Good afternoon or good morning everyone.

Lovely for you to join.

And welcome to our session on Accounting Fundamentals.

My name is Andrea Ward and I'm one of the trainers of financial Edge.

First of all, a couple of housekeeping items you will have seen in the webinar chat a direction to the resource I'm using. There should be some slides in there as well as an Excel, Because we're going to do a couple of exercises throughout the session.

If you have any questions.

Please use the Q&A function, excuse me, and just be aware we are recording this webinar.

But I'm going to dive straight in because we've got quite a lot to cover in the next hour.

In terms of accounting fundamentals, please feel free to ask me any questions and and just put your questions in the Q&A and I will then answer them and stop and make sure that everything has been answered.

Let me just share my screen with the slides I'm going to use.

Just give me two seconds, here we go.

And I'm just going to rearrange my screen a little bit so I can actually see everything.

Okay, fantastic. So accounting fundamentals we're going talk through is how the main three financial statements link

and also regarding some of the important financial terms we use in banking i.e. across active research, across investment banking, across private equity.

So that you are more familiar with those.

As I said, we will do a couple of exercise part of this.

The workout in Excel has got a lot of questions and we will obviously give you both the answer and, and the empty file so you can work through some of those questions in your own time.

So we're going to cover the income statement, balance sheet and cashflow. And I'm going to dive straight in.

First of all, why do we analyze financial statements? Financial statements really give us a view of what is happening in a company and regarding their strategy and the financial position.

I.e. the numbers tell me a story.

Financial statements are created by accountants and audited by them.

And then the users are, you know, us as financial analysts, maybe as an investor, maybe as someone who wants to buy the business, maybe someone who wants to become an employee of a company and actually wants to check that business out first.

So the three financial statements, income stand, balance sheet, and cashflow will be analyst in detail.

We don't analyze every single number. We focus on the value drivers that really have an impact, in terms of the company's performance and calculate a ton of ratios and then form a view on if the company is achieving its stated strategy and what might happen in the future.

Now in terms of what happens in the company in terms of lifecycle, when, when money comes in, et cetera, and how that impacts the financial statements.

I just want to go through this.

So the numbers indicate the different steps.

We're starting here on the top hand left side with shareholders, investor money. So we have an idea. We come with a great idea and decide we form a company, we invest some money to then really work on our idea.

So the money that we've invested will be used to buy some operating assets.

You don't necessarily have a lot of fixed assets, I.e. machines or office buildings, but you might invest in some technology.

You might invest in some office space where you all going to sit together, you might invest some research development. These are all operating assets that is then reflected in the balance sheet.

Now hopefully those assets will produce some profits.

Those profits are reflected in the income statements. So we've already now mentioned two financial statements, which will give us a picture of the company's performance.

Now hopefully the income statement i.e. what we generated in terms of profits will also turn into cash.

And you will see in a minute that profit does not necessarily mean cash.

And that cash is really reflected in the cashflow statement here on the left hand side bottom.

Now that cash is either reinvested for further growth, so maybe spending more time money on research development, more on intellectual property, more on maybe now a factory that you manufacture in. If you're manufacturing something, you know, whatever the operating assets of the company are or, and both of those could happen.

We return some of that money to shareholders in the form of dividends.

Okay? And then the shareholders themselves might decide to invest those dividends elsewhere.

Maybe start yet another company or buy some shares or buy themselves a house.

Who knows. So those three financial statements are very important to give us an idea about the performance of the business.

Now, very important to understand is that the balance sheet will give us a snapshot at the end of a period.

Now this could be at the end of a year, it could be at the end of a quarter, it could be at the end of six months.

What happens, and this is if we just assume in end of period one, what happens throughout the next period, call it period two is reflected in the so-called flow statements of the income statement and the cashflow statement, both for period two.

Okay? So they provide a summary for the period, but they really cover a period of time rather than just a point and time.

Now, when we take the income, so in the cashflow, we can then actually figure out what happens in terms of balance sheet at the end of period two.

So in summary, the balance sheet is a snapshot on a specific date.

The income statement and the cashflow provide flow figures.

I.e. cover a certain period three months, six months, nine months, or 10 months, uh, 12 months even.

I can't count the months in my year any longer. Okay? So that's financial statement dates.

Now when we're looking at the balance sheet, one of the most important equations is that assets equals liabilities and equity.

So if you think about our shareholders who invested money, so that was the red block here on the right hand side to buy operating assets, sometimes we need some more operating assets and we might actually go maybe to a bank.

So if I just keep it nice and simple, maybe to a bank to actually buy some additional assets.

So when we are borrow money from a bank, that's called a liability because we have to pay it back at some point in the future.

Waste equity is permanent capital.

The shareholders can't actually ask back for that.

We don't have to repay it.

So liabilities plus equity will always equal assets or assets minus liabilities equals equity.

So let's assume we're winding up the company, we could take the value of the assets, take off the existing liabilities, and what would be left over is what belongs to shareholders.

It has to balance.

There's no way about, you can't balance it, the secret is in the name of that word.

Let's assume we enter into a transaction.

So let's assume just, just, you know, really having a think about buying, let's say buying a machine.

So we buy a machine for let's say 100 and forgive my handwriting, hopefully you can read this for 100.

So what happens, the assets go up by 100.

Now obviously now I suddenly don't balance any longer and let's assume we borrowed money from a bank for that transaction, which means my liabilities will also go up by 100.

Okay? So in the end, my balance sheet will balance again, if you are studying anything or have studied anything to do with accounting, you might have done, double book, double entry bookkeeping.

We don't really need that in financial analysis.

What we really need to think about is what happens in the balance sheet when I have a transaction.

So what happens if I buy something depending on how I finance it, how do I balance the balance sheet? Okay? And we're gonna go through some examples in a minute for some real transactions for a company.

Okay? The link, the next slide here shows us the link to the income statement.

Because remember what I said earlier on, you start with a balance sheet in period one, then you have period two income statement cashflow, and you end up with a balance sheet at the end of period two.

