Financial Modelling #1: Accounting Equation, Journal, T-Account, Ledger and Trial Balance

Welcome to my blog post series on financial modelling.

Nearly every month I get requests about teaching financial modelling. It is a very interesting field but some of the people who teach it do it in ways too abstract for anyone to make any value of. They start from the middle, expecting the participants to already know the basics, and then proceed to use non-Nigeria relevant examples. The usual result is that the participants leave with more questions than they had before the training, and some plainly give up about understanding financial modelling.

I have set out to amend this. I enjoy finance and all things related to it, including financial modelling. It is one of the fields of knowledge that has everyday practical application and can be easily explained using illustrations from our everyday personal and business experience.

I will be using my usual teaching style -- going from basics to advanced using easy to understand Nigeria relevant case studies.

Introduction To Financial Modelling: The Fundamentals
Financial modelling is the representation of a company's financial position and enterprise value using series of flexible calculations built on sound financial knowledge.

So to begin, we need to establish, first, that sound financial knowledge every aspiring financial modelling guru most have.

Accounting Equation
Every company's core activities generate financial transactions -- even government organizations and non-profit organizations. So at the end of the year a large part of evaluating performance involves creating financial statements. And these financial statements are created from records of financial transactions the company engaged in throughout the year being evaluated. Records of what expenses were made, money that came in from sales, money that came in from investors, money that came in from loans taken, and all the other financial activities the company engaged in.

The principle that underline the recording of those financial transactions is called the accounting equation and it states that Assets = Liabilities and Owner's Equity.

Every financial transaction will cause a change on the Asset side and a balancing change on the Liabilities or Equity side.

For illustration, say we all come together to form a new company called Naija Limited. If we put put together N1 billion to kickstart the company's operations. That means we have increased asset (Cash) by N1 billion and have Equity of N1 billion.

N1 billion Cash Asset = N0 Liability + N1 billion Equity (notice how they balance)

Then we decided to, from the N1 billion, acquire a N300 million land in Lekki Free Trade Zone for our business operations. We have reduced cash asset by N300 million and acquired Land asset of  N300 million. So we have just shuffled our assets from purely Cash to now include Land.

N300 Land Asset - N300 million Cash Asset  = N0 Liability + N0 Equity

This points us to another important detail: each element of our accounting equation has both the plus side and minus side. This is what is called Debit and Credit. For Assets, the plus side is the Debit and the minus side is the Credit. For Liability and Equity, the plus side is the Credit and the minus side is the Debit.

Journal
All these transactions are recorded in a Journal. It is a dated record of financial transactions with debit and credit side. If you have just one for all your company transactions then it would be a general journal, but if you have one for every major transaction type like Cash Receipts, Sales and Purchase, then it would be named after that transaction type (Sales Journal e.t.c.) .

image: myaccountingcourse.com

So an accountant or bookkeeper could record all those Naija Limited transactions in a General Journal.

T-Account
T-Account is a visual representation of the debit and credit side of an account. It is called T-Account because of the T shape.

image: samirkadhim.com

So the T-Account for Naija Limited for each of those transactions earlier stated is shown below,

Usually, you would have one T-Account for each account type, So Cash T-Account would not be drawn more than once.

Ledger
A ledger is the totaled record of transactions, unlike journal it is not dated and shows final value till date (updated).

At the end of an accounting period (a year or quarter, could be anything), you will have T-Accounts that have captured all the financial transactions in that period. Arranging them such that Assets are on the left, arranged vertically while Liabilities and Equity are on the right is called a General Ledger. You can also have them arranged like a journal, rather than the T-Account type.

Assets are debit totalled, a.k.a debit-balanced. While Liabilities and Equities are credit totalled. a.k.a. credit balanced.

You'll get to hear other Ledger types -- Sales Ledger, Purchase Ledger e.t.c. They are essentially totaled record of transactions for that transaction type -- Sales transaction, Purchase transactions. But in dealing with a company's entire financials the one to focus attention on is the General Ledger.

Trial Balance
A trial balance is a listing of all the accounts and their balances (total from the ledger). It is usually arranged in the following order:

1. Assets
2. Liabilities
3. Owners' Equity which is further broken into Income/Revenue, Expenses and Capital

It is not uncommon for companies to allocate numbers to the different accounts and have all assets start with digit 1, liabilities start with digit 2, capital (part of equity) start with digit 3, income/revenue start with digit 4 and expenses start with digit 5. This is called chart of accounts.

The trial balance is then used to build up the financial statement -- Income Statement from the income and expenses account records, Balance Sheet from everything and Cash Flow Statement from cash transactions.

Some practical things to note when building and/or reading the Trial Balance are that:

• Increase in Assets is a debit transaction
• Increase in Liability is a credit transaction
• Increase the Capital part of Equity (and Owners' Equity in general) is a credit transaction
• Increase in Income/Revenue is a credit transaction
• Increase in Expenses is a debit transaction
• Increase in Dividend payout is debit transaction

Watch out for the next post in this series. Reach me for any feedback or noticed an error.