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Management Accounting Notes by

Ahmed Fawzy
Eslesca 45D

Ahmedfawzy_80@hotmail.com















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Summary:
Managerial Accounting, the Business Organization, and Professional Ethics
Understanding Corporate Annual Reports
Basic Financial Statements
Breakeven Analyses

















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Managerial Accounting, the Business Organization, and Professional Ethics

Learning Objectives
1. Describe the major users and uses of accounting information.
2. Describe the cost-benefit and behavioral issues involved in designing an accounting system.
3. Explain the role of budgets and performance reports in planning and control.
4. Discuss the role accountants play in the companys value-chain functions.
5. Explain why accounting is important in a variety of career paths.
6. Identify current trends in management accounting.
7. Explain why ethics and standards of ethical conduct are important to accountants.

The basic purpose of accounting information is to help decision makers company presidents,
production managers, hospital or school administrators, investors, and others.

Decision makingchoice from among a set of alternative courses of action designed to achieve some
objectivedrives the need for accounting information.

Regardless of who is making the decision, understanding accounting information allows for a more
informed, and better, decision. Both internal parties (managers) and external parties use accounting
information, but they often demand different types of information and use it in different ways.

Management Accounting produces information for managers within an organization. It is the process of
identifying, measuring, accumulating, analyzing, preparing, interpreting, and communicating information
that helps managers fulfill organizational objectives.

In contrast, Financial Accounting produces information for external parties, such as stockholders,
suppliers, banks, and government regulatory agencies.






What kinds of accounting information do managers need to achieve their goals and objectives?
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Good accounting information helps answer three types of questions:

Scorekeeping: Evaluate Organizational Performance
Attention Directing: Compare Actual Results to Expect
Problem Solving: Assess Possible Courses of Action

1. Scorecard questions: Is the company doing well or poorly?
Scorekeeping is the classification, accumulation, and reporting of data that help users
understands and evaluates organizational performance. Scorekeeping information must be
accurate and reliable to be useful.
For example, Starbucks produces numerous reports to evaluate results for stores and divisions.

2. Attention-directing questions: Which areas require additional investigation?
Attention directing usually involves routine reports that compare actual results to before-the-fact
expectations. For example, a manager who sees that a Starbucks store has reported profits of
$120,000 when budgeted profit was $150,000 will look for explanations as to why the store did
not achieve its budget.
Attention-directing information helps managers focus on operating problems, imperfections,
inefficiencies, and opportunities.

3. Problem-solving questions: Of the alternatives being considered, which is the best?
The problem-solving aspect of accounting often involves an analysis of the impacts of each
alternative to identify the best course to follow. For example, Starbucks experiments with adding
various items to its menu. After an analysis of how a new product will affect revenues and costs,
management decides which items to add and which to delete

Accounting Information System: Process of gathering, organizing, and communicating financial information

An accounting system is a formal mechanism for gathering, organizing, and communicating information about an
organizations activities. In order to reduce costs and complexity, many organizations use a general-purpose
accounting system that attempts to meet the needs of both external and internal users. However, as outlined in
Exhibit 1-1, there are important differences between management accounting information and financial
accounting information.


Cost-Benefit Balance: Weigh estimated costs against probable benefits

Behavioral Implications: The system must provide accurate, timely budgets and performance reports in a form
useful to managers

Managers must use accounting reports, or the reports create no benefits

The Cost-Benefit Balanceweighing estimated costs against probable benefits is the primary consideration in
choosing among accounting systems and methods.
We will refer again and again to cost-benefit considerations throughout this book. Accounting systems are
economic goodslike office supplies or laboravailable at various costs.


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Managers should also consider Behavioral Implications, that is, the systems effect on the behavior, specifically
the decisions, of managers. In a nutshell, think of management accounting as a balance between costs and
benefits of accounting information coupled with an awareness of the importance of behavioral effects.

Therefore, management accountants must understand related disciplines, such as economics, the decision
sciences, and the behavioral sciences, to make intelligent decisions about the best information to supply to
managers.

Planning and Control:
Accounting information helps managers plan and control the organizations operations
Planning: Setting objectives and outlining how the objectives will be obtained
Control: Implementing plans and using feedback to evaluate the attainment of objectives.

In practice, planning and control are so intertwined that it seems artificial to separate them. In studying
management, however, we find it useful to concentrate on either the planning phase or the control phase to
simplify our analysis.

Planning refers to setting objectives for an organization and outlining how it will attain them.
Thus, planning provides the answers to two questions: What objectives does the organization want to achieve?

When and how will the organization achieve these objectives? Control refers to implementing plans and using
feedback to evaluate the attainment of objectives.

Feedback is crucial to the cycle of planning and control. Planning determines action, action generates feedback,
and the control phase uses this feedback to influence further planning and actions.










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Budget and Performance Reports


Budget: quantitative expression of a plan of action

Performance reports:
compare actual results with budgeted amounts
provide feedback by comparing results with plans
highlight variances

Variances: deviations from plans

A budget is a quantitative expression of a plan of action. Budgets also help to coordinate and implement plans.
They are the chief devices for disciplining management planning, Without budgets, planning may not get the
front-and-center focus that it deserves.

