Corporate Accounting

Public companies are required to report financial data periodically, e.g., yearly, according to formal standards such as GAAP or IFRS. These financial reports show several aspects of their financial situation (German terms in ()):

• Cash flow statement (Kapitalflussrechnung)
• Income statement (Gewinn- und Verlustrechnung GuV)
• Balance sheet (Bilanz)

The management also writes about its view of the current business situation and provides a near-term outlook. 

The following is a very simplified description in layman's terms for people without a formal financial background. It presents the general ideas, but does not try to fully comply with the official accounting standards or terms and neglects a lot of technical details.

Cash Flow Statement

This statement is very similar to the financial statement which private households get for their bank account. It shows how much real money was paid to and from the company over the reporting period. Basically, cash flow consists of three elements:

Cash Flow from Operations (Laufende Geschäftstätigkeit) : Cash Income from Sales (Umsatzerlöse) - Cash paid for Operating Expenses OpEx (Betriebsausgaben)

Income from sales and operating expenses OpEx here only include actual payments from customers or to suppliers, employees, taxes, etc. Revenue from products sold to customers or invoices from suppliers that have not yet been paid immediately show up in the income statement (see below), but not yet on the cash flow statement.

Cash Flow from Investments (Anlagevermögen) : Sales of Business Units or other Assets - Capital Expenditures CapEx - Acquisitions of other Businesses

Capital Expenditures CapEx include purchases of production machinery, real estate for plants and warehouses, or patents and license fees. When CapEx is less than depreciation of existing assets (see below), this can be a warning sign that the company may lose production capacity over the long term.

Cash Flow from Financing (Kapitalmaßnahmen) : New Debt, e.g., issuance of bonds - Repayment of existing debt + Issuance of new or repurchase of existing Shares - Dividend payments

The final result is:

Cash Flow (Kapitalfluss) = Cash Flow from Operations + Cash Flow from Investments + Cash Flow from Financing

Cash flow shows how much liquidity the company was generating in the reporting period. The three cash flow elements typically depend on the state of the company's lifecycle:

• Startup companies often burn cash, i.e., cash flow from operations and investments is negative, while the company is financed via debt or capital from owners and early investors.
• When the company's operations turn positive, CapEx remains high to sustain growth while the company starts to return cash to its early investors, i.e., the cash flow from financing becomes negative.
• Mature companies may turn into real cash cows by reducing CapEx (and thus eventually growth) and distributing more of the earnings to shareholders.
• In a crisis situation, restructuring may require selling assets, i.e., using positive cash flow from investments to compensate for negative cash flow from operations.

Stock analysts often use the so-called free cash flow, which tries to describe what is available to pay dividends, repurchase shares, repay debt, or expand the business in the future:

Free Cash Flow = Cash Flow from Operations - Capital Expenditures CapEx

Income Statement

This statement shows how much the company earned over the reporting period from all products and services that the company provides. In addition to cash flow, which only considers real money transfers within the reporting period, the income statement takes into account non-cash items like depreciation and future payments due to open invoices or unpaid taxes that are already known but have not yet been paid. Net income from an accounting perspective is calculated step-by-step:

Gross Profit (Bruttoergebnis) : Revenue from Sales (Umsatzerlöse) - Cost of Goods or Services sold (Herstellungskosten/Wareneinsatz) 

Expenses from Operations OpEx (Betriebsausgaben) : Research & Development Costs (Forschungs- und Entwicklungskosten) + Sales & General Costs (Vertriebs- und Gemeinkosten) + Depreciation & Amortization of Machines and other Assets (Abschreibungen)

Earnings Before Interest and Taxes EBIT : Gross Profit - Operations Expenses OpEx

Stock analysts often prefer Earnings Before Interest, Taxes, Depreciation, and Amortization EBITDA.

