14.1 Accounting: More than Numbers

Accounting is the language of business, providing crucial financial information for decision-making. It involves recording, analyzing, and communicating a company's financial data to help managers, investors, and other stakeholders make informed choices.

There are two main types of accounting: financial and managerial. Financial accounting focuses on external reporting, while managerial accounting provides detailed internal information. Both play vital roles in helping businesses track performance, plan for the future, and stay financially healthy.

Purpose and Types of Accounting

Financial Reporting

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• Accounting system records, analyzes and communicates a company's financial information
  • Helps managers, investors and other stakeholders make informed decisions based on financial data
• Financial reports provide a snapshot of a company's financial position and performance
  • Balance sheet lists assets (what company owns), liabilities (what company owes) and owner's equity at a specific point in time
  • Income statement shows revenues, expenses and resulting profit or loss over a defined period (quarter, year)
  • Cash flow statement tracks inflows and outflows of cash from operating, investing and financing activities
• Accounting ensures transparency, accountability and compliance with laws and regulations
  • Audited financial statements assure stakeholders that information is accurate and reliable
• Investors and creditors use financial reports to assess a company's financial health when making investment and lending decisions
• Managers rely on accounting information for budgeting, cost control, pricing and other internal decisions to boost profitability and efficiency

Managerial vs Financial Accounting

• Managerial accounting provides information to internal users (managers, employees) for decision-making
  • Includes budgeting, cost accounting, performance evaluation and capital investment decisions
  • Information is detailed, frequent and forward-looking compared to financial accounting
  • Not required to adhere to GAAP (generally accepted accounting principles)
• Financial accounting provides information to external users (investors, creditors, regulators, public)
  • Involves preparing financial statements (balance sheet, income statement, cash flow statement)
  • Information is historical, summarized and must comply with GAAP and other regulations
  • Mandatory for publicly traded companies and frequently audited by independent CPAs

Analyzing Financial Statements

Key Financial Statements

• Balance sheet analysis:
  • Liquidity ratios (current ratio $\frac{current assets}{current liabilities}$, quick ratio) measure short-term ability to pay debts
  • Solvency ratios (debt-to-equity ratio $\frac{total liabilities}{total equity}$) assess long-term financial risk and leverage
  • Efficiency ratios (inventory turnover $\frac{cost of goods sold}{average inventory}$, receivables turnover) evaluate asset utilization
• Income statement analysis:
  • Profitability ratios (gross profit margin $\frac{gross profit}{net sales}$, operating profit margin, net profit margin) measure ability to generate profits
  • Expense ratios (operating expense ratio $\frac{operating expenses}{net sales}$) help control costs
  • Earnings per share (EPS) is a key measure of profitability for shareholders
• Cash flow statement analysis:
  • Shows cash generation and use in operating, investing and financing activities
  • Free cash flow measures cash available for discretionary spending after necessary investments
  • Cash flow coverage ratios assess ability to pay debts and dividends from cash flows
• Comparative and trend analysis examines changes in ratios and numbers over time and versus competitors to identify strengths, weaknesses and red flags