1. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Accounting and Financial Decisions Lecture No. 2 Chapter 2 Contemporary Engineering Economics, 6 th edition

2. Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Contents A.Why do engineers need to understand the financial statements? B.Understanding the balance sheet statement C.Using the income statement to manage a business D.Understanding the cash flow statement

3. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Apple Computer You have money to invest in the market. Apple (AAPL) is trading at $130.42 on May 15, 2015. What kind of information do you need in making your decision?

4. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Whether or Not to Invest Does the company have a consumer monopoly or strong brand name? Does the company have high operational costs, low capital expenditure, or investment cash outflows? Does the company have flat earnings or are they on a consistent upward trend with good margins?

5. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Does the company have high and consistent returns on investment? Does the company reinvest earnings and profit from these investments? Does the company have a low debt-to- equity ratio? When earnings are low, can the company repay its debt?

6. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Does the company have the ability to adjust prices for inflation? Does the company have enough earnings to grow?

7. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved AAPL (Apple) $130.42: May 15, 2015 Market value = $751.2B $77.24: January 17, 2014 $56.25: June 27, 2013 $100.36: September 21, 2012 Market value = $678.85B $60.85: January 19, 2012 Market value = $412.56B What causes the stock price to go up and down?

8. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Objective of the Company Increase the market value of the company (Market value measured by stock price reflected in the financial market) Market values of some of well known U.S. firms CompanyStock Price (January 15, 2015) Number of Shares Market Value (mil) Google$343.03B339.34M$343.03B GE$23.7310.04B$238.40B Coca-Cola$42.524.38B$187.39B Wal-Mart$87.503.22B$279.64B Apple$107.565.86B$641.57B

9. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Factors That Affect the Market Value How is the company doing at a particular time? What is happening to other stock prices; that is, how are the competitors doing? How do investors expect the company to perform in the future? – Decisions to invest in various projects and the actual performance of these projects

10. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved A. Why do engineers need to understand the financial statements?

11. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Understanding Financial Statements  Accounting: The Basis of Decision- Making  Financial Statements: Financial Status for Businesses  Financial Ratios: Using Ratios to Make Business Decisions

12. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Accounting: The Language of Business

13. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Financial Status for Business

14. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved B. Understanding the Balance Sheet  What is the basic accounting equation?  How do you define the capital?  How do you instantly determine liquidity and too much debt?  How does the firm get equity; only two ways?

15. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved The Basic Accounting Equation For the balance sheet presentation For the financial analysis Assets − Liabilities = Owners’ Equity Assets = Liabilities + Owners’ Equity

16. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved J&M, Inc. BALANCE SHEET December 31 20152014Changes Assets Current assets: Cash and cash equivalents Short-term marketable sec. Accounts receivable Inventory Prepaid expenses Deferred charges Total current assets $ 8,500 3,000 23,700 37,700 2,000 2,500 77,400 $ 6,100 5,000 19,500 39,800 1,500 3,000 74,900 +$2,400 –2,000 +4,200 –2,100 500 –500 +2,500 Long-term Assets: Plant and equipment Less accumulated depreciation Total assets 154,000 (70,000) $161,400 145,000 (50,000) $169,900 +9,000 +2,000 –8,500 Liabilities and Shareholders’ Equity Current liabilities: Accounts payable Wages payable Accrued taxes Total current liabilities 10,000 16,000 2,000 28,000 26,000 15,000 3,500 44,500 –16,000 +1,000 –1,500 –16,500 Other liabilities Long-term debt Total liabilities 30,000 $58,000 32,000 $76,500 –2,000 –18,500 Shareholders’ equity Preferred stock, 6%, $100 par value Common stock, $4 par value (10,000 shares) Additional paid-in capital Retained earnings Total owners’ equity Total liabilities and equity 10,000 40,000 11,000 42,400 103,400 $161,400 10,000 40,000 11,000 32,400 93,400 $169,900 0 +9,600 –8,500

17. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Deferred Charges They are conceptually the same as the prepaid expenses. Deferred charges are normally referring to prepaid expenses for intangible assets where the benefits will occur over a long-term period. Example: Goodwill, patents, copyrights, or startup costs during the pre-operating period where there are no revenues to match

18. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Using the Four Quadrants of the Balance Sheet ASSETS LIABILITIES Current Assets Long-Term Assets Current Liabilities Long-Term Liabilities EQUITY = a)Owners’ Contributions b)Retained Earnings

19. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved How the Firm Gets Equity: Two Ways Owners’ Contributions o By issuing stocks through financial markets Retained Earnings o By retaining operating profits instead of paying out cash dividends

20. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved C. Using the Income Statement to Manage a Business  How to use profit check points  Why gross margin is the critical measure for engineers  How does inventory production impact profit?

21. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Methods of Reporting Income Cash Basis Method Accrual Basis Method

22. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Basic Income Statement Equation Revenue Expenses Net Income (Loss) -

23. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Measurement of Revenue Transaction This Year AmountCash ReceiptsSales Revenue Cash sales made this year $400 Credit sales made last year but cash received this year $100 0 Credit sales made this year and cash received this year $200 Credit sales made this year but cash received next year $3000 Total$600$900

24. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Why Gross Margin Is a Critical Measure for Engineers Cost of Goods Sold Overhead Labor Material SalesGross Margin

25. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved How Inventory Production Impacts Profit Calculating the Cost of Goods Sold Beginning Inventory + Additions to Inventory - Ending Inventory Cost of Goods Sold (Cost of Revenue = Cost of Goods Sold)

26. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved How to Use Profit Check Points Bottom line

27. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved How to Use Profit Check Points Bottom line

28. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved The Income Statement for J&M, Inc. 11.09% 6.67% 37.33% 100.00% Gross margin Operating margin Net margin FY 2015 Revenue J&M, INC. INCOME STATEMENT AND RETAINED EARNINGS (For Year Ending December 31, 2015) Total revenue $300,000 Cost of revenue Gross profit 188,000 112,000 Operating expenses Selling/admin Depreciation Lease expense Total 44,720 20,000 14,000 58,720 (58,720) Operating income Interest pmt. Income before income taxes Provision for income taxes Net income 33,280 (5,200) 28,080 (8,080) $20,000

29. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved The Statement of Retained Earnings Cash Dividends Preferred stock$600 Common stock9,400 Total dividends$10,000 Retained earnings Beginning of year (01/01/2015)$32,400 Current year10,000 End of Year$42,400

30. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Relationship Between Balance Sheets and Income Statement Balance Sheet (12/31/2015)Income StatementBalance Sheet (12/31/2014) (01/01/12 - 12/31/12) AssetsTotal revenue300,000Assets Current assets77,400Cost of revenue188,000 Current assets74,900 Fixed assets84,000Gross Profit112,000 Fixed assets95,000 Total161,400Operating Expenses58,720 Total169,900 Operating income33,280 Liabilities & Equities Interest expenses5,200 Current liabilities28,000Taxable income28,080 Current liabilities44,500 Other liabilities30,000Income taxes8,080 Other liabilities32,000 Total58,000Net Income20,000 Total76,500 Preferred stock10,000Cash dividends10,000 Preferred stock10,000 Common stock40,000 Common stock40,000 Additional paid-in capital11,000Retained earnings10,000 Additional paid-in capital11,000 Retained earnings42,000 Retained earnings32,400 Total169,300 Total160,400

31. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved D. Understanding the Cash Flow Statement  The business operating cycle: how a business earns its cash  Sources and uses of cash  The engineer’s focus on the investing section: capital budgeting

32. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Cash Flow Transactions Within Business Shareholders Fixed assets Debt holders Inventory Government Customers CASH From cash sales To pay taxes From credit sales To pay labor, Materials and overhead To pay interest and principal From sale of debt To purchase From sale To pay dividends, To purchase back shares From sale of shares

33. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Statement of Changes in Financial Position Balance Sheet December 31, 2015 Ending financial position Balance Sheet December 31, 2014 Starting financial position Sources and uses of funds Sources and uses of funds Increase in equity Decrease in assets Increase in liabilities Decrease in equity Increase in assets Decrease in liabilities Decrease in equity Increase in assets Decrease in liabilities Sources Uses

34. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Working Capital Requirement

35. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Working Capital Requirement (J&M, Inc.) Net change in working capital = $100 − (−$16,500) = $16,600

36. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved The Cash Flow Statement for J&M, Inc.