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ReviewofAccounting
ChapterOutlineIncomeStatementPrice-earningsRatioBalanceSheetStatementofCashFlowsTax-freeInvestments(Depreciation)BasicFinancialStatementsIncomeStatementStatementofRetainedEarnings(ashortsupplementtotheincomestatement)BalanceSheetStatementofCashFlowsIncomeStatementDevicetomeasuretheprofitabilityofafirmoveraperiodoftimeItcoversadefinedperiodoftimeItispresentedinastair-steporprogressivefashiontoexamineprofitorlossaftereachtypeofexpenseitemisdeductedIncomeStatement(cont’d)Sales–CostofGoodsSold(COGS)=GrossProfit(GP)GP–Expenses=EarningsBeforeInterestandTaxes(EBIT)orOperatingIncome(OI)EBIT–Interest=EarningsBeforeTaxes(EBT)EBT–Taxes=EarningsAfterTaxes(EAT)orNetIncome(NI)IncomeStatement(cont’d)Table2–1ReturntoCapitalThreeprimarysourcesofcapital:Bondholders(receiveinterest)Preferredstockholders(receivedividends)Commonstockholders(receivedividendsafterpreferredstockholders)EarningspershareInterpretedintermsofnumberofoutstandingsharesMaybepaidoutindividendsorretainedbycompanyforsubsequentreinvestmentStatementofRetainedEarningsIndicatesdispositionofearningswith:anyadjustmentstopreviouslyreportedincomeanyrestrictionsoncashdividendsPrice-Earnings(P/E)RatioMultiplierappliedtoearningspersharetodeterminecurrentvalueofcommonstockIndicatesexpectationsaboutthefutureofacompanySomefactorsthatinfluenceP/E:EarningsandsalesgrowthofthefirmRisk(volatilityinperformance)Debt-equitystructureofthefirmDividendpaymentpolicyQualityofmanagementPrice-Earnings(P/E)Ratio(cont’d)AllowscomparisonoftherelativemarketvalueofmanycompaniesFirmswithhigherexpectedreturnswillhavehigherP/EratioPrice-earningsratioscanbeconfusingDropinearningsmaynotmatchthemagnitudeofthefalloffinearnings,whichcausesincreaseinP/EratioPrice-earningsRatios
forSelectedU.S.CompaniesExpectationsofreturnsandP/EratiosdochangeovertimeLimitationsoftheIncomeStatementIncomegained/lostduringagivenperiodisafunctionofverifiabletransactionsStockholders,hence,mayperceiveonlyamuchsmallergain/lossfromactualday-to-dayoperationsFlexibilityinreportingtransactionsmightresultindifferingmeasurementsofincomegainedfromsimilareventsattheendofatimeperiodBalanceSheetIndicateswhatthefirmownsandhowtheseassetsarefinancedintheformofliabilitiesorownershipinterestDelineatesthefirm’sholdingsandobligationsApictureofthefirmatapointintimeItemsarestatedonanoriginalcostbasisratherthanatcurrentmarketvalueBalanceSheetItemsLiquidity:AssetaccountsarelistedinorderofliquidityCurrentassetsItemsthatcanbeconvertedtocashwithinoneyearMarketablesecuritiesTemporaryinvestmentsofexcesscashAccountsreceivableAllowanceforbaddebtstodeterminetheiranticipatedcollectionvalueInventoryIncludesrawmaterials,goodsinprogress,orfinishedgoodsBalanceSheetItems(cont’d)PrepaidexpensesRepresentfutureexpenseitemsthatarealreadypaidforInvestmentsLong-termcommitmentoffunds(atleastoneyear)Includesstocks,bonds,orinvestmentsinothercorporationsPlantandequipmentCarriedatoriginalcostminusaccumulateddepreciationAccumulateddepreciation:SumofpastandpresentdepreciationchargesoncurrentlyownedassetsBalanceSheetItems(cont’d)Totalassets:Financedthroughliabilitiesorstockholders’equityLiabilitiesarefinancialobligationsofthefirmandmovefromcurrentliabilities(duewithinoneyear)tolonger-termobligationsShort-termobligationsAccountspayable(amountowedonopenaccounttosuppliers)Notespayable(short-termsignedobligationstothebankerorothercreditors)Accruedexpense(paymentnotmadefortheobligationincurredontheservicesreceived)Stockholder’sEquityRepresentstotalcontributionandownershipinterestofpreferredandcommonstockholdersPreferredstockCommonstockCapitalpaidinexcessofparRetainedearningsStatementofFinancialPosition(BalanceSheet)ConceptofNetWorthNetworth/bookvalue=Stockholders’equity–preferredstockcomponentMarketvalueisofprimaryconcerntothe:FinancialmanagerSecurityanalystStockholdersLimitationsoftheBalanceSheetMostofthevaluesarebasedonhistorical/originalcostpriceTroublesomewhenitcomestoplantandequipmentandinventoryFASBrulingondisclosureofinflationadjustmentsnolongerinforceItispurelyavoluntaryactonthepartofthecompanyLimitationsoftheBalanceSheet(cont’d)Differencesbetweenpersharevaluesmaybedueto:AssetvaluationIndustryoutlookGrowthprospectsQualityofmanagementRisk-returnexpectationsComparisonofMarketValue
toBookValueperShareStatementofCashFlowsEmphasizescriticalnatureofcashflowtotheoperationsofthefirmItrepresentscash/cashequivalentsitemseasilyconvertibletocashwithin90daysAdvantageofaccrualmethodAllowsmatchingofrevenuesandexpensesintheperiodinwhichtheyoccurtoappropriatelymeasureprofitsStatementofCashFlows(cont’d)DisadvantageofaccrualmethodAdequateattentionnotdirectedtoactualcashflowpositionoffirmCashflowanalysishelpsincombatingdiscrepanciesfacedthroughaccrualmethodofaccountingSectionsofaStatementofCashFlowsThreeprimarysectionsofthestatementofcashflows:CashflowsfromoperatingactivitiesCashflowsfrominvestingactivitiesCashflowsfromfinancingactivitiesTheresultsofthreesectionsareaddedtogethertocomputethenetincreaseordecreaseincashflowConceptsBehindtheStatementofCashFlowsDeterminingCashFlowsfromOperatingActivitiesTranslationofincomefromoperationsfromanaccrualtoacashbasisDirectmethodEveryitemontheincomestatementisadjustedfromaccrualtocashaccountingIndirectmethodNetincomerepresentsthestartingpointRequiredadjustmentsaremadetoconvertnetincometocashflowsfromoperationsNetCashFlowsfrom
OperatingActivities(IndirectMethod)ComparativeBalanceSheetsTable2–6CashFlowsfromOperatingActivitiesDeterminingCashFlowsfromInvestingActivitiesInvestingactivities:Long-terminvestmentactivitiesinmainlyplantandequipmentIncreasinginvestmentsrepresentauseoffundsDecreasinginvestmentsrepresentasourceoffundsDeterminingCashFlowsfromFinancingActivitiesFinancialactivitiesapplytothesale/retirementof:BondsCommonstockPreferredstockOthercorporatesecuritiesPaymentofcashdividendsSaleoffirm’ssecuritiesisasourceoffundsPaymentofdividendsandrepurchaseofsecuritiesisauseoffundsOverallStatement
CombiningtheThreeSectionsAnalysisoftheOverallStatementHowareincreasesincurrentassetsbeingfinanced?Isthereanassociatedbuildupincurrentliabilities?Howareincreasesinlong-termassetsbeingfinanced?Preferably,adequatelong-termfinancingandprofitsshouldexisttofinancelong-termassetsShort-termfundsmaybeusedtocarrylong-termneeds–couldbeapotentialhigh-risksituationasshort-termsourcesoffundsmaydryupwhilelong-termneedscontinuetodemandfundingDepreciationandFundsFlowDepreciationAnoncashexpenseNota‘new’sourceoffundsAddedbacktonetincometodetermineamountofactualfundsonhandAttempttoallocatetheinitialcostofanassetoveritsusefullifeChargingofdepreciationdoesnotdirectlyinfluencethemovementoffundsComparisonofAccounting
andCashFlowsFreeCashFlowFreeCashFlow=Cashflowfromoperatingactivities–Capitalexpenditures–DividendsCapitalexpendituresMaintainproductivecapacityoffirmDividendsMaintainnecessarypayoutoncommonstockandtocoveranypreferredstockobligationsFreecashflowisusedforspecialfinancingactivitiesExample:leveragedbuyoutsIncomeTaxConsiderationsCorporatetaxratesProgressive:thetoprateis40%includingstateandforeigntaxesifapplicable.Thelowerbracketis15–20%Costofatax-deductibleexpense-Interest,Travelexpenditures,Salaries,etc.
CorporationA CorporationBEarningsbeforeinterestandtaxes…………. $400,000 $400,000Interest…………… 100,000 0 _________
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