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Finance Lecture 1

Keating F&A 1-2 Spring 2008

Outline Lecture 1

• Introduction

• Accounting Statements

• Fun with Ratios


Finance and Accounting

• Finance: Assess performance and plan future actions based on accounting information

• Accounting: The scorecard of business. Provide information about a firm’s performance, problems, and prospects

• Accounting exists, in part, to assist corporate finance decisionmaking

• Finance:Accounting::Head Coach:Team Statistician


Financial Accounting andManagerial Accounting

• Financial Accounting: Measuring and recording business transactions and providing financial statements that are based on generally accepted accounting principles

Reports to external lenders, investors Taxation

• Managerial Accounting: Measuring and reporting financial and nonfinancial information that helps managers make decisions

Example: Activity-Based Costing What is firm’s marginal cost of production?

• Often times, we have financial accounting information, but we want managerial accounting information


Important Jargon: “GenerallyAccepted Accounting Principles”

Important Jargon: “Generally AcceptedAccounting ImpPrinciples”

• The Securities and Exchange Commission has statutory authority to establish financial accounting and reporting standards. To date, the SEC’s policy has been to rely on the private sector for this function to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest.

• The not-for-profit, non-governmental Federal Accounting Standards Board (FASB, www.fasb.org) establishes Generally Accepted Accounting Principles

Statements Interpretations Technical bulletins

http://www.fasb.org/




Outline Lecture 1

• Introduction


• Fun with Ratios


The Two Most Famous Accounting Statementsare Balance Sheets and Income Statements

• A balance sheet is a snapshot, at a point in time, of a firm’s assets and liabilities (claims against those assets)

• An income statement reports a firm’s financial results (revenue, costs, profits) in a given year

• Wealth:Income::Balance Sheet:Income Statement


Balance Sheets BalanceBalance Sheets Balance

• Assets = Liabilities + Stockholders’ Equity

• In reality, there is less to this equivalence than meets the eye

In formulating a balance sheet, assets and liabilities are tallied and the (hopefully positive) difference is labeled “Stockholder’s Equity” Computed “Stockholder’s Equity” almost never remotely equals the current stock price multiplied by the number of shares outstanding, i.e., the market value of the firm Computed “Stockholder’s Equity” is an accountant’s additive convenience with little obvious meaning aside from “more is better”


Balance Sheets Traditionally List Assetsand Liabilities from Most Liquid to Least

Assets 2006 Liabilities and Equity 2006

Cash $10 Accounts payable $60Marketable Securities $0 Notes payable $110Accounts receivable $375 Accruals $140Inventories $615 --------- ------- Total current liabilities $310Total current assets $1,000 Long-term bonds $754 ---------Net plant & equipt $1,000 Total Debt $1,064 Stockholders’ equity $936 ---------- Total assets $2,000 Total liabilities/equity $2,000


Yet More Jargon

• Accounts Receivable – Funds owed to the firm by customers who have not yet paid

• Accounts Payable – Firm debts to vendors not yet paid

• Accruals – Wages owed to workers not yet paid (since workers are generally paid with a lag relative to when work was accomplished)


Income Statements Show HowCorporate Income is Disbursed

Net Sales $3,000Costs Excluding Depreciation $2,616Depreciation $100 ----------Earnings before Interest/Taxes $284Interest $88 ----------Earnings before Taxes $196Taxes $78 ----------Net Income $118 Preferred Dividends $4 Common Dividends $58 Retained Earnings $56


Depreciation EstimatesCapital Consumed in a Year

• Facilities, machines wear out

• Faster depreciation is usually advantageous tax-wise

• Generally not valid to expense capitalinvestments in one year

• Note: Depreciation is NOT generally a current-year cash out-flow; the money was already spent in the past


The Federal and State GovernmentsTax Corporate Income

• Earnings after interest (but before dividends) is paid are subject to corporate income taxation

The tax code de facto favors debt financing over equity financing since interest payments are tax deductible

• While a typical corporation’s average corporate income tax rate might be ~35-45%, the corporate income tax system’s complexity dwarfs the personal income tax system’s complexity

• “Double taxation of corporate income”


Corporate IncomeFaces Double Taxation

• Profitable corporations paycorporate income tax

• Dividends paid to stockholders aretaxed as personal income

• Politicians disingenuously like totax corporations, not “people”


There are Accounting ControversiesLurking in the Shadows

• Example: Suppose your firm has a building that is fully depreciated for tax purposes. On the balance sheet, should it be valued at…

0? (Value IRS assumes) Original purchase price? “Mark to market”?

• This controversy does not affect tax liability, but it impairs cross-corporation comparisons


Outline Lecture 1

• Introduction


• Fun with Ratios


Firms’ Accounting StatementsProvide Analysis

Opportunities• Publicly traded companies are required to issue annual balance sheets and income statements

• Analyzing these accounting statements might provide insight as to how the company is doing

Potentially interesting insights for prospective investors, a company’s own employees, a company’s competitors…

• Recurring problem: Business and accounting practices vary both across firms and, especially, across industries

Example: A good inventory turnover (Annual Sales/Inventory) ratio in the aircraft industry would be atrocious for a food store


Higgins’ Three Favorite RatiosCompose Return on Equity

Net Income Net Income Sales AssetsReturn = ----------------- = ---------------- * ---------- * ---------- On Stockholder Sales Assets StockholderEquity Equity Equity


Net Income/Sales is also TermedProfit Margin

• Higher is better (obviously)

• If you have a low profit margin, hopefully you don’t have a lot of assets tied up

• Profit margin varies inversely with the amount of competition the firm faces


Sales/Assets is also TermedAsset Turnover

• Asset turnover is a function of the firm’s technology

A food store has relatively few assets compared to sales Boeing has enormous assets

• Increases in some assets, e.g., accounts receivable, can be a warning sign


Assets/Equity is also TermedFinancial Leverage

• A problem here is that the denominator is an accountant’s construct (to make the balance sheet balance)

• (Assets/Equity Market Value) might be a more interesting metric

• The corporate tax code encourages financial leverage since debt is tax-preferred

But too much leverage risks firm bankruptcy


A Few Other Famous Ratios

• Current Ratio = (Current Assets/Current Liabilities)

Had better be a fair bit greater than 1.0 How able is the firm to cover near-term liabilities?

• P/E Ratio = (Stock Price/Earnings per Share)

A stock’s price can be viewed as the expected discounted sum of its future dividends A higher P/E suggests the market has more optimistic expectations as to the firm’s future earnings


How Should One Use Ratios?

• There is no one “perfect” ratio Multiple ratios form a mosaic depicting a firm’s performance

• Within a specific firm, large-scale changes in any ratios bear noting

• Cross-firm and, especially, cross-industry ratio comparisons are fraught with risk


A Contrarian Perspective:Perhaps Ratio Analysis is Meaningless

• The Theory of Rational Expectations suggests all publicly available information is already reflected in a firm’s stock price

You as an individual investor doing ratio analysis are not going to learn anything the market does not already know

• What ratio analysis can do is give one insight as to what a firm is doing, e.g., is this a high-risk, high leverage firm?

Descriptive information without creating market trading insight May assist with “clientele effect,” e.g., risk-averse investors shouldn’t invest in high leverage firms

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Economy & Finance

accounting finance

income statements

prospects accounting

accounting controversies

famous accounting statements

corporate income tax

corporate income taxation

net income