Practical financial manaegment lasher 7th ed chapter 02

Chapter 2 - Financial background: A Review of Accounting, Financial Statements and Taxes


The Nature of Financial Statements

Numerical representations of a firm’s activities for an accounting period

– A picture of activities within the firm and between the firm and the outside
– But can be counterintuitive

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Accounts Receivable

Most sales are on credit
Seller receives a promise of later payment, rather than immediate cash
The seller records an account receivable as an asset
Net income may not = cash flow


Depreciation

Proration of an asset’s cost over its service life
Can be straight lined or accelerated
Cost recorded on the income statement does not = cash spent


The Nature of Financial Statements

Three Financial Statements

– Income statement
– Balance sheet
– Statement of cash flows
Generated from the income statement and balance sheet

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The Accounting System

A firm’s financial books are a collection of records in which money
transactions are recorded

– Double entry system
– Accounting periods and closing the books
– Implications
– Stocks and flows

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Table 2-1 A Typical Income Statement

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The Income Statement

Sales

Cost and Expenses

– Costs of Goods Sold
– Expense
– Depreciation

Gross margin
Earnings before interest and taxes (EBIT)

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The Income Statement

Earnings Before Tax, and Tax
Net Income
Terminology:

– Income = profit = earnings
– Profit before tax (PBT)
– Profit after tax (PAT)
– Earnings before tax (EBT)
– Earnings after tax (Net Income)
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Earnings

Earnings

– Also called net income
– Paid out as dividends or retained in business
Retained Earnings (RE)

– Each year earnings not paid as dividends become an addition to equity
– Retained earnings account is cumulative earnings not paid out as dividends


The Balance Sheet

Lists everything a company owns and owes at a moment in time

– All sources and uses of money must be equal
A firm’s money sources include creditors and owners

– Borrowing creates a liability for repayment

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The Balance Sheet

Two equal sides
Assets = liabilities + equity

Assets and liabilities are arranged in order of decreasing liquidity
Liquidity – ease with which an asset becomes or a liability requires cash

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Table 2-2 A Conventional
Balance Sheet Format

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Assets

Cash

Accounts Receivable

Checking balances plus currency

Uncollected credit sales

Marketable securities are liquid

–

investments held instead of cash

–

Short-term, modest
risk

return, low

Bad Debt Reserve: some credit sales
will never be paid

–

Write Off: Remove bad debt from gross
and reserve leaving net unchanged

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Concept Connection Example 2-1
Writing Off a Large Uncollectable Receivable

Gross accounts receivable
Bad-debt reserve
Net accounts receivable

Need to Write Off

$5,650
(290)
$5,360

$435,000

Reserve

290,000

Expense

$145,000

Reestablish Reserve (5%)
Profit Reduction

260,750
$405,750

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Assets

Inventory - product held for sale in the normal course of business

– Work-In-Process Inventories (WIP)

Value added as inventory moves through production

– The Inventory Reserve

Some inventory is unusable - balances reported net of reserve

– Writing Off Bad Inventory

Missing, damaged, or obsolete items removed from gross and reserve leaving net
unchanged

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Assets

Overstatements

–

If assets are overstated, firm’s value is less than total shown on balance sheet

Current Assets

–
–

Become cash within a year
Include cash, accounts receivable and

inventory

Fixed Assets

–
–

Long lived, depreciable, also called property, plant and equipment (PPE)
Useful life of at least a year

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Assets

Depreciation

– Spreads asset’s cost over its estimated useful life

Financial Statement Representation

– Appears as an expense or cost
– Accumulated depreciation appears on balance sheet reflecting a wearing out
of the asset

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Table 2-3 Fixed Asset Depreciation

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Assets

Disposing of a Used Asset
The Life Estimate
Tax Depreciation and Tax Books

– Government allows different depreciation schedules for tax purposes and
financial reporting purposes

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Concept Connection Example 2-2 Selling a Fixed Asset

Accounting

Cash Flow

$4,000

$4,000

Revenue
Cost (NBV)
Profit contribution: EBT
Tax (30%)
Contribution: net income
Cash flow

2,500
$1,500
(450)

(450)

$1,050
$3,550

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Liabilities

What a company owes to outsiders
Accounts Payable

– Arise when a firm buys from vendors on credit

Terms of Sale

– Specify when payment is due on credit sales and the early payment discount

Understated Payables

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Liabilities

Accruals

– Recognize expenses and liabilities associated with incomplete transactions
Payroll Accrual

Current Liabilities

– Require cash within one year
– Payable and accruals are classified as current

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Figure 2-1 A Payroll Accrual

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Working Capital

Total current assets = gross working capital

Net Working Capital = Current Assets ─ Current Liabilities

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