Lesson 2

The Business Equation

2

To be a successful financial analyst you have to master the 3 fundamental statements in an annual report: The Balance Sheet, the Income Statement and the Cash Flow Statement.


But before analysing these statements let's start with the business equation or the balance sheet equation which is one of the most important notion in accounting.


ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY


Both sides of the business equation must always be balanced with one another.


Now, let's describe the components of this equation.

  • Assets are bought to increase the value of a firm or benefit the firm's operations. You can think of an asset as something that can generate cash flow. Assets are either current or fixed (non-current). Current means that the asset will be consumed within one year. Generally, this includes things like cash, accounts receivable and inventory. Fixed assets are those that are expected to keep providing benefit for more than one year. They are either fixed tangible assets such as equipment, buildings and real estate or fixed intangible assets such as patents trademarks and copyrights.

  • Liabilities simply refers to any money or service that is currently owed to another party. Liabilities are are either current or long terms. Current liabilities are debts payable within one year and include for example accounts payable and accrued expenses. Long-term liabilities are debts payable over a longer period and include long term loan or long term leases. Liabilities are a powerful tools to company willing to finance operations and pay for large expansions. Unfortunately nothing is free in this world and high interest expenses arising from the loans could harm the company's profitability.

  • Shareholders' equity. The name speaks for itself. It is the value of a company which is the property of its ordinary shareholders (the company's assets less its liabilities). It is composed of two components.

  1. (Share) capital, which is the historical value of the contribution (Cash, ideas, physical assets etc..) to the firm all shareholders have made in the beginning and during the life of the firm.

  2. Retained earnings (or reserve, RE), which is the value created through the firm's operation that shareholders have chosen not to take out of the firm. Net income and RE are not the same! NI refers to the profit or deficit over a specific period whereas the RE is the cumulated profits or deficit over the years. It is also important to understand that the profit generated by the firm belongs to shareholders. Every year the board of directors decides whether the firm should keep the profit in order to invest in new projects or whether they should distribute the profits through dividends. Generally, no firms can afford to pay 100% dividends. We will see why later on, but now let's see how we calculate the RE. RE are basically all the cumulated profits of the firm minus all the dividends paid. So the RE for a specific period is:

RE= Beginning RE + Net income - Dividends


Beginning RE being the net income - dividends for the previous years.


Now that we've covered the basic components of a balance sheet here comes an extremely basic example of how a BS could look like:



In this example, The assets are equal to the Equity and Liabilities. Hence, the business equation is balanced.


In the next lessons we will cover the Income statement and its components.

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