Introduction to Business

1. Introduction to Business Accounting and Finance

2. Module Learning Outcomes Recognize sound accounting practices, and use financial statements and accounting principles to make informed judgements about an organization’s financial health 16.1: Define accounting, and explain its role as a form of business communication 16.2: Identify key financial statements and their components, and explain the primary use of each type of payment 16.3: Calculate the break-even point, where profit will be equal to $0, using information from financial statements 16.4: Use financial statements to calculate basic financial ratios to measure the profitability and health of a business 16.5: Discuss the importance of ethical practices in accounting and the implications of unethical behavior

3. Accounting in Business

4. Learning Outcomes: Accounting in Business 16.1: Define accounting, and explain its role as a form of business communication 16.1.1: Explain the role of accounting as a form of business communication 16.1.2: Identify the users and uses of financial accounting 16.1.3: Identify the users and uses of managerial accounting

5. Class Discussion: Why Accounting?

6. Accounting in Business Accounting is the measurement and communication process used to report on the activities of profit-seeking business organizations. It is the language of business. Accounting represents all of the financial transactions of a business in a format that can be interpreted and understood by both internal and external stakeholders.

7. Internal and External Users Users of accounting information are separated into two groups, internal and external. Internal users are the people within a business organization who use accounting information. For example, the human resource department needs to have information about how profitable the business is in order to set salaries and benefits. Likewise, production managers need to know if the business is doing well enough to afford to replace worn-out machinery or pay overtime to production workers. External users are people outside the business entity that use accounting information. These external users include potential investors, the Internal Revenue Service, banks and finance companies, as well as local taxing authorities.

8. Uses of Financial Accounting Financial accounting information appears on financial statements that are intended primarily for external use. Financial accounting relates to the company as a whole Stockholders and creditors are two outside parties who need financial accounting information. These two parties make decisions pertaining to the entire company, such as whether to increase their investment in the company or to extend credit to the company.

9. GAAP and Tax Accounting Financial accountants adhere to set of rules called Generally Accepted Accounting Principles (GAAP): a uniform set of accounting rules that allow users to compare the financial statements issued by one company to those of another company in the same industry. Tax accounting information includes financial accounting information, written and presented in the tax code of the government. Tax accounting focuses on compliance with tax code and presenting the profit and loss story of a business to minimize its tax liability.

10. Uses of Managerial Accounting Managerial accounting information is for internal use and provides special information for the managers of a company. The information managers use may range from broad, long-range planning data to detailed explanations of why actual costs varied from cost estimates. Managerial accounting is more concerned with forward looking projections and making decisions that will affect the future of the organization, than in the historical recording and compliance aspects of the financial accountants.

11. Bookkeeping vs. Accounting Accounting is often confused with bookkeeping. Bookkeeping is a mechanical process that records the routine economic activities of a business. Accounting includes bookkeeping, but it goes further to analyze and interpret financial information, prepare financial statements, conduct audits, design accounting systems, prepare special business and financial studies, prepare forecasts and budgets, and provide tax services.

12. Practice Question 1 Accounting is referred to as the language of business. In reality, accounting information is communicated in multiple languages, including: A. Financial, managerial, and tax B. Financial and GAAP C. Financial and forensic D. Business and cost

13. Practice Question 2 Financial accounting information is used by both internal and external audiences. Which of the following best describes external users and use? A. A production manager evaluating whether to build or buy manufacturing component B. An IRS employee reviewing a business’s tax return C. A bank officer considering a business’s loan application D. A Human Resource team developing the next year’s compensation plan

14. Practice Question 3 Which of the following best describes users and uses of managerial accounting information? A. A bank officer considering a line of credit increase B. A current stockholder evaluating whether to buy additional shares, sell her shares, or hold C. A prospective employee evaluating an offer of employment with a company D. Department managers developing their budgets and business plans for the next year

15. Key Financial Statements

16. Learning Outcomes: Key Financial Statements 16.2: Identify key financial statements and their components, and explain the primary use of each type of statement 16.2.1: Define the accounting equation 16.2.2: Identify the use and components of the balance sheet 16.2.3: Identify the use and components of the income statement 16.2.4: Identify the use and components of the statement of owner’s equity 16.2.5: Identify the use and components of the statement of cash flows 16.2.6: Explain how the balance sheet, income statement, statement of owner’s equity, and statement of cash flows are connected

