Financial Accounting: University of Toronto

Department of Chemical Engineering
and Applied Chemistry

University of Toronto
Course: CHE349
File: CHE349/FinancialAcctg14
Copyright: Joseph C. Paradi
1996-2004
Centre for Management of Technology and Entrepreneurship
Financial Accounting
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Course: CHE349 Centre for Management of Technology and Entrepreneurship
Accounting Introduction
Engineers typically hate accounting and finance.
The view is that it is dry and wholly uninteresting (and
Economics is not far away from this).
While there is some truth in all this, there is much utility also.
Accounting can not be ignored, it intrudes into every aspect of
work.
The best approach is to learn as much as possible, use it when
appropriate, but you dont have to become accountants, just
understand what they do.
What you need is a good basic understanding of it.
You can not tell how well the business or the project is doing
without accurate and timely financial information.
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Some History
It has been with us since the earliest civilisations. They kept a
record of the goods stored with the temple priests.
"Double-entry" bookkeeping can be traced back as far as 1494
when an Italian monk described such a methodology in a
mathematics textbook.
It is simply put: a way of keeping track or scoring the financial
results of an individual, a corporation etc.
It is very important in today's society when it is common place
for the owners not to be present.
Accounting information in its truest form is used to evaluate
uses of limited economic resources.
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Why do we Need it?
Accounting information is so valuable that many people make a
career out of analysing and evaluating the resulting statements
and advising their clients.
management consultants
business planners
accountants
financial analysts
investment managers
securities brokers/underwriters
There are two fundamental users of accounting information.
They are external and internal groups to the "organisation".
Accounting keeps the score in business.
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Management's Need
Every textbook will discuss planning and controlling as the two
most important uses of accounting info.
By having an historical perspective you can see trends and
relationships appearing.
You can use this information to plan into the future.
One must never forget that history does not always repeat itself
and variances from your plan will occur.
Once a plan is in place you can then monitor results and
control or alter certain activities as needed
The changes or variances - positive or negative - from a plan
provide very useful information.
Costing of products is another common use of information
provided by an accounting system.
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Government Needs
The best example here are the various tax authorities.
Our tax structure is set up to tax "income" or "profits".
It is critical that we all have a "level" playing field and a
common system of "score-keeping" which we use to measure
progress.
We wouldn't want to have the yardsticks or methods of
measurement to move while the "game is on".
It is every taxpayers right to arrange his/her affairs in such a
way as to minimise taxes.
So accounting is important and is required by all levels of
Government so that they can audit your tax paying
methodologies
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Outsiders' Need
There are a number of external stakeholders who also have
an interest in how things are going.
Investors/owners of the firm need information.
Bankers, tax authorities, other government agencies, insurance
companies, suppliers etc. are only a few examples of the
regular contacts that the person in charge of accounting can
expect to have.
In every case it is important that the accountant represent the
company's best interest.
The score keeping process is done according to a set of rules -
the GAAP - so that everyone understands what certain things
really mean.
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The Matching Principle
This is a very important principle:
"Transactions are to be recorded when they occur, not
when the cash is actually exchanged"
This is known as ACCRUAL accounting.
this means that you may pay tax on moneys you have not yet received
but you can also claim expenses that you have not paid for yet
in both cases, however, there is evidence that something has happened
If cash is used as the time to recognise a transaction, then we
have CASH BASIS accounting
While the former is used in almost all businesses, the latter is
useful for small cash based business
Dont confuse this with cash flow however!
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Financial Accounting
Therefore, the accounting function has two parts, financial
accounting and management accounting.
Financial Accounting is concerned with the recording and
organising the financial data of a business:
revenues
expenses
resources owned
obligations to others
owners' value (equity)
Management Accounting is concerned with the costs and
benefits of the various activities of the enterprise.
Provide managers with useful and timely information
assist in decision making by crunching numbers as required
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Firm Performance Measure
Areas of interest to everyone include how the enterprise
gathers revenues and disburses resources.
There are three basic summary statements everyone is
interested in:
Balance Sheet
Income statement
Statement of changes in financial position
There are other interesting statements but we will leave those
for another course.
These statements form the basis of a regular, usually monthly,
written report.
So the use of these statements is the real interest for us.
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The Balance Sheet
Often called a position statement
It is a snapshot in time of the firm's assets owned and liabilities
(debts) owed and the owner(s) equity.
So the first category of financial information lists the assets of
the firm and divides these into current and long term assets
Current Assets lists cash and cash equivalents, such as
marketable securities, receivables, prepaid expenses etc.,
anything that can be quickly converted into cash.
