financial acct g 14 asdasd

8/10/2019 Financial Acct g 14 asdasd

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Department of Chemical Engineering

and Applied Chemistry

University of Toronto

Course: CHE349File: CHE349/FinancialAcctg14

Copyright: Joseph C. Paradi1996-2004

Centre for Management of Technology and Entrepreneurship

Financial Accounting


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ourse: CHE 49entre for Management of Technology and Entrepreneurship

Accounting Introduction

Engineers typically hate accounting and finance.

The view is that it is dry and wholly uninteresting (andEconomics is not far away from this).

While there is some truth in all this, there is much utility also.Accounting can not be ignored, it intrudes into every aspect ofwork.

The best approach is to learn as much as possible, use it whenappropriate, but you dont have to become accountants, just

understand what they do.

What you need is a good basic understanding of it.

You can not tell how well the business or the project is doingwithout accurate and timely financial information.


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Some History

It has been with us since the earliest civilisations. They kept arecord of the goods stored with the temple priests.

"Double-entry" bookkeeping can be traced back as far as 1494when an Italian monk described such a methodology in a

mathematics textbook.

It is simply put: a way of keeping track or scoring the financialresults of an individual, a corporation etc.

It is very important in today's society when it is common place

for the owners not to be present.

Accounting information in its truest form is used to evaluateuses of limited economic resources.


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Why do we Need it?

Accounting information is so valuable that many people make acareer out of analysing and evaluating the resulting statementsand advising their clients. management consultants

business planners accountants

financial analysts

investment managers

securities brokers/underwriters

There are two fundamental users of accounting information.They are external and internal groups to the "organisation".

Accounting keeps the score in business.


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Management's Need

Every textbook will discuss planning and controlling as the twomost important uses of accounting info.

By having an historical perspective you can see trends andrelationships appearing.

You can use this information to plan into the future. One must never forget that history does not always repeat itself

and variances from your plan will occur. Once a plan is in place you can then monitor results and

control or alter certain activities as needed The changes or variances - positive or negative - from a plan

provide very useful information. Costing of products is another common use of information

provided by an accounting system.


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Government Needs

The best example here are the various tax authorities.

Our tax structure is set up to tax "income" or "profits".

It is critical that we all have a "level" playing field and acommon system of "score-keeping" which we use to measureprogress.

We wouldn't want to have the yardsticks or methods ofmeasurement to move while the "game is on".

It is every taxpayers right to arrange his/her affairs in such away as to minimise taxes.

So accounting is important and is required by all levels ofGovernment so that they can audit your tax payingmethodologies


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Outsiders' Need

There are a number of external stakeholders who also havean interest in how things are going.

Investors/owners of the firm need information.

Bankers, tax authorities, other government agencies, insurancecompanies, suppliers etc. are only a few examples of theregular contacts that the person in charge of accounting canexpect to have.

In every case it is important that the accountant represent the

company's best interest.

The score keeping process is done according to a set of rules -the GAAP - so that everyone understands what certain thingsreally mean.



The Matching Principle

This is a very important principle: "Transactions are to be recorded when they occur, not

when the cash is actually exchanged"

This is known as ACCRUALaccounting.

this means that you may pay tax on moneys you have not yet received but you can also claim expenses that you have not paid for yet in both cases, however, there is evidence that something has happened

If cash is used as the time to recognise a transaction, then wehave CASH BASISaccounting

While the former is used in almost all businesses, the latter isuseful for small cash based business

Dont confuse this with cash flow however!



Financial Accounting

Therefore, the accounting function has two parts, financialaccounting and management accounting.

Financial Accountingis concerned with the recording andorganising the financial data of a business: revenues expenses

resources owned

obligations to others

owners' value (equity) Management Accountingis concerned with the costs and

benefits of the various activities of the enterprise. Provide managers with useful and timely information

assist in decision making by crunching numbers as required


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The Balance Sheet

Often called a position statement

It is a snapshot in time of the firm's assets owned and liabilities(debts) owed and the owner(s) equity.

So the first category of financial information lists the assetsofthe firm and divides these into current and long term assets

Current Assetslists cash and cash equivalents, such asmarketable securities, receivables, prepaid expenses etc.,anything that can be quickly converted into cash.

Long Term Assetsshow assets owned which are not likely tobe quickly converted into cash, such as buildings. In fact, thebusiness might have to be sold first.



