Enterprise Code 0454 Lecture 4 Understanding & Using Financial Information

What Is Accounting?

Communication

Interpreting

Measuring

Financial Accounting

Management Accounting

Decision Making
2

Accounting is the system a business uses to identify, measure, and communicate financial information to others, inside and outside the organization. Because outsiders and insiders use accounting information for different purposes, accounting has two distinct facets. Financial accounting is concerned with preparing financial statements and other information for outsiders such as stockholders and creditors (people or organizations that have lent a company money or have extended them credit); management accounting is concerned with preparing cost analyses, profitability reports, budgets, and other information for insiders such as management and other company decision makers. To be useful, all accounting information must be accurate, objective, consistent over time, and comparable to information supplied by other companies.

What Accountants Do

Bookkeeping Bookkeeping

Cost Cost Accounting Accounting Financial Financial Analysis Analysis

3

Tax Tax Accounting Accounting

Some people confuse the work accountants do with bookkeeping, which is the clerical function of recording the economic activities of a business. Although some accountants do perform bookkeeping functions, their work generally goes well beyond the scope of this activity. Accountants design accounting systems, prepare financial statements, analyze and interpret financial information, prepare financial forecasts and budgets, and prepare tax returns. Some accountants specialize in certain areas of accounting, such as cost accounting (computing and analyzing production costs), tax accounting (preparing tax returns and interpreting tax law), or financial analysis (evaluating a companys performance and the financial implications of strategic decisions such as product pricing, employee benefits, and business acquisitions).

Ten Most Important Accounting Skills Analytical Problem solving Interpersonal Listening Communication Leadership Decision making Time management Teamwork Computer

In addition to traditional accounting work, accountants may also help clients improve business processes, plan for the future, evaluate product performance, analyze profitability by customer and product groups, design and install new computer systems, assist companies with decision making, and provide a variety of other management consulting services. Performing these functions requires a strong business background and a variety of business skills beyond accounting.

Fundamental Accounting Concepts

The Accounting Equation Double-Entry Bookkeeping The Matching Principle

5

In their work with financial data, accountants are guided by three basis concepts: the fundamental accounting equation, double-entry bookkeeping, and the matching principle.

The Accounting Equation

Owners Equity:

Assets Liabilities = Owners Equity

Accounting Equation:

Assets = Liabilities + Owners Equity

For thousands of years, businesses and governments have kept records of their assetsvaluable items they own or lease, such as equipment, cash, land, buildings, inventory, and investments. Claims against those assets are liabilities, or what the business owes to its creditorssuch as banks and suppliers. For example, when a company borrows money to purchase a building, the lender or creditor has a claim against the companys assets. What remains after liabilities have been deducted from assets is owners equity: Assets - Liabilities = Owners equity Using the principles of algebra, this equation can be restated in a variety of formats. The most common is the simple accounting equation, which serves as the framework for the entire accounting process: Assets = Liabilities + Owners equity This equation suggests that either creditors or owners provide all the assets in a corporation. However, the equation must always be in balance; in other words, one side of the equation must always equal the other side.

Basic Accounting Concepts

Double-Entry Bookkeeping

Matching Principle

Credit Credit Purchase Purchase

Cash Cash Purchase Purchase

Accrual Accrual Basis Basis

Cash Cash Basis Basis

To keep the accounting equation in balance, companies use a double-entry bookkeeping system that records every transaction affecting assets, liabilities, or owners equity. The matching principle requires that expenses incurred in producing revenues be deducted from the revenue they generated during the same accounting period. This matching of expenses and revenue is necessary for the companys financial statements to present an accurate picture of the profitability of a business. Accountants match revenue to expenses by adopting the accrual basis of accounting, which states that revenue is recognized when you make a sale or provide a service, not when you get paid. Similarly, your expenses are recorded when you receive the benefit of a service or when you use an asset to produce revenuenot when you pay for it. If a business runs on a cash basis, the company records revenue only when money from the sale is actually received. The trouble with cash-based accounting, however, is that it can be misleading. You can misrepresent expenses and income by the way you time payments. Its easy to inflate income, for example, by delaying the payment of bills. For that reason, public companies are required to keep their books on an accrual basis.

Understanding Financial Statements

Income Statement

Balance Sheet

Cash-Flow Statement

Financial statements consist of three separate yet interrelated reports: the balance sheet, the income statement, and the statement of cash flows. Together these statements provide information about an organizations financial strength and ability to meet current obligations, the effectiveness of its sales and collection efforts, and its effectiveness in managing its assets. Organizations and individuals use financial statements to spot opportunities and problems, to make business decisions, and to evaluate a companys past performance, present condition, and future prospects. In sum, theyre indispensable.

