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BU227 – Financial Accounting Module 1 Provided by: Laurier SOS. Things to Cover. All Financial Statement Ratios The Accounting Environment Accounting’s Conceptual Framework Financial Statements Overview Classified Balance Sheet Classified Income Statement Recording Transactions
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Things to Cover All Financial Statement Ratios The Accounting Environment Accounting’s Conceptual Framework Financial Statements Overview Classified Balance Sheet Classified Income Statement Recording Transactions Accrual Accounting
Financial Statement Ratios • Assets = Liabilities + Shareholders’ Equity
Current Ratio • Significance • Short-term liquidity ratio shows the ability of the company to convert assets into cash to pay its short-term debts • A current ratio of 2.4 means that for every $2.4 of current assets, there is $1 of current liabilities • Rule of thumb • A high ratio usually means good liquidity, but too high can mean an inefficient use of resources (traditional rule of thumb between 1 and 2)
Current Ratio Example: ABC Company has total current assets of $1,000,000 and total current liabilities of $500,000. Its current ratio is 2:1.
Debt/Equity Ratio • Significance • To assess the extent to which a company is leveraged • The more leverage (debt) a company has, the riskier its situation and increase in interest payments • A debt/equity ratio of 0.62 means that 62% of financing is achieving using debt relative to financing provided by shareholders • Comparison • Starbucks: 0.37 and Van Houtte Coffee: 0.69 • Financial risk in that a higher leveraged company may have a more difficult time to pay off debt in the event of a business downturn
Debt/Equity Ratio • Total Liabilities ÷ Total Equity • Example: ABC Company has total assets of $3,000,000, total liabilities of $2,000,000 and equity of $1,000,000. The Debt/Equity ratio is 2:1.
Gross Profit Percentage • Significance • To illustrate the profit generated from sales • Depends on the strategy a business is taking • A low-cost strategy relies more on decreasing the costs included in the gross profit calculation • A company charging premium prices relies more on increasing sales • Used to assess the effectiveness of these business strategies
Profit Margin • Significance • The amount of profit being derived from sales (reported as a percentage) • The higher the profit margin, the more efficient management of sales and expenses • Comparison • From year to year A lower profit margin in 2006 compared to 2005 may indicate that expenses are being mismanaged • Example • Reitmans’ =net income =15,886 and sales =241,131Profit margin = 6.59% • La Chateau’s net income =66907 and sales =912473Profit margin = 7.33%
Profit Margin Example • Net Profit Margin ExampleIn 2002, Donna Manufacturing sold 100,000 widgets for $5 each, with a COGS of $2 each. It had $150,000 in operating expenses, and paid $52,500 in taxes. What is the net profit margin?
Solution • First, we need to find the revenue or total sales. If Donna's sold 100,000 widgets at $5 each, it generated a total of $500,000 in revenue. The company's cost of goods sold was $2 per widget; 100,000 widgets at $2 each is equal to $200,000 in costs. This leaves a gross profit of $300,000 [$500k revenue - $200k COGS]. Subtracting $150,000 in operating expenses from the $300,000 gross profit leaves us with $150,000 income before taxes. Subtracting the tax bill of $52,500, we are left with a net profit of $97,500. • Plugging this information into our formula, we get: • $97,500 net profit--------------(divided by)--------------$500,000 revenue • = .195
Return on Assets • Significance • Signals to financial statement users how effective management has been in using the total invested capital from debt holders and shareholders. • An ROA of 12% means that the company earned $0.12 for every dollar invested. • Signifies effective (or ineffective) use of company resources • Comparison • Allows investors to compare ROA against alternative investment opportunities • Van Houtte Coffee • 2003: 3.9% • 2004: 5.1% • 2005: 5.8%
ROA For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%
Total Asset Turnover • Significance • The effectiveness of management in generating sales from assets • A high asset turnover signifies effectiveness in assets generating sales • A decline in this ratio may be due to the inventory not selling or the accounts receivable collection policy being too lax. • Comparison • Starbucks 1.45 • Van Houtte Coffee 0.90
Return on Equity • Significance • Signals to financial statement users how effective management has been in using the total invested capital from shareholders. • In long run, firms with higher ROE are expected to have higher share prices • Short run increases in ROE, that soon decrease, may indicate that a company is failing to invest in R&D and keeping the company competitive
ROE • If you owned a business that had a net worth [shareholder’s equity] of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity [$5 / $100 = .05, or 5%].
Earnings per Share (EPS) • Significance • Earnings per common share • Usually a ratio of interest to common shareholders • Payouts made to preferred shareholders are subtracted from the earnings figure • Common shares are averaged over the period in question
EPS • For example, companies A and B both earn $100, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which company’s stock do you want to own?
EPS Solution • EPS = Net Earnings / Outstanding Shares Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and 50 shares outstanding, which equals an EPS of 2 ($100 / 50 = 2). • So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some ratios.
Price/Earnings • Significance • Comparison of the price per share with the earnings per share of the company • Usually considered the price investors are willing to pay for a dollar’s worth of earnings • High P/E ratio • A higher stock price and lower earnings per share • Companies with a high growth potential • This means that investors are willing to pay more than the current earnings due to the favourable prospects of future growth
EPS • P/E = Stock Price / EPS • For example, a company with a share price of $40 and an EPS of 8 would have a P/E of 5 ($40 / 8 = 5).
