Accounting and Finance

1. Accounting and Finance Dr. Mazharul Islam 2-1

2. Chapter Objectives • Understand the difference between book value (from the Balance Sheet) and market value. • Understand the difference between net profit (from the Income Statement) and cash flow. • Explain the differences between the average tax rate, the marginal tax rate and the flat rate. • Explain the calculation of cash flow from assets, and cash flow to debt-holders and shareholders. Dr. Mazharul Islam 2-2

3. The Balance Sheet • Financial statement that shows the value of the firm’s assets and liabilities at a particular time. Equation:Assets = Liabilities + Owners’/Shareholders’ Equity. • Assets = Current asset + Fixed asset (non-current) A current asset is cash and any other company asset that will be turning to cash within one year. Example: cash, marketable securities, short-term investments, accounts receivable , prepaid expenses, and inventory. Fixed assets (non-current) generally refers to the long-term assets, tangible assets used in a business. Examples of fixed assets are land, buildings, manufacturing equipment, office equipment, furniture, fixtures, and vehicles. Dr. Mazharul Islam 2-3

4. The Balance Sheet • Liabilities:liability is an obligation of the company to transfer cash or other resources to another party. Example: bank loan and it’s interest rate, account payable, accrued expenses (wages, taxes) etc. • Owners’/Shareholders’ Equity is what the owners/shareholders of a company have invested in the business. • Net working capital = Current Assets– Current Liabilities. Dr. Mazharul Islam 2-3

5. a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers (sold goods). d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid (for Property, plant, and equipment). g. Acc. deductions for wear and tear. Cash and equivalents $ 90 Acct. Rec.c $ 394 Inventories $ 696 Prepaid Expd $ 5 Accum. Tax Prepay$ 10Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Intangible assets 50 Other Assets 223Total Assets b $2,169 Petro Rabighs’ Balance Sheet (Asset Side) Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014a Dr. Mazharul Islam 2-4

6. a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. Notes Payable $ 290 Acct. Payablec 94 Accrued Taxesd 16 Other Accrued Liab.d 100Current Liab.e $ 500 Long-Term Debtf530Shareholders’ Equity Com. Stock ($1 par)g200Add Pd in Capitalg 729 Retained Earningsh 210 Total Equity $1,139 Total Liab/Equitya,b $2,169 Petro Rabighs’ Balance Sheet (Liability Side) Petro Rabighs’ Balance Sheet (thousands) Dec. 31, 2014 2-5 Dr. Mazharul Islam

7. Market Value versus Book Value • Book valuerefers the price that never change as long as you own the asset. Example: if you bought a house 10 years ago for 300,000SAR, its book value for your entire period of ownership will remain 300,000SAR • Market value refers the price that could be obtained in the current market place. Example: if the price of that house after 10 years is 350,000SAR then it is called market value. 2-6 Dr. Mazharul Islam

8. The Income Statement • A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Equation: Revenues – Expenses = Profit. • Profit is often expressed on a per-share basis and called earnings per share (EPS). • The difference between net profit and cash dividends is called retained earnings, which is added to the retained earnings account in the Balance Sheet. 2-7 Dr. Mazharul Islam

9. Example—Income Statement of Petro Rabigh Revenue (net sales) 4 000 Cost of Goods Sold 2 800 Selling, general, and administrative expense 500 Other expenses 400 Depreciation 200 EBIT(Earnings Before Interest & Tax ) 100 Interest 30 Taxable Income (EBT) 70 Tax 40 Net Profit (EAT) $30 Dividends 10 Addition to R/E $20 2-8 Dr. Mazharul Islam

10. Taxes • Can be one of the largest cash outflows that a firm experiences. • The size of the tax bill is determined by the Income Tax Assessment Act. • The Tax Act is the result of political, not economic, forces. 2-9 Dr. Mazharul Islam

11. Tax rates • The average tax rate is the total tax bill divided by taxable income; that is, the percentage of income that goes in taxes. • The marginal tax rate is the extra tax paid if one more dollar is earned. • A flat rate is where there is only one tax rate that is the same for all income levels. • It is the marginal rate that is relevant for most financial decisions. 2-10 Dr. Mazharul Islam

12. Tax System in Saudi Arabia 2-11 Dr. Mazharul Islam

13. Cash Flow from Assets • CASH FLOWS: Financial statement that shows the firm’s cash receipts and cash payments over a period of time. • Equation:Cash flow from assets = cash flow to debt-holders + cash flow to shareholders. • The equation states that the cash flow from the firm’s assets is equal to the cash flow paid to suppliers of capital to the firm. 2-12 Dr. Mazharul Islam

14. Cash Flow from Assets The total cash flow from assets = operating cash flow – net capital spending on non-current assets- additions to net working capital • Operating cash flow: the cash flow that results from day-to-day activities of producing and selling. Earnings before interest and taxes (EBIT) + Depreciation – Taxes OR (Revenue –costs –taxes) • Net capital spending:Ending non-current assets – Beginning non-current assets + Depreciation.. • Additions to net working capital (NWC): Ending NWC – Beginning NWC. 2-13 Dr. Mazharul Islam

15. Example―Income Statement ($000s) Sales $1 420.00 Cost of goods sold 960.00 Depreciation 60.00 EBIT $400.00 Interest 40.00 Taxable income 360.00 Tax 108.00 Net profit $252.00 Dividends 52.00 Addition to retained earnings $200.00 2-17 Dr. Mazharul Islam

16. Example―Balance Sheet ($000s) 2-15 Dr. Mazharul Islam

17. Example―Balance Sheet ($000s) 2-16 Dr. Mazharul Islam

18. Example―Cash Flow From Assets ($000s) Operating cash flow: EBIT $ 400.00 + Depreciation + 60.00 – Taxes – 108.00 $352.00 Change in net working capital: Ending net working capital $ 620.00 – Beginning net working capital 610.00 $ 10.00 Net capital spending: Ending non-current assets $ 2 200.00 – Beginning non-current assets – 1 970.00 + Depreciation + 60.00$290.00 Cash flow from assets: $352.00 – $10 – $290 = $ 52.00 2-18 Dr. Mazharul Islam

19. Cash Flow to Debt-holders and Shareholders • The cash flow to debt-holders includes any interest paid less the net new borrowing. Cash flow to debt-holders = Interest paid – net new borrowing • The cash flow to shareholders includes dividends paid out by a firm less net new equity raised. Cash flow to share-holders = Dividends paid – net new equity 2-14 Dr. Mazharul Islam

20. Example―Cash Flow to Debt-holders and Shareholders($000) Cash flow to debtholders: Interest paid $ 40.00 – Net new borrowing (450-410)– 40.00 $ 0.00 Cash flow to shareholders: Dividends paid $ 52.00 – Net new equity raised (580-580) 0.00 $52.00 Cash flow to debt-holders and shareholders = $0.00 + $52.00 = $52.00 2-19 Dr. Mazharul Islam

21. Summary and Conclusions • The book values on an accounting Balance Sheet can be very different from market values. • Net profit as it is computed on the Income Statement is not a cash flow, a primary reason being the deduction of depreciation (a non-cash expense). • Marginal and average tax rates can be different. However it is the marginal tax rate that is relevant for most financial decisions. • Cash flow from assets equals cash flow to debt-holders and shareholders. • It is important not to confuse book values with market values, and accounting income with cash flow. 2-20 Dr. Mazharul Islam