Trigger 7: Accounting terminology

1. What are the main components of an income statement?

Income statement (sometimes also called the profit and loss statement or statement of operations) is one of the three major financial statements. It is used to calculate the profitability of a company. There are two kinds if income statements: Single step and Multiple step. Let's have a look at some terminology one might come across while reading an income statement. (1)

Two main categories in a single step income statement are 1. Revenues and gains, and 2. Expenses and losses. These two categories will together form net income. The formula is below:

(1)


To be more specific, there are several sorts of revenue or income, as well as expenses and losses. Let's have a look at our exemplary income statement, step by step.

NET SALES means all sales the company has made, minus discounts, damaged or missing goods, allowances and returned goods. (2)

From net sales you then deduct EXPENSES which include:
Goods and services 
In a café Expenses from goods and services would mean prices and delivery of the ingredients they use for their products.
Salary related expenses:
Salaries would obviously fall under this category, but also other expenses such as sick leaves, holidays, and employees' insurance.
Depreciation
Book keeping principles require that a company reports the yearly depreciation of their assets. Depreciation of an asset means this: A company buys an equipment, and evaluates that they can use it for 5 years. They first deduct the salvage value from the purchase price, then divide the remaining value for each year they expect to use the equipment. (3)
Operating expenses
Other operating expenses include things that have little to do with the products the company sells.
For a café this could mean, for example office supplies.
Other operating income
For example renting the premises for an event.

When all of the expenses above are deducted from the net sales, what remains under the line is called OPERATING INCOME.

In addition to operating income, a company can receive other income, for example financial income, which means things like income from municipal bonds, tax returns and interest from given loans. Financial expenses generally refer to interests of company's long term dept. (4)

After the financial income/expense has been added to/deducted from the operating income, what's left is called INCOME BEFORE TAXES. Taxes are calculated for this amount. In Finland the tax percentage for organizations is 20%. (5) This amount is called INCOME TAX EXPENSE. 

Once the tax has been deducted, we finally get the NET INCOME. If the amount remaining on the bottom line is negative, it is referred to as NET LOSS.

This example was a single-step income statement. One major difference with a multiple-spet, or a multi-step income statement is that it shows the GROSS PROFIT, which means net sales- cost of sold goods. Multi-step income statement also would have adressed the categories in more detail, showing what kind of expenses fall under Salary related expenses, to give one example.

2. What are the main components of balance sheet?

One of the main financial statements. The balance sheet reports the assets, liabilities, and owner's (stockholders') equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.

Here's a brief video on how balance sheet works:
http://www.investopedia.com/video/play/introduction-balance-sheet/

Assets: 

Things that a company owns. Also costs that have already been paid, but the service is still ongoing.

Non-current assets (something that has been there longer than a year)

For example machinery and supplies
-Intangible assets: immaterial rights, for example, patents, copy rights and such. (6)

Current assets (something that comes and goes)

-Materials and supplies

-Accounts receivables: a sale made with credit, where invoice is yet to be paid. Potential loss, is customer does not pay on time
-Other receivables, long term: Long term assets that are too insignificant to be listed separately.
-Prepaid expenses and  An asset that has already been paid for, but not yet (fully) used (7)
-Accrued income: An adjustment made to a financial statement, where the actual income has not been received yet, but is market in books as debit. (7)(8)
-Other receivables, short-term: Short term assets that are too insignificant to be listed separately.

-Cash and petty cash: Cash is balance on an account, petty cash is actual, concrete cash.
-Investments and securities: Bonds or stock that company owns

Equity:

The difference between company's assets and liabilities. (11)

-Share capital: The amount of funding a company has raised by selling stock to public investors (12)
-Retained earnings: Amount of  net earnings that is not paid out as dividends, but retained by the company to pay dept or to be reinvested in the business itself (13)
-Net Income: The bottom line of an income statement

Liabilities:

An obligation payable by the company, for example wages, loans, invoices and such. 

-Loans from financial institutions: Loans company has taken and has not yet (fully) paid back

-Accounts payable: Invoices for goods or services the company has yet to pay

-Other liabilities: Liabilities that are too insignificant to be listed separately

-Accrued expenses: An expense that has yet to occur, such as a salary that's due to be paid in the future. (14)

-Unearned revenue: Services or good a company has not done yet, but has already received a payment for.