So if you think about it, the income statement really reflects what I had in terms of sales and expense and tells me what the profit for the company is.

Now that profit then goes back into equity.

Remember what we said in our original slide? We either reinvest in the business so we retain the earnings, okay? And you can see the comment up here in terms of retained earnings or we pay out in the form of dividends to the existing shareholders.

So whatever is not being retained is paid out to shareholders.

So the profit we're making goes back into the balance sheet and is accumulated and then used to buy further assets or to reduce liabilities or paid out in the form of dividends. So the link between the balance sheet and the income statement is retained earnings.

Now, in terms actually what we're gonna do, what we're gonna do, let's do our first exercise.

Can you please open the Excel? It's called Accounting Fundamentals.

And we are going to have a look at and let me just make sure that I'm sharing my screen and I am, let me just, make sure that I'm sharing the correct screen.

So one second, but it should have been the correct one. Yep, absolutely. Okay.

So, in terms of what we can see here, it's quite a lot of exercise.

But what we're gonna do is we're gonna go straight to one of those exercises, which allows us to actually have a look at what the impact is on the balance sheet considering individual transactions.

So could you please do me a favor and go to work out number six in the accompanying excel that you found in the resources.

Okay, so we have a business, Annette has started a business making the following transactions.

We've got a beginning balance sheet.

So as you can see the company actually has nothing in the balance sheet at the beginning of the period because she has just started the business.

And we've got a series of transactions from where 128 to 139, which we're now going to put into this balance sheet.

Now I'm going to give each each of these transactions a number.

Oopsy daisy, let me just try that again.

No, let me just put num lock on.

So I'm going to put a number next to each of these transactions if I can somehow get a formula in here.

Let me just try that again so that we can then reflect them in the balance sheet.

Okay? So the first thing I'm gonna do, so number one, my first column is transaction number one, Annette adds capital to the business.

So this is the payment in by a shareholder.

She owns the business. So what happens, my cash goes up by 2000, okay? And my share capital goes up by 2000 because I'm now investing in the business providing the startup capital, providing the startup capital for that company so that I can then buy some operating assets as we saw earlier on.

Okay? Second transaction. So that goes into my second column, bank loan received for repayment in 12 months time.

Okay? So it's a short-term loan effectively, but we're gonna just put that into long-term debt because we're just going to assume all of that debt sits within long-term debt and I'm receiving some additional cash.

So remember, assets equals liabilities plus equity.

So this is a liability to the company.

So we are getting another 1100 into the business, okay? So assets go up in terms of cash and my debt goes up in terms of the 1100.

Okay? So we are balancing again, so I always have two entries to a transaction to make sure that my balance sheet balances.

Transaction number three, I have plant and equipment purchased with cash.

So these are factories, machines, you know, maybe a warehouse.

She buys for cash, one for 1000.

So obviously what happens is that, that my cash goes down by 1000 and I'm now creating a new asset.

So I now actually have an asset swap between cash and net property, plant and equipment.

Okay? So my property plan equipment goes, oops, goes up.

So about this goes up and my cash goes down.

So again, I'm balancing, so I have a swap between the two assets.

Then we are going to do transaction number four.

We are paying some wages in cash. So Annette clearly has hired some employees and she's paying some wages in cash.

So what happens? My cash goes down by 171, okay? And the question is, now what is, what is the, you know balance sheet item that also goes down or goes up now up, nothing will go.

But actually what we now have is a reduction in profit.

We have a cost, and remember for my slides, sales minus costs equals profit.

So this actually then hits my retained earnings in the form of the income statement, which we will build in a minute.

Okay? So the income statement will show a cost of 171 million or thousand, whatever the denomination is.

So again, I am balancing Because the cash actually leaves the company is being paid into the bank account off the individuals.

Then we have our transaction number five, transaction number five, we have employee commission paid in cash.

So clearly Annette is paying some bonus payments maybe to some sales person who has done a really good job in in selling the products.

And again, I have 17 million cash reduction and again, it's a cost to the company, which means I will have exactly the same amount reducing retained earnings, okay? Remember sales minus costs equals profit.

Profit that's not been paid out to shareholders are my retained earnings or reinvested in the business. So at the moment we haven't got any sales, but we've got lots of costs.

Then we have products purchased for cash.

So transaction number six products purchased for cash, intended for resale.

So cash goes down by 900 million, okay? And now I have products effectively in my warehouse, okay? So she's buying something in which is then selling.

And in that respect we have again, a switch in terms the asset because now my inventory will go up by 900 million.

Okay? So again, my balance sheet balance, you can always identify two matching entries in the balance sheet, either on the same side or one on one side or one on the other side, i.e. assets and liabilities and equity transaction number seven, we have products in store room sold on credit.

So that's fantastic news because this is effectively, these are our sales.

Okay? So finally she's actually made some money.

Now they've been sold on credit, which means I'm allowing my customers to wait to pay.

And we call this accounts payable. Okay? So what happens is account, sorry, accounts foreseeable, accounts foreseeable. So let me repeat this because I looked at the wrong title.

So what I'm doing here is I'm allowing my customers to wait to pay, which is an accounts foreseeable position.

I'm going to receive some money from my customers at some point in the future.

So maybe the invoice says within 30 days you have to pay for the products you've received.

So accounts receivable goes up and then the question is what what goes up? At the same time here we've got our retained earnings because remember the income statement, sales minus costs equals profit.

Here we now have a matching entry because this reflects effectively the starting point for that profit calculation.

1482, okay? Then we have our transaction number eight.

Transaction number eight, we have the products above head, an original cost of 619 million.

Okay? So now we need to have a think about what that means.

First of all, the costs will go into retained earnings. So we've got the minus 619 okay happening because I need to recognize the cost that relates to those sales.

Now in terms of those costs, I need to also think about that I've taken the products out of the warehouse.

So my inventory has now reduced by 619 million.

