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Financial background my ppt @ bec doms
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Financial Background: A Review of Accounting,
Financial Statements, and Taxes
2
The Nature of Financial Statements
Three Financial Statements Income statement Balance sheet Statement of cash flows
Generated from the income statement and balance sheet
3
The Accounting System
The Double Entry System In double entry accounting every entry has two
sides that must balance
Example: Borrowing $1,000 to buy a machine, involves increasing an asset account by $1,000 increasing a liability account by $1,000
4
The Accounting System
Accounting Periods and Closing the Books Books are closed by updating the period’s transactions in the
accounting system and creating financial statements
Implications Last period’s statements don’t say anything about what WILL
happen next year Can be used to make predictions
Stocks and Flows Income statement reflects money flows over a period of time Balance sheet represents stocks of money at a point in time
5
A Typical Income StatementSales (Revenue) $1,000
Cost of Goods Sold 600
Gross Margin $ 400
Expenses 230
Earnings bef. interest & tax $ 170
Interest expense 20
Earnings before tax $ 150
Tax 50
Earnings after tax $ 100
6
The Income Statement
Sales or Revenue Total receipts from selling goods from
normal business operations
Cost and Expense Represent money spent to do business
Costs of Goods Sold — money spent on items closely related to the production of the product or service being sold
Expense — spending on items that aren’t closely related to production (such as marketing)
7
The Income Statement
Gross Margin (GM) Represents sales revenue less cost of goods sold
Fundamental measure of profitability
Interest Price the firm pays for borrowing money
Earnings Before Interest and Taxes (EBIT) Profit before considering financing charges
Also called “operating profit” Helps judge the strength of business operations without
onsidering the interest expense a firm with debt pays
8
The Income Statement
Earnings Before Tax (EBT) and Tax Earnings before taxes (EBT) represent gross margin
less all expenses except taxes Tax refers to income taxes on EBT
Net Income (also Earnings After Tax or EAT) Represents the “bottom line”—calculated by
subtracting tax from EBT Belongs to the company’s owners and can be paid out
as dividends or retained
9
The Balance Sheet
Has two sides Assets = liabilities + equity
Also called a Statement of Financial Position
Assets and liabilities are arranged in order of decreasing liquidity Liquidity – ease with which an asset becomes cash
10
A Conventional Balance Sheet Format
11
Assets
Cash Money in checking
accounts plus currency on hand
Marketable securities are liquid investments held instead of cash Short-term, modest
return, low risk
Accounts ReceivableRepresent credit sales that have not yet been paidBad Debt Reserve: some credit sales will never be paidWrite Off: When a receivable is uncollectible, it is taken out of the balance. A like amount is subtracted from the bad debt reserve leaving the net unchanged
12
Assets
Inventory Product held for sale in the normal course of
business Work-In-Process Inventories
As inventory moves through the production process, value is added increasing the balance
The Inventory Reserve Some inventory is usually unusable - inventory
balances are reported net of a reserve Writing Off Bad Inventory
Missing, damaged, or obsolete items are removed and a like subtraction made from the reserve
13
Assets
Overstatements If assets (usually receivables and inventory) are
overstated – firm’s value is less than the amount shown on the balance sheet Can mean a firm is not managed efficiently
Current Assets Become cash within one year Include cash, accounts receivable and inventory Money received from normal business operations
flows through these accounts
14
Assets
Fixed Assets Long lived – not physically fixed Sometimes called property, plant and equipment (PPE) Useful life of at least a year
Depreciation Spreads asset’s cost over its estimated useful life Matching principle – an asset’s cost should be recognized over a
period matching its service life
Financial Statement Representation Depreciation on the income statement reflects an asset’s cost, the
same depreciation also appears on the balance sheet reflecting a wearing out
15
Assets
Disposing of a Used Asset An asset may be sold for more or less than the net asset value on
the books
The Life Estimate An asset remaining in use beyond its depreciation life is “fully
depreciated”
