Basic Accounting
Basic Accounting
Basic Accounting
In this note, we are going to introduce the basics of financial accounting. By the end, you will
be able to understand and interpret simple financial statements.
The graph below shows how an accounting system operates in business and how the flow of
information occurs.
3) Accountants
prepare reports to 1) People make
show the results of decision
business operations
In contrast, when accounting information is used to report the firm’s financial performance to
outsiders, we refer to this activity as financial accounting.
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1.1 Information Conveyed in Financial Statements
The annual report is made public periodically. It is used by people outside the firm to assess
its performance and to evaluate management.
1. Balance Sheet
2. Income Statement
It summarizes the amount of cash and cash equivalents entering and leaving a firm.
The balance sheet is a snapshot of the firm. It summarizes what a firm owns (the assets) and
what a firm owes (the liabilities), and the difference between the two (the equity).
Balance Sheet
Assets Liabilities
Equity
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This insight can be visualized in the balance sheet of the company.
Balance Sheet
Assets Liabilities
A business needs assets to carry on business (1) funds which come from lenders
and generate a return.
Equity
This bundle of resources is financed by: (2) funds which are provided by the
company’ owners
This identity describes the notion that the balance sheet must balance. That is, the left-side
total is equal to the right-side sum. If an asset increases, the amount of its increase must be
matched by (a) a decrease of the same amount in other assets; (b) an increase of an equal
amount in liabilities; (c) an increase of an equal amount in equity; or, (d) some combination of
the above. At the end of the process, the two sides of the equation must remain equal (their
overall totals may change, however).
Example 1.1
Sophie starts a business “Sophie’s Cake Shop” and on day one she:
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Here is the balance sheet:
Equity
Contributed Capital 500,000
900,000 900,000
This statement gives Sophie the state of affairs at the end of day one. It shows her:
Liabilities
Assets What does she owe?
What does she own? Equity
What is her worth?
Let us look at a detailed balance sheet. The heading of the balance sheet indicates the name of
the entity, the name of the statement, and the date. We will now look at the key elements on
both sides of the balance sheet.
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1.2.1.1 Assets
An asset is a resource controlled by the corporation as a result of past events and from which
future economic benefits are expected to flow to the corporation.
Assets are listed by their ease of conversion into cash. They can be classified into current and
fixed (non-current).
A current asset is an asset where the benefit is expected to be fully utilized within
one year; for example, cash, accounts receivable, and inventory.
A fixed asset is an asset where the benefit is expected to be utilized over a
relatively long life; for example, land and building.
Example 1.2
(b) Marks & Spencer sold a pair of shoes for $1,000 to a customer who purchased the shoes
using a credit card.
(c) Caterpillar purchased new equipment it will use in producing engines. The new
equipment substitutes a robotically controlled machining process for a labour-intensive
process. Caterpillar agreed to give the equipment vendor 200,000 shares of its common
stock in payment for the equipment. At the time of the transaction, Caterpillar’s stock
price was $123 per share.
(d) Caterpillar sold 16 trucks to a customer for a total of $10 million. The customer agreed
to pay Caterpillar $2 million at the time Caterpillar delivered the trucks and the rest in
four equal instalments at the end of each of the next four years. At the time of the final
payment, Caterpillar will transfer the legal title of the trucks to the customer.
(e) IBM spends $8,000,000 on tuition-assistance programs for its middle-level managers
to obtain MBAs. Historically, 80% of the managers who received the MBA remain
with the firm five years or more.
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Identifying whether resources satisfy the definition of an asset is often straightforward. In
practice, implementing the criteria for recognition and valuation of assets is conceptually
challenging when:
1.2.1.2 Liabilities
Current liability reflects the sacrifice that is expected to be settled within one year;
for example, accounts payable and notes payable.
A long-term liability is a sacrifice that is expected to be settled in more than one
year; for example, long-term debt.
Example 1.3
(a) Marks & Spencer purchased merchandise inventory and agreed to pay its supplier
$800,000 within 30 days.
(b) IBM borrowed $10 million by issuing long-term bonds whose terms require that on
December 31 of each year, IBM make a payment of 10% of the amount borrowed.
(c) Cathay Pacific signs an agreement with its employees’ labour union, promising to
increase wages by 6% and to increase housing benefits.
