $20,000 as an expense. Now that you get the main idea, let's define depreciation more precisely. If you see this pencil as a fixed asset, then depreciation is the sharpening of the pencil. The more you use the pencil, the more you will have to sharpen it and the shorter the pencil gets until it is eventually fully depleted. In short, you can see depreciation as a pencil losing its pencilness. Now that definition won't get you through an accounting exam or make a big impression in a business meeting. So here's a more robust definition. Depreciation is the accounting process of allocating the cost of tangible assets to current expense in a systematic and rational manner in those periods expected to benefit from the use of the asset. Let me read that to you again to let this thing go. Depreciation is the accounting process of allocating the cost of tangible assets to current expense in a systematic and rational manner in those periods expected to benefit from the use of the asset. The last part of the sentence in those periods expected to benefit from the use of the asset is called the matching principle. Expenses should be recorded during the period in which they are incurred. Depreciation is often referred to as a known cash expense. The cash was spent when we bought the asset. Depreciation allocates the value of the asset over the years in which we use it. We don't pay the depreciation to anyone. In order to determine the duration chart per year, it is important to assess upfront how many years you really stick to think you can use the asset. You then align the number of years that you depreciate to the number of years of the asset's useful life. We bought a truck for our company for $100,000 with a useful life of five years, so $20,000 per year. We also bought a machine for $100,000 with a useful life of 10 years, so $10,000 depreciation per year. Finally, we bought an office building for $100,000 with a useful life of 20 years, so $5,000 depreciation per year. If you are able to extend the useful life of an asset beyond the original expectation, then it is economically beneficial to your company, assuming the maintenance cost of the older asset doesn't go up dramatically. Let's say that after five years of use of the machine, we have solid engineering data that suggests that we can use the machine for a total of 15 years rather than 10 years. We then take the remaining boot value of the machinery, which is $50,000 and divide the amount of the remaining estimated life. So in years 6 through 15, you would depreciate the machine at $5,000 per year rather than $10,000 per year. Here's how you account for depreciation. Let's take the truck which we purchased for $100,000 and use it for five years. When we bought a truck, we put it on the balance sheet for its full value. When we start using it, we book a cost of $20,000 per year as a debit in our income statement or P&L. And the offset of the general entry is a credit to a balance sheet account called accumulated depreciation. If you want to know the book value of the truck at the end of year one, you knit together the historical cost of the fixed asset and the accumulated depreciation on the balance sheet, which in the case of the truck would be $80,000. In year two, you repeat the same general depreciation general entry and get to a book value of $60,000 and all around for years three, and four, and five. As you can see from these general entries, depreciation is not about putting money aside for buying a new asset, once the current one is at the end of its lifetime. This can take the amount you spend to buy the asset and allocate the proportion of the amount to each of the periods of its useful life. Hopefully the company that we are looking at generates very profitable products or services with the building, machine, and truck that they are using, and the cash generated with selling these products and services can be used in the future to buy replacements for the assets that are at the end of their lifetime. What can you include in the value of the asset on the balance sheet when you buy it? This depends on the accounting rules that your company applies, which in turn depends on the country where you are located and where you are accounting for tax or state-owned purposes or for reporting to the stock market. Generally, what you pay for the asset to the supplier, as well as transportation and installation costs can be capitalized. Capitalization means recording things as assets, as fixed assets on your balance sheet. IFRS and the USGAP have different guidance on the level of detail, the number of subaccounts that you have to use when recording fixed assets. Also, the minimum spent or threshold can differ between companies. I don't below the threshold can book as expense straight away in the year of purchase, and don't go through the capitalization depreciation cycle. So far I have explained depreciation as a linear process. We depreciate the same amount every year, all the way until the asset is at the book value of zero on your balance sheet. This would be line number one on the graph. However, a linear pattern might not be the most fair and accurate representation of the asset's value. There are other approved depreciation methods, check your local regulations to see which one's apply, that work with a higher percentage of depreciation in early years and a lower percentage in later years. The book value of the asset that looks more like curve number two. It's important to have consistency of method in the way that you depreciate assets. A company could change from linear depreciation of its trucks to a depreciation based on units of production, which in the case of trucks would be mileage. If that represents a more fair and accurate representation of the value of the assets. However, you can't be flipping back and forth between methods randomly every year, as that would adversely impact the year over year comparisons. And it would not come across as very systematic and rational, where our definition earlier on. You also have to estimate upfront whether there is any expected residual value or salvage value at the end of the lifetime of the asset. What is the ideal asset likely to be worth at the end of its useful life? If you have credible estimates supported by data that you will likely be able to sell the truck after 5 years for $10,000, then the total amount to be depreciated over 5 years would be $90,000, which under a linear depreciation method would be $18,000 per year. Last point. What is the difference between depreciation and amortization? Is this the same thing or something completely different? Well the concept is the same, but depreciation and amortization are applied to different types of assets. We depreciate a tangible asset and amortize an intangible assets. The threshold levels, minimum total spend and capitalization criteria for intangible assets tend to be a lot more stringent than those for tangible assets. I hope this was useful. Thank you for watching. Please subscribe to the Finance Storyteller YouTube channel. More videos coming soon. |
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Welcome to the Finance Storyteller series. In this video I am going to discuss GAP vs Nung GAP metrics, which is the hottest topic in financial reporting. It affects the very core of a company. What is the reality of its financial performance? GAP vs Nung GAP discussions impact investors, analysts, financial journalists, company leadership, employees, the audit committee and external auditors. A lot is a stake here. Here is an overview of how this video is built up so you can make your choice of watching it all the way through from beginning to end or jumping straight to the part that is of particular interest to you. First section, what does GAP mean and what is Nung GAP? Basically, why should I care? Second section, what are common Nung GAP metrics? What does it look like? Third section? Why are there concerns about Nung GAP reporting? Fourth section, which guidance have regulated issued to improve transparency? GAP means generally accepted accounting principles. More specifically, US GAP, the accounting standards used in US or IFRS, the International Financial Reporting Standards used in 126 other countries across the world. Nung GAP provides uniformity in how companies report their financial performance. Having accounting standards like US GAP and IFRS enables you to compare the performance of companies within and across economic sectors so the standards are necessarily generic in nature. GAP numbers should be neutral, comparable and verifiable and provide information that markets can trust. Nung GAP metrics are alternative definitions of in most cases profitability that are supposed to enrich the financial information that investors receive by the company's performance. In other words, free of charge, additional information to provide insights into the company. That sounds like ordering steak at the restaurant like you always do and getting a free side order of vegetables with it. Many companies will include the footnote that states that Nung GAP metrics are useful to investors in their assessment of our operating performance and evaluation of our company. While the steak and vegetables analogy sounds good, a better comparison would be to use the classical optical illusion of the old woman and the young woman. What do you see? A young woman, an old woman, or can you see both? The young woman is on the left and her gaze seems to be away from us, facing towards the top left. The old woman is in the center with her gaze facing downward and to the left. If that is too hard to see, try the duck and the rabbit. It is a drawing of a duck with its beak on the left or a drawing of a rabbit with its mouth on the right and its ears on the left. Having a company present you with both GAP and Nung GAP information is very similar to being asked to spot both perspectives in these drawings. It takes a bit of practice and some people are better at it than others. How does one spot a Nung GAP metric? Well, the words adjusted and excluding often gave it away. Adjusted gross profit, adjusted EBITDA, adjusted net earnings, adjusted earnings per share, operating profit excluding special items, net income excluding non-recurring items, and on and on and on. By the way, some companies don't call Nung GAP information Nung GAP, but speak of core profitability, normalized profitability, underlying profitability, or pro forma measures. Here's an example of a company that provides a list of non-operational items that it excludes to get adjusted EBITDA and adjusted EPS, Verizon Communications. Its profitability according to GAP was unusually low in 2012 and 2014 and unusually high in 2013 and 2015, mostly due to unusual charges or credits in an operating spend line called Severance, Pension and Benefit. It was a very significant charge or extra cost in the range of 6 to 7 billion dollars in 2012 and 2014 and a very significant credit or negative cost in 2013 and 2015. If I want to do a long-term trend analysis as an investor, it is useful to have the company provide me with these numbers to normalize the trend and exclude the noise. Verizon is a very profitable company both under GAP and Nung GAP metrics and adjustments from GAP to Nung GAP can go either way. Nung GAP can become higher or lower when unusual items are excluded. Here's a second example from Sutokal Company Valiant. In their overview of Nung GAP adjustments to get from the GAP net income at the top to the Nung GAP net income at the bottom, Valiant has a long list of up to 15 items and every year the Nung GAP results are higher than the GAP results. In 2015 the company had a gap loss of 292 million but an adjusted Nung GAP profit of 2.8 billion after stripping out amortization of intangible assets, acquisition costs and other expenses. On the revenue of 10.4 billion that means the GAP net profit margin of minus 3% has turned into a Nung GAP profit margin of plus 27%. So why should anyone worry about the proliferation of Nung GAP measures? There are four main reasons for that. First of all, Nung GAP financial measures are not audited. The leadership of companies could be tempted to behave in a more opportunistic way in classifying results and defining metrics of success. Second, more and more companies are using Nung GAP financial measures which defeat the purpose of the word general in the term generally accepted accounting principles. The Wall Street general recently reported that only 6% of companies in the S&P 500 index reported 2015 in financials using solely GAP measures. According to research firm audit analytics this figure was 25% in 2006. Third, analysts and the media have given Nung GAP metrics more prominence. Fourth and perhaps most concerning, Nung GAP results are often very better than those reported on the GAP and the spread between them has been growing. S&P published a study of FTSE 100 companies showing that around 80% of the companies reporting adjusted operating profit that was higher than the unadjusted operating profit. So the big question is how do we avoid Nung GAP measures becoming earnings before bad stuff. Fortunately, this issue is in the spotlight with regulatory agencies and accounting standards boards all the way up to the chairman. They have made some very clear statements about the concerns. Securities and exchange commission chairman Mergeau White has said Nung GAP information is meant to supplement the GAP information but not supplanted. In too many cases the Nung GAP information has become the key message to investors. Hans Hoeghorfost, chairman of the International Accounting Standards Board in charge of IFRS said Nung GAP measures represent the selective presentation of an entity's financial performance. Often that selection is not free from bias. And we have found quite a few examples of financial reporting where the IFRS numbers are over shared out by Nung GAP measures. In some cases it's really difficult to find an income line. Not only have representatives of regulatory agencies and accounting standards boards voiced their concerns, they are taking active steps to reverse the trend of Nung GAP prominence. Let's remember the overarching principle of financial reporting. Financial statements should be fair and accurate representations of the company's financial position, result of operations and cash flows. For both GAP and Nung GAP information, another key principle is that information cannot be misleading. The active steps that are being taken can be at the individual company level with the SEC sending more comment letters to companies questioning their use of Nung GAP metrics. On the aggregate level the SEC has issued formal guidance on this topic. Here are some striking examples of the guidance. A Nung GAP measure that is adjusted only for non-recording charges when there were non-recording gains that occurred during the same period could violate rule 100b of regulation g. When a registrant presents a Nung GAP measure it must present the most directly comparable GAP measure with equal or greater prominence. In this element of the guidance the SEC really spells it out. Do not present a Nung GAP measure using a style of presentation such as bold or larger font that emphasizes the non-GAP measure over the comparable GAP measure. Do not place a Nung GAP measure before the most directly comparable GAP measure. Do not include only a Nung GAP measure in an earnings release headline. Explain what is the purpose of the Nung GAP measure and why management believes investors would find the Nung GAP measure useful. Improvement is underway. Among the S&P 500 companies reporting results in the start of July 2015-16 81% have given prominence to GAP figures in increase from the 52% that did so when reporting first quarter results according to an audit analytics analysis conducted for Wall 3 Journal. I hope this was helpful. Thank you for watching. Please subscribe to the Finance Storyteller YouTube channel. More videos coming soon. |
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Welcome to the final story of the LR series. In this video I am going to discuss the concept of T-accounting in relation to recording sales transactions. T-accounting or making T-accounts is a very helpful way of visually representing accounting entries. You can use it to sketch out the accounting for all kinds of transactions, from straightforward standard transactions to highly complex and rare ones. Let's take a look. In recording a sales transaction you tend to make use of four main accounts. Inventory, Receivables, Cost of Good Salt and Revenue. The first two, Inventory and Receivables are accounts on the balance sheet. The last two, Cost of Good Salt and Revenue are accounts in the income statement. On purpose I am only showing you four accounts. There are obviously many more accounts on the balance sheet as well as the income statement, but these are out of scope in this example. The balance sheet is a picture at a point in time of what you own and what you owe. An income statement is an overview of the revenues and expenses during a period, like a month, quarter or year. Please note that not every company and not every accounting textbook will use the same terms. For example, Receivables are often called accounts receivable or deptors. Revenue is often called sales or turnover. And the income statement is sometimes called the profit and loss statement. The financial terminology that the company uses also depends on its business model. If you sell services, you would talk about cost of services sold instead of cost of good sold. At the start of the period, we have $100 worth of inventory. This is either the cost of what we made it for, materials and labor, or what we paid for it when we purchased it from an external supplier. For a sales transaction takes place, a lot of things have happened. Your salespeople have gone out and praised the features and benefits of your products. The customer has received the quotation. You have negotiated a contract with them and they have sent you a purchase order. For the financial statements, things start to get interesting once you issue an invoice to the customer. Invoicing to the customer generates a debit in the accounts receivable. You create an asset, a claim to future cash, and a credit in revenues. This is called double entry bookkeeping and is represented with a solid line between the two tea accounts. When you send an invoice to the customer, you have to do some work in return. For an invoice to count as revenue, goods have to be delivered or a service has to be rendered. The shipment transaction in this example is a credit to inventory. You no longer have the goods in your possession in your warehouse and financially speaking, you no longer own the asset. The debit of the journal entry goes to the cost of goods sold or COGS account in the income statement. If at the end of the period we now add up the opening balance and the two transactions, sending the invoice and shipping the goods, we get to the ending balances of the four accounts we used. The entry is now zero. Receiveables is $150. This is money still to be collected. Cost of goods sold is $100 and revenue $150. The difference between revenue and cost of goods sold is a positive $50. We have sold the inventory to the customer at the price that is higher than what we made or bought the goods for. You could call that margin or more specifically gross margin. If the sum of the credits in your income statement is bigger than the sum of your debits in the income statement, which is the case in this example, then you generate a profit. We can also express margin as a percentage of revenue. $50 margin on $150 of revenue is 33%. Here's a little bonus for you. Let's assume a company wants to mislead its shareholders by pretending things are going better than they really are. The company decides to issue fake invoices to artificially inflate its revenue and profitability. How would that work in terms of general entries and how would an accountant or auditor detect it? If you overstayed revenues by issuing fake invoices, then revenue would be $175 instead of $150 and receivables would go up accordingly. There are two ways this overstatement could be detected. First of all, fake invoices lead to fake receivables that will never be collected. Autotouch always looked carefully at the outstanding accounts receivable balance and could ask for balance confirmations from the customers mentioned on the invoice, as well as ask for an aging analysis of how old the open invoices are. Second way to detect the overstatement is analyzing the margin trend and finding out what the drivers are for an increase or decrease. Historically, the margin was at 33% of revenue and due to the fake invoices, the margin has now gone up to 43% with no valid business reason. If you issue fake invoices, you do not have a shipment transaction against it. Therefore your margin percentage goes up disproportionately. I hope this was helpful. Thank you for watching. Please subscribe to the Finance Storyteller YouTube channel. More videos coming soon. |