Finally, we arrive at net income:

Net Income = EBIT - Interest on Debt (Financing costs) - Taxes (Ertragssteuern)

A simple example of how accountants view a sales transaction:

• Let us assume a company manufactures a machine for $60,000 and sells it for $100,000 on 1-month payment terms.
• At the time of the sale, revenue is $100000, cash received so far is $0 and accounts receivable is +$100,000. That is: cash flow statement ±0, income statement $100,000 - $60,000 = +$40,000
• One month later, when the customer pays, there is no new revenue ±0, but cash increases by +$100,000 and accounts receivable decreases by -$100,000. That is: cash flow statement +$100,000, income statement ±0.

Balance Sheet

While the cash flow and income statements show if the company earned money over the reported time period, the balance sheet shows how valuable the company is (based on its assets, not on its stock market value!). It lists all assets vs. all liabilities of the company: 

^*1 A term you may frequently find here is working capital, which is the money tied up in day-to-day operations: Materials or products in inventory that the company has already paid for but not yet sold, invoices that have not yet been paid by customers, or bills received that the company has not yet paid.

The right column of the balance sheet shows where the company's funds come from. The left column shows what they are used for. Most elements of the cash flow or income statement have a direct counterpart on the balance sheet. For example, cash flow is the difference between the cash position on the current balance sheet and the cash position of the previous reporting period (possibly with minor adjustments, such as FX rate effects). 

The fundamental principle used in balance sheets is double-entry bookkeeping:

Assets = Liabilities and Equity

Every financial transaction either changes the totals in both columns of the balance sheet by the same amount or leaves both totals constant when one item increases and another item in the same column decreases by the same amount:

• Purchasing new equipment paid with cash reduces current assets while increasing the fixed assets, i.e., the total of the left column does not change, and the right column is not affected at all (balance-sheet neutral, Bilanzneutral).
• When the purchase is financed with new debt, liabilities in the right column go up, as does the equipment value in the left column. Another example: Selling long-term bonds adds to the liability column, but the cash earned from the bond sales also adds to the cash position in the left column. Thus, the totals in both columns grow by the same amount (balance-sheet expansion, Bilanzverlängerung).
• When debt is repaid using cash, cash in the left column and debt in the right column shrink by the same amount (balance-sheet reduction, Bilanzverkürzung).

The equity position in the right column plays a special role as a risk indicator. From the formula above, equity can be written as:

Equity = Assets - Liabilities 

When the company needs money, it will use its cash. However, when there is not enough cash available, it can no longer service short-term liabilities like salaries, supplier invoices or interest payments, i.e. the company becomes illiquid, and needs to get fresh cash via a bank loan, new bond issuance, or asset sales.

If losses accumulate and liabilities grow, the equity position decreases. Once equity turns negative, i.e. liabilities > assets, the company technically is insolvent, i.e., bankrupt. When a company must formally declare insolvency depends on the jurisdiction. Creditors may agree to restructure or forgive debt to restore positive equity, and authorities may allow companies to operate with negative equity for a limited time. 

Another balance-sheet risk lies in the intangible assets & goodwill item in the left column. Intangible assets include, for example, the company's patents or other intellectual property. As long as these assets are not sold, they do not have an actual market price. Thus, their value is estimated according to more-or-less well-defined rules. The same applies to goodwill, which represents a premium paid for an acquisition over fair value because of brand reputation or expected synergies. These estimates are hard to verify, so they can be inaccurate. If they turn out to be too optimistic, they will lead to a sudden drop in asset value.

In many countries, companies must have their financial statements reviewed by statutory auditors such as EY, PwC, Deloitte or KPMG. However, this does not guarantee that they are always correct or immune to outright fraud, as occurred with companies such as Enron or Wirecard.

To get the full picture of a company, one should look at the financial reports over a longer time frame and compare them with those of other companies in the same market sector. Trends and relative values are much more meaningful than single data points. And often the stock price trend vs. the general stock market may give an early indication of what is showing up in the financial reports only much later.

Further Reading

• Securities and Exchange Commission SEC
• Corporate Finance Institute
• Price Waterhouse
• Schwab
• Open EDU
• Khan Academy
• Financial Accounting Standards Board FASB: Generally Accepted Accounting Principles GAAP
• International Accounting Standards Board IASB: International Financial Reporting Standards IFRS

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