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Review of Accounting

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Review of Accounting

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  1. Review of Accounting 2

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

  3. Basic Financial Statements • Income Statement • Balance Sheet • Statement of Cash Flows

  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 profit or loss after each type of expense item is deducted

  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)

  6. 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

  7. Price-Earnings (P/E) Ratio • Multiplier applied to earnings per share to determine current value of common stock • Some factors that influence P/E: • Earnings and sales growth of the firm • Risk (volatility in performance) • Debt-equity structure of the firm • Dividend payment policy • Quality of management

  8. 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 a company • Price-earnings ratios can be confusing

  9. Price-earnings Ratios for Selected US Companies

  10. Balance Sheet • 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

  11. Balance Sheet Items • Liquidity: Asset accounts are listed in order of liquidity • Current assets • Items that can be converted to cash within 12 months • Marketable securities • Temporary investments of excess cash • Accounts receivable • Allowance for bad debts to determine their anticipated collection value • Inventory • Includes raw materials, goods in progress, or finished goods

  12. Balance Sheet Items (cont’d) • Prepaid expenses • Represent future expense items that are already paid for • Investments • Long-term commitment of funds • Includes stocks, bonds, or investments in other companies • Plant and equipment • Carried at original cost minus accumulated depreciation • Accumulated depreciation • Sum of past and present depreciation charges on currently owned assets

  13. Balance Sheet Items (cont’d) • Depreciation expense is the current year’s charge • Total assets: Financed through liabilities or stockholders’ equity • Short-term obligations • Accounts payable • Notes payable • Accrued expense

  14. Stockholder’s Equity • Represents total contribution and ownership interest of preferred and common stockholders • Preferred stock • Common stock • Capital paid in excess of par • Retained earnings

  15. Concept of Net Worth Net worth/book value = Stockholders’ equity – preferred stock component • Market value is of primary concern to the: • Financial manager • Security analyst • Stockholders

  16. Concepts Behind the Statement of Cash Flows

  17. Depreciation and Funds Flow • Depreciation • Attempt to allocate the initial cost of an asset over its useful life • Charging of depreciation does not directly influence the movement of funds

  18. Comparison of Accounting and Cash Flows

  19. 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 a tax-deductible expense

  20. Depreciation as a Tax Shield • Not a new source of fund • Provides tax shield benefits measurable as depreciation times the tax rate Corporation A Corporation B Earnings before depreciation and taxes…… $400,000 $400,000 Depreciation……………………………………… 100,000 0 _________ _________ Earnings before taxed………………………… 300,000 400,000 Taxes (40%)……………………………………… 120,000 160,000 _________ _________ Earnings after taxes…………………………… 180,000 240,000 +Depreciation charged without cash outlay… 100,000 0 _________ _________ Cash flow………………………………………… $280,000 $240,000 Difference………………………………………… $40,000