7 Financial Accounting and Analysis

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7 - Financial Accounting and Analysis
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Contents

• Accounting Principles
• T- Accounts
• Key Financial Statements
• Fundamentals of Financial Analysis
• Balanced Scorecard
• Summary

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Accounting

• Accounting measures the results of business
  activities and communicates the information to
  interested readers.
• Engineers need to develop understanding of
  accounting concepts to use accounting data
  effectively.

4
Financial Managerial Accounting

• Financial accounting deals with preparing general
  purpose reports for people outside the
  organisation to use.
• Managerial accounting deals with providing
  information for managers inside the organisation
  to use.

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Asset, Liability and Shareholders Equity

• Asset a resource with the potential to provide
  future economic benefits, e.g. cash, accounts
  receivable, marketable securities, fixed assets,
  and inventory.
• Liability an obligation that legally binds a
  company to settle a debt, e.g. accounts payable,
  taxes, wages, accrued expenses, and deferred
  revenues.
• Shareholders equity a firms' total assets minus
  its total liabilities.

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Assets and Claims of A Firm

• Assets (A) Liabilities (L) Owners Equities
  (OE)

Retain Profit
Invest
Assets
Investors
Investors
Claim - Equity
Claim Retained Earnings
Liability
Credit
Creditors, suppliers, etc
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Accounting Principles

• Dual Aspect - Assets equal to claims against them
  and each transaction has a dual effect
• Full Disclosure All relevant information must
  be disclosed
• Going Concern - The business of the enterprise
  is assumed to go on forever

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Accounting Principles (contd)

• Accrual - Revenues recognized when earned (upon
  shipment and invoicing), costs and expenses
  recognized when incurred, in contrast to
  cash-based accounting
• Matching - Revenue matches the costs and expenses
  incurred in a given accounting period
• Conservatism - Assets and inventory recorded at
  lowest values consistent with objectivity, losses
  recorded as soon as known

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T-Account
XYZ Account
Rules Increases in assets are debited
to the account. Decreases in assets
are credited to the account.
Liabilities and owners
equity are handled in a reversed
manner.
Debit
Credit
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T-Account
XYZ Account
A L OE
Debit
Credit
Alternative Rule Each transaction has two
entries. The entry that causes the LHS value to
increase temporarily is to be debited to the
account, and vice versa. The equation remains
valid at all time.
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T-Account Example

• Purchase office supplies (500) in cash
• Pay accounts payable of 3,500 in cash
• Purchase office supplies (200) by credit

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Use of T-Accounts

• Accountants enter transactional data to
  T-accounts and verify accuracy
• Data in T-accounts are then regrouped to produce
  standard line items in financial statements
• Financial statements are then prepared for both
  internal and external use.

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Financial Statements

• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Funds Flow Statement

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Balance Sheet

• The balance sheet represents a snapshot of the
  assets of a firm and the financing of the assets
  (liabilities and owners equities) as of a
  specific date.
• Assets Liabilities Shareholders Equity.

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Asset Recognition

• Accounting recognises resources as assets when
• the firm has acquired rights to use in the future
  as a result of a past transaction or exchange,
  and
• the firm can measure or quantify the future
  benefits with a reasonable degree of precision.
• All assets are future benefits not all future
  benefits, however, are assets. Asset recognition
  is not always easy.

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Asset Valuation Bases

• Acquisition or historical cost is the amount of
  cash payment (or cash equivalent value of other
  forms of payment) made in acquiring an asset.
• Current replacement cost is the amount currently
  required to acquire the rights to receive future
  benefits from an asset.
• Current net realisable value is the net amount of
  cash (selling price - selling cost) that the firm
  would receive currently if an asset is sold
  (separately).
• Present value of future net cash flows is a
  measure of the ability of an asset either to
  generate future net cash receipts or to reduce
  future cash expenditures.

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Generally Accepted Practices

• Monetary assets such as cash and account
  receivable appear on the balance sheet at their
  net present value.
• Nonmonetary assets such as merchandise inventory,
  land, buildings and equipment appear at
  acquisition cost.

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Asset Classification

• Current assets (1 year)
• Long-term assets (more than 1 year).

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Liability Recognition

• A liability arises when a firm receives benefits
  or services and in exchange promises to pay the
  provider of those goods or services a reasonably
  definite amount at a reasonably definite future
  time.
• All liabilities are obligations but not all
  obligations are liabilities.

