Slidedeck: The Basics of Accounting

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  • 1. E145/STS173 Workshop A Basics of Accounting Professors Tom Byers and Randy Komisar Stanford University With special thanks to: Roma Jhaveri, Ben Hallen, Filipe Santos, Yosem Companys Copyright © 2004 by the Board of Trustees of the Leland Stanford Junior University and Stanford Technology Ventures Program (STVP). This document may be reproduced for educational purposes only.
  • 2. Goals of the Workshop
    • Review main accounting documents and financial analysis
      • Balance Sheet
      • Income Statement (Statement of Operations)
      • Statement of Cash Flows
    • Please refer also to the handout: How to Read a Financial Report
  • 3. How Does It All Add Up Income Expenses Assets Liabilities When you buy something… When you get paid for a product or service… The value of anything you own… The value of anything you borrow… Assets often generate income Liabilities often generate expenses
  • 4. Some Accounting Principles
    • Accounting items are classified into “accounts” according to their nature, translated into monetary units, and organized in statements
    • Basic Accounting formula:
    • Assets = Liabilities + Equity
    What the company owns How the ownership of assets was financed ( By third parties or by the owners)
  • 5. Accounting vs. Market Value
    • Equity: Ownership of a company is divided in certificates called common shares
    • Accounting Value (or Book Value) = Equity = Assets – Liabilities
    • Accounting Value is different from Market Value !!!
    • Market Value = Share Price * Number of Common Shares Outstanding
  • 6. Income Statement
    • Reports the economic results of a company over a time period. It shows the derivation of earnings or losses.
    • + Revenues
    • - Cost of Revenue (product cost or COGS)
    • = Gross Margin
      • Sales and Marketing
      • General and Administrative
      • Research & Development
      • Depreciation and Amortization
    • = Operating Income (EBIT)
    • + Interest Income(expense) net
    • = Net Income before Taxes
    • - Income Tax Provision
    • - Extraordinary Items
    • = Net Income
    Income Statement of XXX Corp. – year 2000 $ % Rev.
  • 7. Income Statement - Analysis
    • When does a transaction affect income? - When it changes the economic value of the company for the owners
    • Some Profitability Measures :
      • Gross Margin (%) = Gross Profit / Sales
      • Operating Margin = Operating Income / Sales
      • Return on Sales = Net Income / Sales
      • Return on Equity = Net Income / Shareholders’ Equity
    • Other Important Measures
      • Earnings Per Common Share (EPS) = Net Income / Common Shares
      • Price Earnings Ratio (P/E) = Market Price / Earnings Per Share
  • 8. Income Statement - Example
    • The following information was taken from the 2001 financial statements of Kellogg Company. Dollar amounts are in millions.
    • Cost of goods sold $ 4,128.5
    • Selling & admin. expenses 3,523.6
    • Interest expense 351.5
    • Other expense 54.0
    • Net sales 8,853.3
    • Income tax expense 322.1
    From Kimmel et. al. Financial Information For Decision Making
  • 9. Income Statement - Example
    • KELLOG COMPANY
    • Income Statement
    • For the Year Ended December 31, 2001
    • Net sales $ 8,853.3
    • Cost of goods sold 4,128.5
    • Gross Profit 4,724.8
    • Selling & admin. expense 3,523.6
    • Income from Operations 1,201.2
    • Interest expense 351.5
    • Other expense 54.0
    • Net Income Before Taxes 795.7
    • Income tax expense 322.1
    • Net Income $ 473.6
  • 10. Balance Sheet
    • It is a financial snapshot of a company at a given point in time
    Current Assets (liquid in less than a year) Fixed Assets Other Assets Current Liabilities (payable in less than a year) Long-Term Liabilities (bonds issued, bank loans) Shareholders’ Equity Cash and Equivalents Accounts Receivable Inventories Property, plant and equipment (minus Depreciation) Intangibles (minus depreciation) Investment Securities Total Assets = Accounts Payable Accrued Expenses Short Term debt Common Stock Additional Paid-in Capital Retained Earnings Total Liabilities + Shareholder’s Equity Balance Sheet of XXX Corp. - 31 December of 2000 (in thousand $)
