Finance and Accounting For Non-Financial Managers
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1 Finance and Accounting For Non-Financial Managers Accounting/Finance Recording, classifying, and summarizing financial transactions in terms of dollars and their interpretation 1
2 Key Accounting Terms Accounting equation Revenue and expenses Capital and withdrawals Fixed cost and variable cost Accounting Equation Assets=Liabilities + Owner s Equity A = L + OE 2
3 Transactions Any business event or activity that involves monetary value Accounts Used to record and summarize business transactions 3
4 Revenue and Expenses Becomes a portion of owner s equity Revenue Money earned from selling goods or services Increases owner s equity Revenue and Expenses Expense Cost of goods or services that a business buys and uses to earn revenue Decreases owner s equity 4
5 Revenue and Expenses Result in net profit or net loss Revenue Expenses Incorporated as Assets = Liabilities + Owner s Equity + Revenue Expenses A = L + OE + R - E Capital and Withdrawals Determines the owner s equity Capital Owner s investment Increases owner s equity Withdrawals When an owner withdraws assets 5
6 Fixed and Variable Costs Fixed costs do not vary with the amount of activity in a business Property taxes, administration salaries, etc. Variable costs vary with the activity Cost of direct material, direct labor and variable overhead, etc. Accounting Records Chart of Accounts Detailed list of all accounts Coded according to respective class of accounts Assets:1 Liabilities: 2 Owner s equity: 3 Revenue: 4 Expenses: 5 6
7 Cash Basis and Accrual Basis Cash basis of accounting Records transaction only when money is realized or paid Does not accurately reflect period profit/loss Accrual basis of accounting Records transaction when revenue is earned or expense is incurred, not strictly when money has changed hands Presents a truer picture of period profitability/loss Financial Statements Financial statements: Income Statements Balance Sheet Cash Flow Statement Statement of Stockholder s Equity 7
8 Revenue Sales-based income Service-based income Fees income Expenses Cost of goods sold Operating expenses Interest expenses Income tax 8
9 Types of Expenses Cost of goods sold Cost of products sold in an accounting period Cost of goods sold = Beginning inventory + Purchases Ending inventory Manufacturing cost of goods sold = Direct Material + Direct Labor + Variable Overhead + Allocated Factory Overhead Types of Expenses Operating expenses Expenditures that are necessary for the daily operations of a business Marketing expenses Administrative expenses Other general expenses Depreciation Depletion 9
10 Types of Expenses (cont.) Interest expenses Result of the financial structure of a business Incurred if a company has taken a loan to support its asset investment Income tax (Federal, state & local) Profit and Loss Gross profit on sales Gross profit on sales = Total revenue Cost of goods sold Operating profit Operating profit = Gross profit on sales Operating expenses EBIT (Earnings Before Interest and Taxes) EBIT = Operating profit + Other revenue Other revenue: Dividends, Interest, etc. 10
11 Profit and Loss (cont.) Income before taxes Income before taxes = EBIT Interest expenses Net profit or Net loss Net profit or Net loss = Income before taxes Income taxes Interpret Income Statements Ratios used to interpret Income Net operating margin Profit margin on sales 11
12 Net Operating Margin Net Operating Margin = Operating profit/sales Expressed in percentage Compared to previous years percentage to determine financial health Profit Margin on Sales Profit Margin on Sales = Net Profit/Sales Expressed in percentage Financial health determined by comparing this percentage with the percentages of: Previous years Other companies 12
13 Inadequate Level of Gross Profit on Sales The reasons could be: Product volume Price structure Product costs Assets Current Fixed Liabilities Current Long-term Balance Sheet Owner s equity Capital Stock Preferred Common Retained earnings 13
14 Interpret Balance Sheets Liquidity Debt-to-total assets ratio Liquidity Ability to generate adequate amounts of cash to meet current obligations Compared by calculating: Working capital Current ratio 14
15 Working Capital Working Capital = Current Assets Current Liabilities Value should be neither too small nor too large Current Ratio Reflects whether a company has sufficient current resources to meet obligations Current Ratio = Current Assets / Current Liabilities Expressed as a decimal Value should not be below 1 15
16 Debt-to-Total-Assets Ratio Debt-to-Total Assets Ratio = Total Liabilities / Total Assets Indicates: Liabilities per $1 of assets Measure ability to absorb a reduction in assets without hindering its ability to pay creditors Value should be low Cash Flow Statement Includes three categories of accounts: Operating activities Investing activities Financing activities 16
17 Operating Activities Cash inflows and outflows that relate to daily operations Generally result from purchase and sale of product or service Example: Collecting from customers Collecting interest and dividends Paying suppliers Paying employees Paying interest and tax Investing Activities Involve the acquisition and sale of long-term assets Example: Purchasing stocks Selling fixed assets Selling debt or stocks Loaning money Purchasing fixed assets 17
18 Financing Activities Result from issuance and repayment of long-term liabilities and capital stock Example: Issuing stock certificates Buying back your own stock Issuing loans Making loan payments Fundamentals of Budgeting Budgeting is the process of planning and controlling the financial activities for an upcoming accounting period by: Analyzing present performance Setting objectives for improving its future financial health 18