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Liability Valuation Classification

• Most liabilities are monetary.
• Current liabilities (1 year)
• Long-term liabilities (more than 1 year)

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Shareholders Equity

• The shareholders equity in a firm is a residual
  interest.
• The owners have a claim on all assets not
  required to meet the claims of creditors.
• The valuation of the assets and liabilities
  included in the balance sheet therefore
  determines the valuation of total shareholders
  equity.

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Shareholders Equity (continued)

• The net increase in stockholders equity that
  results from business operations is accumulated
  in the Retained Earnings account.
• R.E.t R.E.t-1 N.I.t - Dividendt

Net Income in period t
Retained earning in period t
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Balance Sheet Terms

• Deferred Income Tax - Tax yet to be paid (local
  sales tax, income tax)
• Prepaid Income - Income received in advance of
  being earned (before shipment and invoicing)
• Prepaid Expense - Expenses paid in advance of
  benefits received (registration for seminar,
  vacation booking)

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Balance Sheet Terms (contd)

• Retained Earnings - Accumulated earnings owned by
  shareholders but retained within the enterprise
  for business use
• Capital Surplus - Premium price above the par
  value (e.g., 1/Share) of the stock, due to
  increase of Owners Equity not through earnings
  by normal operations

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Balance Sheet (ABC Company)
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Income statement

• The income statement provides information about
  the operating performance of a firm for some
  particular period of time.
• Net income Revenues - Expenses

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Income Statement Terms

• Sales Revenue - Income realized by the enterprise
  through the sales of products/ service in a
  period
• Cost of Goods Sold (CGS) - Cost incurred for
  producing goods sold in a period ( opening
  inventory plus labor, material and overhead,
  minus closing inventory)
• Gross Margin - Revenue minus cost of goods sold

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Income Statement Terms (contd)

• Net Income - The excess of revenue over costs and
  expenses (overhead, taxes, interests), also
  called Profits, or NOPAT (net operating profit
  after tax)
• EBIT - Earnings before interests and taxes
• Earning Per Share - Net income of the enterprise
  minus preferred stock dividend per common stock
  share
• Dividend - Amount per share declared by the board
  and paid out by the company (annually)

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Income Statement of ABC Corp.
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Cash Basis of Accounting

• A firm recognises revenues from selling goods and
  providing services in the period when it receives
  cash from customers.
• It reports expenses in the period when it makes
  cash expenditures for merchandise, salaries, etc.
  
• Expense recognised in a period does not
  correspond to benefit derived from an asset in
  the same period.

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Illustrative Example

• Ace Hardware Store (AHS) Donald and Joanne Ace
  open a hardware store on January 1, Year 1. The
  firm receives 20,000 in cash from the Aces and
  borrows 12,000 from a local bank. The firm must
  repay the loan on June 30, Year 1, with interest
  at the rate of 12 percent per year. The firm
  rents a store building on January 1, and pays 2
  months rent of 4,000 in advance. On January 1,
  it also pays the premium of 2,400 for property
  and liability insurance coverage for the year
  ending December 31, Year 1. During January it
  acquires merchandise costing 40,000, of which it
  purchases 26,000 for cash and 14,000 on
  account. Sales to customers during January total
  50,000, of which 34,000 is for cash and 16,000
  is on account. The acquisition cost of the
  merchandise sold during January is 32,000, and
  various employees receive 5,000 in salaries.

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Performance Statement on Case Basis for AHS
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Limitations of Cash Basis

• It does not adequately match the cost of effects
  required in generating revenues with those
  revenues.
• It postpones unnecessarily the time when firms
  recognise revenues.

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Accrual Basis of Accounting

• It recognises revenue when a firm sells goods or
  renders services.
• Cost incurred leads to expenses in the period in
  which the firm recognises the revenue that the
  cost helped to generate.
• Costs incurred that a firm cannot closely
  identify with specific revenue streams become
  expense of the period in which the firm consumes
  the services of an asset and the future benefits
  of the asset disappear.

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Income Statement for AHS
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Accrual Basis vs. Cash Basis

• The accrual basis of accounting provides a
  better measure of operating performance because
• revenues more accurately reflect the results of
  sales activity in an accounting period, and
• expenses more closely match reported revenues.

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Timing and Measurement

• Under accrual accounting, we must consider
• when a firm recognises revenues and expenses
  (timing) and
• how much it recognises (measurement).

