Review of Accounting,2,2-2,Chapter Outline,Income Statement Price-earnings Ratio Balance Sheet Statement of Cash Flows Tax-free Investments (Deprecation),2-3,Basic Financial Statements,Income Statement Balance Sheet Statement of Cash Flows,2-4,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,2-5,Income Statement (contd),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),2-6,Income Statement (contd),2-7,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 Statement of retained earnings Indicates disposition of earnings,2-8,Statement of Retained Earnings,2-9,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,2-10,Price-Earnings (P/E) Ratio (contd),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,2-11,Price-earnings Ratios for Selected US Companies,2-12,Limitations of the Income Statement,Income gained/lost during a given period is a function of verifiable transactions Stockholders, 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,2-13,Balance Sheet,Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest Delineates the firms holdings and obligations Items are stated on an original cost basis rather than at current market value,2-14,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,2-15,Balance Sheet Items (contd),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,2-16,Balance Sheet Items (contd),Depreciation expense is the current years charge Total assets: Financed through liabilities or stockholders equity Short-term obligations Accounts payable Notes payable Accrued expense,2-17,Stockholders Equity,Represents total contribution and ownership interest of preferred and common stockholders Preferred stock Common stock Capital paid in excess of par Retained earnings,2-18,Statement of Financial Position (Balance Sheet),2-19,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,2-20,Limitations of the Balance Sheet,Most of the values are based on historical/original cost price Troublesome when it comes to plant and equipment inventory FASB ruling on disclosure of inflation adjustments no longer in force It is purely a voluntary act on the part of the company,2-21,Limitations of the Balance Sheet (contd),Differences between per share values may be due to: Asset valuation Industry outlook Growth prospects Quality of management Risk-return expectations,2-22,Comparison of Market Value to Book Value per Share,2-23,Statement of Cash Flows,Emphasizes critical nature of cash flow to the operations of the firm It represents cash/cash equivalents items easily convertible to cash within 90 days Cash flow analysis helps in combating discrepancies faced through accrual method of accounting,2-24,Statement of Cash Flows (contd),Advantage of accrual method Allows matching of revenues and expenses in the period in which they occur to appropriately measure profits Disadvantage of accrual method Adequate attention not directed to actual cash flow position of firm,2-25,Concepts Behind the Statement of Cash Flows,2-26,Determining Cash Flows from Operating Activities,Translation of income from operations