A Positive Net Cash Flow From Investing Activities Indicates Accounting Equation and Financial Statements

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Accounting Equation and Financial Statements

Accounting can be a difficult subject to grasp if you do not understand the basic concepts. The most basic equation that everyone should know is Assets = Liabilities + Equity. This is called the accounting equation and if you understand what it means it will help you survive any accounting class.

Assets are things that companies own that will ultimately benefit the company. Examples of this would be cash, machinery/equipment, or land. There are two different types of assets called current assets and plant assets. Current assets are things that will eventually be used up, converted to cash, or sold unlike plant assets that are permanent like buildings, land, and equipment. Cash is the most popular asset and will be used the most often in financial accounting.

Liabilities are obligations that a company has to a creditor and they usually consist of money, services, or products. An example of this would be wages payable to employees because the employees have worked for their money but the company has not yet paid them. Once the company pays the employees for their work the company is no longer held liable to the wages payable account.

Equity can be determined by subtracting total liabilities from total assets. It is most commonly known as stockholders’ or shareholders’ equity and all equity has two parts: contributed capital and retained earnings. Contributed capital is the amount of money that stockholders have invested into a particular company. Retained earnings refer to the amount of money that a company retains and does not give to its stockholders. To calculate retained earnings a company would subtract its dividends, add its revenues, and subtract its expenses. They would subtract dividends because a dividend is a chunk of money you must give to a stockholder. The company would add its revenues because that is the money that the company has made through sales, rental fees, services provided, etc. Lastly, the company would subtract its expenses because that money was spent on things like office supplies, employee wages, and utilities and therefore it needs to be deducted from the retained earnings. If a company is doing well they will have a net income which means that their revenues exceed their expenses and that they have made money. If a company is doing poorly they will have a net loss which is when their expenses exceed their revenues and they have ultimately lost money.

Now that we understand the most basic information of accounting, we can plug the data into the appropriate part of a financial statement. Financial statements are made up of four parts: an income statement, statement of retained earnings, balance sheet, and a statement of cash flows. An income statement is pretty simple and only deals with revenues and expenses. You simply subtract the total expenses from the total revenues to give you the net income. A statement of retained earnings takes any prior retained earnings and adds the net income to it. You then subtract the dividends which gives you the current amount of retained earnings. The balance sheet involves assets, liabilities, and equity. On the left side of the balance sheet, under the assets column, you add up all assets including cash, supplies, equipment, etc. to get the total assets number. The liabilities and equity columns go on the right side of the balance sheet. All liabilities get added up under liabilities and the same with equity except the new retained earnings number is also added under equity to produce the total liabilities and equity number. A statement of cash flow is an oversimplified table that breaks down everything that involved cash. It adds together all cash flows from operating activities, investing activities, and financing activities to produce the net increase in cash. That number is then added to the previous cash balance to give you the current cash balance. The current cash balance number is the number for cash that is used on the balance sheet on the left hand side under the assets column.

As you can see, the basics of financial accounting are not too complex once you understand what is going on. The financial statements always take the same form so it is good to learn them early since they will be used a lot. It is also important to memorize the accounting equation (Assets = Liabilities + Equity) since this will also be used in almost all financial accounting problems.

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