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Review of Accounting
2 Chapter
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
2-2
Chapter Outline
• Income Statement
• Price-earnings Ratio
• Balance Sheet
• Statement of Cash Flows
• Tax-free Investments (Depreciation)
2-3
Basic Financial Statements
• Income Statement• Statement of Retained Earnings (a short
supplement to the income statement)
• Balance Sheet
• Statement of Cash Flows
2-4
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
2-5
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)
2-6
Income Statement (cont’d)
Table 2–1
2-7
Return to Capital
• Three primary sources of capital: – Bondholders (receive interest)– Preferred stockholders (receive dividends)– Common stockholders (receive dividends after
preferred 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
2-8
Statement of Retained Earnings
• Indicates disposition of earnings with:– any adjustments to previously reported income– any restrictions on cash dividends
2-9
Price-Earnings (P/E) Ratio
• Multiplier applied to earnings per share to determine current value of common stock
• Indicates expectations about the future of a company
• 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
2-10
Price-Earnings (P/E) Ratio (cont’d)
• Allows comparison of the relative market value of many companies
• Firms with higher expected returns will have higher P/E ratio
• Price-earnings ratios can be confusing
– Drop in earnings may not match the magnitude of the falloff in earnings, which causes increase in P/E ratio
2-11
Price-earnings Ratios for Selected U.S. Companies
• Expectations of returns and P/E ratios do change over time
2-12
Limitations of the Income Statement
• Income gained/lost during a given period is a function of verifiable transactions– Stockholders, hence, may perceive only a
much smaller gain/loss from actual day-to-day operations
• Flexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period
2-13
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– A picture of the firm at a point in time– Items are stated on an original cost basis
rather than at current market value
2-14
Balance Sheet Items
• Liquidity: Asset accounts are listed in order of liquidity– Current assets
• Items that can be converted to cash within one year– 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
2-15
Balance Sheet Items (cont’d)
– Prepaid expenses• Represent future expense items that are already paid
for
– Investments• Long-term commitment of funds (at least one year) • Includes stocks, bonds, or investments in other
corporations
– Plant and equipment• Carried at original cost minus accumulated
depreciation• Accumulated depreciation: Sum of past and present
depreciation charges on currently owned assets
2-16
Balance Sheet Items (cont’d)
– Total assets: Financed through liabilities or stockholders’ equity
• Liabilities are financial obligations of the firm and move from current liabilities (due within one year) to longer-term obligations
• Short-term obligations– Accounts payable (amount owed on open account to
suppliers)
– Notes payable (short-term signed obligations
– to the banker or other creditors)
– Accrued expense (payment not made for the obligation incurred on the services received)
2-17
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
2-18
Statement of Financial Position (Balance Sheet)
2-19
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
2-20
Limitations of the Balance Sheet
• Most of the values are based on historical/original cost price– Troublesome when it comes to plant and
equipment and inventory
• FASB ruling on disclosure of inflation adjustments no longer in force – It is purely a voluntary act on the part of the
company
2-21
Limitations of the Balance Sheet (cont’d)
• Differences between per share values may be due to:– Asset valuation– Industry outlook– Growth prospects– Quality of management– Risk-return expectations
2-22
Comparison of Market Valueto Book Value per Share
2-35
Depreciation and Funds Flow
• Depreciation – A noncash expense– Not a ‘new’ source of funds– Added back to net income to determine
amount of actual funds on hand– Attempt to allocate the initial cost of an asset
over its useful life
• Charging of depreciation does not directly influence the movement of funds
2-37
Free Cash Flow
Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends– Capital expenditures
• Maintain productive capacity of firm
– Dividends• Maintain necessary payout on common stock and to
cover any preferred stock obligations
• Free cash flow is used for special financing activities– Example: leveraged buyouts
2-38
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 - Interest, Travel expenditures, Salaries, etc.
Corporation A Corporation BEarnings before interest and taxes…………. $400,000 $400,000Interest…………………………………………… 100,000 0
_________ _________
Earnings before taxes (taxable income)…… 300,000 400,000Taxes (40%)……………………………………… 120,000 160,000
_________ _________ Earnings after taxes…………………………… $180,000 $240,000Difference in earnings after taxes…………… $60,000
2-39
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 BEarnings before depreciation and taxes…… $400,000 $400,000Depreciation……………………………………… 100,000 0
_________ _________
Earnings before taxes………………………… 300,000 400,000Taxes (40%)……………………………………… 120,000 160,000
_________ _________ Earnings after taxes…………………………… 180,000 240,000+Depreciation charged without cash outlay… 100,000 0
_________ _________ Cash flow………………………………………… $280,000 $240,000Difference………………………………………… $40,000