Journal entries and adjusting journal entries
Outgoings
Incomings
Issued shares for cash consideration of 40 000
DR - Cash (40 000)
CR - Share Capital (40 000)
Paid $30,000 for three months of rent covering 1
June 2020 to 31 August 2020.
DR - Prepaid rent (30 000)
CR - Cash (30 000)
DR - Rent expense (10 000)
CR - Prepaid rent (10 000)
Prepaid petrol cards at 31 May 2020 are $1,500. The
petrol cards were used up during the month ending
30 June 2020
DR - Petrol expense (1 500)
CR - Prepaid Petrol (1 500)
Depreciation on a motor vehicle for the month ending
30 June 2020 is $1,000.
DR - Depreciation expense (1 000)
CR - Accumulated depreciation ( 1 000)
Paid wages of $80,000 for the month. Wages
payable at 30 June 2020 are $15,000.
DR - Wages expense ( 80 000)
CR - Cash (80 000)
DR - Wages expense (5 000)
CR - Wages payable (5 000)
Interest on a bank loan for the month of June is $800
but has not yet been paid
DR - Interest expense ( 800)
CR - Interest payable (800)
Cash dividends of $5,000 declared and paid.
DR - Retained profits (5 000)
CR - Cash (5 000)
OR
Cash dividends of 20 000 declared and paid
DR - Dividends payable (20 000)
CR - Cash (20 000)
Borrowed $80 000 cash from the bank with an
agreement to pay back the loan in 4 yrs with interest
of 10% pa
DR - Cash (80 000)
CR - Loan (80 000)
Purchased inventory costing $64 000 with cash
DR - Inventory (64 000)
CR - Cash (64 000)
Purchased inventory costing $ 30 000 with credit
DR - Inventory (30 000)
CR - Accounts payable (30 000)
Paid 10 000 to a supplier
DR - Accounts payable (10 000)
CR - Cash (10 000)
Cost of goods sold 80 000
DR - COGS (80 000)
CR - Inventory (80 000)
Paid tax payable 6 000
DR - Tax payable (6 000)
CR - Cash (6 000)
Delivered 20 days of training (x8000) during month
ending 20 june 2020
DR - Accounts receivable (160 000)
CR - Service revenue (160 000)
Received $176,000 cash for invoices previously
raised in May 2020.
DR - Cash (176 000)
CR - Accounts receivable (176 000)
Received cash for five days (x 8 000) of training to
be delivered in the first week of July 2020.
DR - Cash (40 000)
CR - Unearned revenue (40 000)
Received a 16 000 deposit on a rental property for
the month of january 2023
DR - Cash (16 000)
CR - Revenue received in advance (16 000)
Sold inventory costing 16 000 to customers for 29
000 on credit
DR - COGS (16 000)
CR - Inventory (16 000)
DR - Accounts receivable (29 000)
CR - Sales (29 000)
Received $11 000 from customers owing
DR - Cash (11 000)
CR - Accounts receivable (11 000)
Credit sales of 200 000
DR - Accounts receivable (200 000)
CR - Sales revenue (200 000)
Cash sales of 6 000
DR - Cash (6 000)
CR - Sales revenue (6 000)
Collections from customers of 150 000
DR - Cash (150 000)
CR - Accounts receivable (150 000)
Adjusting - Earned commission of 2000 during june,
but will not be paid until july
DR - Commission receivable (2 000)
CR - Commission revenue (2 000)
Shareholders invest $200 000 cash in the business.
DR - Cash (200 000)
CR - Share capital (200 000)
Sold inventory for 40 000. 40% on cash
DR - Cash (16 000)
DR - Accounts receivable (24 000)
CR - Sales revenue (40 000)
On 30 June 2021, the company sold obsolete
inventory it purchased for $25,000 for
$15,000 cash.
DR - Cash (15 000)
CR - revenue (15 000)
DR - COGS (25 000)
CR - Inventory (25 000)
Dividends receivable declared
DR - dividends receivable
CR - Dividends income
Adjusting - Employees are paid every Friday for the
5 day work week from monday to friday. The weekly
wage expense is 115 000. The account year ends 31
december. Assume this falls on a Thursday
DR - Wages expense (92 000)
CR - Wages payable (accrued salaries) (92 000)
- 1 january staff paid
- DR wages payable (92 000)
- DR Wages expense (23 000)
- CR Cash (115 000)
Adjusting - 100 000 fixed deposit at 12% where
interest is paid in arrears on 30 april and 30
november
DR - Accrued revenue (2 000)
CR - Interest revenue (2 000)
Adjusting - office supplies account had an opening
balance of 1 000 on 1 july 2021. Supplies of 8 000
were purchased throughout the year, and 9 00 of
supplies were on hand at 30 june 2022
DR - Office supplies expense (8 100)
CR - Office supplies inventory (8 100)
Adjusting - on 1 july 2022, obtained a bank loan of
100 00 at 12% interest, payable yearly in arrears.
Accounting year end is 31 december.
DR - Interest expense (6 000)
CR - Interest payable (6 000)
- 1 july 2023 first interest payment is made for
the above
- DR - Interest expense ( 6 000)
- DR - Interest payable (6 000)
- CR - Cash (12 000)
Land and building is purchased for $300 000, which
is financed by a loan from the seller repayable in five
years.
DR - Land and buildings ( 300 000)
CR - Long term loan ( 300 000)
Equipment worth $90 000 is purchased by paying
$20 000 cash and signing an agreement to pay the
remainder in 90 days.
DR - Equipment (90 000)
CR - Cash (20 000)
CR - Notes payable (70 000)
Damaged inventory that was purchased on credit at
a cost of $5000 was returned to the supplier.
DR - Accounts payable (5 000)
CR - Inventory (5 000)
Cash sales of $30 000 were made. The cost of the
goods that were sold amounted to $12 000.
