2Learning Objectives14.1 Describe the importance of accounting and financial information.14.2 Differentiate between managerial and financial accounting.14.3 Identify the six steps of the accounting cycle.14.4 Explain the purpose of the three key financial statements.14.5 Describe the short- and long-term financing options available to businesses.14.6 Discuss the use of ratio analysis to evaluate organizational performance.
4Organizations often survive or fail based on how well they manage their finances. Managers must be able to read, understand and analyze financial information in order to make operational decisions and evaluate organizational performance. A manager’s role in managing accounting and financial information can vary by position and organization. Accounting – recording, classifying, summarizing, and interpreting financial events and transactions to provide management and other interested parties with the information they need to make good decisions.
5Type of AccountingFirst level managers are primarily concerned with two types of accounting:Managerial Accounting – A type of accounting that provides information and analysis to managers to assist them in decision making and evaluating organizational performance.Financial Accounting – A type of accounting that generates information about the financial health of an organization for use outside of the organization.
6Accounting Standards and Principles Financial Accounting Standards Board (FASB) – The group that oversees accounting practices.Generally Accepted Accounting Principles (GAAP) – A set of principles followed by accountants in preparing reports.GAAP includes certain accounting information that is required by law to be made public.Most public organizations produce an annual report that is distributed to its stakeholders.An annual report discloses the financial condition, progress, and expectations of the organization.
8Debit – a value added to an account Credit – a value removed from an accountEvery transaction recorded in the accounting process is either a debit or a credit.Debits and credits are part of a double-entry-system.Double-entry-system – for every debit there is an equal credit.
10In accounting, there are five classifications of financial accounts: AssetsLiabilitiesEquityIncomeExpensesDebits and credits are reflected differently in each type of account.A debit increases an asset account and a credit decreases an asset account.Businesses possess a chart of accounts or list that identifies all accounts by name and number.
12Revenues – the monetary value or income that an organization receives for its goods and services. Revenues are received primarily in the form of sales, but may also include income from leasing property, renting patents, earning interest, or collecting service fees.Revenues are offset by the cost of goods sold (CGS).Cost of Goods Sold – the cost of merchandise used to produce goods for sale. Cost of goods sold is also used to determine a products price.Operating Expenses – Costs involved in operating a business, such as rent, utilities, and salaries. Costs are classified as selling expenses and general expenses.Selling Expenses – expenses related in the sales of goods, such as salespersons salaries and marketing expenses.General Expense – administrative expenses of the organization, such as office salaries, rent, utilities, insurance, and more.
13Depreciation and Net Income Depreciation – The systematic write-off of the cost of a tangible asset over its estimated useful life.Depreciation allows companies to recapture the cost of high value assets over time rather than at the time of purchase.Depreciation helps lower net income for tax purposes.Net Income – determined by subtracting operating expenses and taxes from gross profit.Net income reveals an organizations operational performance by detailing how revenues, cost of goods sold and expenses contribute either to a profit or a loss.
15Accounts Receivable – monies owed to an organization by customers for credit sales. Accounts Payable – monies owed by an organization to suppliers or vendors for credit sales.Both accounts receivable and accounts payable are recorded on the balance sheet.
17Liabilities – what a business owns to others such as debts or loans. Assets – resources owned by a business, such as cash, equipment, land, buildings, vehicles, and fixtures.Assets are classified according to how quickly they can be converted to cash or liquidated.Current Assets – can be converted to cash within one year or less, such as accounts receivable and bank accounts.Fixed Assets – are long-term assets that are relatively permanent, such as land, buildings, and equipment.Liabilities – what a business owns to others such as debts or loans.Liabilities are classified by how quickly they can be converted to cash or liquidated.Current Liabilities – debts due within one year or less, such as accounts payable.Fixed Liabilities – long-term liabilities, which are not due for a year or more, such as bonds payable.
18Working Capital and Owners’ Equity Working Capital – The combination of current assets and current liabilities, which details the money available to meet short-term cash needs and a measure of an organization’s liquidity.Owners’ Equity – The amount of a business that belongs to its owners minus any liabilities owed by the business.A public owned company owners’ equity is called stockholders’ equity, which may be distributed to stockholders in the form of dividends or retained in the business, called retained earnings.Retained Earnings – the accumulated earnings from a firm’s profitable operations that were reinvested in the business and not paid out to stockholders in dividends.
20Assets – Liabilities = Equity The accounting equation is the foundation of all accounting transactions and ensures that debits and credits always remain in balance.The equation:Assets – Liabilities = Equity
22The accounting cycle is made up of six steps that result in the preparation of the three key financial statements:Income StatementBalance SheetStatement of Cash FlowsThe accounting cycle normally involves the work of a bookkeeper and an accountant:Bookkeeper – an individual who records financial transactions for a business.Accountant – an individual who classifies and summarizes financial data for a business according to accepted accounting standards and principles.
