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.

Activity #3: Return to the example balance sheet above.

• 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?

Business Plan Aspects

1. Create a balance sheet for the estimated activity of your business for the first year. What equity will be required to start the business? What loans might be necessary? What do you expect to be expenses and revenues?