- Before we get into financial statement analysis,
let's do a quick review of the financial statements,
these mythical creations that tell us so much
about a company's performance.
- The financial statements are built around
one of the most awesome creations of the human mind,
the accounting equation,
assets equal liabilities plus equity.
There it is.
Assets equals liabilities plus equity.
- Now, I can tell you're a bit underwhelmed.
You're expecting a little bit more,
something like Einstein's famous E equals MC squared.
Well, in its own way, the accounting equation
is just as great as E equals MC squared.
- Let me tell you about this accounting equation
and where it comes from.
First, the assets side.
Now, people have been listing assets
for thousands of years.
Assets are resources owned or controlled
by an individual or a company.
- The great insight behind this accounting equation
was created a little bit over 500 years ago in Italy.
- The traders in Venice and other traders in Italy
had this insight.
They said, "Listen, let's keep a list of our assets
"like we've always been doing but let's also,
"every time we get an asset,
"let's write down where we got the money
"to buy that asset."
We write down the assets and we write down
the source of the financing to buy that asset.
- Now this simple insight imposed discipline
on the financial statements.
The accounting equation always has to balance.
What do you have, the asset,
and what is the source of the funding for that asset?
- An example.
Your assets increased.
Did that increase come from borrowing a liability
or from selling something, a revenue?
- Your assets decreased,
did you pay the bank back for the amount you borrowed,
reduced your liability,
or did you pay an expense to the business?
Expenses will be listed on the income statement.
- It's not enough to say,
"We have more stuff."
The accounting equation forces you to explain
how did you get that "more stuff?"
- Now, there are three fundamental financial statements:
the balance sheet, the income statement,
and the statement of cash flows.
Each of these statements will be discussed
in more detail in the modules that follow.
- These three financial statements
tell us very different
and very important things about a company.
And these three financial statements
are all derived from the accounting equation.
- The balance sheet provides us detail
about the components of the accounting equation,
details about assets and liabilities and equities.
- The income statement provides details about a component
of one of the equity accounts, retained earnings.
- And the statement of cash flows
provides detail about one of the asset accounts, cash,
since cash is the life-blood of a business,
how much do we have, where did it come from,
and where did it go?
There is a financial statement
tracking exactly that account.
- I tip my hat to those medieval accountants in Italy
who invented the accounting equation:
assets equal liabilities plus equity.
Keep track of the assets as we've been doing for 7000 years
and we're also going to keep track
of the sources of financing to buy those assets.
That is the accounting equation.