(d) A customer files a suit claiming damages of $1 million from faulty engines that Ford
manufactured. The case has not yet gone to trial, so no court has yet rendered a decision
or verdict.
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1.2.1.3 Equity
Shareholders’ equity is the total equity interest that all shareholders have in a corporation. It
is the residual value remained to the shareholders after repaying all debts by selling its assets.
To demonstrate the significance of the two quantities, “contributed capital” and “retained
earnings”, consider the following two corporations of similar size. Let us assume that both
companies are of the same age.
Company X
Balance Sheet in $ millions
Assets 100 Liabilities 40
Equity
Contributed Capital 10
Retained Earnings 50
100 100
Company Y
Balance Sheet in $ millions
Assets 100 Liabilities 40
Equity
Contributed Capital 55
Retained Earnings 5
100 100
The only difference between the two balance sheets is in the amounts of contributed capital
and retained earnings. Company X was started with an initial capital of $10 million and
Company Y with $55 million. Company X proved to be very successful and managed to
reinvest $50 million of its profits to help finance its asset growth. Company Y struggled during
its existence and only managed to reinvest $5 million of its profits.
Of course, other explanations and scenarios could account for the differences. Dividend policy,
for example, impacts the level of retained earnings.
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1.2.1.4 Managerial Issues
Net working capital is the difference between a firm’s current assets and its current
liabilities.
The level of working capital naturally expands and contracts with sales activities.
Too little working capital can put a firm in a bad position since the firm may be
unable to pay its bills or to take advantage of profitable opportunities.
Too much working capital reduces profitability since that capital has a carrying
cost.
2. Inventory
Having too many inventories can fill customer orders without delay and provides
a buffer against potential production stoppages.
The flip side of plentiful inventory is the risk of deterioration in the market value
of inventory itself.
Inventory can be valued using either the FIFO, LIFO, or average cost valuation
method.
Example 1.4
A new company in its first year of operations purchases five products for sale in the order and
at the prices shown:
The company sells three of these items, all at the end of the year. The cash flow assumptions
would be:
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The effect would be:
It can be seen that during a period of inflation, with product prices increasing, the LIFO method
produces the highest cost of goods sold and the lowest ending valuation in inventory.
3. Financial Leverage
Financial leverage refers to the use of debt in acquiring an asset. The more debt a
firm has, the higher is its degree of financial leverage.
Financial leverage creates an opportunity for a firm to gain a higher return on the
capital invested.
(a) A firm issues a $1.2 million cheque to an insurance company for liability insurance
over the next year.
(e) A well-known scientist is hired to manage the R&D function for $1.8 million a year.
Employment starts next month.
(g) The firm writes a cheque for $1 million to obtain an option to purchase a tract of land.
(h) A firm receives notice from a supplier that it has shipped raw materials of $200,000.
The firm has title to the goods while in transit.
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2. Do the following pass the definition of a liability?
(c) The firm borrows $6 million from the bank for 90 days.
The income statement indicates the results of operations over a specified period. Unlike the
balance sheet, which is a snapshot of the firm’s position at a point in time, the income statement
indicates cumulative business results within a defined time frame.
For this reason, the income statement is also called the profit and loss statement (P&L). Net
income is an important figure because it reveals whether the firm is making money or not. It
is a summary figure for the performance of the firm.
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1.3.1 Typical Layout of Income Statement
While each company may adapt categorization of revenues and expenses as appropriate, the
general format of an income statement is as follow:
Income Statement
Sales Revenue
– Cost of Good Sold
Gross Profit
– Marketing and Selling Expenses
– Administration Expenses
– Research and Development Expenses
– Other Operating Expenses
Earnings before Interest and Tax (EBIT)
+ Interest Income
– Interest Expenses
Profit before Tax
– Taxes
Net Income
1.3.1.1 Revenue
An income statement starts with the firm’s revenues. The recognition of revenues is a key
event in the life of any firm. Accounting standards contain specific rules on revenue
recognition.
A firm recognizes revenues when the transaction fulfills the following conditions:
The earnings process is substantially complete. The firm has done all that it has
promised to do for the customer: the firm has delivered the products or performed
the services it has agreed to provide. This means that the firm has earned the
revenues.