And you can see there's clearly a huge markup on that product.

She bought it in cheaply, maybe stuck the name of her company on it, maybe, you know, added something to that product.

We don't know, we don't have the information, but she sold it for more than double the cost she bought it for.

So that's clearly a very good business.

So my inventory now goes down by exactly the same amount because I have less products that I can sell within my warehouse.

Then we have transaction number nine.

Transaction number nine tells us, and I'm just gonna make that first column a little bit smaller so you can actually put them all into one single, on one single screen.

We have supplies expense paid in cash.

So again, cash will go down by 53 million.

This is a cost, right? So this might be that I have you know, shipping costs, whatever, and I have to pay that in cash of 53 million.

Okay? Then we have marketing expenses paid in cash.

So that's number 10, okay? And again, I have a negative number in both cash as well as retained earnings.

So I'm just going to balance my boundary.

I think you've got the trick now in terms of how to work through this.

And then I'm gonna make this even smaller so I have a bit more space here.

And then we have our transaction number 11.

Now this is an interesting one.

We've got financing expense for the period paid in cash.

So clearly she's borrowed some money and we need to make sure we pay the interest.

So that would be a financing expense.

And here again, my cash goes down by 57 million and my retained earnings because it is a cost to the business paying interest will go down by exactly the same amount.

Okay? And then forgive me, I'm gonna make this even smaller because I don't wanna split my screen so that you could see it all in one go.

Then we have tax expense for the period unpaid, that is our final transaction, transaction number 12.

So we now have a cost of tax, which we need to recognize because it belongs to that period.

So we are showing minus the 38 million, okay? And now the big question is what happens? Because it's unpaid.

So we don't have a cash reduction in this case.

The tax man effectively will wait, the tax authorities will wait for a little while until you pay your taxes.

Normally you have, you know, maybe a month's time or something like that.

So what we create here is a, so-called tax payable, which is very similar to an accounts payable I.e. I owe my supplier some money accounts payable.

In this case I pay, I owe the tax authority some money.

So the 38 million is being to add it as a positive number, to the tax payable. So again, you can see we're balancing the balance sheet, okay? So lots of different transactions all reflecting a real company, a real company would probably have some more accounts, silver and accounts payable from some of these transactions.

But we're just keeping it nice and simple.

So what I can do now is I can now create a, and now I'm going to make this column one more small time smaller.

So you can see what I'm gonna do.

I'm gonna do a balance sheet at the end of the period.

So balance sheet end, okay? And I'm gonna just sum this all up and hopefully my balance sheet will actually balance.

Now to sum this all up, I'm just gonna start with the beginning balance sheet. Highlight everything to the right, including transaction number 12 and hit enter.

I'm gonna copy this down Ctrl C and then enter down to net property plan equipment.

And uh, hang on a second, we're gonna make that even smaller, that first column and then I'm just going to sum that up.

So my total assets, my total assets will be 36310.0.

Okay? So hopefully our liabilities in E will be exactly the same number.

But since we had a balancing item for every single item, I'm pretty hopeful on this one.

If you wanna know how to get a shortcut in for the sum, alt equal is your shortcut.

Okay? Then I'm gonna copy this down again, all the way down to equity and I'm going to sum up total liabilities and equity to make sure that I can check if I'm balancing.

And you can see I am balancing at the end of the period.

So through the combination of my balance sheet and the income statement effectively either retain earnings, I can identify the ending balance sheet.

Okay? So this works really, really well. Hopefully that wasn't too quick.

But remember you also have the solution file so you can have another look at this at the end of the session, okay? And please remember, use the Q&A function to ask me any questions, right? Let's go back to the slides.

So we've talked about retained earnings, we talked about the balance sheet. So let's just have a look at the income statement in a little bit more detail.

Really important is that we are matching, so the, the driver sales, right? I'm recognizing sales, they don't have to be for cash as we saw earlier on.

They can absolutely be on account i.e. but create an accounts receivable.

But I really important is that I match any costs relating to those sales for the same period and re and really record them in the income statement.

So even if you have not paid the costs yet, you have to recognize them because they match the sales achieved in the period.

You might have not received the invoice yet, right? So you might have to estimate a cost.

And again, you have to recognize this for the sales.

So for instance, your marketing agencies might, might have not sent you the invoice yet for their services, but you will have to recognize the cost. So what you do is you make an estimate.

They're so-called accruals, okay? So estimating a cost where I have not received an invoice yet.

Typical, presentation of an income statement is we start with our sales, then we have cost of goods sold.

So that's basically the cost of making or buying the product.

So in the earlier example, we had Annette buying the product into the warehouse, or it might be the cost of you actually manufacturing, right? So you would have in there the raw material, you would have the factory cost, you would have the cost of the people who who are making the product.

Once I take that off, I get to the gross profit.

The gross profit is a really good indication of your value add by you sticking the Annette name onto that product for how much more can you sell the product compared to the actual cost of manufacturing it.

So we quite often compare gross profits, across different companies.

Then we have selling general and admin.

So these are all the overhead costs.

So in there would be my head office would be marketing, would be research development, you know, it would be all the overhead staff, the finance department.

Um, and then we get to our operating profit.

The operating profit is a very important number because it tells us what we have made from our operations. So the main driver of the business, we take off any finance or interest expense and get to our profit before tax, unfortunately, you will have to pay some tax.

So then the government comes along and says, Hey guys, please give me some tax.

And we then end up with a net income net, that net income being the number that belongs to the shareholders, okay? That can then be we invested in the business.

The shareholders decide not to pay a dividend or they'll be paid out as a dividend. And normally dividends are proposed by the board of directors.

If we have a board, I presume that Annette is probably the only shareholder in the company.

So she will make the decision.

Let's go back to our exercise because what we now want to do is just create the income statement for Annette's business.

Okay? So we've got all the numbers and what we can quickly do is identify where those items go in terms of the income statement, right? So I'm just going to write on here on the top in income statement, okay? Adding capital is not an income statement item because it is permanent capital, it's long-term capital.