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Welcome to the final storyteller series. In this video we are going to cover T accounting in a special way by looking at the balance sheet as a family of T accounts. This helps to understand the context of accounting entries and allows you to see the interdependencies. The term T account refers to the visual representation that we use while T accounting, a big horizontal line at the top and a vertical line below that in the middle, like a capital letter T. If you think about the visual structure of the capital letter T, then you could consider the balance sheet as a prime example. A balance sheet is a picture at a point in time of what you own on the left hand side and what you owe on the right hand side. What we own is called assets, what we owe is called liabilities. If we fill in the balance sheet with an example of accounts and amounts, then these are some of the terms you would often come across. In assets, cash, accounts receivable, invoices sent to your customer that they have not paid yet, inventory, goods that you hold to sell, and plan an equipment, fixed assets, buildings and machine. In liabilities, accounts payable, invoices sent to you by your supplier that you have not paid yet, accrued liabilities, liabilities for which you have not received an invoice, debt, borrings and equity, the book value of shareholder capital. As the word balance sheet suggests, the sum of the assets has to equal the sum of the liabilities and equity. A very useful way to view your balance sheet is to look at each of these asset and liability accounts as their own T account. Cash, accounts receivable, inventory and plan an equipment have a number on the left hand side of the T as they are asset accounts. Accounts payable, accrued liabilities, debt and equity have a number on the right hand side of the T as they are liability accounts. We can now start doing our T accounting for movements on the balance sheet. For illustration purposes, I will walk you through five balance sheet to balance sheet transactions. On purpose, I am not involving any transactions that touch the income statement as that would greatly increase the scope and complexity of this example. Our first transaction is a payment by the customer of the full accounts receivable balance. This is recorded as a debit to cash and a credit to accounts receivable. The second transaction is the purchase of a new piece of equipment. This is recorded as a debit to plan an equipment and a credit to cash. The third transaction is the delivery of new inventory to our warehouse. We purchase new inventory and our supplier sends us an invoice that we have to pay later. This is recorded as a debit to inventory and a credit to accounts payable. Our inventory asset increases and our accounts payability accounts payable liability goes up at the same amount. The fourth transaction is a reclass between accrued liabilities and accounts payable on the liability side of the balance sheet. We had a significant amount of outside services performed just before year end last year, for which we had not received any invoices yet. At that point, we recorded the cost and the income statement as a debit and the liability on the balance sheet as a credit and accrued liabilities. Now that we received the invoice from the supplier, we booked a credit to accounts payable further increasing our balance of money that we owe to suppliers and we booked a debit to accrued liabilities. The last transaction in this example is paying down part of the loan we have with the bank. We use some of our favorable cash position to pay down that. To record this, we credit cash as money is moving out of our account and we debit that. The balance sheet has now become overly busy with these transactions, so it is time to clean it up for the new upcoming year end by calculating the ending balances. In cash, we had an opening balance of 20, a further debit of 80 when the accounts receivable were paid are an ongoing amount of 10 and 30. If you sum this, you get to a debit ending balance of 60. In the accounts receivable, the opening balance of 80 was fully settled, so we have an ending balance of 0. In inventory, we had an opening balance of 40, received the delivery of 20, so we ended up with 60. In plant and equipment, we started with 60 and added 10 in new equipment for an ending balance of 70. In accounts payable, we had an opening credit balance of 30, which was further increased by 30 to end at 60. Acroed liabilities started with 10 and this amount was reclased to accounts payable when we received the invoice, so we ended with the credit balance of 0. In debt, we started with the credit balance of 70, paid down 30 over outstanding balance, so we ended with an outstanding liability of 40. Equity wasn't touched by any of the transactions in the example, so it stays equal to the opening balance of 90. Total assets are now 190 and total liabilities and equities also 190, so our balance sheet balances between left and right. T accounting or making tier accounts is a very helpful way of visually representing accounting entries. You can use it to sketch out the accounting for all kinds of transactions from straightforward standard transactions to highly complex and rare ones. I hope the idea of looking at the balance sheet as a family of tier accounts is helpful for your conceptual understanding. On the Finance Storyteller YouTube channel, you can find lots of videos covering business, finance and accounting topics. Please subscribe to the Finance Storyteller YouTube channel and take the time to like the video and comment below. 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Profit margin versus profit markup or margin on selling versus markup on cost is a distinction that is often misunderstood by small business owners, contractors, consultants as well as employees and large corporations. With painful consequences, margin versus markup is a fundamentally different approach to pricing and profitability. Let me walk you through the calculations and underlying thinking. If you like my story and explanation is helpful then please press the like button below the video. Let's go. We're going to walk through the calculation of profit margin versus profit markup. In this example, let's take a revenue for your product or service of $100, a cost of $80 and a profit of $20. In both the margin and the markup calculation, the profit of $20 is the numerator and the equation. However, what you take as the denominator is different. When you calculate margin, you divide profit by a revenue. When you calculate markup, you divide profit by cost. So for margin, we take $20 profit divided by $100 in revenue, which equals 20%. For markup, we take $20 profit divided by $80 cost, which is a 25% markup. The underlying thinking for using margin is that you start with value-based thinking and set the price accordingly. What is the value my product or service creates for the customer? When you use markup, you start with cost-based thinking. What markup can I charge to the customer on top of my cost to buy or produce? Let's sing in for a minute. What is the direction of your pricing thinking? If you think in terms of margins, you start with the value to the customer with drives revenue, then you evaluate cost and then profit is the dependent variable. If you think in terms of markup, you start with the evaluating cost, then determine an acceptable profit and have revenue as the dependent variable. My preference is to go for the scenario on the left, thinking about creating value for your customer and aligning your pricing with that value. If you provide value, all the pieces of the puzzle should fall into place. As a bonus, I will show you how markups grow exponentially if margins go up. Remember, margin is profit divided by revenue and markup is profit divided by cost. In our earlier example, we talked about the situation with profit margin of 20% and a markup of 25%. If we double the profit margin to 40%, 40 over 100, our markup is now 67%, 40 over 60. Next step, the margin is 60%, 60 over 100, with this corresponding markup of 150%. 60 over 40. Last step, the margin is 80%, 80 over 100, and the corresponding markup is 400%, 80 over 20. Play around with this table a bit for the profitability in your company or industry, so you know how margin and markup relate. Thank you for watching. If you enjoyed this short explanation of profit margin versus profit markup, then please press the like button for me. On this end screen, there are a few suggestions of videos you can watch next. Please subscribe to the Finance Storyteller channel, so you stay up to date on my latest videos for free. Thank you. |
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Growth margin and operating margin are two key financial terms to understand if you want to evaluate the financial performance of a company on the income statement or P&L, profit and loss statement. In this video, we will discuss the definition of growth margin and operating margin and work through the calculation of growth margin and operating margin for four well-known global companies in different industries. If you like my story and explanation is helpful, then please press the like button below the video. Growth margin and operating margin are financial terms used in the income statement. We will cover the income statement or P&L for a manufacturing company first and then show variations on the wording for companies in other industries. The top line of an income statement is revenue, the sum of the invoice is sent to customers, for the goods that you have delivered or the services that you have rendered, assuming that all invoices meet revenue recognition criteria. In-cost select material, labor and manufacturing overheads eventually end up in the P&L as cost of goods sold. Revenue minus cost of goods sold is Growth margin. SGNA is selling general administrative expenses, basically the cost of the general manager, sales people, marketing team, customer service, human resources, finance, legal and IT. Research and development gets reported as a separate line item. Growth margin minus SGNA and R&D is Operating margin or EBIT. Operating margin minus interest and taxes is net income, for the bottom line of the P&L. This video focuses on Growth margin and Operating margin. So what happens if you are not working in the manufacturing company but in an industry like services or software? Most of the P&L looks the same, but your company probably has a term like cost of sales, cost of services sold or cost of revenue, replacing the cost of goods sold that the manufacturing based company would use. Now that you understand the definition of Growth margin and Operating margin, let's get the feeling for the relative size of these numbers as a percentage of revenue. I will show you four names of companies that all happen to have a name starting with a letter A. We will go through the calculation of Growth margin and Operating margin for each of those four companies in the rest of this video. Which of these companies has a Growth margin as percentage of revenue of 39% and Operating margin as percentage of revenue of 28%. Is it A. Accenture? A leading global professional services company providing a range of strategy consulting, digital, technology and operation services and solutions. B. Adobe, the multinational computer software company, C. Amazon, and electronic commerce and cloud computing company, D. Apple, a multinational technology company that designs develops and sells consumer electronics, computer software and online services. These companies operate in very different industries and there are large differences in absolute size of their key financial numbers. So it is useful to compare them on a relative basis by taking Growth margin as a ratio of revenue and Operating margin as a ratio of revenue. You will see in this video that the Growth margins of these four companies range from 31% to 86% and the Operating margins of these four companies range from 3% to 28%. So which one of these four companies has the second highest Growth margin at 39% of revenue and the highest Operating margin at 28% of revenue. Please vote now and let's find out in the rest of this video how good your financial intuition is. To practice calculating Growth margin and Operating margin we will go through the results of each of these four companies in alphabetical order. Accenture's financial year ended on August 31, 2016. In the 12 months of their fiscal 2016, they generated 32.9 billion in net revenues and 4.8 billion in operating income. Growth margin is not mentioned in this overview as a separate line item but we can calculate it by taking revenues minus cost of services. Growth margin is $10.3 billion or 31% of the net revenue. Sales, marketing, general and administrative expenses take up 16% of revenue therefore Operating margin is 15% of revenue. A Dobe's financial year ended on December 2, 2016. In 12 months they generated revenue of $5.9 billion from three types of revenue streams. Subscriptions, product sales, services and support. Subscriptions were 50% of revenue in 2014 and have now grown to 78% of revenue in 2016 as the company transitions to the SaaS model. Growth margin is $5 billion or is stunning 80% 86% of revenue. Every incremental dollar of revenue generates a lot of extra margin. The technology company like Adobe, sales and marketing expenses are very significant at 33% of revenue and research and development is large as well at 17% of revenue. Due to the large operating expenses, even though growth margin is 86%, the highest out of the four companies we are reviewing, the operating margin is 26%, second highest out of the four. What is very interesting for investors in Adobe is that at 1.06 billion in incremental revenue in 2016 versus 2015 has generated 983 million in incremental growth margin. Despite the extra spending in R&B and sales of marketing, operating income has still gone up by $591 million. Adobe has a very high operating leverage. Incremental revenue translates to a lot of incremental margin. Amazon had net sales of 136 billion. Growth margin can be calculated by taking revenue and deducting cost of sales. Growth margin is $47.7 billion or 35% of revenue. Operating expenses like fulfillment, technology and content, marketing and general administrative expenses, take up 32% of revenue, therefore operating margin is only 3%. The last company in our list is Apple. In the financial year ended on September 24, 2016, Apple had revenues of $215.6 billion. Growth margin is 39% of revenue. If you have revenues the size of Apple Inc, you can spend 10 billion on R&B and 14.2 billion on selling general administrative expenses, and that still only adds up to 11% of revenue. Operating margin is the highest in our list of 4 companies that is stunning $60 billion or 28% of revenue. In this video we have gone through the definitions and calculations for Growth margin and Operating margin. Accenture's Growth margin is 31% of revenue and Operating margin 15%. Adobe's Growth margin is 86% and Operating margin 26%. Amazon's Growth margin is 35% and Operating margin 3%. Apple's Growth margin is 39% and Operating margin 28%. So the answer to our quiz question is D. Thank you for watching. If you enjoyed this explanation of Growth margin and Operating margin, then please press the like button for me. On this end screen there are a few suggestions of videos you can watch next. Please subscribe to the Finance Storyteller channel so you can stay up to date on my latest videos for free. Thank you. |
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What is Goodwill? We will discuss the definition of the finance and accounting term Goodwill and make sense of how Goodwill works by discussing one of the largest technology acquisitions in recent history, the acquisition of social network linked in by Microsoft. We will review the calculation of Goodwill for the headline grabbing deal, which is a great example of how to record Goodwill on the balance sheet. For some companies, Goodwill is in the top three of the largest categories of assets on their balance sheet. If you want to make sense of a company's financial statements, then the basic understanding of the concept of Goodwill is invaluable. Let's start with the definition of Goodwill. Please don't panic if this sounds somewhat cryptic to you. It will all become clear very soon. Goodwill is the access of the purchase by its prey for an acquired firm over the fair value of its separately identifiable net assets. Let's illustrate the definition of Goodwill with an example. The businessman in the blue suit and the businessman in the red suit come to an agreement. Blue pays a larger sum of money to red and then return red transfers the ownership of a factory to blue. How does Goodwill come into this picture? If the purchase price is $3 billion and the net assets are $2 billion, then the difference of $1 billion is Goodwill. You could disrespectfully call Goodwill an accounting plug in order to make the general entry balance. It's $3 billion of cash leave the door and on paper I only get net assets of $2 billion in return, then I need to plug $1 billion somewhere in order for the debuts to equal the credits. So here is the definition of Goodwill in simpler terms. Goodwill is the difference between what the company pays to buy an acquisition target and what a acquired company is worth on paper. Goodwill is recognized only in a business combination and Goodwill is not amortized. Why would any acquiring company pay a premium for an acquisition target above what that company's net assets are worth? Goodwill reflects the perceived superior earnings capacity of the business combination. Let's make the concept of Goodwill come alive by reviewing one of the most exciting technology deals of 2016, the acquisition of social network linked in by Microsoft. On June 13, 2016, Microsoft and LinkedIn announced that Microsoft will acquire LinkedIn for $196 per share, which adds up to purchase price of $26.2 billion. The transaction had been unanimously approved by the board of directors of both LinkedIn and Microsoft and the CEOs of both companies held a joint conference call to explain the rationale of the deal and their optimism for the opportunities created when combining the companies. Nearly six months later, on December 8, 2016, the deal closed, once regulatory approvals had been obtained. $26 billion was a very large purchase price, including a significant premium. Microsoft believes the benefits of the business combination between the world's leading professional cloud and the world's leading professional network justified the deal. So how does the accounting for Goodwill work in the Microsoft linked in acquisition? Microsoft's filing with the SEC of its FY17 Q2 quarterly report on January 26, 2017, which is called a 10Q filing, gives us the answers we are looking for. Goodwill is recorded as an asset on the balance sheet, so let's look up Microsoft's balance sheet per the end of the quarter, December 31, 2016. If we look at the left-hand side of the balance sheet, we get a listing of the assets on the balance sheet date. Goodwill is a non-current or long-term asset, so we need to look towards the bottom of the list, as the balance sheet for American companies starts with the most liquid assets, cash and items that are ready to cover to cash, and ends with the least liquid assets. There we have it. Goodwill per December 31, 2016, has $34.5 billion. The second largest line item out of the balance sheet with a total of $224.6 billion in assets. Goodwill has increased by $16.7 billion since June 30, 2016. More detail on how the deal was accounted for can be found in notes to the financial statements, most specifically in note 8 business combinations. Microsoft states, on December 8, we completed the acquisition of LinkedIn for $27 billion. Most of the purchase price was cash. The acquisition is expected to accelerate the growth of LinkedIn, Office 365 and the Demix 365. The purchase price allocation as of the date of the acquisition was based on the preliminary evaluation in subject to revision. In other words, this is the accounting for the time being, it might change, so check the annual report once the full fiscal year is complete. It's good to remember that the quarterly report publishes unordered financial statements, while an annual report has ordered financial statements. Here is the overview of the purchase price allocation, $27 billion paid in total. What does Microsoft get in return? First of all, LinkedIn's tangible assets, such as cash and cash equivalents, short-term investments, other current assets and property and equipment. This adds up to $5.7 billion. If you acquire a company, you don't just take on the assets or the company owns, you also take up the liabilities or the company owes. LinkedIn's liabilities that Microsoft took on were primarily short-term debt, other current liabilities and deferred income taxes. This added up to $3.4 billion. Microsoft paid $27 billion in total, got tangible net assets in return, or $5.7 billion, minus $3.4 billion is $2.3 billion. So is the rest of the amount to be booked as good will? Not quite. In an acquisition, you first have to figure out what the value is of the intangible assets. Non-monetary assets without physical substance. Microsoft's valuation of the intangible assets that were acquired by purchasing LinkedIn is $7.9 billion. Faluation of intangible assets is a separate topic, which is out of scope for this video. The important thing for us in this discussion of the purchase price allocation, based on fixed amount of purchase price and tangible net assets, is that if the value of intangible assets is high, then goodwill will be low. And if the value of intangible assets is low, then goodwill will be high. Microsoft assessed the fair value of the intangible assets acquired a $7.9 billion. The intangible assets are thought to have a useful life of nine years on average and will be amortized over this period. On average, this will lead to an incremental amortization charge for Microsoft due to the LinkedIn deal of $875 million per year. Now that we have looked at all the items except goodwill, we have a fair value of the net assets of $5.7 billion plus $7.9 billion minus $3.4 billion is $10.2 billion. The purchase price is $27 billion. The fair value of the net assets is $10.2 billion, therefore goodwill is $16.8 billion. So is that it? Amortize the intangible assets over their useful lives, keep goodwill on the balance sheet forever, as goodwill is never amortized? Not necessarily. Check the risk factor section of Microsoft's Thank You. Companies have to perform an annual impairment test to both goodwill and intangible assets. With what that impairment test does, it is basically to assess whether the carrying value of goodwill intangible assets is recoverable. In simple terms, if the financial results and future prospects of the business you acquired are dramatically dropping, you need to write off all or part of the goodwill and intangible assets. Microsoft acquired Nokia's devices and services business for a total purchase price of $9.4 billion on April 25, 2014. During the fourth quarter of fiscal year 2015, just over one year later, almost all of the goodwill and half of the intangible assets of that deal were written off due to impairment. Time will tell whether the acquisition of LinkedIn by Microsoft will live up to the optimistic, strategic and financial expectations. Thank You for watching. If you enjoyed this discussion of the definition of goodwill and the example of how to calculate goodwill, then please press the like button for me. On this end screen, there are a few suggestions or videos you can watch next. Please subscribe to the Finance Storyteller channel so you can stay up to date on my latest videos for free. Thank You. |