Performance reports provide feedback by comparing results with plans and by highlighting variances, which are
deviations from plans. Organizations use performance reports to judge managers decisions and the productivity
of organizational units.

Example

The Mayfair store report shows that the
store met its targeted sales, but the
$2,500 unfavorable variance for
ingredients shows that these costs were
$2,500 over budget. Other variances show
that store labor costs were $400 under
budget, and other labor was $50 over
budget. At the Mayfair store, management
would undoubtedly focus attention on
ingredients, which had by far the largest
unfavorable variance.



Product life cycle refers to the various stages through which a product passes: conception and product
development; introduction into the market; maturation of the market; and, finally, withdrawal from the market.
At each stage, managers face differing costs and potential returns.




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The Value Chain: In addition to considering a
products life cycle, managers must recognize
those activities necessary for a company to create
the goods or services that it sells.

These activities comprise the value chain, the set
of business functions or activities that add value to
the products or services of an organization.



Management Accountants Role as Internal Consultant

The role of management accountants in organizations
has changed rapidly over the last decade or so.

Consider the following four work activities of
management accountants:
Collecting and compiling information
Preparing standardized reports
Interpreting and analyzing information
Being involved in decision making




Organizational Authority and Responsibility
Line managers: directly involved with making and selling products or services.
Staff managers: Advisory Support line managers.
Cross-functional teams: Found in modern, flatter organizations; Functional areas work together in
decision-making process.

As an organization grows, it must divide responsibilities among a number of managers and executives,
each with specific responsibilities. Line managers are directly involved with making and selling the
organizations products or services. Their decisions lead directly to meeting (or not meeting) the
organizations objectives.

In contrast, staff managers are advisorythey support the line managers. They have no authority over
line managers, but they help the line managers by providing information and advice. The organizational
chart shows how a traditional manufacturing company divides responsibilities between line and staff
managers. The line managers in manufacturing are supported by sales, engineering, personnel, and
financial staff support at the corporate level, and by receiving and storeroom, inspection, tool room,
purchasing, production control, and maintenance staff at the factory level.
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Accounting Functions

The Chief Financial Officer (CFO), a top executive who deals with all finance and accounting issues,
oversees the accounting function in most organizations.
Both the treasurer and controller generally report to the CFO,

The treasurer is concerned mainly with the companys financial matters such as raising and managing
cash, while the controller (also called comptroller in many government organizations) is concerned with
operating matters such as aiding management decision making.

In a small company, one person may perform both treasury and controllership functions.

Nevertheless, it is useful to differentiate the two different roles.

Chief Financial Officer (CFO)

Controller Functions
Planning for control
Reporting and interpreting
Evaluating and consulting
Tax administration
Government reporting
Protection of assets
Economic appraisal
Treasurer Functions
Provision of capital
Investor relations
Short-term financing
Banking and custody
Credits and collections
Investments
Risk management and Insurance


Career Opportunities in Management Accounting

The Certified Management Accountant (CMA) designation is the internal accountants counterpart to
the CPA.

The Institute of Management Accountants (IMA), the largest U.S. professional organization focused on
internal accounting, oversees the CMA program.

CMAs must pass an examination covering
(1) Financial planning, performance and control, (2) Financial decision making.
Like the CPA designation, the CMA confers higher status and leads to more responsible positions and
higher pay.

CMAs must pass a four-part examination:
1. Business Analysis
2. Management accounting and reporting
3. Strategic Management, and
4. Business Applications.

The accounting system is used to maintain records for all businesses, whether a multinational corporation or a
small business.
To account for something means to keep a record of something in your business by using the accounting system.


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Management Accounting Change Drivers

Four major business trends are influencing management accounting today:
1. Shift from a manufacturing-based to a service-based economy in the United States
2. Increased global competition
3. Advances in technology
4. Changes in business process management


Major Influences on Management Accounting

Advances in technology:
E-commerce
Enterprise resource planning (ERP)
B2C and B2B

Business process reengineering:
Just-in-time (JIT) philosophy
Lean manufacturing
Computer-integrated manufacturing
Six sigma


A major effect of technology on accounting systems has been the growing use of enterprise resource
planning (ERP) systems integrated information systems that support all functional areas of a company.
Accounting is just one part of such a system.

One of the most rapidly growing uses of technology is electronic commerce or e-commerce
conducting business online. While the Internet boom that focused on business-to-consumer (B2C)
transactions ended in 2001, e-commerce focusing on business-to-business (B2B) transactions continued to
grow at nearly 50% a year.

B2B creates real savings to the companies involved. One management change leading to increased
efficiency in business processes has been the adoption of a just-in-time (JIT) philosophy.

Another management approach focused on efficiency is lean manufacturing, which applies continuous
process improvements to eliminate waste from the entire enterprise.