It doesn't show up in the income statement, neither does the bank loan.

Neither does the purchase of plant equipment because these are long-term assets.

And as you will see in a minute, we depreciate them.

So we recognize the cost of using up over time wages paid in cash, absolutely. And we don't put this into SG&A in Annette's income statement.

Same for ri um, commission.

I'm just gonna make this a bit bigger again, this column so that we can actually see what is happening.

Okay? Normally I would say I would split my screen, but I wanted to make sure you could see everything here.

Products purchased for cash, okay? That's got nothing to do with the income statement, but it's actually a cashflow item.

Products in the storm sold on credit, these are my sales, okay? So that's really important because I am recognizing the sales for those products.

Products sold above had an original cost of 619.

This is my cost of goods sold.

So note I did not use the 900.

I'm only using the costs that are associated with those sales.

So clearly Annette still has some products sitting in the warehouse.

Then I have supplies expense paid in cash.

So I'm going to assume again that this is sg and a okay? Marketing expense, ditto, this is my interest, and then this is my tax.

So now that we've classified the items that go into the, into the income statement, we can actually build the income statement.

So I'm just gonna scroll down and quickly hook this all up.

So I have my sales, okay, so my sales are 1482 and I'm going to predict to you that my, my profit for the year is 493 million.

I either bold number, which was our retained earnings at the end of the period two or period one my costs of sales.

I'm gonna show you that as a negative number so that we can just sum it all up.

Okay? Is the 619 million.

So that means my gross profit if we wanted to calculate is around 800 million.

Then I'm going to sum up the SG&A. So I'm just gonna use the sum function and I'm going to add in here all of the ones I've said are SG&A.

So 171 plus 17 plus 53 plus 34.

And I'm going to again, make this negative. So I'm just gonna say times minus 1. So let me just show you my formulate so you can see what I'm doing.

Okay? Then we can calculate the operating profit.

So the operating profit, what I generated from the main drivers of my business, 588 million, I'm going to get my interest expense, which we identified earlier on of 57 million, which gives me my profit before tax, okay? And then I'm going to take off my tax expense of 38 million and hopefully that will now give us 493 million.

That is exactly the same number hooray as we calculated for retained earnings.

So you can see this is the link to the balance sheet where income statement and balance sheet meet, okay? There are a couple of other links which we'll see in a minute, but this is a very important one.

Okay? So the net income effectively is my retained earnings.

You do not need to know double entry bookkeeping.

You can do this just by thinking about what happens in the balance sheet, okay? Which I love. I had to, I had to learn double entry bookkeeping and it certainly took me quite some time to understand that debits does not mean minus and credit doesn't mean plus, right? Because it does depend on which side of the balance sheet you're on.

So we've done our first income statement, right? We understand how an income statement is structured.

Let's talk about a very important number in terms of, in terms of financial analysis.

So we in the financial service industry, it doesn't matter if you are a research analyst, if you're going into private equity, if you're doing investment banking, asset management, we do not really talk about operating profit.

We talk about earnings before interest and tax.

So EBIT, okay? And effectively it is the operating profit, but one big difference is that EBIT is cleaned of any non-recurring expenses.

So because we're always projecting into the future.

So if you were to go into corporate banking, you're probably gonna do a lot of lending, which means I need a starting point for my projections, which, which I can really forecast.

If there is a non-recurring event such as a big impairment, I write off off the value of an asset which sits above operating profit because it's an operating asset, then I can't really predict that in the future.

Neither can I predict an again, which only happened in one year, right? Because you sold an asset or something like this.

So EBIT is the clean operating profit or the underlying operating profit in terms of numbers that I can predict into the future.

In investment banking, we value companies every two minutes, right? For IPO purposes, for investment purposes, for M&A purposes, again, I buy the future of the business.

So I need to know what the underlying profitability of the business is to show you how that works.

We're gonna do another exercise.

Can you go please into question number 11 in our, in our little workout.

And we're going to have a quick look at Graham Limited, okay? And we're going to calculate not just ebit, but also EBITDA. And the first thing I'm gonna do is just focus on EBIT and then explain to you the concept of EBITDA.

So EBIT, earnings before interest and tax, a clean operating profit.

And actually that exercise is not a great idea because I didn't obviously look at this version perfectly.

Can you do me a favor and can you actually go into our number ten first and then we do number 11, okay? Because we need to have one non-recurring item in here.

So the way we think about ebit, we're gonna start with your operating profit, Simon, work out number 10 for LGW Inc.

Operating income.

We start with this, we are not restating the whole income statement and we're starting with a 365 million dollars in terms of operating income.

Okay? I'm just assuming it's in dollars now, then I look above the line to make sure that anything in there is recurring.

So it's part of the normal business of that company.

And you can see there are two items which look a bit funny, okay? Penalties and a gain on sale of subsidiary. So I'm going to assume, first of all, the gain on sale of subsidiary is always non-recurring.

'cause you can only do that once. You can never do it again, okay? Means you sold the subsidiary at a higher price than it was in your books.

So what I'm gonna do is I'm going to take this number off to get to my underlying operating profit or to EBIT, okay? So I'm reversing it as if it had not happened.

And then, I'm going to also assume even though I dunno what the company is, because some companies might have a lot of penalties every year for whatever reason, but no company really is in the business of having any penalty, okay? So this might have been a penalty from, from, you know, you know, whatever.

In terms of you commission, you know, that you mispriced something, you know, um, that you did something wrong with one of your employees, et cetera, whatever the penalty is.

You know maybe they had lots of driving offenses, which I doubt that would be true, but who knows what this is.

So the penalties I'm also going to assume are non-recurring.

So in this case I'm going to reverse it because it would've been a cost to the business and I'm going to add it back as if I had made more operating profit.

So the EBIT of the company really is not 365 million, but actually 255 million. And you can see that's quite a big difference in terms of number.