Long Term Assets show assets owned which are not likely to
be quickly converted into cash, such as buildings. In fact, the
business might have to be sold first.
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More on the Balance Sheet
Liabilities are also split into "current" and "long-term".
Obligations due within a year of the statement are current while
those repayable at a date more than a year in the future are
classified as Long-term Liabilities.
The difference between assets and liabilities represent the
value that the owners have in the enterprise the Owner's Equity
and that typically has two parts: Paid-in Capital and Retained
Earnings.
We have then:
Assets = Liabilities + Owner's Equity put another way:
What a business has = Creditors' contribution + Owners' contribution
If the owner's Equity is negative, the firm is almost certainly in
trouble!
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Assets
Assets are everything of value that belong to the business.
Value only implies future usefulness. It does not reflect the
liquidation value of the assets.
When presented on the balance sheet the most liquid assets
are listed first.
Assets are placed on the books at their full cost, whether they
have been paid for or not - some examples are:
Current Assets:
Cash in bank
Government securities
Market investments
Accounts Receivables
Inventories
Pre-paid Expenses
Mortgages receivable
Fixed Assets:
Land
Buildings
Equipment and fixtures
Vehicles
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Liabilities and Shareholders'
Equity
Liabilities represent everything owed to creditors.
These claims to creditors are against the assets of the company.
Examples of liabilities would be accounts payable, payroll, taxes
payable, bondholders etc.
Arrange them according to their urgency to be paid
Shareholders' Equity is also a liability and:
This represents the excess of assets over liabilities.
Assets = Liabilities + Shareholders' equity
It would begin with an investment in the company through the purchase
of shares and then each year would grow or shrink by the profits/losses
less any dividends.
In plain language, this the "worth" of the company from a shareholder's
investment point of view
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Example of a Balance Sheet
The ABC Shutters Manufacturing Co.
ASSETS
Current Assets
Cash 25,000
Accounts Receivable 115,000
Raw materials 8,500
Work in progress 7,000
Finished good in inventory 15,500
Total current Assets 171,000
Fixed Assets
Land 30,000
Buildings (net of depreciation) 150,000
Equipment (less of depreciation) 600,000
Office equipment (net of depreciation) 10,000
Total fixed Assets 790,000

Total Assets 961,000
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Example of a Balance Sheet
continued
LIABILITIES
Current Liabilities
Accounts Payable 32,000
Payroll Taxes payable 15,000
Total current Liabilities 47,000
Long-term Liabilities
Mortgage payable 130,000
Equipment loan payable 350,000
Total long-term Liabilities 480,000
Owner's Equity
Common stock 325,000
Retained Earnings 109,000
Total Equity 434,000
Total Liabilities and Equity 961,000
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Income Statement
The ABC Shutters Manufacturing Co.
SALES
Goods and services 1,200,000

EXPENSES
Labour 532,000
Materials 302,000
Depreciation 98,000
Maintenance and repairs 41,500
Utilities 11,500
Administration 76,000
Marketing 49,000
Interest payments 35,000
Total Expenses 1,145,000
Net Profit before taxes 55,000
Income Taxes 26,000
NET PROFIT 29,000
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Statement of Changes in
Financial Position
One shortfall of both the balance sheet and income statement
is that neither one gives you any indication of cash flow and
sources and uses of cash.
The Statement of Changes in Financial Position statement is
relatively new compared to the balance sheet and income
statements. Its quick acceptance is likely due to the fact that it
offers a wealth of information to the analyst.
Using both the balance sheet and income statement
information, cash is reconciled during a particular period from
its opening to closing position.
Many firms found themselves with healthy profits but had
expanded too fast to fund their short term liabilities.
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Statement of Changes in
Financial Position - Cont'd
Four major sections: cash from operations, financing activities,
investing activities and change in cash.
Cash from operations shows movement from one period to the
next in net working capital plus net income adjusted for any
non-cash expenses (eg: depreciation).
Financing activities shows the change in any long term debt
and any equity financing or dividend payments.
Investing activities: long term assets acquired in period.
This all ties into the net change in cash from one period to the
next. There really is never enough cash.
Many would argue that this is the most critical statement early
on in the life of a new business.
Many great ideas never turn into thriving businesses because
of the lack of proper/adequate financing.
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Some Thoughts
Financial statement preparation is designed to be conservative
to avoid "surprises".
Assets are recorded at cost or market value, whichever is less -
so land goes up in value over the years but no change in the
value of the asset, inventory values are adjusted only
downward if there is a doubt of the value.
So while the statements appear accurate and authoritative,
many items are estimates:
accounts receivables
finished goods value in inventory
depreciated assets - any assets, especially long term
So remember that many figures are estimates when you read a
financial statement.
