Management - Accounting

Sem 1 - 1st Partial

Define institutional equilibrium

Sustainable relationship between the organization and its core stakeholders: they remain willing to participate

What are the two conditions of an institutional equilibrium

• All core stakeholders share the values, objectives, governance and organization of the firm

• All core stakeholders recieve rewards and benefits which are considered fair given the contributions provided

Organizations (esp. corporations) are often characterized by:

• Transferability

  • Participants or ownership interests can change while the organization continues

• Autonomous existence

  • The organization has its own identity and decision-making structure

• Durability

  • The organization can exist for a prolonged period

To remain autonomous and exist over time, organizations need __

To remain autonomous and exist over time, organizations need economic sustainability

What are the four dimensions of economic sustainability?

• Profitability: Does the firm generate enough income to cover costs over time

• Solvency: Can the firm make payments when they are due — debt generates financial charges and increases corporate risk

• Efficiency: How well does the firm turn resources into outputs

• Fairness of remuneration of input: does the business earn enough to compensate contributors adequately?

Define profitability

A firm’s ability to cover negative components (including loan and equity capital) with positive components of income at market conditions without systematically getting support from third parties

Define solvency

The firm’s ability to cover debt at any given moment

Draw a diagram showing how the: profit and loss account, balance sheet, and cash-flow statement relate to: profitability and solvency

Define a balance sheet

A snapshot of the assets used by the company and the funds that are related to these assets at an instant in time

Define the profit and loss account

Measures the gains or losses from both normal and abnormal operations over a period.

Define a cash flow statement

A report of the inflows and outflows of cash. It links the most significant elements of B/S and income statement.

What are the 5 boxes of the balance sheet?

Define inventories

Goods and raw materials held for purpose of resale such as ingredients for a food manufacturer

Define account receivable

Amount due from customers within a year (trade credit)

when customers purchase goods or services on credit

Define cash and equivalents

Liquidity means available to the firm

Define miscellaneous

Other readily payable credits such as pre-paid taxes

e.g. a business pays €1000 in taxes but only owes €800, it has €200 of prepaid tax. It can get that money back or use it to reduce a future tax payment. That makes it an asset

Define issued common stock

Ordinary shares the company has given investors in exchange for investment

Define capital reserves

Equity from sources other than normal business profits

e.g. re-evaluation of assets such as buildings or investors paying ‘share premium’s

Define revenue reserves

Accumulated profits that the company keeps instead of distributing them to shareholders as dividends (trading profits), often used to finance firm growth

How is the value of issued common stock calculated

Number of shares issued x their face value, or par value (official value, not market price)

How are capital reserves calculated

Amounts recorded from capital transactions or adjustments, such as money paid above face value

How are revenue reserves calculated

Profits kept over the years, after losses and payments to shareholders

Define long term loans

Debts that shall be paid within 2-5 years (medium-term) or even more than 20 years (long-term) such as issued bonds and mortgage loans

What are corporate bonds?

Loans investors give to a company. The company promises to pay interest and repay the borrowed money on an agreed date

What are mortgage loans?

Loans secured by property, such as land or a building. The borrower repays the loan plus interest over time. If they fail to repay, the lender can take and sell the property to recover the money

Define short term loans

Debts towards financial institutions or other entities (debt-holders) which are due within one year, such as bonds to be paid within 12 months.

Define accounts payable

Amount due to suppliers within one year

Define miscellaneous

Other debts that should be paid within one year such as current taxes and due dividends

How do we calculate total assets

Fixed assets + current assets = total assets

the whole ‘assets’ side of the table

How do we calculate capital employed

Total assets - current liabilities = capital employed

(or Owner’s funds + long-term loans )

How do we calculate working capital

current assets - current liabilities

(also owners’ funds + long term loans - fixed assets)

Define working capital

Indicates the companys’ short-term financial cushion/operating liquidity for its day-to-day operations

What is the purpose of the profit and loss (P&L)?

A profit and loss account shows whether a business made a profit or a loss over a period, such as a year

What does the p&l account do?

compares the business’s revenue with its expenses

revenue - expenses = profit or loss

We define Profit And Loss as:

Gains or losses from both normal and abnormal company operations over a period

What are normal operations?

The company’s usual business activities.

For a bakery, selling bread generates revenue, while rent is an expense.

What are abnormal operations or events?

Unusual operations/events or outside the company’s main business.

For example, a bakery may make a gain by selling an old delivery van for more than its recorded accounting value

What are revenues

Mainly refer to the value of a company’s sales of goods and services to its customers

Define operating costs

The expenses a company incurs in running its regular business activities

Define overhead costs

The indirect costs of running a business - costs that cannot easily be traced to a specific product or service

What does EBITDA stand for

Earnings before interests, taxes, depreciations, amortizations

What is EBITDA

It represents the cash that is thrown off from the normal trading activities of the business

What is a good thing of EBITDA

It’s largely free from distortions that can arise from accounting policies

What basic job do depreciation and amortization do?

Spread an asset’s cost over the years it is used, instead of recording the whole cost as an expense immediately.

What is depreciation used for?

Tangible assets - physical things

What is amortization used for?

Intangible assets - nonphysical rights or resources

What does EBIT stand for

Earnings before Interests and Taxes

What is EBIT

It is largely the operating or trading profit of the business - It captures the total operating income and total operating cost of the business

Why is EBIT significant

It is from EBIT that a company generates resources to pay interest to bankers, tax to the government, dividends to shareholders

What is interest expense

Interest expense is the cost a firm incurs on borrowed funds, such as bank loans and bonds. It excludes returns paid to shareholders, such as dividends.

