2 Chapter Review of Accounting

Income Statement (I/S) P/E Ratio Balance Sheet (B/S) Chapter 2 - Outline Income Statement (I/S) P/E Ratio Balance Sheet (B/S) Statement of Cash Flows (CFs) Tax-Free Investments

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)

The Statement of Retained Earnings (Table 2-2)—Page 29

Price-Earnings Ratio is Applied to Earnings per Share

The P/E ratio compares market prices with accounting earnings

The P/E ratio is one of the most commonly used measures of performance

Generally, a high P/E ratio suggests two things High expectations (return) High risk (disappointments)

In examining Table 2-3 (next slide) you should look for two things P/E ratios for any given firm can change greatly over time. P/E ratios at any point in time vary greatly from firm to firm and industry to industry

Limitations of the Income Statement

Accounting numbers (historical cost) do not reflect economic changes

There is great flexibility in choosing the accounting conventions.

Next, we examine the Balance Sheet for Kramer.

A Balance Sheet (B/S) shows what a firm owns and what it owes Remember the ALOE! Assets = Liabilities + Owners’ Equity

PPT 2-3

Concept of Net Worth (Common Stockholder Equity)—Page 33

Price-to-Book (P/B) is similar to P/E ratio

P/B ratio is commonly used as a measure of relative value

P/B ratio compares market price with accounting book value

Generally, a high P/B ratio suggests: High market expectations. High risk due to heightened expectations.

Limitations of Balance Sheet Historical cost is used. Table 2-5 shows the large disparities between market value per share and historical book value for a number of publicly traded companies.

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Next, we turn to the Statement of Cash Flow

To create a Statement of Cash Flow for Kramer, we will need: Balance sheet for beginning of year Balance sheet for ending of year Income statement for year.

Net increase (decrease) in cash 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

PPT 2-5

PPT 2-6

PPT 2-7

Healthy Operations should provide cash flow to the business

PPT 2-8

Table 2-8 Cash flows from Investing Activities—Page 38

Financing activities are transactions on the “right side” of the balance sheet (liabilities and owners equity) (Table 2-9)—Page 39

PPT 2-9

Depreciation and Funds Flow

Depreciation is the accountant’s way of allocating the cost of capital equipment over the life of the equipment

You must remember that the actual expenditure occurs at the time of purchase—NOT later when depreciation is written off.

Depreciation is a NON-CASH expense on the balance sheet—no disbursement of funds actually occurs

Depreciation smoothes accounting earnings, but distorts cash flows.

Depreciation affects cash flows by providing a tax benefit that is spread over time.

Consider a company that purchases new equipment for $500, which it will write off (depreciate) over a 5-year period.

Table 2-11a Comparison of accounting and cash flows—Page 40 Year 1 (A) (B) Accounting Flows Cash Flows Earnings before depreciation and taxes (EBDT) . . $1,000 $1,000 Depreciation . . . . . . . . . . . . 100 100 Earnings before taxes (EBT) . . . . . . . 900 900 Taxes . . . . . . . . . . . . . . 300 300 Earnings after taxes (EAT) . . . . . . . . $600 600 Purchase of equipment . . . . . . . . . -500 Depreciation charged without cash outlay . . . +100 Cash flow . . . . . . . . . . . . $ 200

Table 2-11b Comparison of accounting and cash flows—Page 41 Year 2 (A) (B) Accounting Flows Cash Flows Earnings before depreciation and taxes (EBDT) . . $1,000 $1,000 Depreciation . . . . . . . . . . . 100 100 Earnings before taxes (EBT) . . . . . . . 900 900 Taxes . . . . . . . . . . . . . 300 300 Earnings after taxes (EAT) . . . . . . . $ 600 600 Depreciation charged without cash outlay . . . +100 Cash flow . . . . . . . . . . . . $ 700

Free cash flow is a very important concept to lenders

Free Cash Flow = Cash flow from operating activities minus: Required capital expenditures (to maintain productive capacity) minus: Required dividends (necessary to maintain stock price and satisfy preferred requirements)

Income Tax Considerations

Income 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 Investments

Municipal 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

Cost of a Tax-deductible Expense

All tax-deductible expenses provide a tax benefit equal to: Corporate tax rate X amount of deductible expense.

If the expense requires actual cash outlays, then the net (after-tax) cost is: Expense – tax benefit.

If the expense is non-cash (depreciation) then there is only a tax benefit: benefit of non-cash expense = Corporate tax rate X deductible expense.

Because depreciation carries only a tax benefit, we say that depreciation offers a “tax shield”

This example (Page 43) shows how taxes reduce deductible expenses

This example (Page 43) shows how depreciation acts as a tax shield

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