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Timing measurement of revenues

• A firm recognises revenues when
• it has performed all, or a substantial portion,
  of the services it expects to provide, and
• it has received either cash, a receivable, or
  some other asset susceptible to reasonably
  precise measurement.
• A firm measures the amount of revenues by the
  cash or cash-equivalent value of other assets it
  receives from customers.
• Adjustments are made for uncollectible accounts,
  sales discounts and allowance, and delayed
  payments.

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Timing measurement of expenses

• Asset expirations become expenses as follows
• Asset expirations associated directly with
  particular type of revenues are expenses in the
  period when a firm recognises revenues. This
  treatment, called matching convention, matches
  cost expirations with revenues.
• Asset expirations not clearly associated with
  revenues become expenses of the period when a
  firm consumes services in operations.

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Product Costs and Inventory

• Product costs are assets they become expenses
  only when a firm sells the products.
• In a merchandising firm, the inventory is
  evaluated at acquisition cost in the balance
  sheet. The same amount of acquisition cost is
  stated as the cost of goods sold in the income
  statement when the products are sold.
• In a manufacturing firm, there are two types of
  inventory work-in-process and finished goods
  inventory.

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Direct and Indirect Costs

• Three types of costs are reported direct labour,
  direct material, and manufacturing overhead.
• Selling costs are period expenses. Accounting
  reports selling costs (advertising costs,
  marketing costs, etc.) as expenses in the period
  when a firm uses their services.
• Administrative costs are also period expenses.
  The amount of an expense is the cost of the
  expired asset.

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Statement of Cash Flows

• This statement reports the net cash flows
  relating to operating, investing, and financial
  activities for a period of time.
• Remember that not all revenues result in an
  immediate increase in cash and that not all
  expenses result in an immediate decrease in cash.

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Statement of Cash Flows (contd)

• Cash flow statement shows the actual cash flow
  generated by the firm for the year. The primary
  categories for this statement include
• Cash flow from operations collections from
  customers, payments to suppliers, other operating
  cash outflows and interest payments, tax
  payments.
• Cash flow from investment activities amount of
  cash used for investments by the firm.
• Cash flow from financing transactions cash
  inflows or outflows to or from the firms lenders
  and owners.

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Statement of Cash Flow ABC Corp.
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Funds Flow Statement

• Also called Statement of Changes in Financial
  Position, or Statement of the Sources and Uses of
  Funds
• Objective Compare the companys activities
  between two consecutive periods related to the
  sources and uses of funds (financial resources)

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Funds Flow Analysis Principles

• Increase of Assets - A use of funds (e.g., paying
  cash to buy a new car)
• Decrease of Assets - A source of funds (e.g,
  selling a used car to receive cash to spend)
• Increase of Liabilities - A source of funds
  (e.g., Borrowing money from the bank to have more
  money to spend)
• Decrease of Liabilities - A use of funds (e.g.,
  paying down mortgage needs to spend cash)
• Information can be obtained from Income
  Statement, Balance Sheet and other accounts

