Accounting and Financial Decisions Lecture No. 2 Chapter 2 Contemporary Engineering Economics, 6e, GE

Contents Why do engineers need to understand the financial statements? Understanding the balance sheet statement Using the income statement to manage a business Understanding the cash flow statement

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?

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?

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?

Does the company have the ability to adjust prices for inflation? Does the company have enough earnings to grow?

AAPL (Apple) What causes the stock price to go up and down? $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?

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 Company Stock Price (January 15, 2015) Number of Shares Market Value (mil) Google $343.03B 339.34M GE $23.73 10.04B $238.40B Coca-Cola $42.52 4.38B $187.39B Wal-Mart $87.50 3.22B $279.64B Apple $107.56 5.86B $641.57B

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

A. Why do engineers need to understand the financial statements?

Accounting: The Language of Business

Financial Status for Business

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?

The Basic Accounting Equation For the balance sheet presentation For the financial analysis Assets = Liabilities + Owners’ Equity Assets − Liabilities = Owners’ Equity

J&M, Inc. BALANCE SHEET December 31   2015 2014 Changes Assets Current assets: Cash and cash equivalents Short-termmarketable 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 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 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 – 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 40,000 11,000 42,400 103,400 32,400 93,400 + 9,600

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

How the Firm Gets Equity: Two Ways Owners’ Contributions By issuing stocks through financial markets Retained Earnings By retaining operating profits instead of paying out cash dividends

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?

Methods of Reporting Income Cash Basis Method Accrual Basis Method

Basic Income Statement Equation Revenue - Expenses Net Income (Loss)

Measurement of Revenue Transaction This Year Amount Cash Receipts Sales Revenue Cash sales made this year $400 Credit sales made last year but cash received this year $100 Credit sales made this year and cash received this year $200 Credit sales made this year but cash received next year $300 Total $600 $900

Why Gross Margin Is a Critical Measure for Engineers Cost of Goods Sold Overhead Labor Material Sales Gross Margin

How Inventory Production Impacts Profit (Cost of Revenue = Cost of Goods Sold) Calculating the Cost of Goods Sold Beginning Inventory + Additions to Inventory Ending Inventory Cost of Goods Sold

How to Use Profit Check Points ABC Company, Inc. Statement of Operations (Year Ended December 31, 20xx) Sales $5,000,000 100.0% Less: Cost of Goods Sold 3,250,000 65.0% Gross Profit (margin) 1,750,000 35.0% Less: Selling, General, and Administration Expenses 1,000,000 20.0% Operating Profit (margin) 750,000 15.0% Less: Interest 250,000 5.0% Net Income Before Taxes (NIBT) 500,000 10.0% Less: Taxes 175,000 3.5% Net Income (margin) 325,000 6.5% Bottom line

How to Use Profit Check Points ABC Company, Inc. Statement of Operations (Year Ended December 31, 20xx) Sales $5,000,000 100.0% Less: Cost of Goods Sold 3,250,000 65.0% Gross Profit (margin) 1,750,000 35.0% Less: Selling, General and Administration Expenses 1,000,000 20.0% Operating Profit (margin) 750,000 15.0% Less: Interest 250,000 5.0% Net Income Before Taxes (NIBT) 500,000 10.0% Less: Taxes 175,000 3.5% Net Income (margin) $325,000 6.5% Bottom line

The Income Statement for 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 FY 2015 100.00% Revenue 37.33% Gross margin Operating margin 11.09% 6.67% Net margin

The Statement of Retained Earnings Cash Dividends Preferred stock $600 Common stock 9,400 Total dividends $10,000 Retained earnings Beginning of year (01/01/2015) $32,400 Current year 10,000 End of Year $42,400

Relationship Between Balance Sheets and Income Statement   Balance Sheet (12/31/2015) Income Statement Balance Sheet (12/31/2014) (01/01/12 - 12/31/12) Assets Total revenue 300,000 Current assets 77,400 Cost of revenue 188,000 74,900 Fixed assets 84,000 Gross Profit 112,000 95,000 Total 161,400 Operating Expenses 58,720 169,900 Operating income 33,280 Liabilities & Equities Interest expenses 5,200 Current liabilities 28,000 Taxable income 28,080 44,500 Other liabilities 30,000 Income taxes 8,080 32,000 58,000 Net Income 20,000 76,500 Preferred stock 10,000 Cash dividends Common stock 40,000 Additional paid-in capital 11,000 Retained earnings 42,000 32,400 169,300 160,400

D. Understanding the Cash Flow Statement The business operating cycle: how a business earns its cash Sources andusesof cash The engineer’s focus on the investing section:capital budgeting

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 To pay dividends, To purchase back shares of shares

Statement of Changes in Financial Position Sources Increase in equity Decrease in assets Increase in liabilities Starting financial position Ending financial position Balance Sheet December 31, 2015 Balance Sheet December 31, 2014 Sources and uses of funds Decrease in equity Increase in assets Decrease in liabilities Uses

Working Capital Requirement

Working Capital Requirement (J&M, Inc.) Net change in working capital = $100 − (−$16,500) = $16,600

The Cash Flow Statement for J&M, Inc. Period Ending 31-Dec-2015 Cash from Operating Activities Net Income 20,000 $ Depreication Changes in working capital (16,600) Total Cash Flow from Operating Activities 23,400 Cash Flow from Investing Activities Capital expenditure (9,000) Total Cash Flow from Investing Activities Cash Flow from Financing Activities Cash dividends paid (10,000) Reduction of long-term debt (2,000) Total Cash Flow from Financing Activities (12,000) Change in Cash (Net cash flow) 2,400 J&M, INC. CASH FLOW STATEMENT