Review of Accounting
Chapter 2
Chapter 2 – Outline
Income Statement (I/S)P/E RatioBalance Sheet (B/S)Statement of Cash Flows (CFs)
Tax-Free Investments
3 Basic Financial Statements
Income Statement (I/S)Balance Sheet (B/S)Statement of Cash Flows (CFs)
Income Statement
An Income Statement shows profitability
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)
Limitations of the Income Statement
2-6
Income gained/lost during a given period is a function of verifiable transactions over a specific time periodStockholders, 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
P/E RatioP/E Ratio = Price/Earnings Ratio
P/E Ratio = Market Price of Stock / Earnings per share (EPS)
Way of measuring desirability of a stock
Indicates expectations about future of a company
Price-earnings Ratios for Selected US Companies
2-8
Balance Sheet
2-9
Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interestDelineates the firm’s holdings and
obligationsItems are stated on an original cost basis
rather than at current market value
Balance Sheet
A Balance Sheet (B/S) shows what a firm owns and what it owes
Remember the ALOE!
Assets = Liabilities + Owners’ Equity
Limitations of the Balance Sheet
2-13
Most of the values are based on historical/original cost priceTroublesome when it comes to plant and
equipment inventoryFASB ruling on disclosure of inflation
adjustments no longer in force It is purely a voluntary act on the part of the
company
Limitations of the Balance Sheet (cont’d)
2-14
Differences between per share values may be due to:Asset valuationIndustry outlookGrowth prospectsQuality of managementRisk-return expectations
Comparison of Market Valueto Book Value per Share
2-15
Accrual Method of Accounting
Will be used in finance
Revenues and expenses are recognized when they occur, rather than when cash changes hands
For example, a credit sale in December 2003 is shown as revenue in that year (2003), even though payment is not received until March 2004
Statement of Cash Flows
2-17
Emphasizes critical nature of cash flow to the operations of the firmIt represents cash/cash equivalents items
easily convertible to cash within 90 daysCash flow analysis helps in combating
discrepancies faced through accrual method of accounting
Statement of Cash Flows
The Statement of Cash Flows (CFs) measures the flow of cash throughout a firm
CF from operating activities PLUS
CF from financing activities PLUS
CF from investing activities EQUALS
Net increase (decrease) in cash
FIGURE 2-1Illustration ofconceptsbehind thestatement ofcash flows
FIGURE 2-2Steps in computing netcash flows fromoperating activitiesusing the indirectmethod
TABLE 2-7Cash flows fromoperating activities
TABLE 2-10
TABLE 2-11Comparisonof accountingand cashflows
Free Cash Flow
2-24
Free Cash Flow = Cash flow from operating activities – Capital expenditures –
DividendsCapital expenditures
Maintain productive capacity of firmDividends
Maintain necessary payout on common stock and to cover any preferred stock obligations
Free cash flow is used for special financing activitiesExample: leveraged buyouts
Income Tax ConsiderationsIncome taxes affect financial decisions.
For instance, there is “double taxation” of corporate earnings.
This means that the same $ is taxed twice:Corporate income tax (on earnings)Personal income tax (on dividends)
Tax-Free InvestmentsMunicipal Bonds are:
–exempt from federal income tax– issued by local governments (or municipalities)
To compare a municipal to a taxable bond:After-tax i rate = Actual i rate x (1-TR)
Ex., at 28% tax rate (TR), 12% taxable bond is equivalent to 8.64% municipal bond