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Welcome to a quick explanation of the main differences between CWA and NetIncome. Let's assume we run a small factory. If we purchase raw material and pay the supplier for it, then this transaction does not impact profitability but it does impact cash from operating activities. If you use the machines in the factory to produce, you book a depreciation charge in the income statement. Your costs become higher and your profit lower. For cash flow, depreciation is not relevant as you do not pay a depreciation to anyone, hence there is no cash outflow. If you sell goods to a customer on credit, you book the revenue and cost of a good sold of that sale when the goods are delivered and you meet all the revenue recognition criteria. The difference between the revenue and the cost of goods sold is your margin. For cash flow, this transaction does not do anything, as no cash is coming into the company yet until the customer actually pays you. If you sell goods to a customer with a cash payment, both profit and CWA are positively impacted. Now that you understand the difference between NetIncome and CWA conceptually, you are able to put together a cash flow statement using the indirect method. You start with the NetIncome and then make adjustments to reconcile the NetIncome to CWA. For many companies, adding back depreciation and amortization and adjusting for the changes in working capital, items such as accounts receivable, inventory and accounts payable are the main items of that calculation. Speaking of cash flow, I have a lot of material available that can help you to get a good understanding of the topic of cash flow and its related items. For example, I have full walkthroughs for you of the cash flow statements of Shell, Tesla and Walmart. I think the best way to learn how to read a cash flow statement is to go through as many real-life examples as you can. Please subscribe to the Finance Storyteller channel so you can stay up to date on my latest videos. On this end screen, there are a few suggestions of videos you can watch next. Thank you! |
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Business life is full of acronyms. Here's the top 10 financial acronyms that you should learn, so you are able to join the conversation with the CEO at your company. Number 10. S-GNA. Selling, General and Administrative Expenses. The cost of support functions like sales, marketing, HR, finance, etc. S-GNA, in contrast to COGS and R&D. S-GNA is often used in sentences like, we need to dramatically cut S-GNA. Number 9. GAP. Generally accepted accounting principles. Used in sentences like, GAP results for the quarter with this booning, but non-GAP results looked a lot better. Number 8. EBITDA. EBITDA is earnings before interest, taxes, depreciation and amortization, used as a cash proxy in profitability analysis. Number 7. DSO. Days sales outstanding. How many days does it take on average for your customers to pay you? Influenced by the terms you set as well as late payments or past use? DSO is a key metric when discussing working capital performance. If the cash from your customers is not flowing in, you can't pay your bills, you can't invest, and you can't pay dividends. Number 6. CAPEX. Capital expenditures. Money spent by a business or organization to acquire or upgrade fixed assets, such as buildings, machines and equipment, as opposed to COPEX or operating expenditures. Number 5. EPS. Earnings per share. The number that CEO gets nervous about when the quarterly earnings are about to be published. Number 4. V. Percentage. Variance percentage. Also used as V.P.Y. percentage, which is version's prior year percentage or V.O.P. percentage, which is the variance version operating plan. Number 3. EBIT. EBITDA is earnings before interest and taxes. Revenue minus cost of goods sold is Gross margin. Gross margin minus SGNA and RD is EBITDA. Number 2. ROA. Return on assets. A key indicator of business success. ROA is an income divided by assets. ROA has many variations. Some companies measure ROIC, ROTC, ROCE or RONOWA. These are all variations on the same theme. You look at the returns generated during a period and compare them to the capital invested in the company to generate the return. Number 1. CFO. Y. Cash from operating activities. A key financial metric that business managers can influence by working on improving profitability and keeping working capital in the control. Thank you for watching. If you enjoyed this short overview of key financial acronyms, then please press the like button for me and share it with your colleagues. On this end screen, there are a few suggestions of videos you can watch next. Please subscribe to the Finance Storyteller channel and when doing so, please hit the bell icon so you can receive automatic notifications when I post new videos. Thank you. |
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What is the definition of inventory turns and how do I calculate it? Inventory turnover is an indicator of speed or velocity in a company. How quickly does a company turn its inventory into sales? How many times is the inventory sold or used in a year? Inventory returns can be a very meaningful metric for a retail company or an industrial company. Inventory companies and different people use different definitions of inventory turnover. Rather than asking what is the right definition, I would like to ask what is the most useful definition. A, inventory turns as the ratio between sales and inventory, or B, inventory turns as the ratio between cost of goods sold and inventory. When you drill down into the components, you will see that the first definition has units sold times the selling price per unit in the numerator and units in stock times the cost per unit in the denominator. The second definition has units sold times cost per unit in the numerator and units in stock times cost per unit in the denominator. As cost per unit divided by cost per unit equals 1, you are in the second definition basically just dividing unit sold by units in stock. And those are the only two variables that can be influenced when you strive for improvement. In my opinion, option A, inventory turns as the ratio between sales and inventory is the most useful definition. As a finance director in a company, you can help create value for this company by providing visibility of the drivers of this key ratio of inventory turns. The management team can then ask the right questions to drive results. How do we sell more units? How do we increase the price per unit sold? How do we optimize our supply chain so we have fewer units in stock? How do we work on productivity to lower the cost per unit? The second reason I prefer option A is that the links closely to asset turnover, sales over assets in the DePont formula, a key business equation that every business and finance person should understand. If you prefer option B, then there are several videos available on other YouTube channels that take you through the calculation. How do I calculate inventory turns for a company? Let's take retailer Walmart as an example. In their annual report, you can find net sales in the income statement and the inventory balance on the asset side of the balance sheet. Inventory turns equals sales over inventory. We take the 12 months sales of 481.3 billion and divide it by the average inventory of 43.8 billion. You could even make this most sophisticated by looking up Walmart's quarterly reports and making the average inventory a 5.0 average rather than a 2.0 average. Walmart in fiscal year 2017 had inventory turns of 11. For some people, inventory turnover is a bit abstract and stock days is a more tangible metric. Stock days or inventory days are calculated by taking the 365 days in a year and dividing them by the number of inventory turns. In this example of Walmart, the stock days are 33. Thank you for watching. If you enjoyed this example of how to calculate inventory turnover, then please press the like button for me and share it with friends and colleagues. On this end screen, there are a few suggestions of video jiggle watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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How do suspense accounts work? The very important question for anyone working accounting or auditing or studying these fields? In this video, Rudu can fairy as aspect of suspense accounts. First, suspense accounts as temporary waiting accounts for unclassified transactions. Second, suspense accounts as plug accounts to balance the trial balance. These first two roles of suspense accounts are often perceived as a potential control risk, so we will review indicators of suspense accounts posing a control risk and discuss how to recognize suspense accounts. The third section of this video takes a more positive view, using suspense accounts as a proactive control procedure. To understand the concept of suspense accounts, it is important to know that the word suspense comes from the verb to suspend, which has various meanings. The most appropriate in relating to suspense accounts is temporarily prevent from continuing or being in force or effect and most specifically defer or delay an action, event or judgment. Use of a suspense account allows a person making a general entry to temporarily postpone his or her judgment about where an amount really belongs in the chart of accounts. Let's assume you are a junior accountant that is tasked with booking journal entries related to movements on the bank account. You have four items to record. One of these items in the example will include use of a suspense account. Item number one is related to telephone usage, as the vendor name Vodafone suggests. In the bank statement detail, you find the invoice number, so if needed, you could retrieve line item details from that invoice to split the telephone costs over various cost centers. The entry is straightforward, credit the cash account and debit telephone expenses. Please note that different countries have different habits of using decimal points or commas. The amount here is 40 euros and 67 cents. Item number two is related to travel expenses, as the vendor name Brussels Airlines suggests. The entry is credit cash account and debit travel expenses. Item number three is a bit more complicated, as this seems to have been an online purchase going through a payment provider called Global Collect. In the bank statement detail, you will find that this item is for a KLM flight and we even find a booking code for the flight. Just like in the previous entry, you credit the cash account and debit travel expenses. Item number four has also gone through the payment provider called Global Collect. In the bank statement detail, you find that this item is for Dell products. As Dell sells a wide range of products and services, you would like to find out what specifically was bought here. The person in your company who is in charge of buying computer equipment is not in the office today, so in order to finish your cash journal entries, you temporarily booked this amount to a suspense account and when on the next day you hear that the power supply for a laptop was bought, you reclash the amount from suspense to office supplies. This is the first use of suspense accounts. You park an unclassified transaction there, which should be temporarily only as you work to reclash the amount to the correct account as soon as possible. As any corporate controller or accounting textbook will tell you, the best balance for the suspense account is zero, with no open items. Suspense accounts are an unfortunate but necessary part of any general legion system. To understand the second use type of use of suspense accounts, you need to understand a little bit about the history of accounting. Luca Patioli is often called the father of accounting because he was in 1494, the first to publish a detailed description of the double entry system, does enabling others to study and use it. From those Renaissance days to the 1970s, manual bookkeeping, by hand, recording entries in ledger books was the way to go. You would have separate accounting teams working on various sub ledger books such as payroll, cash, inventory, receivables and many others depending on the type of company you work working for. From each of these sub ledger books, summary amounts would be transferred into a central place called the general ledger. As you can imagine, due to the manual nature of the process, this process is prone to errors, like transposition errors, like writing 51 instead of 15, or accidentally posting a single entry rather than a double entry. The control mechanism that was put in place is called a trial balance. A trial balance is a list of all the general ledger accounts contained in the ledger of a business. This list will contain the name of each nominal ledger account and the value of the nominal ledger balance. Each nominal ledger account will hold either a debit balance or a credit balance. The debit balance values will be listed in the debit column of the trial balance and the credit value balance will be listed in the credit column. If the total of the debit column does not equal the total value of the credit column, then this would show that there is an error in the nominal ledger accounts. In this example, our debuts on the left are bigger than our credits on the right. This is where a suspense account comes in. You plug the missing amount, a credit amount of 3 in the suspense account, in order to artificially and temporarily balance the trial balance. You then start the error view and correction process. This error, or multiple errors, causing the imbalance must be found before a profitable law statement and balance sheet can be produced. We have moved from the days of manually writing our journal entries into large ledger books to electronic posting of journal entries into large databases. Every accounting system that I have ever used has a validation rule that checks whether a journal entry is balanced, so the need to check whether a trial balance is balancing between debuts and credits has decreased. It's still worthwhile to know how suspense accounts work in the days of electronic postings as somebody could have forced a journal entry to go through by plugging amounts into suspense. When is a suspense account a control risk? First of all, if the suspense account is used frequently, do you have the right data feeds to correctly classify entries? Do you have properly qualified people making the entries? If journal entry amounts are high? If there is complicated account activity, which is hard to follow. If items stay unresolved for a long time, this could indicate insufficient staffing levels or is an insufficient focus. If the balance of the suspense account is not zero at the end of the reporting period, if no formal procedure is in place to resolve open items, incorrect use of suspense accounts could lead to material accounting statements. If there is a large debit on the suspense account rolling up into the balance sheet, then expenses could be understated. Incorrect use of suspense accounts can also be a sign of fraud. For both of these reasons, controllers and auditors should be on top of this topic. How to recognize a suspense account? In most cases, the word suspense is in the account name. However, there could be multiple accounts with the word suspense in there, so review the whole chart of accounts for completeness. Furthermore, an account could function as a suspense account but be named differently. Undistributed debits or undistributed credits, for example. The last section of this video is about turning the concept of suspense accounts around and proactively using it as a control mechanism. Let's say that you have historically processed incoming payments from customers using method A. You receive a bank statement, book the cash receipt by a customer in the general ledger by debiting cash and crediting accounts receivable. You have the same person close the open invoice in the receivable sub ledger and periodically, but infrequently, reconcile the receivables amount in the sub ledger to the amount in the receivables general ledger account. An alternative method using a suspense account to your benefit would be method B. You receive a bank statement, have employee number one book the cash receipt by a customer in the general ledger by debiting cash and crediting the payment suspense account. A different person, employee number two, closes the open invoice for this customer in the receivable sub ledger and this system feeds this data into the general ledger by debiting the payment suspense account and crediting receivables. If all goes well, the payment suspense account has a balance of zero at the end of the day. If any mistake is made, you have your employees and possibly their manager reconcile the entries until they have found and corrected the error. With today's accounting systems, you could use sub ledger codes to simplify this process. This method incorporates the four eyes principle, or two-person rule, which means that certain activities must be approved or recorded by at least two people. In this video, we have looked at the various aspects of suspense accounts. Suspense accounts as temporary waiting accounts for unclassified transactions. Suspense accounts as plug accounts to balance the trial balance. Suspense accounts as a control risk and using suspense accounts as a proactive control procedure. Thank you for watching. If you enjoyed this video on suspense accounts, then please press the like button for me. On this end screen, there are a few suggestions of videoji can watch next. Please subscribe to the Finance Store and Teller in YouTube channel. Thank you. |
