Chapter

McGraw-Hill/IrwinCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Review of Accounting2

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Chapter Outline

• Income Statement

• Price-earnings Ratio

• Balance Sheet

• Statement of Cash Flows

• Tax-free Investments (Deprecation)

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Basic Financial Statements

• 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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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

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Price-Earnings (P/E) Ratio

• Multiplier applied to earnings per share to determine current value of common stock

• 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 based on $1 of earnings per share

– Indicates expectations about the future of a company

• Price-earnings ratios can be confusing

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Price-earnings Ratios for Selected US Companies

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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– 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 12 months– 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• Includes stocks, bonds, or investments in other

companies

– 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)

• Depreciation expense is the current year’s charge

– Total assets: Financed through liabilities or stockholders’ equity

• Short-term obligations– Accounts payable– Notes payable– Accrued expense

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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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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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Concepts Behind the Statement of Cash Flows

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Depreciation and Funds Flow

• Depreciation – 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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Comparison of Accounting and Cash Flows

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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

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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 taxed………………………… 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