Review of Accounting Chapter 2

Chapter 2 – Outline Income Statement (I/S) P/E Ratio Balance Sheet (B/S) Statement of Cash Flows (CFs) Tax-Free Investments

3 Basic Financial Statements Income Statement (I/S) Balance Sheet (B/S) Statement of Cash Flows (CFs)

Income Statement An Income Statement shows profitability 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)

Limitations of the Income Statement 2-6 Income gained/lost during a given period is a function of verifiable transactions over a specific time period Stockholders, hence, may perceive only a much smaller gain/loss from actual day-to-day operations Flexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period

P/E Ratio P/E Ratio = Price/Earnings Ratio P/E Ratio = Market Price of Stock / Earnings per share (EPS) Way of measuring desirability of a stock Indicates expectations about future of a company

Price-earnings Ratios for Selected US Companies 2-8

Balance Sheet 2-9 Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest Delineates the firm’s holdings and obligations Items are stated on an original cost basis rather than at current market value

Balance Sheet A Balance Sheet (B/S) shows what a firm owns and what it owes Remember the ALOE! Assets = Liabilities + Owners’ Equity

Limitations of the Balance Sheet 2-13 Most of the values are based on historical/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price Troublesome when it comes to plant and equipment inventory FASB ruling on disclosure of inflation adjustments no longer in force It is purely a voluntary act on the part of the company

Limitations of the Balance Sheet (cont’d) 2-14 Differences between per share values may be due to: Asset valuation Industry outlook Growth prospects Quality of management Risk-return expectations

Comparison of Market Value to Book Value per Share 2-15

Accrual Method of Accounting Will be used in finance Revenues and expenses are recognized when they occur, rather than when cash changes hands For example, a credit sale in December 2003 is shown as revenue in that year (2003), even though payment is not received until March 2004

Statement of Cash Flows 2-17 Emphasizes critical nature of cash flow to the operations of the firm It represents cash/cash equivalents items easily convertible to cash within 90 days Cash flow analysis helps in combating discrepancies faced through accrual method of accounting

Statement of Cash Flows 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

FIGURE 2-1 Illustration of concepts behind the statement of cash flows

FIGURE 2-2 Steps in computing net cash flows from operating activities using the indirect method

TABLE 2-7 Cash flows from operating activities

TABLE 2-10

TABLE 2-11 Comparison of accounting and cash flows

Free Cash Flow 2-24 Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends Capital expenditures Maintain productive capacity of firm Dividends Maintain necessary payout on common stock and to cover any preferred stock obligations Free cash flow is used for special financing activities Example: leveraged buyouts

Income Tax Considerations 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)

Tax-Free Investments Municipal Bonds are: –exempt from federal income tax – issued by local governments (or municipalities) 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