Review of Accounting

Chapter 2

Chapter 2 – Outline

Income Statement (I/S)P/E RatioBalance Sheet (B/S)Statement of Cash Flows (CFs)

Tax-Free Investments

3 Basic Financial Statements

Income Statement (I/S)Balance Sheet (B/S)Statement of Cash Flows (CFs)

Income Statement

An Income Statement shows profitability

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)

Limitations of the Income Statement

2-6

Income gained/lost during a given period is a function of verifiable transactions over a specific time periodStockholders, 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

P/E RatioP/E Ratio = Price/Earnings Ratio

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

Way of measuring desirability of a stock

Indicates expectations about future of a company

Price-earnings Ratios for Selected US Companies

2-8

Balance Sheet

2-9

Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interestDelineates the firm’s holdings and

obligationsItems are stated on an original cost basis

rather than at current market value

Balance Sheet

A Balance Sheet (B/S) shows what a firm owns and what it owes

Remember the ALOE!

Assets = Liabilities + Owners’ Equity

Limitations of the Balance Sheet

2-13

Most of the values are based on historical/original cost priceTroublesome when it comes to plant and

equipment inventoryFASB 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adjustments no longer in force It is purely a voluntary act on the part of the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)

2-14

Differences between per share values may be due to:Asset valuationIndustry outlookGrowth prospectsQuality of managementRisk-return expectations

Comparison of Market Valueto Book Value per Share

2-15

Accrual Method of Accounting

Will be used in finance

Revenues and expenses are recognized when they occur, rather than when cash changes hands

For example, a credit sale in December 2003 is shown as revenue in that year (2003), even though payment is not received until March 2004

Statement of Cash Flows

2-17

Emphasizes critical nature of cash flow to the operations of the firmIt represents cash/cash equivalents items

easily convertible to cash within 90 daysCash flow analysis helps in combating

discrepancies faced through accrual method of accounting

Statement of Cash Flows

The Statement of Cash Flows (CFs) measures the flow of cash throughout a firm

CF from operating activities PLUS

CF from financing activities PLUS

CF from investing activities EQUALS

Net increase (decrease) in cash

FIGURE 2-1Illustration ofconceptsbehind thestatement ofcash flows

FIGURE 2-2Steps in computing netcash flows fromoperating activitiesusing the indirectmethod

TABLE 2-7Cash flows fromoperating activities

TABLE 2-10

TABLE 2-11Comparisonof accountingand cashflows

Free Cash Flow

2-24

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

DividendsCapital expenditures

Maintain productive capacity of firmDividends

Maintain necessary payout on common stock and to cover any preferred stock obligations

Free cash flow is used for special financing activitiesExample: leveraged buyouts

Income Tax ConsiderationsIncome taxes affect financial decisions.

For instance, there is “double taxation” of corporate earnings.

This means that the same $ is taxed twice:Corporate income tax (on earnings)Personal income tax (on dividends)

Tax-Free InvestmentsMunicipal Bonds are:

–exempt from federal income tax– issued by local governments (or municipalities)

To compare a municipal to a taxable bond:After-tax i rate = Actual i rate x (1-TR)

Ex., at 28% tax rate (TR), 12% taxable bond is equivalent to 8.64% municipal bond