MultiMedia by Stephen M. Peters© 2001 South-Western College Publishing Saturday, November 16th Midterm Topic: Accounting & Finance Quiz #5 Extra Credit

MultiMedia by Stephen M. Peters © 2001 South-Western College Publishing

Saturday, November 16th

• Midterm

• Topic: Accounting & Finance

• Quiz #5

• Extra Credit #1


Accounting and Financial

Analysis

Earnings of Firm

Value of Firm

Accounting Function

Summary and Analysis of a

Firm’s Financial Condition

Management decisions such as

how much to produce and how many employees

to hire

Marketing decisions such as pricing and the

amount of promotion necessary

Finance decisions such as

the amount of debt financing versus equity

financing that is appropriate


Accounting

Firms use accounting to:

Process of:•Report financial conditions•Support decisions•Control business operations

Process of:•Report financial conditions•Support decisions•Control business operations


Guideline Establishment

• GAAP (Generally Accepted Accounting Principles)• FASB (Financial Accounting Standards Board)• SEC (Securities and Exchange Commission)• IRS (Internal Revenue Service)

• GAAP (Generally Accepted Accounting Principles)• FASB (Financial Accounting Standards Board)• SEC (Securities and Exchange Commission)• IRS (Internal Revenue Service)


Two Types of Accounting

Managerial: concerned with preparing information for review by those on the inside of the firm.

Financial: concerned with preparing information for review by those on the outside of the firm.


Audit for Control

Is a formal evaluation of the records used to prepare a firm’s financial statement.

Internal AuditorsInternal Auditors

External AuditorsExternal Auditors

Employees who analyze and evaluate the company.

Public accountants who work for an independent accounting firm.


Two Major Financial Statements

Income Income

Balance SheetBalance Sheet

Reports the book value of assets, liabilities, and owner’s equity of a firm at a given point in time.

Indicates the revenue, costs, and earnings of a firm over a given time frame.


Sample Income Statement

Net sales $20,000

Cost of goods sold 16,000

Gross profit $ 4,000

Selling expense $1,500

General & administrative 1,000

Total operating expense 2,500

Earnings before interest and taxes 1,500

Interest expense 500

Earnings before tax $1,000

Income tax (at 30%) 300

Net income $ 700

Net sales $20,000

Cost of goods sold 16,000

Gross profit $ 4,000

Selling expense $1,500

General & administrative 1,000

Total operating expense 2,500

Earnings before interest and taxes 1,500

Interest expense 500

Earnings before tax $1,000

Income tax (at 30%) 300

Net income $ 700


Assets (in thousands)Current assets Cash $ 200Marketable securities 300Accounts receivable 500Inventory 1,000Total current assets $ 2,000Fixed assetsPlant and equipment $10,000 Less accumulated depreciation 2,000Net fixed assets 8,000Total assets $10,000Liabilities & Owner’s Equity (in thousands)Current liabilities Accounts payable $ 600Notes payable 400Total current liabilities $ 1,000Long-term debt $ 5,000 Common stockholder’s equity Common stock $ 1,000Additional paid-in capital 2,000 Retained earnings 1,000Total owner’s equity $ 4,000Total liabilities and owner’s equity $10,000

Assets (in thousands)Current assets Cash $ 200Marketable securities 300Accounts receivable 500Inventory 1,000Total current assets $ 2,000Fixed assetsPlant and equipment $10,000 Less accumulated depreciation 2,000Net fixed assets 8,000Total assets $10,000Liabilities & Owner’s Equity (in thousands)Current liabilities Accounts payable $ 600Notes payable 400Total current liabilities $ 1,000Long-term debt $ 5,000 Common stockholder’s equity Common stock $ 1,000Additional paid-in capital 2,000 Retained earnings 1,000Total owner’s equity $ 4,000Total liabilities and owner’s equity $10,000

Balance Sheet


Ratio Analysis

• Liquidity• Efficiency• Leverage• Profitability

• Liquidity• Efficiency• Leverage• Profitability

A quantitative measurement used to evaluate a firm’s financial performance.


Three Profitability Ratios

Indicates a firm’s overall performance in terms of its ability to generate revenue in excess of expenses.

Return on Assets = Net Income/ Total assets

Net Profit Margin = Net Income/Net Sales

Return on Equity = Net Income/ Total Owners’ Equity


Liquidity

Measures a firm’s ability to meet its short term obligation.

Current Ratio = Current Assets/Current Liabilities

Acid-Test Ratio or Quick Ratio = Quick Assets/Current Liabilities


Measures of Efficiency

Inventory Turnover = Costs of Goods Sold/Average Value of Inventory For A Period of Time

Asset Turnover = Net Sales/Total Assets

Used to analyze how well the firm is managing its assets.


Leverage or Debt Ratios

The degree to which a firm is relying on debt financing.

Debt to Owners’ Equity = Long-Term Debt/Owners’ Equity

Times Interest Earned = Earnings Before Interest & Taxes/Annual Interest Expense


Debt vs Equity Financing

Firm’s Financing Decisions

Firm’s cost of capital (funds) used to support

business operations

Firm's Earnings

Firm's Value


Four Factors in Determining Creditworthiness

• The planned use for the borrowed funds.• Financial condition of the firm.• Outlook of the industry and environment of the firm.• Available collateral.


Major Types of Financing

Debt financing• Act of borrowing funds.

Equity financing• Act of receiving investment from owners (by

issuing stock or retaining earnings).


Methods of Debt Financing

• Borrowing From Financial Institutions

Fixed-rate loans

Floating-rate loans• Issuing Bonds

Secured

Unsecured

Call Feature• Issuing Commercial Paper


Three Interest Rate Charge Scenarios

I1 (Fixed rate)

I2 (Floating ratewhile interest ratesare rising)

I3 (Floating ratewhile interest ratesare declining)

Inte

rest

Rat

e


Prime Rates

0%

5%

10%

15%

20%

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98


Methods of Equity Financing

• Retaining Earnings

Keep earnings after taxes for expansion.• Issuing Stock

Common.

Preferred.

The act of receiving investment from owners by retained earning or issuing stock.


Initial Public Offering (IPO)Advantages of IPOs:• Gain access to more funds.• Obtain funds without increasing existing debt level.Disadvantages of IPOs:• Must inform shareholders of their financial condition.• Expenses associated with reporting of information

must be filed with SEC.• Difficulty in encouraging stock purchase.• Ownership structure is diluted.• Investment banks charge high fees.


Issuing of Securities

Origination• Investment bank advises firm on amount of stock

and bonds to issue.

Underwriting• Investment bank guarantees a price to the issuing

firm.

Distribution• Prospectus is distributed to investors.


Capital Structure

•Use of Debt

Interest payments are tax deductible.

Can claim interest payments during year as expense.

Increased risk of default.

May result in high interest payments.

Creditors may not be willing to provide additional credit.•Equity Financing

Eliminates many of the above concerns.

The composition of debt versus equity financing.


Return on Equity& Financial Leverage

0

10

20

30

40

50

60

10 20 30 40 50 60 70 80 90 100

Proportion (%) of Assets Financed with Equity

Pe

rce

nt


Interest Expense& Financial Leverage

0

100

200

300

400

500

600

700

800

900

10 20 30 40 50 60 70 80 90 100

Proportion (%) of Assets Financing with Equity

Do

llars

(th

ou

sa

nd

s)

Documents

MultiMedia by Stephen M. Peters© 2001 South-Western College Publishing Saturday, November 16th Midterm Topic: Accounting & Finance Quiz #5 Extra Credit