DR - Cash (30 000)
CR - Sales revenue (30 000)
DR - COGS (12 000)
CR - Inventory (12 000)
Received an advertising invoice for $2000 for a radio
advertisement broadcast on 5 April. The bill will be
paid next month.
DR - Advertising expense (2 000)
CR - Accounts payable (2 000)
Wages paid 300 000. 80k from the previous year
DR - Wages expense (220k)
DR - Wages payable (80k)
CR - Cash (300k)
Dividends receivable paid
DR - Cash
CR - Dividends receivable
On 30 June, declared dividends worth 50 000
dividend declared, 20 000 the total was immediately
paid to shareholders
DR - Retained profits (50 000)
CR - Cash (20 000)
CR - Dividends payable (30 000)
Declared dividends 8 000 but not yet paid
DR - Retained profit (8 000)
DR - Dividend payable (8 000)
On 1/6/23 took out loan for 480 000 with interest rate
of 20% pa on a term of 10 yrs. As of 30/6/23 3000
interest paid
DR - Cash (480 000)
CR - Bank loan / loan payable (480 000)
DR - Interest expense (8 000)
CR - Interest payable (5 000)
CR - Cash (3 000)
Prepaid 30 000 rent in advance for next 6 months
DR- Prepaid rent (30 000)
CR - Cash (30 000)
DR - Rent expense (5 000)
CR - prepaid rent (5 000)
30 june paid wages of 20 000. 4 000 were owed for
the month of may. 6 000 outstanding at the end of
june
DR - Wages expense (16 000)
DR - Wage payable ( 4 000)
CR - Cash (20 000)
DR - Wages expense (6 000)
CR - Wages payable (6 000)
When deposit received
DR - Cash
CR - Unearned revenue
When service provided
DR - Unearned revenue
CR - Sales / service revenue
On date of prepayment
DR - Prepaid insurance
CR - Cash
After using the supplies
DR - Insurance expense
CR - Prepaid insurance
Receivables at the end of a period
DR - Interest receivable
Cr - Interest revenue
When cash is received in next period
DR - Cash
CR - Interest receivable
CR - Interest revenue
Payable at the end of the fiscal year (middle of the
week)
DR - Wages expense
CR - Wages payable
When cash is paid in next period
DR - Wages payable
DR - Wages expense
CR - Cash (p+e)
At the beginning of June 2021, the Balance Sheet
showed supplies worth $15,000 as a
current asset. A purchase of $10,000 supplies was
correctly debited to the supplies
account during June. A physical count of supplies at
the end of the month shows the
balance of supplies at 30 June needs to be adjusted
to $21,000
DR - Supplies Expense 4000
CR - Supplies 4000
On 30 June 2021, received a dividend payment of
$20,000. This relates to dividend income recorded
earlier in the financial year. On the same date,
announced a dividend of $30,000 to its shareholders
DR - Cash (20000)
CR- Dividend Receivable (20000)
DR - retained profits (30000)
CR - Dividend Payable (30000)
On April 1st, 2021, took out a loan of $100,000 at an
interest rate of 6%. While the loan is correctly
recorded on the balance sheet, no interest expense
is recorded on the balance sheet. Interest is paid
annually in arrears meaning the first interest
payment will occur in 2022.
DR - interest expense (1500)
CR - interest payable (1500)
On May 1st, 2021, THE DATA INCUBATOR
purchased a machine worth $100,000. While the
Machine was correctly recorded on the balance
sheet, no depreciation expense is recorded on the
balance sheet. Depreciation of $24,000 is charged
annually.
DR - dep expense (4000)
CR - accumulated depreciation (4000)
Before the above adjustments for THE DATA INCUBATOR were recorded, the balance sheet showed
a cash balance of $55,000 and retained profits of $150,000. You are required to calculate the
updated balances for cash and retained profits that would be shown in the financial statements for
THE DATA INCUBATOR. You should show all the workings.
Income statement
→ Full name and “month ending” in title
- Eg Income statement of stu Limited for the month ending 30 JUNE 2020
→ Include AUS $ above cost column
→ Find gross margin (sales (not including - COGS)
→ Find next profit ( - operating expenses - income tax)
- Operating expense =
- Rent
- Petrol
- Depreciation
- Wages
- Interest
→ leave answer at net profit
EG 1
Sales revenue (only from main business operation - ONLY FOR SERVICE PERFORMED) =
- b) 20 days x 8000 = $160 000
Expenses =
- d) 30 000 / 3 months = 10 000
- e) 1 500 petrol
- g) 1 000 depreciation
- h) 80 000 paid, 5 000 wages owing for the month
- i) 8 000 interest
EG 2
Statement of retained profit
→ ‘Full name’ statement of retained profits for the year ending ‘...’
→ Retained profit from previous year balance sheet + net profit from current year - dividends declared
Balance sheet
→ Balance Sheet of ‘.....’ as at ‘......’
Week 4 - adjusting journal entries
Recap
Explain how the timing of revenue and expense recognition differs from cash inflows and outflows. Prepare
journal entries for accrual accounting adjustments
Unearned Revenue
[seller] → cash
received before
earned
Prepayments
[customer]--> cash
paid before incurred
Accrued revenue
(receivables)[seller]-->
cash received after
earned
Accrued Expenses
(payables)[customer]
→ cash paid after
incurred
Understand concepts of earnings management
Common approaches to manage earnings:
- Improper recognition of revenue→
recording rev that hasn't taken place
- Recording fictitious revenue→ recording fake credit sales towards the end of the year to boost rev
- Channel stuffing→ sell a large quantity of stock legally at the end of the year at a discount
- Improper management salary estimates→ lying about salary of staff
- Improper capitalization of expenses
- Improper expense recognition→ recording expenses that shouldn’t be recorded or not recording
expenses that need to be recorded
Week 5 - auditing and internal control
Explain GAAP and its components
→ Rules, standards and practices that companies must follow when preparing financial statements
Understanding the importance of quality reporting
→ Who prepares the financial information (management)
- Makes subjective judgement about assets / liabilities / revenues / expenses
→ Who approves the statement (board of directors)
- Legal responsibility to present a true report. If a false report is approved, can be fined or jailed.