Because we obviously now have less amount of money to borrow money again, to borrow money against, you know, and in terms of valuation, it's a lower number, which means the value of the company would be lower.

So if I had not made those assumptions or adjustments, then I would've misjudged this company particularly for my forecast.

Okay? So really important to understand what EBITDA is.

Now EBITDA, we might do another calculation just in the interest of time.

All you do is you then add back depreciation and amortization.

Now depreciation is the using up, and I'm just going to write this on here, is the using up of property, plant and equipment, right? So that you have, you have a factory, you've got a machine, you using this up.

So each year the value reduces, right? Until the end of the life of this asset where the asset will be either 0 or will have some salvage value, right? Because the metal might still a worth suming amortization is exactly the same thing, but we are now using up intangibles, right? So for instance, a patent has a life of 15 to 20 years.

And obviously if you're buying the patent or recognizing the patent, at some point, you know that patent doesn't have any value any longer because everyone else, for instance, in the pharmaceutical sector can now make that product, that drug without ever spending any money on research development. They can just get the formula and can copy it. Okay? So amortization is exactly the same as depreciation.

It just indicates it's an intangible asset.

More an intangibles in a minute. Okay? EBITDA is a super important number for us because it's a proxy for cashflow. It's quite close to cashflow, okay? Proxy means it's similar to cashflow because depreciation, amortization are non cash figures.

We often use EBITDA as a measure of um, particularly debt capacity, right? How much debt I can borrow.

We might also look at EBITDA in the context of valuation because it gives us a good idea. It's independent of capital structure because it's before interest and it's independent of the policy of your depreciation amortization approach because companies can have different opinions on the life of the assets, okay? Within reason, you can't have one company saying that machine has a life five years and another company saying, no, no, no, it's a life of 20 years, right? So it's within reason. But EBITDA is a really nice clean figure.

We start with EBIT, as you saw, calculated operating profit, get rid of anything that's non-recurring and then add depreciation and amortization, okay? So that's EBIT and EBITDA.

Now, in terms of a couple other things on EBIT, we have our, we've just dealt with our non-recurring items, okay? We might also have some non-core items where we're saying that's not really part of the underlying business.

So for instance, in this country, Tesco's, a supermarket company has got an investment property, right? And they identified in the balance sheet as a property for investment purposes, but they get rental income from this.

But it's a supermarket company.

So their main operations are retail, food, retail, okay? And I sell a couple of clothes, et cetera.

So we would treat the rental income as non-core and probably look at it separately.

And then you have a non-controlled, which means you have ownership below 50%, okay? So below 50%, let me just write this down below, 50% percent ownership.

And again, we will look at this separately rather than part of EBIT.

EBIT really is anything where I have majority, okay? So I really control the business which are core operations and which are recurring.

So really important EBITDA we already talked about. Okay? So EBIT is a really important figure.

A lot of companies give us their numbers, but uh, sometimes we have to calculate it ourselves as we just did in that little example in our spreadsheet, okay? So leave the income statement behind.

What we're gonna talk about now is a very important concept, particularly for cashflow called working capital.

Okay? So let's have a look at the, we're starting on the left hand side on the pink side.

What we have is a balance sheet.

We have non-current assets, which means assets with a life above 12 months.

And we have current assets, particularly operational assets and They, and they tend to be mainly operational, which have a life less than 12 months.

So when we talk about working capital, we really mean anything below 12 months.

Big picture, if you think about debt and equity as being, being the engine of the company, right? Because they allow us to buy assets, to employ people, et cetera.

Then working capital is really the stuff that makes that engine run.

So the oil that keeps that engine running smoothly, okay? So operational assets would be for instance, inventory, right? And it would be particularly accounts receivable, i.e.

the stuff I have in my warehouse and the time period effectively I allow my customers to pay. So the accounts receivable, so that's on the left hand side.

On the right hand side we've got our equity as we saw from a net.

We have non-current liabilities.

So for instance the debt and we have current operational liabilities.

So liabilities which are a result of operating a company.

And in our nets business we saw taxes payable.

We could also have accounts payable, i.e. what we owe our suppliers. So we don't always pay our suppliers immediately, but we are preserving cash and saying let's, you know, try and sell the product first before I pay the supplier.

Because then effectively I have cash in and cash out at the same time.

Okay? Now the cash in the pink side is included initially, but in most cases we don't actually know how much of the cash is truly operating cash.

So when we talk about operating cash, we mean cash that is needed by the company to operate.

So for a retailer for instance, it would be the cash and the tools.

Okay? So if someone goes in with a 10 pound note or with a $10 bill or with a 10 euro bill and I need to give them some change, then that cash is truly operating cash because it doesn't sit in a bank account and doesn't earn interest.

No company tells us what their operating cash is, okay? Which means we often treat cash separately and say it's part of the capital structure.

So what you now have is current operational assets and current operational liabilities.

And let me repeat what they are.

They're in particular inventory accounts receivable. So that's your assets side and accounts payable on the operational liability side and the taxes payable.

When I have positive operating working capital I, the assets are larger than the liabilities because we deduct one from the other.

Then we need cash to finance the business because I have think about if you just had tons of inventory and nothing else, then that cash to buy the inventory needs to come from somewhere.

Okay? So I would need a loan to buy the inventory.

On the other hand, on the green side, again, remember working capital is defined as assets minus liabilities.

We have 20 minus 30, so minus 10 of operational, of working capital because the operational liabilities are larger and here they provide cash.

Think about it, you have 20 of inventory and 30 are your accounts payable.

So basically you haven't paid your Supplier yet for that inventory you received from them, which means you don't have to fund anything, you can wait, right? And hopefully cash will come into the business from selling the inventory and then the, the invoice due to the account, supplier will be paid are your accounts payable will go down.

This is all very interesting but it's much easier to understand with some numbers.

So what I would like you to do, can you please go down to work out number 20 for me.

