Open Finance Academy

Accounting and financial analysis

Learn to read a business’s financial statements, distinguish profit from cash, and use a few calculations to ask better questions about performance.

← All knowledge areas · Glossary

No accounting experience is needed. You will use addition, subtraction, division, and percentages. New finance terms are bold, explained on first use, and linked to the glossary, which links back to their explanations here.

In this lesson

  1. Start with the business
  2. What the business has and owes
  3. When to record sales and costs
  4. Spreading the cost of equipment
  5. Did the shop make a profit?
  6. Where did the cash go?
  7. How the statements connect
  8. Using ratios to ask better questions
  9. Reading beyond the totals
  10. Check your understanding

Start with the business

Maya starts a small stationery shop. At the end of its first month, she wants to know: Did selling stationery cover the month’s costs? How much money is available? What does the shop still owe?

Accounting records, organizes, and reports the business’s financial events. Financial analysis examines those records to understand results and identify questions worth investigating.

Example assumptions

All amounts are invented dollars for the shop’s first month, September. The business starts with zero balances immediately before Maya’s investment on September 1. Keep the business’s records separate from Maya’s personal spending.

Assume no taxes, borrowing, interest, fees, owner withdrawals, returns, or discounts. All customer amounts owed will be collected next month. Unsold goods remain usable and saleable at their recorded cost. Equipment is available for use from September 1. We use simplified accrual accounts and show only the transactions listed below; this is not a tax return or a complete set of statutory accounts. Reporting rules and presentation vary by jurisdiction and accounting framework.

Event during September Amount and timing
Maya invests her own money in the business $10,000 received in cash
The shop buys equipment $2,400 paid in cash
The shop buys stationery to sell $4,000 paid in cash
Customers receive stationery sold for $6,000 $4,500 collected; $1,500 due next month
The stationery sold originally cost the shop $2,500
September rent and wages $1,000 rent and $1,200 wages, both paid
September utilities $300 used this month, billed but unpaid
Equipment cost assigned to September $100, calculated below

What the business has and owes

Immediately after Maya invests $10,000, the shop has $10,000 in cash and owes nothing to outside parties. Maya’s recorded ownership interest is $10,000.

An asset is a resource the business controls that is expected to provide future benefit. A liability is a present obligation to transfer money or other resources. Equity is the owners’ remaining interest in recorded assets after liabilities are subtracted.

The accounting equation is:

Assets = liabilities + equity

At that moment: $10,000 = $0 + $10,000. Maya’s investment increases equity; it is not a sale to a customer.

A balance sheet reports these three categories at a particular date. Inventory means goods held for sale, or materials and unfinished goods that will become products. Buying $4,000 of stationery moves $4,000 from cash into inventory. Total assets initially stay the same.

The SEC’s introductory guide explains the balance sheet and accounting equation.

When to record sales and costs

The shop delivers $6,000 of stationery in September but receives only $4,500 immediately.

Revenue is the amount earned from ordinary business activities before subtracting costs. An expense is a cost; in these business accounts it is recognized in the period when resources are consumed or the obligation arises, which may differ from the payment date.

Under accrual accounting, revenue is recorded when earned and expenses when incurred, rather than only when money changes hands. Here, the completed sales generate $6,000 of September revenue. Cash basis accounting generally records revenue on receipt and expenses on payment; tax rules can require exceptions. See OpenStax on accounting timing.

The unpaid $1,500 is accounts receivable: amounts customers owe for goods or services already provided. It is an asset, but cannot yet pay the shop’s bills. Collecting it in October exchanges a receivable for cash; it does not create another sale.

The unpaid $300 utility bill is accounts payable: amounts owed to suppliers for goods or services received. It is both a September expense and a liability at month-end. Paying it next month settles that liability rather than creating a second utility expense.

Cost of goods sold is the recorded cost of the goods actually sold during the period. Our shop bought $4,000 of stationery but sold goods costing $2,500:

Ending inventory = $0 starting inventory + $4,000 purchases − $2,500 cost of goods sold = $1,500.

The remaining $1,500 is still an asset. Charging all $4,000 as September’s cost of goods sold would incorrectly include unsold stock. OpenStax’s merchandising introduction explains inventory and the cost of sales.

Spreading the cost of equipment

The $2,400 equipment purchase uses cash immediately, but the equipment will help the shop for more than one month.

Depreciation spreads the depreciable cost of a tangible, long-lived asset over its estimated useful life. Assume the equipment lasts 24 months, has no value left at the end, and its cost is spread evenly:

Monthly depreciation = ($2,400 cost − $0 expected end value) ÷ 24 months = $100.