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Prepaid expenses and accounting term that deals with timing differences between paying for something and using it. This short video covers examples of prepaid expenses in your personal life, in small business, as well as large public list of corporations. We will also go through the prepaid expenses accounting entries. Let's make it personal first. One or more of the following examples of prepaid expenses probably applies to you. Have you ever put money on a travel card for using a future travel? Did you buy a prepaid phone card? Did you book an airline ticket for your summer holiday? If so, then you transfer cash prior to using the service you bought. That's a prepaid expense. If you check your balance on your London Oyster card or your New York MTA Metro card, then you are looking at the monetary value of the transportation services you have yet to use. Do you have any other examples of prepaid expenses in your personal life? Please post them in the comments below this video, as I would love to compile a list of as many good prepaid expenses as possible. Prepaid expenses also apply in the business world. As a small business owner, I have a subscription to a financial newspaper. The current subscription period is running from June 1, 2017 to May 31, 2019. I prepaid 848 euro and 11 cents, including discount and excluding VAT at the start of the subscription period. Would it be appropriate to record that full amount as a cost in the income statement in the year in which I receive and pay the invoice? No it would not, as the delivery of the newspapers will be spread over the next 24 months. A core accounting convention is the matching principle. Expenses should be recorded during the period in which they are incurred. This is where the balance sheet account of prepaid expenses comes in. In prepaid expenses, you record the right to receive future services that have already been paid for but not consumed. Here's how the journal entries for prepaid expenses work step by step. We first record the full invoice by crediting cash, money is leaving the company and debiting prepaid expenses. Both cash and prepaid expenses are balance sheet accounts. In the asset category, cash goes down and prepaid expenses goes up. We then have to figure out how to allocate the total amount to the years in which the service is delivered when the newspapers are received. 848 euro and 11 cents for 2 years or 24 months equates to roughly 35 euro and 34 cents per month. In 2017, June 1 to December 31 is 7 months, so we transfer 7 times 35 euro from assets on the balance sheet to cost or expense in the income statement. By crediting prepaid expenses on the balance sheet and debiting subscription expenses in income statement. At the end of 2017, the remaining balance in the prepaid expense account on the balance sheet represents 70 months worth of newspaper. Around 600 euro, 848 minus the 247 we have now expense. In 2018, a full 12 months worth of newspapers is delivered. Hence we transfer half of the total amount of the invoice by crediting prepaid expenses on the balance sheet and debiting subscription expenses in the income statement. At the end of 2018, the remaining balance in prepaid expenses is 177 euro. 848 minus 247 minus 424. The remaining 5 months are booked in 2019 and I will then have to decide whether or not to renew my subscription. It is important to check at the end of the subscription period that the full amount of the original invoice has now been expensed. Is the sum of the debits and credits on the prepaid expenses account the same and the balance deb for zero? It's not just small businesses that record prepaid expenses, large corporations do it as well, but with far bigger numbers. The Coca-Cola Company is one of the Dow Jones 30. When you look at the balance sheet and their annual report, you will find a line item called prepaid expenses and other assets. In the narrative that discusses the balance sheet accounts, the Coca-Cola Company states that prepaid asset expenses and other assets includes advance payments to certain customers for distribution rights as well as to fund future marketing activities. The company expends its such payments over the periods benefited. Prepaid expenses, a useful accounting concept in your personal life, in small business, as well as for large publicly listed corporations. Remember to put your examples in the comments box below this video. Thank you for watching. If you enjoyed this explanation of prepaid expenses, then please give it a thumbs up. On this end screen, there are a few suggestions of videos you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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Accruals and Accrual Accounting Use extensively in the business world but not intuitively clear to everyone. This short tutorial provides clear and simple examples of the accruals concept and accrual journal entries so you can contribute to the discussion in your company next time the topic comes up. In many companies the topic of accruals resurfaces at the end of every period, usually as a variation on this question as by the CEO or corporate controller. Quarter-end is near, do you have any accruals that need to be included? Most finance people would know what the CEO means here and the CEO probably assumes the rest of the business does as well but that is often not the case. The question from the CEO could actually mean two things, are there any expensive accruals to be made or are there any revenue accruals to be made? You would make an expensive accrual when expenses have been incurred for which we have not yet received an inflow from a supplier. You would make a revenue accrual when goods or services have been delivered, in other words the revenue has been earned but we have not yet actually built the customer. Using accruals allows a business to more closely adhere to the matching principle. Let's start with the most common type of accruals, expensive accruals. Accruid expenses are the opposite of prepaid expenses. In prepaid expenses you record the right to receive future services that have already been paid for but not consumed. In accrual expenses you record the obligation to pay for services in the future that you have already consumed. Here are some examples of expensive accruals and the related accrual journal entries. Travel expenses that were paid by an employee out of their personal account and have not been claimed back from the company yet by the end of the accounting period. If the employee communicates in writing the nature and amount of the expenses to the finance department then an accrual can be made to correctly state the costs for the period by debiting travel expenses in the profit or loss statement or income statement and crediting accrual expenses on the liability side of the balance sheet. When the employee then claims the travel expenses in the next period no costs will be incurred in that period as the amounts were already accrued for. Outside services such as legal services, advertising or cleaning that have been received during the current period but not yet built to the company by the end of the period. When the accrual can be made to correctly state the costs for the period by debiting outside service expenses in the profit and loss statement or income statement and crediting accrued expenses on the liability side of the balance sheet. When the invoice does come in during the next period the accrual amount can be reclassed to accounts payable. Bonuses related to current year or quarter to be paid out next year or quarter. Paying bonus targets, tracking progress and processing payments is usually a cross-functional responsibility between HR, finance and functional managers. An accrual can be made to correctly state the costs for the period by debiting employee bonus expenses in the profit or loss statement or income statement and crediting accrued expenses on the liability side of the balance sheet. When the payment do take place during the next period this will be a balance sheet to balance sheet entry where the accrual is debited and the cash is credited. If you have any accrual examples for your company then please share them as a comment below this video. We will now discuss the second example of outside services in more detail with numbers and accrual journal entries. This month a maintenance company performed $900 worth of outside services for us. In the same month you received $1200 worth of invoices of which $400 related to last month services and $800 related to current month services. Your budget for the month was $1,000. The payment sent to the supplier is $600 in the current month. Which of these numbers should be recorded as the current month expenses? This should be recorded during the period in which they are incurred so $900 is the correct answer. Let me talk you through why the other options are incorrect and subsequently talk you through the related journal entries. The $400 related to last month services was accrued last month and can now be released. The $800 of invoices received related to current month services will be booked into the P&L but we will have to accrue an additional $100 for invoices to be received. This $100 is the difference between the $900 of work performed and the $800 of invoices received for it. Having a copy of the full set of sign time sheets of the external vendor for the work he performed for us would be a good basis to make the accrual calculation. Having a budget of $1,000 is a spending restriction, not a dimension of your actual income statement. If your budget was $1,000 and only $900 of outside services was performed then you understand $100 first of the budget. A payment to the supplier of in this case $600 is a journal entry that only affects balance sheet accounts, not expense accounts. This is the way that the example looks in journal entries. Last month $400 was recorded as a debit in outside service expenses in the income statement and as a credit in accrued expenses liability on the balance sheet. This month when the invoices come in the $400 is reclased within the liability side of the balance sheet by debiting accrued expenses and crediting accounts payable. You could also reverse the original journal entry to release the accrual and then book expenses versus accounts payable which has exactly the same effect but more journal entry line items. The $800 of invoices related to the current period are recorded by debiting outside service expenses in the income statement and crediting accounts payable on the balance sheet. For the $100 worth of work performed for which no invoice has yet been received you record a debit in outside service expenses and a credit in accrued expenses. Last step for the actual payment to the supplier you debit accounts payable and credit cash. At the end of the current month you have $900 of outside service expenses in the P&L, you have $100 in the crude expenses on the balance sheet and $600, $12 on the balance minus $600 in accounts payable related to this vendor on the balance sheet. Hopefully the finance department of your company is well organized and has a list of usual suspects for accruals so no material amounts are missed. But what if most of the expense accounting go through manual accrual journal entries rather than systems? This could pose a control risk as accuracy and completeness are at risk. For each of the earlier three examples you could put the system in place with appropriate routines and controls if the number of accrual entries and related amounts are significant. For travel expenses you can implement a travel and living system with an automated fee to the general ledger and get all employees into the habit of feeding this system in real time. For outside services it would be good to use a purchase order system where you can record the receipt of a service and receipt of the invoice for that same service separately. Messer related documents and use the list of open purchase orders for your accruals. For bonus target setting, progress tracking and payment processing a bonus tracking system can be put in place. The second type of accruals is revenue accruals. Good or services have been delivered by our company for which we have not yet built the customer. Two examples. If you are in the service business you may have performed work to a client under an existing contract for which you have not built yet by the end of the period. You could record this assuming revenue recognition criteria are met by debiting the unbuilt revenue asset account on the balance sheet and crediting revenue in the income statement or profit and loss statement. If you ship goods at the very end of the period, after the sub ledger has fed its data to the general ledger but before the period is over, you could record these shipments by debiting the unbuilt revenue asset account on the balance sheet and crediting revenue in the income statement or profit and loss statement. Once again this only applies when revenue recognition criteria are met. I hope I have been able to clarify and illustrate the concept of accruals for you. Remember to put your examples in the comment box below this video. Thank you for watching. If you enjoyed this explanation of accruals, then please give it a thumbs up. On this end screen there are a few suggestions of videos you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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The third revenue, an accounting term that deals with a specific type of timing difference between getting paid by your customer and providing goods or services in return. The short video starts with real-life examples of the third revenue in companies in very different industries. We subsequently discuss a common definition of the third revenue, talk about why this is such a great business model and review the third revenue accounting entries. Let's start with some examples. What do Home Depot, the world's largest home improvement retailer, Salesforce, a leading provider of enterprise software, and United Continental Holdings, a transporter of people in cargo, having common. Each of these companies has a significant amount of the third revenue. Home Depot, $1.7 billion, Salesforce, $5.5 billion, and United, $8.6 billion. If you have any more examples of the third revenue, please share them as a comment. How does the third revenue work for Home Depot? Here are some excerpts from Home Depot's annual report. Where we receive payment from customers before the customer has taken possession of the merchandise or the service has been performed, the amount received is recorded as the third revenue in the accompanying consolidated balance sheets until the sale or service is complete. We also record the third revenue for the sale of gift cards and recognize this revenue upon the redemption of gift cards in net sales. How does the third revenue work for Salesforce? The third revenue primarily consists of buildings or payments received in advance of revenue recognition from subscription services, and is recognized as the revenue recognition criteria are met. We generally invoice customers in annual installments. How does the third revenue work for United? United actually has two types of the third revenue that are recognized in separate accounts on the balance sheet. The value of unused passenger tickets is included in current liabilities as advanced ticket sales until the time the transportation is provided, $3.7 billion. The second type of the third revenue relates to frequent flyer miles. Mileage plus program participants earn miles by flying on United and certain other participating airlines. The company records its obligation for future award redemptions using a deferred revenue model. The miles are recorded in frequent flyer deferred revenue on the company's consolidated balance sheet and recognized into revenue when transportation is provided. This liability is $4.9 billion. So what is the common theme and an accurate definition of the third revenue? The third revenue is a balance sheet account on the liability side with a company O's representing the obligation to deliver goods or perform services in the future for which billing has already occurred and or cash has been received. If that accounting definition of the third revenue still sounds a bit cryptic to you, then think of the business model in construction. Step 1 is to sign a contract for work to be performed. Then the construction contractor gets a down payment from the customer. The contractor uses this to buy materials and labor, deliver to finish project and recognizes the revenue. Here's how the journal entries for deferred revenue work step by step. We will record the journal entries for a two-year service contract that runs from mid-2018 to mid-2020. The customer pays the full amount of the contract upfront. Debit cash on the asset side of balance sheet credits the third revenue on the liability side of the balance sheet. For 2018, we book six months' word of revenue. Debit the third revenue on the balance sheet credits revenue in the income statement. At the end of 2018, 18 months of the third revenue for the remainder of the contract is still on the balance sheet. For 2019, we book 12 months' word of revenue. Debit the third revenue on the balance sheet credits revenue in the income statement. For 2020, we book the remaining six months of the revenue. At the end of the contract, the sum of the debits and the credits in the deferred revenue account should be equal. Deferred revenue, a useful accounting concept and a great business model. Remember to put your examples in the comments box below this video. Thank you for watching. If you enjoyed this explanation of the deferred revenue, then please give it a thumbs up. On this end screen, there are a few suggestions of videos you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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What is the meaning of the term retained earnings? Where do retained earnings show up in the financial statements? What makes retained earnings go up or down? In this video we walk through the definition of retained earnings, and lies two real-life examples of well-known companies to understand how retained earnings get accounted for, and provide bonus tips above and beyond what other videos and textbooks would give you unthinkable to know about retained earnings. The retained means to keep, and earnings means profit. Retained earnings is commonly defined as that part of a company's cumulative historical profits that has not been distributed to shareholders through a dividend. Retained earnings are one of the items that connect the income statement and the balance sheet. The income statement or profit-alos statement is like a movie about profitability during a period, usually a month, a quarter or a year. The balance sheet or statement of financial position is like a picture at a point in time, usually the end of a month, a quarter or a year, of what a company owns and what it owes. You start a new income statement at the start of every new year. In order to close out the year and make the balance sheet balance at the end of the year, you add the profit that was made during the year to shareholder's equity. Retained earnings is a component of equity as we will see in the upcoming examples. Why is retained earnings on the credit or right-hand side of the balance sheet? Two ways to think about that. One, you all retain earnings to the shareholders and the right-hand side of the balance sheet is an overview of the company's owes. Two, if you are a profitable as a company, you grow the assets left-hand side of the balance sheet quicker than the liabilities right-hand side of the balance sheet. Therefore you need to plug in a mountain equity to make the balance sheet balance. The concept of retained earnings becomes a lot more clear if you walk through an example. Here's the overview of Telecom Company Verizon's equity balance at the end of 2015 and the end of 2016. Equity was $17.8 billion at the end of 2015 on the right and $24 billion at the end of 2016 on the left. Equity consists of many line items as you see in the overview. One of the largest items in equity is retained earnings. It's $11.2 billion at the end of 2015 and $15.1 billion at the end of 2016. Verizon actually calls this reinvested earnings rather than retained earnings, indicating that if you do not distribute all your earnings to shareholders, then you can reinvest them in the business. Let's review how the account balance has increased year-over-year. Rene retained earnings plus that income minus dividends equal ending retained earnings. In the case of Verizon 2016, reinvested earnings of $11.2 billion at the start of the year plus that income of $13.1 billion minus dividends of $9.3 billion equal reinvested earnings of $15.1 billion at the end of the year. The interesting element here is that only net income attributable to Verizon is taken to into account. If you look at Verizon's income statement for 2016, you see a revenue of $126 billion at the top and net income of $13.6 billion at the bottom. The total net income of $13.6 billion is split between about 500 million of net income attributable to non-controlling interests related to wireless partnership entities where Verizon is not a 100% owner and $13.1 billion of net income attributable to Verizon. Non-controlling interests is a line item in equity. You can make a walk from beginning balance to ending balance, just like we retained earnings. Beginning non-controlling interests, balance plus net income attributable to non-controlling interests minus distributions equals ending balance. A second example to understand the concept of retained earnings better applied Apple Inc. fiscal year 2017. Equity was 128.2 billion at the end of fiscal 2016 on the right and 134 billion at the end of fiscal 2017 on the left. Retained earnings grew from 96.4 billion on the right to 98.3 billion on the left. This more detailed overview shows how the equity balance