Finance for Non-Financial Managers I Review of Basic Terms Asset/liability: An asset is an economic resource that a company owns. A liability is a resource

Finance for Non-Financial Managers I

Review of Basic Terms• Asset/liability: An asset is an economic resource that a company owns. A

liability is a resource that the company owes.• Book value/market value: Book value is the amount of an asset or liability

shown on the companies’ official financial statements based on the historical, or original, cost. Market value is the current value of the asset or liability. In most cases, book value does not equal market value.

• Capital goods: These are machines and tools used to produce other goods. • Depreciation/amortization: Depreciation is a system that spreads the cost of a

tangible asset, such as machinery, over the useful life of the asset. Amortization is a system that spreads the cost of an intangible asset, such as a patent, over the useful life of the asset.

• Fiscal year: A company’s financial reporting year. In most cases the fiscal year is not the same as the calendar year.

• Profit margin: This is profit—what the company’s owners keep after paying all the bills—a percentage of sales or revenues.

• Receivables/payables: Receivables are money owed to the company. Payables are money the company owes to others.

• Revenue/expenses: Revenue is income that flows into a company. Revenue includes sales, interest, and rents. Expenses are costs that are matched to a specific time period.


Managerial and Financial Accounting

Managerial accounting provides information for managers of an organization who direct and control its operations.

Financial accounting provides information to stockholders, creditors and others who are outside the organization.

Cash vs. Accrual Methods of Accounting

January Expenses

Rosie sells three Spouse Houses at $1,500 each, for cash.

She purchases the three Spouse Houses from Fred’s Sheds for $900 each. She pays him for two of the Spouse Houses ($1,800) and promises to pay him for the third one on February 5.

She pays $800 for her office ($400 for January rent and $400 as a security deposit).

She pays $150 to purchase a telephone and $30 for service during January.

She pays $300 for advertising in a newspaper.

On February 5, she receives an electric bill for electricity used in January for $100.

She charges the January rent of the automobile ($280) to her credit card, which she does not pay until February 15.



Cash AccountingBasic Concept (Cash Accounting and Accrual Accounting)

Report Version 1 (Cash Basis)

January ReportCash Receipts

Sale of 3 spouse houses $4,500Cash Disbursements

Purchase of 2 spouse houses $1,800Office deposit and rent 800Telephone purchase 150Telephone service 30Advertising 300

Total Cash Disbursements $3,080Excess of receipts over disbursements $1,420


Accrual Accounting

Basic Concept (Cash Accounting and Accrual Accounting)

Report Version 2 (Accrual Basis)

January ReportRevenues

Sale of 3 spouse houses $4,500Less Cost of Good Sold (3 Spouse Houses @ $900 each) (2,700)

Gross profit 1,800Expenses

Office rent $400Telephone service 30Automobile rent 280Electricity 100Advertising 300

Total Cash Disbursements $1,110Excess of receipts over disbursements $690


Gross Profit (Margin)

Selling price, each Spouse House

Subtract cost of each Spouse House

Gross profit (margin)

Gross profit (margin) percentage ($600/$1,500)

Markup percentage ($600/$900)

$1,500

(900)

$600

40%

67%


The Importance of Timing

• Matching principle: The accrual method matches revenues with associated expenses.

• Timing: The accrual method records revenue that has been earned but not paid and expenses owed but not paid.

• Cash flow: The accrual method does not track cash inflows and outflows.


Types of Sales

• Cash sales

• Credit sales

• Consignment (sale?)

• Secured sales

• Floor plan sales

• Sales of services

• Long-term contracts


Reduction of Sales

• Bad debts

• Sales returns

• Sales allowances

• Warranties

• Cash discounts


Allowance for Bad Debt

Year Sales ExpensesBad DebtIncurred

AccumulatedAllowance for

Bad Debt1 $250,000 $10,000 $10,000.002 650,000 26,000 36,000.003 1,500,000 60,000 $1,800 94,200.004 2,000,000 80,000 174,200.005 2,500,000 100,000 3,600 270,600.006 3,500,000 140,000 410,600.007 4,000,000 160,000 450,000 120,600.00


Cost of Sales

• Cost of Goods Sold (COGS)