The amount to be collected is reasonably determinable. The firm has received
cash or some other asset. If the asset is not cash, the firm must be reasonably
certain of converting it into cash. This means that the firm can reliably measure
the revenues.
If the firm has not performed all its obligations, it must adjust the amount of revenue recognized
to reflect those unperformed obligations.
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Example 1.5
During a busy Christmas season, DisneyToy Inc., a manufacturer of doll clothing, furniture,
and accessories, receives an email from one of its best longtime customers requesting
immediate shipment of 100,000 doll dresses for next-day delivery, with payment later.
DisneyToy ships the order as instructed. As is customary in the industry, the customer is
expected to pay for the goods 30 days after shipment.
There are many points when revenue may be recognized as a result of the sale of goods or
services to customers. Five of the most common are:
1.3.1.2 Expenses
Expenses shown on the income statement are based on the matching principle. The basic idea
is first to determine revenues and then match those revenues with the costs associated with
producing them.
The consumption of asset results from a transaction that leads to the recognition
of revenue. The expense is recognized in the period when the firm recognizes the
revenue. This is known as the matching principle.
The consumption of asset results from the passage of time.
As a result of the way revenues and expenses are reported, the figures reported in the statements
may not be at all representative of the actual cash inflows and outflows that occurred during a
particular period.
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1.3.1.3 Depreciation
An income statement for U.S. Corporation is shown below. It reports revenues and expenses
for the period.
To illustrate the accounting for transactions, we consider eleven events and analyze each in
terms of its effect on CU Car Wash Inc.
Gary opened CU Car Wash Inc. in April 2019. The details of transactions:
1. Gary and a few friends invest $50,000 to open CU Car Wash, and the business issues
ordinary share capital to the shareholders.
3. The business buys supplies on account, agreeing to pay $3,700 within 30 days.
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4. CU Car Wash earns $7,000 of service revenue by providing services for customers.
The business collects the cash.
5. CU Car Wash cleans a fleet of UPS delivery trucks, and UPS promises to pay CU Car
Wash $3,000 within one month.
6. During the month, CU Car Wash pays $2,700 for the following expenses: equipment
rental, $1,100; employee salaries, $1,200; and utilities $400.
7. CU Car Wash pays $1,900 on account, which means to pay off an account payable.
8. Gary, the major shareholder of CU Car Wash, paid $30,000 to remodel his home.
9. In transaction 5, CU Car Wash performed services for UPS on account. The business
now collects $1,000 from UPS.
10. CU Car Wash sells some half of the land it bought for $22,000. CU Car Wash receives
$22,000 cash and makes a $2,000 gain on the sale of the land.
11. CU Car Wash declares a dividend and pays the shareholders $2,100 cash.
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1.4.1 Transactions and Financial Statements
Note that every transaction maintains the equality of the accounting equation: Assets = Liabilities + Equity.
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From the above information, we can generate financial statements.
The worksheet approach to recording transactions is fine in concept, but it would never work
in practice due to the volume and variety of transactions occurring in the ordinary business
environment.
To overcome this problem, accountants record business transactions using accounts, journals,
and ledgers.
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Test Yourself 1.2
Shelly opens a research service near a college campus. She names the corporation Herzog
Researchers Ltd. During the first month of operations, July 2019, the business engages in the
following transactions:
(a) Herzog Researchers Ltd issues its ordinary shares to Shelly, who invests $25,000 to
open the business.
(c) Herzog Researchers pays cash of $20,000 to acquire a lot next to the campus. The
company intends to use the land as a building site for a business office.
(d) Herzog Researchers performs research for clients and receives cash of $1,900.
(e) Herzog Researchers pays $100 on the account payable it created in the transaction (b).
(g) Herzog Researchers pays cash expenses for office rent $400 and utilities $100.
(h) The business sells a quarter of its land parcel for $6,000.
1. Analyze the preceding transactions in terms of their effects on the accounting equation
of Herzog Researchers Ltd.
2. Prepare the income statement and the balance sheet of Herzog Researchers Ltd after
recording the transactions.
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Test Yourself 1.2
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Herzog Researchers. Ltd
Income Statement for the Month ended 31 July 2019
Income
Service revenue
Gain from sale of land
Expenses
Rent expense
Utility expense
Net Income
Dividend
Retained Earnings
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1.5 Double-Entry Accounting
In the previous section, we understand all business transactions include, at least, two effects on
an entity’s financial statement elements. We have seen how every transaction affects at least
two accounts.
