McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Accounting and Finance
Understanding financial accounting is essential to understanding corporate finance.
Key Components of the Financials:
The Balance Sheet
The Income Statement
The Statement of Cash Flows
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The Balance Sheet
The Balance Sheet is a financial statement that shows the firm’s assets and liabilities at a particular time.
Why is it useful?
Shareholders’ Equity = Total Assets – Total Liabilities
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Current Assets
•
Cash & Securities
•
Receivables
•
Inventories
+
Fixed Assets
•
Tangible Assets
•
Intangible Assets
___________________
Total Assets
The Balance Sheet
=
Current Liabilities
•
Payables
•
Short-term Debt
+
Long-term Liabilities
+
Shareholders’ Equity
____________________
Total Liabilities &
Shareholders’ Equity
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Assets
Assets represent the uses of a firm’s funds i.e. Assets show what the firm “owns”
•
Liquid Assets can be converted easily into cash
•
Current vs. Fixed Assets
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Current Assets: Examples
Which of the following assets is typically considered most liquid? Least liquid?
• Marketable securities
• Accounts receivable
• Inventories
Which of the following is a current asset?
• Property that a firm owns
• A firm’s production equipment
• Unsold inventories
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Fixed Assets

Tangible Assets

Intangible Assets

Goodwill
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Fixed Assets: Example

Which of the following represent tangible assets? Intangible assets?
• Property
• Production Facilities
• Patents
• Production Equipment
• Trademarks
• Copyrights
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Liabilities
Liabilities represent the sources of a firm’s funding.
(i.e. Liabilities represent what a firm “owes.”)

Current vs. Long-Term Liabilities
Current Assets – Current Liabilities = Net Working Capital
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Liabilities: Example

Which of the following is a current liability?
• Bond debt that matures in 3 years
• A bank loan that is due in 24 months
• An obligation to pay a supplier within 6 months
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Net Working Capital: Example
In the balance sheet below, what was the value of net working capital in 2008? 2009?
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Book Values vs. Market Values

GAAP
(Generally Accepted Accounting Principles)

Book Value
•
Value of assets or liabilities according to the balance sheet.
•
Values recorded at their historical cost adjusted for depreciation

Market Value
• The value of assets or liabilities were they to be resold in a market
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Common-Size Balance Sheet
All balance sheet items are expressed as a percentage of total assets.
Why is this useful?
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Common-Size Balance Sheet:
Example
Note the changes from 2008 to 2009.
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The Income Statement
Income Statement: a financial statement that shows the revenues, expenses, and net income of a firm over a period of time.
Why is this useful?
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Common-size Income Statement
All items on a common-size income statement are expressed as a percentage of revenues.
Why is this useful?
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Income Statement: Example
In the income statement below, what was the value of Home
Depot’s EBIT in 2009?
Common
Size
Income
Statement
(right column)
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Profits vs. Cash Flow
Differences between profits & cash flow:

Depreciation

Cash vs. accrual accounting
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Cash Flows: Example
Consider a firm that spends $1,000 to produce goods in period 1. In period 2, it sells half of these goods for $750 and collects payment one period later.
The firm sells the other half in period 3 for another $750, and collects payment on these sales in period 4.
What are the cash flows in each of the 4 periods for the firm?
Period:
Sales ($)
-Accounts Receivable
- Cost of Goods Sold
- Changes in Inventories
= Net Cash Flow
1
0
0
0
1000
(1000)
2
750
750
500
(500)
0
3
750
0
500
(500)
750
4
0
(750)
0
0
750
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The Statement of Cash Flows
The Statement of Cash Flows shows the firm’s cash receipts and cash payments over time.
Why is it useful?
Free Cash Flow is cash available for distribution to investors after the firm pays for new investments or additions to working capital.
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The Statement of Cash Flows
Structure :
Cash flow from operations
+
Cash flow from investments
+
Cash flow from financing
____________________________
Change in cash balance
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Cash Flow: Example
Net income for your firm was $10,000 last year.
The depreciation expense was $2,500; accounts receivable increased
$1,250; accounts payable increased $800; and inventories increased by $2,000.
What was the total cash flow from operations for the period?
Net income:
Depreciation:
Accounts Receivable:
Accounts Payable:
Inventories:
Cash flow from operations:
10,000
2,500
(1,250)
800
(2,000)
10,050
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Accounting Practice
Most managers say that accounting earnings is the single most important number reported to investors.
What implications does this have for the investor?
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Accounting Practice
Grey areas for financial managers:
Revenue recognition
Cookie-jar reserves
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Accounting Practice
Additional grey areas for financial managers:
Off-balance sheet assets and liabilities
Mark-to-market accounting
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Corporate Taxes
In the United States, corporations pay tax on their income.
US Corporate Tax Rates, 2011
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Corporate Taxes: Example
What is the marginal tax rate for a corporation with $60,000 taxable income and an average tax rate of 16.67% if the next-lowest marginal tax rate of 15% covers taxable incomes up to $50,000?
($60,000) * (16.67%) = $10,000 total taxes paid
Income Rate Taxes Paid
$0 - $50,000
$50,001 - $60,000
Total:
15%
?
$7,500
$2,500
$10,000
($10,000) * (marginal tax rate) = $2,500
Marginal Tax Rate = 25%
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Personal Tax
US Personal Tax Rates, 2011
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Personal Tax: Example
What is the average tax rate for an individual with a net income of $50,000 and a total tax liability of $10,704.50?
Taxable Income = $50,000 + $10,704.50
Average Tax Rate =
Tax Liability

$10, 704.50
Taxable Income 60, 704.50

17.63%
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The Problem of “Double Taxation”
When a corporation issues a dividend, each dividend dollar is effectively taxed twice:
1.
Each dollar of earnings taxed at corporate rate.
2.
Shareholders pay personal income taxes on all dividends received.
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