The Balance Sheet Assets

Current Assets Fixed Assets

Liabilities and Shareholders Equity

Current Liabilities

Long-Term Liabilities

Shareholders Equity
9

The balance sheet, also known as the statement of financial position, is a snapshot of a companys financial position on a particular date. This statement includes all elements in the accounting equation and shows the balance between assets on one side and liabilities and owners equity on the other side. Assets can consist of cash, things that can be converted into cash, and equipment. Current assets include cash and other items that will or can become cash within the following year. Fixed assets are long-term investments in buildings, equipment, furniture and fixtures, transportation equipment, land, and other tangible property used in running the business. Fixed assets have a useful life of more than one year. Liabilities represent claims against the companys assets. The balance sheet gives subtotals for current liabilities (obligations that will have to be met within one year of the date of the balance sheet) and long-term liabilities (obligations that are due one year or more after the date of the balance sheet), and then it gives a grand total for all liabilities. The owners investment in a business is listed on the balance sheet under shareholders equity. Shareholders equity for a corporation is presented in terms of the amount of common stock that is outstanding, meaning the amount that is in the hands of the shareholders. Shareholders equity also includes a corporations retained earningsthe portion of shareholders equity that is not distributed to its owners in the form of dividends.

The Income Statement

Revenues Revenues

Cost of Cost of Goods Sold Goods Sold Net Income Net Income After Taxes After Taxes
10

Operating Operating Expenses Expenses

The income statement shows an organizations profit performance over a specific period of time, typically one year. It summarizes all revenues (or sales), the amounts that have been or are to be received from customers for goods or services delivered to them, and all expenses, the costs that have arisen in generating revenues. Expenses and income taxes are then subtracted from revenues to show the actual profit or loss of a company, a figure known as net incomeprofit, or the bottom line.

10

The Cash-Flow Statement

Operations

Investments

Financing
11

In addition to preparing a balance sheet and an income statement, all public companies and many privately owned companies prepare a statement of cash flows to show how much cash the company generated over time and where it went. The statement tracks cash flows from operations, investments, and financing. It reveals the increase or decrease in the companys cash for the period and summarizes (by category) the sources of that change. From a brief review of this statement you should have a general sense of the amount of cash created or consumed by daily operations, the amount of cash invested in fixed or other assets, the amount of debt borrowed or repaid, and the proceeds from the sale of stock or payments for dividends. In addition, an analysis of cash flows provides a good idea of a companys ability to pay its short-term obligations when they become due.

11

Analysing Financial Statements

Trend Analysis
Uncover Business Shifts Consider Extraordinary Circumstances

Ratio Analysis
Consider More Than One Ratio Check Specific Data

12

The process of comparing financial data from year to year in order to see how they have changed is known as trend analysis. You can use trend analysis to uncover shifts in the nature of the business over time. Of course, when you are comparing one period with another, its important to take into account the effects of extraordinary or unusual items such as the sale of major assets, the purchase of a new line of products from another company, weather, or economic conditions that may have affected the company in one period but not the next. Ratio analysis compares two elements from the same years financial figures. They are called ratios because they are computed by dividing one element of a financial statement by another. The advantage of using ratios is that it puts companies on the same footing; that is, it makes it possible to compare different-size companies and changing dollar amounts. Before reviewing specific ratios, consider two rules of thumb: First, avoid drawing too strong a conclusion from any one ratio. Second, once ratios have presented a general indication, refer back to the specific data involved to see whether the numbers confirm what the ratios suggest. In other words do a little investigating, because statistics can be misleading.

12

Types of Financial Ratios

Profitability

Liquidity

Activity

Leverage

13

You can analyze how well a company is conducting its ongoing operations by computing profitability ratios, which show the state of the companys financial performance or how well its generating profits. Liquidity ratios measure the ability of the firm to pay its short-term obligations. As you might expect, lenders and creditors are keenly interested in liquidity measures. A number of activity ratios may be used to analyze how well a company is managing its assets. You can measure a companys ability to pay its long-term debts by calculating its debt ratios, or leverage ratios. Lenders look at these ratios to determine whether the potential borrower has put enough money into the business to serve as a protective cushion for the loan.

13

Financial Management
Amount of funds Sources of funds Uses of funds Cash Inventory Receivables and payables Financial control Capital investments Capital budgeting
14

Developing and Implementing a Financial Plan

Monitoring Cash Flow

Developing a Budget

Planning for a firms current and future money needs is the foundation of financial management, or finance. Normally in the form of a budget, a financial plan is a document that shows the funds a firm will need for a period of time as well as the sources and uses of those funds. When you prepare a financial plan for a company, you have two objectives: achieving a positive cash flow and efficiently investing excess cash flow to make your company grow. An underlying concept of any financial plan is that all money should be used productively. This concept is important because without cash a company cannot purchase the assets and supplies it needs to operate. One way financial mangers improve a company's cash flow is by monitoring its working capital accounts: cash, inventory, accounts receivable, and accounts payable. In addition to developing a financial plan and monitoring cash flow, financial managers are responsible for developing a budget, a financial blueprint for a given period (often one year). Once a budget has been developed, the finance manager compares actual results with projections to discover variances and recommends corrective actiona process known as financial control. In addition, financial managers forecast and plan for a firms capital investments such as major expenditures in buildings or equipment. This process is called capital budgeting.

14