Finansal Yönetim Review of Accounting Chapter McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Review of Accounting 22- 2 Chapter Outline Income Statement • Price-earnings Ratio • Balance Sheet • Statement of Cash Flows • Tax-free Investments (Deprecation) •2- 3 Basic Financial Statements 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 deducted2- 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)2- 7 Return to Capital Three primary sources of capital: • Bondholders – Preferred stockholders – Common 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 Statement of retained earnings • Indicates disposition of earnings –2- 8 Statement of Retained Earnings2- 9 Price-Earnings (P/E) Ratio Multiplier applied to earnings per share to • determine current value of common stock 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 based on $1 of earnings per share Indicates expectations about the future of a – company Price-earnings ratios can be confusing •2- 11 Price-earnings Ratios for Selected US Companies2- 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 period2- 13 Balance Sheet Indicates what the firm owns and how these • assets are financed in the form of liabilities or ownership interest Delineates (describes) the firm’s holdings and – obligations Items are stated on an original cost basis rather – than at current market value2- 14 Balance Sheet Items Liquidity: Asset accounts are listed in order • of liquidity Current assets – Items that can be converted to cash within 12 months • Marketable securities – Temporary investments of excess cash • Accounts receivable – Allowance for bad debts must be taken into account to • determine their anticipated collection value Inventory – Includes raw materials, goods in progress, or finished • goods2- 15 Balance Sheet Items (cont ’ d) Prepaid expenses – Represent future expense items that are already paid • for Investments – Long-term commitment of funds • Includes stocks, bonds, or investments in other • companies Plant and equipment – Carried at original cost minus accumulated • depreciation Accumulated depreciation • Sum of past and present depreciation charges on currently – owned assets2- 16 Balance Sheet Items (cont ’ d) Depreciation expense is the current year’s charge • Total assets: Financed through liabilities or – stockholders’ equity Short-term obligations • Accounts payable – Notes payable – Accrued expense –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 (problematic) 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 – company2- 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 Value to Book Value per Share2- 23 Statement of Cash Flows Emphasizes critical nature of cash flow to • the operations of the firm It represents cash/cash equivalents items easily – convertible to cash within 90 days Cash flow analysis helps in combating • (fighting with) discrepancies faced through accrual method of accounting2- 24 Statement of Cash Flows (cont ’ d) Advantage of accrual method • Allows matching of revenues and expenses in – the period in which they occur to appropriately measure profits Disadvantage of accrual method • Adequate attention not directed to actual cash – flow position of firm2- 25 Concepts Behind the Statement of Cash Flows2- 26 Determining Cash Flows from Operating Activities Translation of income from operations from • an accrual to a cash basis Direct method • Every item on the income statement is adjusted – from accrual to cash accounting Indirect method • Net income represents the starting point – Required adjustments are made to convert net – income to cash flows from operations2- 27 Indirect Method2- 28 Comparative Balance Sheets2- 29 Cash Flows from Operating Activities2- 30 Determining Cash Flows from Investing Activities Investing activities: • Long-term investment activities in mainly plant – and equipment Increasing investments represent a use of funds • Decreasing investments represent a source of funds •2- 31 Determining Cash Flows from Financing Activities Financial activities apply to the • sale/retirement of: Bonds – Common stock – Preferred stock – Other corporate securities – Payment of cash dividends – Sale of firm’s securities is a source of funds • Payment of dividends and repurchase of securities is • a use of funds2- 32 Overall Statement Combining the Three Sections2- 33 Analysis of the Overall Statement How are increases in long-term assets being • financed? Preferably, adequate long-term financing • and profits should exist Short-term funds may be used to carry long- • term needs – could be a potential high-risk situation Example: trade credit and bank loans –2- 34 Depreciation and Funds Flow Depreciation • Attempt to allocate the initial cost of an asset – over its useful life Charging of depreciation does not directly • influence the movement of funds2- 35 Comparison of Accounting and Cash Flows2- 36 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- 37 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 •2- 38 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 B Earnings before depreciation and taxes …… $400,000 $400,000 Depreciation ……………………………………… 100,000 0 _________ _________ Earnings before taxed ………………………… 300,000 400,000 Taxes (40%) ……………………………………… 120,000 160,000 _________ _________ Earnings after taxes …………………………… 180,000 240,000 +Depreciation charged without cash outlay … 100,000 0 _________ _________ Cash flow ………………………………………… $280,000 $240,000 Difference ………………………………………… $40,000