Here we go. Work out number 20 and we're gonna calculate the operating working capital. And I'm only going do the operating working capital.

I'm going to exclude any cash, okay? So I'm going to focus on the definition which we use across the industry.

Working capital tends to be more one use by accountants, but we are really here in financial statement. And also I'm going to focus on operating working capital.

I'm gonna just go and build the formula for one year and then copy to the right.

So the first thing I need to find are all of the assets use some function, actually all the assets that make up operating short-term assets.

Okay? So I'm gonna start on the top. Definitely cash, no investments, no because we're gonna treat that as if it's cash. So some of your cash is being invested in a higher earning, account in this court in investment inventory.

Absolutely. Then we have the receivables. Absolutely. So this is what our customers owe us.

Prepaid expenses, absolutely right.

So we have prepaid an expense. So let's assume you entered into an insurance contract.

The insurance contract runs for let's say 18 months because our financial period is always one year. If we're talking about a year or you might even be looking at a quarter.

So let's assume you're looking at the whole year.

So we've paid for an extra six months but that insurance does not relate to the period in which we are generating sales.

So effectively cash down and prepaid expense up by six months of that insurance contract, okay? Remember we are matching the costs to the sales because that insurance six months insurance contract does not fall into the current period.

I need to recognize the prepaid expense. Lovely.

Because I don't have to pay it next year. Okay? So we include that also in working capital.

So that's it from the asset side because anything below is a long-term asset.

From this we deduct the operating short-term liabilities.

So we've got our accounts payable perfect.

We also have the income taxes payable, that's UPS taxes, always an operating activity because you only pay tax if your operate company.

And we also have some accrued expenses.

So these might be wages we've accrued because we haven't paid them yet.

They might be that marketing cost you've accrued but you haven't received an invoice yet.

Okay? We have to make an estimate of this because we have to reflect in our balance sheet all of the liabilities that we are facing, okay? And I've received the service from the marketing agency or my employee.

So my working capital is positive 8534.9.

I'm gonna copy that to the right and it goes up to 12,895.

So observations.

First of all, the operating working capital needs financing because the assets are larger than the liabilities.

Okay? So I need to make sure I have got either enough cash sitting around and you can see the company's got a ton of cash to actually finance that working capital.

Just think about it. I have effectively more inventories than anything else, okay? Which means I need to finance that 8.5 million.

And secondly the change is it's becoming bigger, which means it meets more financing.

So needs more financing, needs more financing in the next year.

Okay? So the company somewhere needs to make sure that it has enough money.

And you can see the ca you know, we, we can see cash position has gone down, so maybe they've used some of that and also my debt position has gone up a little bit.

So maybe they've used some of that. There's obviously a lot of other stuff happening in the balance sheet.

Okay? And that is the analysis of working capital.

Often we talk about days foreseeable or days payable.

I.e. how long does it take us on average to pay our suppliers? So days payable or how long does it take our customers on average to pay their bills? But that is more for another session. Okay? So that's our working capital. Excellent.

So going next to the next item in our balance sheet, we've got the non-current assets.

So I've already mentioned this.

So we have tangible assets, so things that you can touch, smell, whatever.

And there would be land buildings, plant equipment, fixtures, vehicles, intangible assets, which are anything, you know, which doesn't really, you can't really see or touch, right? So these would be licenses, franchise fees, patents, copyrights and goodwill.

And goodwill. And you know, the last four probably all makes sense to you. Goodwill is what is created when we buy a business and we pay more than the book value, just in very simple terms.

And then we have financial assets, right? So we might have investments in other companies and depending on how much we've invested they're either called financial investments or equity method investments, which is between 20 and 50% or joint ventures, which is F at 50%.

Okay? Could also be at 40%. We call it a joint venture.

So we have three different types of assets, okay? We already know that we u use up these assets and uh, the way we actually, let me just jump on forward.

The way we think about property, plant and equipment is in the form of depreciation.

So let's assume I've bought an asset and the asset has a useful life of five years, then I can say that I'm using up 20,000 every single year.

There are different methods of depreciation, but this is the most commonly used one.

Straight line depreciation. Okay? So coming back to my slide in terms of my tangible assets, we depreciate all of these assets excluding land, okay? Because land, what land can lose values, you might have to impair the land, but long term, because it's a limited resource, we never ever depreciate land, okay? We might deplete what is in the land i.e. oil resources, you know, gold resource, whatever, that's depletion.

But we never ever depreciate the actual value of the land.

Then we said intangible we amortize and oops a daisy.

I didn't wanna do that. That was too big.

But, and we amortize all intangibles other than goodwill because we assume that goodwill is a long-term and indefinite life asset, okay? Financial assets are not depreciated or um, amortized because we don't use them up.

Now how do we forecast property plant and equipment? Well we think about a, so-called base analysis. So beginning edition, subtraction and ending.

Basically we add the capital expenditure. Capital expenditure is the term for buying new assets and we subtract the using up each year, which is the depreciation, which we saw already.

Okay? So what we're gonna do is we're gonna do another quick exercise.

Can you please go to workout number 23 in my workout in my Excel workout.

I'm just gonna wait a second so that you can have a quick look.

At the exercise.

So we have property and equipment at the start of the year of 9 82.

We have depreciation and we have amortization and we have capital expenditure. So what we want to calculate is the property, plant and equipment.

Okay? So what I'm gonna do is PP&E property plant and equipment at the beginning of the period, which is my 982, we add, so remember this is my base analysis.

We add the capital expenditure because it makes it go up.

I bought more assets, so cash down property plan equipment, up and I deduct my depreciation only.

So you do not need the amortization because we're not looking at intangible assets, we're only looking at tangible assets.

Our property, plant and equipment.

So property, plant and equipment at the end of the year will be 985229, right? So you can see we're expanding our asset base a little bit because we're spending more money on CapEx than we're using up every in that particular year.

So that's the way we think about property, plant and equipment.

Okay? Now going further in terms of our transactions.