and its components have developed year over year. For retained earnings, 2016's balance of 96.4 billion is at the top and 2017's balance of 98.3 billion is at the bottom. Same as in the previous example, net income makes retained earnings go up and dividends pay to shareholders makes it go down. Additionally, the repurchase of common stock has an effect on retained earnings. In the case of Apple, the repurchase of common stock is not considered treasury stock, as the shares received are retired in the periods they are delivered. What is the opposite of retained earnings? Empty pockets. The retained earnings account contains both the gains earned and losses incurred by a business, so it nets together the two balances. On going losses, it wrote any historical positive retained earnings balance. It could get worse if you have a negative retained earnings balance, in other words, net retained losses. Negative retained earnings would appear as a debit balance in the retained earnings account as accumulated deficit, rather than the credit balance that normally appears for a profitable corporation. A company could be in an imminent danger of bankruptcy if the accumulated deficit has exceeded the amount of contributed capital. Net wraps up are retained earnings discussion. Concept and definition real-life examples, accounting and bonus tips. Thank you for watching. If you enjoyed this explanation of retained earnings, then please give it a thumbs up. On this end screen, there are a few suggestions of videos you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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What is in the asset category of intangible assets on the balance sheet? This video provides you with a big picture on intangible assets. We start off with the definition of intangible assets, review examples of companies with a significant amount of intangible assets on the balance sheet, walk through an example including journal entries for acquired intangibles, discuss internally created intangibles, and end with intangible assets, amortization and impairment. In the international financial reporting standards, or I-VRS, an intangible asset is defined as an identifiable non-monetary asset without physical substance. In USGAP, an intangible asset is defined as an asset other than a financial asset that lacks physical substance. The first common factor is a lack of physical substance. An intangible asset does not physically exist, unlike a tangible asset such as a factory or a machine which would be in property plant and equipment. Second common factor, an intangible asset is not a financial asset. Examples of monetary or financial assets are cash and cash equivalents, marketable securities and account receivable. When reviewing annual reports, you will find that companies have various ways of grouping intangible assets. Some use the term intangible assets as a category label, with items such as Goodwill, Computer Software and Patents as line items inside it. Others simply list Goodwill and Intangible assets as separate line items. What they really mean, here comes the language purist, Goodwill on one hand and other intangible assets on the other. Revealing intangible assets in an annual report, check carefully whether you are looking at the category as a whole or a subset. Many companies have a substantial amount of Goodwill on the balance sheet if they have done acquisitions at some point in their history. Our fewer companies have a significant amount in other intangible assets. An example of a company with substantial intangible assets is the Coca-Cola company. On their December 31, 2016 balance sheet, almost 25% of the balance sheet total is an intangible assets, such as trademarks, bottler's franchise rights and Goodwill. Proctor and Gamble has 57% of the balance sheet total in intangible assets at the end of their fiscal year 2017, on June 30, 2017, split between $44.7 billion in Goodwill and $24.2 billion in trademarks and other intangible assets. Intangible assets can be either acquired or internally created. An example of acquired intangibles is the acquisition of LinkedIn by Microsoft. In the valuation of the acquisition and subsequent consolidation of the accounts in Microsoft's books, the intangible assets of LinkedIn were valued at $7.9 billion. On average, these intangible assets were deemed to have a useful economic life of 9 years. Let's review the simplified high-level journal entry for the acquisition of LinkedIn by Microsoft. Five main categories of accounts were impacted. $27 billion was the purchase price, this is a credit to cash. Debit-to-assets acquired are $5.7 billion, debit-to-assets. Liabilities assumed are $3.4 billion, a credit to liabilities. Intangible assets are valued at $7.9 billion, debit-to-assets. The remainder is Goodwill, the excess of the purchase-pride paid for an acquired firm over the fair value of its separately identifiable net assets, for $16.8 billion, debit-to-Goodwill. An example of internally created intangible assets can be found in the Elly Report of Rolls-Royce, an engineering company focused on power and propulsion systems, such as aircraft engines, headquartered in the UK. Total net book value of intangible assets at the end of 2016 was $5.1 billion, of which Goodwill was the largest item at $1.5 billion and capitalized development expenditure second largest at $1.1 billion. In the notes to the financial statements, the treatment of R&D costs at Rolls-Royce is explained. All research phase expenditure is charged with the income statement. Development expenditure is capitalized as an internally generated intangible asset only if it meets strict criteria relating in particular to technical feasibility and generation of future economic benefits. Expanded to capitalized is amortized over a useful economic life on a straight line basis, up to a maximum of 15 years from the entry into service of the product. That last phrase about the Rolls-Royce treatment of intangible assets nicely leads us into the topic of amortization. What is the difference between depreciation and amortization? The concept is the same, but depreciation and amortization are applied to different types of assets. You depreciate intangible assets and amortize some of the intangible assets. Intangible assets with definite lives are amortized. Debit amortization expands in income statement, credit intangible asset accumulated amortization, a contra-asset account on the balance sheet. Intangible assets with indefinite lives are not amortized, but you test them for impairment. Same with goodwill, not amortized, but tested for impairment. That wraps up our intangible assets discussion. Definition, real-life examples, acquired versus internally created intangible assets, journal entries and amortization and impairment. Thank you for watching. If you enjoyed this explanation of intangible assets, then please give it a thumbs up. On this end screen, there are a few suggestions of video you can watch next. Please subscribe to the Finestory Teller YouTube channel. Thank you. |
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How does the payback method in the investment analysis work? How to calculate the payback period? Find out all about the beauty of the payback method as well as its shortcomings. The payback method asks a very simple central question. How many years does it take to recover the initial investment? Let's calculate the payback period for Project A. In year 0, today, we have a cash outflow of $1,000. The brackets around the number indicate that it is a negative, a cash outflow. Over the course of the project, we have $1,600 worth of benefits, cash inflows, in total. Split evenly over four years of $400 each. It's fairly easy to calculate that the payback period is 2.5 years. $400 of benefits in year 1, plus $400 of benefits in year 2, plus 6 months worth of benefits in year 3, making up the final $200, at which point the total investment equals the total benefits. What if we have multiple projects in our company that we want to force rank? We only have $1,000 of investment money to spend, which project is financially speaking the most attractive? In total, for the full four years combined, each of these three projects has $1,600 worth of cumulative benefits, but the timing of these benefits varies. Applying the payback method can help. We already calculated the payback period for Project A at 2.5 years. Project B has a payback period of 1.8 years. $600 in year 1, and assuming we have benefits evenly spread over the year, $400 of the year 2 benefits. Project C has a payback of three years. $200 in year 1, $300 in year 2, $500 in year 3. The payback method does a good job here. It recognizes that time is money. Earlier benefits are more valuable than later benefits. Project B is the most attractive. However, the payback method while nice and simple has a crucial blind spot. It answers the question, how many years does it take to recover the initial investment? Nothing more? Nothing less. So if Project A has an investment of $1,000 and $400 benefits per year, and Project D has an investment of $1,000 with $500 benefits per year, the payback method tells you that both projects are equally attractive at the payback period of 2.5 years. This is where more sophisticated methods like net present value or internal rate of return have to come in to provide the calculation. Or just plain common sense, as any entrepreneur with skin in the game would intuitively and correctly choose Project D over Project A without having heard of any of the more fancy terms. I hope you enjoyed this short explanation of the payback period method. If you enjoyed this video, then please give it a thumbs up. On this end screen there are a few suggestions of related videos you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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What is the meaning of EBIT, EBIT R and EBIT D? Which companies use EBIT? Which companies use EBIT R? Which companies use EBIT D? How do you calculate EBIT, EBIT R and EBIT D? Let's find out. A lot of companies and a lot of financial analysts talk about EBIT, earnings before interest and taxes. EBIT is a proxy for the more official gap term called operating income. If a firm does not have non-operating income and non-operating expenses, then operating income is the same as EBIT. Some companies find the non-gap term EBIT R a more meaningful financial metric to report on current financial performance. If a company has done significant acquisitions in the past, then the current income state bit of the company may have a significant charge, expense, related to amortization of acquired intangible assets. An example of acquired intangible assets can be trade names. If these are judged to have a definite rather than an indefinite life, then an annual amortization charge is booked. Reporting on EBIT R rather than EBIT excludes this amortization charge. There is a third metric in heavy use. EBIT D. Companies that have a significant historical fixed asset base may find as a meaningful metric. If a company has done significant investments in fixed assets in the past, then the current income state bit of the company may have a significant charge, expense, related to depreciation of these intangible assets. An example of a intangible asset is a building or a machine. Reporting on EBIT D rather than EBIT or EBIT A excludes this depreciation charge. Let's see how EBIT, EBIT A and EBIT D fit into the P&L, profit or loss statement or income statement. A P&L is usually viewed from the top down. You start with revenue, the top line, and make your way down to net income, the bottom line. If you look at the financial metrics EBIT, EBIT A and EBIT D, you reverse the direction over your analysis. You start with net income and work your way up in the direction of revenue. Let's walk through step by step how to get from net income to EBIT D. If you add back corporate income tax, expense to net income, you get to EBIT earnings before taxes. If you add back interest expense to EBIT, you get to EBIT earnings before interest and taxes. If you add back amortization expense to EBIT, you get to EBIT A. earnings before interest, taxes and amortization. If you add back depreciation to EBIT A, you get to EBIT D. Earnings before interest, taxes, depreciation and amortization. Let's do that one more time, but now with some numbers for illustration. If you add back corporate income tax expense of 20 to net income of 80, you get to earnings before taxes of 100. If you add back interest expense of 10 to EBIT of 100, you get to earnings before interest and taxes of 110. If you add back amortization expense of 15 to EBIT of 110, you get to earnings before interest, taxes and amortization of 125. If you add back depreciation of 25 to EBIT R of 125, you get to earnings before interest, taxes, depreciation and amortization of 150. If you understand the definition of EBITDA, you automatically understand EBIT, EBIT and EBITDA. EBITDA is earnings before interest, taxes, depreciation and amortization. Earnings is the same as income or profit. The word before suggests that we are excluding certain items from our operational performance metric. Interest is excluded as it depends on your financing structure. How much did you borrow and at what interest rate? Access are excluded because it depends on the geography that you work in. Depreciation is excluded as it depends on the historical fixed asset investment decisions that the company has made. Amortization is excluded as it depends on the acquired intangible assets that may have been created in making acquisitions in the past. I hope you enjoyed this explanation of EBIT, EBITDA and EBITDA and the relationship between them. If you enjoyed this video, then please give it a thumbs up. On this end screen, there are a few suggestions of related videos you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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NetPresent value and internal rate of return in short NPV and IRR. What is the purpose of the NPV and IRR methods of investment analysis and how do you calculate NPV and IRR? The main idea of netPresent value is very simple. Time is money. The netPresent value or discounted cashflow method takes the time value of money into account by translating all future cash flows into today's money and adding up to today's investment and the present values of all future cash flows. If the netPresent value of a project is positive, then it is worth pursuing as it creates value for the company. Let's perform a netPresent value calculation step by step. What is the present value, PV, of all the cash inflows and cash outflows of the following project? NetA requires an investment of $1,000 today, year zero, and is expected to provide 4 years worth of benefits of nominally $400 per year. The $1,000 of investment is already in today's money. $1,000 today equals $1,000 today. What is the present value of a $400 benefit that we expect one year from now? To calculate that present value, we need to take the nominal amount of $400 and divide it by 1 plus defweighted average cost of capital. The weighted average cost of capital or WAC is a calculation of a firm cost of capital in which each category of capital is proportionally weighted. The riskier or more uncertain the company and the riskier or more uncertain the project, the higher the WAC becomes. Let's take a fairly high WAC of 20% in this calculation. 1 plus 20% equals 1.2. $400 divided by 1.2 equals $33. The present value of a nominal amount of $400 one year from now is $333 as today's equivalent. What is the present value of a $400 benefit that we expect two years from now? To calculate that present value, we need to take the nominal amount of $400 and divide it by 1 plus 20% to the power 2. As we need to take two steps from year 2 to year 1, from year 1 to today. This is the same as saying $400 divided by 1.2 times 1.2 or $400 divided by 1.44, which is $278. The present value of a nominal amount of $400 two years from now is $278 as today's equivalent. What is the present value of a $400 benefit that we expect three years from now? To calculate that present value, we need to take the nominal amount of $400 and divide it by 1 plus 20% to the power 3. As we need to take three steps from year 3 to year 2, from year 2 to year 1, from year 1 to today. This is the same as saying $400 divided by 1.2 times 1.2 times 1.2 or $400 divided by 1.728, which is $231. The present value of a nominal amount of $400 three years from now is $231 as today's equivalent. What is the present value of a $400 benefit that we expect four years from now? To calculate that present value, we need to take the nominal amount of $400 and divide it by 1 plus 20% to the power 4. This is the same as saying $400 divided by 1.2 times 1.2 times 1.2 times 1.2 or $400 divided by 2.0736, which is $193. The present value of a nominal amount of $400 four years from now is $193 as today's equivalent. We have now translated all cash flows into today's equivalent. To get to NPV, you now simply sum across and find an NPV of 35. As the net present value of this project is positive, it is worth pursuing as it creates value for the company. How to calculate the internal rate of return or IRR? IRR is the discount rate at which the net present value becomes zero. In other words, you solve for IRR by setting NPV at zero. We take the same project A and write down the formulas to calculate NPV. Through trial, error and error, or the use of the IRR formula in Excel, we will find that the IRR for project A is 22%. This IRR of 22% exceeds the weighted average cost of capital of 20%, so the project is worth pursuing as it creates value for the company. What if we have multiple projects in our company that we want to force rank? We only have $1,000 of investment money to spend. Which project is financially speaking the most attractive? In total, for the full four years combined, each of the three projects has $1,600 worth of cumulative benefits. But the timing of these benefits varies. Evenly distributed for project A, high benefits in early years shrinking to lower benefits in later years for project B, and low benefits in early years growing to higher benefits in later years for project C. Applying the NPV and IRR methods can help. We already calculated that at 20% weighted average cost of capital, the NPV of project A is $35. The HIRR is 22%. For project B, due to the high benefits in early years that don't get discounted too much by the time value of money, the NPV is $170, and the IRR is 27%. For project C, due to the long wait for the bigger benefits to come in, the NPV is negative at minus 46 dollars, and the IRR is 18%. Project C is not worth pursuing with negative NPV and an IRR which is below the weighted average cost of capital. Project B is the most attractive. I hope you enjoyed the short explanation of the net present value and IRR internal rate of return. If you enjoyed this video, then please give it a thumbs up. On this end screen, there are a few suggestions of related videos you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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Debits and credits made easy. I guarantee that you will understand the accounting term Debits and credits once and for all after watching this video. There is very broad agreement globally on some terminology. For example, any captain will tell you that when facing forward on a ship, the left side is called port and the right side is called starboard. In the same way, any accountant will tell you that when making accounting journal entries, the debits go on the left and the credits go on the right. How do debits and credits work? Does a debit increase in account and does a credit decrease in account? Or is it the other way around? That really depends on the type of account we are looking at. For balance sheet accounts, we essentially have three types of accounts. As such accounts, where the natural state is for an asset account to have a debit balance. Acquity accounts where the natural state is for a liability account to have a credit balance. Equity accounts where the natural state is for an equity account to have a credit balance. As such, increase with a debit. Liabilities and equity increase with a credit. For income statement accounts, we have two types of accounts. Expand accounts where the natural state is for an expanse account to have a debit balance. Revenue accounts where the natural state is for a revenue account to have a credit balance. Expenses increase with the debit, revenues increase with the credit. Let's go through some general entry examples for business transactions to illustrate that. If a company raises cash from shareholders when it starts out, then assets and equity are affected. Most specifically, the cash account within assets increases the debit side of the general entry and so does the shareholder capital in equity, the credit side of the journal entry. If a company raises cash through a loan from a bank, assets and liabilities are affected. Most specifically, the cash account within assets increases the debit side of the journal entry and so does the liabilities, the credit side