- Agency theory = the relationship between an agent (someone who does something), and principal
(the person who wants it done), and what happens when the interests of the parties don't match
- Here, shareholders want management to run the business in their best interest
- Management can typically exploit the shareholder
- The board of directors is elected to supervise management on the shareholders behalf to
ensure they are acting in the best interest of them.
→ Who adds credibility by ensuring the financial statements (auditors)
- Only verifies the financial statements, no other part of an annual report (eg only balance sheet, income
statement, statement of changes in equity, cash flow statement and notes)
- Can be subject to fraud, if there is collusion (corruption) between the auditors and management of the
company
Explain the nature and purpose of an audit (why independent external audits happen and are important)
→ Auditors generally enhance the credibility of the information included in financial statements
→ Audit = an objective and independent analysis of the financial statements of a company to ensure they are
a fair and accurate representation of all financial statements presented
→ shareholders can’t verify whether the financial statements;
- Present a true and fair view
- Are free from material misstatements
- Are free from bias
→ must comply with:
- Corporation act 2001
- Generally accepted accounting principles (GAAP)
→ Auditors report put in the annual report
Describe the types of audit opinion issued (unmodified) (modified)
→ (um) Unmodified / unqualified opinion
- When accounting standards have been applied correctly and financial statements are presented
consistently
→ (m) Qualified opinion (except for opinion)
- Auditors saying the reports have been prepared correctly except for one or two small issues
- Small part of the report where they believe the accounting standards have not been applied correctly
that they specify (eg they believe depreciation should have been calculated differently)
→ (m) Adverse opinion
- Auditor indicating that the financial statements are misinterpreted or misstated, or do not accurately
reflect its financial performance and position
- Saying the financial statements are useless and they haven't used accounting rules correctly
- Would result in a collapse in share price
→ (m) Disclaimer opinion
- Issued when they were not able to issue sufficient and appropriate evidence on the preparation of the
financial statements to draw on a conclusion
- Saying we were not able to find evidence to support the preparation of the financial statements for
specific reasons
- EG management did not keep enough documents to support the reports, or management did not give
the auditors access to all the information needed. Withholding something
- Not a good look - would result in a loss in share price
Threats to auditor independence
→ Professional ethics = must ensure that auditors remain INDEPENDENT so that reports can maintain
credibility. Rules out the possibility of corruption
→ Threats to auditors independence (APES 110) (when audit quality is reduced)
- Self interest threat : financial or other interest will influence the behaviour of the auditor (eg financial
interest in the client. You shouldn’t be auditing a company you own stocks in, because if you find fraud,
you’re less likely to report it to avoid a drop in share price)
- Self review threat: auditors will not appropriately evaluate the results of a previous work performed by
the auditor on which they will rely when performing the current service (SIMPLY: auditors can’t both
prepare the statement, and audit it, as they’re less likely to pick up mistakes)
- Advocacy threats: auditors will promote a client's position of interest to the point that their objectivity is
compromised (eg promoting shares in a listed company when you are also their auditor. You should not
be consulting them on listing the company, and then performing their audits)
- Familiarity threat: due to a close relationship with a client, the auditor will be too sympathetic to the
clients interests or too accepting of their work (eg having a friend or immediate family member
appointed as director of a business, then you auditing them, or becoming too comfortable with the
business and their quality of reporting)
- Intimidation threats: auditor will be deterred from acting objectively because of pressure from the client.
This influence attempts to influence the auditor (eg being pressured to reduce the extent of the work
performed to reduce fees, or threaten to be fired if they don’t sweep something under the rug)
Describe fundamental principles of professional accountant (APES 110)
→ 1. Integrity : honest in business relationships and engage in fair dealing and truthfulness (no bribery)
→ 2. Objectivity : don’t compromise their judgement because of bias, conflict of interest or undue influence
→ 3. Professional competence and due care : maintain knowledge at a level to ensure competent service
(continued professional development) and act diligently in accordance with professional standards when
providing their service
→ 4. Confidentiality: refrain from disclosing confidential information from businesses relationships without
authority from the client, or using this information to their advantage
→ 5. Professional behaviour: obligation to comply with relevant laws and avoid actions which may discredit the
profession
Understand the function of internal control
→ A process effected by a companies board of directors, management and other personnel designed to
provide reasonable assurance regarding the achievement of objectives relating to:
- Effectivement and efficient of operations (including safeguarding assets against loss)
- Safeguard against waste, fraud (locks, keys, insurance, patents)
- Reliability of internal and external reporting
- Separation of accounting function, separation of duties, processes in place to stop stealing
- Compliance with applicable laws and regulations
- OHS, complaints, whistleblowing
→ Rules and processes integrated by a company to ensure the
integrity of financial and accounting information, promote
accountability and prevent fraud
→ Internal control components:
- Control environment : policies and procedures
- Risk assessment : identify and analyse source of risk
- Control activities: preventative / detective
- Information and communication; timely, flow, feedback
- Monitoring: ongoing, separate evaluations
Week 7 - ratios
Explain the purpose of financial ratio analysis
- Can be used for comparisons (previous years, competitors or industry, against projections or targets)
Identify key ratios and their usefulness
1. Profitability Ratios =
- These provide information on how well the company performed in the past and guidance on how lit is
likely to perform in the future
- Return on Assets (ROA) (net) operating profit after tax / total assets. How much profit is
generated each year based on the amount of assets the company holds. Assesses the
effectiveness of asset utilisation. Want it to be as high and positive as possible. The range is
industry specific.
