Overview of Accounting and Finace

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Finance

Finance can be thought of as the study of thefollowing three questions:

1- In what long-lived assets should the firminvest?

2- How can the firm raise cash for requiredcapital expenditures?

3- How should short-term operating cash flowsbe managed?

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Financial Statement Analysis

The objective is to show how to rearrange

information from financial statements intofinancial ratios that provide information aboutfive areas of financial performance:

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Financial Statement Analysis (Cont.)

1. Short-term solvency

2. Activity

3. Financial Leverage

4. Profitability

5. Value

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Short-Term Solvency


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Short-Term Solvency

Ratios of short-term solvency measure the abilityof the firm to meet recurring financial

obligations (that is, to pay its bills).

The most widely used measures of accountingliquidity are the current ratio and the quick ratio.

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Short-Term Solvency

Current ratio= Total current

assets/ Total current liabilities

Quick ratio= *Quick assets/

Total current liabilities

* Quick assets= Total current assets- inventories

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Activity

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Activity

Ratios of activity are constructed

to measure how effectively thefirms assets are being managed.

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Activity

Total asset turnover= Total operatingrevenues/ Total assets

This ratio is intended to indicate howeffectively a firm is using all of its assets. Ifthe asset turnover ratio is high, the firm is

presumably using its assets effectively ingenerating sales.

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Activity

Receivables Turnover= Total

operating revenues/Receivables

Average collection period=Days in period(365)/Receivables turnover

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The receivables turnover ratio and the

average collection period provide someinformation on the success of the firm inmanaging its investment in accountsreceivable.

The actual value of these ratios reflects thefirms credit policy. If a firm has a liberalcredit policy, the amount of its receivableswill be higher than would otherwise be thecase.

One common rule of thumb that financialanalysts use is that the average collectionperiod of a firm should not exceed the timeallowed for payment in the credit terms bymore than 10 days.

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Activity

Inventory Turnover= Cost of goods sold/Inventory

The inventory ratio measures howquickly inventory is produced and

sold. It is significantly affected by theproduction technology of goods beingmanufactured.

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Financial Leverage

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Financial Leverage

Financial leverage is related to the extent towhich a firm relies on debt financing ratherthan equity.

Measures of financial leverage are tools indetermining the probability that the firm

will default on its debt contracts. The moredebt a firm has, the more likely it is that the

firm will become unable to fulfill itscontractual obligations (too much debt canlead to a higher probability of insolvencyand financial distress).

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Financial Leverage

Debt ratio= Total debt/ Total assets

Debt-to-equity ratio= Total debt/ Totalequity

Equity multiplier= Total assets/ Totalequity

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Financial Leverage

Interest Coverage= Earnings beforeinterest and taxes/ Interest expense

Interest expense is an obstacle that a firmmust surmount if it is to avoid default.

The ratio of interest coverage is directlyconnected to the ability of the firm to payinterest.

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Profitability

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Profitability

Profitability ratios measure the extentto which a firm is profitable.

The most important conceptualproblem with accounting measures ofprofitability is they do not give us abenchmark for making comparisons.

In general, a firm is profitable in theeconomic sense only if its profitabilityis greater than investors can achieveon their own in the capital markets.

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Profitability

Net profit margin= Net income/ Totaloperating revenues

Gross profit margin= Earnings beforeinterest and taxes/ Total operatingrevenues

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Profit Margins

In general, profit margins reflect thefirms ability to produce a product orservice at a low cost or a high price.

Profit margins are not direct measuresof profitability because they are basedon total operating revenue, not on theinvestment made in assets by the firmor the equity investors.

Trade firms tend to have low marginsand service firms tend to have highmargins.

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Profitability

Net Return on Assets= Net income/Average total assets

Gross return on assets= Earnings beforeinterest and taxes/ Average total assets

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Profitability

One of the most interesting aspects of returnon assets (ROA) is how some financial ratioscan be linked together to compute ROA.

One implication of this is usually referred toas the DuPont system of financial control.

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Profitability

ROE= Profit margin * Asset turnover * Equitymultiplier

= (Net income/ TOR* ) * (TOR/ ATA* *) * (ATA/ASE* * *)

* TOR: Total Operating Revenue

** ATA: Average Total Assets

*** ASE: Average stockholders equity

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Value

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Value

One very important characteristic of afirm that cannot be found on an

accounting statement is its market value.

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Value

1- Market price

2- Price-to-earnings (P/E) ratio

3- Dividend Yield

4- Market-to-book (M/B) value ratio

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Value

1- Market price: The market price of a share ofcommon stock is the price that buyers and

sellers establish when they trade the stock.The market value of the common equity of afirm is the market price of share of commonstock multiplied by the number of sharesoutstanding.

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Value

2- Price-to-earnings (P/E) ratio: One way tocalculate the P/E ratio is to divide the current

market price by the earnings per share ofcommon stock for the latest year.

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Value

3- Dividend Yield= Dividends per share/Market price per share.

Dividends yields are related to the marketsperception of future growth prospects forfirms. Firms with high growth prospects will

generally have lower dividend yields.

