We are going to start out this topic with a quick test question.
Accounting is _________.
a. the language of business
b. a means of keeping score
c. A means of monitoring management
e. all of the above
The answer is —drum roll please—.e. all of the above.
Accounting is the language of business. Just as if you wanted to take a trip to Spain you would brush up on your Spanish, to understand finance we need to brush up on accounting. It is for this reason that we will begin our trip through finance by first revisiting accounting. Accountants create several reports that help outsiders know what is going on at the firm.
The most common of these reports is the Income Statement. It reports how much money the firm made (or lost) over the last period. Here the period of time can be a year, a quarter, a month, or even a week. The simple version of this is merely Revenue- Expenses = Income. This is of course grossly oversimplified and many assumptions must be made to come up with any Net Income number.
Unfortunately since their is some leeway in the assumptions, people made different assumptions and the results can become meaningless. To prevent this Generally Accepted Accounting Practices have been developed. These include revenue recognition which is governed by the matching principle. This however lead to a difference in cash flow and income. Another set of assumptions deals with non cash expenses. These are for things that you do not pay for each period but you do use it up or wear it out some. Due to the matching principle we have to account for the expense in the period we use it (even though we may have paid for it years ago).
Depreciation is the classic example of this. There are other problems with income statements. For example, take a look at a typical income statement. You see an interest deduction but no deduction for shareholder returns. Does that mean shareholders do not demand a return? No of course not. It merely says that for whatever reason we have decided to leave that cost off of the income statement (probably because it is not deductible for tax purposes). Economic Value Added (EVA) is a solution to the typical income statements and is growing in popularity but it is never going to replace traditional income statements.
Because of these assumptions and the information asymmetry problem, we have to take steps to assure the quality of the accounting numbers that firms release. Chief among the ways to prevent cheating is have external auditors (who presumably have nothing to gain by lying) audit the financial statements. Need another quote to help remember this? How about: Net Income is an accounting fiction.
A final point about income statements is that expenses are are deductible for tax purposes. Thus they lower the amount of taxes that you must pay. For this reason many (indeed most) public companies keep at least two sets of accounting books. One is for tax purposes and the other is released to the public. Additionally many keep their own internal statements that need not follow GAAP accounting standard but is for improving decision making.
The second most important report that accountants make is the balance sheet. This shows all of the assets, liabilities, and owners equity that exists at the time the balance sheet was made. For this reason sometimes a balance sheet is referred to as a snap shot. It captures the information that exists at the point in time. Not before or after. The balance sheet identity is at the heart of the balance sheet. It says that Total Assets = Total Liabilities + Total Equity. You definitely want to remember this one. It is probably the most important thing in the entire chapter! The ordering of the balance sheet follows a set pattern: Current assets and Current liabilities are at the top, followed by longer term assets and liabilities. Equity (or owner’s equity as it is often called) is on the bottom.
Generally Balance Sheets are generally laid out just as the equation so the left hand side of the balance sheet is the asset side (I often abbreviate this LHS) while the RHS is how the firm finances the assets (this would then be the RHS). However, if you are examining a firm’s balance sheet do not be surprised if the assets are on top and the Debt and Equity appears below. This is mainly for presentation purposes.
Some other key terms associated with Balance Sheets:
Net Working Capital = Current assets – Current liabilities Liquidity: ability to the ability to quickly and cheaply turn an asset into cash. More liquid assets are listed near the top of the assets.
Leverage: The idea that a little change can result in a larger overall change. (think of a lever). In business it can be one of two types: operating leverage (generally associated with high fixed costs and a capital intensive business) and financial leverage (associated with debt). A “strong balance sheet” is generally one where the firm does not have too much debt.
Financial Slack- the ability to borrow more or have the cash on hand to respond quickly to a changing environment (thus a strong balance sheet). Like all thinks this is both good and bad. Some slack is good, but too much can be a sign of a poorly run firm. (wow, you can be too strong–mercifully I have nothing to worry about in that regard!)
One of my favorite sayings about debt is that Debt makes good times Great and Bad times Terrible. Go ahead, repeat it to yourself a couple thousand of times. It is a good thing to remember with your own personal finance as well. Why is it so true?
Cash Flow Statement
Cash flow is probably the most important thing we want to look at in finance.
Cashflow is so impirtant because we are concerned withhow much cash is available to pay for teh firm’s operations, growth, and have money back to pay investors. (think back to the model of a financial system. Cash is what is flowing through the system.)
Investors (and therefore firms) are mainly concerned with cash flows. An additional benefit of focusing cash flows is that cash flows are harder to trick or play games with.
There are two ways to find cash flows. The ideal way would be if firms told us. Unfortunately most do not completely. This problem is made worse because to find it we have to rely on income numbers that have already been gathered using noncash expenses etc.
Cash flow Identity:
Cash flow from assets = Cash flows to creditors + cash flow to stock holders Cash flow from assets = operating cash flow – capital spending + decrease in net working capital – increase in Net working capital Where Operating Cash flow = EBIT – taxes + depreciation
(note while not quite correct, many people use Net Income instead of EBIT)
Capital Spending = Ending net Fixed assets- beginning fixed assets + depreciation
(the text also calls this net investment in fixed assets) Next turn your attention to the RHS of the cash flow identity. This is easier. Cash flow to creditors = interest paid – net new borrowing Cash flow to shareholders = Dividends paid – net equity raised.
Fortunately cash flow and income are highly correlated so investors can get a good idea from earnings announcements as to what the cash flow is.
Super Short Summary:
Financial Accounting has developed as a means of keeping score. Income statments and Balance Sheets are the key statemenst. Accounting utilizes many assumptions which is a problem.
1. What does the balance sheet measure?
2. What does an income statement measure?
3. What is EVA?
4. Explain the quote: Net income is an accounting fiction..
Assignment: 1. Go to Yahoo’s Finance Page and look up 3 stocks in different industries and print off their financial statements. 2. It is time to Excel! Hand in 2-20 in Excel. 3. You have now completed the second chapter. You are expected to go to the Text’s web page and take the end of chapter quiz. You can take it as many times as you want. When you get a satisfactory score, copy the page and email it to FinanceProfessor@yahoo.com
Answers to Quick Quiz . 1. A balance sheet is a snap shot of the assets, liabilities, and equity of a firm. All are measured at book values and not market values. 2. An income statement measures the difference between revenue and expenses for a given time period. 3. EVA stands for Economic Value Added. It is an alternative to income statements. It changes the way some expenses are accounted for and recognizes a charge for the money shareholders invest. 4. Because there are so many assumptions that go into a Net Income calculation, there is no single answer that represents Net Income. Further like any fiction, the author (in the case the accountant) can change the story.