- Return on Equity (ROE) (net operating profit after tax/ shareholders equity. How much return the
company is generating on the shareholders investment. Want it to be a high positive. Range is
industry specific
- You don't want ROE or ROA to have a negative or downward trend in comparison to previous
years. Cross comparisons of ROE and ROA are most meaningful when the companies are
direct competitors.
- Profit Margin (PM) (Net) operating profit after tax / sales revenue. How much sales rev ends up
as profit after all expenses are paid. We want it to be high and positive. Range is industry
dependent. Intense competition leads to lower profit margins. Gives indication of pricing
strategy and competition intensity in the industry
- Gross Margin (GM) Gross profit / sales revenue. Sales rev a company retains after the direct
costs associated with producing the goods it sells (COGS) and the services it provides.
Measures profitability in buying and selling goods before other expenses are covered. How
much profit we made on the transaction after deducting the cost of inventory. Gives important
info about product pricing in the industry its in. Small changes are very important
-
Earnings Per share (EPS). (net) operating profit after tax - dividends on preference shares /
weighted average of ordinary shares outstanding. Relates earnings attributable to ordinary
shares to number of ordinary shares issued. Higher the better. Range is industry dependent.
- Values of all these profitability ratios generally range between 5% - 20%. We have to look at
industry norm, whether ours are increasing or decreasing and why and unusual events (covid)
2. Activity (turnover/ efficiency) ratios =
- How efficient a company is at converting assets and liabilities into cash
-
-
-
-
Asset turnover sales / total assets. Companies ability to use its assets to generate sales. Indication of
operating efficiency. How effectively we use our assets to create sales e.g a ratio of 3 indicates that a
company generates $3 in sales for every $1 of assets. We want this to be high. Range is industry
dependent. Mining industry will generally have low levels of asset turnover. Tech companies (jb hi fi)
will have high ratios
Inventory turnover COGS / Closing inventory. Number of times inventory is sold during the year.
Efficiency of inventory management. Low turnover = risking obsolescence or deterioration in inventory.
We want to have low levels of inventory and replace it quickly. The lowest our closing stock in
comparison to cogs, the higher our ratio. The higher it is the more efficient we are at managing
inventory levels and lower risk over holding stock. Range is industry dependant Days in inventory = 365
/ inventory turnover. How long, in days, inventory is held on average. The higher the days in inventory,
the worse it is.
Debtors turnover credit sales / accounts receivable how efficient companies are at collecting their
accounts receivable. Proportion or credit sales to accounts receivable. Efficiency of the company to
collect the amount due from debtors. We want to collect credit sales quickly and low accounts
receivable. We want this ratio to be high. Range is set by credit terms of the business (e.g giving
suppliers 30 days to pay)
Days in debtors 365 / debtors turnover. Average number of days to collect accounts receivable
Accounts payable turnover total inventory purchase / accounts payable. Measures the rate at which a
company pays off its suppliers. Efficiency of the company to pay its suppliers. Can also be a liquidity
ratio. Short term ability of a company to pay its debts. Need to look at trends over time. If it decreases =
accounts payable is probs increasing which is good cash management, sometimes it could signal
liquidity problems.
Days in payable 365 / payable turnover average number of days to pay accounts payable.
3. Liquidity Ratios=
-
Current ratio. Current assets / current liabilities. Companies ability to pay its current liabilities with
current assets. Ability to pay short term debts. Whether there is enough cash to finance current
liabilities (next 12 months). Need to identify trends over time. We want it to be stable. Decreases
indicate that a company is struggling to generate cash and have a lot of liabilities they may not be able
to pay in the next 12 months. Range above 1 is good. Means a company has more assets than
liabilities. If the ratio is too low then a company can’t pay short term debts. Too high = not efficiency
using assets, could be invested in more assets for the business. Could also mean high levels of
-
inventory or accounts receivable which isn’t good. Range of 2 is decent too but is a bit outdated. If a
long term loan is included, it becomes an asset
Quick ratio. Cash + accounts receivable + short term investment / current liabilities. Companies ability
to pay its current liabilities with liquid current assets. Similar to current ratio : current assets without
inventory. We need to pay current liabilities with cash equivalents. Can't pay liabilities with inventory. So
we remove the inventory effect. We want this to be above 1. Means we have enough cash to pay all
liabilities that will fall over the next 12 months. Will always be below current ratio as inventory is
removed. Most companies operate around 0.5. We want to see how it's changing. If it falls, then a
company will struggle to pay financial obligations. These are called liquidity problems.
4. Financial structure ratios (solvency ratios) =
- Ability of a company to continue to operate in the long term. These all tell us the same thing in a slightly
different way. How much debt a company has and is it likely to be repaid. How assets are financed
(debt and equity)
- Debt to equity ratio. Total liabilities / total shareholders equity. A measure of the proportion of
borrowings to owners investment. Indicates the company's policy regarding financing of its assets. >1
We know that most assets are financed by debt. Increasing debt to equity ratio is worrying. A very high
ratio is associated with high risk (company financed its growth using a large amount of debt). If our high
amounts of debt means the business has increased sales, then it's good debt as we know it can most
likely be repaid. If the debt to equity is heaps more than others in the industry then it's a problem for
investors.
- Debt to assets ratio total liabilities / total assets. Indicates the proportion of assets financed by
liabilities. The greater the risk that is associated with the firm's operation, the higher the ratio. Trends
over time are important. If it increases then companies are taking on more debt. Need to determine
what the company is doing with the debt and can it be repaid
- Leverage ratio total assets / total shareholders equity. A measure of how much assets are financed by
equity. The smaller the ratio, the larger proportion of total assets are funded by equity, the higher the
proportion of total assets are funded by liabilities / debt. The closer this is to 1. The more a company is
funded by shareholders equity. When it increases, the more it is funded by debt.