Total equity and liabilities:

Same as assets.

3. How to analyze income statement and balance sheet?

Evaluating BALANCE SHEET is important for shareholders and potential buyers, as it can reveal information about working capital adequacy, asset performance and capitalization structure. These three are categories of investment-quality measurements. (15) 

I will briefly explain what these measurements mean:

Capitalization structure: What different sources of funds a company uses to finance its growth and overall operations. Most important measurement in capital structure is company's dept-to-equity ratio. Company with a greater percentage of dept can pose a greater risk for investors. (16)

Asset performance: A company's ability to turn resources into subsequent returns. Following metrics can be used to evaluate asset performance:
-cash conversion cycle
-return on assets ratio
-fixed asset turnover ratio

 Improvement in asset ratio means that it can now produce higher proofits with same resources or, can produce same results with lesser resources. Asset performance, and changes in asset performance are an important consideration for investors. (17)

Working capital adequacy: Measures a company's short-term financial health and its efficiency. Is calculated as follows:

Working Capital = Current Assets - Current Liabilities

If this figure is negative, a company can run into trouble paying it's bills, which can lead to short or long term financial diffuculties, or even bankruptcy. (18)

When analyzing INCOME STATEMENT, it is most important to look at the profitability calculations:

Gross margin= Gross profit/sales 
This calculation gives a percentage, but the plain number does not tell whether a company's gross margin is good or bad. To evaluate this, we need to also look at other profitability ratios, such as:

Operating margin= Operating profit/ sales

Pretacx margin= Pretax income/sales

Net income margin= Net income/sales

Here's an example of mentioned calculations:

Picture from Youtube video: Income Statement Analysis - Beginners Guide (19)

For example the Net income margin in this example would mean, that for every $1000 the company generates income, they get $33 as profit.

To determine whether the calculates ratios are good, the figures need to be compared to something.

The first comparison would be with other companies' figures in the same line of business. Different lines of business have different expextations of profitability, and thus there's not much use in looking at other industries for comparison.

It is also worth looking at how the profitability is changing over time in a company. Normally these figures are looked at for the period of past three years. It is also worh following the quarterly figures. If profitability is not consistent, or is going down, then there might be reason to worry.

One can also analyse the growth rate over time. If growth is slowing down, it might not be concerning in and of itself, but it definitely gives reason to look at other figures to see if there's something wrong. If at the same time gross margin would be going down, for example, then this could be a reason for concern, especially, if the same is not happening in other companies in the industry.

What is relevant in analyzating the income statement, is that all figures are interconnected, and don't really give any real information when looked at separately. (19)

References:
1. http://www.accountingcoach.com/income-statement/explanation/1
2. http://www.accountingcoach.com/terms/N/net-sales
3. http://www.accountingcoach.com/depreciation/explanation

4. https://www.ventureline.com/accounting-glossary/F/financial-expense-definition/
5. https://www.vero.fi/fi-FI/Yritys_ja_yhteisoasiakkaat/Tuloverotus
6. http://www.accountingcoach.com/terms/I/intangible-assets
7. http://www.accountingcoach.com/terms/P/prepaid-expense
8. http://www.investopedia.com/terms/a/accruedincome.asp
9. http://www.accountingcoach.com/adjusting-entries/explanation
10. http://www.investopedia.com/terms/s/security.asp
11. http://www.accountingcoach.com/terms/E/equity
12. http://www.investopedia.com/ask/answers/072815/what-difference-between-issued-share-capital-and-subscribed-share-capital.asp?ad=dirN&qo=serpSearchTopBox&qsrc=1&o=40186
13. http://www.investopedia.com/terms/r/retainedearnings.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186
14. http://www.investopedia.com/terms/a/accruedexpense.asp
15. http://www.investopedia.com/articles/basics/06/assetperformance.asp
16. http://www.investopedia.com/terms/c/capitalstructure.asp
17. http://www.investopedia.com/terms/a/assetperformance.asp
18. http://www.investopedia.com/terms/w/workingcapital.asp
19. https://www.youtube.com/watch?v=yAfvKWk0zyI

Trigger 7: Accounting terminology

1. What are the main components of an income statement?

Income statement (sometimes also called the profit and loss statement or statement of operations) is one of the three major financial statements. It is used to calculate the profitability of a company. There are two kinds if income statements: Single step and Multiple step. Let's have a look at some terminology one might come across while reading an income statement. (1)

Two main categories in a single step income statement are 1. Revenues and gains, and 2. Expenses and losses. These two categories will together form net income. The formula is below:

(1)


To be more specific, there are several sorts of revenue or income, as well as expenses and losses. Let's have a look at our exemplary income statement, step by step.