• Inventory

• Freight on Purchases

• Discounts

• Cost of Services


Inventory Value

• FIFO

• LIFO

• Average Cost


FIFO vs. LIFONovember--First In, First Out (FIFO)

Sales of 10 Spouse Houses @ $1,500 15,000$ Subtract Cost of Goods Sold:

Inventory at beginning of November(4 houses @ $900 each) 3,600$

Purchase 15 houses @ $1,000 each 15,000

19 houses available for sale 18,600$ Subtract remaining inventory:

9 houses (purchased in November)@ $1,000 each 9,000

Cost of Spouse Houses sold 9,600

Gross profit 5,400$


FIFO vs. LIFONovember--Last In, First Out (LIFO)





9 houses, 5 @ $1,000 5,000 4 @ $900 each 3,600


Gross profit 5,000$


FIFO vs. LIFOInventoryavailablefor sale(at cost) FIFO LIFO

1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$

Purchased 1,000$ Left at end Sold during 1,000$ in November 1,000$ of November (9) November (10) 1,000$

1,000$ $9,000 $10,000 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ 1,000$ Sold during Left at end 1,000$ 1,000$ November (10) of November (9) 1,000$ 1,000$ $9,600 $8,600 1,000$

900$ 900$ Purchased 900$ 900$ in October 900$ 900$

900$ 900$

Total Inventory $18,600 $18,600


Average Cost MethodNovember--Average Cost Method





9 houses @ $979 ($18,600/19 = $979) 8,811


Gross profit 5,211$


Projected SalesSpouse House Company

Projection of Operating ReportMarch 2011

Projected Sales = 20 30 40

Sales of Spouse Houses 1,500$ 30,000$ 45,000$ 60,000$ Variable Expenses

Cost of goods sold 60.00% 18,000 27,000 36,000 Sales commissions 5.00% 1,500 2,250 3,000 Delivery 3.33% 1,000 1,500 2,000 Bad debt expense 4.00% 1,200 1,800 2,400 Warranty expense 2.00% 600 900 1,200 Liability insurance 0.24% 73 110 147 Product liability insurance 0.51% 153 230 307 Supplies, warehouse 0.31% 93 140 187 Business license 0.51% 153 230 307

Total variable expenses 22,773 34,160 45,547 Fixed Expenses

Executive salary 2,000 2,000 2,000 Administrative salaries 1,500 1,500 1,500 Warehouse and repair salaries 2,000 2,000 2,000 Advertising 2,000 2,000 2,000 Automobile 430 430 430 Worker's compensation insurance 110 110 110 Fire and casualty insurance 100 100 100 Rent 1,000 1,000 1,000 Supplies, office 30 30 30 Property taxes 130 130 130 Payroll taxes 550 550 550 Telephone 150 150 150

Total fixed expenses 10,000 10,000 10,000

Total expenses 32,773 44,160 55,547

Net income (loss) before income tax (2,773)$ 840$ 4,453$

Income tax 0 210 1,113 Net income (loss) (2,773)$ 630$ 3,340$


Break Even

Spouse House CompanyProjection of Variable Expenses per Spouse House

March 2011

Projected Sales 20 30 40

Total variable expenses 22,773$ 34,160$ 45,547$ Variable expense per house sold 1,139 1,139 1,139

Using the information from the previous slide, compute the variable cost per house:

Each house sells for $1,500

Subtract variable cost per house 1,139

Contribution toward fixed expenses $361

Divide the fixed cost by the contribution margin to determine how many houses must be sold to break even -- $10,000/361 = 27.7 or 28 houses (since you can’t sell .7 house).


Maintenance and Depreciation Expense

Depreciation and Maintenance Costs-Straight Line

0

5

10

15

20

25

30

1 2 3 4 5

Year of equipment life

Th

ou

san

ds

($)

Maintenance

Depreciation

Depreciation and Maintenance-Accelerated

0

5

10

15

20

25

30

1 2 3 4 5

Year of equipment lifeT

ho

usa

nd

s ($

)

Maintenance

Depreciation


Payback Method

Spouse House’s clients want three windows put in their houses. Assume it costs $300 per house for the supplier to install the windows. Spouse House could purchase an Automatic Window Machine that would cost $55,000 and would require the following expenses:

