In case you had other things on your mind in college and missed accounting and finance, there are seven important concepts you need to know to build and lead an organization. All of these apply regardless of your tax status.
1. Profit & Loss. The change in income and expenses over a period of time is called an income statement or profit and loss (P&L) statement. Transactions are usually booked monthly and reported quarterly and annually. As organizations grow, they usually build an annual monthly budget and use it to manage expenses.
It may not reflect the change in cash for several reasons. Generally Accepted Accounting Principles of revenue recognition requires sales (“top line”) to be recognized as they are realized and matched with expenses. As a result, a business may book a sale but not receive the cash in the same period. Non-cash expenses, including depreciation and write offs, are another difference. The final reason that a P&L may not reflect the change in cash are balance sheet changes including capital expenditures and changes in debt or equity positions. See Fred Wilson’s post and Wikipedia for more.
2. Gross Margin. The difference between revenue and cost of goods sold is the gross margin. It does not include operating or overhead costs. In a tech business the gross margin can be 70 percent or more; in retail it may be less than 25 percent (particularly in big box stores that try to sell inventory before they pay for it). It’s the first of several key P&L lines to plan and monitor.
The other important number on the P&L is operating income: revenue minus expenses. If it’s positive you may have a sustainable enterprise, if it’s negative you are probably consuming capital. The revenue at which an organization begins to earn an operating profit is called the breakeven point.
EBITDA, Earnings Before INterest, Taxes, Depreciation and Amortization, is also a frequently monitored P&L line–it’s a better proxy for free cash flow that operating income and useful for comparing companies with different asset and capital structures. It’s helpful to look at several years of P&L and look at gross margin, EBITDA, and operating income as a percentage of sales. See Fred Wilson’s post on EBITDA for more.
3. Balance Sheets. The balance sheet shows the assets, short and long term, that you have built up compared to liabilities and invested capital. Current accounts include cash and account receivables. Long-term assets include categories like real estate and equipment. The IRS requires you expense a portion of the cost asset each year rather than expensing it when purchased. The cost less accumulated depreciation is called net assets.
After cash, the liabilities section is the most important balance sheet category. It includes short term or Current Liabilities like accounts payable and longer term loans and leases.
A for-profit company has a Shareholder Equity section that shows capital contributions and Retained Earnings accumulated over the years. See Fred Wilson’s post and Sal Khan’s video on balance sheets.
4. Cash Flow. The difference between cash at the beginning and end of an accounting period is cash flow. A cash flow statement isn’t always that useful except for budgeting and monitoring cash balances. For more, see Fred Wilson’s post.
5. Time Value of Money. Money on hand is worth more than money in the future. Investing $100 in a savings account with a 3 percent interest rate earns $3 interest over the course of a year. See Fred Wilson’s post and Sal Khan’s video introduction to interest.
6. Internal Rate of Return. Understanding rate of return is the key to putting assets to work and improving productivity. When you make a expenditure (i.e., buying a long lived asset or launching a campaign) you want it to produce a return larger than your cost of capital–the return your investors or bankers expect. For a quick investment you can estimate the return by dividing profit by expense (e.g. $500 profit /$400 invested = 1.25 or 25 percent return on investment).
For a longer project, especially investments expected to yield multiyear benefit, you need to consider the time value of money by calculating the Internal Rate of Return. Read Fred Wilson’s post to learn how to use the IRR function in Excel.
7. Present Value. If you’d take $920 now rather than $1000 a year from now, that’s an 8.7 percent discount rate (8/92). Discount rates are used to haircut projected future cash flow. They take into account time value of money as well as risk. If an investment is risky, an investor will use a higher discount rate on projected cash flows. See Fred Wilson’s post and Sal Khan’s video on Present Value.
Net Present Value (NPV) is the difference between the present value of a cash stream compared to the cost (e.g., $10 million in present value minus cost of $5 million = $5 million in NPV). A positive NPV means that the cash flow is projected to be worth more than the discount rate.
I have a friend who believes that most of the math that college and career ready graduates need can and should be taught through spreadsheet modeling–with the added benefit of inquiry and systems thinking deepened by application and simulation. I think he is on to something. These seven concepts above could be taught in two units about starting a company. Students could play with an existing simplified P&L, Balance Sheet and Cash Flow Statement and then build their own for the company they want to start. Then they could analyze the benefits of an asset purchase. This would be a great application of the Common Core emphasis on functions and modeling ( see page 68-73 of the math summary).
This blog first appeared on EdWeek.