Lecture 11: Business Plans and Financial Accounting

Financial Accounting

Concerned with recording/analyzing the financial data of a business

• Includes revenue and expenses, its resources and claims on those resources (for managers, investors, creditors)

Managerial Accounting

Concerned with costs and benefits of activities of an enterprise

• Provides information to managers for decision-making

• Engineers often play a part in cost-accounting

Every organization has _____ and _______

assets and liabilities

Assets

Assets: items to which the organization has legal title

• Current assets can be converted into cash within one year

• Fixed assets (capital assets) have a life greater than one year

Liabilities

Liabilities: debt owed (suppliers, employees, government)

• Current liabilities - debt normally paid within a year (accounts payable, taxes, wages payable, bank loan payable…)

• Long-term liabilities - debt normally paid beyond current year

Owner’s Equity

The difference between assets and liabilities is a means of measuring what the organization is worth - it’s equity:

Assets - Liabilities = Owner’s Equity

Often appears as two components in a balance sheet:

• Stock, or shares

• Retained earnings

As equity builds up, the better off are the owners (eg, a sole proprietor, partnership or shareholders)

The Balance Sheet

The Income Statement

Income statement summarizes revenues and expenses over a specified accounting period.

Major components: Revenue, Expenses, Profits

Revenues increase owner’s equity

• Usually from sales of goods/services

Expenses decrease owner’s equity

• Cost of goods sold, rent, insurance, wages, depreciation

Profits before taxes is revenue - expenses

After deducting taxes we arrive at net profit

Estimated values in financial statements

• Financial statements are often estimates - they may not reflect market values - use cost principle of accounting

• Assets are valued on the basis of their cost (book value)

• Land is listed as the price paid, not its market value

• Plant and equipment is listed at the price paid less accumulated depreciation

  • depreciation on equipment computed using depreciation model

• Finished goods inventory - manufacturing cost

Financial Ratio Analysis

• Financial ratios calculated from items on the income statement and balance sheet are a key performance measure

• In interpreting ratios, analysts should calculate the ratios over a number of periods to do a trend analysis

• Ratios should also be compared to industry standards

Financial Ratios - Liquidity Ratios

• Assess firm’s ability to meet short term financial obligations and weather fluctuations in cash flows

• Reserve of cash and liquid assets called working capital

Working capital = current assets - current liabilities

1. Current ratio = current assets / current liabilities

   • A current ratio of 2 is considered adequate

2. Acid test ratio = quick assets / current liabilities

   • An acid test ratio of 1 is considered adequate

Financial Ratios - Debt Management Ratios

• The extent firm relies on debt

3. Equity ratio = total equity / (total liabilities + total equity)

   = total equity / total assets

   • Smaller the ratio, the more dependent a firm is on debt and the higher the risk of not being able to manage debt

Financial Ratios - Efficiency Ratios

• Assess efficiency of use of its assets

4. Inventory turnover ratio = sales / inventories

Financial Ratios - Profitability Ratios

• Productive assets have been employed in producing a profit

5. Return on assets = Net income / total assets

6. Return on equity = Net income / total equity

Summary of Financial Ratios and Definitions