A focus on quality is also important in todays competitive environment. A decade or more ago, many
companies undertook total quality management (TQM) initiatives. TQM minimizes costs by
maximizing quality. It focuses on continuous improvement in quality and satisfying ones customers.

Recently the focus on quality has shifted to Six Sigma, a disciplined, data-driven approach to eliminating
defects in any process.

Ethics: Trust, Reliability, Integrity

No regulation can be as effective in ensuring reliability as high ethical standards of accountants.

Accounting report An accountant (or bookkeeper) collects documentation and records this information,
categorizes it (i.e. organizes the different bits of information under certain categories), and presents it in specific
formats.
Accounting information is finally presented in the form of financial statements the key reports of a business.
Bookkeepers are usually involved more in data collection and entry.
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Understanding Corporate Annual Reports and Basic Financial Statements

Learning Objectives
1. Recognize and define the main types of assets in the balance sheet of a corporation.
2. Recognize and define the main types of liabilities in the balance sheet of a corporation.
3. Recognize and define the main elements of the stockholders equity section of the balance sheet of a
corporation.
4. Recognize and define the principal elements in the income statement of a corporation.
5. Recognize and define the elements that cause changes in retained earnings.
6. Identify activities that affect cash, and classify them as operating, investing, or financing activities.
7. Assess financing and investing activities using the statement of cash flows.
8. Use both the direct method and the indirect method to explain cash flows from operating activities.
9. Explain the role of depreciation in the statement of cash flows.
10. Describe and assess the effects of the four major methods of accounting for inventories

The Financial Statements are the Annual reports for the company

The facts and figures shown on the financial statements give the people and businesses using them a
birds-eye view of how well the business is performing.

For example, looking at the balance sheet, you can see how much debt the business owes and what
resources it has to pay that debt.

The income statement shows how much money the company is making, both before and after business
expenses are deducted. Finally, the statement of cash flows shows how well the company is using its
cash. A company can bring in a boat-load of cash, but if its spending that cash in an unwise manner, its
not a healthy business.


The Balance Sheet Statement: (also referred to as the Statement of Position) : Describes the financial
position of a company at a specific point in time.
A balance sheet may be prepared monthly, quarterly, or annually depending on the needs of management
and external users. The balance sheet is sometimes referred to as the statement of financial position.

Balance sheet: This statement has three sections: assets, liabilities, and equity. Standing on their own,
these sections contain valuable information about a company.
However, a user has to see all three interacting together on the balance sheet to form an opinion
approaching reliability about the company.

Assets: Resources owned by a company, such as cash, equipment, and buildings.
Liabilities: Debt the business incurs for operating and expansion purposes.
Equity: The amount of ownership left in the business after deducting total liabilities from total assets

The Balance Sheet: We will examine the five main sections of the balance sheet:
Assets Liability and Shareholder equity
Current assets Shareholders' equity
Noncurrent assets Current Liabilities
Noncurrent liabilities
Total = XXX Total = XXX

Assets = Liabilities + Equity
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Assets Section
Current assets:
o Cash and equivalents
o Short-term investments
o Accounts Receivable
o Net Inventories
o Deferred Income Taxes
o Prepaid expenses and other current assets
Total current assets
Noncurrent assets
o Property, plant, and equipment at cost
o Less: Accumulated depreciation
o Net property, plant, and equipment
o Identifiable intangible assets, net Goodwill
o Deferred income taxes and other assets
Total noncurrent assets

Total Assets = Total current assets + Total noncurrent assets

Operating Cycle: Current assets include cash and all other assets that a company reasonably expects to convert
to cash or sell or consume within one year or during the normal operating cycle, if longer than a year.

A companys operating cycle is the time span during which it spends cash to acquire goods and services that it
uses to produce its outputs, which in turn it sells to customers, who in turn pay for their purchases with cash.



Cash Equivalents are short-term investments that can easily be converted into cash with little delay

Cash consists of bank deposits in checking accounts plus money on hand.
Such as money market funds and Treasury bills.
They represent an investment of excess cash that a company does not immediately need.
The balance sheet shows these securities at their market price.

Short-Term Investments are temporary investments in marketable securities.
Companies often invest cash, which otherwise would be idle, in short-term investments,(items that will be
converted to cash within one operation year)
Such as the stocks or bonds of other companies or debt securities issued by governments.

Accounts Receivable is the total amount owed to the company by its customers.
Accountants often classify all accounts receivable as current assets, even though they may not fully collect
them within one year.
Because some customers ultimately will not pay their bill, we reduce the total receivables by an allowance
or provision for doubtful accounts or bad debts.

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Inventories for wholesalers and retailers consist of merchandise held for sale.
Manufacturing companies generally have three inventory accounts: raw materials, goods in the process of
being manufactured and finished products.
Accountants regard all inventories as current assets.
Companys state inventories at their cost or market price (defined as replacement cost by U.S. GAAP and
net realizable value by IFRS), whichever is lower.

Prepaid Expenses and Other Current Assets
Prepaid expenses are advance payments to suppliers. They are usually small in relation to other
assets. Examples are prepayment of rent and insurance premiums for coverage over the coming
operating cycle.
They belong in current assets because, if they were not present, the company would need more
cash to conduct current operations.
Other current assets are miscellaneous current assets that do not fit into the listed categories.

