1. 2
Chapter
Review of Accounting

2. 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

3. Income Statement

4. An Income Statement shows profitability

5. Sales - Cost of Goods Sold (COGS) = Gross Profit (GP)

6. GP - Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI)

7. EBIT - Interest = Earnings Before Taxes (EBT)

8. EBT - Taxes = Earnings After Taxes (EAT) or Net Income (NI)

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

11. Price-Earnings Ratio is Applied to Earnings per Share

12. The P/E ratio compares market prices with accounting earnings

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

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

15. 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

17. Limitations of the Income Statement

18. Accounting numbers (historical cost) do not reflect economic changes

19. There is great flexibility in choosing the accounting conventions.

20. Next, we examine the Balance Sheet for Kramer.

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

22. PPT 2-3

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

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

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

26. P/B ratio compares market price with accounting book value

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

28. 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.

29. PPT 2-4

30. Next, we turn to the Statement of Cash Flow

31. 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.

32. 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

33. PPT 2-5

34. PPT 2-6

35. PPT 2-7

36. Healthy Operations should provide cash flow to the business

37. PPT 2-8

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

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

40. PPT 2-9

41. Depreciation and Funds Flow

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

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

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

45. Depreciation smoothes accounting earnings, but distorts cash flows.

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

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

48. 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
Earnings before taxes (EBT)
Taxes
Earnings after taxes (EAT) $
Purchase of equipment
Depreciation charged without cash outlay
Cash flow $ 200

49. 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
Earnings before taxes (EBT)
Taxes
Earnings after taxes (EAT) $
Depreciation charged without cash outlay
Cash flow $ 700

50. Free cash flow is a very important concept to lenders

51. 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)

52. Income Tax Considerations

53. 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)

54. Tax-Free Investments

55. Municipal Bonds are: exempt from federal income tax
issued by local governments (or municipalities)

56. 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

57. Cost of a Tax-deductible Expense

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

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

60. 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.

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

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

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

64. THE END