Calculate Du Pont Analysis
- What ratios influence ROE to change from period to period
- Tells us that ROE changes based on ROA changes
- ROE is influenced by leverage. Changes to a company's financial structure will impact on return on
equity
- Drivers of ROE = leverage ratio, profit margin, asset turnover
NOTE : OPERATING PROFIT AFTER TAX AND NET PROFIT ARE DIFFERENT
-
When we calculate ROE we need to understand which of these subcomponents are changing in a way
that impact ROE
Extra stuff
-
-
Div Yield ratio (week 8). Annual dividends declared per share / share price. Measure amount of
dividends paid as a portion of share price. It is considered one measure to estimate a return of
investment in shares. Limitation is that users must analyse stock price movements as falling stock price
can increase ratio on year end. Must consider whether they are being driven by decreasing share price
or increasing dividend payments.
Price / Earning Ratio (PE ratio) (Week 8) Market price per share / earnings per share. Ratio used for
valuing a company that measures its current share price relative to its per share earnings (EPS). A high
P/E ratio could mean that a company's stock is overvalued or else that investors are expecting high
growth rates in the future. These are common in young companies that investors think will grow in the
future. Indicates high risk.
Limitations of ratio analysis
-
Can manipulate numbers at year end. Different methods of depreciation
Week 8 - types of analysis and firm vs equity value
Difference between accounting and finance
Difference between fundamental analysis and technical analysis
Fundamental = Top - Bottom Start with bigger picture (economic- where we gonna invest- country). PESTLE.
Then go to industry. Then we went to firm. This analysis depends on accounting ratios.
Technical = trend analysis of market. Predict price movement. Based on assumptions that the past will repeat
itself. Can predict through trends. Based on resistance (top lines- sell signal) and support (bottom lines- buy
signal)
Fundamental = periodic financial statements (bi annually or annually- have no idea how a company is doing
until the statement is released. We use past and present data of the economy, industry and firm. Mainly used
for long term investment. Don’t worry about day to day fluctuations (blue chip stocks). Can be used for trading
and investment. Objective = valuation and corporate restructure. Can tell us why shares go up or down in the
future because it analyses everything about the economy, industry and firm. This is why it takes a longer time
Technical = daily data. Based on price level and volume of past data. Short term investment. Just used for
trading. Objective = when to buy and sell. Cannot explain why shares prices go up or down because doesn’'t
talk about fundamentals.
Difference between firm value and equity value
Firm value = what a firm is worth. Building, resources, machinery
Equity value = what their shares and retained profits are worth
Comparable company analysis (multiple valuation)
Comparable company analysis (relative valuation)
- Depends on value of other similar/ comparable firm
- Uses target firm metrics (share price, enterprise value, earning per share, sales,) to derive value based
on the metrics of related firms. Estimate value of our firm cpmared to other comparable firms
To work out valuation: Peer firms. Multiples (ratio of firm value related to performance metrics- Earnings,
sales). Key assumptions (similar performance characteristics related to similar value, they should have the
same multiples)
Intrinsic valuation
- Value depends on present value of all future cash flow
- The more cash flow a firm generates in the future, the higher the value
Advantages and disadvantages of multiple valuation
Types of multiples
Equity
- Related to shareholders (share price)
Firm
- Related to entire firm (debtors and shareholders)
Week 8 - operating activities and cash conversion cycle
Explain the components of cash flow statements
→ cash flow statement reconciles cash movement from year to year within a company (separates into 3
categories being operating, investing and financing activities)
→ cash flow statements use cash accounting. Recognises impact of transactions when paid, shows overall
increase or decrease in cash by entity over the period
→ provide details of movements in an entities cash balance over a specific time period
→ reports inflows and outflows of cash
→ operating activities = main revenue producing assets
- Cash flows related to the provisions of goods and services e.g receipts from customers, payments to
suppliers and employees, interest paid, income tax paid, cash flow
- Provides users with important information about the ability of the business to generate positive cash
flows from its business activities
→ investing activities = acquisition and disposal of long term assets
- Relate to the sale and acquisition of noncurrent assets and investments that are not cash equivalents
e.g purchases / sales of property, equipment, equity investments, businesses, loans to other bizzos,
dividends
- Provide users with important information about asset investment strategy and thus can provide signals
about future revenue growth
- Can use assets for future growth to generate growth and profit. Often use money from operating
activities to invest
→ financing activities = equity capital and borrowing
- Related to changing the size and/ or composition of the financial structure e.g borrowing /repaying
debt, issuing shares / buying back shares, paying dividends
- How companies source cash e.g banks, shareholders. How they fund their operations (debt or equity)
Why is the cash flow statement important?
- Informs the user of the business cash position and how it generates cash
- Business must have sufficient cash at all times, needs cash to pay its expenses, pay bank loans, pay
taxes and to purchase new assets
Benefits of a cash flow statement
- Reveals opening and closing balance of cash
- Provides info about what caused the movement in the cash balance
- Need to consider: market conditions (covid) → no money from operation activities but still need to pay
landlord and suppliers, changes in working capital over time (CA + CL), changes in financial ratios over
time (liquidity ratios), where the bizzo is in its life cycle (takes a while to generate positive cash flow coz
paying for assets in the beginning is expensive and you won’t need to pay for this later on)
How we can use the cash flow statement
- Did the company generate cash flow operations?
- If generating cash flow activities from operations, how did it use that cash? (did it invest)
- How did profit increase when there was a net decrease in cash flow from operations? (maybe sold a lot
more on credit)→ more accounts receivable
- Is cash flow greater or less than net profit?
- How was the expansion in plant and equipment financed? (performance or external finance)
- How was debt repaid?