of the journal entry, as you owe this money to the bank. If a supplier invoices you for cleaning services, expenses in the income statement and liabilities on the balance sheet are affected. Expenses increase the debit of the journal entry and so do liabilities, the credit of the journal entry, most specifically the accounts payable account within liabilities. If you subsequently pay the supplier, settle your debt to the supplier, then the liabilities decrease, the debit of the journal entry and the assets decrease. Decrease the credit of the journal entry as cash is transferred from your company to the supplier. If you invoice your customer for services rendered, the assets on the balance sheet increase the debit of the journal entry in an asset account called accounts receivable and the revenue in the income statement increases the credit of the journal entry. Balance sheet accounts assets, debit balance, liabilities and equity, credit balance. Income statement accounts, expenses, debit balance, revenue, credit balance. At year end closing, the results of the income statement during the year get added to the balance sheet position at the end of the year. If the company had a revenue of 100 credit balance during the year and expenses of 90 debit balance during the year, then the sums to a net income of positive 10 credit balance a profit, which gets added to retained earnings in equity. If the company instead only had a revenue of 90 credit balance during the year and expenses of 100 debit balance during the year, then the sums to a net income of negative 10 debit balance a loss, which gets deducted from retained earnings in equity. Revenue increases shareholder equity, expenses decrease shareholder equity, profits increase shareholder equity, losses decrease shareholder equity. Debit's on the left, credits on the right. I hope you enjoyed this short explanation of debits and credits in accounting. If you enjoyed this video, then please give it a thumbs up. On this end screen there are a few suggestions of related videos you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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Adjusted earnings per share How do you calculate adjusted EPS and what are some examples of adjusted EPS from real-life companies? To understand adjusted earnings per share, let's first review the definition of regular earnings per share. EPS is simply net income divided by the number of outstanding shares. Examples of companies using some form of adjusted earnings per share I have four examples that I want to share in this video. American Express, which uses adjusted EPS, Boeing which uses core EPS, Intel which uses non-GAP EPS, and Proctor & Gamble which uses core EPS. Guess what? The way Boeing defines core EPS is different from the way Proctor & Gamble defines core EPS. If you review the annual reports of other companies, you might also come across terms such as operational EPS. All of these are some form of adjusted EPS. You take GAP EPS and adjust it for certain items to get to adjusted EPS. What the items are that are adjusted for is different by company. Let's go through the examples to illustrate this. American Express 2017 EPS, US GAP, US generally accepted accounting principles was $2.97 per share in 2017, which is much lower than the $5.65 in 2016 and the $5.5 in 2015. What cost is this client in EPS? Guess what American Express explains in the calculation of adjusted EPS. AMEX had a huge one-time effect of the Change in the US Tax Act, an effect of $12.90 on EPS, from Repatriation Tax on certain non-U.S. earnings, and Remeslement of the Third Tax Assets and Liabilities. This one-time effect decreased the 2017 EPS, and AMEX argues that in their opinion, the more meaningful metric for investors to review for a year-over-year comparison would be adjusted EPS, excluding the one-time tax charges. That way, you compared 2017, excluding the one-time tax charges, to 2016, excluding one-time tax charges. Adjusted EPS for American Express in 2017 is significantly higher than GAP EPS. Boeing 2017 Boeing provides a reconciliation for the past three years. Let's review it from top to bottom. The eluded earnings per share, as reported, is at the top, with 2017 a very good year for Boeing. The items in the middle are all related to income or expense, relating to non-operational pension and post-retirement benefits. Core earnings per share, in Boeing's definition at the bottom, excludes these pension-related gains or losses. In two of the three years in this overview, 2017 and 2016, Core EPS is lower than diluted EPS. Intel 2017 Intel provides a reconciliation for the past three years. Let's review it from top to bottom. Diluted earnings per share, as reported, is at the top. The list with adjustments is below that. A large adjustment is the charge, expense, for amortization of acquisition-related intangibles, which Intel argues is a non-operational item and therefore added back in the non-GAP EPS calculation. Another significant item is restructuring expense. And a third item, the impact of tax reform, which for Intel, just like for American Express, had one-time charges related to it, that are taken out to get to non-GAP EPS. Non-GAP earnings per share is at the bottom and it is higher than GAP EPS at the top in each of the three years. Proctor and Gamble fiscal year 2018. Here we go from left to right. GAP EPS on the left, which is adjusted by adding back restructuring charges, the transitional impact of the US tax act, and charges related to early debt extinguishment, to get to PNG's definition of core EPS on the right. PNG's core EPS for fiscal year 2018 is higher than its GAP EPS. As you see, what Proctor and Gamble adjust for to get from EPS to core EPS is very different than what Boeing adjust for to get from EPS to core EPS. So what is important to understand about adjusted earnings per share? Adjust EPS is a term that has many variations. It can for example also be called core EPS, non-GAP EPS or operational EPS. The formula for adjusted EPS is you take GAP EPS and adjust it for certain items to get to adjusted EPS. The adjustment can relate to one-time tax charges, pension gains or losses, amortization of intangibles, restructuring and many other items. Adjusted EPS can be higher or lower than GAP EPS, but as we saw in the examples in this video, it is very often higher. I hope you enjoyed this short explanation of adjusted earnings per share. If you enjoyed this video, then please give it a thumbs up. On this end screen there are a few suggestions of related videos you can watch next. Please subscribe to the Finance Story and Teller YouTube channel. Thank you. |
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What is double entry accounting? Double entry accounting or double entry bookkeeping can be explained in several ways. Perhaps the easiest way to explain double entry accounting is to say that every debit needs a credit. When making accounting journal entries, the debit is going on the left and the credit is going on the right. Another way of describing double entry accounting is, both sides of the journal entry need to be recorded. As a lot of journal entries simply have one debit and one credit, in most cases this is a correct statement. An example is shown here. You receive an invoice for 800 dollars worth of outside services. One leg of the entry, the debit, goes to outside service expense. The other leg of the entry, the credit, goes to accounts payable. Technically speaking, the sum of the debit entries needs to equal the sum of the credit entries would be a better way of describing double entry accounting. Here is a summary example of a more complex journal entry, recording the large acquisition of a company. There are three debits and two credits in this journal entry. Let's check whether the sum of the debit entries equals the sum of the credit entries. The sum of the amounts in the debit entries is 5.7 billion dollars debit plus 7.9 billion dollars debit plus 16.8 billion dollars debit equals 30.4 billion dollars debit. The sum of the amounts in the credit entries is 3.4 billion dollars credit plus 27 billion dollars credit is 30.4 billion dollars credit. The sum of the debit entries equals the sum of the credit entries. Here are some more ways of describing double entry accounting. There are always two or more entries for every transaction. Every business transaction will involve two accounts or more. This complying with the accounting equation assets equals liabilities plus equity. Let's dive into that last description of double entry accounting a little bit deeper. Why do assets need to equal liabilities and equity? Well at the end of the accounting period, you will be making a balance sheet, an overview of what you own and what you owe and as the name balance sheet suggests, the sum of the amounts on the left has to equal the sum of the amounts on the right. This also means that on the journal entry level, any increase in one element of the accounting equation has to be offset by an increase in another element. Assets increase with a debit, liabilities and equity increase with a credit. Let's check that for the acquisition journal entry that we saw before. We first classified the accounts as assets A or liabilities L. There are four asset accounts involved in this journal entry and one liability account. The increase in the assets accounts is 5.7 billion dollars debit plus 7.9 billion dollars debit plus 16.8 billion dollars debit minus 27 billion dollars credit is 3.4 billion dollars. The increase in the liability account is also 3.4 billion dollars. So this journal entry complies with the accounting equation assets equals liabilities plus equity. What about the other example of outside service expenses? In this example, it is very clear that recording the invoice increases accounts payable, which is a liability. What about the outside service expenses which is a debit in the income statement? Remember that at the end, a profit gets added to equity and the loss gets subtracted from equity. So this journal entry also complies with the accounting equation as liabilities go up and equity goes down. So is it ever possible to post a journal entry that is not balanced? Well yes and no. But that's a topic for a different video, suspense accounts. There are several ways to explain double entry accounting. I hope that one or more of these explanations resonates with you. I hope you enjoyed this short explanation of double entry accounting. If you enjoyed this video, then please give it a like. On this end screen there are a few suggestions of related video you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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Return on investment versus the payback method. Why do we need them and what are the similarities and differences between these methods for investment analysis? Let's start with the central question that each of the methods tries to answer. For ROI that question is, what percentage annual return do I get on my investment? For the payback method, the central question is, how many years does it take to recover the initial investment? Let's apply both methods to Project A. Year zero, today we have a cash outflow of $1,000. The brackets around the number indicate that it is negative. Cash outflow. Over the course of the project we have $1,600 worth of benefits, cash inflows in total. Split evenly over 4 years of $400 each. Return on investment is the annual benefit of $400 divided by the investment of $1,000, so 40% ROI for 4 years. The payback period is 2.5 years. $400 of benefits in year 1 plus $400 of benefits in year 2 plus 6 months worth of benefits in year 3 for the final $200. And which point the total investment equals the total benefits? Which table annual benefits like in Project A? ROI equals 1 divided by payback, 1 divided by 2.5 is 0.4 or 40% and payback equals 1 divided by ROI, 1 divided by 0.4 is 2.5. Both return on investment and payback are simple to understand, but their ability to deal with a bit more complexity differs. What if we have multiple projects in our company that we want to force rank? We only have $1,000 of investment money to spend. Which project is financially speaking the most attractive? In total for the full four years combined, each of the three projects has $1,600 worth of cumulative benefits, but the timing of these benefits varies. Applying the payback method can help. We already calculated the payback period for Project A at 2.5 years. Project B has a payback period of 1.8 years. Project B is the most attractive. The unfortunate limitation of the payback method is that it is unable to help you select between projects with a different duration. For both Project A with 4 years of annual $400 benefits and Project D with 5 years of annual $400 benefits, the payback period is 2.5 years. The project D is obviously the most attractive project, but the payback method is unable to tell you that. We could compare the same three projects A, B and C using return on investment. Remember that for ROI, the central question is, what percentage annual return do I get on my investment? The answer to that question for Project A is 40% per year from year 1 through year 4. For Project B, the answer would be 60% year 1, going down to 20% in year 4. For Project C, the opposite, 20% in year 1, going up to 60% in year 4. Now for most people, it is not intuitively clear which project to choose based on these ROI numbers. Should I go for the stable return of Project A, the decreasing ROI over the years of Project B, or the increasing ROI over the years of Project C? ROI doesn't seem to be a great decision tool here, as it doesn't really provide a clear answer. How about using average ROI then? Well in my opinion things just get worse with average ROI, as each of the projects has 1600 dollars cumulative benefits over 4 years, the average benefits are 400 dollars per year for each of the projects. Everage ROI would not help you to develop a preference for one project over the other and feels to support your decision making. In summary, the central question for the ROI method is, what percentage annual return do I get on my investment? For the payback method, the central question is, how many years does it take to recover the initial investment? While they are both fairly easy to understand, each has inherent limitations. Most sophisticated methods like net present value or internal rate of return may have to be applied to improve the decision making process. I hope you enjoyed this short discussion of ROI versus payback. If you enjoyed this video, then please give it a thumbs up. On this end screen, there are a few suggestions over later videos you can watch next. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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How do the income statement and balance sheet connect and interact? Which financial statement is more important? The balance sheet or the income statement? The answer is both. They each have their own focus and purpose. This video provides you with deep understanding in less than 5 minutes. The balance sheet is an overview of companies assets and liabilities at a point in time. At the end of a quarter or the end of the year. A balance sheet shows you what a company owns on the left hand side and what a company owes on the right hand side. As the term balance sheet suggests, the total assets should match the total liabilities. What we own equals what we owe. A balance sheet shows you where you got the capital for the company on the right and what you have invested it in on the left. The income statement or profit and loss statement is an overview of how much a company has earned during a period. Some companies use the terms revenue, expenses and profit. Others use sales, costs and earnings or income. If your revenue is bigger than your expenses, you make a profit. If expenses are bigger than revenue, you make a loss. The way to remember these easily is to think of the balance sheet as a picture at a point in time and the income statement as a movie about a certain period. Let's put the balance sheet and income statement side by side starting with a blank sheet. We will make some simple journal entries to show the relationship between balance sheet and income statement. If we start a company, we need to raise capital. The certificates of ownership that we give to shareholders are called equity and they send us cash. Our company now owns a cash balance on the left and owes equity to the shareholders. Until we might apply for a loan from the bank, when we signed a loan agreement, we are in debt to the bank. In return, we receive cash. With the money we raised, we might plant an equipment in short P&E or fixed assets, a building as some machines. We now own the plant and equipment and in return for getting the keys to the building and the keys to a forklift truck, our cash is reduced. We order inventory from a supplier. The delivery truck brings you the inventory, another asset, something you now own and you receive an invoice from your supplier that you have not paid yet. Accounts payable, you owe money to your supplier. So far, we have only touched the balance sheet, growing both what we own and what we owe. Let's record some costs or expenses. We receive an interest charge related to the bank loan and paid in cash. We count for the usage, value deterioration of the plant and equipment through a depreciation entry. We record salaries, compensation and benefits for the staff in our shop and pay them in cash. Then we finally make our first sale. Note that this took quite a while after starting the company. For the sales transaction, we record the invoicing of the revenue and the claim to future cash accounts receivable from our customer. We also record the shipment of the goods to the customer and the related cost of sales. Then we can calculate sub-totals, gross profit, operating profit or EBIT, earnings before interest and tax, profit before tax. We record the tax charge of 20% of the EBIT, paying it in cash. And then, to finish off the income statement, we calculate net income. Now we seem to have a problem. Our balance sheet does not balance. Our assets are bigger than our liabilities. What are we missing? This is where we need to remember that the balance sheet is a picture at a point in time and the income statement is a movie about a certain period. We need to somehow connect the picture and the movie. To do that, we add the net income earned during the year to the balance sheet of the end of the year. That is the reward for the bank for granting us a loan. Net income is the reward for the shareholders for making risk-bearing capital available. We add the net income earned during the year to equity in a sub account called retained earnings and the balance sheet balances. That's how the balance sheet and income statement fit together. Please subscribe to the Finance Storyteller YouTube channel. Thank you. |
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What does asset impairment mean and which types of assets could run the risk of getting impaired? Let's start off with reviewing the word impaired first. There are warning labels on certain medications stating that the medications might negatively affect or impair your driving. There are warning labels in high-noise areas mandating the use of hearing protection. Once your driving skills or hearing ability are impaired, it means that they are weakened, diminished or damaged. The same concept could apply to assets in your company. The error on the left has low value at the bottom and high value at the top. If the carrying value or book value of an asset is higher than the recoverable amount of the asset, then the company should be recognizing an impairment loss. Which types of assets could be impaired? Well, let's review the balance sheet which is an overview of the company's own on the left and what the company owes on the right and the point in time. Cash, accounts receivable, inventory, fixed assets and goodwill are common asset categories on the company's balance sheet. Any of these could be impaired. The cash impairment can occur when your bank goes out of business. In other words, bankrupt. Creditors of the bank might be queuing up in front of the bank in the bank run to see if they can recover some of their cash. Receivables impairment is usually called bad debt. You review the invoices you have sent to your customers. Three out of five are current, not due yet. Two out of five are past due. Customers are late paying them. Especially invoice number five, which is 97 days past due, might be a case of bad debt for which you could be taking an impairment or write-off. Inventory impairment is usually called obsolescence. To review potential inventory obsolescence, we go into the warehouse and check some boxes. The materials in box number one were produced last week and will be shipped tomorrow. The materials in box number two were produced last month and are expected to be shipped next week. The materials in box number three were produced two years ago, have not moved since then, and that does not seem to be a customer for them. That last one is a potential case for impairment or obsolescence. Fixed asset impairment or impairment of property plant and equipment in most cases happens in the factory. We have three machines operational in excellent shape and producing good quality product. On the side, there is a rusty machine that hasn't operated in three years but still has a value on the books. That last one should be reviewed for fixed asset impairment, especially if there are no plans to bring it back into an operational state. Goodwill impairment. Goodwill is the excess of the purchase price paid for an acquired firm over the fair value of its separately identifiable net assets. So if you buy a company for $3 billion with net assets of $2 billion, the $1 billion gets booked on the balance sheet of the acquiring company as Goodwill at the time of purchase. Each year, we check the performance of the acquired company. Net income is growing steadily from year one through year four, but drops dramatically in year five is this an incidental drop or structural. The drop in profitability could be an indication of impairment of all of or part of the $1 billion in Goodwill on the books. Asset impairment. If the carrying value or book value of an asset is higher than the recoverable amount of the asset, then the company should be recognizing an impairment loss. Want to learn more about business, finance and accounting? Then subscribe to the Finance Storyteller YouTube channel. Thank you for watching. |
