Debit & Credit – What does it really mean?

All accounting and financial statements are based on the two concepts of credit & debit.

Wait... doing complicated stuffIf you have full understanding of debit & credit save your time and stop reading.

Still reading... ok then we are two

The Basics:
Debit = An entry that increases an asset or decreases a liability
Credit =An entry that increases a liability or decreases an asset

All companies use the "double-entry system", meaning that every credit entry is followed by a corresponding debit entry, thereby always keeping the balance between asset and liability accounts.

Income and expenses are transferred into the Profit & Loss (P&L account), reflecting the operative results, dividends etc.

• Income entries equals additions to Surplus and therefore they appear as credit or liability
• Expense entries are actually deductions from Surplus, appearing as debit or asset accounts.

= The total of all debit and credit accounts must be equal to the total of all credit balances.

The abbreviation for debit is dr. and the abbreviation for credit is cr, associated with the Latin or Italian word used more than 500 years ago when double entry accounting was first documented.

Balance Sheet – Definition of Shareholder Interest

Here comes a 60 second recapitulation of what shareholder equity or shareholder interest really is.

Remember - understanding of the financial terms and the numbers behind your financial status strenghten you when negotiating with lenders and investors.

Let's start with the balance sheet, the "best" and most proper description of how a company stands at a given moment. A balance sheet is thus, not a description over a time period, but only the financial status related to one single date. Even though a balance sheet could give an indication of the past, the financial history is best understood by analyzing the income accounts - profit & loss.

The Balance Sheet attempts to show the assets and liabilities of a company
Assets consist of physical property, money it holds or has invested, money that is owed to the company and intangible assets (e.g. goodwill).
Liabilities consist of the debt, reserves of various kinds and the equity (what a company owes it shareholders). Debts due to ordinary course of business is presented as "Account Payable", formal borrowing such as Bonds / Notes Outstanding and finally Reserves.

Where do we find the shareholders' interest?
The shareholders' interest is shown on the liability side often as "Capital & Surplus". This equity appears on the liability side since they are actually money that the company owe to it's shareholders. Consider the shareholders' interest as the difference between the company's assets and it's liabilities.

SUMMARY: The shareholders' interest (or "Capital & Surplus") is the amount required in order to balance the two sides - Assets vs Liabilities.

Warren Buffet’s view on Cash Flow – the (c) factor..

Valuing a business based on cash flow is a wide spread method - .. Here comes a great add on from Warren Buffet, by many people regarded as THE #1 business man in the world today and share holder in Berkshire Hathaway, a really ugly web page with great content.

Most Peoples view on Cash Flow: (a) operating earnings and adding back (b) non-cash charges.

Mr Buffet view on Cash Flow: You must also subtract something else: (c) required reinvestment in the business.

Mr Buffet's definition of (c) required reinvestment:
"The average amount of capitalized expenditures for plant and equipment etc., that the business requires to fully maintain it's long-term competitive position and it's unit volume". Mr Buffet calls the result of (a) + (b) - (c) = "owners earning"

Mr Buffet's powerful summary and key takeaway for you and me
If (b) and (c) differ, cash flow analysis and owner earnings analysis differ too. For most business (c) actually exceeds (b), thus cash flow analysis usually overstates economic reality. Think about that one and relate it to your business...