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Review of Accounting

Chapter 2

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Chapter Outline

• Income Statement

• Price-earnings Ratio

• Balance Sheet

• Statement of Cash Flows

• Tax-free Investments (Depreciation) 2

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Basic Financial Statements

• Income Statement

• Statement of Retained Earnings (a short supplement to the income statement)

• Balance Sheet

• Statement of Cash Flows3

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Income Statement

• Device to measure the profitability of a firm over a period of time

• It is presented in a stair-step or progressive fashion to examine profit or loss after each type of expense item is deducted

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Income Statement (cont’d)Table 2–1

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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)

Earnings per share (EPS)= Earrings to common stockholders/common shares outstanding

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Return to Capital• Three primary sources of capital:

• Bondholders (receive interest)

• Preferred stockholders (receive dividends)

• Common stockholders (receive dividends after preferred 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

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Statement of Retained Earnings• Indicates disposition of earnings with:

• any adjustments to previously reported income

• any restrictions on cash dividends

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Price-Earnings (P/E) Ratio• Multiplier applied to earnings per share to determine

current value of common stock

• Indicates expectations about the future of a company• Firms with higher expected returns often will have higher

P/E ratio

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

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Price-Earnings (P/E) Ratio (cont’d)

• Allows comparison of the relative market value of many companies

• Price-earnings ratios can be confusing

• Drop in earnings means drop in price as well; it may not match the magnitude of the falloff in earnings, which causes increase in P/E ratio.

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Price-earnings Ratios for Selected U.S. Companies

• Expectations of returns and P/E ratios do change over time

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Limitations of the Income Statement

• Income gained/lost during a given period is a function of verifiable transactions

• Stockholders, hence, may perceive only a much smaller gain/loss from actual day-to-day operations

• Flexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period

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Balance Sheet

• Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest

• Delineates the firm’s holdings and obligations

• A picture of the firm at a point in time

• Items are stated on an original cost basis rather than at current market value

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Balance Sheet Items• Liquidity: Asset accounts are listed in order of

liquidity• Current assets

• Items that can be converted to cash within one year

• Marketable securities• Temporary investments of excess cash

• Accounts receivable • Allowance for bad debts to determine their

anticipated collection value• Inventory

• Includes raw materials, goods in progress, or finished goods 14

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Balance Sheet Items (cont’d)• Prepaid expenses

• Represent future expense items that are already paid for

• Investments• Long-term commitment of funds (at least one year) • Includes stocks, bonds, or investments in other

corporations• Plant and equipment

• Carried at original cost minus accumulated depreciation

• Accumulated depreciation: Sum of past and present depreciation charges on currently owned assets 15

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Balance Sheet Items (cont’d)• Total assets: Financed through liabilities or

stockholders’ equity

• Liabilities are financial obligations of the firm and move from current liabilities (due within one year) to longer-term obligations

• Short-term obligations

• Accounts payable (amount owed on open account to suppliers)

• Notes payable (short-term signed obligations

• to the banker or other creditors)

• Accrued expense (payment not made for the obligation incurred on the services received)

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Stockholder’s Equity• Represents total contribution and ownership

interest of preferred and common stockholders

• Preferred stock

• Common stock

• Capital paid in excess of par (common stock)

• Retained earnings

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Statement of Financial Position (Balance Sheet)

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Concept of Net Worth

• Net worth (book value) = Stockholders’ equity – preferred stock component

• Market value is a primary concern to the:

• Financial manager

• Security analyst

• Stockholders

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Limitations of the Balance Sheet

• Most of the values are based on historical/original cost price

• Troublesome when it comes to plant and equipment and inventory

• FASB ruling on disclosure of inflation adjustments no longer in force

• It is purely a voluntary act on the part of the company

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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

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Comparison of Market Valueto Book Value per Share

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Statement of Cash Flows

• Emphasizes critical nature of cash flow to the operations of the firm

• It represents cash/cash equivalents items easily convertible to cash within 90 days

• Advantage of accrual method

• Allows matching of revenues and expenses in the period in which they occur to appropriately measure profits

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Statement of Cash Flows (cont’d)

• Disadvantage of accrual method

• Sufficient attention not directed to actual cash flow position of firm

• Cash flow analysis helps in combating discrepancies faced through accrual method of accounting

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Sections of a Statement of Cash Flows

• Three primary sections of the statement of cash flows:

• Cash flows from operating activities

• Cash flows from investing activities

• Cash flows from financing activities

• The results of three sections are added together to compute the net increase or decrease in cash flow

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Concepts Behind the Statement of Cash Flows

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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 27

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Net Cash Flows fromOperating Activities (Indirect

Method)

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Comparative Balance Sheets

Table 2–6

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Cash Flows from Operating Activities

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Determining Cash Flows from Investing Activities

• Investing activities:

• Long-term investment activities in mainly plant and equipment

• Increasing investments represent a use of funds

• Decreasing investments represent a source of funds

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Determining Cash Flows from Financing Activities

• Financial activities apply to the sale/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 dividends and repurchase of

securities is a use of funds 32

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Overall Statement Combining the Three Sections

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Analysis of the Overall Statement

• How are increases in current assets being financed?

• Is there an associated buildup in current liabilities?

• How are increases in long-term assets being financed?

• Preferably, adequate long-term financing and profits should exist to finance long-term assets

• Short-term funds may be used to carry long-term needs – could be a potential high-risk situation as short-term sources of funds may dry up while long-term needs continue to demand funding

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Depreciation and Funds Flow

• Depreciation

• A noncash expense

• Not a ‘new’ source of funds

• Added back to net income to determine amount of actual funds on hand

• Attempt to allocate the initial cost of an asset over its useful life

• Charging of depreciation does not directly influence the movement of funds 35

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Comparison of Accounting and Cash Flows

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Free Cash Flow

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

• Capital expenditures• Maintain productive capacity of firm

• Dividends• Maintain necessary payout on common stock

and to cover any preferred stock obligations• Free cash flow is used for special financing

activities• Example: leveraged buyouts 37

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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 a tax-deductible expense - Interest, Travel expenditures, Salaries, etc.

Corporation A Corporation BEarnings before interest and taxes…………. $400,000 $400,000Interest…………………………………………… 100,000 0

_________ _________ Earnings before taxes (taxable income)…… 300,000 400,000Taxes (40%)……………………………………… 120,000 160,000

_________ _________ Earnings after taxes…………………………… $180,000 $240,000Difference in earnings after taxes…………… $60,000

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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 BEarnings before depreciation and taxes…… $400,000 $400,000Depreciation……………………………………… 100,000 0

_________ _________ Earnings before taxes………………………… 300,000 400,000Taxes (40%)……………………………………… 120,000 160,000

_________ _________ Earnings after taxes…………………………… 180,000 240,000+Depreciation charged without cash outlay… 100,000 0

_________ _________ Cash flow………………………………………… $280,000 $240,000Difference………………………………………… $40,000