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What is liquidity in finance, investing and accounting? Let's look at liquidity for a company, liquidity in markets and liquidity for investors. The term liquidity is used very often in financial news. There might be worries about liquidity of ABC Corp. Will it be able to pay its bills and survive? Central banks might be providing more liquidity to financial institutions in times of economic turbulence, so they in turn can provide loans to consumers and businesses. Consumers might decide to hold more liquidity if they are seeking a safety net for unplanned expenses. What is the definition of liquidity? Liquidity is the availability of liquid assets to a company, market or trader investor. What is the first thing you think of when you hear the word liquid? Water. Here is a glass of tap water in my kitchen. Here is another glass of water, solidly frozen. If you turn it upside down, nothing happens. Ice is not liquid, water is. So is liquid versus frozen binary? Water is either liquid or frozen. Not quite. There is an intermediate state. Water might be in the process of freezing and ice might be in the process of defrosting. The third glass in the middle is 20% liquid, 80% frozen. When I pour out the water, a big chunk of ice remains. When you think about liquidity in finance investing and accounting, think about an infinite number of intermediate stages. 1090, 2080, 3070, 4060, etc. Ice assets can be fully liquid like water, fully frozen like ice or anywhere in between. Let's go one level deeper into liquidity for companies. If you review a company's financial statements, liquidity means the ability to pay short-term obligations. An example is a CFO stating that his company has ample liquidity of $3 billion. $2 billion in cash and $1 billion in the revolving loan. Also called Revolving Credit Facility, a loan where the funds are drawn and repaid as needed by the borrower. If you want to review the liquidity of a company from its financial statements, the current ratio is a very useful financial ratio. Let's look at liquidity on the balance sheet. For reporting in the US, the assets of a company are listed from most liquid at the top to least liquid at the bottom. Cash is very liquid. In most cases, you can use it immediately to pay your obligations. Accounts receivable are very close to cash. Once the customer pays you, you can use that cash to pay your own bills. Inventory is still reasonably liquid, but you will have to sell it first and then collect a receivable for inventory to turn into cash. These assets are not very liquid. To convert them to cash, you will need to produce product on it, sell the product and collect a receivable. Goodwill is an example of an intangible asset that is very illiquid. So if you judge the balance sheet of this company purely on the asset side of the balance sheet, you could say that it is not very liquid. As most of the asset value is in fixed assets and goodwill. If you compare current assets to current liabilities, things look a little bit better. The company has a current ratio of 2. For every dollar of current liabilities, there are 2 dollars of current assets. A strong level of liquidity. Market liquidity When I look at the most active stocks on the NASDAQ on the day I made this video, well-known names like Amazon, Apple and Elf Abed Inc show up. These are heavily traded stocks with billions of dollars of transaction volume on normal days. So that's the first version of defining market liquidity, having lots of buyers and sellers available forming an active market. A second version of market liquidity is the ability to buy or sell something without causing a large price change. If I need to liquidate my portfolio today, will I be able to do so as stable prices? Or will my selling cause a price drop which would decrease the amount of cash I get in return for selling my stocks? Individual liquidity for a trader or investor. Let's look at the investment portfolios of Jim and Jane. Jim has invested directly in private companies, real estate and vintage cars. Jane has invested in blue chip stocks, bonds and holds cash. You could say that Jim's portfolio is largely frozen or illiquid, and Jane's portfolio is relatively liquid. We are looking at her returns here, either Jim or Jane could outperform. We are only judging how flexible the investment portfolios are in exchanging assets for other assets. If Jim and Jane both love art and go to an auction, who is in the best position to bid? Most likely that will be Jane. You can pay in cash or quickly sell stocks or bonds on the day of the auction, whereas it would take Jim a lot longer to turn his assets into cash. Or if Jim does want to sell his existing investments fast, he might need to sell at a significantly lower price. Liquidity is the availability of liquid assets to a company, market or trader investors. This can be fully liquid like water, fully frozen like ice or anywhere in between. Want to learn more about business finance and accounting? Then subscribe to the Find the Storyteller YouTube channel. Thank you. |
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How does the accounting equation work and what are some examples of using the accounting equation? The accounting equation states that assets always equal liabilities plus equity. Assets are what a company owns and they are recorded on the left hand side of the balance sheet. What a company owes is recorded on the right hand side of the balance sheet and can be split between liabilities with its owed to creditors and equity. What's owed to shareholders? Assets equal liabilities plus equity. If assets go up, then liabilities and equity also must go up. If assets go down, then liabilities and equity also must go down. Let's illustrate the accounting equation with some examples. When the company is started, the entrepreneurs starting the company sent cash from their personal bank account to the company's bank account. The company records $100,000 in assets. It is cash that the company owns and $100,000 in equity. The money is owed to the shareholders. If we check the accounting equation, we find that assets of $100,000 equals liabilities which are zero plus equity of $100,000. What we own equals what we owe. The company then buys some inventory from a supplier on credit. Inventory is an asset that the company owns. Accounts payable, an invoice received from a supplier but not paid yet, is a liability that the company owes. Let's check the accounting equation. Assets of $150,000 equal liabilities of $50,000 plus equity of $100,000. Next step is for the company to sell the inventory to a customer on credit. Accounts receiveable are an asset to company owns, invoices sent to a customer that have not been paid yet. To complete the sales transaction, the company not only sends an invoice but also ships the goods. Inventory therefore goes to zero. As the company sells the goods for $80,000 while it bought the goods for $50,000, the company makes a profit of $30,000. Assuming no corporate income taxes for startup companies, which is not the case in real life, the profit on that transaction will end up in retained earnings, which is part of equity. Let's once again check the accounting equation. Assets of $180,000 equal liabilities of $50,000 plus equity of $130,000. There can also be movement between accounts within one category. The company decides to buy a small delivery event to deliver the goods. Fix assets, property, plant and equipment, go up $25,000, cash goes down $25,000. Assets of $180,000 equal liabilities of $50,000 plus equity of $130,000. The accounting equation is the foundation for double entry bookkeeping. You could even see the accounting equation as the most important concept in accounting period. Assets equal liabilities plus equity. Want to learn more about business finance and accounting? Then subscribe to the Finance Storyteller YouTube channel. Thank you. |
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What is a general ledger? The general ledger is the backbone of any accounting system which holds financial data for an organization. Until the 1970s and 1980s, recording entries manually in big ledger books was the way to go. You would have separate sub ledger books such as payroll, cash, inventory, receivables, and many others depending on the type of company. From each of these sub ledger books, summary amounts would be transferred manually into a central place called the general ledger. As you can imagine, due to the manual nature of the process, this process is prone to errors like writing 51 instead of 15. Today's enterprise resource planning systems are a lot less manual, and the closing cycle tends to be a lot faster. But the general idea of sub ledgers and general ledger is still the same. For example, in an ERP system like SAP, original documents are registered in the accounts receivable sub ledger by customer account and in the accounts payable sub ledger by vendor account. The amounts posted in the sub ledger are then transferred from the sub ledger to accounts in the general ledger. Sub ledgers generally hold a lot more detail than the general ledger. Compared to the manual process of recording entries, computerized systems have the advantage of validation rules that can prevent a user from posting if a journal entry is not balanced. This can save a lot of time downstream in the accounting process. Here's how that process works all the way from recording individual transactions to preparing financial statements. Transactions based on source documents are recorded in the appropriate sub ledger, payroll, cash, inventory, receivables, payables, fix assets, etc. The sub ledger activity is then posted as debits and credits to the appropriate accounts in the general ledger. The listing of the account names is called the chart of accounts. Getting a transaction into the general ledger can be done through a sub ledger, but also through a manual journal entry directly into the general ledger. The extraction of account balances is called a trial balance. The purpose of the trial balance is to ensure that the value of all the debit value balances equal the total of all the credit value balances and that the individual balances per account or per group of accounts makes sense. If an error is found in the trial balance, the finance team goes through a process to rectify errors. Some of these errors may be very easy to correct, others might take a substantial amount of analysis. Is there an error in the general ledger itself? Is there an error in how the data from the sub ledger is posted in the general ledger? Or is there an error in how the data was recorded in the sub ledger? Or any of the manual journal entries? Or in the source documents themselves? Find the error and correct it. Once the trial balance is deemed accurate, the next step in the process can be taken, repairing the financial statements, income statement, balance sheet, cashflow statement. Using the financial statements, you can connect the financial numbers to the operational reality by calculating financial ratios and analyzing the trends. The general ledger is the backbone of any accounting system. It is the central repository for accounting data transferred from all sub ledgers. Want to learn more about business, finance, accounting and investing? Then subscribe to the Finance Storyteller YouTube channel. Thank you. |
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What are some of the key insights from the field of finance for business owners, managers and investors? Let me walk you through five big ideas that can help you improve your business and build a better understanding of decision making and financial reporting. Finance idea number one. Profit is not necessarily the same as cash flow. Let's say you are full of ideas. You like to invent stuff. You have come up with a breakthrough product and got a prototype working. However, your personal strength is really in inventing, not in manufacturing, nor in selling. So you get somebody else to do the manufacturing of your product for you. They produce the goods according to your specifications, ship them to you and you pay cash on delivery. You also get somebody else for the selling of the product to consumers. You ship the goods to a retailer, but instead of the retailer paying you immediately, you will receive payment after 30 days. This month you buy 100 units at $80 each and sell 50 units at $100 each. The other 50 units stay in inventory. How much profit do you make? You deliver and sell 50 units at $100 each, so your revenue is $5,000. The cost to you of sourcing those 50 units that you have now sold is 50 units at $80 each, so your cost of goods sold is $4,000. In short, you sell 50 units at $20 margin per unit, so generate a profit of $1,000. How much cash flow do you generate? Well, you don't get paid by the retailer until one month from now, so cash in is zero. You pay your supplier on delivery, so cash out is $8,000. Total cash flow is negative $8,000. Profit on your shipment is recognized when you deliver the goods to your customer, the retailer. Cash flow is recognized when cash comes in or cash flows out. You could be profitable yet go bankrupt. Finance IDN 2 Each financial statement tells a story. The balance sheet gives you an overview of assets, liabilities and equity. It shows what we own on the left and what we owe on the right. The income statement shows you how revenue minus expenses equals profit or loss. Or in other words, how sales minus costs equals income or loss. The cash flow statement shows you how you got from the cash balance at the start of the year through cash inflows and cash outflows during the year to the cash balance at the end of the year. A balance sheet is a picture at a point in time, usually the end of the month, end of the quarter or end of the year. An income statement is a movie of profitability during a month, quarter or year. A cash flow statement is a documentary movie about movements in the most fascinating account on the balance sheet. Cash Finance IDN 3 Book value, what a company is worth on paper based on the balance sheet, is not necessarily the same as market value. What someone is willing to pay for it. Let's look at Apple Inc. The book value of its equity on the balance sheet of March 30, 2019 is around 106 billion dollars. The number of outstanding shares, 4.7 billion units. So the book value per share is around 22.55 cents. If you look at the market value of the share price in early May 2019, you see the share price around 200 dollars. Book value or accounting value is based on the company's historical financial results looking back. Market value or economic value depends on the expectations of investors for the future of the company, looking forward. Finance IDN 4 There are many ways to drive operating income. If you listen to CEOs and CEOs, it sometimes seems that the only thing they can think of is cost cutting, cost cutting and more cost cutting. While that could certainly be in an appropriate way forward, there are more options to choose from. Price Are you charging a price to your customers for your goods and services that accurately reflects the value you are creating for them? Volume What opportunities do you have to sell more units? Mix Can you focus more resources on selling the higher margin products and services in your portfolio versus the lower margin ones? Productivity Can you generate the same amount of output with fewer resources or more output with the same amount of resources? Sourcing benefits Can you renegotiate your contract with your existing suppliers to get lower price on more value? Or can you find alternative suppliers that give you a better deal? Spending more Can you spend more or research and development to develop your product or service faster and better and generate more revenue and margin? Can you spend more on marketing to establish your brand? Can you spend more on learning and development to improve the skills of your employees? Finance IDN 5 It's your lucky day. Money wants to give you $100. Would you like to receive that $100 right now today or would you like it one year from now? I'm pretty certain you would say $100 today. All sorts of things could happen during a year, right? Mr. Somebody, my changes might about giving you the money. Mr. Somebody could go bankrupt and be unable to give you the money or there could be inflation that decreases the purchasing power of the $100 you receive. That's the idea of time value of money. $100 today is not the same as $100 one year from now. If I ask you what it would take for you to agree to wait for a full year, the answer might be an extra $5. In that case $100 today equals $105 one year from now and we have put a price on time. That's what time value of money means. It's a key concept in evaluating investment proposals using net present value and internal rate of return. Want to learn more about business, finance, accounting and investing? Then subscribe to the Finance Storyteller YouTube channel. Thank you. |
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What is equity? Equity is a term used in accounting, in real estate and home ownership, in investing, as well as in startup financing and valuation. The meaning of the term equity is very similar in the various areas where it is used, so it will be good to review all four of these to get the best understanding. In accounting, equity is a term that you will find on the balance sheet. What you own is on the left, assets. What you owe is on the right, liabilities and equity. Equity is the book value of the shareholder capital. Here's an example. A company in the manufacturing industry has a machine that they bought for one million dollars as its asset, what it owns. This asset is financed through a bank loan of $800,000, money that is owed to the bank, and through equity, shareholder capital of $200,000, that is owed to Jane, the owner of the business. The accounting equation tells you that assets equal liabilities plus equity. That also means that equity equals assets minus liabilities. Equity on the balance sheet goes up when the company is profitable. The then income for the year gets added to equity through retained earnings. Equity on the balance sheet goes down when the company is lost making. This is the equity. Or when the company pays a dividend to its shareholders. Equity in homeownership works very similar to equity on the balance sheet. What we own is on the left, the house worth $500,000. What we owe is on the right, $400,000 of mortgage loan from the bank, and the owner of the house, Jim, has $100,000 of equity in the house. Equity in homeownership is what the home is worth minus how much you owe to the bank. Just like equity on the balance sheet of a company can go up or down, the equity that you have in your home can go up or down. If Jim is paying down the mortgage on his house by $50,000, then the amount of the loan outstanding will decrease and his equity in the house will increase. If the market value of the house increases, then Jim's equity in the house will increase. Remember that equity is what the home is worth minus how much you owe to the bank. If the market value of the house decreases, then Jim's equity in the house will decrease or even become negative. Jim will need to have a conversation with the bank to make a remediation plan to get back to positive equity. Or in the worst case scenario, Jim might lose the ownership of the house and the bank will need to take a partial right off of its outstanding loan. Investing in equity. Remember the example of the small manufacturing business that owned the machine, had a loan from a bank and equity from one shareholder. What if we make that a big manufacturing business that owns lots of machines at different sites totaling $1 billion? Has many loans outstanding totaling $800 million that are publicly traded in the bond market and has many different shareholders as the certificates ownership the equity is traded publicly as well. As an investor, you have the choice of buying bonds which would have a predetermined interest rate and has the machines as collateral or the choice of buying stocks which are perceived as having more downside risk as well as more upside potential. Invest in debt or investing equity. Equity in a startup company. How do you put a price on what is essentially so far just an idea that still has to be developed and will find many ups and downs along the way? The company does not have any assets, liabilities and equity yet. The financing and valuation depend on the estimate of the revenue, profit and cash flow that the business idea might bring in the future. A good way to learn about startup companies in the tech field is the comedy series Silicon Valley. What happens if the app you are developing turns out to have a great compression algorithm? You are courted by investors ready to fund you and your friends and roommates suddenly become your employees while you become the CEO. In season one of Silicon Valley, Lent-Los-Lash Incubator, Eurlie Buckman has 10% of the shares in startup company Pipe Piper. Accentric billionaire Peter Gregory buys 5% for $200,000 and the three employees Gillfoil Dinesh and Jarrett get 3% each in what someday might be a multi-billion dollar company. By my math, that says the CEO Richard Hendrix up with 76% of the shares in the company. In subsequent seasons of the comedy series, Pipe Piper goes through various runs of financing as well as acquisitions and other ownership changes. Having equity can be a great thing. Money has potential risks as well as potential rewards. The term equity is used in accounting, in homeownership, in investing and in startup financing evaluation. Probably the easiest metaphor to remember is equity in homeownership. What a home is worth? Minus how much you owe to the bank. Want to learn more about business and finance? Then subscribe to the Finance Storyteller YouTube channel. Thank you. |
