Module 2 – Background

Principles of Accounting

Consider that accounting terms are not always obvious in their meanings. If you are learning terminology or need to clarify a vocabulary item, a good reference for accounting terms is:

New York Society of Certified Public Accountants (2017) Accounting Terminology Guide – Over 1,000 Accounting and Finance Terms. Retrieved from: http://www.nysscpa.org/professional-resources/accounting-terminology-guide#sthash.UMS3kGjf.dpbs

For a glossary of general business terms:

Berry, T. (n.d.) Business terms glossary. BPlans. Retrieved from http://articles.bplans.com/business-term-glossary/

The Annual Report

The annual report is the way a firm summarizes its performance over the past year and where it sets a vision for the future. Publicly held companies (traded on the stock exchange) must prepare annual reports, and annual reports are usually public documents. Investors and the general public use annual reports as sources of information about the financial health of a company. We will be learning about reading annual reports to learn general accounting principles in the context of learning about a company and the industry in which it operates. Although we will not discuss all sections of an annual report, we will touch on the sections that have the most relevance to providing the HRM professional with the most helpful insights into the operations of the firm.

Front matter

This is largely text material that sets the stage for the quantitative data that follows.

The Opening letter to the Shareholders

The opening letter is generally the first section of the annual report and is a statement by the chairman of the board. The letter sets the stage for how the firm’s management wants you to view the report and the previous year’s performance, and so in this sense sets the “strategic intent” of the report. A careful reading of the letter can give context to the numbers that follow by giving you clues of what to look for in terms of goals met – or problems that prevented goal attainment. The firm may be on the verge of explosive growth, or a meltdown.

Sales and Marketing

This section covers the company’s product/service line. Typically, it also contains descriptions of key departments or groups and the work they do. By reading this section, you can deduce what products or services are most important to the firm and which divisions are seen as most critical to its success. This section can also give you clues as to what the future may hold.

The Auditor’s Letter

You might be tempted to skip this section, because it probably seems superfluous (like the terms and conditions acknowledgment on software updates. You know you don’t read those!). However, you should know that by law, a publicly traded firm needs to be independently audited every year. This is to protect the investor, and the auditors will state whether or not the data the company presents is accurate and if they have sufficient controls in place to prevent fraud. Auditors are required to point out any uncertainties or qualifications regarding the preparation of financial statements. The majority of auditors’ opinions are positive, but anything less than a positive report should alert the reader that there may be a major problem and the data may not be reliable.

The Financial Statements

Financial statements are the heart of the annual report and present the performance data for the past year. Look for trends or patterns in profitability, growth, and dividend performance.

The Income Statement

The first report you are likely to come across is the income statement. Simply stated, the income statement lets you know if the business made any money. This report summarizes all sales activities, costs of making or acquiring the goods or services sold, and other expenses involved in running the business. Income statements capture performance over time, such as a three-month period for a “monthly” statement, three quarters for a “quarterly” statement, and three years for a “yearly” statement. This allows you to see trends in performance over a period of time.

Key data displayed in the income statement:

• Sales or Revenue: The total amount of money received by the company for goods sold or services provided during a certain time period.
• Cost of Goods Sold (COGS): How much money was spent producing the products/services. (Sometimes called “Cost of Revenue.”)
• Gross Profit: How much money was earned when subtracting COGS from the total revenue. (Also called “Gross Margin.”)
• Operating Profit: How much was made after subtracting money spent on running the business itself (e.g., salaries, facilities, advertising, R&D, administrative costs, etc.). This is also called “EBIT or EBITDA”: Earnings before interest, taxes, depreciation, and amortization.
• Interest, Taxes, Depreciation, Amortization Expense: Self-explanatory.
• Net Income or Loss: This number tells you if the company made or lost money. It is calculated by subtracting all expenses from Gross Profit.

Here is a simple example of an income statement (Imagine you or a young person you know are running a lemonade stand):

The income statement answers the following questions:

1. Is the company making or losing money?
2. What are the trends? Are the company profits increasing or decreasing over time? Is this due to changes in sales, expenses, or both?
3. Is the change in profits due to changes in ordinary operating expenses, or are they due to one-time or extraordinary events unlikely to recur?

The following video offers a good overview of the income statement, using Walmart as the example:

The Finance Storyteller (2017) How to analyze an income statement. Retrieved from
https://www.youtube.com/watch?v=jovKWaUxdmU

For a written overview of the income statement read:

Fields, E. (2016) Chapter Two – The Income Statement. The Essentials of Finance and Accounting for Nonfinancial Managers, Third Edition. AMACOM. Available in the Skillsoft database in the Trident University Library.

