The world’s economy and financial markets owe much of its status to the great evolution not only of technologies but also to the evolution of accounting and the accounting methods. It has been necessary, throughout the times, to calculate and register the production, sales and expenses, in a way that accounting has always been present in the history of economy and mankind, even in it’s most basic form. We can describe accounting as the science that studies the best way to register the economical facts, simplifying and categorizing operations and transactions, resuming their information in the financial statements, comparable between entities: balance sheet, income statement and cashflow statement as the three most important ones.

Accounting has two ways to be registered: the simple and direct one, where the registry is made in a direct way (expense in the Expenses book, sales in the Sales book), or the double entry way, which the one we use today, developed by the italian mathematician Luca Pacioli in his Summa di Arithmetica (1994). The latter one registers the same operation in two book or entries, as every transaction involves at least two parts: when you sell something, your product gets out of the inventory and you receive cash for it, so you register the sale on both books.

The facts are registered in appropriated places or accounting cathegories by their nature. These rubrics can be more or less specific, depending on the needs and the reality of the organization. In its most simple way, these cathegories belong to a class, which is an aggregation of naturally similar rubrics. Notoriously, accounting is very close to fiscality, as the last one uses the first to calculate the basis for the taxes. Accounting is the very basis for Economics, for investing and for valuating a business, it allows to take conclusions and make measurements, being fundamental knowledge.

In essence, a company, just like an individual, has Assets, which are the resources and rights of a company used in order to develop the business activity and to produce revenues. Liabilities which are the obligations of a company, just like the debt it owes to the bank or the debt to the suppliers, and that will develop expenses; and the difference between these two which is Equity, the residual interest in a company assets after all liabilities are paid: it is the capital of the organization, it’s reserves, it’s own stock held and others.

Assets = Equity + Liabilities

Assets: cash, machines, debt from clients, stock portfolio, real estate and many others.

Liabilities: suppliers debt, bank debt, credit card debt, provisions, others.

Equity: shareholder capital, reserves, last year(s) profits, others.

Revenues are the entries of economical benefits just like sales, royalties, interest or dividends, mainly originated from the Assets, while the Expenses are the outflows of economical benefits just like the expenses with lawyers, accountants, designers, and others, but also with rents of space, machines or cars, administrative material or even water and electricity bills, coming all from the Liabilities. The difference between the Revenues and Expenses is the period Profit, which can be:

• EBITDA: earnings before the interest, taxes and depreciations/amortizations expenses;
• EBIT: earnings before interest and taxes (after deducting the depreciations and amortizations);
• EBT: earnings before taxes (after deducting the interest from EBIT);
• Net Profit: the liquid profit after ALL expenses are deducted

The financial statements allow for a different way to visualize a company’s financial information, organized in a specific form. The three most important financial statements are the Balance Sheet, Income Statement and Cash Flow Statement:

• Balance Sheet: reveals the financial position of the organization, the relation of the Assets, Liabilities and Equity, disclosing the classes of each one.
• Income Statement: reveals the performance of the organization, the display of the Revenues and Expenses, and the different Earnings we talked before.
• Cash Flow Statement: displays the inflows and outflows of cash and equivalents, like the capital expenditures payments, clients and suppliers payments, dividends received and payed, and others.

We’ll talk in another post about each one of these Financial Statements, as it is important to know the advantages and disadvantages and what information each one transmits to the reader. This post hopes to share the basic knowledge of accounting and its method, as well as how it works so that it’s easier to read financial information, plan and decide how to grow as an investor.