Accounting for Dummies Part 1

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WARNING: If you have studied accounting, business, economics, finance or banking; please by all means, ignore this post because it will bore you to death.

any of us went through college, university and started a good career (I hope). Malaysians being Malaysian somehow have this 'thing' about Science-oriented faculties particularly the Malays. My observation is that the sons and daughters of the working class during the 50's and 60's were encouraged to take up Science stream studies. This was heavily influenced by the nations need to produce more doctors, engineers, chemists, architects, .... - The list goes on and on but I think, it may have failed to have 'Accountants' - or if it did, it was probably at number 113 out of 120.

These scholars, the Baby Boomers, I think, grew and progressed into professionals and senior management of the mainstream corporations you see today. Unlike their younger competitors (Generation X - who seems to favour Business and Economics), they struggled in their role as senior management simply because they cannot relate their expertise to what appears in the financial statements. Imagine Senior Engineers, Specialists in Hospitals and Architects sitting in the Board of Directors of ICT Companies, Hospitals and Property Development Companies. They cannot escape exercising their responsibilities as Directors which, among others, includes approval of the financial statements - a judgement call by them on how the Company has performed financially.

So, to all you engineers, architects, doctors, quantity surveyors, chemists, microbiologists, pilots, computer programmers - you ought to know some 'Accounts' before you progress further. Some of these may sound like I am explaining to a 6-year old but you'll be surprised on how many professionals and senior management have no clue on some of these things.

First things first. There are a few indicators that you ought to know. Not so much of trying to be smart, but to appreciate the achievement of your Company. These are the key indicators:

• Revenue
• Gross profit
• EBITDA
• Depreciation and Amortisation
• Profit Before Tax (PBT)
• Profit After Tax (PAT)
• Earnings Per Share (EPS)
• PATAMI

Revenue

Cash that you obtained from selling goods and services or cash that you are entitled to receive, ie people owe you when you have completed your delivery. This is really how much of other people's money you can exchange in return to what you can offer them.

Gross Profit

Getting other people's money is only good if it increases your cash. What you spent 'directly' in delivering to your customers has to be less than your revenue, giving a surplus, ie Gross Profit. Notice the word 'directly'? Well this is best explained in an example. Say you sell sandwiches. The cost of bread, tuna, chillies and cheese would be the costs incurred directly in producing the sandwich that sell to your customers. However, the electricity bills and the rental for the shop are not 'directly' related to the sandwiches. Why not? well, I don't see your sandwiches glowing like a light bulb nor do I see red bricks and cement stuck in between two bread. Do you?

Overheads

Costs that are not directly attributable to the production of the sandwiches. For example, the lectricity bills and the rental expenses. Don't under estimate overheads. It can be huge! Think of other expenses that you have to incur regardless of whether you are making those sandwiches or not. To name a few, telephone bills, dish washing liquid, wages for your helper in the kitchen whom you agreed to pay weekly regardless of the volume of sandwiches to be produced. These are all overheads. Imagine McDonalds the fast food chain, who are in the same business as our sandwich outlet. How much does McDonalds have to pay for their employees? Huge.

EBITDA

EBITDA is actually one of financial analysts' favourite indicators - they use EBITDA when they are assessing a company. It does wonders for a whole lot of valuations that no one can understand. Well, for your purpose, I will just explain what it represents. EBITDA is the abbreviation for Earnings Before Interest, Taxation, Depreciation and Amortisation. So taking the sandwich example again. You sell to get revenue, then you offset against what you have spent directly in producing the sandwich; and you get Gross Profit.

Then, At month end you get electricity bills and the landlord is waiting at the door for the rentals - ie Overheads obligation. You pay them and your Gross Profit becomes smaller. Now at that point of time, things can turn out differently depending on individual's state of affair. How did you start the business? Did you get the money from your Dad free of interest? or was it from the bank that charges you 7% interest per year? Did you sacrifice your savings to but the toasters or did you just rent those toasters? Do you fall within the income bracket that warrants the Inland Revenue officers to go after you or do you fall within the low income earners who does not have to pay taxes?

You can answer YES or NO and each answer gives you different commitment. Before you even consider paying taxes or interests or start thinking about whether you have recovered the savings sacrificed for the toasters, what you have in your wallet is basically your EBITDA.

Depreciation and Amortisation

When you set up the sandwich business, you had to buy the toasters. The toaster is probably made in China and will fall apart after 2 years. So you tell yourself "What the heck, I spent RM100 and it only lasts 2 years. Now I have to find another RM100. Ooopss wait,.. the price in Tesco for toasters is now RM150". So really, your first toaster costs you RM50 per year (RM100 divide by 2 years)and your second toaster will cost you RM75 per year (RM150 divide by 2 years - assuming the same brand and type of toaster that is expected to fall apart in 2 years time as well). That RM50 and RM75 is your depreciation.

Amortisation is just another word for depreciation but instead of referring to objects such as toasters, cars, machines and buildings, it is used for other more complex belongings such as intangibles. Now hold on there. Don't you worry about intangibles just as yet. We will get there but not here. Just to give you a flavour of what items you use the word amortisation instead of depreciation, I'll give you an example within our small sandwich business. Say in the town that you live in the mayor only releases licenses for sandwich business to selected parties. Your company happens to be one of the companies who got the license which expires after three years. To get the license you need to pay RM100. So you now have amortisation of RM33.33 per year (RM100 divide by three years).

Profit Before Tax (PBT) and Profit After Tax (PAT)

Really it means what it means. Your profit after deducting the costs of sardines, cheese, bread, electricity, rentals, interest payment to the bank, the depreciation for the toasters and amortisation of the license gives you Profit Before Tax. Then you fill up your tax returns and submit them to the Inland Revenue. As usual, you eventually have to pay taxes which reduces your profit further to Profit After Tax. This should be the final profit. Would be good if the accountants call it PAE, short form for Profit After EVERYTHING!!.

Earnings Per Share (EPS)

Well, now I am going to get a bit technical. When you set up a company, or buy a company, you buy the 'ownership' units in the company. Say you and your mate have RM50 each and the two of you invested the total sum of RM100 into the company so that the company can buy the toaster. That RM100 is the 'Share Capital' often measured as RM1 per each share. Since you invested RM50, you own 50 units of the share capital representing 50% of the business. Say your Profit After Tax is RM500 for the year - you practically grown your wealth by RM400 from that RM100 initially invested. You actually got a surplus of RM4 for every 1 unit of share capital that you put into the business. That my friend, is your Earnings Per Share.

PATAMI

PATAMI stands for Profit After Tax And Minority Interests. This I think is quite difficult to explain to you bloody engineers. Nevertheless, I need to explain this now because it belongs to the same family as Revenue, Gross Profit, EBITDA and the other indicators above. Imagine that in your town, there is only one baker who makes bread. You find it difficult to produce your sandwiches because sometimes the baker won't wait for you and sells all of his bread to the early customers. To ensure that your bread supply is not interrupted, buy bought 70% of the baker's share capital in the bakery - thus having control over the supply of the bread because you are a majority shareholder. The baker now becomes a minority shareholder since he only owns 30%.

The bakery somehow makes profit, say, RM1,000 for the year but you don't really own that RM1,000! You ought to give 30% of it (RM300) to the baker. So now, you have Profit After Tax of RM500 from your sandwich business and RM1,000 from your bakery, giving a total of RM1,500. Then you pay Mr baker RM300 leaving behind RM1,200, which is your Profit After Tax And Minority Interest a.k.a PATAMI.

This will do for Part 1. See you again in Part 2 and subsequent Parts.




* kopihangtuah


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