September includes $100 of expense. The equipment’s carrying amount, meaning its amount in the accounts after adjustments, falls to $2,400 − $100 = $2,300.

There is no extra $100 cash payment when depreciation is recorded. Nor does it mean the equipment’s resale price has fallen by exactly $100. The useful life and expected end value are estimates. See OpenStax’s explanation of depreciation.

Did the shop make a profit?

An income statement shows revenue, expenses, and profit or loss over a period. Gross profit is sales revenue minus the cost of goods sold. Net profit is what remains after all recognized expenses; a negative result is a net loss. Net profit is also called net income, which differs from the everyday use of “income” to mean money received.

Shop income statement — September

Item Amount
Sales revenue $6,000
Less cost of goods sold −$2,500
Gross profit $3,500
Rent −$1,000
Wages −$1,200
Utilities −$300
Depreciation −$100
Net profit $900

The remaining expenses total $1,000 + $1,200 + $300 + $100 = $2,600. Therefore, $3,500 − $2,600 = $900 profit. Taxes and financing costs are absent only because of our assumptions.

The shop earned $900 under these assumptions, but it has not received all sales money. Use the income statement alongside the other statements, as explained in OpenStax’s financial statement overview.

Where did the cash go?

Cash flow means money moving in and out over a period. A cash flow statement explains the change in cash, separating everyday operations, investment in longer-lived resources, and funding from owners or lenders. Actual statements also include qualifying cash equivalents, which this example does not use.

Shop cash flow statement — September

Category Cash movements Net cash flow
Operating activities: running the shop $4,500 from customers − $4,000 inventory purchases − $1,000 rent − $1,200 wages −$1,700
Investing activities: buying long-lived resources Equipment purchase −$2,400
Financing activities: obtaining or returning funding Maya’s investment +$10,000
Total change in cash −$1,700 − $2,400 + $10,000 +$5,900

Beginning cash was zero, so ending cash is $0 + $5,900 = $5,900. These categories are described in OpenStax’s guide to cash flow activities.

We can also reconcile profit to operating cash:

$900 profit + $100 noncash depreciation − $1,500 increase in receivables − $1,500 increase in inventory + $300 increase in payables = −$1,700.

Receivables and inventory used resources without generating matching cash receipts this month. The unpaid utility bill reduced profit but has not yet used cash. The equipment purchase and owner’s investment are accounted for outside operating cash flow.

The shop is profitable but used cash in its operations. Its $5,900 cash balance depends on Maya’s initial funding. Neither profit nor a positive bank balance alone tells the whole story.

How the statements connect

Shop balance sheet — September 30

Assets Amount
Cash $5,900
Accounts receivable $1,500
Inventory $1,500
Equipment after depreciation $2,300
Total assets $11,200
Liabilities and equity Amount
Accounts payable: utilities $300
Maya’s original investment $10,000
September profit kept in the business $900
Total liabilities and equity $11,200

The equation still holds: $11,200 assets = $300 liabilities + $10,900 equity.

A statement of changes in equity explains movements in the owners’ recorded interest. Our simplified version is:

$0 beginning equity + $10,000 owner investment + $900 profit − $0 owner withdrawals = $10,900 ending equity.

The income statement’s $900 profit increases equity, the cash flow statement’s $5,900 ending cash appears as an asset, and the $100 depreciation reduces equipment. Statements for a period explain changes between balance sheet dates. A balanced equation is a consistency check, not proof that every sale, estimate, or classification is correct.

Using ratios to ask better questions

A financial ratio divides one financial amount by another to make a comparison. Match the periods, units, and definitions before comparing businesses.

Gross profit margin is gross profit divided by sales revenue. Net profit margin is net profit divided by revenue. Multiplying a decimal by 100 expresses it as a percentage.

September measure Calculation Meaning
Gross profit margin $3,500 ÷ $6,000 × 100 = 58.33% About 58 cents per sales dollar remain after the goods’ cost, before other expenses.
Net profit margin $900 ÷ $6,000 × 100 = 15% Fifteen cents per sales dollar remain after all expenses in this example.

See OpenStax on profitability ratios. A larger sales total need not produce a larger profit: if next month’s sales are $7,000 but net profit is $700, the margin is $700 ÷ $7,000 × 100 = 10%. Investigate prices, goods costs, and other expenses before explaining the decline.