How do we calculate net interest expense and net interest income

Net interest expense = Interest expense - Interest income

Net interest income = Interest income - Interest expense

What is pre-tax income

Earnings before payment of taxes

What are income taxes

The amount a company records as an expense to reflect the income taxes it expects to owe on its profits for the period

How is net income used

This is the bottom line, which is the most commonly used indicator of a company’s profitability

It is used to give an idea of the general wealth of the company

Define dividends

Dividends are distributions of a company’s earnings to shareholders, usually paid in cash

Define retained earnings

The percentage of net earnings not paid out as dividends, but retained by the company to be reinvested in its core business or to pay debt

Define EPS

Earnings Per Share

It tells us the profit that shareholders get for each share held (the higher the better)

How do we calculate EPS

Earnings per share

Net income (EAT)

— — — — — —

N_o of stocks

What is a downside of EPS

Not comparable across companies (firms may have few/many shares of low/large value)

What is the P/E

Price to earnings ratio

Reflects the number of years of earnings to pay back the purchase price

How do we calculate Price to earnings ratio

Share price

— — — —-

Earning per share

What does a high P/E mean

The investors are paying more for each share of current net income

the market loves the company

it also may:

• Make hostile takeovers more expensive, potentially discouraging bidders

• Help the company finance acquisitions by offering its own shares as payments

What does a today share price of 50€ and an earnings per share of €5 mean?

P/E = 50/5 = 10

10 years of earnings to pay back todays share price

P/E is __ across companies

P/E is comparable across companies

What does MtB reflect?

Market to book ratio

How the market values a company’s equity compared with its accounting value. It reflects expectations of future profitability and growth, as well as value not fully captured on the balance sheet

How do we calculate MtB

Market capitalisation = _{^{Total market value of company’s outstanding shares}}

— — — —

Owners’ funds = _{Book value of equity (assets - liabilities)}

What does MtB > 1 mean

Market value exceeds book equity

Investors may expect strong future profits

What does MtB < 1 mean

Market value is below book equity

This may reflect weak profit expectations, financial difficulties, concerns about asset values

What is DPS

Dividend per share

Like EPS, but with dividends in place of net income

It determines the dividend earned by each shareholder.

How do we calculate DPS

Dividends paid

— —- —- —- —

Number of stocks

What is the payout ratio

The fraction of earnings that is paid out to shareholders

How do we calculate the payout ratio

Dividends paid

— — — — —

Net income (EAT)

Name the 4 profitability ratios

• ROTA

• ROS

• Asset turnover

• ROE

Write out the calculations of the 4 profitability ratios

Write out the calculations of the 2 financial strength ratios

Write out the calculations of the 3 liquidity ratios

What are the three types of financial ratios

• Profitability ratios

• Financial strength ratios

• Liquidity ratios

Define profitability ratios

Profitability ratios measure the capacity to preserve the income equilibrium in the future

Define financial strength ratios

Financial strength ratios measure the capacity to preserve the income equilibrium in the future

Define liquidity ratios

Liquidity ratios measure (short/long-term solvency) i.e. the capacity for the company to pay bills as they arrive

What are the two types of analysis approaches for these ratios

• Time series: over time within the same firm

• Cross-sectional: At one point in time, across firms

How do we calculate ROTA

Return on Total Assets

EBIT

——————-

Total Assets

(earnings before interests and taxes) / (current assets + fixed assets)

How do we caclulate EBIT

Revenues - operating costs - amortizations - depreciations

What does ROTA measure

The rate of return a company generates on its total assets

Measures how well management uses its assets to generate an operating surplus

What are 3 problems with ROTA

• Hides product differences: Shared assets/cost can make individual product contributions hard to isolate

• Affected by sales volume: ROTA can rise or fall with demand even without changes in operational efficiency

• Depends on asset valuations: Asset age and depreciation affect ROTA: older assets can make returns appear higher

When are ROTA comparisons most meaningful and what might an above-average ROTA indicate?

• Most meaningful between companies in the same industry

• ROTA above the industry average may indicate a competitive advantage

Into what calculation can ROTA be ‘decomposed’

ROS x Asset Turnover

What does ROS measure

ROS measures operating profit as a percentage of sales, also called the operating profit margin

How do we calculate ROS

EBIT / Total Sales

What may increases in ROS over time reflect?

• Higher prices

• A more profitable product mix

• Better cost control

What does a ROS of 10% mean

The company earns $0.10 in operating profit per $1 of sales

What does asset turnover measure

Sales generated per dollar of assets

How do we calculate asset turnover

Total sales / Total assets

What does an asset turnover of 2 mean

$2 of annual sales for every $1 of assets

What can high asset turnover compensate for?

High asset turnover can compensate for low profit margins

What values are included in total assets on a balance sheet?

_{^{idk if this is the full list of values}}

• Fixed assets

• Inventories

• Accounts receivable

• Cash

What does ROE measure

Return on equity

Measures the absolute return delivered to shareholders

How do we calculate ROE

Net income / Owners’ funds

What does a good ROE enable

Makes it easy to attract new funds and enables the company to grow

Why should ROE be high

It should be high enough to compensate shareholders for the specific risk of investing in the company. Riskier companies should earn higher ROE to convince shareholders to invest