More on the Balance Sheet

Liabilitiesare also split into "current" and "long-term".Obligations due within a year of the statement are currentwhilethose repayable at a date more than a year in the future areclassified as Long-term Liabilities.

The difference between assets and liabilities represent thevalue that the owners have in the enterprise the Owner's Equityand that typically has two parts: Paid-in Capital and RetainedEarnings.

We have then:Assets = Liabilities + Owner's Equityput another way:

What a business has = Creditors' contribution + Owners' contribution

If the owner's Equity is negative, the firm is almost certainly in

trouble!



Assets

Assetsare everything of value that belong to the business. Value only implies future usefulness. It does not reflect the

liquidation value of the assets. When presented on the balance sheet the most liquid assets

are listed first. Assets are placed on the books at their full cost, whether they

have been paid for or not - some examples are:

Current Assets:Cash in bankGovernment securitiesMarket investments

Accounts ReceivablesInventoriesPre-paid ExpensesMortgages receivable

Fixed Assets:

LandBuildingsEquipment and fixturesVehicles



Liabilities and Shareholders'Equity Liabilitiesrepresent everything owed to creditors.

These claims to creditors are against the assets of the company.

Examples of liabilities would be accounts payable, payroll, taxespayable, bondholders etc.

Arrange them according to their urgencyto be paid Shareholders' Equityis also a liability and:

This represents the excess of assets over liabilities.

Assets = Liabilities + Shareholders' equity

It would begin with an investment in the company through the purchaseof shares and then each year would grow or shrink by the profits/lossesless any dividends.

In plain language, this the "worth" of the company from a shareholder'sinvestment point of view



Example of a Balance Sheet

The ABC Shutters Manufacturing Co.ASSETSCurrent AssetsCash 25,000

Accounts Receivable 115,000

Raw materials 8,500Work in progress 7,000Finished good in inventory 15,500

Total current Assets 171,000

Fixed AssetsLand 30,000Buildings (net of depreciation) 150,000Equipment (less of depreciation) 600,000Office equipment (net of depreciation) 10,000

Total fixed Assets 790,000

Total Assets 961,000



Example of a Balance SheetcontinuedLIABILITIESCurrent Liabi l i t ies

Accounts Payable 32,000Payroll Taxes payable 15,000

Total current Liabilities 47,000

Lon g-term Liabi l it iesMortgage payable 130,000Equipment loan payable 350,000

Total long-term Liabilities 480,000

Owner 's EquityCommon stock 325,000Retained Earnings 109,000

Total Equity 434,000

Total Liabilities and Equity 961,000


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Income Statement

The ABC Shutters Manufacturing Co.SALESGoods and services 1,200,000

EXPENSES

Labour 532,000Materials 302,000Depreciation 98,000Maintenance and repairs 41,500Utilities 11,500

Administration 76,000

Marketing 49,000Interest payments 35,000Total Expenses 1,145,000Net Profi t before taxes 55,000Income Taxes 26,000

NET PROFIT 29,000


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Statement of Changes inFinancial Position One shortfall of both the balance sheet and income statement

is that neither one gives you any indication of cash flow andsources and uses of cash.

The Statement of Changes in Financial Position statement is

relatively new compared to the balance sheet and incomestatements. Its quick acceptance is likely due to the fact that itoffers a wealth of information to the analyst.

Using both the balance sheet and income statement

information, cash is reconciled during a particular period fromits opening to closing position. Many firms found themselves with healthy profits but had

expanded too fast to fund their short term liabilities.


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Some Thoughts

Financial statement preparation is designed to be conservativeto avoid "surprises".

Assets are recorded at cost or market value, whichever is less -so land goes up in value over the years but no change in the

value of the asset, inventory values are adjusted onlydownward if there is a doubt of the value.

So while the statements appear accurate and authoritative,many items are estimates:

accounts receivables finished goods value in inventory

depreciated assets - any assets, especially long term

So remember that many figures are estimates when you read afinancial statement.


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Costs and Management

In all businesses there are many different costs:1. Discretionary costs - can decide to postpone

2. Relevant costs - trade-in, training, space etc.

3. Sunk costs - costs which incurred in the past

4. Fixed costs - rent, machine costs, HVAC etc.5. Variable costs - raw materials, labour, etc.

6. Semi fixed/variable costs - most costs are of this type

7. Standard costs - based on some assumptions

Then there are various cost analyses where a decision isinvolved once all the costs are known - which piece ofequipment to buy, is a company worth the price, should weclose the dining room at the Golf Club in the winter, can we beabsent from a trade-show etc.