None-Current Assets:
Property, plant, and equipment are examples of fixed assets or tangible assets physical items that a
person can see and touch.
Companies usually provide details about property, plant, and equipment in a footnote to the financial
statements. Footnotes are an integral part of financial statements. They contain explanations for the
summary figures that appear in the statements.

Depreciation: Depreciation expense= Acquisition cost Estimated residual value
o The purpose of depreciation is to allocate the assets original cost to the particular periods
that benefit from the use of the asset.
o The value that appears on the balance sheet is the original cost less the accumulated
depreciation (the sum of all depreciation to date on the asset), which we call the net book
value. The net book value is simply the result of the allocation process.
o It is not necessarily a good approximation to other common concepts of value, such as
replacement cost or resale value.

Companies typically show land as a separate asset and carry it indefinitely at its original cost.
They also initially record buildings and machinery and equipment at cost: the invoice amount, plus
freight and installation, less cash discounts. However, unlike land, the recorded values of
buildings, machinery, and equipment gradually decline through depreciation.

The amount of depreciation charged as an expense each year depends on three factors:
1. The depreciable amount, which is the difference between the total acquisition cost and the
estimated residual value. The residual value is the amount a company expects to receive when
selling the asset at the end of its economic life.

2. The estimate of the assets useful life. This estimate often depends more on technological
changes and economic obsolescence than on physical wear and tear. Thus, the useful life is usually
less than the physical life.

3. The depreciation method. There are three general methods of depreciation:
o The straight-line method allocates the same cost to each year of an assets useful life.
Accelerated methods allocate more of the cost to the early years and less to the later
years.
o The activity-based method allocates cost based on either input activity (such as hours of
machine time used) or output activity (such as units of production).
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The value that appears on the balance sheet is the original cost less the accumulated depreciation
(the sum of all depreciation to date on the asset), which we call the net book value.

The net book value is simply the result of the allocation process. It is not necessarily a good
approximation to other common concepts of value, such as replacement cost or resale value.

Intangible Assets: We can physically observe tangible assets such as cash or equipment. In contrast,
intangible assets are a class of long-lived assets that are not physical in nature. They are rights to expected
future benefits. Examples are franchises, patents, trademarks, and copyrights.

Liabilities Section

Current Liabilities
o Current portion of long-term debt
o Notes payable
o Accounts payable
o Accrued liabilities
o Income taxes payable
Total current liabilities

Noncurrent Liabilities
o Long-term debt
o Deferred income taxes and other liabilities
Total noncurrent liabilities

Total liabilities = Total Current Liabilities + Total noncurrent Liabilities

Current Liabilities are an organizations debts that fall due within the coming year or within the normal
operating cycle, whichever is longer.
Examples: Notes Payable, Current portion of long-term debt, Accounts Payable, Accrued Liabilities

Assets are only part of the picture of any organizations financial health.
Its liabilities, both current and noncurrent, are equally important.

Current liabilities are an organizations debts that fall due within the coming year or within the normal
operating cycle if longer than a year.
The first current liability is the current portion of long-term debt, which shows the payments due within
the next year on bonds and other long-term debt.
Notes payable are short-term debts backed by formal promissory notes held by a bank or business
creditors.
Accounts payable are amounts owed to suppliers who extended credit for purchases on open
account.
Accrued liabilities (also called accrued expenses payable) are amounts owed for wages, salaries,
interest, and similar items.
The accountant recognizes expenses as they occur regardless of when a company pays for them in
cash. Income taxes payable is a special accrued liability of enough magnitude to warrant a separate
classification.



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Noncurrent liabilities, also called long-term liabilities, are an organizations debts that fall due beyond
one year.
Examples: Notes Payable, Long-Term Debt and Deferred Income Taxes

Long-term debt may be secured or unsecured. Secured debt provides debt holders with first claim
on specified assets.
Mortgage bonds are an example of secured debt. If the company is unable to meet its regular
obligations on the bonds, it may sell the specified assets and use the proceeds to pay off the firms
obligations to its bondholders, in which case secured debt holders have first claim to these
proceeds.
Unsecured debt consists of debentures (bonds, notes, or loans), which are formal certificates of
indebtedness accompanied by a promise to pay interest at a specified annual rate. Unsecured debt
holders are general creditors who have a general claim against total assets rather than a specific
claim against particular assets.
Stockholders Equity Section

Shareholders equity
o Contributed or paid-in capital
o Retained earnings
Total shareholders equity

Total liabilities and shareholders equity

The main elements of stockholders equity arise from two sources:
Contributed or paid-in capital
Retained income and other comprehensive income.

Paid-in capital typically comes from owners who invest in the business in exchange for shares of
stock that specify their ownership interest.
Holders of stock are stockholders or shareholders. There are two major classes of capital stock:
Common stock and Preferred stock.
Some companies have several categories of each, all with a variety of different attributes.