Accounting, therefore, based on a double-entry system, which records the dual effects on the
entity. Each transaction affects at least two accounts. An increase or decrease in one account
must be matched by a corresponding increase or decrease in another account or accounts.
The most straightforward representation of an account is by the letter “T”. We call them T-
accounts. The vertical line in the letter divides the account into its two sides: left and right.
The account title appears at the top of the T-account.
The left side of each account is called the debit (Dr) side.
The right side is called the credit (Cr) side.
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1.5.2 The Rules of Debits and Credits
The type of account determines how we record increases and decreases. The rules of debit and
credit are:
Increases in assets, dividends, or expenses are recorded on the debit side of the
account.
Decreases in assets, dividends, or expenses are recorded on the credit side.
Increases in liabilities and equity or revenue are recorded by credits.
Decreases in liabilities and equity or revenue are recorded by debits.
The following summary shows how debits and credits are used to record increases and
decreases in various types of accounts.
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1.5.3 Recording Transactions
Now, let us revisit the CU Car Wash business and record the same eleven transactions we
illustrated earlier using debits and credits.
Gary opened CU Car Wash Inc. in April 2019. The details of transactions:
1. Gary and a few friends invest $50,000 to open CU Car Wash, and the business issues
ordinary share capital to the shareholders.
Accounting equation:
In real life, accountants first enter transactions into the accounting system as they occur by
using journal entries. A journal entry is a standardized way of indicating which accounts are
debited and credited and the amounts.
Journal entry:
Dr Cr
Cash 50,000
Share Capital 50,000
Issued share capital.
Once the transactions have been recorded, the accounting system automatically posts the
journal entries to the appropriate T-accounts.
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2. CU Car Wash purchases a parcel of land and pays cash of $40,000.
Dr Cr
Land 40,000
Cash 40,000
Paid cash for land.
Cash Land
(1) 50,000 (2) 40,000 (2) 40,000
3. The business buys supplies on account, agreeing to pay $3,700 within 30 days.
Dr Cr
Supplies 3,700
A/P 3,700
Purchase office supplies on account.
Supplies A/P
(3) 3,700 (3) 3,700
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4. CU Car Wash earns $7,000 of service revenue by providing services for customers.
The business collects the cash.
Dr Cr
Cash 7,000
Service Revenue 7,000
Performed services for cash.
5. CU Car Wash cleans a fleet of UPS delivery trucks, and UPS promises to pay CU Car
Wash $3,000 within one month.
Dr Cr
A/R 3,000
Service Revenue 3,000
Performed services on account.
6. During the month, CU Car Wash pays $2,700 for the following expenses: equipment
rental, $1,100; employee salaries, $1,200; and utilities $400.
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Dr Cr
Rent Expense 1,100
Salary Expense 1,200
Utility Expense 400
Cash 2,700
Paid expenses.
7. CU Car Wash pays $1,900 on account, which means to pay off an account payable.
Dr Cr
A/P 1,900
Cash 1,900
Paid cash on account.
Cash A/P
(1) 50,000 (2) 40,000 (7) 1,900 (3) 3,700
(4) 7,000 (6) 2,700
(7) 1,900
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8. Gary, the major shareholder of CU Car Wash, paid $30,000 to remodel his home.
This is not a transaction of the car-wash business, so the business does not record the
transaction.
9. In transaction 5, CU Car Wash performed services for UPS on account. The business
now collects $1,000 from UPS.
Dr Cr
Cash 1,000
A/R 1,000
Collected cash on account.
Cash A/R
(1) 50,000 (2) 40,000 (5) 3,000 (9) 1,000
(4) 7,000 (6) 2,700
(9) 1,000 (7) 1,900
10. CU Car Wash sells some half of the land it bought for $22,000. CU Car Wash receives
$22,000 cash and makes a $2,000 gain on the sale of the land.
Dr Cr
Cash 22,000
Land 20,000
Gain on Sale of Land 2,000
Sold land costing $20,000 for $22,000.
Cash Land
(1) 50,000 (2) 40,000 (2) 40,000 (10) 20,000
(4) 7,000 (6) 2,700
(9) 1,000 (7) 1,900
(10) 22,000 Gain on Sale of Land
(10) 2,000
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11. CU Car Wash declares a dividend and pays the shareholders $2,100 cash.
