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Financial Accounting:

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Presentation on theme: "Financial Accounting:"— Presentation transcript:

1 Financial Accounting:
Copyright 2004 The McGraw-Hill Companies, Inc. Permission required for reproduction or display. PowerPoint Presentation Materials For Financial Accounting: A New Perspective by Paul Solomon

2 Using the Balance Sheet to Make Decisions
CHAPTER 5 Using the Balance Sheet to Make Decisions

3 PERFORMANCE OBJECTIVES: Ratios
PO3: Calculate, interpret, & discuss ratios for Liquidity Activity or turnover Financial leverage Profitability Valuation

4 PERFORMANCE OBJECTIVES: Valuation
PO 16: Describe valuation by Distinguishing among Historical cost Replacement cost Fair market value Present value of future cash flows Identifying GAAP methods for major asset, liability accounts

5 PERFORMANCE OBJECTIVES: Other
PO 17: Identify limitations of financial statements

6 USER FOCUS Annual report on liquidity, leverage

7 INSIGHTS Executory contracts
When are all valuation methods equivalent? Limitations of balance sheet

8 TOPICS Using classified balance sheet to make better decisions
Using balance sheet ratios to make better decisions Using information not found in balance sheet to make decisions How assets are measured

9 CLASSIFIED BALANCE SHEET
Classifies assets, liabilities into current and noncurrent categories Current categories Accounts expected to be Turned into cash Sold Exchanged Discharged Within one year

10 CMU Balance Sheet 12/31 Assets Current assets Investments
Property, plant, Equipment $56,300 2,000 16,700 Liabilities Current Noncurrent Owner’s Equity $9,000 4,000 61,900 Total assets $75,000 Total liabilities & Equity

11 WHY DISTINGUISH BETWEEN CURRENT, NONCURRENT?
To allocate resources to meet needs Timing influences decisions

12 HOW TO DISTINGUISH BETWEEN CURRENT, NONCURRENT
Operating cycle Related to current assets, liabilities Average length of time it takes to move through 3 phases Purchasing Selling Collecting

13 CURRENT ASSETS Current assets are Cash Noncash assets that will be
Converted into cash Sold Consumed Within 1 year or operating cycle, whichever is longer

14 LIQUIDITY Measure of availability of cash Sign of financial health
How quickly noncash assets can be turned into cash Sign of financial health

15 CURRENT LIABILITIES Current liabilities are
Obligations that will be eliminated within one year or operating cycle of business Paid by Current assets Creating other current liabilities

16 USING BALANCE SHEET RATIOS
Show percentage relationship between 2 numbers Summarize information Easily understood, interpreted, compared Example: Return on equity Measures performance

17 HOW TO USE LIQUIDITY RATIOS
Help determine solvency Ability to meet obligations that come due in current period Working capital Current assets – Current liabilities Limitation: measures absolute ability to meet debts

18 LIQUIDITY RATIOS Current ratio Acid test (Quick) ratio Bank ratios

19 CURRENT RATIO Measures relative ability to meet maturing current debts (solvency) High ratio desirable Current Asset Current Liabilities

20 Current assets – (Inventories + prepaid Assets)
ACID TEST RATIO Measures relative ability to meet maturing current debts (solvency) High ratio desirable Current assets – (Inventories + prepaid Assets) Current Liabilities

21 BANK RATIOS Approving Susan’s Loan
Banker’s measure of loan risk To protect lender Loan to value Loan to liquidation value

22 LOAN TO VALUE Maximum Loan Liability Market value of collateral
Lower is better

23 LOAN TO LIQUIDATION VALUE
Maximum Loan Liability Liquidation Value of Asset Lower is better

24 LEVERAGE RATIOS Evaluate financial risk Debt to Assets Ratio
Debt to Equity Ratio

25 DEBT TO ASSETS RATIO Total Liabilities Total Assets
Indicates long-run solvency of business Describes relative amount of financial risk Total Liabilities Total Assets

26 DEBT TO EQUITY RATIO Total Liabilities Total Owners’ Equity
Indicates long-run solvency of business Describes relative amount of financial risk Total Liabilities Total Owners’ Equity

27 USER FOCUS: Discussions of Liquidity, Leverage
Contained in Annual Report Management’s Discussion & Analysis (MD&A) Provides liquidity, leverage ratios Provides discussion/interpretation of ratios Example: Merck

28 USING INFORMATION TO MAKE DECISIONS: MD&A
Outside balance sheet Management’s Discussion and Analysis of Operations (MD&A) Relates to balance Liquidity and Capital Resources

29 USING INFORMATION TO MAKE DECISIONS: Notes 1
Information that documents, supports, elaborates on specific items Summary of significant accounting policies Essential accounting principles of business Other notes Detail for balance sheet accounts

30 USING INFORMATION TO MAKE DECISIONS: Notes 2
Commitments Executory contract Example: noncancelable lease arrangements Contingency May never materialize Potential future obligation

31 INSIGHT 5-1: Executory Contract
Promise to perform duties in future Commitment No current liability Definition: liability Probably future sacrifices of economic benefits arising from present obligations

32 HOW ARE ASSETS MEASURED?
Entry prices Historical cost Current cost Exit prices Fair market value (FMV) Present value of future cash flows

33 INSIGHT 5-2: When are Valuation Methods Equivalent?
At point of exchange when recorded Historical costs = current cost = fair market value (FMV) = present value of future cash flows Valuation methods differ when reported

34 ASSET VALUATION Personal balance sheet Business balance sheet
Estimated current value or fair market value (FMV) Business balance sheet Follows GAAP

35 ASSET VALUATION: Current Assets
Category Account Measurement Current Cash Marketable Sec. A/R Inventory Monetary FMV or cost FMV less allowance LCM

36 ASSET VALUATION: Investments
Category Account Measurement Investments Equity Bonds Long term Notes Receivables FMV Present value of future cash flows

37 ASSET VALUATION: Property, Plant, Equipment
Category Account Measurement Property, Plant, Equipment Buildings, Equipment, etc. Cost less Accumulated Depreciation

38 ASSET VALUATION: Intangible Assets
Category Account Measurement Intangibles Patents, Goodwill, etc Cost less Amortization

39 KEY QUALITATIVE CHARACTERISTICS
Characteristics of accounting information Relevance Makes a difference in a decision Reliability Degree of confidence in information Verifiability Traceable

40 INSIGHT 5-3: Limitations of Balance Sheet
Not all obligations reported in liabilities Asset valuation not always current market value Qualitative information incomplete Money measurement assumes stable dollar; no inflation Human resources not reported, valued

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