Additionally, the following reading offers an example of an income statement and suggests how to go about reading and interpreting one:

Liston, H. (2015). How to read and analyze an income statement. Bplans. Retrieved from
http://articles.bplans.com/how-to-read-an-income-statement/

The Balance Sheet

The balance sheet looks more complicated than the income statement, but its premise is simple. The balance sheet is a snapshot of what the business owns and what it owes at a specific point in time. The difference between what a firm owns and what it owes is called equity. Just as the company wants to increase profit, it also wants to increase equity. Profits and equity are related. If the firm gains profit in any period, it gains in equity. If it loses money, the equity will decrease.

The balance sheet reports the following:

• Assets: These are the items of value that are owned by the company.
• Liabilities: These are the amounts the business owes other people, other businesses, or the government.
• Capital: This is the money that the owners and/or shareholders have invested or reinvested in the business. (Also called owner’s equity.)

The relationship between these elements is simple. The assets must equal the sum of the liabilities plus the owner’s equity. They must balance. This relationship is called the Accounting Equation.

Here is a video that explains the accounting equation in easy-to-follow terms:

AccountingWITT. (2010). The accounting equation – Conceptual analogy. [Video file]. Retrieved from https://www.youtube.com/watch?v=YK4FJ7QrFY0

Note that balance sheets come in two basic formats. The traditional format shows assets on the left side of a table and liabilities and owner’s equity on the right. This is the format you will see in the reading. The other format lists the assets at the top of the table, the liabilities in the middle and the owner’s equity at the bottom. Here is a really simple balance sheet to illustrate. Again, imagine that you or a young friend are running a lemonade stand. The balance sheet might look like this:

Notice how the cash and inventory of supplies (assets) equals the amount owed on the Visa bill to buy supplies, plus the money reinvested from previous sales and cash kicked in by Mom and Dad as seed money (Liabilities + Owner’s Equity).

In a business, the balance sheet is much more complex. Assets can include not only Cash and Inventory, but also Accounts Receivables, Property, Plant and Equipment, and Intangible Assets. Liabilities can be classified as current (Accounts Payable or Taxes Payable) or Long-term debt.

The balance sheet can help answer the following questions:

1. Does the company have sufficient assets to meet its liabilities? In other words, is the firm able to pay its bills over the long term? In financial terms, is it solvent?
2. Does the firm have sufficient cash to pay immediate bills such as payroll? Accountants would call this liquidity, or the ability to quickly turn assets into cash.
3. Has the owner’s equity been increasing over time? (This requires comparing balance sheets over a specified time period.)
4. What is the mix of assets? For example, too much cash may signal a lack of investment in assets that will help the business grow. Too many assets in speculative ventures can also be a reason for concern. Another red flag might be that there were assets on the balance sheet that appeared to have no relationship to the business.
5. Is the mix of financing healthy? There should be some debt, but too little or too much can be a cause for concern. Odd categories of capital (excessive personal loans, convertible subordinate notes) may warrant further investigation.

The following video offers an introduction to the balance sheet:

Tutor2u. (2017) Introduction to the Balance Sheet. Retrieved from https://www.youtube.com/watch?v=Syu2sKv05rQ

For a written introduction to balance sheets:

Fields, E. (2016) Chapter One – The Balance Sheet. The Essentials of Finance and Accounting for Nonfinancial Managers, Third Edition. AMACOM. Available in the Skillsoft data in the Trident University Library.

Additionally, the following reading goes over these concepts in a little more detail and gives some examples of how when one side of the balance sheet changes, the other must change as well to compensate.

Youderian, A. (2013). How to read a Balance Sheet (The non-boring version). Retrieved from http://www.ecommercefuel.com/how-to-read-a-balance-sheet/

The Statement of Cash Flows

Along with the balance sheet and income statement, the Statement of Cash Flows is a required financial report. It shows where the cash is coming from and how it is being spent. It is different from the income statement and balance sheet in that this report only accounts for current cash on hand – not future income from sales on credit. Thus, cash is not the same as “net income.”

View this video for an overview of the cash flow statement:

Small business basics: How to understand a cash flow statement. (2009). eHow. Retrieved from https://www.youtube.com/watch?v=4xfcNNAMcNk

Sources of Cash

There are three ways that cash can enter and leave a company:

Operations. This measures the cash in and cash out from sales of products or services. Included are actual cash, accounts receivable, depreciation, inventory, and accounts payable.

Investing. This is normally a “cash out” item as the firm invests in new equipment, facilities, or other assets. However, it can be a “cash in” item if the firm sells or divests assets.

Financing. “Cash in” items in this category might include loans or other changes in debt. “Cash out” might be when the company pays dividends on stock or interest on bonds.