Dr Cr
Dividends 2,100
Cash 2,100
Declared and paid dividends.
Cash Dividends
(1) 50,000 (2) 40,000 (11) 2,100
(4) 7,000 (6) 2,700
(9) 1,000 (7) 1,900
(10) 22,000 (11) 2,100
When the posting is completed, most of the accounts have entries on both sides of the accounts.
The process of finding out the difference between the totals of the two sides of a ledger account
is known as balancing. The difference in the total debits and the total credits of accounts is
known as balance.
Assets:
Cash A/R
(1) 50,000 (2) 40,000 (5) 3,000 (9) 1,000
(4) 7,000 (6) 2,700 Bal c/f 2,000
(9) 1,000 (7) 1,900 Bal b/f 2,000
(10) 22,000 (11) 2,100
Bal c/f 33,000
Bal b/f 33,000
Supplies Land
(3) 3,700 Bal c/f 3,700 (2) 40,000 (10) 20,000
Bal b/f 3,700 Bal c/f 20,000
Bal b/f 20,000
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Liabilities:
A/P
(7) 1,900 (3) 3,700
Bal c/f 1,800
Bal b/f 1,800
Equity:
Salary Expense
(6) 1,200 Bal c/f 1,200
Bal b/f 1,200
Each account has a balance. If an account’s debits exceed its total credits, that account has a
debit balance. If the sum of the credits is greater, the account has a credit balance.
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1.5.5 The Trial Balance
A trial balance lists all accounts with their balances – assets first, then liabilities and equity.
The trial balance summarizes all the account balances for the financial statements and shows
whether total debits equal total credits.
Cash 33,300
A/R 2,000
Supplies 3,700
Land 20,000
A/P 1,800
Share Capital 50,000
Dividends 2,100
Service Revenue 10,000
Gain on Sale of Land 2,000
Rent Expense 1,100
Salary Expense 1,200
Utility Expense 400
63,800 63,800
The trial balance ensures that the debits equal the credits. Once the trial balance is prepared
and the debits and credits balance, the next step is to prepare the financial statements.
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CU Car Wash Inc.
Income Statement for the Month ended 30 April 2019
Income
Service revenue (7,000 + 3,000) 10,000
Gain from sale of land 2,000
12,000
Expenses
Salary expense 1,200
Rent expense 1,100
Utility expense 400
2,700
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Test Yourself 1.3
On September 1, 2018, Michael Moe incorporated Moe’s Mowing, Inc., a company that
provides mowing and landscaping services. During the month of September, the business
incurred the following transactions:
(a) To begin operations, Michael deposited $10,000 cash in the business’s bank account.
The business received the cash and issued shares to Michael.
(e) The business paid $500 cash toward the equipment previously purchased on account in
transaction (b).
(f) The business received $2,000 in cash for services provided to a new customer.
(h) The business paid $900 cash for September’s salary expense.
(i) The business received a utilities bill amounting to $150; it has not paid this bill.
2. Total each T-account to determine its balance at the end of the month.
3. Prepare the trial balance of Moe’s Mowing, Inc., at September 30, 2018.
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Test Yourself 1.3
Dr Cr
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
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Assets:
Cash A/R
Supplies Equipment
Liabilities:
Equity:
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Moe’s Mowing, Inc.
Trial Balance
September 30, 2018
Balance
Account Title Debit Credit
Cash
A/R
Supplies
Equipment
A/P
Utilities Payable
Share Capital
Dividends
Service Revenue
Repair Expense
Salary Expense
Utility Expense
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1.6 Financial Ratio Analysis
Next, we are going to analyze the financial statements in a meaningful manner. Quantitatively,
we can compute financial ratios to interpret the financial results.
Financial ratios can help us to examine the financial health of a corporation. The ratios fall
into five classes:
Liquidity
Solvency
Asset Management
Profitability
Market Value
Let us look at the financial statements of City Corporation and calculate some common
financial ratios.
