Financial background my ppt @ bec doms
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- 1. Financial Background:A Review of Accounting, Financial Statements,and Taxes
2. The Nature of Financial Statements
- Three Financial Statements
- Income statement
- Balance sheet
- Statement of cash flows
- Generated from the incomestatement and balancesheet
2 3. The Accounting System
- The Double Entry System
- In double entry accounting every entry has two sides that must balance
- Example:Borrowing $1,000 to buy a machine, involves
- increasing an asset account by $1,000
- increasing a liability account by $1,000
3 4. The Accounting System
- Accounting Periods and Closing the Books
- Books are closed by updating the periods transactions in the accounting system and creating financial statements
- Implications
- Last periods statements dont say anything about what WILL happen next year
- Can be used to make predictions
- Stocks and Flows
- Income statement reflects money flows over a period of time
- Balance sheet represents stocks of money at a point in time
4 5. A Typical Income Statement
- Sales (Revenue) $1,000
- Cost of Goods Sold 600
- Gross Margin $400
- Expenses 230
- Earnings bef. interest & tax $170
- Interest expense 20
- Earnings before tax $150
- Tax 50
- Earnings after tax $100
5 6. The Income Statement
- Sales or Revenue
- Total receipts from selling goodsfrom normal business operations
- Cost and Expense
- Represent money spent to do business
- Costs of Goods Sold money spent on itemsclosely related to the production of theproduct or service being sold
- Expense spending on items that arent closelyrelated to production (such as marketing)
6 7. The Income Statement
- Gross Margin (GM)
- Represents sales revenue less cost of goods sold
- Fundamental measure of profitability
- Interest
- Price the firm pays for borrowing money
- Earnings Before Interest and Taxes (EBIT)
- Profit before considering financing charges
- Also called operating profit
- Helps judge the strength of business operations without onsidering the interest expense a firm with debt pays
7 8. The Income Statement
- Earnings Before Tax (EBT) and Tax
- Earnings before taxes (EBT) represent gross margin less all expenses except taxes
- Tax refers to income taxes on EBT
- Net Income (also Earnings After Tax or EAT)
- Represents the bottom linecalculated by subtracting tax from EBT
- Belongs to the companys owners and can be paid out as dividends or retained
8 9. The Balance Sheet
- Has two sides
- Assets = liabilities + equity
- Also called aStatement of Financial Position
- Assets and liabilities arearranged in order of decreasing liquidity
- Liquidity ease with which an asset becomes cash
9 10. 10 A Conventional Balance Sheet Format 11. Assets
- Cash
- Money in checking accounts plus currency on hand
- Marketable securities are liquid investments held instead of cash
- Short-term, modestreturn, low risk
- Accounts Receivable
- Represent credit sales that have not yet been paid
- Bad Debt Reserve :some credit sales will never be paid
- Write Off : When a receivable isuncollectible, it is taken out of the balance. A like amount is subtracted from the bad debt reserve leaving the net unchanged
11 12. Assets
- Inventory
- Product held for sale in the normalcourse of business
- Work-In-Process Inventories
- As inventory moves through the production process, value is added increasing the balance
- The Inventory Reserve
- Some inventory is usually unusable - inventory balances are reported net of a reserve
- Writing Off Bad Inventory
- Missing, damaged, or obsolete items are removed and a like subtraction made from the reserve
12 13. Assets
- Overstatements
- If assets (usually receivables and inventory) are overstated firms value is less than the amountshown on the balance sheet
- Can mean a firm is not managed efficiently
- Current Assets
- Become cash within one year
- Include cash, accounts receivable andinventory
- Money received from normal business operations flows through these accounts
13 14. Assets
- Fixed Assets
- Long lived not physically fixed
- Sometimes called property, plant and equipment (PPE)
- Useful life of at least a year
- Depreciation
- Spreads assets cost over its estimated useful life
- Matching principle an assets cost should be recognized over a period matching its service life
- Financial Statement Representation
- Depreciation on the income statement reflects an assets cost, the same depreciation also appears on the balance sheet reflecting a wearing out
14 15. Assets
- Disposing of a Used Asset
- An asset may be sold for more or less than the net asset value on the books
