Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Review of Accounting 2

2-2 Outline Income Statement Price-earnings Ratio Balance Sheet Statement of Cash Flows Tax-free Investments (Deprecation)

2-3 Basic Financial Statements Income Statement Balance Sheet Statement of Cash Flows

2-4 Income Statement Device to measure the profitability of a firm over a period of time. –It covers a defined period of time. –It is presented in a stair-step or progressive fashion To examine the profit or loss after each type of expense item is deducted.

2-5 Income Statement (cont’d) Sales – Cost of Goods Sold (COGS) = Gross Profit (GP) GP – Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI) EBIT – Interest = Earnings Before Taxes (EBT) EBT – Taxes = Earnings After Taxes (EAT) or Net Income (NI)

2-6 Income Statement (cont’d)

2-7 Return to Capital Three primary sources of capital: –Bondholders –Preferred stockholders –Common stockholders Earnings per share –Interpreted in terms of number of outstanding shares. –May be paid out in dividends or retained by company for subsequent reinvestment. Statement of retained earnings –Indicates the disposition of earnings.

2-8 Statement of Retained Earnings

2-9 Price-Earnings (P/E) Ratio Refers to the multiplier applied to earnings per share to determine current value of the common stock. P/E Ratio = Market Price of Stock / Earnings per share (EPS). Some factors that influence P/E: –Earnings and the sales growth of the firm. –Risk (volatility in performance). –Debt-equity structure of the firm. –Dividend payment scheme. –Quality of management.

2-10 Price-Earnings (P/E) Ratio (cont’d) Allows comparison of the relative market value of many companies based on $1 of earnings per share. –Indicates expectations about the future of the company. Price-earnings ratios can be confusing.

2-11 Price-earnings Ratios for Selected U.S. Companies

2-12 Limitations of the Income Statement Income that is gained or lost during a given period is a function of verifiable transactions. –Stockholders, hence may perceive only a much smaller gain or loss from actual day-to-day operations. Flexibility in the reporting of transactions might result in differing measurements of income gained from similar events at the end of a time period.

2-13 Balance Sheet Indicates what the firm owns and how these assets are financed in the form of liabilities and ownership interest. –Delineates the firm’s holdings and obligations. –A cumulative chronicle of all transactions that have affected the corporation since its inception. –Items are stated on an original cost basis rather than at current market value.

2-14 Balance Sheet Items Liquidity: Asset accounts are listed in order of liquidity. –Current assets: items that can be converted to cash within 12 months or within the normal operating cycle of the firm. –Marketable securities: temporary investment of excess cash. –Accounts receivable: allowance for bad debts, to determine their anticipated collection value.

2-15 Balance Sheet Items (cont’d) –Inventory: includes raw materials, goods in progress or finished goods. –Prepaid expenses: represents future expense items, that are already paid for. Example: insurance premiums or rent –Investments: long-term commitment of funds (at least one year). Includes stocks, bonds or investments in other companies.

2-16 Balance Sheet Items (cont’d) –Plant and equipment: carried at original cost minus accumulated depreciation. Accumulated depreciation: sum of all past and present depreciation charges on currently owned assets. Depreciation expense is the current year’s charge.

2-17 Balance Sheet Items (cont’d) –Total assets: Financed through liabilities or stockholders’ equity. Short-term obligations –Accounts payable: amounts owed on open accounts to suppliers. –Notes payable: short-term signed obligations to bankers and other creditors. –Accrued expense: payment yet to be made towards - service already provided or an obligation incurred.

2-18 Stockholder’s Equity Represents total contribution and ownership interest of preferred and common stockholder’s. –Preferred stock. –Common stock. –Capital paid in excess of par. –Retained earnings.

2-19 Statement of Financial Position (Balance Sheet)

2-20 Concept of Net Worth Net value/ book value = Stockholder’s equity – preferred stock component Market value is of primary concern to the: –Financial manager –Security analyst –Stockholders

2-21 Limitations of the Balance Sheet Most of the values are based on historical or original cost price. –Troublesome when it comes to plant and equipment inventory. FASB ruling on disclosure of inflation adjustments no longer in force. –It is purely a voluntary act on the part of the company.

2-22 Limitations of the Balance Sheet (cont’d) Differences between per share values may be due to: –Asset valuation –Industry outlook –Growth prospects –Quality of management –Risk-return expectations.

2-23 Comparison of Market Value to Book Value per Share

2-24 Statement of Cash Flows Emphasizes the critical nature of cash flow to the operations of the firm. –It represents cash or cash equivalents items easily convertible to cash within 90 days. Cash flow analysis helps in combating the discrepancies faced through the accrual method of accounting.

2-25 Statement of Cash Flows (cont’d) Advantage of accrual method: –Allows the matching of revenues and expenses in the period in which they occur to appropriately measure profits. Disadvantage of accrual method : –Adequate attention is not directed to the actual cash flow position of the firm.

2-26 Concepts Behind the Statement of cash Flows

2-27 Determining Cash Flows from Operating Activities Translation of income from operations from an accrual to a cash basis. Direct method –Every item on the income statement is adjusted from accrual to cash accounting. Indirect method –Net income represents the starting point. –Required adjustments are made to convert net income to cash flows from operations.

2-28 Indirect Method

2-29 Comparative Balance Sheets

2-30 Cash Flows from Operating Activities

2-31 Determining Cash Flows from Investing Activities Investing activities: –Long-term investment activities in mainly plant and equipment. Increasing investment is a use of funds. Decreasing investments is a a source of funds.

2-32 Determining Cash Flows from Financing Activities Financial activities apply to the sale or retirement of: –Bonds –Common stock –Preferred stock –Other corporate securities –Payment of cash dividends. Sale of firm’s securities is a source of funds. Payment of dividend and the repurchase of securities is a use of funds.

2-33 Overall Statement Combining the Three Sections

2-34 Analysis of the Overall Statement How are increases in long-term assets being financed? Preferably, adequate long-term financing and profits should exist. Short-term funds may be used to carry long- term needs – could be a potential high-risk situation. –Example: trade credit and bank loans

2-35 Depreciation and Fund Flows Depreciation attempts to allocate the initial cost of an asset over its useful life. Charging of depreciation does not directly influence the movement of funds.

2-36 Comparison of Accounting and Cash Flows

2-37 Free Cash Flow Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends. –Capital expenditures: Maintains the productive capacity of firm. –Dividends: Maintains the necessary payout on common stock and to cover any preferred stock obligations. Free cash flow is used for special financing activities. –Example: leveraged buyouts

2-38 Income Tax Considerations Corporate tax rates –Progressive: the top rate is 40% including state and foreign taxes if applicable. The lower bracket is 15-20%. Cost of tax-deductible expense

2-39 Depreciation as a Tax Shield Not a new source of fund. Provides tax shield benefits measurable as depreciation times the tax rate. Corporation ACorporation B Earnings before depreciation and taxes……..$400,000$400,000 Depreciation……………………………………… 100,000 0 _________ _________ Earnings before taxed………………………….. 300, ,000 Taxes (40%)………………………………………. 120, ,000 _________ _________ Earnings after taxes…………………………… , ,000 +Depreciation charged without cash outlay…. 100,000 0 _________ _________ Cash flow…………………………………………... $280,000 $240,000 Difference…………………………………………...$40,000