Chapter

2
Review of Accounting
 ‘Brinker International is a restaurant chain and
is one the leading chains in the US and it doing
very well these days’ What do you understand
by this statement? How would be analyze the
meaning of this statement?
 Income Statement- focus on profitability of the
firm
 Balance Sheet- what the firm owns and how these
assets are financed in the form of liabilities or
ownership interest
 Statement of Cash Flows- shows the critical
nature of cash flow to the operation of the firm.

3
 An Income Statement shows profitability for a
time period (ex: 1 year)
 Revenues from customers for services or
goods/merchandise.
 Expenses from vendors for merchandise,
production, services or supplies.
 Can be prepared in steps Revenues
Less: Expenses
Equals: Net Income
 Sales/Revenue
– Cost of Goods Sold
Step 1 = Gross Profit
– Operating Expenses
Step 2 = Operating Profit (EBIT)
– Interest Expense
Step 3 = Earnings Before Taxes
– Income Taxes
Step 4 = Earnings After taxes
 KRAMER CORPORATION
Income Statement
For the Year Ended December 31, 2010

1. Sales . . . . . . . . . . . . . . . . . $2,000,000
2. Cost of goods sold . . . . . . . . . . . (1,500,000)
3. Gross profits . . . . . . . . . . . . . 500,000
4. Selling and administrative expense . . . . (220,000)
5. Depreciation expense . . . . . . . . . . (50,000)
6. Operating profit (EBIT)* . . . . . . . . 230,000
7. Interest expense . . . . . . . . . . . . (20,000)
8. Earnings before taxes (EBT) . . . . . . . 210,000
9. Taxes . . . . . . . . . . . . . . . . . (99,500)
10. Earnings after taxes (EAT) . . . . . . . . 110,500
11. Preferred stock dividends . . . . . . . . 10,500
12. Earnings available to common shareholders. $ 100,000
13. Shares outstanding . . . . . . . . . . . 100,000
14. Earnings per share . . . . . . . . . . . $1.00
*Earnings before interest and taxes.
 Three sources of capital:
 bondholders,
 preferred stockholders, and
 common stockholders.

 After paying interest to bondholders and

dividends to preferred shareholders, the
remaining amount are available for the
common stockholders. However, the firm
may or may not disburse this amount as
dividends to common stockholders. The firm
may retain the whole/part of the profit as
Retained Earnings for future investment.
 P/E ratio is used to  P/E ratio depends on
determine the current - Sales growth of the firm
value of the common - The risk in performance
stock. - The debt equity of the
 If our earning per firm
share or EPS is $1 and
- The dividend pmt policy
p/e ratio is 20. The
- The Quality of mgt
market value of the - P/E ratio helps us to
compare the relative
common stock is 20*
market value of many
1= $20 companies based o $1 of
earning per share.
 Why is P/E confusing
 When a firm’s
earning is dropping
rapidly its stock price
although declining
may not match the
magnitude of the fall
off in earning and can
give a high P/E ratio
in adversity. (refer to
pg 29 in text book)
A Balance Sheet (B/S) shows what a firm
owns and how it is financed at a point in
time (ex.; December 31)

Remember the ALOE!

Assets = Liabilities + Owners’ Equity

Assets: what a business Liabilities: what a business
owns owes
Current Assets Current Liabilities
Ex:Accounts receivable, Inventory Ex:Accounts payable
Will be sold or used up within 1 year Dues within 1 year

Capital Assets Long-term Liabilities

Ex: Building, Plants, Lands Due some time after 1 year

Equity: what the owner(s) have

invested in the business
Shareholders’ Equity
Capitalstock
Retained earnings
 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
 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
 There is nearly always a disparity between book value and market
value, since the first is a recorded historical cost, and the second is
based on the perceived supply and demand for an asset, which can
vary constantly.

 For example, a company buys a machine for $100,000 and

subsequently records depreciation of $20,000 for that machine,
resulting in net book value of $80,000. If the company were to then sell
the machine at its current market price of $90,000, the business would
record a gain on the sale of $10,000.

 Market value is of primary concern to the:

 Financial manager
 Security analyst
 Stockholders
 Total Asset..................................................... $1,000,000
 Total Liabilities................................................ (300,000)
 Stockholders’ equity...................................... 700,000
 Preferred Stock* obligation.......................... (50,000)
 Net worth assigned to common.................... 650,000
 Common shares outstanding........................ 100,000
 Net worth, or book value per share.............. $6.50

 Book value/ net worth is calculated by subtracting preferred

stock component from stockholder’s equity. In other words,
what is left to common stockholders after we deduct debt and
preferred stock obligation from everything the firm owns.

preferred share represents neither a debt claim nor an ownership interest in the firm. It is a
hybrid, or intermediate type of security. It will be further discussed in chapter 17.
 There are situations when the market value of a
fixed asset is much higher than book value, such
as when the market value of an office building sky
rockets due to increased demand.

 Market value is of primary concern to the:

 Financial manager
 Security analyst
 Stockholders
TABLE 2-5 Comparison of market value to book value per share in January 2003
 Based on past transactions rather than future
forecasts
 May not recognize important economic changes as
they occur
 increase in property values
 new competition
 Variety of accounting policies and methods are
used
 depreciation
 inventory valuation
 The purpose of the statement of cash flows is to
emphasize the critical nature of cash flow to the
operations of the firm.
 Cash flow represents cash or cash equivalent
items that can easily be converted into cash
within 90 days.
 The IS & BS are based on accrual method of
accounting, in which revenues and expenses
are recognized as they occur rather than when
cash actually changes hands.
 The cash flow statement represents the actual
cash flow position of a firm.

 The three primary sections of the cash flow

statement:
1. Cash flows from operating activities.
2. Cash flows from investing activities.
3. Cash flows from financing activities.
 Net income
+
Depreciation
–
Increase in Current Assets
+
Decrease in Current Assets
+
Increase in Current Liabilities
-
Decrease in Current Liabilities

= Net cash flow from operating activities

Cash Flow from investment activity are related to
Long Term Investment in Plant and Equipment

Other Issuers’ Securities

Increasein investment represents use of cash and

decrease in investment represent source of cash
Cash Flow from financing activities shows

Sale or retirement of Bonds, Common Stock,

Preferred Stock or other corporate securities
Payment of Cash dividend

Sale of firm’s securities represent source of funds

and retirement or repurchase of such securities

represent use of fund.
 We should observe that the increase or
decrease in cash flows obtained in Cash Flow
Statement must be equal to the change in the
cash account on the balance sheet.
 If they match it means that the statement is
correct.
 Depreciation
 Attempt to allocate the initial cost of an asset over its
useful life.

 Charging of depreciation does not directly

influence the movement of funds.
 Not a new source of fund
 Provides tax shield benefits measurable as depreciation times the tax
rate
Corporation A Corporation B
Earnings before depreciation and taxes…… $400,000 $400,000
Depreciation……………………………………… 100,000 0
_________ _________
Earnings before taxed………………………… 300,000 400,000
Taxes (40%)……………………………………… 120,000 160,000
_________ _________
Earnings after taxes…………………………… 180,000 240,000
+Depreciation charged without cash outlay… 100,000 0
_________ _________
Cash flow………………………………………… $280,000 $240,000
Difference………………………………………… $40,000
NOW, TO The 3 basic financial statements
REVIEW . . . are the income statement, the
balance sheet, and the statement of
cash flows
The price-earnings ratio relates

the net income per the financial

statements to the market value of
the company’s shares
There are inherent limitations in

the income statement and balance

sheet as to reporting current
values and economic events
Cash flows after tax are essential

information for business decision-

making