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Variable Costs

Some costs that a company incurs are directly proportional tothe level of production.

Raw materials would be a good example of a variable cost.

They increase in direct proportion to the production.

Labour component in manufacturing may be variable but not ina direct relationship with production.

Thus, if an employee can produce 2 devices an hour, then ifyou only make 1 device you still need the staff, but, if 3 devicesare made, another employee is needed

Although "smoother" than fixed costs, there are still marginaldecisions that must be made.


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Fixed Costs

Fixed costs are those costs that do not go up or down withslight fluctuations in volume. E.g: the building costs or thePresident's base salary.

These costs, within certain parameters, are fixed.

Also, typically, fixed cost steps come in large values - you mustbuy a whole machine even if you need only 10% for the newsales available at this time.

Fixed costs are the difficult ones to deal with as you attempt tocost out a future production.

It is critical to forecast sales volumes. If you could only sell 100pens you would have to either raise your selling price or decidewhether or not to stay in business, if you can not change yourfixed costs component.


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Fixed/Variable Cost Example

We are Selling $1.00 Pens, and expect to sell 200 a dayVariable costs: Raw Materials $.20/pen

Labour $.30/pen

Fixed Costs: Rent $50/day

Support Staff $25/day

No matter what, the fixed costs are $75.00 per day, so:

200 pens fixed cost is $75/200=$0.375/pen

Now let's compare the situation at different sales levels:At 100 At 200 At 400

Revenue $ 100 $ 200 $400Expenses

- Variable 50 100 200

- Fixed 75 75 75

Profit $(25) $ 25 $125


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Financial Statement Analysis

The June 1994 Issue of "Better Investing" magazine, page 26has a three-page article about this topic: Start with the notes and read from back to front since the front is

management fluff. Look for litigation that could obliterate equity, a pension plan in sad

shape, or accounting changes that inflated earnings. Use it to evaluate management. The boring things need be read for long

term growth. A quick in and out, such as buying depressed stocks, don'twaste time.

Look for notes on relevant details; not "selected" and "certain" assets.

Profits of operating divisions, geographical divisions, etc. How the company keeps its books, especially as compared to other

companies in its industry. Inventory. Is it down because of a different accounting method? What assets does the company own and what assets are leased?


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Financial Ratios

It is natural then that people use the "standard" financial dataavailable from financial statements to judge the performance ofthe firm.

Performance measures thus developed can be used to answer

questions such as: is the firm able to meet its short term obligations? are the firm's assets generate sufficient profits? how dependent the firm is on its creditors? do their customers pay them promptly?

do they pay their suppliers promptly? Financial Ratios are a common way to answer these and other

questions. They provide the analyst a framework for asking questions

about various performance measures.


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Interpretation of Financial Ratios

While calculating these ratios are simple enough, interpretationis not as simple and require some skill.

Ratios also have problems because of: overly simplistic approaches

they lack support tools there is a lack of analytical framework

dont reflect process complexities

not multidimensional

assumption of comparable units

constant returns to scale

often contradictory ratios - lack objectivity

Nevertheless, they are used everywhere and some actuallyshow meaningful results on the firm as a whole


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Interpretation Rules

To properly interpret ratios, analysts compare such ratios fromthe same company's results over time.

The ratios can also be compared to industry standard ratiosand thus judge company performance.

Such financial ratio analysiscan be done when industrystandard ratios are available from companies like Dun &Bradstreet, TRW, StasCan and others.

When comparing specific company financial statements tothose from, say, StatsCan composites, the firm's financialhealth can be judged.

Care must be taken to use more than one source of standarddata because regional difference can count.

Ratios in Orangeare in the book others are additional.


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Financial Ratio: Liquidity

Liquidity Ratios: evaluate the business' ability to meet its current cash obligations

Working Capital adequacy is measured here

Working Capital = Current Assets - Current Liabilities

The Current Ratio(or Working Capital Ratio) is:Current Ratio = Current Assets/Current Liabilities

all the current assets are involved, even those which may be difficult toturn into cash quickly (prepaid expenses, etc.)

