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Chapter 2 Understanding Financial Statements

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Chapter 2 Understanding Financial Statements

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  1. Chapter 2Understanding Financial Statements • Accounting: The Basis of Decision-Making • Net Worth: How well am I doing? • Financial Status for Businesses • Using Ratios to Make Business Decisions (c) 2001 Contemporary Engineering Economics

  2. Accounting – The Language of Business (c) 2001 Contemporary Engineering Economics

  3. Financial Status for Business (c) 2001 Contemporary Engineering Economics

  4. Why Do Engineers Need to Understand the Financial Statements? (c) 2001 Contemporary Engineering Economics

  5. Accounting Equation Liabilities Assets Owners’ Equity Assets = Liabilities + Owners’ Equity (c) 2001 Contemporary Engineering Economics

  6. The Balance Sheet – Dell Computer Co. (c) 2001 Contemporary Engineering Economics

  7. Income Statement – Dell Computer Co. (c) 2001 Contemporary Engineering Economics

  8. Cash Flow Statement – Dell Computer Co. (c) 2001 Contemporary Engineering Economics

  9. Cash Flow Statement Tells how much cash a company’s business generates or uses and contains clues to how healthy earnings are Cash used to buy or received from selling stock, assets, and businesses, plus capital expenditures. Lists cash at the beginning and end of the period covered by the filing, plus the change in cash. Cash from or paid to outsiders—such as banks or stockholders (c) 2001 Contemporary Engineering Economics

  10. Key Summary of Dell’s Financial Statements (c) 2001 Contemporary Engineering Economics

  11. Key Summary Continued (c) 2001 Contemporary Engineering Economics

  12. Using Financial Ratios (c) 2001 Contemporary Engineering Economics

  13. Debt Management Analysis Ratios that show how a firm uses debt financing and its ability to meet debt repayment obligations • Debt ratio • Times-interest-earned ratio (c) 2001 Contemporary Engineering Economics

  14. Debt Ratio • What It Measures: The extent to which a form uses debt financing • How You Compute: The ratio of total debt to total assets (c) 2001 Contemporary Engineering Economics

  15. Time-Interest-Earned Ratio • What It Measures: The ability of the firm to meet its annual interest payments • How You Compute: The ratio of earnings before interest and taxes (EBIT) to interest charges (c) 2001 Contemporary Engineering Economics

  16. Liquidity Analysis Ratios that show the relationship of a firm’s cash and other assets to its current liabilities • Current ratio • Quick ratio (c) 2001 Contemporary Engineering Economics

  17. Current Ratio • What It Measures: The extent to which the claims of short-term creditors are covered by assets • How You Compute:The ratio computed by dividing current assets by current liabilities (c) 2001 Contemporary Engineering Economics

  18. Quick (Acid Test) Ratio • What It Measures: The firm’s ability to pay off short-term obligations without relying on the sale of inventories. • How You Compute: This ratio is computed by deducting inventories from current assets and dividing the remainder by current liabilities. (c) 2001 Contemporary Engineering Economics

  19. Asset Management Analysis A set of ratios which measure how effectively a firm is managing its assets • Inventory turnover ratio • Days sales outstanding ratio • Total assets turnover ratio (c) 2001 Contemporary Engineering Economics

  20. Inventory Turnover • What It Measures: How effectively a firm is managing its inventories. • How You Compute: This ratio is computed by dividing sales by inventories (c) 2001 Contemporary Engineering Economics

  21. Days Sales Outstanding • What It Measures: The average length of time the firm must wait after making a sale before receiving payment (also known as, average collection period) • How You Compute: The ratio computed by dividing accounts receivables by average sales per day (c) 2001 Contemporary Engineering Economics

  22. Total Asset Turnover • What It Measures: How effectively the firm uses its plant and equipment in generating its sales • How You Compute: The ratio computed by dividing sales by total assets (c) 2001 Contemporary Engineering Economics

  23. Profitability Analysis A set of ratios which show the combined effects of liquidity, asset management, and debt on operating results • Profit margin on sales • Return on total assets • Return on common equity (c) 2001 Contemporary Engineering Economics

  24. Profit Margin on Sale • How It Measures: the profit per dollar of sales • How You Compute: Computed by dividing net profit after taxes by sales (c) 2001 Contemporary Engineering Economics

  25. Return on Common Equity • What It Measures: The rate of return on common stockholders’ investment • How You Compute: The ratio of net income after taxes to common equity (c) 2001 Contemporary Engineering Economics

  26. Market Trend Analysis A set of ratios that relate the firm’s stock price to its earnings and book value per share • P/E ratio • Market/book ratio (c) 2001 Contemporary Engineering Economics

  27. Price/Earnings Ratio • What It Measures: The dollar amount investors will pay for $1 of current earnings • How You Compute: The ratio of the price per share to earnings per share (c) 2001 Contemporary Engineering Economics

  28. Market/Book Ratio • What It Measures: Indicates how investors regard the company – a higher ratio indicates that investors are willing to bet a higher return on investment • How You Compute: The ratio of a stock’s market price to its book value (c) 2001 Contemporary Engineering Economics

  29. Limitations of Financial Ratios • Ratio analysis is useful, but analysts should aware of ever-changing market conditions and make adjustments necessary. • It is difficult to generalize about whether a particular ratio is good or bad. • Ratio analysis based on any one year may not represent the true business condition. (c) 2001 Contemporary Engineering Economics

  30. Summary The primary purposes of this chapter were (1) to describe the basic financial statements and (2) to present some background information on cash flows and corporate profitability, and (3) to discuss techniques used by investors and mangers to analyze them. (c) 2001 Contemporary Engineering Economics