City Corporation
2018 Income Statement
($ in thousands)
Sales 1,506
Less: Cost of goods sold 1,004
Gross profit 502
Depreciation 10
Lease rental costs 30
Other operating expenses 360
EBIT 102
Interest 5
Taxable income 97
Tax 47
Net income 50
Less: Dividends
- Preferred 1
- Common 29
Change in retained earnings 20
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City Corporation
Balance Sheet as of 31 December, 2017 2018
($ in thousands)
2018 2017
Current assets:
Cash 20 30
Accounts receivable 95 95
Inventory 130 110
Total current assets 245 235
Fixed assets:
Land 10 10
Building and equipment 120 100
Total fixed assets 130 110
Other assets:
Goodwill 10 10
Current liabilities:
Accounts payable 50 40
Estimated income taxes payable 10 10
Total current liabilities 60 50
Fixed liabilities:
Mortgage bonds, 10% 50 50
Shareholders’ equity:
Convertible preferred stock, 5% 20 20
Common stock (10,000 shares) 50 50
Retained earnings 205 185
Total shareholders’ equity 275 255
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1.6.1 Liquidity Ratios
A corporation’s liquidity is measured by its ability to raise cash to meet its current obligations.
1. Current Ratio
Current Assets
Current Liabilities
245
The current ratio in 2018 4.1 times
60
The higher the ratio, the more protection the firm has against liquidity problems.
However, the ratio may be distorted by seasonal influences, slow-moving
inventories built up out of proportion to market opportunities, or abnormal
payment of accounts payable just prior to the balance sheet date.
3. Cash Ratio
Cash
Current Liabilities
20
The cash ratio in 2018 0.3 times
60
A very short-term creditor might be interested in this ratio.
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1.6.2 Solvency Ratios
Solvency ratios generate insight into a firm’s ability to meet long-term debt payment.
Total Liabilities
Total Assets
110
The total debt ratio in 2018 0.29
385
Total debt ratio indicates the proportion of a firm’s total assets financed by short-
and long-term credit sources.
Another variation of this ratio is to measure the relative mix of funds provided by the owners
and the creditors.
2. Debt-equity Ratio
Total Liabilities
Shareholders' Equity
110
The debt-equity ratio in 2018 0.4
275
EBIT
Interest
102
Times interest earned in 2018 20.4 times
5
This ratio indicates the extent to which operating profits can decline without
impairing the firm’s ability to pay interest on its long-term debt.
EBIT Depreciation
Interest
102 10
Cash coverage in 2018 22.4 times
5
This ratio uses EBIT plus non-cash charges as the numerator. The modification
indicates the ability of the firm to cover its cash outflow for interest from its funds
from operations.
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1.6.3 Asset Management Ratios
Asset management ratios measure how a firm manages its investment and fixed assets. The
focus of these ratios is on the efficiency of the uses of the assets. That is, how good a firm
utilizes its assets.
1. Inventory Turnover
365 days
Inventory Turnover
365
The average days’ sales in inventory in 2018 47 days
7.7
This ratio estimates the average length of time items spent in inventory.
3. Receivables Turnover
Sales
Accounts Receivable
1,506
The receivable turnover in 2018 15.9 times
95
Only credit sales should be used.
This ratio shows a firm’s credit policy. It looks at how fast the firm collects on
credit sales.
365 days
Receivables Turnover
365
The average collection period in 2018 23 days
15.9
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5. Asset Turnover
Sales
Total Assets
1,506
The asset turnover in 2018 3.9 times
385
This ratio is an indicator of how efficiently management is using its investment in
total assets to generate sales.
High turnover rates suggest efficient asset management.
We look at profits in two ways. First, as a percentage of net sales; second, as a return on the
funds invested in the business.
1. Profit Margin
Net Income
Sales
50
The profit margin in 2018 3.3%
1,506
It measures the total operating and financial ability of management.
Net Income
Total Assets
50
The ROA in 2018 13%
385
This ratio measures the return on total assets after recognition of taxes and
financing costs.
Net Income
Total Equity
50
The ROE in 2018 18%
275
The fact that ROE exceeds ROA reflects the firm’s use of financial leverage.
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1.6.5 Market Value Ratios
The market value ratios are based on information on the market price of the stocks. These
measures can be calculated directly for publicly traded companies.
Net Income
Shares Outstanding
50
The EPS in 2018 $5 per share
10
This EPS figure is known as “basic earnings per share”.
3. Price-Sales Ratio
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4. Market-to-Book Ratio (MB)
We can gain more significant insights into a firm’s ROA and ROE by linking together selected
financial ratios.