19 Importance of Budgeting Outlines a plan for managers and employees Fortifies effective pricing and spending efforts Benefits Requires planning Enhances communication Reinforces accountability Identifies problems Motivates employees Analyze Financial Statements Methods of analysis Horizontal analysis Trend analysis Vertical analysis Ratio analysis 19
20 Horizontal Analysis Analyzes month-to-month or year-toyear changes for each line item on a financial statement Determines the method, the reason, and the outcome of change Trend Analysis Analyzes changes for three or more years Shown in dollar amount and percentage With first year as base year and subsequent years as percentage of base year amount 20
21 Vertical Analysis Concentrates on the relationships between various items in the same period Top-down budgeting Ratio Analysis Studies relationships between multiple items on financial statements Identifies strong and weak areas Compares business operations of similar companies 21
22 Information Provided by Ratio Analysis Liquidity ratios Determine a company s ability to generate cash Activity ratios Evaluate how well a company uses its assets Leverage ratios Determine a business s ability to meet its long-term obligations Profitability ratios Determine returns for investors Information used in Budgeting Working Capital Current ratio Acid test Inventory turnover ratio Days sales outstanding Total assets turnover ratio Debt-to-total-assets ratio Times-interest-earned ratio Net operating margin Profit margin on sales 22
23 Liquidity ratio Current Ratio Current Ratio = Current Assets / Current Liabilities Expressed as a decimal Value should not be below 1 Generally 2:1 satisfactory Acid Test or Quick Asset Rate More Restrictive Cash, marketable securities and accounts receivable to current liabilities 23
24 Inventory Turnover Rate Activity ratio Calculates the frequency of inventory to be sold out and restocked, per year Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Average Inventory = (Beginning Inventory + Ending Inventory) / 2 Value should be high Days Sales Outstanding Activity ratio Indicates the length of time a business must wait after making a sale before receiving cash Days Sales Outstanding = Accounts Receivable / Average Sales Per Day Average Sales Per Day = Annual Sales / 360 Value should be low 24
25 Total Assets Turnover Ratio Activity ratio Indicates a business s ability to generate sales in relation to its total assets Total Assets Turnover Ratio = Sales / Total Assets Value should be high Total Debt-to-Total Assets Ratio Leverage ratio Indicates a company s Liabilities per $1 of assets Ability to absorb a reduction in assets without hindering its ability to pay creditors Total Debt-to-Total-Assets Ratio = Total Liabilities / Total Assets Value should be low 25
26 Times-Interest-Earned Ratio Leverage ratio Measures ability to meet its annual interest payments Times-Interest-Earned Ratio = Operating Profit / Interest Charges Value should be high The Profit Margin on Sales Profitability ratio Indicates how satisfactory business activities have been Profit Margin on Sales = Net Profit / Sales Value should be high 26
27 The Break-Even Point Occurs when Total sales = Total expenses, with nothing left over for profit Operating income = zero Break-Even Point = Total Fixed Operating Expenses / Contribution Profit Margin per unit The Break-Even Example Fixed Cost = $2,000,000 R = $100 VC = $60/unit Profit Contribution PC = $100-$60 = $40/unit BE = $2,000,000 = 50,000 units $40 at 50,000 units R = 50,000 ($100) = $5,000,000 VC = 50,000 ($60) = $3,000,000 FC = = $2,000,000 Total Cost $5,000,000 Profit 0 27
28 Relevant Budget Objectives To your business s vision Measurable In quantitative terms Realistic Challenging but not impossible Monitor Performance Record the actual performance of the business on pro forma statements To compare actual performance with the budgeted amount 28
29 Pro Forma Financial Statements Forward-looking documents Created when setting a budget Used to establish the projected financial activity for an upcoming accounting period Used only for internal purposes and not viewed by external parties IMXMPLE, INC. Income Statement For year ending 12/31/04 (01/01/04 12/31/04) Sales $12,000,000 Cost of Goods Sold 7,000,000 Gross Profit on Sales 5,000,000 Operating Expenses Selling $300,000 Gen & Adm 400,000 Dep & Depl 500,000 Total Operating Expenses 1,200,000 Operating Profit 3,800,000 Other Revenue Dividends & Interest 20,000 Earnings before Int. & Taxes 3,820,000 Other Expenses Interest Expense 500,000 Income Before Taxes 3,320,000 Provision for all taxes 1,200,000 Net Profit for year $2,120,000 29
30 Accounting Equation Total Assets = Total Liabilities + Total Equity $18,610,000 = $8,789,000 + $9,821,000 $18,610,000 = $18,610,000 Working Capital Current Assets Current Liabilities $6,610,000 $2,900,000 = $3,710,000 30
31 Current Ratio Total Current Assets Total Current Liabilities $6,610,000 $2,900,000 = 2.28 Acid Test or Quick Ratio (Cash+Securities+AR-BadDebt) Total Current Liabilities $4,310,000 $2,900,000 =
32 Inventory Terms COGS/Inventory $7,000,000 $2,300,000 = 3.04 Days Sales Outstanding Average Sales: $12,000,000 = $33, Accounts Receivable / Average Sales Per Day $3,210,000 = days $33,
33 Total Asset Turnover Total Fixed Assets/Total Assets $12,000,000 = 0.64 $18,610,000 Debt to Total Asset Total Liabilities/Total Assets $ 8,789,000 = 0.47 $18,610,000 33
34 Times Interest Earned Operating Profit/Interest Expense $3,800,000 = 7.6 $500,000 34
35 Profit Margin on Sales Net Profit/Sales $ 2,120,000 = $12,000,000 Net Operation Profit Operating Profit/Total Fixed Assets $ 3,800,000 = 0.32 $12,000,000 35
36 Return on Equity Net Profit After Taxes/Total Equity $2,120,000 = $9,821,000 36
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