The cash flow statement can help answer the following questions:

1. What is the health of the business? A consistently healthy operating cash flow indicates that the company is probably being successful at turning its profits into cash. What does this mean to HR? If HR is responsible for staffing the accounting department, a positive value for cash from operations would indicate that the company is doing a good job of collecting on its accounts receivable. It would also indicate that production and sales are also going well. In addition, cash from operations indicates whether or not the firm can finance growth out of its own operations (internally), rather than having to go outside and borrow from banks or sell stock/bonds to raise money.
2. Does the company anticipate growth? The report also shows how much money the company is spending on the future. If the company is not investing in new equipment or facilities, it could be treating the business as a “cash cow” and milking it for current cash, but not investing in future growth. Is the company making increasing investments? This could indicate that the firm expects those investments to pay off in increased sales. On the other hand, is the company selling off assets to raise the cash to fund losses in operations? The answers to these questions has implications for HRM because different decisions would be made about recruiting and training new staff than if the company was a cash cow, gearing up for high growth, or struggling to turn operations around.
3. How dependent is the firm on outside financing? Does it have to borrow heavily just to stay alive? Is the company borrowing more than it is paying off? Are they raising money by selling new stock to investors, or are they using cash to buy back their own stock (so each shareholder owns a larger piece of the company)?

The following reading gives an overview of the cash flow statement:

Fields, E. (2016) Chapter Three – The Statement of Cash Flows”. The Essentials of Finance and Accounting for Nonfinancial Managers, Third Edition. AMACOM. Available in the Skillsoft database in the Trident University Library.

The following article is a blog post on how to analyze cash flow statements from an investor’s point of view. However, I think it is helpful for our purposes because you won’t get bogged down in determining what numbers go where, but rather in how to read the “story” that the cash flow statement is telling you:

Jun, J. (2008). How to master analyzing the cash flow statement. Old School Value. Retrieved from http://www.oldschoolvalue.com/blog/valuation-methods/analysing-financial-statements-and-aerogrow/

Footnotes to the Financial Statements

The final part of the annual report that you should know about are the footnotes. These notes contain important information concerning specific methodologies used to prepare the financial statements that might make the statements themselves too crowded and difficult to read. Footnotes may be of particular interest to HR professionals w hen they contain information about pensions or compensation plans.

Putting it all together

Here is the “so what?” question. Now that you know what the main financial statements are and what information they contain – SO WHAT? What does one have to do with the other? How do they fit together?

In order to make sense out of what seems to be a jumble of numbers, go back to the fundamental accounting equation: Assets = Liabilities + Owners Equity. Always remember this relationship. This ties together the three financial statements.

1. The statement of cash flows tracks how changes in the firm’s cash balance are the result of changes in assets, liabilities, and owner’s equity.
2. The balance sheet shows the changes in assets and liabilities.
3. The income statement demonstrates changes in owner’s equity resulting from changes in net income.

Thus, any changes in one part of the firm’s accounting picture can be explained by changes to the other parts. This is the essence of accounting.

Analyzing the Financial Health of the Firm: Ratios

While learning to read financial statements is one of the best ways to learn accounting principles, the best way to assess the financial health of a firm is by comparing key financial ratios. These ratios help us attain a deeper understanding of the company’s performance, particularly when viewed in terms of changes over time or in relation to other firms in the same industry. There are many ratios, some of which are specialized for a type of organization, or function within an organization. Because this is a course designed to acquaint non-MBAs with financial ratios, we will review a set of ratios that are most commonly used by management in the majority of organizations. These ratios fall into four categories measuring different areas of strategic interest:

Profitability ratios

Just looking at net income does not tell you very much about how well the company is doing at generating a profit given the level of sales or amount of assets owned by the firm. The higher the profitability ratio, the better job the company is doing at generating a profit from their assets. Examples of profitability ratios include Profit Margin and any of the “return” ratios (e.g., Return on Assets or ROA; Return on Equity or ROE). The following site explains in plain language some of the key profitability ratios you will run across, how they are calculated, and how they are used.

Profitability Ratios. (2015). My Accounting Course. Retrieved from http://www.myaccountingcourse.com/financial-ratios/profitability-ratios

Liquidity Ratios

It is essential for an organization to know if it can pay its bills comfortably. Liquidity ratios let you know how much the company has on hand that can be quickly converted to cash. From this same plain-language site, here is some reference material on liquidity ratios you are likely to see and need to understand:

Liquidity Ratios. (2015). My Accounting Course. Retrieved from http://www.myaccountingcourse.com/financial-ratios/liquidity-ratios

Leverage Ratios

These ratios tell you how heavily the firm is burdened by debt and how much the company is being financed by investors or shareholders. The higher the amount of debt, the higher the leverage. In general, highly leveraged firms are considered to be more risky because more of the income generated by the business must be used to simply pay off the debt rather than support operations or increase owner’s equity.

