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Review of Accounting. 2. Chapter Outline. Income Statement Price-earnings Ratio Balance Sheet Statement of Cash Flows Tax-free Investments (Deprecation). Basic Financial Statements. Income Statement Balance Sheet Statement of Cash Flows. Income Statement.

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chapter outline
Chapter Outline
  • Income Statement
  • Price-earnings Ratio
  • Balance Sheet
  • Statement of Cash Flows
  • Tax-free Investments (Deprecation)
basic financial statements
Basic Financial Statements
  • Income Statement
  • Balance Sheet
  • Statement of Cash Flows
income statement
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 deducted
income statement cont d
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)

return to capital
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
price earnings p e ratio
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
price earnings p e ratio cont d
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
balance sheet
Balance Sheet
  • Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest
    • Delineates the firm’s holdings and obligations
    • Items are stated on an original cost basis rather than at current market value
balance sheet items
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 to determine their anticipated collection value
    • Inventory
      • Includes raw materials, goods in progress, or finished goods
balance sheet items cont d
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 assets
balance sheet items cont d1
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
stockholder s equity
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
concept of net worth
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
depreciation and funds flow
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 funds
income tax considerations
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
depreciation as a tax shield
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

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