Accounting, Finance & Banking. Business uses accounting: Who uses accounting data? The Basics

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1 Accounting, Finance & Banking The Basics Copyright 1997 by Donald Jenner All Rights Reserved Based on material developed by Harcourt Brace & Co. and Katherine Conway 1 Business uses accounting: Financing: securing funding for start-up or expansion Investment: securing valuable assets necessary to carry on the business Operations: reconciling various categories of costs and benefits in the course of carrying on business 2 Who uses accounting data? Users Owners, Stockholders Potential Investors, Creditors Management Employees, Union Officials Lenders, Suppliers Government Agencies, Economic Planners Consumer Groups Applications Evaluate firm s operations Make investment decisions Plan and Control Use in contract negotiations Evaluate credit ratings Evaluate tax liabilities Approve new issues of stocks and bonds 3

2 Accounting overview Input Transactions: receipts, invoices &c. on each transaction are entered into the accounting record Processing Transactions are recorded in chronological order in journals Journal entries are posted to individual accounts kept in ledgers Accounts are summarized at the end of each accounting period Output Balance sheets, income statements, cash flow statements 4 Principal accounting equations Assets = Liabilities + Equity Liquidity: Current ratio = Current Assets / Current Liabilities Acid-test ratio = Quick Assets / Current Liabilities Profitability Ratios Earnings per share = Net after tax / Outstanding shares Return on sales = Net income / Net sales Return on equity = Net income / Total Owners Equity Debt to Owners Equity Ratio = Total liabilities / Owners Equity 5 Financial Planning What funds are needed in the next operating period? How is the funding to be obtained? [What options exist?] When will more funding be required? 6

3 What is money? Divisible Portable Durable Difficult to counterfeit Has a stable value How much of this is really true? To what extent is what we think of as money a exemplar of these elements? Some history. 7 Money s use in business Money is a medium of exchange, commonly more convenient than direct exchange (i. e., barter) Money is a common denominator for accounting; everything has a dollar value Money can be accumulated and stored (in banks ) for future needs 8 The Money Supply: M1 M1 = Currency + Demand Deposits + NOW Accounts + Share Drafts + Travelers Checks 9

4 The Money Supply: M2 M2 = Time Deposits + Government Bonds + Money Market Mutual Funds + Bank Money Market Deposits M2 is not quite money the same way M1 is. 10 Ways to use money Short term Cash Marketable securities Accounts receivable Inventory Short-term invest- ments in T-bills, commercial paper, CDs Long term Land Buildings Equipment Purchase of other firms 11 Sources of funds Debt Capital Short term Trade Credit Unsecured bank loans Commercial paper Secured loans Factoring Long Term Long term loans Sale of bonds Equity Capital Plowed back earnings Owners additional contributions Venture capital Stock issued to general investing public 12

5 Debt vs Equity Debt Equity Maturity Specific Date No Maturity Date Claim on Assets Paid first Claim on Income Voice in Management Prior claim on fixed amt. of interest None (creditors, not owners) Paid after lenders Residual claim after all creditors paid Owners + common stockholders can vote 13 Leveraging Leveraged Common Stock $10K Bonds (@10%) $90K $100K Earnings $30K less bond interest $ 9K $21K Equity only Common Stock $100K Bonds (@10%) $ 0K $100K Earnings $30K less bond interest $ 0K $30K Return to owners $21K/$10K = 210% Return to owners $30K/$100K = 30% 14 Decision-making One thing businesspeople do; NOT the only thing. And we really should ask, do they make prudent decisions, and if they ever do so, when and how so? 15

6 SWOT Analysis List Strengths (advantages, what you do well, resources, other people s views of your strengths List Weaknesses (what you can do better, what you do badly, what to avoid) Opportunities (and trends) Threats (obstacles, competition, changes in tech, products, specs, &c., financial problems) and how they threaten your business. 16 Pareto Analysis List problems and rank them List possible changes related to each problem Assess changes for costs and benefits (i. e., will the change help fix the problem, at what cost?) Focus on implementing best options 17 Decision Trees Question: Develop new product or consolidate? New Product thorough development rapid devlopment market reaction This tree shows all the obvious options in the decision to be made Consolidate strengthen products Decision nexus Possible Outcome reap devlopment 18

7 Decision Trees #2 Question: Develop new product or consolidate? New Product Consolidate thorough development devlopment rapid devlopment strengthen products market reaction $200K $2K Assign values to different possibilities. Assign probabilities to uncertain (circle) nodes (values total 1). Calculate possible outcomes) Decision nexus Possible Outcome reap devlopment 0.6 $1K 19 Decision Trees #2 Question: Develop new product or consolidate? New Product Consolidate Decision nexus Possible Outcome thorough development devlopment rapid devlopment strengthen products reap devlopment market reaction $200K $2K $1K 1 st step: Branch probability times branch value 2 nd step: Sum of 1 st step calcs. These are the values for the circles. 20 Decision Trees #3 Question: Develop new product or consolidate? New Product Consolidate Decision nexus Possible Outcome thorough development devlopment cost=? rapid devlopment cost=? strengthen products cost=? reap devlopment cost=? market reaction $200K $2K $1K Fill in cost figures for each major option branch. Subtract cost from circlenode value. Result is bestguess at which course works 21

8 Business Decision problems The decision-making process looks objective but depends on highly subjective interpretations of data. The data themselves may be less than reliable. Relies heavily on art not science 22