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Class 2 – chapter 2. Financial Fundamentals of Accounting (Cont.). Assets are Financial Uses. The left-hand side of the balance sheet shows the assets on which the company has used its resources. Hence, the left hand side displays “company owned wealth.” Assets are uses of wealth
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Class 2 – chapter 2 Financial Fundamentals of Accounting (Cont.)
Assets are Financial Uses • The left-hand side of the balance sheet shows the assets on which the company has used its resources. Hence, the left hand side displays “company owned wealth.” • Assets are uses of wealth • Liabilities, as discussed last class are sources of wealth. • Increase in assets = use of funds = decrease in liabilities • Decrease in Assets = source of funds = increase in liabilities • Net working capital: Some balance sheets show a line item called net working capital (“NWC”.) This is simply the difference between current assets and current liabilities. A positive ΔNWC implies CA > CL => use of Funds A negative ΔNWC implies CL > CA => source of Funds
The Income Statement • The income statement summarizes many types of flows that occur over the specified time period. (monthly, quarterly, yearly, etc.) • The income statement documents all wealth transfers occurring during the year, and the previous time period’s balance sheet represents a snapshot at the exact moment the income statement concludes. Sales – company cash inflows (only one) COGS – cash outflow due to production Selling, general, and admin. expenses – periodic overhead expenses. Depreciation – writing off PPE value
The Income Statement Operating Income (EBIT) – Earnings before Income and Taxes Interest expense – cost paid for borrowing from creditors Taxable Income – income susceptible to government taxation. Taxes – cost of living in the particular country Net Income – Earnings after taxes – wealth available to shareholders Can be paid directly as divided, or reinvested as new retained earnings. Net Income – Dividends = New Retained Earnings
Financial Ratios • A financial ratio compares two different financial measures in fraction form. They typically convey important information about financial health. • E.g. Asset Turnover Ratio = Sales/Total Assets • Compare an ATR of 5 to an ATR of ½. • The first company generates $5 of sales for every $1 of assets • The second company generates $.5 of sales for every $1 of assets • This implies big differences in total assets for similar sales figures • Many types of Ratios (Read on your own pages 38-41)
Shareholder's Rate of Return The rate of return a stockholder expects to receive. Do example 2 and problems FA8, FA9, and FA15a-c on board.
Return on equity • The Return on Equity is a profitability ratio that is a key financial ratio for shareholders. ROE is the book measure of shareholder returns. • ROE = is the book measure of shareholder returns • = Net Income/Stockholders’ Equity • = Rate of return , according to the books, that shareholders earn. • ROE varies substantially across time and/or across companies. The “Dupont Analysis” • is a technique that enables insight about the source of variation in ROE.
Problems • Work Example 4 in Class • Work Problem BA6 on test packet in Class
Breakeven Ratios • The breakeven formulas we will use to analyze a companies relies upon the stylized income statement below to estimate the amount of sales required for realizing specific income targets. • Suppose as a business I want to reach some target level of income – How do I do it? The Operating breakeven point occures when company sales revenue equals fixed plus variable operating costs. (You earn just enough to cover costs or “break even.” Typically this is undesirable. The Operating Break Even Ratio allows us to compute for any level of EBIT.
Breakeven Ratios • Consider the Following Formulas: Example 5 – Work in Class
Breakeven Ratios • The “Total breakeven point” occurs when the Sales Revenue pays all operating costs, inter to creditors, taxes, and preferred dividends, and EAC equals zero . • EAC = earnings available for common = EBIT – Interest (I) – Taxes -Preferred dividends • EAC= (EBIT – IE)(1-tax rate) - PD
The Income Statement • The Income statement link adjacent balance sheets. • The initial balance sheet is a snapshot of finances at a certain point in time. Afterwards time elapses and the income statement records all cash flows that occur. Then at the end of the period another balance sheet is created. • Two processes link the income statement with the two adjacent balance sheets:
Homework • Do Problems BA6, BA9c, FA15c, BE4b, Be7b, BE3, BA11a, BA12b, BS30, FF12, TR38, TR42, FA5, FA8, FA16