So when we're buying an asset then we increase property plan equipment, right? So cash might go down but actually, it might be debt goes up, right? So it doesn't necessarily cash going down, but let's assume we buy for, for cash as we saw in Annette when we depreciate the asset, then property plant and equipment goes down and that is a cost to the business.

So it would sit within Costco sold.

If you have a machine being used in the manufacturing process, if it's part of your office building would sit in SG&A and reduces the profit of the company.

It's a non-cash figure, it doesn't matter.

We still recognize the using up of the asset when we sell a a machine or the factory or whatever, then cash would go up and we reduce property, plant and equipment.

Okay? So there are quite a few um, transactions in terms of, in terms of what's happening in property, plant and equipment.

Okay? So that's what happens with our fixed assets.

So fixed, we talked about the short-term asset liabilities.

We talked about the long-term asset liabilities.

What we now want to quickly do is to have a look at equity and debt.

So important debt you have to repay. If you don't repay, you're in default.

And basically the company is effectively bankrupt.

They receive interest every year, every quarter, every month.

It depends what type of instruments you have have.

And you are a senior creditor, I.e. if the company goes bust bankrupt, then you get your money back before the shareholder and then you can have lots of different levels of debt.

But you're definitely senior to the equity holders or shareholders.

Whereas equity receives dividends. Now dividends are not guaranteed, whereas interest has to be paid, right? So whilst it's not guaranteed because what if I don't have any cash? You have to pay the interest, otherwise you're in default.

Shareholders receive the dividends which have to be declared.

It's a perpetual or ongoing investment.

So the company doesn't have to repay the equity and they have a residual claim on the company if it were to be wound up due to bankruptcy or because you've decided you had enough and you want to retire and you're winding up the company, okay? So in terms of debt, it's actually really good news to have a little bit of debt or in some cases in private equity have quite a lot of debt because we have the, so-called leverage effect.

If I just go have a quick look at a house.

So let's assume you buy a house for five, whatever, 5,000, 5 million, 500,000, you put in your own money of two and you have a mortgage of three.

What if you now repay some of that mortgage over time and the house well doesn't change then having repaid the mortgage down to two, your active value is now three, right? What belongs to you if you were to sell the house again at five, but let's now assume the house has gone up in value.

And then generally housewives tend to go up rather than down unless you're in the UK at the moment because our housing market is a little bit iffy, but let's assume we have a hundred percent appreciation in the housewives has gone from 5 to 10, you still have two of mortgage 'cause you've repaid down to two.

But now whatever is left over when you sell the house for 10 belongs to you.

I.e. the equity value and you can see the leverage impact whilst the house rate has gone up by a hundred, actually the equity value has gone up by 300%.

This is the whole idea of a private equity transaction, right? Buy a company with quite a bit of debt, we pay some of the debt and hopefully sell the business for more value after three to five years.

Okay? So some debt is really good news.

Now when we talk about debt, there is a very important ratio or number which we calculate in financial services.

That is net debt.

Now net debt is effectively debt minus cash, right? A debt net of cash.

So debt minus cash, we are assuming that the cash is excess cash.

So you don't need it in your operations.

Because as I said you earlier on, we can't really identify the operating cash no company tells us in the financial statements.

And you can see on the left hand side the list of all the types of debt you could have.

Starting with an overdraft again, which is also called a revolving credit facilities. You can see that there's more of a, you know, term which we use tend to use, but sometimes companies just call you overdraft.

You have short-term debt, you have long-term debt, you have commercial paper in the United States particularly where you raise short-term money in the markets you have bonds.

So these are traded in the market, whichever a fixed interest can also have a floating interest. But a bit more unusual. You have bank loans, you have something called loan notes.

Again, someone lent you some money and has a note which says you're going to repay them.

You have convertible debt which can be converted into equity.

You have leases which you know are basically just borrow from Alea company rather than a bank.

And you could have preference shares which we sometimes treat as debt. So this is a slice of, equity which sits above an net shareholder's equity and might have to be repaid in the future, right? So they're called redeemable preference.

And then on the cash side you have commercial paper. Again, I might have invested in that.

Remember we had in that one company some investments might have some short term deposits. Money market instruments just all means short term.

So anything I can make into cash immediately, including marketable securities.

So to calculate net debt, what we're gonna do, can you please go back into my little exercise sheet and go to workout number 25 and we're going to calculate net debt and it asks us to calculate net debt, of am Kensington, which is used in workout 20.

So I now need to go back up to workout 20. Okay? You can see I'm just jump with control up arrow and we're just gonna calculate the net debt on the site here. So I'm not going to scroll up and down every two minutes.

Okay? So the first thing I'm going to figure out is what is the debt? Oops, what's the debt? So the debt is a liability.

So we'll sit on the bottom of the balance sheet in this case.

So I have accounts pay as part of working capital doesn't carry any interest because debt needs to carry interest.

Income tax pay doesn't carry interest, only will carry interest if you don't pay on time.

So we want to find any instrument that carries interest from day one.

Accrued expenses, no, absolutely no interest.

But we have some normal debt, right? So I don't actually need that tightly again because we just have this item.

I'm gonna do it for year two, which is the one on the right hand side.

So debt is 234 million, okay? Then we have share capital, that's permanent capital.

None of this is debt. And then what we want is our cash.

Okay? And our cash is 64.7 million.

And our investments, Remember we treat them like cash because they're like a money market investment because we are trying to get a bit of extra interest is 7.9 million, which means my net debt for this company is debt minus the sum of the two effectively cash elements.

So therefore the net debt is a hundred and sixty two one six six, okay? And this is a really important number because it gives us an idea about the indebtedness of the company.

And we will then put that in relation for instance, to EBITDA to identify how many times EBITDA have they borrowed.

And the higher that number is a 4, 5, 6 times, the more worried we're about the company or the more leverage the company is, okay? So you know, you would expect for a relatively mature business, which is not too cyclical, maybe a maximum of two and a half to three times debt if they're a leader in their sector, okay? But obviously it depends on the underlying industry.