Common stock has no predetermined rate of dividends and is the last to obtain a share in the assets when
the corporation is dissolved.

Common shares usually have voting power to elect the board of directors of the corporation.
All corporations have common stock. Such stock has no predetermined rate of dividends and is the
last to obtain a share in the assets when the corporation liquidates.
Common stockholders usually elect the board of directors of the corporation.
Common stock is the riskiest investment in a corporation, being unattractive in dire times but
attractive in prosperous times because, unlike other stocks, there is no limit to the stockholders
potential participation in earnings.
The corporate form of ownership provides one additional benefit to shareholderslimited
liability. This means that a companys creditors cannot seek payment from stockholders as
individuals if the corporation itself cannot pay its debts.




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Preferred Stock: Preferred stock has some priority over other shares regarding dividends or the
Distribution of assets upon liquidation
About 40% of the major companies in the United States issue preferred stock. It typically has
some priority over other shares in the payment of dividends or the distribution of assets on
liquidation.

Treasury Stock This is a corporations own stock that was issued and subsequently repurchased by the
company and is being held for a specific purpose
Many companies have treasury stock, which is a corporations own stock that the company issued
and subsequently repurchased but has not permanently retired.
It is held only temporarily in the treasury to be distributed later, possibly as a part of an
employee stock purchase plan or as an executive bonus or for use in acquiring another company.
Such a repurchase is a decrease in ownership claims.
Therefore, it should appear on a balance sheet as a deduction from total stockholders equity. A
company does not pay cash dividends on shares held in the treasury.
Companies distribute dividends only to the outstanding shares (those in the hands of
stockholders).

Example:






Assets Liabilities and Equity
Land Capital or Owner Equity Restricted Equity
Building Return Earnings None Restricted Equity
Equipotent
Cash Loans Long Term Liabilities
Inventory
A/R (Account Receivables) A/P (Account Payable) Short Term Liabilities
Economic Resources ,
None Current Assets
Cash , or assets that
will be converted to
cash within one year
Money the Company have to pay
to the owner in case of
liquidation
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Financial Leverage: The degree to which an investor or business is utilizing borrowed money.
Leverage Ratio: The most well-known financial leverage ratio is the debt-to-equity ratio

The use of borrowed money to increase production volume, and thus sales and earnings.

It is measured as the ratio of total debt to total assets. The greater the amount of debt, the greater the
financial leverage.

Financial Restricting: Get Extra cash from the owners to increase owner equity and increase equity

Equity Ratio or the Owner Equity (What I have after paid all my liabilities)
= Capital + Return Earnings / Assets
= Restricted Equity + None Restricted Equity / Assets
= Equity / Assets

Owners equity is officially defined as: the residual interest in the assets of the enterprise after
deducting all its liabilities.

The owners equity is simply the owners share of the assets of a business.



You see, assets can only belong to two types of people: the first type is people outside the business you
owe money to (liabilities), and the second is the owner himself (owners equity).
Owners equity, often just called equity, represents the value of the assets that the owner can lay claim to.

In other words, it's the value of all the assets after deducting the value of assets needed to pay liabilities.

In other words: It is the value of the assets that the owner really owns.

ASSETS = EQUITY + LIABILITIES

Thus the accounting equation indicates how much of the assets of a business belong to, or are owned, by
whom.

These three elements assets, owners' equity and liabilities,
When compared to one another, show what we call the financial position of the business.


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Let me give you an example, would you invest in the following business?




Probably not. 90% of the assets of this business will be used to pay debts in future.
The equity, which reflects the net worth of the business (the real worth to the owner or owners), is only
$10,000.
The financial position of this business is thus poor.


What about this business would you invest in it?



Well, in this case you certainly would be quite apprehensive about investing.

The total debts of the business are greater than the assets it has to pay off these debts. As a result the
owner or owners are making a loss. The owner or owners may have to fork out $20,000 out of their own
pockets to pay the liabilities.
Where the total debts of the business are greater than its assets, we say that the business is insolvent. This
means that it cannot pay all its debts.
Obviously the financial position of this business is terrible.


Now how about this business?



This business looks a bit healthier. The business can comfortably pay all of its debts. In fact, only 40% of
the assets will be used up to pay the debts 60% of the assets are really owned by the owner. The net
worth of the business is $60,000.
The financial position of this business is quite good.

Bear in mind that it is not always a bad thing to have debts where you have a project that will bring you
$40,000, but you need to invest $5,000 to start with (and you dont have the money yourself), it would be
a wise move to borrow the $5,000 (thereby creating a liability of $5,000 towards the bank).