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BALANCE SHEET FOR XYZ COMPANY (Million) Y
ear 2000 Year 2001 Change ASSETS Cash 231.
00 245.70 14.70 (m) Marketable
Securities 450.80 314.90 -135.90 (c) Accounts
Receivable 807.10 843.50 36.40
(n) Inventories 1,170.70 1,387.10 216.40
(o) Total Current Assets 2,659.60 2,791.20 131.
60 Fixed Assets 11,070.40 11,897.70 827.30
(k) Accumulated Depreciation 6,410.70 6,618.50 2
07.80 Net Fixed Assets 4,659.70 5,279.20 619.50
Long-term Receivables and Other
Investments 574.80 735.20 160.40 (k) (p) Prepaid
Expenses 260.90 362.30 101.40 (s) Total
Long-term Assets 5,495.40 6,376.70 881.30 TOTAL
ASSETS 8,155.00 9,167.90 1,012.90 LIABILI
TIES Notes Payable 65.30 144.50 79.20
(d) Accounts Payable 571.20 622.80 51.60
(e) Accrued Taxes 346.30 275.00 -71.30
(q) Payroll and Benefits Payable 433.70 544.30 1
10.60 (f) Long-term Debt Due Within a
Year 30.40 50.80 20.40 Total Current
Liabilities 1,446.90 1,637.40 190.50 Long-term
Debt 1,542.50 1,959.90 417.40 (h) Deferred Tax
on Income 288.40 405.30 116.90 (g) Deferred
Credits 27.00 36.30 9.30 (j) Total Long-term
Liabilities 1,857.90 2,401.50 543.60 TOTAL
LIABILITIES 3,304.80 4,038.90 734.10 Common
Stock (1.00 Par Value) 81.40 82.20 0.80
(i) Capital Surplus 1,549.10 1,589.60 40.50
(i) Accumulated Retained Earnings 3,219.70 3,457
.20 237.50 TOTAL OWNER'S EQUITY 4,850.20 5,129.0
0 278.80 TOTAL LIABILITEIS AND OWNERS'
EQUITY 8,155.00 9,167.90 1,012.90
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FUNDS FLOW STATEMENT FOR XYZ COMPANY
(Million) 2000-2001 SOURCES Net
Income 410.30 (a) 24.11 Depreciation 308
.60 (b) 18.14 Decrease in Marketable
Securities 135.90 (c) 7.99 Increase in Notes
Payable 79.20 (d) 4.66 Increase in Accounts
Payable 51.60 (e) 3.03 Increase in Payroll
and Benefits 110.60 (f) 6.50 Increase in
Deferred Tax on Income 116.90 (g) 6.87 Increas
e in Long-term Debt 437.80 (h) 25.73 Increase
in Common Stock and Capital 41.30
(i) 2.43 Increase in Deferred Credit 9.30
(j) 0.55 TOTAL SOURCE OF FUNDS
1,701.50 100 USES Increase in
Plants and Equipment 928.10 (k) 54.55 Divide
nd Paid 172.80 (l) 10.16 Increase in
Cash 14.70 (m) 0.86 Increase in Accounts
Receivable 36.40 (n) 2.14 Increase in
Inventories 216.40 (o) 12.72 Increase in
Long-term Receivables and Other
Investments 160.40 (p) 9.42 Increase in
Accrued Taxes 71.30 (q) 4.19 Increase in
Prepaid Expenses 101.40 (s) 5.96 TOTAL USES
OF FUNDS 1,701.50 100 Depreciation is
a non-cash expenditure, which must be added back
here to represent a source of funds available to
the firm Additional information is needed from
other relevant accounts
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Financial Analyses

• Objective To Assess the Business
  Factors (1) Liquidity, (2) Activity,
  (3) Profitability related to the wellbeing of a
  company

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Liquidity

• It represents the companys capability of
  satisfying its current liabilities. Without
  liquidity, there will be no activity.
• Working Capital Current Assets (CA) - Current
  Liabilities (CL), indicating companys financial
  reserve strength to weather adversities
• Current Ratio CA/CL

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Liquidity (contd)

• Quick Ratio Quick Assets/CL Quick Assets
  Cash Marketable Securities Accounts
  Receivables
• Interest Coverage Ratio EBIT/Interest Number
  of times interest payments can be covered by EBIT
  earned in current year
• Capitalization Long-term Debit Owners Equity

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Liquidity (contd)

• Long-Term Debit to Capitalization Ratio
  Percentage of debts in companys capital
  structure
• Total Liability to Owners Equity Ratio A
  measure of the companys financial independence
• Total Debt to Total Asset Ratio A measure of
  companys debt level in relation to assets

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Exercise XYZ Company (2001)

• Working Capital
• Current Ratio
• Quick Ratio
• Interest Coverage Ratio
• Capitalization
• Long-Term Debit to Capitalization Ratio
• Total Liability to Owners Equity Ratio
• Total Debt to Total Asset Ratio

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Activity

• Activity is measured by sales and inventory.
  Successful activity level leads to company
  profitability
• Collection Period Receivables divided by
  average daily sales (average daily sales total
  annual sales/360). It indicates the companys
  effectiveness in collecting receivables.

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Activity

• Cost of Goods Sold to Average Inventory Ratio
  (Turn Ratio) The frequency by which the average
  inventory is recouped (or turned over) through
  operations (inventory turnover rate)
• Inventory to Sales Ratio A measure of inventory
  investment per sales dollar
• Sales to Asset Ratio A measure of sales
  activities per unit assets deployed

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Activity Assessment for XYZ

• Collection Period
• Inventory Turnover Rate
• Inventory to Sales Ratio
• Sales to Asset Ratio

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Profitability

• Profitability is the ultimate goal of all firms.
  Without liquidity and activities, there can be no
  profitability for the firm.
• Gross Margin to Sales Ratio A measure of
  profitability based on sales (Gross Margin
  Percentage)
• Net Income to Sales Ratio Return on Sales (ROS)

