th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 2 2 Chapter Review of Accounting

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Chapter 2 - Outline Income Statement (I/S) P/E Ratio Balance Sheet (B/S) Statement of Cash Flows (CFs) Tax-Free Investments

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Income Statement

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt An Income Statement shows profitability

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Sales - Cost of Goods Sold (COGS) = Gross Profit (GP)

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt GP - Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI)

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt EBIT - Interest = Earnings Before Taxes (EBT)

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt EBT - Taxes = Earnings After Taxes (EAT) or Net Income (NI)

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt The Statement of Retained Earnings (Table 2-2)—Page 29

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Price-Earnings Ratio is Applied to Earnings per Share

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt The P/E ratio compares market prices with accounting earnings

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt The P/E ratio is one of the most commonly used measures of performance

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Generally, a high P/E ratio suggests two things –High expectations (return) –High risk (disappointments)

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Limitations of the Income Statement

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Accounting numbers (historical cost) do not reflect economic changes

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt There is great flexibility in choosing the accounting conventions.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Next, we examine the Balance Sheet for Kramer.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Balance Sheet A Balance Sheet (B/S) shows what a firm owns and what it owes Remember the ALOE! Assets = Liabilities + Owners’ Equity

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt PPT 2-3

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Concept of Net Worth (Common Stockholder Equity)—Page 33

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Price-to-Book (P/B) is similar to P/E ratio

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt P/B ratio is commonly used as a measure of relative value

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt P/B ratio compares market price with accounting book value

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Generally, a high P/B ratio suggests: High market expectations. High risk due to heightened expectations.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt PPT 2-4

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Next, we turn to the Statement of Cash Flow

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt PPT 2-5

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt PPT 2-6

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt PPT 2-7

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Healthy Operations should provide cash flow to the business

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt PPT 2-8

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Table 2-8 Cash flows from Investing Activities—Page 38

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Financing activities are transactions on the “right side” of the balance sheet (liabilities and owners equity) (Table 2-9)—Page 39

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt PPT 2-9

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Depreciation and Funds Flow

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Depreciation is the accountant’s way of allocating the cost of capital equipment over the life of the equipment

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt You must remember that the actual expenditure occurs at the time of purchase—NOT later when depreciation is written off.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Depreciation is a NON-CASH expense on the balance sheet— no disbursement of funds actually occurs

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Depreciation smoothes accounting earnings, but distorts cash flows.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Depreciation affects cash flows by providing a tax benefit that is spread over time.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Consider a company that purchases new equipment for $500, which it will write off (depreciate) over a 5- year period.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt (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 Year 1 T 2-10 Table 2-11a Comparison of accounting and cash flows—Page 40

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt T 2-10 Table 2-11b Comparison of accounting and cash flows—Page 41 (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 Year 2

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Free cash flow is a very important concept to lenders

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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)

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Income Tax Considerations

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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)

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Tax-Free Investments

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Municipal Bonds are: –exempt from federal income tax –issued by local governments (or municipalities)

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Cost of a Tax- deductible Expense

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt All tax-deductible expenses provide a tax benefit equal to: Corporate tax rate X amount of deductible expense.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt If the expense requires actual cash outlays, then the net (after-tax) cost is: Expense – tax benefit.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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.

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Because depreciation carries only a tax benefit, we say that depreciation offers a “tax shield”

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt This example (Page 43) shows how taxes reduce deductible expenses

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt This example (Page 43) shows how depreciation acts as a tax shield

th 9 ©The McGraw-Hill Companies, Inc Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt THE END