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Value

4- Market-to-book (M/B) value ratio:

It is calculated by dividing the market price pershare by the book value per share.

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Accounting is the process of measuring, interpreting, and

communicating financial information to support internal andexternal business decision making.


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Financing activities provide necessary funds tostart a business and expand it after it beginsoperating.

Investing activities provide valuable assetsrequired to run a business.

Operating activities focus on selling goods and

services, but they also consider expenses asimportant elements of sound financialmanagement.


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Public Accountants

Provide accounting services to individuals orbusiness firms for a fee

Management Accountants

Provide timely, relevant, accurate, and conciseinformation that executives can use to operatetheir firms

Government and Not-for-ProfitAccountants


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Generally accepted accounting principles (GAAP) encompass

the conventions, rules, and procedures for determining acceptable

accounting practices at a particular time.

Financial Accounting Standards Board (FASB) is primarilyresponsible for evaluating, setting, or modifying GAAP in the U.S.

Sarbanes-Oxley Act responded to cases of accounting fraud.

Created the Public Accounting Oversight Board, which sets audit

standards and investigates and sanctions accounting firms that certify

the books of publicly traded firms.

Senior executives must personally certify that the financial

information reported by the company is correct.

Resulted in increase in demand for accountants.
http://www.fasab.gov/accepted.htmlhttp://www.fasb.org/http://www.fasb.org/http://www.fasab.gov/accepted.html


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Accounting process -set of activities involved in converting

information about transactions

into financial statements.


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Assets -anything of value owned or leased by a business.

Liability -claim against a firms assets by a creditor.

Owners equity -all claims of the proprietor, partners, or

stockholders against the assets of a firm, equal to the excess of

assets over liabilities.

Basic accounting equation - relationship that states that assets

equal liabilities plus owners equity.

Double-entry bookkeeping - process by which accounting

transactions are entered; each individual transaction always has an

offsetting transaction.


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Simplifies the accounting process by automating data entry and

calculations.

Available products are customized for businesses of different sizes.

Entrepreneurs and small businesses use: QuickBooks, Peachtree, andBusinessWorks.

Larger firms use larger scale software packages like: Computer

Associates, Oracle, and SAP.

Software that handles accounting information for internationalbusinesses is another option. Offers different country

information/language.

Some systems offer web-based packages for small and medium

businesses.
http://quickbooks.intuit.com/http://www.peachtree.com/http://www.blytheco.com/businessworks/default.asphttp://www.ca.com/http://www.ca.com/http://www.oracle.com/http://www.sap.com/http://www.sap.com/http://www.oracle.com/http://www.ca.com/http://www.ca.com/http://www.blytheco.com/businessworks/default.asphttp://www.peachtree.com/http://quickbooks.intuit.com/


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Balance sheet - statement of a firms financial position

what it owns and the claims against its assetsat a

particular point in time.

Photograph of firms assets together with its liabilities and

owners equity

Follows the accounting equation


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Income Statement - financial record of a companys

revenues and expenses, and profits over a period of

time.

Firms financial performance in terms of revenues,

expenses, and profits over a given time period.

Reports profit or loss.

Focus on revenues and costs associated with

revenues.


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Statement of Owners Equity - is designed to show the

components of the change in equity from the end of one

fiscal year to the end of the next.

Begins with the amount of equity shown on the balance

sheet.

Net income is added, and cash dividends paid to ownersare subtracted.


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Statement of cash flows - a firms cash receipts and cash

payments that presents information on its sources and

uses of cash.

Accrual accounting - method that records revenue and

expenses when they occur, not necessarily when cash

actually changes hands.


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Ratio analysis - tool for measuring a firms liquidity, profitability, and

reliance on debt financing, as well as the effectiveness of managements

resource utilization.


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Acid-test (or quick)ratio

measures the ability of a

firm to meet its debt

payments on short notice.

Cash and equivalents

+ short-term investments

+ accounts receivable


Current ratio compares

current assets to current

liabilities.

Total current assets



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Inventory turnoverratio indicates the

number of times

merchandise moves

through a business.

Net sales

Average of inventory

Total asset turnover ratio

indicates how much in

sales each dollar invested

in assets generates.

Net sales

Average of total assets


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Profitability ratiosmeasure the organizations overall financial

performance by evaluating its ability to generate revenues in excess of

operating costs and other expenses.


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Leverage ratios measure the extent to which a firm relies on debt

financing.

Total liabilities to total assets ratio > 50 percent indicates that a firm

is relying more on borrowed money than owners equity.


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International Accounting Standards Committee (IASC) promotes

worldwide consistency in financial reporting practices. In 2001,

became theInternational Accounting Standards Board (IASB).

International Financial Reporting Standards (IFRS) are the

standards.

Exchange Rates -ratio at which a countrys currency can be

exchanged for other currencies.

Consolidated financial statements must reflect gains and losses due

to changes in exchange rates.

Can have significant impact on financial statement.

Documents

Overview of Accounting and Finace