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

2. 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

3. Apple Computer You have money to invest in the market.
Apple (AAPL) is trading at $ on May 15, 2015.
What kind of information do you need in making your decision?

4. 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?

5. 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?

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

7. 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?

8. 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

9. 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

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

12. Accounting: The Language of Business

13. Financial Status for Business

14. 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?

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

16. 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

17. 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

19. 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

20. 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?

21. Methods of Reporting Income
Cash Basis Method
Accrual Basis Method

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

23. 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

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

25. 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

26. 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

27. 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

28. 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

29. 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

30. Relationship Between Balance Sheets and Income Statement
Balance Sheet (12/31/2015)
Income Statement
Balance Sheet (12/31/2014)
(01/01/ /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

31. 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

32. 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

33. 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

34. Working Capital Requirement

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

36. 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