Overview of Accounting Part 2

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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

Industrial & Manufacturing Engineering Department Cal Poly Pomona

EGR 403 - The Big Picture

Framework: Accounting & Breakeven Analysis Time-value of money concepts - Ch. 3, 4 Analysis methods
Ch. 5 - Present Worth Ch. 6 - Annual Worth Ch. 7, 8 - Rate of Return (incremental analysis) Ch. 9 - Benefit Cost Ratio & other techniques

Refining the analysis

Ch. 10, 11 - Depreciation & Taxes Ch. 12 - Replacement Analysis
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Financial Statements
Balance Sheet (General Accounting)
Snap shot of what the company owns and how much they owe. Discloses information to investors.

Income Statement (Cost Accounting)

Shows profit for the period based on Generally Accepted Accounting Practices (GAAP)

Cash Flow Statement (Sources & Uses of Funds)

Shows the actual need for cash over time so that the company can manage their cash properly

The first two statements will be discussed

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The Balance Sheet

The balance sheet is a picture of the financial health of a corporation at a point in time It is based on the accounting equation: Assets = Liabilities + Equity or Corporate Value = Value owed + Value owned
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Assets
Assets are traditionally shown on the left side of the balance sheet Asset are what the company owns:
Current Assets: Cash, Short-Term Investments, Accounts Receivable, Inventory, and Prepaid Expenses Property, Plant & Equipment Long-Term Investments Intangible Assets (goodwill) Other Assets (patents, copyrights, etc.)
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Liabilities
Liabilities are amounts owned to third parties. Two types of liabilities
Current (bills): Accounts Payable, Accrued Liabilities, Notes Payable Long-Term (loans, bonds): Long-Term Notes Payable, Mortgages Payable, Long-Term Accrued Liabilities
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Equity
Equity is sometimes called Owners Equity or Shareholders Equity Equity is a valuation of what has been invested and reinvested. It is a total of:
Common Stock Additional Paid-In Capital Retained Earnings (from P&L)
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Balance Sheet
(Left Side Total = Right Side Total)

Assets Current Assets

Cash Inventory Accounts Receivable

Liabilities Current Liabilities

Accounts Payable Line of Credit

Long Term Debt

Mortgages Bonds

Long Term
Equipment Building and Land Goodwill

Equity Stock Retained Earnings

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Balance Sheet Uses

The balance sheet reveals to managers, owners, and potential investors the financial health of the company. Each industry has a different blend of assets, liabilities, and equity that typify a successful company. Ratios are used to analyze the balance sheet (e.g., Acid Test = Current Assets/Current Liabilities, Debt/Equity Ratio, etc.)
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Inventories
Inventory refers to the raw materials, work-inprocess, and finished goods that are owned by the company. Inventory represents capital that is tied up. Until the product is sold it is not an expense...it is still an asset. High inventory costs can hurt your profitability. Much emphasis is placed on business today on meeting customer needs with minimal inventory.
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Bonds
Sold to raise money. Also popular with utilities, state, and local governments. Bonds are rated based on the financial stability of the company, city, or state. The higher the rating, the less the risk of losing your investment. Bonds have a Face Value of $1000, but are bought and sold at market value. The market value determines the true interest rate on the bond. EGR 403 - Cal Poly Pomona - SV2

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Bonds (Contd)
Face value: $1,000 Stated interest rate: 10% Term: 5 Years Date sold: April 1, Year 1 Interest payment dates: April 1 & October 1 Market value: What the bond is actually selling for in the bond market
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Bonds (Contd)
The relationship between the stated interest rate for a bond issue and the market interest rate (effective interest rate) determines whether the bonds will sell for:
a discount: sells for < $1000 (stated interest rate < market interest rate) face value: sells for $1000 (stated interest rate = market interest rate) a premium: sells for > $1000 (stated interest rate > market interest rate)
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Common Stock
Shares of ownership are sold to provide capital to finance the beginning or expansion of a corporation. These shares are called common stock. Owners of common stock usually receive dividends from profits four times a year (quarterly dividends). An IPO is the Initial Public Offering of common stock to make ownership available to the public. The New York Stock Exchange (NYSE), Amex, and NASDAQ are places where many common stocks are then sold or traded by shareholders.
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Common Stock
Common stockholders have the right to: Share in the residual assets of a corporation when it is liquidated Share proportionately in common stock dividends Maintain their fractional ownership interest (the preemptive right) Vote on key matters facing the corporation Participate in annual stock holder meeting (if any)
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Preferred Stock
Preferred stockholders generally have the right to: Receive an annual dividend before common stockholders are paid a dividend Receive the liquidation value of their stock (upon the termination of a corporation) before common stockholders receive any distribution

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Investing in Stocks and Bonds

Stock is usually traded in blocks of 100 shares. Profit is made two ways:
Dividends - distributions of quarterly profits Appreciation - selling the stock for more than you paid for it

Bonds are purchased at market value. Profit is made two ways:

Dividends at rate & schedule stated on the bond Sold for market value or held until maturity for $1000 face value
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Investment Considerations
The stock and bond markets often vary in opposite directions. Many investors diversify their portfolios as a hedge against different economic situations (e.g., inflation, recession). If a company grows in size, so does the value of the common stock and the size of the dividends. Length of ownership affects tax treatment. Generally less risk in bonds. If a company is liquidated, bond holders are paid off ahead of common stockholders. Poly Pomona - SV2 EGR 403 - Cal 18