Financial background my ppt @ bec doms

• 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

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