A more stringent ratio is the Acid Test Ratio(or Quick Ratio):Acid Test Ratio = Quick Assets/Current Liabilities

Quick assets are: cash, government securities, A/R, notes receivable -highly liquid assets can turn into cash immediately


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Financial Ratio: Leverage

Leverage or Debt Management Ratios: Captures the extent to which the firm relies on debt for its operations.

The Equity Ratiomeasures owner's equity to total assets the smaller this is, the more the reliance on debt

Total Owner's Equity Total Owner's EquityEquity Ratio = ------------------------------------------ = ----------------------------

Total Liabilities+Total Equity Total Assets

Debt to Total Assets this compares the debt level to the total assets of the firm

Total DebtDebt to Total Assets = -----------------------Total Assets


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Financial Ratio: AssetManagement This ratio assesses how efficiently the firm is using its assets. Inventory-Turnover Ratiolooks at how efficiently inventories

are utilised.Sales

Inventory turnover ratio = -----------------------

Inventories note however that sales are generated over a period of time while

inventories are at a point in time. Average inventory over the salesperiod would be more accurate

also, sales are achieved at market prices while inventories are at cost ofmanufacturing them - thus the ratio overstates the facts

Net Profit (Return-on-total-assets) RatioProfit after taxes (before extraordinaries)

Return on Total Assets = --------------------------------------------------------------Total Assets


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Financial Ratio: Profitability

Return on Sales- measures the profit margin on salesNet Profit

Return on Sales = -----------------------Sales

Return on Equity- measures the returns on funds invested byshareholders.

Net ProfitReturn on Equity = -----------------------

Tangible net worth

Dividend Payout- shows how much cash is received onmoneys invested in the firm.Dividend on Common Shares

Dividend Payout = ---------------------------------------------Net Profit - Preferred Dividend


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Financial Ratio: CashManagement Receivables in Daysmeasures the firm's ability to collect its

money from customersAccounts Receivables

Receivables in Days = ----------------------------------Daily Sales

Inventory in Daysmeasures the inventory levels in daysInventory

Inventory in Days = -------------------------------------Daily Cost of Goods Sold

Accounts Payables in Days- shows how promptly the firmpays its creditors.Accounts Payable

Payment Period in Days = ------------------------------Daily Purchases


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Financial Ratio: Markets (stock)

Earnings per Share- returns on a share ownedNet Profit - Preferred Dividend

Earnings/Share = ------------------------------------------------Number of Common Shares

Price Earnings Ratio- share price to earningsMarket price of Common Shares

Price Earnings Ratio = --------------------------------------------------Earnings/Share

Dividends per Share- cash returns per shareCommon Stock Dividends

Dividends/Share = -----------------------Number of Common Shares

Dividend Yield- % cash received to share priceDividends/Common Share

Dividend Yield = -----------------------------------------------------Market price of Common Shares


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Leverage

This is a concept that is tied into ownership (equity)considerations as well as needs for cash. Leverage works ifyou could sell more if you had more money:

Simply put it works like this:

The company makes a profit of $1,200 with an equityinvestment of $10,000. If there were 1,000 shares issued forthe investment, the EPS = $1.20

Now we borrow $5,000 at a yearly interest of 8% and thus

make a profit of $1,800 less the interest $400.00 this results inan EPS of $1.40

We did not give up equity, so earnings rose per share as thereborrowing cost less that the profit we made.


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Leverage Risks

Naturally, there is no free lunch! There are problems! If sales fall, interest is still paid, so profit falls much faster, profit

can decline to $400 before losses start repayment of the debt requires the recovery of the cash which in poor

times will be difficult lenders get nervous when leverage works against you, so they become

less tolerant

So, what is the best debt/equity ratio? Sorry, there is no suchnumber. But, lenders like to have it at the published industryaverage.

Be careful about debt if it can not be paid back quickly.

But manageable debt increases profitability and henceshareholder value.


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Summary

Remember when calculating numbers, use 360 days for a yearand 5 days for a week, 8 hours for a day.

Financial Accounting is a big subject and can not be dealt withhere adequately, so if interested, read up or take a course in

Accounting 101. Balance Sheets MUST balance, if they don't, find the problem.

Knowing what item is a Balance Sheet item and what is Incomestatement is crucial if you are constructing financial statements.

Everyone must adhere to the rules GAAP or the statements willmean different things to different readers - consistency isessential

financial acct g 14 asdasd

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