- How much money was borrowed during the year?
- What amount was paid in dividends?
Understand working capital management
- Business strategy designed to ensure a company uses its current assets and liabilities effectively
- Crucial to ensure a company maintains sufficient cash flow to meet its short term operating costs and
obligations
Net working capital = current assets - current liabilities
- Ensure short term operating costs and obligations are paid
-
Linked to generating positive cash flows from operating activities. Efficient in turning credit sales into
cash receipts
Investors don't want working capital to be too low as it looks like the company may not be able to pay
its financial obligations
If it's too high then it invests excessively in cash and liquid assets. Could invest to generate a return,
could buy assets to grow company, could do a share buyback
A trend of decreasing CCC values over multiple periods is a good sign while rising one should lead to more
investigation and analysis based on other factors
How do we improve the CCC?
- Reduce inventory outstanding
- Reduce debtors days (accounts receivable days)
- Increase accounts payable days
Firm (Enterprise) value
Eg woolworths v coles
Equity value (market capitalisation / MVE value)
Equity multiples
→ related to shareholders
Price earnings multiple
-
Earnings per share = Net income / shares
outstanding (no of shares)
Price book multiple
Fim multiples
→ related to debt and shareholders
EV / EBITDA
-
EBITA = earnings before interest, tax,
depreciation and amortisation
EV = share price x shares outstanding + debt cash - non operating assets
EV / EBIT
BVOE = Shareholders equity / shares outstanding
Price per sales per share multiple
EBIT = earnings before interest and tax
EV / SALES
EXAMPLE
→ P/E multiple = price per share / earnings per share
→ Find the average of comparable firms
→ Find implied share price for target firm
Implied share price = av p/e multiple x earnings
per share of target firm
EXAMPLE
→ EV / EBITDA
→ Find the average of comparable firms
→ EV EV/EBITDA x TF EBITDA - TF debt + TF cash = TF
price x TF shares outstanding
-
X = target company
→ PS / multiple
→ EV / sales
Week 9 - Free cash flow and incremental cash flow
Distinguish the accounting concept of cash flow from the finance concepts of free cash flow and incremental
cash flow
→ 2 uses of cash flows in finance
- Free cash flow = focus on the entire firm
- Incremental cash flow = focus on a particular project
→ Accounting v finance cash flow
Cash flow accounting statement
Finance cash flows (free cash flow)
Net cash flow = Operations CF + Investing CF +
Financing CF
→ Focus on the ability of a firm to generate future
surplus cash flow for its debt and equity holders
(creditors and shareholders)
Cash balance at year end = Cash balance at start of
period + net cash flow
→ Gaps between cashflow and profit are a warning
sign that somethings wrong , as this shows us our
cash inflows and outflows , so everything should
match up
→ The stronger the ability for a business to generate
surplus cash, the more valuable it is to investors
→ A businesses ability to generate cash can be
measured by:
- EBITDA
- Operations cash flow
- Free cash flow
- To firm (one we focus on)
- To equity
→ Goal of free cash flow is to estimate firm value and is related to intrinsic valuation
- Uses the discounted cash flow method → The price of an asset = PV of all future cash flows
- Value depends on the present value of all future cash flows, and the more cash flow that is
generated, the higher the value
- Basically, buying an asset gives you the right to its future benefits. These benefits are ‘cash
flows’
→ Free cash flow example
- Buying a share for $10 today. You then receive dividends every year forever. If we get the present
value of all these future dividends, this will give us the target share price today.
→ What is free cash flow
- To firm = what can be paid to capital holders (equity + debt investors) once all costs are paid off
-
Free Cash flow Can be calculated by dividends + share repurchases + interest + principal + change in
cash
- Change in cash = net cash flow from Operations + Investing + financing (income statement)
- Change in cash = change in cash between 2 yrs (balance sheet)
Distinguish incremental non non-incremental cash flows
→ Incremental cash flow of a project = all cash flow arising as a consequence of this project available to the
owners of the project after paying all expenses (including maintaining the project operations)
→ Eg we are trying to measure the incremental cash flow of a project, to determine its feasibility
→ The new operation (eg new machine, change in sales strategy, new employee perks) will generate some
new cash flow, however some of that will be re invested
→ There will then either be a negative or positive effect on the existing operations
- NEGATIVE Eg cannibalization (when a company introduces a new product, and existing customers
switch form the original to the new product) → Pepsi introduced pepsi max. Some existing customers
of Pepsi switched from original, to max (no sugar).
- Therefore , businesses need to check what the introduction of the new product will do to old products
- POSITIVE Eg of cross selling → the introduction of the apple watch. It had a positive effect on the
existing operations of Apple because it was the first of its type and consumers wanted to buy it. In order
to use it however, they had to have another apple product to connect it to, some consumers would
switch to apple iphones in order to be able to utilize the apple watch
→ The incremental cash flow (all funds made - expenses) will then go to owners
→ The main goal of incremental cash flow is making corporate investment decisions .
- It is helpful to international management to judge the value of a proposed project for capital budgeting
○ Should the firm start the project/
○ Does it add value (net positive cash flows)
→ Free cash flow is helpful for investors and analysts to judge the value of the firm
→ Types of incremental / free cash flow
→ 3 stages
Initial outlay
> purchasing fixed assets (capex)
> development costs (installment etc)
> more raw material (increase in net
working capital)
Ongoing cash flow
> FCF it is bringing
> additional revenue this project brings
- incremental costs - taxes - changes in
NWC (changes in inventory, AR, AP)
Maturity (terminal)
> sale value of equipment ( - tax on
sale) - shut down costs
> + changes in NWC (Sale of extra)
Evaluate the components that are part of FCF / ICF
→ 2 Methods to compute FCF / ICF (FIRST ONE USED IN STEP 7)
FCF = (EBIT) X (1 - tax rate) + depreciation - capital expenditures - change in net working cap + terminal Cash
flow
- EBIT = revenue - cost - depreciation
- Depreciation is considered a non-cash expense (depreciation = tangible assets / amortization =
intangible)
- Adding terminal cash flow occurs in the last year (eg decommissioning costs, after tax salvage, and
recovery of nwc
(Rev - cost) x (1 - tax rate) + tax rate x depreciation - capex - change in nwc + terminal cash flows
→ Working out changes in net working capital
Current assets - current liabilities
- To operate a new project, a business buys more material (increase inventory), sells more on credit
(increase AR → additional cash in nwc). It also means more is owed to suppliers, increasing AP
(decrease in NWC)
- An increase in NWC means more long term capital is needed to fund the operations of the company,
and less free cash flow is available to capital providers. Means FCF decreases.