So that is debt equity.

We're going to have a very quick, actually here we go. Sorry, I forgotten this was the next slide.

You can see now these are some of the ratios I've already talked about.

Net debt to ebitda, which is the leverage ratio.

The other one really important one is the coverage ratio, which tells us how safe our finance costs are.

Because remember, EBITDA is a proxy for cashflow.

If we divide by interest, we can see how many times EBITDA covers interest expense.

I.e. how many years could you pay interest expense with that potential or proxy of cashflow.

And then one other one is debt to equity where we just have a look at the balance overall.

You know, how much debt we have not used in that many sectors.

Because obviously the equity is at book value so it doesn't get revalued to what the current share price might be in a company.

Okay? So some mature companies have very little equity because they've done a lot of share buybacks.

So that ratio, whilst it's interesting is, is maybe interesting for some companies which are, you know, not really that involved in share buybacks.

Okay? Then in terms of retained earnings, um, we've already talked about what retained earnings are.

They go up with net income and they go down with dividends.

Okay? So we had our net income for net of 4,431 or whatever the number was of 490 something.

And we started at zero add that to get to the retained earnings. At the end, however, we then subtract the dividends to get to the ending retained earnings if the company pays any dividends, okay? So a lot of companies don't pay any dividends.

So you would just add the retained profit to the retained earnings.

It's a cumulative account or you have a retained loss, right? So not every company is making a profit.

So you would have to add the retained loss. Okay? Our last statement is the cashflow statement.

And here importantness, we have, we have now the link to both income statement and balance sheet.

We saw in our nets business this, that a transaction such as taxes was not a cash transaction. We actually created a tax payable, okay? So this is now then covered by the cashflow then because basically you are waiting to pay, which means you're holding the cash back until the tax actually becomes payable, you know, maybe 30 days, maybe at the end of the quarter, who knows.

So when we think about cashflow statements, right? So the third very important statement, we normally split this into three activities operations, okay? So it's anything to do with what the company does investing activities. And the most important one here is the investment in long-term assets, i.e. particularly property, plant and equipment. So you can immediately think the number that will sit in there is capital expenditure.

Okay? Remember what I said earlier on? Annette's purchase of machines does not hit the income statement because it's a long-term asset.

The use of that asset is more than one period.

As soon as that happens, it cannot go into the income statement.

You reflect the using up of the asset through depreciation in the income statement.

Remember that matching principle? So that's investing activities.

And then we have some financing activities, right? Basically saying, okay, I am borrow some debt.

So debt cash comes in, so debt goes up, I'm paying interest out which of often actually sits in the operating activities and I'm paying some, some dividends to the equity investors and maybe I'm also getting more share capital.

So three different cash flows, we can classify anything in the balance sheet into those three activities.

And we get to the net cash flow.

Think about the cash flow as being the reconciliation of two balance sheets, I going forward period to the next.

Okay? Then you're quite safe in terms of, in terms of your assumptions and you remember they're effectively three different activities.

So let's have a quick look at a sample cashflow. Unfortunately we don't have the time to do a bigger cashflow, but you've got my exercise sheet and also the solution. So please have a look at that.

But in terms of the cashflow, we can see the cash has gone up by 15.

So the question is why has this happened? Let's go through the individual items, right? So we have accounts receivable, you can see has gone up by five.

So that means I am waiting to receive money from my customers that has a negative impact on cashflow. Think about it. You've paid everyone to make that sofa, whatever you're manufacturing and but you haven't actually received any cash in, so this is a minus five, okay? Accounts are silver going up is is great news of having more assets, but actually bad news from a cash perspective because you are missing at the moment the cash from your customer and it's only the delta.

Remember the cashflow is the reconciliation of two balance sheets.

My inventory has gone up by 20 million.

So again, because you now have more sitting in the warehouse, you haven't sold it yet, you know, it's also bad news for cash.

That means my cash has gone up by 20 million.

So it gone down by 20 million.

I wrote it right and said the wrong thing gone down by 20 million.

You've bought the inventory but you haven't sold it yet, right? So companies sitting on a tonne of inventory is really bad news. They need to sell this stuff. Now debt has gone up by 20.

So you can see from this that there is an inverse relationship to the cashflow with the asset with an asset goes up, cash goes down, remember really important.

Now my debt, let me just get rid of this thing.

My debt has gone up by 20 million, so cash has gone up by 20 million.

Okay? More debt means I have more cash, yes, I have to repay in the future, but I now have more cash sitting in the bank account.

And we can see that our share capital has gone up by 20.

So either we've retained some earnings or more capitalists come up.

So we now have another 20 million because Annette has paid on more money into her business.

That means my cash has changed by 50 million if you add 15 million, if you add all of that up, okay? So we can quite clearly see where the drivers of cash flow sit both on the operating side. So council C1 inventory changes would go into the operating cashflow, the change in debt goes into the finance cashflow.

So does the change in share capital. Okay? And our net change was 15 million.

So if I just summarize,for 20 seconds, we come back to assets equals liabilities and equity.

We saw that the income statement is the plug into our equity through retained earnings, okay? And ultimately the cashflow statement explains that change in cash.

So things going up and down in terms of in terms of our actual balance sheet and they have a cash flow impact therefore resulting in the ending cash because our beginning cash plus the cash flow for the year will give us our ending cash.

Now hopefully that has given you a good introduction to, um, accounting or financial statement analysis, particularly the three main financial statements.

Have a look at the rest of the materials in terms of the questions.

Feel free to ask us any questions in terms of just just shooting us an email through Felix.

Also in Felix, we have a lot more content on financial statement analysis and accounting. So if you want to know more about detail on working capital, just search up for Working Capital.

And I would love for you just to quickly fill out at the end some feedback on how you found this session, which you hopefully found useful.

And with this, I wish you a fantastic weekend.

Thank you and see you next time. Goodbye to everyone.