- The Life Estimate
- An asset remaining in use beyond its depreciation life is fully depreciated
- Tax Depreciation and Tax Books
- Government allows different depreciation schedules for tax purposes and financial reporting purposes
- Tax books financial records generated using tax rules
- Financial books regular financial statements
15 16. Liabilities
- What a companyowes to outsiders
- Accounts Payable
- Arise when a firm buys from vendors on credit
- Trade Credit vendor delivers product withoutdemanding immediate payment
- Terms of Sale
- Specify when payment is due on credit
- sales and the early payment discount
- 2/10, n/30 -payment in 30 days with a2% discount if paid within 10 days
16 17. Liabilities
- Accruals
- Represent incomplete transactions
- Recognizes expenses and liabilities associated with incomplete transactions
- Common example is a Payroll Accrual
- Current Liabilities
- Require cash within one year
- Includes payables, accruals, notes payable, short-term loans, long-term debt due within the year
17 18. Working Capital
- Total current assets aregross working capital required to run a business day to day
- Net working capital is the difference between current assets and current liabilities
- Cant run a business without it
18 19. Liabilities
- Long-Term Debt
- The most significant non-current liability
- Consists of bonds and long-term loans
- Leverage
- A business partially financed with debt is leveraged
- In good times leverage enhances return on investment
- But in bad times it makes return on investment worse
- Fixed Financial Charges
- The most significant concern about borrowed money is fixed interest charges
- Interest Must be paid regardless of profitability
- Can lead to bankruptcy in bad times
- I.e., too much debt can cause business failure
19 20. 20 Leverage 21. Equity
- Funds supplied to a business by owners
- Direct investment price paid for stock or entrepreneurs contribution
- Retained earnings profits kept in the business rather than paid to owners
- Balance sheet Representation of Equity
- Money paid for stock
- Common stock accountcarries a par value per share
- Par is an arbitrary number
- Excess or surplusrepresents amounts paid for the stock in excess of (over) par value
21 22. Equity
- Retained Earnings
- Profits that have not beendistributedto owners
- As dividends if firm is a corporation
- Do not represent a reserve of cash
- Adds up all the earnings ever retained by the firm
22 23. Example: Equity Accounts
- A firm is started by selling 20,000 shares of $2 par value stock at $8 per share.Subsequently the company earns $70,000 out of which it pays dividends of $15,000
- Common stock ($2 x 20,000 =)$ 40,000
- Paid in excess ($6 x 20,000=) 120,000
- Retained earnings
- ($70,000 - $15,000 =)55,000
- Total equity$215,000
23 24. The Relationship Between Net Income and Retained Earnings
- If no dividends are paid and no new stock is sold
- Beginning equity + net income = ending equity
- If dividends are paid
- Beginning equity + net income dividends
- = ending equity
- If new stock is sold
- Beginning equity + net income dividends + stock
- = ending equity
24 25. Equity
- Preferred Stock
- Equity that has some of thecharacteristics of debt
- Although a hybrid, it is classified as equity
- Total Capital
- The sum of long-term debt and equity
- Total Liabilities and Equity
- Sum of the right-hand side of the balance sheet
- Must always equal total assets
25 26. The Tax Environment
- Taxing Authorities and Tax Bases
- Taxes are imposed by various government authorities
- Federal, state and local
- A tax base is the item that is taxed
- Income, wealth or consumption
26 27. Taxing Authorities andTax Bases
- Income Tax
- Individuals pay a fraction ofincome in a certain timeperiod to the taxing authority
- Wealth Tax
- Based on the value of certain types of assets, usually real estate
- Consumption Tax
- Based on the amount of certain goods used, usually sales taxes
27 28. Income TaxesThe Total Effective Tax Rate
- Total effective tax rate(TETR) is the combined rate to which the taxpayer is subject
- State tax is deductible from income whencalculating federal tax
- TETR = T federal tax rate+ T state tax rate (1 T federal tax rate )
- If a taxpayer is subject to a 30% federal tax rate and a 10% state tax rate, the TETR is
- 30% + 10%(1 30%) = 37%
- Less than the sum of the two rates
28 29. Progressive Tax Systems, Marginal and Average Rates
- Progressive tax system- higher tax rateson incrementallyhigher income
- Tax bracket- range of income inwhich the tax rate is constant
- Marginal tax rate- rate paid on thenext dollar of income a taxpayer earns