Maybe it takes you a year to pay the debts, which comes to $6,000 in total after all the bank charges and
interest. Well, youve still made $34,000 from this ($40,000-$6,000).
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New Shape of the Balance Sheet or the Statement of Position

Fixed Assets 1000

Current Assets 400
Current Liability -300
Working Capital 100

Working Capital 100
Fixed Assets 1000
Invested Capital 1100


Working Capital = Current Assets+ Current Liability
Invested Capital = Working Capital+ Fixed Assets

Invested Capital (1100) Financed By:
o Owner Equity (400)
o Long Term Liability (700)

Total Assets
Fixed Assets+ Current Assets = 1400
Total Liability
Current Liability+ Long Term Liability=1100


Owner Equity = 1400
























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Income Statement (Aka statement of profit or loss or P&L): shows income, expenses, gains, and losses.
The income statement shows financial results for the period it represents.
It lets the user know how the business is doing in the short-term.

And you have to keep in mind that the companys performance is not just a question of whether it made
or lost money during the financial period.
The issue at hand is more a matter of the relationship among the different accounts on the income
statement.

Net Revenue 45,000
Less : Cost of goods sold -20,000
Gross Margin 25,000
Less : Operating expenses -10,000
Operating Income 15,000
Less : Other gains and losses -5,000
EBIT (Earnings Before interest and Taxes) 20000
Less : Taxes -4000
EBI (Earnings Before Interest) 16000
Less : Interest -3000
Net Income 13000

Revenue is the inflow of assets, such as cash or accounts receivable, that the company brings in by selling
a product or providing a service to its customers. In other words, its the amount of money the company
brings in doing whatever its in the business of doing.
The revenue account shows up on the income statement as sales, gross sales, or gross receipts. All three
names mean the same thing: revenue before reporting any deductions from revenue. Deductions from
revenue can be sales discounts,

Cost of goods sold (COGS) reflects all costs directly tied to any product a company makes or sells,
whether the company is a merchandiser or a manufacturing company.
If a company is a merchandiser (it buys products from a manufacturer and sells them to the general
public), the COGS is figured by calculating how much it cost to buy the items the company holds for
resale,
Because a manufacturer makes products, its COGS consists of raw material costs plus the labor costs
directly related to making any products that the manufacturer offers for sale to the merchandiser.
COGS also includes factory overhead, which consists of all other costs incurred while making the
products.

Operating expenses are expenses a company incurs that relate to central operations and arent directly
tied to COGS.

Two key categories of operating Expenses show up on the income statement:

Selling expenses: Any expenses a company incurs to sell its goods or services to customers. Some
examples are salaries and commissions paid to sales staff; advertising expense; store supplies; and
depreciation of a retail shops furniture, equipment, and store fixtures. Typical retail shop depreciable
items include cash registers, display cases, and clothing racks.

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General and administrative (G&A) expenses: All expenses a company incurs to keep up the normal
business operations. Some examples are office supplies, officer and office payroll, non-factory rent
and utilities, and accounting and legal services. If, after getting an A in your financial accounting
class, youre so bowled over by the subject that you seek employment as a financial accountant, your
payroll is lumped into G&A too

Other income and expense: You classify all other income the company brings in peripherally as other
revenue or other income; either description is fine. This category includes interest or dividends paid on
investments or any gain realized when the company disposes of an asset.
For example, the company purchases new computers and sells the old ones; the amount the company
makes from the sale of the old ones is included in this category. Other expenses are expenses the company
incurs that arent associated with normal operations.

Here are two types of expenses you typically see:
Interest expense: cost of using borrowed funds for business operations, expansion, and cash flow.
Loss on disposal of a fixed asset: If the company loses money on the sale of an asset, you report the
loss in this section of the income statement.

Most investors are vitally concerned about a companys ability to produce long-run earnings and
dividends. In this regard, income statements are more important than balance sheets. (Other names for the
income statement include statement of earnings, statement of profit and loss, and P&L statement.)
Income statements first list revenues, the total sales value of products delivered and services rendered to
customers. From revenues they deduct expenses to get net income. We next examine how the format of
the income statement can help users judge a companys performance.

Operating management focuses on the major day-to-day activities that generate sales revenue.

Financial management focuses on where to get cash and how to use cash for the benefit of the
organization. That is, financial management attempts to answer such questions as:
How much cash should we hold in our checking accounts?
Should we pay a dividend?
Should we borrow money or issue common stock?
The best managers are superb at both operating and financial management.

The amount left after deducting all operating and none-operating expenses from revenue is net income,
sometimes called the bottom line. Although this book tends to use the term income most often, you will
also see the terms earnings and profits used as synonyms.

Earnings Per Share: Income statements conclude with disclosure of earnings per share, which is net
income divided by the average number of common shares outstanding during the year.










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The Statement of Cash Flows (Showing the Money)
The purpose of the statement of cash flows is to show cash sources (money coming into the business) and
uses (money going out of the business) during a specific period of time. This information is used by
investors and potential creditors to gauge whether the business should have sufficient cash flow to pay
dividends or repay loans.

The statement of cash flows is very important for financial accounting because generally accepted
accounting principles require you to use the accrual method of accounting. This means that you record
revenue when it is earned and realizable (regardless of when money changes hands), and you record
expenses when they are incurred (regardless of when they are paid). On the flip side, when using the cash
method of accounting, a transaction isnt acknowledged until money changes hands. (A company may use
a cash-basis statement for income tax return preparation.)