NET SALES means all sales the company has made, minus discounts, damaged or missing goods, allowances and returned goods. (2)

From net sales you then deduct EXPENSES which include:
Goods and services 
In a café Expenses from goods and services would mean prices and delivery of the ingredients they use for their products.
Salary related expenses:
Salaries would obviously fall under this category, but also other expenses such as sick leaves, holidays, and employees' insurance.
Depreciation
Book keeping principles require that a company reports the yearly depreciation of their assets. Depreciation of an asset means this: A company buys an equipment, and evaluates that they can use it for 5 years. They first deduct the salvage value from the purchase price, then divide the remaining value for each year they expect to use the equipment. (3)
Operating expenses
Other operating expenses include things that have little to do with the products the company sells.
For a café this could mean, for example office supplies.
Other operating income
For example renting the premises for an event.

When all of the expenses above are deducted from the net sales, what remains under the line is called OPERATING INCOME.

In addition to operating income, a company can receive other income, for example financial income, which means things like income from municipal bonds, tax returns and interest from given loans. Financial expenses generally refer to interests of company's long term dept. (4)

After the financial income/expense has been added to/deducted from the operating income, what's left is called INCOME BEFORE TAXES. Taxes are calculated for this amount. In Finland the tax percentage for organizations is 20%. (5) This amount is called INCOME TAX EXPENSE. 

Once the tax has been deducted, we finally get the NET INCOME. If the amount remaining on the bottom line is negative, it is referred to as NET LOSS.

This example was a single-step income statement. One major difference with a multiple-spet, or a multi-step income statement is that it shows the GROSS PROFIT, which means net sales- cost of sold goods. Multi-step income statement also would have adressed the categories in more detail, showing what kind of expenses fall under Salary related expenses, to give one example.

2. What are the main components of balance sheet?

One of the main financial statements. The balance sheet reports the assets, liabilities, and owner's (stockholders') equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.

Here's a brief video on how balance sheet works:
http://www.investopedia.com/video/play/introduction-balance-sheet/

Assets: 

Things that a company owns. Also costs that have already been paid, but the service is still ongoing.

Non-current assets (something that has been there longer than a year)

For example machinery and supplies
-Intangible assets: immaterial rights, for example, patents, copy rights and such. (6)

Current assets (something that comes and goes)

-Materials and supplies

-Accounts receivables: a sale made with credit, where invoice is yet to be paid. Potential loss, is customer does not pay on time
-Other receivables, long term: Long term assets that are too insignificant to be listed separately.
-Prepaid expenses and  An asset that has already been paid for, but not yet (fully) used (7)
-Accrued income: An adjustment made to a financial statement, where the actual income has not been received yet, but is market in books as debit. (7)(8)
-Other receivables, short-term: Short term assets that are too insignificant to be listed separately.

-Cash and petty cash: Cash is balance on an account, petty cash is actual, concrete cash.
-Investments and securities: Bonds or stock that company owns

Equity:

The difference between company's assets and liabilities. (11)

-Share capital: The amount of funding a company has raised by selling stock to public investors (12)
-Retained earnings: Amount of  net earnings that is not paid out as dividends, but retained by the company to pay dept or to be reinvested in the business itself (13)
-Net Income: The bottom line of an income statement

Liabilities:

An obligation payable by the company, for example wages, loans, invoices and such. 

-Loans from financial institutions: Loans company has taken and has not yet (fully) paid back

-Accounts payable: Invoices for goods or services the company has yet to pay

-Other liabilities: Liabilities that are too insignificant to be listed separately

-Accrued expenses: An expense that has yet to occur, such as a salary that's due to be paid in the future. (14)

-Unearned revenue: Services or good a company has not done yet, but has already received a payment for.

Total equity and liabilities:

Same as assets.