23Accounting Cycle Steps The six steps of the accounting cycle are:Assemble and analyze source documents (sales receipts, invoices, etc.).Record source information into electronic journals in chronological order.Post journal entries to ledger accounts.Prepare a trial balance to ensure information is correct and balanced.Trial Balance – a summary of all the financial data in the account ledgers that is used to check if the figures are correct and balanced.Prepare the financial statements.Analyze financial statements.
25Financial Statement – a summary of financial transactions that have occurred over a period of time. Financial statements indicate an organization’s health and stability.Both managers and stakeholders are interested in financial statements.The key financial statements include:Balance SheetIncome StatementStatement of Cash Flows
26Assets = Liabilities + Owners’ Equity Balance SheetBalance Sheet – the financial statement that reports a firm’s financial condition (assets, liabilities, and owners’ equity) at a specific time.A managers uses the balance sheet to determine if the business is producing a profit.A balance sheet is normally required to support a loan application.The equation:Assets = Liabilities + Owners’ Equity
28Income StatementIncome Statement – the financial statement that summarizes all the resources that have come into an organization from operating activities.Taxes and interest are listed at the bottom of an income statement, because they are not a direct product of operations.Income statements are sometimes referred to as Profit and Loss statement or P&L.
30Statement of Cash Flows Statement of Cash Flows – the financial statement that reports cash receipts and disbursements related to the three major activities of a firm: operations, investments, and financing.Operations – cash transactions associated with running a business.Investments – cash used in or provided for investment activities.Financing – cash raised from the issuance of debt, such as taking out a loan.Cash flow management is important to ensure all financial obligations and debts are met on a timely basis.
33Time Value of MoneyTime Value of Money (TVM) – the concept that money received today is worth more than money received in the future, or cash received earlier is preferable to cash received later.Time value money also looks at opportunity cost.Opportunity Cost – what must be given up in order to get something in return.A common technique used to evaluate future cash flows is to discount them to today’s value by finding their present value (PV).Present Value (PV) – the value today of a stream of cash flow.Discount Rate – the minimum rate of return used in calculations of the time value of money.
34Time Value of Money - continued Time value money can be calculated by applying one of two methods:Net Present Value – compares the present value of all cash inflows of an investment with the present value of all cash outflows.If the net present value is greater or equal to zero, the investment is acceptable.If the net present value is negative, the investment is unacceptable.Internal Rate of Return – the actual yield or rate of return earned by an investment.The yield is the discount rate that equates the present value of all cash inflows to the present value of all cash outflows.The internal rate of return tells a manager exactly what the return on investment is.
35Future Value and Capitalization Rate Future Value (FV) – the future value of a stream of cash flows.Capitalization Rate – the return on investment at a certain point in time.The equation for capitalization rate is:Net Income ÷ Purchase Price = Capitalization Rate
37Valuations are used in business for many reasons: Asset Valuation – is the process of estimating what an asset (property, plant, equipment or intangibles) is worth.Valuations are used in business for many reasons:To include investment analysisCapital budgetingFinancial reportingFinancingInsurance claimsTax determinationBusiness valuationSome common terms and techniques for asset valuations include:Absolute ValueAppraised ValueSalvage ValueFair Market Value (FMV)Book ValueNet Asset ValueReplacement ValueActual Cash Value
38Asset Valuations used in Investment Analysis Valuations used in investment analysis include:Absolute Value – the present value of an asset’s expected future cash flows discounted back at a rate that reflects the riskiness of the revenue stream.Appraised Value – the same as an absolute value, except an appraised value is determined by an independent third party that values assets for a living.Salvage Value – the liquidation value that would be received if an asset were sold at market value before the end of its useful life.
39Asset Valuations used in Capital Budgeting Valuations used in capital budgeting include:Fair Market Value – represents the market price that a knowledgeable and willing buyer would buy and seller would sell and asset.Fair market value is a subjective estimate, since the buyer and seller had negotiating power.Fair market value is generally the basis used for tax assessment.
40Asset Valuations used in Financial Reporting Valuations used in financial reporting include:Book Value – is the cost of an asset net of depreciation, as reflected on the balance sheet. It represents the remaining value of an asset, for accounting purposes.Net Asset Value – is the total value of all assets less the value of its intangible assets and liabilities. It represents the underlying value of a business.
41Asset Valuations used for Insurance Purposes Valuations used for insurance purposes include:Replacement Value – is the cost to replace an asset with one in the same or similar condition.Replacement value takes into account for such factors as years of service, hours of use, maintenance frequency, and useful life.Actual Cash Value – is the value derived by subtracting depreciation from replacement cost.