  • 11. Balance Sheet - Analysis
    • Working Capital : measure of the amout of cash available in the short-term; Also, indication of the funds needed operate within a given business size
    • = Current Assets – Current Liabilities
    • Liquidity ratios : measures of the ability to meet short term financial obligations
      • Current Ratio: Current Assets / Current Liabilities
      • Acid-test: (Cash + Accounts receivable) / Current Liabilities
    • Operational Efficiency Measures
      • Inventory Turnover = Cost of Sales per year / Current Inventory
      • Accounts Receivable Collection Period = accounts receivable / sales
      • Accounts Payable Collection Period = accounts payable / cost of sales
  • 12. Balance Sheet - Example
    • These financial statement items are for Tweeter Entertainment Group at year-end on September 30, 2001. (in millions)
    • Accounts payable $ 38.6
    • Property, plant & equipment 109.1
    • Receivables 31.3
    • Other current liabilities 23.3
    • Stockholders’ equity 332.4
    • Cash 3.3
    • Long-term debt 36.7
    • Inventories 129.2
    • Accrued expenses 38.9
    • Other current assets 7.5
    • Other liabilities 10.5
    • Other assets 200.0
    From Kimmel et. al. Financial Information For Decision Making
  • 13. Balance Sheet - Example Assets Current assets Cash $ 3.3 Receivables 31.3 Inventories 129.2 Other current assets 7.5 Total current assets 171.3 Property, plant & equipment 109.1 Other assets 200.0 Total assets $ 480.4 Liabilities and Stockholders’ Equity Current liabilities Accounts payable $ 38.6 Accrued expenses 38.9 Other current liabilities 23.3 Total current liabilities 100.8 Long-term debt 36.7 Other liabilities 10.5 Total liabilities 148.0 Stockholders’ equity 332.4 Total liab. & stock. equity $ 480.4 TWEETER HOME ENTERTAINMENT GROUP Balance Sheet (in millions) September 30, 2001
  • 14. Statement of Cash Flows
    • The Statement of Cash Flows reports cash receipts and payments over a period, separating operational, investing and financing activities.
    + Cash Flow from operating activities (reconciled from income statement) = income - net changes in working capital (except cash and equivalents) + depreciation and amortization + Cash Flow from investing activities + Cash Flow from financing activities = Net Change in Cash or Equivalents + Cash or Equivalents at beginning of period = Cash or Equivalents at end of period Statement of Cash Flows of XXX Corp. – 2000 $
  • 15. Statement of Cash Flows - Analysis
    • CFIMITYM !!!
    • (Cash Flow is More Important Than Your Mother!! )
    • Especially for an entrepreneurial firm...
    • How is cash flow different from income?
      • Income accrual is not necessarily linked to cash transactions (e.g., depreciation, sales by credit)
      • Some activities affect cash flows but not income (e.g., investments in fixed assets, additional capital from shareholders)
    • Growth often absorbs cash flow because of a higher need for working capital and fixed investments (Entrepreneurial firms with negative income and high growth can have a very fast cash burn rate)
  • 16. Statement of Cash Flows - Example
    • SIERRA CORPORATION
    • Statement of Cash Flows
    • For the Month Ended October 31, 2004
    • Cash flows from operating activities
    • Cash receipts from operating activities $ 11,200
    • Cash payments for operating activities (5,500)
    • Net cash provided by operating activities $ 5,700
    • Cash flows from investing activities
    • Purchased office equipment (5,000)
    • Net cash used by investing activities (5,000)
    • Cash flows from financing activities
    • Issuance of common stock 10,000
    • Issued note payable 5,000
    • Payment of dividend 500
    • Net cash provided by financing activities 14,500
    • Net increase in cash 15,200
    • Cash at beginning of period 0
    • Cash at end of period 15,200
    From Kimmel et. al. Financial Information For Decision Making