Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Review of Accounting 2

2-2 Chapter 2 - Outline What is Accounting? The Income Statement (I/S) The Price/Earnings Ratio The Balance Sheet (B/S) Comparison of Market Value to Book Value Limitations of Financial Statements The Statement of Cash Flows (CFs) Comparison of Accounting and Cash Flows Income Tax Considerations Summary and Conclusions PPT 2-2

2-3 What is Accounting? Accounting provides financial information about a business Of interest to stakeholders in business: – shareholders – managers – creditors – governments Information is used to make decisions about a business Financial statements summarize accounting information Most important financial statements: –Income Statement –Balance Sheet –Statement of Cash Flows PPT 2-3

2-4 Basic Financial Statements Income Statement Balance Sheet Statement of Cash Flows

2-5 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

2-6 Income Statement An Income Statement shows profitability for a period (ex.; 1 year). Can be prepared in steps: ( 1) Sales - Cost of Goods Sold (COGS) = Gross Profit (GP) (2) GP - Operating Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI) (3) EBIT - Interest = Earnings Before Taxes (EBT) (4) EBT - Taxes = Earnings Aftertaxes (EAT) or Net Income (NI)

2-7 Income Statement (cont’d)

2-8 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 Statement of retained earnings –Indicates disposition of earnings

2-9 Statement of Retained Earnings

2-10 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

2-11 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

2-12 Price-earnings Ratios for Selected US Companies

2-13 Limitations of income statement 1. Income Vs Real worth 2. Income Vs Cash flow 3. Income may vary with different accounting method employed by the accountant

2-14 The Balance Sheet A Balance Sheet (B/S) shows what a firm owns and how it is financed at a point in time (ex.; December 31) Remember the ALOE! Assets = Liabilities + Owners’ Equity PPT 2-9

2-15 Classifications on the Balance Sheet Assets:what a business owns Current Assets –Ex: Accounts receivable, Inventory –Will be sold or used up within 1 year Capital Assets –Ex: Building Liabilities: what a business owes Current Liabilities –Ex: Accounts payable –Due within 1 year Long-term Liabilities –Due some time after 1 year Equity: what the owner(s) have invested in the business Shareholders’ Equity –Capital stock –Retained earnings PPT 2-10

2-16 Statement of Financial Position (Balance Sheet)

2-17 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

2-18 Limitations of the Balance Sheet Most of the values are based on historical/original cost price –Troublesome when it comes to plant and equipment inventory FASB ruling on disclosure of inflation adjustments no longer in force –It is purely a voluntary act on the part of the company

2-19 Limitations of balance sheet 1. Book value Vs Market value 2. Contingent Liability, Off balance-sheet activities.

2-20 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

2-21 Comparison of Market Value to Book Value per Share

2-22 Limitations of Financial Statements Based on past transactions rather than future forecasts May not recognize important economic changes as they occur –increase in property values –new competition Variety of accounting policies and methods are used –amortization –inventory valuation PPT 2-14

2-23 The Statement of Cash Flows The Statement of Cash Flows (CFs) measures the flow of cash into and out of a firm CF from operating activities PLUS CF from financing activities PLUS CF from investing activities EQUALS Net increase (decrease) in cash PPT 2-15

2-24 Operations: cash paid and received from buying and selling of goods and services Investments: cash paid and received from investment activities (bonds, stocks, property, equipment) Financing: cash paid and received from financing activities (dividends, borrowing or issuing stocks, repayment of borrowings) Sources (uses) of Cash

2-25 Statement of Cash Flows (cont’d) Advantage of accrual method –Allows matching of revenues and expenses in the period in which they occur to appropriately measure profits Disadvantage of accrual method –Adequate attention not directed to actual cash flow position of firm

2-26 Concepts Behind the Statement of Cash Flows

2-27 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

2-28 Indirect Method

2-29 Comparative Balance Sheets

2-30 Cash Flows from Operating Activities

2-31 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

2-32 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

2-33 Overall Statement Combining the Three Sections

2-34 Analysis of the Overall Statement How are increases in long-term assets being financed? Preferably, adequate long-term financing and profits should exist Short-term funds may be used to carry long- term needs – could be a potential high-risk situation –Example: trade credit and bank loans

2-35 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

2-36 Comparison of Accounting and Cash Flows

2-37 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

2-38 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

2-39 Depreciation as a Tax Shield Not a new source of fund Provides tax shield benefits measurable as depreciation times the tax rate Corporation ACorporation B Earnings before depreciation and taxes……$400,000$400,000 Depreciation……………………………………… 100,000 0 _________ _________ Earnings before taxed………………………… 300, ,000 Taxes (40%)……………………………………… 120, ,000 _________ _________ Earnings after taxes…………………………… 180, ,000 +Depreciation charged without cash outlay… 100,000 0 _________ _________ Cash flow………………………………………… $280,000 $240,000 Difference…………………………………………$40,000