3. How to analyze income statement and balance sheet?

Evaluating Balance sheet is important for shareholders and potential buyers, as it can reveal information about working capital adequacy, asset performance and capitalization structure. These three are categories of investment-quality measurements. (15) 

I will briefly explain what these measurements mean:

Capitalization structure: What different sources of funds a company uses to finance its growth and overall operations. Most important measurement in capital structure is company's dept-to-equity ratio. Company with a greater percentage of dept can pose a greater risk for investors. (16)

Asset performance: A company's ability to turn resources into subsequent returns. Following metrics can be used to evaluate asset performance:
-cash conversion cycle
-return on assets ratio
-fixed asset turnover ratio

 Improvement in asset ratio means that it can now produce higher proofits with same resources or, can produce same results with lesser resources. Asset performance, and changes in asset performance are an important consideration for investors.

Working capital adequacy: Measures a company's short-term financial health and its efficiency. Is calculated as follows:

Working Capital = Current Assets - Current Liabilities

If this figure is negative, a company can run into trouble paying it's bills, which can lead to short or long term financial diffuculties, or even bankruptcy.

When analyzing income statement, it is most important to look at the profitability calculations:

Gross margin= Gross profit/sales 
This calculation gives a percentage, but the plain number does not tell whether a company's gross margin is good or bad. To evaluate this, we need to also look at other profitability ratios, such as:

Operating margin= Operating profit/ sales

Pretacx margin= Pretax income/sales

Net income margin= Net income/sales

Here's an example of mentioned calculations:

Picture from Youtube video: Income Statement Analysis - Beginners Guide (19)

For example the Net income margin in this example would mean, that for every $1000 the company generates income, they get $33 as profit.

To determine whether the calculates ratios are good, the figures need to be compared to something.

The first comparison would be with other companies' figures in the same line of business. Different lines of business have different expextations of profitability, and thus there's not much use in looking at other industries for comparison.

It is also worth looking at how the profitability is changing over time in a company. Normally these figures are looked at for the period of past three years. It is also worh following the quarterly figures. If profitability is not consistent, or is going down, then there might be reason to worry. 

References:
1. http://www.accountingcoach.com/income-statement/explanation/1
2. http://www.accountingcoach.com/terms/N/net-sales
3. http://www.accountingcoach.com/depreciation/explanation

4. https://www.ventureline.com/accounting-glossary/F/financial-expense-definition/
5. https://www.vero.fi/fi-FI/Yritys_ja_yhteisoasiakkaat/Tuloverotus
6. http://www.accountingcoach.com/terms/I/intangible-assets
7. http://www.accountingcoach.com/terms/P/prepaid-expense
8. http://www.investopedia.com/terms/a/accruedincome.asp
9. http://www.accountingcoach.com/adjusting-entries/explanation
10. http://www.investopedia.com/terms/s/security.asp
11. http://www.accountingcoach.com/terms/E/equity
12. http://www.investopedia.com/ask/answers/072815/what-difference-between-issued-share-capital-and-subscribed-share-capital.asp?ad=dirN&qo=serpSearchTopBox&qsrc=1&o=40186
13. http://www.investopedia.com/terms/r/retainedearnings.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186
14. http://www.investopedia.com/terms/a/accruedexpense.asp
15. http://www.investopedia.com/articles/basics/06/assetperformance.asp
16. http://www.investopedia.com/terms/c/capitalstructure.asp
17. http://www.investopedia.com/terms/a/assetperformance.asp
18. http://www.investopedia.com/terms/w/workingcapital.asp
19. https://www.youtube.com/watch?v=yAfvKWk0zyI

Trigger 6: Accounting for a start-up

1. WHAT TO CONSIDER WHEN SETTING UP A FINANCIAL PLAN?

To make a financial plan, our example entrepreneurs need to consider three things. How much money they will need to start the business up, before it starts producing money, and where they will get this money from? Then they will need to calculate how much they will need to make in order to break even, this is called profitability calculation. Third thing to do is to evaluate sales, in other words they need to make a sales calculation.

Investment calculation

For investment calculation, one should roughly estimate the amount of money they will need, and get, before the company will start producing money.

Below are some explanations of terms:

*For example in Finland registering fees vary from 110 EUR to 330 EUR depending on type of business.