- EG if NWC increases, because its a - , the fcf will decrease
- A decrease in NWC means less need for long term funds to cover operations . Means more cash flow
available for capital providers (FCF increases)
- Be careful because it means it's better to decrease the change in net working capital so free
cash flow increases. Means less inventory etc is purchased, and therefore not as much is
produced. It means cash flow will be freed up, but also will have an impact on operations
income.
→ Increase of 4 above means more capital is required to finance the additional working capital (decrease cash
flow / incremental cash flow)
→ Working out terminal cash flow
- Includes all actual cash inflows and outflows that involve terminating a project
TCF = shutdown costs + recovery of NWC + After tax salvage
- From shutting down / decommissioning
- Eg machines transported to other places , waste disposal, write offs of machines with positive
book value, but 0 market value
- From recovery of NWC
- Prior investment in working capital is recoverable at book value and can be reused in the firm
- From sale of equipment / after-tax salvage cash flow (capital gain tax if selling for above book value)
- Selling price - taxes paid on any profit from sale
- If the selling price is below book value , we made a loss. Means taxes paid will be reduced
1. What revenue figure
Revenue → 1063 x 53 = $56 339 (profit and loss)
- 1063 x 53 = amount of units sold at cost
4. + 7 Accounts receivable change
Accounts receivable → 20 000 - 25 161 + 1063 x 53 x (1-42%) = $ 27 515.62 (partial balance sheet)
- 20 000 previous year AR
- 25 161 received payments from customer that purchased on credit in previous years
- 1063 x 53 x (1 - 42%) amount bought on credit this year
2. Cost figure
Cost → 1063 x 37 = 39 331 (profit and loss)
- 1063 amount of items sold
- 37 cost price
7. Inventory → 70 000 + (1853-1063) x 37 = 99 230 (partial balance sheet)
- 70 000 previous year inventory
- 1853 total units produced
- 1063 total units sold
- 37 cost to produce
3. Accounts payable change
Accounts payable → 80 000 - 62 780 + 1853 x 37 x (1-67%) = 39 845.13 (partial balance sheet)
- 80 000 previous year AP
- 62 780 payments to suppliers on credit
- 1853 items produces
- 37 item cost
- (1 - 67%) suppliers paid in credit
5. Depreciation and amortization costs
Depreciation → 80 000 / 6 = 13.33333 (profit and loss)
- 80 000 machine sold for
- 6 years
7. Non current assets (net ppe) → 53 533.33 - 13 333.33 = 40 000 (partial balance sheet)
- 53 533.33 previous year property , plant and equipment
- 13 333.33 current year depreciation
6. Profit margin
Gross margin (profit) → 59 339 - 39 331 = 17 008 (profit and loss)
- 59 339 revenue
- 39 331 cost
Operating profit
Operating profit (profit and loss) → 17008 - 0 - 0 - 13 333.33 = 3 674.67
- 17 008 gross profit
- 0 sales, general and administrative costs
- 0 research and development costs
- 13 333.33 depreciation cost
Earnings before tax
EBIT → 3674.67 + 0 (profit and loss)
- 3674.67 operating profit
- 0 other income
Tax
Tax amount → 3674.67 x 30% = 1102.40 (profit and loss)
- 3674.67 EBIT
- 30% tax rate
Earnings
Earnings → 3674.76 - 1102.40 = 2572.27 (profit and loss)
- 3674.67 EBIT
- 1102.40 tax
Cleaning up EBIT to get free cash flow
Apply the pro forma statements to estimate free cash flows
→ Step 1 : Estimate net working capital and change in net working capital
→ Step 2 : calculate capital expenditure schedule
-
Year 0 = 1 070 000 (initial outlay cost)
Year 2 = 60 000 (maintenance)
Year 3 = 80 000 (maintenance)
→ Step 3: calculate the depreciation schedule
-
Initial cap ex depreciation (starts the next year) → 1 070 000 / 5 = 214 000
Cap maintenance yr 2 depreciation (starts next year) → 60 000 / 5 = 12 000
Cap maintenance yr 3 depreciation (starts next year) → 80 000 / 5 = 16 000
Annual depreciation expense = all depreciation for the year added
→ Step 4 : find accumulated capex cash flow and depreciation
-
To find accumulated value → Previous years capex / depreciation + current year
→ Step 5: find, after x years, the book value of the machine
-
Accumulated CAPEX - accumulated depreciation
In this question, the book book value of the machine, on the balance sheet, at the end of year 5, will be
$72 000
→ Step 6: estimate terminal value
- Enter in price of machine sale
- Here : 80 000
- Enter in decommissioning costs
- Here : - 75 000
- To estimate tax → Price of machine sale - book value (at specified year) x tax rate
- Here : (80 000 - 72 000) x 30% = - 2 400
- To Work out recovery of net working capital investment → sum of change in NWC (from step 1)
- Here : 115
- TCF = machine sale - tax - decommissioning cast + receiver NWC investment
- Here : 80 000 - 2 400 - 75 000 + 115 000 = 117 600
- NOTE : Price of machine - tax on profit of machine sale = after tax salvage value
→ Step 7 : find operating cash flow and FCF
- 1. Incremental cash flow
- HERE : 500 000 every year
- 2. Incremental cost
- HERE : - 150 000 every year
- 3. Annual depreciation expense (take from step 4)
- HERE : see step 4
- 4. Find EBIT → Incremental revenue - incremental costs - depreciation
- HERE : In year 1 → 500 000 - 150 000 - 214 000 = 136 000
- 5. Subtract tax → EBIT X tax rate
- HERE: In year 1 → 136 000 X 30%= - 40 800
- 6. Find incremental earnings → EBIT - income tax
- HERE: for year 1 → 136 000 - 40 800 = 95 200
- 7. Add back annual depreciation expense (step 4)
- Here : for year 1 → 214 000
- 8. Subtract CAPEX (Step 2)
- HERE: for year 1 → 0
- 9. Subtract change in net working capital (step 1)
- HERE : for year 1 → - 25 000 (will always be negative as its a cash outflow)