Current assets are short-term resources, generally including cash and items expected to be sold, used, or collected within the normal operating cycle or twelve months. Current liabilities are short-term obligations, generally due within that cycle or twelve months. Detailed classification depends on the reporting framework. Assume the shop’s cycle is shorter than a year.

The shop’s current assets are $5,900 cash + $1,500 receivables + $1,500 inventory = $8,900. Its only current liability is the $300 utility bill.

The current ratio divides current assets by current liabilities: $8,900 ÷ $300 = about 29.67 times. Working capital subtracts current liabilities from current assets: $8,900 − $300 = $8,600. See OpenStax on short-term financial resources.

That unusually high ratio reflects a newly funded shop with very few unpaid bills. It is not a target for other businesses. Working capital is not the bank balance: some of it is tied up in stock and customer debts. Ratios cannot show whether a particular customer will pay before tomorrow’s bill is due. If current liabilities were zero, division by zero would make this ratio undefined.

Compare several periods and similar businesses. A seasonal shop, a bank, and a software company have different financial patterns; a single universal “good ratio” is misleading.

Reading beyond the totals

Financial statement notes explain the policies, estimates, and details behind the numbers. Read them alongside the statements. The SEC guide’s discussion of notes explains why they matter.

In our shop, investigate these questions:

Recorded equity is not a quoted business sale price. Our $10,900 includes amounts measured under accounting assumptions; a buyer may value the shop differently.

An audit is an independent examination supporting an opinion on financial statements under applicable standards. For U.S. public-company audits, the Public Company Accounting Oversight Board describes the aim as reasonable assurance that statements are free of material misstatement—errors or omissions important enough to affect users’ decisions. This is not absolute assurance. An audit does not promise future profitability or detect every fraud. See PCAOB AS 1000, consulted September 13, 2026. Other jurisdictions use their own applicable standards.

Our invented shop’s statements have not been audited. Use financial analysis to develop questions, then check supporting records and explanations.

Check your understanding

Use the September assumptions. Questions 3–5 are independent changes to the original example, not cumulative changes.

  1. The shop collects the $1,500 receivable in October. Does that create another $1,500 of revenue? What changes instead?
  2. Why is September’s cost of goods sold $2,500 when the shop paid $4,000 for inventory?
  3. If the utility bill had been paid during September, what would happen to net profit, ending cash, and liabilities?
  4. Suppose equipment cost is spread evenly over 12 months instead of 24, still with no expected end value. What are September depreciation, profit, and ending cash?
  5. Maya adds another $2,000 of her own money on September 30. What happens to revenue, profit, cash, and equity?
  6. Another shop has current assets of $4,000 and current liabilities of $2,000. Calculate its current ratio and working capital. Does the result guarantee timely payment?
  7. Our shop reports $900 profit, −$1,700 operating cash flow, and $5,900 ending cash. Which number answers whether operations generated cash during September?

Answers

  1. No new revenue. Cash increases by $1,500 and accounts receivable decreases by $1,500. September already included the completed sale; total assets are unchanged by collection.
  2. Only goods sold enter this expense. $4,000 purchased − $2,500 sold at cost = $1,500 still held as inventory. Cash spent and goods consumed are different measures.
  3. Profit stays $900; cash falls to $5,600; liabilities fall to zero. The $300 expense was already included. Paying it removes $300 of cash and the $300 obligation.
  4. Depreciation becomes $200, profit becomes $800, and cash stays $5,900. $2,400 ÷ 12 = $200. The extra $100 expense reduces $900 profit to $800 but requires no additional cash payment.
  5. Revenue and profit are unchanged; cash becomes $7,900 and equity becomes $12,900. Add $2,000 to the original $5,900 cash and $10,900 equity. Owner funding is not earnings from customers.
  6. Current ratio: 2 times. Working capital: $2,000. $4,000 ÷ $2,000 = 2, and $4,000 − $2,000 = $2,000. No guarantee follows: assets may include slow-paying customers or goods that take time to sell.
  7. Operating cash flow: −$1,700. Operations used cash. Profit measures recognized earnings, while ending cash also reflects the owner’s funding and equipment purchase.

Terms introduced in this lesson

Use these links to revisit definitions and return to their explanations above.

Keep learning

Revisit Money and financial fundamentals for interest, time, and risk. Personal finance and financial wellbeing applies cash timing to household decisions.

Continue with Investing and portfolio management to connect investment research with portfolio decisions. Corporate finance and business funding applies cash forecasts and financial analysis to funding choices and project evaluation. For further reading, explore the open textbooks and reading lists on Books.

Planned follow-up lessons