Review of Accounting

2 Chapter

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)

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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 Flows

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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 profit or loss after each type of expense item is deducted

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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)

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Income Statement (cont’d)

Table 2–1

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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

• 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

• Firms with higher expected returns will have higher P/E ratio

• Price-earnings ratios can be confusing

– Drop in earnings 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

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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

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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– 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 of 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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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

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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

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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