1. ROA
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In financial strategy, we are trying to maximize the ROE in the long-run. To achieve this, we
pursue various courses of action that enable us to raise one or two of the three ratios without
too severe a decline in the others. This is easier said than done. Usually, the attempt to raise
one of the three ratios brings about a drop in the others. A successful financial strategy creates
a favourable trade-off, whereby a 10% increase in asset turnover, for instance, is “bought” at
the cost of only a 3% drop in sales profitability, resulting in a higher ROE.
So far, we have looked at the five major types of financial ratios. You would probably ask,
“How can we interpret all the ratios together?”
A simple way to analyze the overall picture is to group the ratios into a matrix. For example:
Ratio analysis deals only with quantitative data. It does not look at qualitative
factors such as the quality of management.
Management can take short-run actions to influence the ratios.
Comparison of ratios between companies must be on a comparable accounting
basis. Differences in accounting practices in such areas as depreciation, income
recognition, and intangible assets can make the comparisons misleading.
Accounting records are maintained in historical dollars. In periods of inflation the
ratios may be biased upwards.
Ratios must be evaluated in the correct business context.
Past data does not necessarily reflect the current situation or future expectations.
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1.7 Cash Flow Statement
Now, we introduce the third of the three financial statements, namely, the cash flow statement.
Cash is extremely important, and maintaining liquidity is essential to guaranteeing the survival
of any firm. The vast majority of business failures occur because firms run out of cash. Users
of financial information want to know how cash is generated and how cash is used every period.
To satisfy this informational need on the part of investors, firms prepare the cash flow statement,
which shows how cash is generated and used during every period and classifies the different
cash flows into three categories:
Investing activities usually involve cash flows from the acquisition and disposal
of fixed assets.
Cash outflows arise from purchasing (investing in) property, plant, and equipment,
making loans, and acquiring investments in other corporations.
Cash inflows result from disposing of property, plant, and equipment; collecting
loans (other than the interest), and selling investments.
Financing activities include cash flows from obtaining and repaying the financing.
Cash inflows result from contributions by owners (issuing stock to shareholders
in exchange for cash) and from loans.
Cash outflows arise from payments to shareholders (as dividends or payments to
repurchase their shares) and the repayment of loans (but not the associated interest).
To understand the preparation of the cash flow statement, we are going to use an example.
Below you are given a summary of the movements in the cash account of CU Company.
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Cash
Bal b/f 72 Payments to suppliers (O) 782
Collections from customers (O) 1,191 Salaries paid (O) 280
Sale of PPE (I) 5 Interest paid (O) 14
New share capital (F) 15 Taxes paid (O) 22
PPE purchase (I) 72
Land purchase (I) 2
Loan repayment (F) 31
Dividends paid (F) 10
Bal c/f 70
1,283 1,283
Bal b/f 70
We need to group the different cash flows into the three categories. We have written its nature
using the letters O, I, or F to indicate operations, investing, or financing, respectively.
Investment activities:
Land purchase –2
Purchase of PPE –72
Sale of PPE 5
Cash flow from (used in) investing activities (CFI) –69
Financing activities:
Loan payment –31
New share capital 15
Dividends paid –10
Cash flow from (used in) financing activities (CFF) –26
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Some companies’ cash flow items may not being categorized in the same way we have done it
above. IAS 7 allows for alternative classifications. IAS 7 provides guidance on some of these
alternatives:
Interest paid, usually categorized as an operating cash flow item, may be classified
as financing cash flow items or investing cash flows.
Interest and dividend received, usually categorized as an operating cash flow item,
may be classified as investing cash flows.
Dividend paid, usually categorized as a financing cash flow item, may be classified
as cash flows from operations.
Taxes paid, usually categorized as an operating cash flow item, may be classified
as financing or investing activities.
For the purposes of learning cash flow items, we will use the “usual” classifications of cash
flow items. But remember that when you look at companies’ real financial statements, you
may see alternative placements of these items.
In summary, a cash flow statement summarizes the sources and uses of cash. Operating cash
flows are needed for the long-term survival of a corporation. Future investments are paid for
through operating cash flows in the long-run.
In the initial stages of a firm’s life, financing cash flows are positive, and investing cash flows
are negative.
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