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Profitability

• Net Income to Owners Equity Return on Equity
  (ROE)
• Net Income to Total Asset Ratio Return on
  Assets (ROA)
• Other Ratios EBIT to Assets, EBIT to Sales, CGS
  to Sales
• Sales to Employees Ratio Worker Productivity
  Measure

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Profitability Assessment for XYZ

• Gross Margin to Sales Ratio
• ROS
• ROE
• ROA

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Use of Performance Ratios

• Ratios provide an instantaneous description of
  the firms financial conditions
• Cautions in applying ratios (1) Financial data
  may not be based on the same assumptions
  (inventory, depreciation accounting, interest
  rates), (2) Past performance may not predict the
  future

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Example (Dell versus Compaq)
63
Example (Dell versus Compaq)

• Operational Efficiency Comparable
• Assets utilization - Dell is significantly
  better than Compaq (e.g., outsourcing most
  manufacturing operations, reduced inventory by
  build to order, faster collection of account
  receivables using direct sales model, use higher
  leverage in debt financing)

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Economic Value Added (EVA)

• A registered trademark of Stern Stewart Co.
  1989
• Periodic financial value-based performance
  measure
• Focuses on maximizing the wealth of shareholders
  (shareholder value)
• Calculates a companys true economic profit
• Helps managers to create value for shareholders

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EVA Calculation

• For a single period
• EVA EBIT Tax WACC(Total Capital Employed),
  where WACC weighted average of cost of capital
• EBIT Tax Net Income Interest
• For multiple periods
• Calculate EVA for each period
• Calculate NPV using i WACC

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Interest is A Cost of Capital
Total Value Net Income Interest EBIT
Tax Total capital Total Debt Owners equity
67
EVA Calculation Example

• Calculate the EVA for XYZ in 2001 if the
  companys cost of capital is 10
• Total value
• Total Capital
• EVA

68
EVA Implementation

• Stern Stewart Co. supports approximately 250
  large companies around the world
• General correlation between EVA and stock returns
  of many companies
• Companies apply EVA include ATT, Eastman
  Chemical. Coca-Cola, Eli Lilly, Wal-Mart, and US
  Postal Service
• Few implementations reported in small companies

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EVA Deficiency

• Not easy to use too complicated for small
  companies (e.g. to transform traditional income
  statements into EVA, 164 adjustments have to be
  made)
• Recommends inexpensive debt in order to reduce
  cost of capital rather to a very questionable
  strategy for small business
• A passive accounting tool measures past
  performance because the business environment
  for small companies changes extremely quickly
  frequent financial evaluations are essential

70
Balanced Scorecard (BS)

• Performance metrics are critically important in
  guiding the progress of companies - Employees
  focus on tasks/programs which contribute to
  career advancements, bonus and other rewards
• Measurement metrics need to be easily measurable
  (quantitative), broad based and balanced
  (short-term profits and long-term growth)

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Areas for Corporate Performance Assessment

• Financial Shareholder value (ratios in
  traditional scorecard)
• Customers quality, time, service, cost
• Internal business processes core competencies,
  response to customer needs
• Innovation and corporate learning new products,
  continuous improvement, value addition to
  customers

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BS Example

• Financial Cash flow, quarterly sales growth and
  operational income, market share increase, ROE
• Customer - sales from new products, sales
  from proprietary products, on-time delivery as
  defined by customers, share of key accounts
  purchase, ranking by key accounts, of
  collaborative efforts with customers

73
BS Example (contd)

• Internal Business Process Manufacturing
  capabilities versus competitors, manufacturing
  excellence (cycle time, unit cost and yield),
  design engineering efficiency, new product
  introduction schedule versus plan)
• Innovation and learning Time to develop next
  generation technology, speed to learn new
  manufacturing process, products that equal 80
  of sales (the critical few), new product
  introduction versus competition

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Balanced Scorecard Results

• United Parcel Service 30 to 40 increase in
  profitability
• Mobile Oil (North American Marketing and Refining
  Division) improved its industrial standing from
  last to first

75
Summary

• Review of basics in Financial Accounting
  -T-accounts, Income Statement, Balance Sheet,
  Funds Flow Statement, accounting terms, ratio
  analysis, economic value added, and balanced
  scorecard
• How scores are being kept and where engineers can
  add value are indicated