Salary for a carpenter for 1 hour $12

Benefit costs for the carpenter 8

Lumber and glass 65

Maintenance 10

Electricity 5

Total cash expenses $100

Depreciation expense 15

Total expenses $115


Payback Method (cont.)The computation of cash flow from the Automatic Window Machine from the previous slide is:

If Spouse House used the service of the supplier to install the windows, it would cost (per house) $300

If Spouse House used the Automatic Window Machine, the cash expense would be (per house) 100

The amount saved per house $200

Multiplied by the number of house sold annually x 100

Annual cash saved by purchasing the Automatic Window Machine $20,000

The payback, assuming no interest on a loan and $5,000 salvage value of the equipment would be 2.50 years ($50,000/$20,000).


Time Value of MoneyInterest earned on a $55,000 investment that can

earn 10% interest

Initial investment (present value) 55,000$ Interest, first year 5,500

Balance, end of first year 60,500 Interest, second year 6,050

Balance, end of second year 66,550 Interest, third year 6,655

Balance, end of third year 73,205 Interest, fourth year 7,321

Balance, end of fourth year 80,526 Interest, fifth year 8,053

Balance, end of fifth year 88,578

or, using a future value table, 55,000$ x 1.6105 = 88,578$


Time Value of Money (cont.)End of yr # 10% 15% 20% 25.365%

1 0.90909 0.86975 0.83333 0.79767

2 0.82645 0.75615 0.69444 0.63628

3 0.75132 0.65752 0.57870 0.50754

4 0.68302 0.57176 0.48225 0.40485

5 0.62093 0.49718 0.40188 0.32294Use the “10%” column to determine if purchase of the Automatic Window Machine should be purchased:

End of yr # Cash Flow Factor Present Value

1 $20,000 0.90909 $18,181

2 20,000 0.82645 16,529

3 20,000 0.75132 15,026

4 20,000 0.68302 13,660

5 25,000 0.62093 15,523

Total of present value 78,919

Since $78,919 is significantly greater than $55,000 the machine would be justified.



1 0.90909 0.86975 0.83333 0.79767

2 0.82645 0.75615 0.69444 0.63628

3 0.75132 0.65752 0.57870 0.50754

4 0.68302 0.57176 0.48225 0.40485

5 0.62093 0.49718 0.40188 0.32294

Using the above table to calculate the Internal Rate of Return on the $20,000 annual saving on a $55,000 investment with $5,000 salvage value:

Year Cash Flow Factor Present Value

1 $20,000 0.79767 $15,953

2 20,000 0.63628 12,725

3 20,000 0.50754 10,150

4 20,000 0.40485 8,097

5 25,000 0.32294 8,073

Total of Present Values $54,998



1 0.90909 0.86975 0.83333 0.79767

2 1.73554 1.62571 1.52778 1.43395

3 2.48685 2.28323 2.10648 1.94149

4 3.16987 2.85498 2.58873 2.34634

5 3.79079 3.35216 2.99061 2.66928

Using the above table to calculate the Internal Rate of Return on the $20,000 annual saving on a $55,000 investment with no salvage value:

$20,000 x = $50,000

X = 2.50

x > 25.365%


Cash Flow from Purchase of Equipment

Cash Flow from Purchase of Copy Machine

Existing cost (local printer) 5,000$ Subtract cash expenses if copy

machine is purchased:Paper 500$ Maintenance 1,500 Supplies 300 Electricity 100 Machine operator 1,000

Total cash expense 3,400

Cash flow 1,600$

Cost of machine 3,000$ Payback period (machine cost ÷ cash flow) = 1.88 years


Repair or ReplaceCash Flow Analysis--Repair or Replace

NewMachine

RefurbishOld

Alternative cost (printer) 5,000$ 5,000$

Subtract cash expenses:Paper 500 500 Maintenance 2,000 1,750 Supplies 500 500 Electricity 100 100 Machine operator 500 1,000

Total cash expenses 3,600 3,850 Cash flow 1,400$ 1,150$

Cost of machine 5,000$ 2,800$

Payback, in years 3.57 2.43 Internal rate of return 12.4% 30.0%

Documents

Finance for Non-Financial Managers I Review of Basic Terms Asset/liability: An asset is an economic resource that a company owns. A liability is a resource