Tax Depreciation and Tax Books Government allows different depreciation schedules for tax
purposes and financial reporting purposes Tax books – financial records generated using tax rules Financial books – regular financial statements
16
Liabilities
What a company owes to outsiders
Accounts Payable Arise when a firm buys from vendors on credit
Trade Credit – vendor delivers product without demanding immediate payment
Terms of Sale Specify when payment is due on credit
sales and the early payment discount 2/10, n/30 - payment in 30 days with a 2% discount
if paid within 10 days
17
Liabilities
Accruals Represent incomplete transactions Recognizes expenses and liabilities associated with
incomplete transactions Common example is a Payroll Accrual
Current Liabilities Require cash within one year Includes payables, accruals, notes payable, short-term
loans, long-term debt due within the year
18
Working Capital
Total current assets are gross working capital – required to run a business day to day
Net working capital is the difference between current assets and current liabilities Can’t run a business without it
19
Liabilities
Long-Term Debt The most significant non-current liability Consists of bonds and long-term loans
Leverage A business partially financed with debt is leveraged
In good times leverage enhances return on investment But in bad times it makes return on investment worse
Fixed Financial Charges The most significant concern about borrowed money is fixed
interest charges Interest Must be paid regardless of profitability
Can lead to bankruptcy in bad times I.e., too much debt can cause business failure
20
Leverage
21
Equity
Funds supplied to a business by owners Direct investment – price paid for stock or
entrepreneur’s contribution Retained earnings – profits kept in the business rather
than paid to owners
Balance sheet Representation of Equity Money paid for stock
Common stock account carries a par value per share Par is an arbitrary number
Excess or surplus represents amounts paid for the stock in excess of (over) par value
22
Equity
Retained Earnings Profits that have not been distributed to
owners As dividends if firm is a corporation
Do not represent a reserve of cash Adds up all the earnings ever retained by the
firm
23
Example: Equity Accounts
A firm is started by selling 20,000 shares of $2 par value stock at $8 per share. Subsequently the company earns $70,000 out of which it pays dividends of $15,000
Common stock ($2 x 20,000 =) $ 40,000Paid in excess ($6 x 20,000=) 120,000Retained earnings
($70,000 - $15,000 =) 55,000Total equity $215,000
24
The Relationship Between Net Income and Retained Earnings
If no dividends are paid and no new stock is sold Beginning equity + net income = ending equity
If dividends are paid Beginning equity + net income – dividends
= ending equity
If new stock is sold Beginning equity + net income – dividends + stock
= ending equity
25
Equity
Preferred Stock Equity that has some of the characteristics of
debt Although a “hybrid,” it is classified as equity
Total Capital The sum of long-term debt and equity
Total Liabilities and Equity Sum of the right-hand side of the balance sheet Must always equal total assets
26
The Tax Environment
Taxing Authorities and Tax Bases Taxes are imposed by various government
authorities Federal, state and local
A tax base is the item that is taxed Income, wealth or consumption
27
Taxing Authorities and Tax Bases
Income Tax Individuals pay a fraction of income in a
certain time period to the taxing authority
Wealth Tax Based on the value of certain types of assets, usually
real estate Consumption Tax
Based on the amount of certain goods used, usually sales taxes
28
Income Taxes—The Total Effective Tax Rate
Total effective tax rate (TETR) is the combined rate to which the taxpayer is subject State tax is deductible from income when calculating
federal tax
TETR = Tfederal tax rate + Tstate tax rate(1 – Tfederal tax rate)
If a taxpayer is subject to a 30% federal tax rate and a 10% state tax rate, the TETR is 30% + 10%(1 – 30%) = 37% Less than the sum of the two rates
29
Progressive Tax Systems, Marginal and Average Rates
Progressive tax system - higher tax rates on incrementally higher income
Tax bracket - range of income in which the tax rate is constant
Marginal tax rate - rate paid on the next dollar of income a taxpayer earns
Average tax rate - the percentage of total income paid in taxes
30
Progressive Tax Systems, Marginal and Average Rates
Q: Given the following tax brackets, calculate the tax on an income of $11,000. Also calculate the taxpayer’s marginal and average rates.