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Costs and Management
In all businesses there are many different costs:
1. Discretionary costs - can decide to postpone
2. Relevant costs - trade-in, training, space etc.
3. Sunk costs - costs which incurred in the past
4. Fixed costs - rent, machine costs, HVAC etc.
5. Variable costs - raw materials, labour, etc.
6. Semi fixed/variable costs - most costs are of this type
7. Standard costs - based on some assumptions
Then there are various cost analyses where a decision is
involved once all the costs are known - which piece of
equipment to buy, is a company worth the price, should we
close the dining room at the Golf Club in the winter, can we be
absent from a trade-show etc.
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Variable Costs
Some costs that a company incurs are directly proportional to
the level of production.
Raw materials would be a good example of a variable cost.
They increase in direct proportion to the production.
Labour component in manufacturing may be variable but not in
a direct relationship with production.
Thus, if an employee can produce 2 devices an hour, then if
you only make 1 device you still need the staff, but, if 3 devices
are made, another employee is needed
Although "smoother" than fixed costs, there are still marginal
decisions that must be made.
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Fixed Costs
Fixed costs are those costs that do not go up or down with
slight fluctuations in volume. E.g: the building costs or the
President's base salary.
These costs, within certain parameters, are fixed.
Also, typically, fixed cost steps come in large values - you must
buy a whole machine even if you need only 10% for the new
sales available at this time.
Fixed costs are the difficult ones to deal with as you attempt to
cost out a future production.
It is critical to forecast sales volumes. If you could only sell 100
pens you would have to either raise your selling price or decide
whether or not to stay in business, if you can not change your
fixed costs component.
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Fixed/Variable Cost Example
We are Selling $1.00 Pens, and expect to sell 200 a day
Variable costs: Raw Materials $.20/pen
Labour $.30/pen
Fixed Costs: Rent $50/day
Support Staff $25/day
No matter what, the fixed costs are $75.00 per day, so:
200 pens fixed cost is $75/200=$0.375/pen
Now let's compare the situation at different sales levels:
At 100 At 200 At 400
Revenue $ 100 $ 200 $400
Expenses
- Variable 50 100 200
- Fixed 75 75 75
Profit $(25) $ 25 $125
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Financial Statement Analysis
The June 1994 Issue of "Better Investing" magazine, page 26
has a three-page article about this topic:
Start with the notes and read from back to front since the front is
management fluff.
Look for litigation that could obliterate equity, a pension plan in sad
shape, or accounting changes that inflated earnings.
Use it to evaluate management. The boring things need be read for long
term growth. A quick in and out, such as buying depressed stocks, don't
waste time.
Look for notes on relevant details; not "selected" and "certain" assets.
Profits of operating divisions, geographical divisions, etc.
How the company keeps its books, especially as compared to other
companies in its industry.
Inventory. Is it down because of a different accounting method?
What assets does the company own and what assets are leased?
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Financial Ratios
It is natural then that people use the "standard" financial data
available from financial statements to judge the performance of
the firm.
Performance measures thus developed can be used to answer
questions such as:
is the firm able to meet its short term obligations?
are the firm's assets generate sufficient profits?
how dependent the firm is on its creditors?
do their customers pay them promptly?
do they pay their suppliers promptly?
Financial Ratios are a common way to answer these and other
questions.
They provide the analyst a framework for asking questions
about various performance measures.
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Interpretation of Financial Ratios
While calculating these ratios are simple enough, interpretation
is not as simple and require some skill.
Ratios also have problems because of:
overly simplistic approaches
they lack support tools
there is a lack of analytical framework
dont reflect process complexities
not multidimensional
assumption of comparable units
constant returns to scale
often contradictory ratios - lack objectivity
Nevertheless, they are used everywhere and some actually
show meaningful results on the firm as a whole
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Interpretation Rules
To properly interpret ratios, analysts compare such ratios from
the same company's results over time.
The ratios can also be compared to industry standard ratios
and thus judge company performance.
Such financial ratio analysis can be done when industry
standard ratios are available from companies like Dun &
Bradstreet, TRW, StasCan and others.
When comparing specific company financial statements to
those from, say, StatsCan composites, the firm's financial
health can be judged.
Care must be taken to use more than one source of standard
data because regional difference can count.
Ratios in Orange are in the book others are additional.
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Financial Ratio: Liquidity
Liquidity Ratios:
evaluate the business' ability to meet its current cash obligations
Working Capital adequacy is measured here
Working Capital = Current Assets - Current Liabilities
The Current Ratio (or Working Capital Ratio) is:
Current Ratio = Current Assets/Current Liabilities
all the current assets are involved, even those which may be difficult to
turn into cash quickly (prepaid expenses, etc.)