There are three sections on a statement of cash flows: operating, investing, and financing. Each section
addresses cash ins and outs that the business experiences under completely different circumstances:

Operating: This section shows items reflecting on the income statement. The three big
differences between the cash and accrual methods will be accounts receivable, which is money
owed to the company by its customers; accounts payable, which is money the company owes to its
vendors; and inventory, which are goods held by the business for resale to customers.

Investing: This section usually shows the sale and purchase of long term assets. The purchase of
long-term assets reflects on the balance sheet.
The sale of long-term assets reflects both on the balance sheet and income statement, (Income
statement if we pay it in cash)
It reflects on the balance sheet as a reduction of the amount of assets the company owns, and on
the income statement as a gain or loss from disposing of the asset.

Financing: The financing section shows the cash effects of long-term liability items (paying or
securing loans beyond a period of 12 months from the balance sheet date) and equity items (the
sale of company stock and payment of dividends).




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Investments by and payments to the owners are not included on the Income Statement
Operating activities include the cash effects of revenue and expense transactions.
Investing activities include the cash effects of purchasing and selling assets
Financing activities include the cash effects of transactions with the owners and creditors

Window dressing occurs when management takes measures to make the company appear as strong as
possible in it financial statements
Creditors are more likely to extend credit if financial statements show a strong statement of financial
positionthat is, relatively little debt and large amounts of liquid assets



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Statement of Changes in Stockholders Equity (Return Earning Statement)
To explain the changes in the stockholders equity accounts, companies prepare a statement of
stockholders equity which shows the changes in each of the stockholders equity accounts:
Common Stock, Retained Earnings
Capital in Excess of Stated Value, Accumulated Other Comprehensive Income ,




Notes from Lecture:
Managers are responsible for managing assets and liabilities
Manager Role is to get investment with low cost , and get financial resources with higher value
Golden Rule of Finance : Financing Short term liabilities with short term assets, and long term with
liabilities with long term assets

Three Types of Decision in Finance:
Financing Decision
Investment Decision
Operation Decision


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Financial Statement Analysis and How to Interpret & Analyze Financial Statements


Evaluating Financial Performance
This section provides a clear and concise overview of specific financial ratios used to measure
financial performance.

Performance areas covered include liquidity, asset management, profitability, leverage, market
value ratios, and comparative analysis.

The objective of this section is to provide the user with methodologies that can be useful in
measuring and monitoring financial performance.

Why Ratio Analysis? You must measure what you expect to manage and accomplish.

Without measurement, you have no reference to work with, and thus, you tend to operate in the
dark.

One way of establishing references and managing the financial affairs of an organization is to use
financial ratios.

Ratios are simply relationships between two financial balances or financial calculations.

These relationships establish our references so we can understand how well we are performing
financially.

Ratios also extend our traditional way of measuring financial performance; i.e. relying on financial
statements.

By applying ratios to a set of financial statements, we can better understand financial performance.

The Use of Financial Ratios
Ratio analysis is used to compare a company's performance and status with that of another
company or itself over time.
The basic inputs to ratio analysis is items from Income statement and Balance Sheet
Whats important in ratio analysis is the interpretation, rather than the calculation itself.
We should Consider the following
A single ratio does not generally provide sufficient information from which to judge the overall
performance of the firm. A group of ratios should be used
The financial statements being compared should be dated at the same point in time during the
year. To avoid the effect of seasonality.
Use audited financial statements.
Compare financial statements with similar accounting treatments.



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Types of Ratio Comparison
Cross Sectional: The comparison of different Companies financial ratios at the same point in
time; involves comparing the companys ratios to those of an industry leader or to the industry
average.

Times series: Evaluation of the companys financial performance over time utilizing financial
ratio analysis

Combined analysis : Mix from the Cross Sectional and Times series


Dollar and Percentage Changes
Dollar Change = Analysis Period Amount - Base Period Amount

Percent Change = Analysis Period Amount - Base Period Amount

Trend Analysis is used to reveal patterns in data covering successive periods
o Trend Percentages = (Analysis Period Amount / Base Period Amount ) *100

Component Percentages
Examine the relative size of each item in the financial statements by computing component
(or common-sized) percentages.
Component Percentage = (Analysis Amount / Base Amount) *100

Notes: The owners equity is simply the owners share of the assets of a business.
Or In other words, it's the value of all the assets after deducting the value of assets needed to pay liabilities.

In other words: It is the value of the assets that the owner really owns.


Main Groups of Financial Ratios
Analyzing Liquidity
Analyzing Debt
Analyzing Activity (Asset Management)
Market Base Ratios
Analyzing Profitability


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Analyzing Liquidity: The liquidity of a business firm is measured by its ability to satisfy its short-term
obligations as they come due.

