3.Week two discussion

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Chapter

McGraw-Hill/Irwin

Review of Accounting

Outline

Income Statement
Price-earnings Ratio
Balance Sheet
Statement of Cash Flows
Tax-free Investments (Deprecation)

Basic Financial Statements

Income Statement
Balance Sheet
Statement of Cash Flows

Income Statement

Device to measure the profitability of a firm over a period of time.
It covers a defined period of time.
It is presented in a stair-step or progressive fashion
To examine the profit or loss after each type of expense item is deducted.

Income Statement (cont’d)

Sales – Cost of Goods Sold (COGS)

= Gross Profit (GP)

GP – Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI)

EBIT – Interest = Earnings Before Taxes (EBT)

EBT – Taxes = Earnings After Taxes (EAT) or Net Income (NI)

Income Statement (cont’d)

Return to Capital

Three primary sources of capital:
Bondholders
Preferred stockholders
Common stockholders
Earnings per share
Interpreted in terms of number of outstanding shares.
May be paid out in dividends or retained by company for subsequent reinvestment.
Statement of retained earnings
Indicates the disposition of earnings.

Statement of Retained Earnings

Price-Earnings (P/E) Ratio

Refers to the multiplier applied to earnings per share to determine current value of the common stock.

P/E Ratio = Market Price of Stock / Earnings per share (EPS).

Some factors that influence P/E:
Earnings and the sales growth of the firm.
Risk (volatility in performance).
Debt-equity structure of the firm.
Dividend payment scheme.
Quality of management.

Price-Earnings (P/E) Ratio (cont’d)

Allows comparison of the relative market value of many companies based on $1 of earnings per share.
Indicates expectations about the future of the company.
Price-earnings ratios can be confusing.

Price-earnings Ratios for Selected U.S. Companies

Limitations of the Income Statement

Income that is gained or lost during a given period is a function of verifiable transactions.
Stockholders, hence may perceive only a much smaller gain or loss from actual day-to-day operations.
Flexibility in the reporting of transactions might result in differing measurements of income gained from similar events at the end of a time period.

Balance Sheet

Indicates what the firm owns and how these assets are financed in the form of liabilities and ownership interest.
Delineates the firm’s holdings and obligations.
A cumulative chronicle of all transactions that have affected the corporation since its inception.
Items are stated on an original cost basis rather than at current market value.

Balance Sheet Items

Liquidity: Asset accounts are listed in order of liquidity.
Current assets: items that can be converted to cash within 12 months or within the normal operating cycle of the firm.
Marketable securities: temporary investment of excess cash.
Accounts receivable: allowance for bad debts, to determine their anticipated collection value.

Balance Sheet Items (cont’d)

Inventory: includes raw materials, goods in progress or finished goods.
Prepaid expenses: represents future expense items, that are already paid for.
Example: insurance premiums or rent
Investments: long-term commitment of funds (at least one year).
Includes stocks, bonds or investments in other companies.

Balance Sheet Items (cont’d)

Plant and equipment: carried at original cost minus accumulated depreciation.
Accumulated depreciation: sum of all past and present depreciation charges on currently owned assets.
Depreciation expense is the current year’s charge.

Balance Sheet Items (cont’d)

Total assets: Financed through liabilities or stockholders’ equity.
Short-term obligations
Accounts payable: amounts owed on open accounts to suppliers.
Notes payable: short-term signed obligations to bankers and other creditors.
Accrued expense: payment yet to be made towards - service already provided or an obligation incurred.

Stockholder’s Equity

Represents total contribution and ownership interest of preferred and common stockholder’s.
Preferred stock.
Common stock.
Capital paid in excess of par.
Retained earnings.

Statement of Financial Position (Balance Sheet)

Concept of Net Worth

Net value/ book value = Stockholder’s equity – preferred stock component

Market value is of primary concern to the:
Financial manager
Security analyst
Stockholders

Limitations of the Balance Sheet

Most of the values are based on historical or original cost price.
Troublesome when it comes to plant and equipment inventory.
FASB ruling on disclosure of inflation adjustments no longer in force.
It is purely a voluntary act on the part of the company.

Limitations of the Balance Sheet (cont’d)

Differences between per share values may be due to:
Asset valuation
Industry outlook
Growth prospects
Quality of management
Risk-return expectations.

Comparison of Market Value to Book Value per Share

Statement of Cash Flows

Emphasizes the critical nature of cash flow to the operations of the firm.
It represents cash or cash equivalents items easily convertible to cash within 90 days.
Cash flow analysis helps in combating the discrepancies faced through the accrual method of accounting.

Statement of Cash Flows (cont’d)

Advantage of accrual method:
Allows the matching of revenues and expenses in the period in which they occur to appropriately measure profits.

Disadvantage of accrual method :
Adequate attention is not directed to the actual cash flow position of the firm.

Concepts Behind the Statement of cash Flows

Determining Cash Flows from Operating Activities

Translation of income from operations from an accrual to a cash basis.
Direct method
Every item on the income statement is adjusted from accrual to cash accounting.
Indirect method
Net income represents the starting point.
Required adjustments are made to convert net income to cash flows from operations.

Indirect Method

Comparative Balance Sheets

Cash Flows from Operating Activities

Determining Cash Flows from Investing Activities

Investing activities:
Long-term investment activities in mainly plant and equipment.
Increasing investment is a use of funds.
Decreasing investments is a a source of funds.

Determining Cash Flows from Financing Activities

Financial activities apply to the sale or retirement of:
Bonds
Common stock
Preferred stock
Other corporate securities
Payment of cash dividends.
Sale of firm’s securities is a source of funds.
Payment of dividend and the repurchase of securities is a use of funds.

Overall Statement Combining the Three Sections

Analysis of the Overall Statement

How are increases in long-term assets being financed?
Preferably, adequate long-term financing and profits should exist.
Short-term funds may be used to carry long-term needs – could be a potential high-risk situation.
Example: trade credit and bank loans

Depreciation and Fund Flows

Depreciation attempts to allocate the initial cost of an asset over its useful life.
Charging of depreciation does not directly influence the movement of funds.

Comparison of Accounting and Cash Flows

Free Cash Flow

Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends.

Capital expenditures: Maintains the productive capacity of firm.
Dividends: Maintains the necessary payout on common stock and to cover any preferred stock obligations.
Free cash flow is used for special financing activities.
Example: leveraged buyouts

Income Tax Considerations

Corporate tax rates
Progressive: the top rate is 40% including state and foreign taxes if applicable. The lower bracket is 15-20%.
Cost of tax-deductible expense

Depreciation as a Tax Shield

Not a new source of fund.
Provides tax shield benefits measurable as depreciation times the tax rate.

Corporation A Corporation B

Earnings before depreciation and taxes…….. $400,000 $400,000

Depreciation……………………………………… 100,000 0

_________ _________

Earnings before taxed………………………….. 300,000 400,000

Taxes (40%)………………………………………. 120,000 160,000

_________ _________

Earnings after taxes……………………………... 180,000 240,000

+Depreciation charged without cash outlay…. 100,000 0

_________ _________

Cash flow…………………………………………... $280,000 $240,000

Difference…………………………………………... $40,000