17. Key Financial Statements Financial statements are the means by which companies communicate their story. Together these statements represent the profitability and financial strength of a company. Key Financial Statements include: • Income statement: reflects a company’s profitability • Statement of owner's equity: shows the change in retained earnings between the beginning and end of a period • Balance sheet: reflects a company’s solvency and financial position • Statement of cash flows: shows the cash inflows and outflows for a company during a period of time

18. The Accounting Equation Three terms used in the accounting equation Asset: An asset is an economic resource that can be tangible or intangible. Assets represent value that can be converted into cash. They can include cash, vehicles, buildings, equipment, patents, and debts owed to the company. Liability: future sacrifices of economic benefits that the entity is obliged to make to other entities as a result of past transactions or other past events. Liability can include loans, monies owed to a supplier or creditor that the business will use assets to settle. Equity: the difference between the value of the assets and the amount of the liabilities of something owned. Owner’s equity consists of the net assets of an entity (net assets = total assets - total liability) The Accounting Equation: Assets - Liability = Owner’s or Shareholder’s Equity

19. Income Statement • Also called “earnings statement” or “profit and loss statement” • First financial statement prepared because it provides information for the remaining 3 statements • Provides information about the profitability of a stated period of time • Made up of 3 types of accounts 1. Revenue: inflows of cash resulting from the sale of products or the rendering of services to customers 2. Expenses: costs incurred to produce revenues 3. Net Income(Revenues - Expenses = Net Income)

20. Example of an Income Statement

21. Statement of Owner’s Equity • Explains the changes in retained earnings between two balance sheet dates • We start with beginning retained earnings (in our example, the business began in January, so we start with a zero balance) and add any net income (or subtract net loss) from the income statement. Next, we subtract any dividends declared (or any owner withdrawals in a partnership or sole-proprietor) to get the ending balance in retained earnings (or capital for non-corporations)

22. Example: Statement of Retained Earnings

23. Balance Sheets • Provides a snapshot of company’s financial position at a particular moment in time. That specific moment is the close of business on the date of the balance sheet. • Lists a company’s • Assets • Liabilities • Equity The Accounting Equation Assets – Liabilities = Owner’s or Shareholders’ Equity

24. Example of Balance Sheet

25. Statement of Cash Flow • Reports the cash receipts and cash disbursements during an accounting period • Reports effects on cash of a company’s • Operating activities • Investing activities • Financing activities • Includes both cash and cash equivalents (ex. investments)

26. Operating Activities: Cash Inflows Cash inflows from operating activities include: • Cash from sales of goods or services • Interest received from making loans • Dividends received from investments in equity securities • Cash received from the sale of trading securities • Other cash receipts that do not arise from transactions defined as investing or financing activities

27. Operating Activities: Cash Outflows Cash outflows for operating activities include payments to: • Acquire inventory • Suppliers and employees for other goods or services • Lenders and other creditors for interest • Purchase trading securities • All other cash payments that do not arise from transactions defined as investing or financing activities

28. Investing Activities Cash inflows from investing activities include: • Sale of property, plant, and equipment • Sale of available-for-sale and held-to-maturity securities • Collection of long-term loans made to others Cash outflows for investing activities include: • Purchase of property, plant, and equipment • Purchase of available-for-sale and held-to-maturity securities • Long-term loans to others

29. Financing Activities Cash inflows from financing activities include: • Cash received from issuing capital stock and bonds, mortgages, and notes, and from other short- or long-term borrowing Cash outflows for financing activities include: • Payments of cash dividends or other distributions to owners (including cash paid to purchase treasury stock) and repayments of amounts borrowed

30. The Break-Even Point

31. Learning Outcomes: The Break-Even Point 16.3: Calculate the break-even point, where profit will be equal to $0, using information from financial statements 16.3.1: Define the break-even point 16.3.2: Differentiate between fixed and variable costs 16.3.3: Calculate the break-even point 16.3.4: Calculate the contribution margin 16.3.5: Calculate the contribution margin ratio 16.3.6: Calculate the margin of safety

32. The Break Even Point Businesses, both large and small, are concerned with determining the point at which their revenues exceed their expenses and they begin to make a profit. The point at which revenue equals expenses (and profit is therefore $0) is called the break-even point.

33. Difference Between Fixed and Variable Costs Fixed costs are expenses that are not dependent on the amount of goods or services produced by the business. • Examples: salaries or rents paid per month Variable Costs are volume related and are paid per quantity or unit produced. • Examples: gas or tires for a car

34. Calculate the Contribution Margin Contribution margin is the portion of revenue that is not consumed by variable cost. It is important to know the contribution margin in order to calculate what portion of the revenue from a product is consumed by the variable costs and what portion can be used to cover, or contribute to, fixed costs.

