Finally, you decided to take that first step – you want to be part of the so called business world where money just doubles. You’ve heard rags to riches stories of people who invested in stocks, your office mate is suddenly all about mutual funds, and your neighbour bought a new car thanks to his business. So maybe this time, it’s your money’s turn to grow.
Unfortunately, when you first ventured out, everyone’s talking about their equity, their leverage, the indices, the debits and credits. You just don’t follow the jargon. So let me break it down for you.
As an overview, accounting is a made up world. It is based on arbitrary rules that are set in the so called “Framework”. Hence it is expected that you don’t understand it first. You have to understand the foundations, and then work from there.
1. Accounting Equation: Assets = Liabilities + Equity
Assets are a company’s properties – cash, receivables, property and equipment, etc. Assets are acquired in two ways – through debt (liabilities) or through the owner (equity). Hence, the total assets that you have can be attributed to third parties and to owners. That is why with a quick transposition, the total equity is equal to the total assets less assets acquired by debt.
2. Debits and Credits
Debit means left, credit means right. Yes, that’s all there is. So what about those credit memos you hear? Those messages from the bank that they’ve credited your account?
You see, in the world of accounting has “journal entries”. They are used to record your assets, liabilities and equity. It is but for monitoring purposes. Assets, being on the left side of the equation, increase in value through a debit, and its normal balance is a debit. Liabilities and equity increase in value through a credit, and its normal balance is a credit. A credit memo means a credit was recorded and a debit memo means a debit was recorded.
Let’s take the bank example. They say they have credited your account. When you have cash in the bank, that is your asset. So it is a debit amount. However, on the perspective of the bank, that is a liability (they are to pay that to you), and a credit amount. So if the bank says that they have credited your account, it means they have recorded a credit to their liability to you – so their liability to you has increased. And this is how it works on all accounts. As said earlier, the accounting world is composed of manmade rules, and this is one of those rules.
When they say financials, it is a report on the financial status of a company. It can mean two things – the financial statements or the financial ratios/analysis.
The financial statements are the balance sheet (statement of financial position), profit or loss (income statement), statement of cash flows, statement of changes in equity and notes to financial statements.
The balance sheet shows your accounting equation – assets = liabilities + equity. Profit or loss shows the financial performance of the company for a specific period – usually a year. It has the total revenue and expenses, ending with the net income. Statement of cash flows details the movement in the company’s cash. This is critical because if the company is not liquid, they will not be able to pay its liabilities and operations might have to be stopped (liquidity refers to the ability to pay your liabilities as they come due). These three financials are the usual documents needed in a business. The other two (statement of changes in equity and notes to financial statements) are required by the standards (the manmade rules of accounting) though they are not used much in business.
Another meaning of the word financials refer to the analysis of the company’s operations. These might refer to the financial ratios that are derived from the company’s financial statements. Financial ratios give a quick overview of the status of the company. For example, the average days of inventory is a financial ratio that shows how long the company holds its inventory before they are sold. This is critical because if the company is a restaurant business, an average days of inventory that is more than 30 days implies that its food products are held on hand for more than 30 days before being sold.
These are the jargon you are expected to encounter as you go along the business world. It will get more complicated, yes, but as they say, taking the first step is the most difficult step of all. As you’ve taken it now, I say it is time to grow your money.