Finance Skills - FAQ

Why do I need to understand basic accounting principles?
As a manager, you will usually be expected to understand simple financial reports and communicate effectively with financial people in your own organization. You may also be asked to contribute financial data about your own business unit.

What is the best way to learn about basic accounting concepts?
The basic principles of accounting are best understood by considering some simple businesses and how they might document their financial activities.

Why is cash based accounting not widely used in business?
The main limitations of cash accounting are that: there is nowhere to show 'unpaid bills'; there is no way of seeing any historical trend in the figures; and no allowance is made for major purchases or asset acquisition.

What is accrual accounting?
Accrual accounting is considered to be the standard accounting practice for most organizations, and is mandated for organizations of any real size. It provides a more accurate financial picture, but is more difficult to administer.

What financial jargon do I need to know?
Terms like 'revenue,' 'expenses,' 'gross profit,' 'depreciation,' 'bad debt,' and 'fixed assets' have precise definitions when used in business accounting. You need to understand exactly what is meant by accounting terms like these.

What is the revenue recognition principle?
Revenue is something that is generated by the business in exchange for goods or services. It does not include things like bank loans or overdraft facilities. Any payment for a service or product in advance of any work being performed is a 'receipt.' It only becomes a 'revenue' item once work (on behalf of the customer) actually begins.

What is the matching principle?
The matching principle aims to minimize any mismatch in timing between when an organization incurs costs and when it realizes any associated revenue.

What is an income statement?
An income statement is an accounting of revenue, expenses, and profit for a given period. This can also be an internal document that can be used to make management decisions about almost any activity where you have a record of the money spent and the associated return.

What is a balance sheet?
The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any organization's financial statements. The main concept of a balance sheet is that total assets must equal the liabilities plus the equity of the company at a specified time.

What are assets, liabilities, and equity?
Assets include things like stock/inventory, buildings, equipment, and money owed to the company. Liabilities include money owed by the company to suppliers and its own workers in the form of wages that have not yet been paid. Equity includes net assets, often referred to as shareholder equity, and consists of issued capital and reserves, both controlling interests, as in a parent or holding organization, and non-controlling interest in equity.

How are assets defined on the balance sheet?
Current assets include cash and cash equivalents, short-term investments, accounts receivable, and bad debt provision. Inventory includes raw materials, work in process, and finished goods. Prepaid expenses are those things that have been paid in advance like insurance premiums, property taxes, and income tax installments. Property and equipment includes such items as buildings, manufacturing equipment, vehicles, and office equipment.

How are liabilities defined on the balance sheet?
Liabilities are a company's legal debts or obligations that arise during the course of business operations and include loans, accounts payable, mortgages, deferred revenues, and accrued expenses. Current liabilities are those that will become due, or must be paid, within one year.

How is equity defined on the balance sheet?
Equity is the difference between total assets and total liabilities. The items that will appear under this section include loans from shareholders, capital stock, contributed capital, and retained earnings.

What does a balance sheet tell you?
An organization's balance sheet allows you to determine its liquidity and solvency as well as the ratios of its tangible and intangible assets. You can also use it to determine key ratios like the current ratio and the quick ratio. Assessing the ability of an organization to liquidate its tangible assets will give you an idea of how well it could deal with a liquidity problem.

What is a common-size analysis?
Performing a common-size analysis on a balance sheet can be done either horizontally or vertically. A vertical common-size analysis expresses inventory, liabilities, and equity as a percentage of total assets. A horizontal common-size analysis compares the change year on year for each item of the balance sheet enabling you to look at how an item has changed relative to total assets.

What is an income statement?
The primary purpose of the income statement is to report an organization's earnings to investors over a specific period of time. It can also be used to judge how well the organization is managed financially; decide the type of investment opportunity it presents; make comparisons with its competitors; and assess its operating performance.

What is the format of an income statement?
There are a variety of different types of income statements that organizations use, but the most common are the single-step format and the multi-step format

What is a multiple-step income statement?
The multiple-step income statement explicitly segregates the operating revenues and operating expenses from the non-operating revenues, non-operating expenses, gains, and losses. This makes it easy to see the gross profit, operating profit, and the net profit.

When are transactions entered onto the income statement?
Do not be surprised if a monthly income statement does not show the effects of individual transactions that you might expect to see. Income statements ONLY show irrevocable transactions; they do not show requests or promises.

What are operating expenses?
There are accounting standards to help you define operating and non-operating expenses. These cover research and development costs, sales and marketing costs, general and administrative costs, and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).

How can I use an income statement?
The best way to use an income statement is to compare a recent one with earlier ones for a similar period. Income statements used for comparison can use dollar amounts, percentages, or a combination. Using income statements to make comparisons is an extremely useful management decision-making tool.

