Financial Accounting

Pre Reading Comment – Chapter 13

Chapter 13 has a good overview of the main accounting instruments.  Read the chapter carefully, paying special attention beginning from page 393.  Be sure to note the descriptions of the balance sheet and income statement.

Lecture Notes

Lecture Summary

·        Financial statements

·        Income statement content, format

·        Income statement analysis

·        Balance Sheet content, format

·        Balance sheet analysis

Major Points

The Balance Sheet

The book provides good definitions of assets, liabilities, and equity.  Most people have an intuitive sense of these areas.  We sense that our current net worth is equal to the value of all we own, minus the amount we owe.  Unfortunately for students, their net worth is often negative until they have graduated and worked several years

By tradition, the accounting equation presents assets, liabilities, and equity in the following equation:

Assets = liabilities + owner’s equity

The example balance sheet in the textbook looks like this:

 Assets Current cash 7050 marketable securities 2300 Accts receivable 26210 less- doubtful accts -650 Inventory 21250 Prepaid expenses 1050 Total 57210

 Fixed land 18000 Building 65000 less-depreciation -22500 Equipment 72195 Less - depreciation -24815 Total 107880 Intangible patents 7100 trademarks 900 Total 8000 Total Assets 173090

 Liabilities Accounts payable 16315 wages payable 3700 taxes payable 1920 total 21935 Long-term Liabilities notes due 2005 10000 notes due 2007 30000 total 40000 Total Liabilities 61935 Owner's Equity Stock (8000 shares) 40000 paid-in capital 15000 retained earnings 56155 total 111155 Total Liability and Owner’s Equity 173090

Notice that total assets have to equal total liabilities and owner’s equity – they have to “balance.”

Activity #1

To see what happens as events happen in a business, try to adjust the balance sheet in the following ways.  Remember to keep the sheet in balance.

·        You get a shipment of goods for inventory, along with a bill for \$9000 for these goods.

·        A customer who owes you \$1000 pays you.

·        The end of the month arrives so you pay off \$3400 in bills you have received.

·        Your marketable securities increase \$1000 in value.

·        You buy a \$13,000 piece of equipment.

·        You take out a \$20,000 loan at 7% interest so you can expand your business.

The income (Profit and Loss) statement

Here is another form that most people can intuitively understand.  Profit is what you have left of your income after expenses.  You increase profit, either by increasing revenue, or by decreasing expenses.   Of course it gets trickier for businesses, since they can have many forms of expenses.  The income statement on page 397 provides a good  example.

 Revenues 256425 Cost of Goods sold start inventory 22380 purchases 103635 less - remaining inventory -21250 total 104765 Gross Profit 151660

 Operating Expenses salaries 49750 advertising 6380 Depreciation 3350 total 59480 Administrative expenses Salaries 55100 supplies 4150 utilities 3800 depreciation 3420 interest exp 2900 miscellaneous 1835 total 71205 Total Expenses 130685

Gross Profit                                     151,660

Total Operating Expenses            130,685

Income before taxes                        20,975

Taxes                                                     8,390

Net Income                                         12,585

Activity #2:  To practice using an income statement, try making these adjustments to the income statement:

• Assume that inflation had pushed up the costs of goods from suppliers by 8%.  What would the final operating income be?
• Employees demand a 5% wage hike.  If that wage had been in effect for the year, what would operating income be?
• You decide to only produce products that have been ordered, so you no longer have any inventory on hand.  What would operating income be?

Analyzing Financial Statements

We hope all companies make a profit, or have more assets than liabilities.  But what would we look for to see how healthy a company is?  A series of ratios have been designed to help determine that level of health.

Liquidity – can a company pay its debts?  Since debt is both short-term (due within one year) and long term (due over more than one year), we need to know if a company can meet both kinds of debts.

Current ratio –

This is all current assets (cash, accounts receivable, and inventory) divided by liabilities that are currently due.  A business should have at least twice the assets as it has debts.

Debt to Equity ratio -

This is all the debt you have in all forms (immediate and longer term), divided by the equity the owners have in the business.  The owners should have enough investment in the company to cover all debts, so the ratio should be less than 1.

• What is the current liquidity ratio for this company?
• What would it be if they had \$30,000 in accounts payable?
• How high would accounts payable have to be before you got nervous about their ability to pay their bills?
• What is the long-term solvency ratio (debt to equity ratio) of this company?
• What would it be if the owner decided to take all his retained earnings out so he could go buy a condo in Florida?
• What would it be if he left his money in the company, but borrowed \$100,000 to open a new office in St. Louis?
• If you were his banker, which of the last two actions would you prefer to see?

Profitability – What is a good level of profitability?  Here we have two common approaches.  The first works for all companies, while the second only works for corporations.

Net income / owner equity (return on equity)

Net income / number of common shares (earnings per share)

Activity #4:

• If instead of investing in a company, the owners of Perfect Posters had put the money in 10-year Treasury notes, what kind of return on equity would they have received?
• What would the earnings per share be if the owners had decided to begin with 10,000 shares of stock, rather than 8,000?
• If the owner pulled \$50,000 out of retained earnings, what would his future return on equity be?  Should he do so?