- 10. Add terminal cash flow ( Step 6)
- HERE : For year 5 → 117 600
- 11. Find incremental free cash flow (6 + 7 - 8 - 9 + 10) {first FCF formula- from higher up the page}
- HERE : For year 1 → 95 200 + 214 00 - 0 - 25 00 + 0 = 284 200
Critically analyze and estimate free cash flows
Estimate ICF directly (method 2)
→ For year 2 : 350 000 x 245 000 - 60 000 - 0 + 64 200 + 0 = 249 200
- 350 000 = rev - costs (2 & 3)
- 245 000 = incremental cash profit (5)
- 60 000 = cap ex (6)
- - 0 = change in NWC (7)
- 64 200 = Depreciation tax shield (8)
- 0 = terminal cash flow (9)
Practice questions:
a)
→ NET INCOME : (Sales rev - cogs - depreciation expenses - interest expense) x (1-tax rate)
b)
→ Capital expenditure, and capital expense are the same thing
c)
→ To find new value when already have ratio of peer firm, multiply information we have by the multiple
d)
e)
Week 10 - Responsible financial management
Understand the link between corporate social responsibility and financial management
- Citizenship: Relo company holds shareholders and stakeholders. Ethical legal and moral
responsibilities
- CSR: responsibilities that all companies have to integrate social and environmental matters into their
business operations.
- Must consider how economic activities that a company pursue impact the communities and broader
environment that these companies operate within
- All companies should produce higher standards of living in quality for the communities that surround
them while maintaining profitability for stakeholders
- Sustainability reporting: provides info to a company's stakeholders. Report on what issues are material
to the company
- Expectation that all organisations manage the social and environmental impact of their economic
activities
- The financial performance of a company can be impacted when it fails to identify and manage social
and environmental risks
- Every company has a ‘licence to operate’ referring to the importance of the company being accepted
by society and upholding stakeholder expectations
- How companies are encouraged to adopt social and environmental policies : shareholders, directors,
governments, stakeholders
Understand the different forms and components of non financial reporting
- Sustainability Reporting: provided disclosures on an organisation's impacts on the environment, society
and the economy. Allows organisations to measure impact on society to make improvements and make
operations more sustainable. This is voluntary
- Set the standard for sustainability reporting (rulebook) → Global Reporting Initiative standards create a
common language for organisations to report on their sustainability impacts in a consistent and credible
way
- The GRI standard is divided into 3 sections :
❖ economic (economic performance, tax, anti corruption, anti competitive behaviour)
❖ Environmental (energy, water, emissions, sustainable packaging, supplier environmental
assessment)
❖ social (employment, health and safety, child labour, sponsoring community initiatives, how well
employees are paid, diversity and equal opportunity, local communities)
-
Allows stakeholders to understand the extent of companies use of natural resources and employee policies
Understand the importance of tax within the sustainability reporting framework
- Companies are criticised for avoiding tax
- Companies seek to take advantage of low tax countries (Netherlands and Ireland). Saves companies
may as they pay lower tax on the profits they generate as they move profits to different countries
- 3 types of tax behaviour.
❖ Evasion (not paying tax, illegal, can be done through not declaring income, concealing or
transferring assets illegally, claiming inflated deductions)
❖ Avoidance Aggressive tax planning(legal but ethically questionable, minimises tax liabilities,
exploiting loopholes in tax law, grey area {legally shifting profit from a high tax jurisdiction to a
low tax jurisdiction}. This is within the letter of the law but contrary to the spirit of the law
❖ Planning/ minimisation (use law to reduce tax liabilities→ income timing, capital structure {debt
v equity}, maximising use of concessions {research and development incentive}
- Companies receive negative attention from media when they reduce tax liabilities through aggressive
tax avoidance schemes
- Companies are receiving increased calls to disclose the tax paid in all countries they operate within.
Represent an importance contribution to society
Importance of sustainability reporting
Understand the assurance of non financial reporting
- Only ⅓ of sustainability reports are assured as assurance is not mandatory
- Non financial reporting have limited assurance
- Researchers have criticised that sustainability reports lack completeness and credibility as companies
often seek to include positive disclosures in their sustainability reports. These negative disclosures are
often purposely unreported. There is no external verification so they lack credibility. We don’t know if all
material has been included due to lack of independent auditing or verification due to its optional nature
- Approximately ⅔ of those who provide assurance engage the major accounting firms to carry out this
assurance work
- Accounting professionals have an advantage in this area as they understand independence, familiarity
with assurance (evidence collection) as well as ethical guidelines and well structured procedures
- Non accountants have an advantage where they have expertise in the measurement and assurance of
scientific and technical data (scientists and engineers). Having training in and understanding skills in
environmental science. Have knowledge of Human Rights laws