Financial Leverage Ratios. (2019). My Accounting Course. Retrieved from
http://www.myaccountingcourse.com/financial-ratios/financial-leverage-ratios

Efficiency ratios

As its name would suggest, this ratio measures whether or not the firm is making the most out of its assets. If a firm can speed up its collection of receivables or sell its inventory faster, it increases its efficiency, positively affects its cash position, and thus its profitability. Efficiency ratios vary widely by industry. Walmart makes its money by quickly turning over inventory at rock-bottom prices. The profit margin on a single item is so thin that any extra money spent on warehousing or storing products on the shelf cuts into profit (high turnover ratio). On the other hand, Jaguars sell for a high price that includes the probability that the cars will sit on the lot for a while before the right buyer comes in (low turnover ratio).

Efficiency Ratios (2019). My Accounting Course. Retrieved from http://www.myaccountingcourse.com/financial-ratios/efficiency-ratios

Specialized Ratios

Not all industries pay the same amount of attention to the same ratios. Retailers pay a lot of attention to inventory; small businesses and start-ups may keep a close eye on the current ratio to make sure they have enough cash to pay bills. Similarly, different parts of a company may place special attention on specialized ratios. Here are some metrics that are particularly applicable to human resource managers:

• Revenue per employee
• Compensation as a percent of revenue
• Benefits cost as a percent of compensation
• Cost per hire
• Employee turnover
• HR department expense as a percent of total expenses

You will be delving into Human Resource metrics further in later classes in the MSHRM curriculum, but here is an excellent overview of the topic. The video at the end raises some controversial views as to what HR measurements are valuable to the firm from a strategic viewpoint.

Evans, M.H. (2015). Metrics for Human Resource Management. Retrieved from http://www.exinfm.com/board/metrics_for_hr_management.htm

Videos

AccountingWITT. (2010). The accounting equation – Conceptual analogy. [Video file]. Retrieved from https://www.youtube.com/watch?v=YK4FJ7QrFY0. Standard YouTube License.

Harris, M. (2018, May 22). Liquidity Ratios. Retrieved from https://youtu.be/D48_G40JACI. Standard YouTube License.

Profitability Ratios. (2015). Corporate Finance Institute. Retrieved from https://youtu.be/hgRLUdWVl3Q. Standard YouTube License.

Quantopian. (2019, August 1). How to read a Balance Sheet. Retrieved from https://youtu.be/q4HOhxCS1u8. Standard YouTube License.

Quantopian. (2019, July 25). How to read an Income Statement. Retrieved from https://youtu.be/bvjRacnAz9I. Standard YouTube License.

The Finance Storyteller (2017) How to analyze an income statement. Retrieved from https://www.youtube.com/watch?v=jovKWaUxdmU. Standard YouTube License.

Towns, P. (2016, January 5). How do you read a cash flow statement? Retrieved from https://youtu.be/X17bUV-EfIM. Standard YouTube License.

Tutor2u. (2017). Introduction to the Balance Sheet. Retrieved from https://www.youtube.com/watch?v=Syu2sKv05rQ. Standard YouTube License.

Required Reading

Efficiency Ratios. (2015). My Accounting Course. Retrieved from http://www.myaccountingcourse.com/financial-ratios/efficiency-ratios

Fields, E. (2016). The essentials of finance and accounting for nonfinancial managers (3rd ed.). New York, NY: AMACOM. Available in the Skillsoft database in the Trident Online Library.

Marler, J. H., & Boudreau, J. W. (2017). An evidence-based review of HR Analytics. International Journal of Human Resource Management, 28(1), 3–26. Available in the Trident Online Library.

Omondi-Ochieng, P. (2018). US table tennis association: A case study of financial performance using effectiveness indicators and efficiency ratios. Managerial Finance, 44(2), 189-206. Available in the Trident Online Library.

Synaptics 2017 Annual Report. (2018). Retrieved from http://www.annualreports.com/Company/synaptics-inc

Optional Reading

Financial Leverage Ratios. (2015). My Accounting Course. Retrieved from http://www.myaccountingcourse.com/financial-ratios/financial-leverage-ratios

Grigorescu, A., & Chiper, A. (2016). The importance of human capital in the strategic development of an organization. Studies and Scientific Researches: Economics Edition. University of Bacău, Romania. DOI 10.29358/sceco.v0i0.344. CC BY-SA