What are common-size income statements?
Common-size income statements using percentages can only be used to compare organizations of differing sizes. These can provide valuable input into the management decision-making process. Common-size income statements can also be used to compare your organization's figures to the average for your industry.

How do I perform a common-size analysis?
When performing a common-size analysis the profitability indicators you should look at are gross profit margin, operating profit margin, and net profit margin.

How do I relate an income statement to a cash flow statement?
Comparing an income statement with the relevant cash flow statement shows how much of the profit is supported by cash actually coming into the company. Understanding how aggressive an organization is in their revenue recognition helps you determine the quality of the data that is shown on the income statement.

What is cash flow analysis?
Cash flow is simply the flow of cash through the organization over time. Working capital is required to ensure that the organization is able to continue its day-to-day operations.

Why does an organization need to manage working capital?
The management of working capital involves actively controlling inventories, accounts receivable, accounts payable, and cash. The effective management of working capital can increase profitability in the private sector and reduce the amount of capital required by nonprofit organizations.

What is cash flow?
Cash includes all of the money that the organization has in bank accounts and short-term investments that can quickly be turned into available cash. Cash flow can refer to actual past flows or projected future flows.

How are changes in the cash account recorded?
The way in which the 'cash account' is used in published accounts is to some extent counter-intuitive. When owner's equity increases, the cash account increases. When an asset (other than cash) increases, the cash account decreases. When a liability increases, the cash account increases.

What is a direct format cash flow statement?
Presenting cash flow using the 'direct' method is straightforward but not very useful because it does not show net income or make any attempt to explain the difference between any net income and net cash flow.

What is an indirect format cash flow statement?
An indirect format cash flow statement begins with net income and adjusts for changes in account balances that affect available cash. It is slightly more difficult to understand initially but has far more potential for analysis. A statement prepared using this method has four distinct sections: operations, investing, financing, and supplemental information.

How is cash flow from operations detailed?
Adjustments are all the operating items that had an impact on cash that were not included in the income statement. Depreciation is recorded each month after the asset is put into use yet no cash changes hands as a result of these depreciation entries. Cash received from customers would would increase the cash figure but decrease the accounts receivable figure.

How is cash flow from investments detailed?
Capital expenditures describes the amount spent for all fixed assets that are not charged to expense when purchased but are recorded on the organization's balance sheet. When investment is sold the net proceeds of the sale, except for the gain or loss on sale (which appears in the income statement), become an additional source of cash.

How is cash flow from financing detailed?
Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends.

How is financial performance measured?
The financial position of another organization can be determined using 'key financial ratios' derived from information in the organization's income statement, balance sheet, cash flow statement, and statement of retained earnings. These can either be benchmarked against past performance or another organization in the same business area.

What background information is needed to interpret key financial ratios?
It is important to know something about how an organization operates and what the accepted practices are within it's industry before drawing conclusions from key financial ratios.

What can be measured by financial ratios?
There are several different key financial ratios that can be classified by the characteristic they measure: for example, solvency, profitability, performance, and investment history. The trend over time is often more revealing than any one figure in isolation.

Is an organization solvent?
The current ratio and quick ratio can help you to determine whether an organization is solvent. The quick ratio does not include the value of stock within current assets and is therefore a better indication of liquidity.

How profitable is an organization?
You can see if an organization is profitable by looking at the income statement, but you need to put that profit into perspective. This can be done by looking at various ratios that compare profit as a percentage of sales or assets.

Is an organization performing?
Ratios for measuring performance include: gearing, number of days credit granted, number of days credit taken, stock turnover, and overheads as a percentage of turnover.

What is a price/earnings ratio?
A P/E ratio can be thought of as the length of time a stock will take to pay back the investment if there is no change in the business. The P/E ratio can be used to compare an organization to others in the industry same sector or to market indices e.g. S&P 500, FTSE 100, etc. This ability to make such comparisons is one of the reasons it is widely used by management. It also offers the flexibility to use either quarterly or annual data. Many management teams use sites such as Reuters' comparison tables to help with this activity.

What is the price-to-book ratio?
The price-to-book (P/B) ratio represents the value of the company if it is broken up and sold. The book value usually includes equipment, buildings, land, and anything else that can be sold, including stock holdings and bonds.

What is the PEG (price/earnings to growth) ratio?
The PEG (Price/earnings to growth) ratio illustrates the relationship between stock price, earning per share, and an organization's expected growth rate.

What is the dividend yield?
The dividend yield is used to calculate the earnings on investment (shares) considering only the returns in the form of total dividends declared by an organization during the year.