From the course: Corporate Financial Statement Analysis
The accounting equation
From the course: Corporate Financial Statement Analysis
The accounting equation
- Before we get into financial statement analysis, let's do a quick review of the financial statements, these mythical creations that tell us so much about a company's performance. - The financial statements are built around one of the most awesome creations of the human mind, the accounting equation, assets equal liabilities plus equity. There it is. Assets equals liabilities plus equity. - Now, I can tell you're a bit underwhelmed. You're expecting a little bit more, something like Einstein's famous E equals MC squared. Well, in its own way, the accounting equation is just as great as E equals MC squared. - Let me tell you about this accounting equation and where it comes from. First, the assets side. Now, people have been listing assets for thousands of years. Assets are resources owned or controlled by an individual or a company. - The great insight behind this accounting equation was created a little bit over 500 years ago in Italy. - The traders in Venice and other traders in Italy had this insight. They said, "Listen, let's keep a list of our assets "like we've always been doing but let's also, "every time we get an asset, "let's write down where we got the money "to buy that asset." We write down the assets and we write down the source of the financing to buy that asset. - Now this simple insight imposed discipline on the financial statements. The accounting equation always has to balance. What do you have, the asset, and what is the source of the funding for that asset? - An example. Your assets increased. Did that increase come from borrowing a liability or from selling something, a revenue? - Your assets decreased, did you pay the bank back for the amount you borrowed, reduced your liability, or did you pay an expense to the business? Expenses will be listed on the income statement. - It's not enough to say, "We have more stuff." The accounting equation forces you to explain how did you get that "more stuff?" - Now, there are three fundamental financial statements: the balance sheet, the income statement, and the statement of cash flows. Each of these statements will be discussed in more detail in the modules that follow. - These three financial statements tell us very different and very important things about a company. And these three financial statements are all derived from the accounting equation. - The balance sheet provides us detail about the components of the accounting equation, details about assets and liabilities and equities. - The income statement provides details about a component of one of the equity accounts, retained earnings. - And the statement of cash flows provides detail about one of the asset accounts, cash, since cash is the life-blood of a business, how much do we have, where did it come from, and where did it go? There is a financial statement tracking exactly that account. - I tip my hat to those medieval accountants in Italy who invented the accounting equation: assets equal liabilities plus equity. Keep track of the assets as we've been doing for 7000 years and we're also going to keep track of the sources of financing to buy those assets. That is the accounting equation.
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