A more stringent ratio is the Acid Test Ratio (or Quick Ratio):
Acid Test Ratio = Quick Assets/Current Liabilities
Quick assets are: cash, government securities, A/R, notes receivable -
highly liquid assets can turn into cash immediately
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Financial Ratio: Leverage
Leverage or Debt Management Ratios:
Captures the extent to which the firm relies on debt for its operations.
The Equity Ratio measures owner's equity to total assets
the smaller this is, the more the reliance on debt
Total Owner's Equity Total Owner's Equity
Equity Ratio = ------------------------------------------ = ----------------------------
Total Liabilities+Total Equity Total Assets
Debt to Total Assets
this compares the debt level to the total assets of the firm
Total Debt
Debt to Total Assets = -----------------------
Total Assets
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Financial Ratio: Asset
Management
This ratio assesses how efficiently the firm is using its assets.
Inventory-Turnover Ratio looks at how efficiently inventories
are utilised.
Sales
Inventory turnover ratio = -----------------------
Inventories
note however that sales are generated over a period of time while
inventories are at a point in time. Average inventory over the sales
period would be more accurate
also, sales are achieved at market prices while inventories are at cost of
manufacturing them - thus the ratio overstates the facts
Net Profit (Return-on-total-assets) Ratio
Profit after taxes (before extraordinaries)
Return on Total Assets = --------------------------------------------------------------
Total Assets
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Financial Ratio: Profitability
Return on Sales - measures the profit margin on sales
Net Profit
Return on Sales = -----------------------
Sales
Return on Equity - measures the returns on funds invested by
shareholders.
Net Profit
Return on Equity = -----------------------
Tangible net worth
Dividend Payout - shows how much cash is received on
moneys invested in the firm.
Dividend on Common Shares
Dividend Payout = ---------------------------------------------
Net Profit - Preferred Dividend
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Financial Ratio: Cash
Management
Receivables in Days measures the firm's ability to collect its
money from customers
Accounts Receivables
Receivables in Days = ----------------------------------
Daily Sales
Inventory in Days measures the inventory levels in days
Inventory
Inventory in Days = -------------------------------------
Daily Cost of Goods Sold
Accounts Payables in Days - shows how promptly the firm
pays its creditors.
Accounts Payable
Payment Period in Days = ------------------------------
Daily Purchases
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Financial Ratio: Markets (stock)
Earnings per Share - returns on a share owned
Net Profit - Preferred Dividend
Earnings/Share = ------------------------------------------------
Number of Common Shares
Price Earnings Ratio - share price to earnings
Market price of Common Shares
Price Earnings Ratio = --------------------------------------------------
Earnings/Share
Dividends per Share - cash returns per share
Common Stock Dividends
Dividends/Share = -----------------------
Number of Common Shares
Dividend Yield - % cash received to share price
Dividends/Common Share
Dividend Yield = -----------------------------------------------------
Market price of Common Shares
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Leverage
This is a concept that is tied into ownership (equity)
considerations as well as needs for cash. Leverage works if
you could sell more if you had more money:
Simply put it works like this:
The company makes a profit of $1,200 with an equity
investment of $10,000. If there were 1,000 shares issued for
the investment, the EPS = $1.20
Now we borrow $5,000 at a yearly interest of 8% and thus
make a profit of $1,800 less the interest $400.00 this results in
an EPS of $1.40
We did not give up equity, so earnings rose per share as there
borrowing cost less that the profit we made.
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Leverage Risks
Naturally, there is no free lunch! There are problems!
If sales fall, interest is still paid, so profit falls much faster, profit
can decline to $400 before losses start
repayment of the debt requires the recovery of the cash which in poor
times will be difficult
lenders get nervous when leverage works against you, so they become
less tolerant
So, what is the best debt/equity ratio? Sorry, there is no such
number. But, lenders like to have it at the published industry
average.
Be careful about debt if it can not be paid back quickly.
But manageable debt increases profitability and hence
shareholder value.
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Summary
Remember when calculating numbers, use 360 days for a year
and 5 days for a week, 8 hours for a day.
Financial Accounting is a big subject and can not be dealt with
here adequately, so if interested, read up or take a course in
Accounting 101.
Balance Sheets MUST balance, if they don't, find the problem.
Knowing what item is a Balance Sheet item and what is Income
statement is crucial if you are constructing financial statements.
Everyone must adhere to the rules GAAP or the statements will
mean different things to different readers - consistency is
essential

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