A: Since the taxpayer earned more than $5,000 (but less than $15,000) she will be taxed at two rates. The first $5,000 is taxed at 10%: $5,000 x .10 = $ 500 The remaining $6,000 is taxed at 15% $6,000 x .15 = $ 900 Thus, her total tax is $1,400
Her marginal tax rate is 15%, since she would pay that on her next dollar of income, and her average tax rate is $1,400 $11,000 = 12.7%
Exa
mpl
e 25%Over $15,000
15%$5,000 - $15,000
10%0 - $5,000
Tax RateBracket
31
Capital Gains and Losses
Two major types of income
Ordinary income results from normal money-making activity Wages, business profits, dividends and interest Negative profits are an ordinary loss
Capital gains or loss arises when something is purchased, held for a while and sold at a different price
32
The Tax Treatment of Capital Gains and Losses
Historically capital gains have been taxed at lower rates than ordinary income
If holding period < 1 year then short-term capital gain is not eligible for favorable tax treatment
Gains on assets held for > 1 year qualify for long-term treatment Tax rate capped at 15% for individuals Capital losses offset capital gains Corporations do not receive favorable rates on capital gains
33
Personal Taxes Taxes on people (households) are called
personal or individual taxes Separate schedules exist for single individuals,
married couples filing jointly, married people filing separately and certain heads of household
Between 2001 and 2003 Congress lowered personal tax rates to stimulate the economy Before 2001 the top rate was 39.6% Since 2003 it is 35%
34
Personal Tax Schedules - 2006 Table 2.4
35
Personal Taxes
Tax Rates and Investment Decisions When comparing municipal bond investments to
corporate bonds, an adjustment must be made
Interest on muni’s are not taxed If a muni and corporate bond, of similar risk, are paying the
same rate, the muni’s return is higher after taxes If the rates differ, the corporate bond must be adjusted to an
after tax yield by multiplying by
(1 – marginal tax rate)
36
Example 2.2 - Comparing Corporate and Municipal Bonds
The Smith family has the following choiceAT&T 11%Boston 9%
State AT&T after tax at marginal rate11% (1 - .25) = 8.25%Boston bond is better
If marginal rate is 15%, AT&T is better: 11% (1 - .15) = 9.35%
37
Corporate Taxes
Similar in principle to personal taxes Total income is business revenue Deductions are the charges and expenditures required to run the
company Exemptions are not allowed
Earnings Before Tax (EBT) is taxable income
Corporate tax rates do not consistently rise as taxable income rises With personal taxes taxpayers pay a lower rate on income in the
bottom brackets Corporate tax tables are constructed so that firms with high
incomes pay a constant rate on all of their income
38
Corporate Income Tax ScheduleTable 2.5
The rate increases from 34% to 39% and 35% to 38% recover the benefit of lower rates on earlier income. So a corporation earning more than
$18,333,333 pays 35% on all of its income from the first dollar.
39
Corporate TaxesExample 2.3
Q: Calculate, using the corporate tax rates in Table 2.5, the tax liability for a corporation making EBT of $280,000.
A: Applying the corporate tax table results in the following tax liability:
Exa
mpl
e
$92,450 Total
$70,200$180,000 x .39
$8,500$25,000 x .34
$6,250$25,000 x .25
$7,500$50,000 x .15
40
Corporate Taxes
Taxes and Financing The tax system favors debt over equity financing
Interest payments made to debt investors are tax deductible to the paying company
Dividend payments to equity investors are not deductible
Result: A debt financed firm pays less tax than an otherwise identical equity financed company
But the availability of debt is limited because it makes the borrowing company risky
41
Taxes and Financing
42
Corporate Taxes
Dividends Paid to Corporations Dividends paid to another corporation are
partially tax exempt The percentage exempted depends on the amount
of stock owned by the company Avoids more than double taxation of corporate
earnings
43
Corporate Taxes
Tax Loss Carry Back and Carry Forward Business losses can be carried backward or
forward in time to offset taxes that might otherwise be excessive