The Accounting Environment Sell ownership interest in the future for more than they paid. Receive a portion of the company’s earnings in cash (dividends). • Key External Users • Business owners (called investors or shareholders) • Creditors for interest and investment security
The Accounting System Financial Accounting System (preparation of four basic financial statements). Managerial Accounting System (preparation of detailed plans, forecasts and reports). External Decision Makers (investors, creditors, suppliers, customers, etc.). Internal Decision Makers (managers throughout the organization).
Generally Accepted Accounting Principles (GAAP) • Affect the selling price of shares. • Affect the amount of bonuses received by managers and other employees. • Cause a loss of competitive advantage.
Auditor Responsibilities • Auditor’s have a responsibility to general public to assess the fairness of financial statements • Ensure compliance with GAAP • Examining financial statements and transactions • Expressing an opinion as to the fairness
Accounting Conceptual Framework Primary Characteristics • Understandability:easy to read • Relevance: predictive value, feedback value, and timeliness. • Reliability: verifiability, representational faithfulness, and neutrality. Secondary Characteristics • Comparability: across companies. • Consistency: over time.
Generally Accepted Accounting Principles (GAAP) • Separate entity: Transactions of the business entity are separate from transactions of owners. • Continuity (Going Concern): The entity is expected to continue its operations into the near future (>= 1year). • Unit-of-measure: Accounting figures are reported in the national monetary unit ($). • Periodicity: The long life of a company can be reported over a series of short time periods. • The historical-cost principlerequires an asset to be recorded at the historical cash-equivalent cost • The full-disclosure principlerequires: • a complete set of financial statements and • notes to the financial statements that disclose other information of consequence to the users (ex. Pending Lawsuits)
Accounting Objectives Materiality – An amount large enough to affect a financial statement user’s judgment Cost-Benefit – The cost of disclosing a piece of financial information should not exceed the benefits of the disclosure Conservatism – do not overstate assets or revenues, or understate liabilities and expenses Industry standards – if industry standards dictate a certain accounting treatment for something, follow that standard
Financial Statements Overview • Assets - Listed in order of liquidity
1. Name of entity 2. Title of statement 3. Specific date (financial snapshot as at a specific point in time) 4. Unit of measure (thousands of dollars)
1. Name of entity 2. Title of statement 3. Specific date (Unlike the balance sheet, this statement covers a specified period of time.) 4. Unit of measure (in thousands of dollars)
1. Name of entity 2. Title of statement 3. Specific date (like the income statement, this statement covers a specified period of time.) 4. Unit of measure (in thousands of dollars)
STATEMENT OF CASH FLOWS • To assess the firm’s ability to generate cash and cash equivalents and • To assess the firm’s cash requirements • Statement of Cash Flows shows: • Where the cash came from • What the cash was used for • What was the change in the cash balance
STATEMENT OF CASH FLOWS • Cash activities are divided into three main categories: 1. Operating Activities • Main revenue-producing activities 2. Investing Activities • Changes in long-term assets and investments 3. Financing Activities • Changes in equity and non-operating liabilities
Cash Inflows and Outflows Cash Outflows Cash Pool • Operating Activities • Whenoperating cash expenditures > cash receipts • Investing Activities • Purchase of property, plant, and equipment • Purchase of debt or equity securities of other entities • Loans to other entities • Financing Activities • Payment of dividends • Redemption of debt • Reacquisition of capital stock
Statement of Cash Flows 1. Name of entity 2. Title of statement 3. Specific date (like the income statement and statement of retained earnings, this statement covers a specified period of time.) 4. Unit of measure (in thousands of dollars)
Classified Balance Sheets • Current assets - are turned into cash within one year. • Long-term (non-current) assets - used or turned into cash over a period longer than one year. (e.g., capital assets, investments, intangible assets) • Current liabilities - normally paid within one year. • Long-term liabilities - debts that are due beyond one year from the balance sheet date. • Retained earnings - accumulated earnings of the company less the accumulated dividends declared.
Classified Income Statements • Revenue - Increases in assets or settlement of liabilities from ongoing operations. • Expense - Decreases in assets or increases in liabilities to generate revenues during a period. • Gross Profit (Gross Margin) -Net sales less cost of goods sold. • Operating Income - Net sales less cost of goods sold and other operating expenses. • Gains - Increase in assets or settlement of liabilities from peripheral transactions. • Losses - Decreases in assets or increases in liabilities from peripheral transactions. • Income before Income Taxes - Revenue minus all expenses except income tax expense.
Classified Income Statement • Net Sales - Revenues earned from operations • CGS - The cost of products sold to customers • Gross Profit - difference between revenues and cost of goods sold (aka Gross Margin) • Operating Expenses - Usual expenses incurred to earn revenues in business operations • Operating Income - Items relating to activities outside the business’s normal course of operations • Earning from Continuing Operations - After-tax earnings from all ongoing operations of the business • Discounted Operations - After-tax earnings/loss from business operations that have been, or soon will be, shut down or sold
Recording Transactions • External events:exchanges of assets and liabilities between the accounting entity and one or more other parties. Ex borrowing money from bank • Internal events:not an exchange between the entity and other parties, but have a direct effect on the accounting entity. • Example: Loss Due to Fire
Financial Statement Relationships SHAREHOLDERS’ EQUITY = + ASSETS LIABILITIES Increases Increases SHARE CAPITAL RETAINED EARNINGS + Decrease DIVIDENDS NET INCOME = – REVENUES EXPENSES
Expanded Accounting Equation A = L + SC + R – E – D