42Assessing Borrowing Needs A Manager’s role inAssessing Borrowing Needs
43Organizations continuously monitor their money flows to stay abreast of financial needs. Organizations have needs for short-term and long-term funds, which include:Short-Term FundsMonthly expensesUnanticipated emergenciesCash flow problemsExpansion of inventoryTemporary promotional programsLong-Term FundsNew-product developmentReplacement of capital equipmentMergers or acquisitionsExpansion into new marketsNew facilities
44Sources for Short-Term Borrowing A number of sources of short-term borrowing exist, which include:Trade Credit – a form of short-term borrowing where goods received today are paid for in 30 or 45 days. It is one of the most convenient and least expensive forms of short term borrowing.Credit Cards – allow for businesses to buy goods today and pay for them in days or make a minimum payment on the due date and pay interest on the balance.Secured Loan – a loan backed by collateral or something of value, such as property or equipment, which can be taken if timely payment is not made. Usually the type of loan required for a new business, or one with credit history problems.Unsecured Loan – a loan that doesn’t require any collateral. It is a difficult loan to obtain, and is only offered to businesses with good credit history.Factoring – the process of selling accounts receivable for cash. It is an expensive form of borrowing and should only be used as a last resort.
45Sources for Long-Term Borrowing A number of sources of long-term borrowing exist, which include:Debt Financing – funds raised through various forms of borrowing that must be repaid.In debt financing, raising funds through borrowing to increase the rate of return is referred to as leverage.Cost of capital – the rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders.Equity Financing – money raised from within the firm, from operations or through the sale of ownership in the firm (stock or venture capital).Decisions about long-term financing are normally made by senior management, the board of directors, and finance and accounting executives.
47Managers, accountants, investors, business buyers, lenders and others use financial ratios to evaluate organizational performance and assess the overall financial condition of an organization.Financial ratios are categorized into four key types:Liquidity RatiosDebt (Leverage) RatiosProfitability RatiosActivity Ratios
48Liquidity RatiosLiquidity Ratios – measure an organization’s ability to turn assets into cash to pay its short-term debts or liabilities.Two key liquidity ratios include:Current Ratio – a measure of any organization’s financial security to repay short-term debt from current assets. The equation is:Current Assets ÷ Current Liabilities = Current RatioQuick Ratio – a measure of an organization’s financial security to repay short-term debt from cash, marketable securities and accounts receivables. The equation is:Current Assets – Inventories ÷ Current Liabilities = Quick Ratio
49Debt (Leverage) Ratios Debt Ratios – measure the degree to which an organization relies on borrowed funds in its operations.Two key debt ratios include:Debt to Equity Ratio – a measure of long term liquidity that compares an organization’s debt to equity. The equation is:Total Liabilities ÷ Owners’ Equity = Debt to Equity RatioTotal Debt to Total Asset Ratio – a measure of liquidity that shows the percentage of assets financed through borrowing. The equation is:Total Liabilities ÷ Total Assets = Total Debt to Total Asset Ratio
50Profitability RatiosProfitability Ratios – measure how effectively an organization’s managers are using resources to achieve profits.Key profitability ratios include:Gross Profit Margin Ratio – a measure of performance that represents production and distribution efficiency. The equation is:Sales – Cost of Goods Sold ÷ Net Sales = Gross Profit MarginNet Profit Margin – a measure of performance that represents net profits relative to sales. The equation is:Net Income After Tax ÷ Net Sales = Net Profit Margin
51Profitability Ratios - continued Return on Sales – a measure of performance that represents how much profit a company earns for every dollar it generates in sales. The equation is:Net Operating Income ÷ Net Sales = Return on SalesReturn on Investment (ROI) – a combined measure of operating performance and asset turnover which represents the financial performance of an organization’s core operations. The equation is:Net Operating Income ÷ Average Operating Assets = ROIReturn on Assets (ROA) – a measure of return to investors on all assets invested in a company. The equation is:Net Income After Tax ÷ Total Assets = ROA
52Profitability Ratios - continued Return on Equity (ROE) – a measure of return to owners on each dollar invested in a company. The equation is:Net Income After Tax ÷ Owners’ Equity = ROEEarnings Per Share (EPS) – a measure of performance that represents the profit earned by a company for each share of common stock outstanding. The equation is:Net Income After Tax ÷ Shares of Common Stock Outstanding = EPS
53Asset RatiosAsset Ratios – show how effectively management is turning over inventory and assets in order to produce revenue.Key asset ratios include:Asset Turnover Ratio – a measure of performance that tells how well a company is utilizing its assets to produce revenue. The equation is:Net Sales ÷ Total Assets = Asset Turnover RatioInventory Turnover Ratio – a measure of performance that tells how efficiently an organization is using its inventory to produce sales. The equation is:Cost of Goods Sold ÷ Average Inventory = Inventory Turnover Ratio
54Asset Ratios - continued Average Collection Period – the approximate amount of time that it takes for an organization to collect accounts receivable from its customers. The equation is:Average Accounts Receivable x 365 Days ÷ Net Credit Sales for the Year = Average Collection Period