35. Break-Even in Units Example: Video Productions produces videotapes selling for USD 20 per unit. Fixed costs per period total USD 40,000, while variable costs is USD 12 per unit. We find the break-even point in units by dividing the total fixed costs by the contribution margin per unit. The contribution margin per unit is USD 8 (USD 20 selling price per unit - USD 12 variable cost per unit).

36. Break-Even in Sales Dollars Companies frequently measure volume in terms of sales dollars instead of units. The formula to compute the break-even point in sales dollars looks a lot like the formula to compute the break-even point in units, except we divide the fixed cost by the contribution margin ratio instead of the contribution margin per unit. The contribution margin ratio expresses the contribution margin as a percentage of sale

37. Calculate the Contribution Margin Ratio The Contribution Margin Ratio expresses the contribution margin as a percentage of sales. To calculate this ratio, divide the contribution margin per unit by the selling price per unit, or total contribution margin by total revenues. Example: Video Production’s contribution margin ratio would be USD 8 (contribution margin per unit) divided by USD 20 (the selling price per unit) which would equal .40.

38. Margin of Safety If a company’s current sales are more than its break-even point, it has a margin of safety equal to current sales minus break-even sales. The margin of safety is the amount by which sales can decrease before the company incurs a loss. Margin of safety = Current Sales - Break-even sales Example: Margin of safety = USD 120,000 - USD 100,000 when Video Productions has sales of USD 120,000 and its break-even sales are USE 100,000

39. Margin of Safety Rate Sometimes people express the margin of safety as a percentage, called the margin of safety rate. When Video Productions has sales of USD 120,000 and its break-even sales are USE 100,000, the margin of safety rate would be 16.67 percent. This means that Sales volume could drop by 16.67 percent before the company would incur a loss.

40. Financial Ratios

41. Learning Outcomes: Financial Ratios 16.4: Use financial statements to calculate basic financial ratios to measure the profitability and health of a business 16.4.1: Explain how financial ratios are used 16.4.2: Calculate the current ratio using information from financial statements 16.4.3: Calculate the acid-test (quick) ratio using information from financial statements 16.4.4: Calculate inventory turnover using information form financial statements

42. Financial Ratio Analysis • Financial ratios allow us to look at profitability, use of assets, inventories, and other assets, liabilities, and costs associated with the finances of the business. • Used to measure a firm’s financial health in four areas • Liquidity • Long-term solvency • Profitability tests • The market • These ratios can be used to compare the company’s performance across periods (months, quarters, years) or to similar companies within the same industry.

43. Financial Ratios Chart

44. Calculate the Current Ratio Working capital is the excess of current assets over current liabilities. The ratio that relates current assets to current liabilities is the current (or working capital) ratio. The current ratio indicates the ability of a company to pay its current liabilities from current assets, and thus show the strength of the company’s working capital position. The current ratio is usually expressed in current assets to one dollar of current liabilities. Example: 1.25:1 means that the company has $1.25 for every $1 of liabilities

45. Calculate the Acid-Test Ratio The acid-test (quick) ratio is the ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities. Short-term creditors are particularly interested in this ratio which relates to the pool of cash and immediate cash inflows to immediate cash outflows. In deciding whether the acid-test ratio is satisfactory, investors consider the quality of marketable securities and receivables.

46. Calculate Inventory Turnover A company’s inventory turnover ratio shows the number of times its average inventory is sold during a period. Other things being held equal, a manager who maintains the highest inventory turnover ratio is the most efficient. Other things are not always equal, for example, a company that achieves a high inventory turnover ratio by keeping extremely small inventories on hand may incur larger ordering costs, lost quantity discounts, and lose sales due to lack of adequate inventoy.

47. Summary of Liquidity Ratios

48. Interpretation and Use of Ratios Standing alone, a single financial ratio may not be informative. Investors gain a greater insight by computing and analyzing several related ratios for a company. Analysts must be sure their comparisons are valid, especially if those comparisons are from different time periods. Analysts must consider many items including • Business conditions • Important events that may have a large impact on a ratio • The seasonal nature of some businesses

49. Quick Reference Financial Ratio Calculations

50. Practice Question 5 Financial ratios allow a business, potential creditor or investor to: A. conduct a manager’s performance review B. compare the performance of unrelated business C. determine the health of a company individually and relate to similar businesses or alternative investment options D. evaluate market conditions