For all three liquidity measures; the higher the value, the more liquid the firm is typically considered to
be.
However this low risk sacrifices profitability
Current assets are less profitable/productive than fixed assets
Current liabilities are a less expensive financing source than long term funding

o Current Ratio: It is a measure of liquidity calculated by dividing the firms current assets by its
current liabilities
o Current Ratio = Current Assets / Current Liabilities

o Quick (Acid-test) Ratio: It is similar to the current ratio; except it excludes the inventory; which is
generally the least liquid current asset.
o Quick Ratio = (Current assets Inventory) / Current Liabilities

o Cash Ratio It is a measure of liquidity
o Cash Ratio = Cash / Current Liabilities

o Net Working Capital : A measure of liquidity calculated by subtracting current liabilities from
current assets
o Net Working Capital = Current Assets Current Liabilities

Net Working Capital It is only useful for internal control inside the company, not for comparison
with other companies


Analyzing Debt: The debt position of a firm indicates the amount of other peoples money being used in
attempting to generate profits.
Generally, the more debt a firm uses in relation to its total assets, the greater its financial leverage.

Debt Ratio: It measures the proportion of total assets financed by the firms creditors

o Debt Ratio = Total Liabilities / Total Assets

Debt to Equity ratio: It measures the ratio of long-term debt to stockholders equity

o Debt to Equity Ratio = Long-Term Debt/Equity

Assets to Equity ratio: It measures an entity's leverage.

o Assets to Equity Ratio = Assets/Equity

Times Interest Earned : It measures the firms ability to make contractual interest payments
o Times Interest Earned= Earnings Before Tax / Interest Expense


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Asset Management: Activity ratios are used to measure the speed in which various accounts are
converted into sales or cash.

Inventory Turnover: It measures the activity or liquidity of a firms inventory

o Inventory Turnover = COGS / Inventory

Inventory Days on Hand (IDOH) : It is the average length of time inventory is held by the firm

o Inventory Days on Hand = 365 / Inventory Turnover

Average Collection Period : It is the average amount of time needed to collect accounts
receivable
o Accounts Receivable Turnover = Sales / Accounts Receivable
o Average Collection Period (ACP or Days Sales Outstanding) = 365 / A/R
Turnover

Average payment Period : It is the average amount of time needed to pay accounts payable
o Accounts Payable Turnover = COGS / Accounts Payable
o Average Payment Period (APP) = 365 / A/P Turnover

Fixed Assets Turnover: It measures the efficiency with which the firm has been using its fixed or
earning, assets to generate sales
o Fixed Assets Turnover = Sales / Net Fixed Assets

Total Assets Turnover : It indicates the efficiency with which the firm uses all its assets to
generate sales
o Total Assets Turnover = Sales / Total Assets

Cash conversion Cycle =
Inventory Days on Hand + Accounts Receivable Turnover - Accounts Payable Turnover
o CCC= IDOH+ ACP- APP

Market Base Ratios: These ratios evaluate the firms stock price. These are indicators of what investors
think of their previous and future earnings.


Earnings per Share (EPS): It represents the number of dollars earned on behalf of each
outstanding share of common stock.

o EPS=Net Profit / Number of Shares of Common Stocks Outstanding

Price/Earnings Ratio (P/E Ratio) : It reflects the amount investors are willing to pay for each
dollar of the firms earnings; the higher the P/E ratio, the greater the investor confidence in the firm

o P/E Ratio=Market Price per Share of Common Stocks/Earnings Per Share

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Analyzing Profitability: Profitability Ratios measure how effectively a firms management is generating
profits on sales, total assets, and stock holders equity.

Gross Profit Margin : It measures the percentage of each sales dollar remaining after the firm
paid for its goods
o Gross Profit Margin = Gross Profit / Sales

Operating Profit Margin: It measures the percentage of profit earned on each sales dollar before
interest and taxes
o Operating Profit Margin= Operating Profit / Sales

Net Profit Margin : It measures the percentage of each sales dollar remaining after all expenses,
including taxes, have been deducted
o Net Profit Margin= Net Profit / Sales

Return on Total Assets: It measures the overall effectiveness of management in generating
profits with its available assets.
o Return on Total Assets=Net Profit after Tax/Total Assets


Return on Assets (ROA): It measures the efficiency with which a company allocates and
manages its resources.
o ROA = Net Income / Assets

o ROA = Net Profit Margin X Assets turnover

Net Income Net income Sales
ROA = -------------- = ---------------- X -----------
Assets Sales Assets

Return on Equity: It measures the return earned on the owners equity in the firm

o Return on Equity = Net Profit / Stockholders Equity

o ROE = Net Profits Margin x Assets Turnover x Financial Leverage

Net income Sales Assets
ROE = __________ x ___________ x _________________
Sales Assets (Shareholder's equity)
Is ROE a reliable Financial Yardstick?
The Timing Problem: Because ROE necessarily includes only one years earning, it fails to
capture the full impact of multi period decision.
The Risk Problem : ROE say nothing about what risks a company has taken to generate it
The Value Problem: The market value of equity is more significant to shareholders because it
measures the current, realizable worth of the share, while book value is only history.

Return on Investment: It measures the return earned on the Investment in the firm
o ROI = Net Income / Investment

Investment = Equity + Long Term Liability = Fixed Assets + Net working Capital