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What are assets and liabilities? Once you understand how the terms assets and liabilities are used in business, you can use that knowledge to your benefit in your personal life as well. In accounting, assets and liabilities are terms that you will find on the balance sheet. What you own is on the left, assets. What you owe is on the right, liabilities and equity. Let's work through some examples of assets and liabilities. What about the machine, the company bought, to produce goods that is selling? This is a tangible fixed asset, something that the company owns and that has physical form. Let's place that in assets on the left. What about accounts receivable? These are invoices sent to the customer, which the customer has not paid yet. This is an asset as well. We own the right to collect the money for the goods or services we have delivered. What about accounts payable? These are invoices received from a supplier, which the company has not paid yet. This is a liability. We owe money to the supplier. Let's place that on the right. Cash. Cash is a financial asset. Cash is very liquid. In most cases, you can use it immediately to pay your obligations. Inventory. Inventory is an asset as well. These are goods that we own and intend to sell. A loan agreement borrowing that the company owes money to the bank. This is a liability. We now have many of the elements of a balance sheet for a company. There is one more very important element, which fits in the bottom right corner of the balance sheet. Equity. Equity is the shareholder capital. You can calculate it by taking the total value of the assets minus the total value of the liabilities. Now that you understand the picture of assets liabilities and equity on the balance sheet, let's think of the dynamics going on in the company. A company will try to generate a return on assets. If the revenues generated from selling goods and services are bigger than the expenses, such as labor, materials and depreciation of manufacturing equipment, then the company generates a profit. Return on assets, release the amount of profit made to the assets needed to generate a profit. Some companies need very few assets to generate a substantial profit. Other companies may need a lot of assets to generate only a modest profit. Increasing RWA is generally a good thing. On the liability side, having that generates a cost of borrowing. The amount of interest that the company pays depends on the amount borrowed and the interest rate. If a company improves its financial health, its cost of borrowing tends to go down. In general, it is good to have a return on assets that far exceeds the cost of borrowing. Let's apply what we learned about assets and liabilities to assets and liabilities in your personal life. What if you own a house? That's an asset. However, if you rent a house as a tenant, then you wouldn't put a house on your balance sheet as an asset as you don't own it. What if you own a car? That is an asset as well. If you lease a car, you wouldn't put a car on your balance sheet as an asset as you don't own it. What about cash? That is an asset. Unpaid credit card bills. A liability. A portfolio of stocks. An asset. A loan agreement with a bank. For example, the mortgage loan on your house. A liability. There is one more element which fits in the bottom right corner of the balance sheet. Equity. You can calculate it by taking the total value of the assets minus the total value of the liabilities. Within the assets in your personal life, there can be items that we call potential earning assets. Cash in a savings account that pays you interest and stocks in investment portfolio that pay a dividend or go up or down in value. Just like companies monitor their cost of borrowing closely, you should also keep track of your cost of borrowing on various types of debt you might have outstanding. Chances are that the unpaid credit card bills carry the highest interest rate and therefore should get the highest priority in paying down. So what is financial wealth in somebody's personal life? A lot of people mistake wealth for assets. We tend to think that the more assets somebody has, the wealthier that person is. But what if that beautiful yacht, as well as that fancy sports car, are all debt financed? That increase, the person owns more, but liabilities also increase, the person owns more. The more debt you add, the more fragile you get. The true measure of financial wealth, which is often not visible to the outside world, is the amount of equity that somebody has. Assets minus liabilities. Looking at some of these assets without knowing how they are financed might be deceiving. It might actually be the person with a smaller house and the older car, but with very few or even no liabilities, that is the more financially wealthy. Want to learn more about business investing and finance? Then subscribe to the Finance Storyteller YouTube channel. Thank you. |
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USGAP for IFRS USGAP United States generally accepted accounting principles. IFRS International Financial Reporting Standards USGAP and IFRS are the two main accounting standards in the world for use by public-listed companies. USGAP is developed by the FASB, US-based Financial Accounting Standards Board, headquartered in Norwalk, Connecticut. IFRS is developed by the IASB, the International Accounting Standards Board, headquartered in London, United Kingdom. USGAP is obviously the standard in using the United States. Accountry with a highly diverse and very large economy and a very long history of an active market for buying and selling stocks and bonds. Where companies need to synchronize the way they report financial results to investors. How many countries use IFRS? The self-proclaimed global standard for global markets. The global solution for a global need. Take a guess. Here are some maps of various parts of the world with countries that require IFRS in red and countries that permit IFRS in green. According to the IFRS Foundation, 144 jurisdictions in total now require the use of IFRS standards for all or most publicly-listed companies. Thus the further 12 jurisdictions permit its use. So 156 countries in total. The European Union adopted IFRS standards as the required financial reporting standards for the consolidated financial statements of all European companies whose debt or equity securities trade in a regulated market in Europe effective in 2005. In Japan, voluntary adoption is allowed since 2010, but no mandatory transition date has been established. China has continued to amend Chinese accounting standards so that its principles are generally consistent with IFRS. Indian accounting standards are based on and substantially converged with IFRS standards. So if USGAP and IFRS are different accounting standards, should this topic only be interesting for accountants? Quite the opposite. Of course, accountants, CEOs and finance directors need to have the most in-depth knowledge of how accounting standards work, but many others should have at least a high level understanding. It is essential for any investor to understand how USGAP and IFRS work. It is very important for anybody comparing the performance of companies, business leaders, stock market analysts, business developers, marketing leaders. There are several high quality documents that can help you understand similarities and differences between USGAP and IFRS in great detail. The 52-page SEC document from 2011. All more recent publications like the 51-page document from accounting firm Ersen Young. The APMG is 515-page handbook, the Lloyds 72-page publication and PWCs 237-page guide, or maybe get a high-level idea first by watching this final storyteller video. Let's take an example in the oil and gas industry, the income statements of ExxonMobile and Shell. ExxonMobile has a number of companies that report financial results in US dollars, the currency of choice for transactions in your oil business. That should make the comparison easy, right? Revenue at the top, $279 billion for ExxonMobile, $388 billion for Shell. Net income at the bottom, $21 billion for ExxonMobile, $23 billion for Shell. Now that we have found those two key numbers of revenue and net income for both companies, you can jump straight into financial ratio analysis for this year, trend analysis over the past three years, etc. No, no, no, no. We could be comparing apples to oranges. ExxonMobile prefers its financial statements based on US gap. Shell prepares its financial statements based on I of R.S. If the standards you apply are different, the calculation of a number like net income is different. We have no indication what Shell's net income would have been under US gap, no or what ExxonMobile's net income would have been under I of R.S. Comparing ExxonMobile to Chevron, US gap to US gap is apples to apples. Comparing Shell to BP, I of R.S. to I of R.S. is oranges to oranges. But sadly, comparing the financial performance of ExxonMobile to Shell is not possible without a lot of rough estimates, well guesses and disclaimers. Is there any way of finding out exactly how much the difference is between US gap and I of R.S. for one and the same company in the same year, for example in the area of profitability? I have searched far and wide but have only found one recent example of a company that provides a recent risk-onciliation between their US gap and their I of R.S. numbers. One company, ASML, the world's leading supplier of semiconductor manufacturing equipment and the innovator behind ever-advancing lithography systems. ASML shares are listed for trading on NASDAQ and EUR next Amsterdam. They publish an annual report based on US gap as well as an annual report based on I of R.S. and the reconciliation between the two. In both 2016 and 2017, I of R.S. net income for ASML was higher than US gap net income by around $100 million per year, a difference of around 5%. Specifically for ASML, there are two main differences. The way development expenditures are treated under US gap, fully charged with operating expense versus I of R.S., capitalized and then amortized, and the way income tax expense and divert tax assets are recorded. This is a very small sample, one company in one specific industry. The same or different elements of the US gap and I of R.S. accounting standards may cause differences for other companies. Who knows. Why is it not easy to find more examples of companies that publish the financial results for both US gap and I of R.S.? There surely must be more companies like ASML that have a dual listing. In other words, companies that have the shares listed in US, NYSE or NASDAQ as well as somewhere else in the world. Yes, there are plenty of those companies around 500 to be more precise. Under current rules of the United States Securities and Exchange Commission, SEC, foreign issuers, corporations incorporated on the laws of any foreign non-US country are allowed to use I of R.S. financial statements in the registration statements and periodic reports. This saves foreign issuers a lot of time, money and effort as they don't have to prepare dual annual reports under both US gap and I of R.S., but it's not great for global comparability. In addition, in November 2007, the SEC unanimously approved a proposal that no longer requires foreign registrants to reconcile the financial statements with US gap, as long as they use I of R.S. as issued by the International Accounting Standard Board. So there are lots of examples of US gap to I of R.S. comparison for 2006, but few to none for more recent financial years. Let's face it, 2006 in today's VUCA world is pretty much ancient history. If you do find a recent example of a company publishing both US gap and I of R.S. numbers and the reconciliation between them, then please let me know in a comment below. So if you can't start a comparison between US gap and I of R.S. from a sufficiently large sample of actual differences for real life companies, let's take a look at the possible differences that could occur. US gap and I of R.S. each provide a way to map economic events onto financial reports, providing principles, rules and guidance to book accounting general entries and put together financial statements. For most common transactions, there are more similarities than differences between US gap and I of R.S. However, it is important to realize that significant differences in treatment can and do occur. Some differences are cosmetic. If we compare the balance sheets of two companies that we discussed earlier, ExxonMobil and Shell, we find that ExxonMobil, US gap, lists assets from most liquid to least liquid. And Shell, I of R.S. lists assets from least liquid to most liquid. A cosmetic difference, you just have to look in a different place for the information you need. What is more worrisome is substantive differences. differences in the way revenues and expenses are recorded in the income statement. Differences in how assets, liabilities and equity are valued on the balance sheet. And differences in how cash flow items are classified on the cash flow statement. Let's zoom out to the big picture on US gap for I of R.S. US gap is mostly rules based, while I of R.S. is mostly principles based. What does rules based for the principles based mean? There's a metaphor that viewers with children or those that grew up with the brother or sister might relate to. The two ways to run a family. Some parents use a rules based system. They tell their kids which behaviors are allowed and what is prohibited. You can't kick or punch your brother or sister, but you may give him or her a hug. Other parents may use a principle based system. In this family, we are nice and friendly to each other. Is rules based, better than principle based, or is principles based, better than rules based? I don't think one is better than the other. Each has advantages and disadvantages. With rules, you try to provide clarity and be specific. The more specific the guidance, the more consistently application, right? Or not quite? Unfortunately, in the case of families, by making a list of rules, you might also encourage children to try things behind your back as a parent. Kids might test the limits of the rules, and your list of rules is probably never ever going to be complete to describe each and every possible interaction between siblings. An equivalent of this in the US gap accounting standards is the use of bright lines. When the fast-beef specifies a percentage as a minimum or maximum for applying a certain rule, companies might adapt their behavior to just meet the minimum requirements. Complying with a letter of the standard, but not necessarily with the spirit of the accounting standard. With principles, you leave a lot of room for interpretation. Different people might each have their own subjective interpretation of the principle. Opponents of principle based structures would say that a lack of detailed rules might lead to more abuse, and in the business context, to different interpretation for similar transactions. The night-ass system will be perfect, and it is not easy to find the optimal mix between rules and principles that works best. A rules-based standard like US gap is definitely more sizable than the principles based standard like IFRS. Estimates of the size of US gap version IFRS vary from 72 hundred pages of US gap, when printed, there is a 1,300 for IFRS, to 25,000 pages of US gap, to 2,000 pages for IFRS. Whether it's a 6 to 1 ratio or a 12 to 1 ratio, rules-based is more extensive. This remains one of the criticisms of US gap by practitioners, standards overload with too much detail in a high level of complexity. It is important to understand that both US gap and IFRS are changing over time. New industries emerge, new types of transactions occur, and the thinking about how certain economic transactions need to be treated accounting-wise changes. Some years, big impact changes in the standards occur. In other years, the number of changes might be large, but the impact fairly low. And sometimes things are fairly quiet in the area of standard setting. So even if you compare numbers for one of the same company over a large number of years, you might be comparing various types of apples. An interesting question is whether US gap and IFRS will converge, grow more close, or diverge, grow further apart. The FASB and IAASB have been working together over the years to try to develop common standards in various areas. The success story in convergence between US gap and IFRS is the new standard for recognizing revenue from contracts with customers. ASC 606 in US gap and IFRS 15 in IFRS, effective 2018. With the exception of a few fairly minor areas, the new model eliminates many of the existing differences in accounting for revenue between the two frameworks. As revenue is, for most companies, the biggest line item in the profit and loss statement, it is great from comparability if recognition of revenue is synchronized between the two accounting standards. A project with mixed results is the new standard for leasing. ASC 842 in US gap and IFRS 16 in IFRS, effective 2019. While both the new standard basically require less ease to recognize right of use assets and leased liability on the balance sheets, there are significant differences between the standards. The new standards narrowed the differences but did not eliminate them. What are some examples of areas where US gap and IFRS could yield very different outcomes? Valuation recognition evaluation of financial instruments is one such complex area. Valuation of inventory is another, with the question whether to LIFO or not to LIFO as a central theme. LIFO is acceptable under US gap but prohibited under IFRS. Inventory value on the balance sheet tends to be lower on the LIFO, last in, first out, then under FIFO, first in, first out. Therefore cost of goods sold tends to be higher on the LIFO than under FIFO and profit tends to be lower on the LIFO than on the FIFO. This might sound like a trivial matter but it makes a major financial difference. For all companies in the US that still use LIFO to change to FIFO could generate a one time taxable profit of tens of billions of dollars. So will listed US public companies ever be required to or allowed to transition from US gap to IFRS? It was certainly hinted at and discussed in the past. The SEC and financial accounting standards board FASB have been hesitant to relinquish control over accounting rules. There may be more convergent projects in the future, maximizing similarities and minimizing differences which effectively brings US gap and IFRS closer. With a full transition, I think that US adopting IFRS is as likely as the US converting to the metric system. Possible, maybe even advisable but very unlikely. Want to learn more about business investing in finance than subscribe to the Finance Storyteller YouTube channel. Thank you. |
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