**Fixed costs are categorized below in the profitability calculation.

***Investors who invest into small businesses either one-time or ongoing.

****Finnvera is a special financing company for businesses.

*****Usually for 6 months, and around EUR 705 - 1,130 per month.

Profitability calculation

After evaluating the total sales needed in order to cover all the costs, in other words, to break even, the entrepreneurs need to calculate sales prices for their products. It is done as follows:    

-total costs of the product (for the entrepreneur)

+total sales margin

=sales price exc. Vat

Price+24%

=price incl vat

Reference: Https://prezi.com/hmih9mo11kgu/guide-to-entrepreneurs-in-finland-by-juan-borra/

Sales calculation

Next step is to evaluate the sales by product, calculate the margins they will be getting, and see whether they will earn enough to keep the business running.

In here they should take into consideration following things:

-product losses

-competitors and their prices

-total sales should be equal or exceed the total sales required in the profitability calculation.

2. HOW TO SET UP ACCOUNTING OF A SMALL BUSINESSES?

All companies in Finland are required to keep book of all their transactions. Investopedia defines accounting as follows: "accounting is the systematic and comprehensive recording of financial transactions pertaining to a business". (2) in Finland, company's size determines, what kind of bookkeeping they must uphold. (3) our entrepreneur's café would fall under the "micro enterprise" category.

It is the entrepreneur's duty to do daily bookkeeping, which consist of following:

-sales invoices (or receipts)

In other words, all material that is generated when dealing with other companies, customers, banks and authorities. (4)

The accounting records may be either paper or electronic records. These days, however there is an abundance of electronic financial management systems, which facilitate bookkeeping, so many entrepreneurs opt for electronic accounting. (3)

It is advisable for a small company to hire an accountant. In addition, an accounting company can help out with payrolls as well as cash flow planning. (3)

By law a company must document transactions including receivables, payments, liabilities, capital, corrections and transfer instalments. Everything must be marked as a plus or a minus. Every transaction needs to have some form of verification document, such as a receipt.

Every transaction will be registered to a balance sheet. (5)

-purchase invoices

-payslips

-bank statements (3)

3. WHAT LEGAL ASPECTS SHOULD ONE CONSIDER WHEN STARTING A SMALL BUSINESS IN FINLAND?

Being an entrepreneur differs from being an employee. For example, the legal responsibilities of an entrepreneur are quite different. Let’s have a quick look at what type of laws are applied to an entrepreneur:

Accounting:

We already looked at accounting before. There are, however several legal aspects to consider. The decree 1753/2015 defines these aspects. (6)

For a micro enterprise there's no need to make an annual report, a financial statement, however is necessary.

Pension:

An entrepreneur is justified to start their employment at the same age as an employee, but with a 0,4 percents lower for each month they brought their pension forward from that, allowed in the entrepreneur law. 72/2016 

Unemployment:

An entrepreneur is not equal to an employee in case of unemployment benefits, if the business goes down. An entrepreneur need to have an insurance to cover their possible unemployment. 

Unfortunately, when dealing with an insurance company instead of Kela, the unemployment is not always covered as insurance companies tend to work more in their own interests instead of their customer's interest. For an example, see the case http://yle.fi/uutiset/3-8791666.

Hiring an employee:

When hiring an employee, the entrepreneur need to follow certain rules:

-contract of employment must be drawn

-salary needs to be in accordance with Finnish collective labour agreement

• How much to pay
• When to pay
• What fees to pay in addition to the salary (taxes, tyel, etc.)

-insurance

-working hours

-healthcare (7)

Permits: 

In finland an enterprise will need applicable permits. For a café these permits would include a permit for selling food, and possibly a permit for selling alcohol. In order to serve food or alcohol, strict set of rules has to be followed. (3)

Taxes:

Unlike an employee, an entrepreneur needs to do their own taxes. If an accounting company is hired, this task can also be allocated to them.

References:

1. Https://prezi.com/hmih9mo11kgu/guide-to-entrepreneurs-in-finland-by-juan-borra/

2. Http://www.investopedia.com/terms/a/accounting.asp

3. Https://prezi.com/hmih9mo11kgu/guide-to-entrepreneurs-in-finland-by-juan-borra/

4. Anttonen, m. Hakonen, m. 2011, Taloushallinon taitajaksi

5. Black, g. 2009, Introduction to accounting and finance

6. Http://finlex.fi/fi/laki/alkup/2015/20151753

7. Https://www.palkkaus.fi/cms/article/ensimmaisen_tyontekijan_palkkaaminen

8. Http://yle.fi/uutiset/3-8791666