- Average tax rate- the percentage of total income paid in taxes
29 30. Progressive Tax Systems, Marginal and Average Rates 30 Q: Given the following tax brackets, calculate the tax on an income of$11,000.Also calculate the taxpayers marginal and average rates. A: Since the taxpayer earned more than $5,000 (but less than $15,000) she will be taxed at two rates.The first $5,000 is taxed at 10%: $5,000 x .10 = $500The remaining $6,000 is taxed at 15% $6,000 x .15 =$900 Thus, her total tax is $1,400 Her marginal tax rate is 15%, since she would pay that on her next dollar of income,and her average tax rate is$1,400$11,000 = 12.7% Example 25% Over $15,000 15% $5,000 - $15,000 10% 0 - $5,000 Tax Rate Bracket 31. Capital Gains and Losses
- Two major types of income
- Ordinary income results fromnormal money-making activity
- Wages, business profits, dividendsand interest
- Negative profits are an ordinary loss
- Capital gains or lossarises when something is purchased, held for a while and sold at a different price
31 32. The Tax Treatment of Capital Gains and Losses
- Historically capital gains have beentaxed at lower rates than ordinaryincome
- Ifholding period < 1 yearthen short-termcapital gain is not eligible for favorabletax treatment
- Gains onassets held for > 1 yearqualifyfor long-term treatment
- Tax rate capped at 15% for individuals
- Capital losses offset capital gains
- Corporations do not receive favorable rates on capital gains
32 33. Personal Taxes
- Taxes on people (households) are calledpersonal or individual taxes
- Separate schedules exist for single individuals, married couples filing jointly, married people filing separately and certain heads of household
- Between 2001 and 2003 Congress lowered personal tax rates to stimulate the economy
- Before 2001 the top rate was 39.6%
- Since 2003 it is 35%
33 34. Personal Tax Schedules - 2006 Table 2.4 34 35. Personal Taxes
- Tax Rates and Investment Decisions
- When comparing municipal bond investments to corporate bonds, an adjustment must be made
- Interest on munis are not taxed
- If a muni and corporate bond, of similar risk, are paying the same rate, the munis return is higher after taxes
- If the rates differ, the corporate bond must be adjusted toan after tax yield by multiplying by
- (1 marginal tax rate)
35 36. Example 2.2 - Comparing Corporate and Municipal Bonds
- The Smith family has the following choice
- AT&T 11%
- Boston 9%
- State AT&T after tax at marginal rate
- 11% (1 - .25) = 8.25%
- Boston bond is better
- If marginal rate is 15%, AT&T is better:
- 11% (1 - .15) = 9.35%
36 37. Corporate Taxes
- Similar in principle to personal taxes
- Total income is business revenue
- Deductions are the charges and expenditures required to run the company
- Exemptions are not allowed
- Earnings Before Tax (EBT) is taxable income
- Corporate tax rates do not consistently rise as taxable income rises
- With personal taxes taxpayers pay a lower rate on income in the bottom brackets
- Corporate tax tables are constructed so that firms with high incomes pay a constant rate on all of their income
37 38. Corporate Income Tax Schedule Table 2.5 38 The rate increases from 34% to 39% and 35% to 38% recover the benefit of lower rates on earlier income.So a corporation earning more than $18,333,333 pays 35% on all of its income from the first dollar. 39. Corporate Taxes Example 2.3 39 Q: Calculate, using the corporate tax rates in Table 2.5, the tax liability for a corporation making EBT of $280,000. A: Applying the corporate tax table results in the following tax liability: Example $92,450 Total $70,200 $180,000 x .39 $8,500 $25,000 x .34 $6,250 $25,000 x .25 $7,500 $50,000 x .15 40. Corporate Taxes
- Taxes and Financing
- The tax systemfavors debtover equity financing
- Interest payments made to debt investors are tax deductible to the paying company
- Dividend payments to equity investors are not deductible
- Result : A debt financed firm pays less tax than an otherwise identical equity financed company
- But the availability ofdebt is limitedbecause it makes the borrowing company risky
40 41. Taxes and Financing 41 42. Corporate Taxes
- Dividends Paid to Corporations
- Dividends paid to another corporation are partially tax exempt
- The percentage exempted depends on the amount of stock owned by the company
- Avoids more than double taxation of corporate earnings
42 43. Corporate Taxes
- Tax Loss Carry Back and Carry Forward
- Business losses can be carried backward or forward in time to offset taxes that might otherwise be excessive
43
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