Review of Basic Terms

Asset/liability: An asset is an economic resource that a company owns. A liability is a resource that the company owes. Book value/market value: Book value is the amount of an asset or liability shown on the companies official financial statements based on the historical, or original, cost. Market value is the current value of the asset or liability. In most cases, book value does not equal market value. Capital goods: These are machines and tools used to produce other goods. Depreciation/amortization: Depreciation is a system that spreads the cost of a tangible asset, such as machinery, over the useful life of the asset. Amortization is a system that spreads the cost of an intangible asset, such as a patent, over the useful life of the asset. Fiscal year: A companys financial reporting year. In most cases the fiscal year is not the same as the calendar year. Profit margin: This is profitwhat the companys owners keep after paying all the billsa percentage of sales or revenues. Receivables/payables: Receivables are money owed to the company. Payables are money the company owes to others. Revenue/expenses: Revenue is income that flows into a company. Revenue includes sales, interest, and rents. Expenses are costs that are matched to a specific time period.
Finance for Non-Financial Managers I

Managerial and Financial Accounting

Managerial accounting provides information for managers of an organization who direct and control its operations. Financial accounting provides information to stockholders, creditors and others who are outside the organization.

Finance for Non-Financial Managers I

Cash vs. Accrual Methods of Accounting

January Expenses Rosie sells three Spouse Houses at $1,500 each, for cash. She purchases the three Spouse Houses from Freds Sheds for $900 each. She pays him for two of the Spouse Houses ($1,800) and promises to pay him for the third one on February 5. She pays $800 for her office ($400 for January rent and $400 as a security deposit). She pays $150 to purchase a telephone and $30 for service during January. She pays $300 for advertising in a newspaper. On February 5, she receives an electric bill for electricity used in January for $100.

She charges the January rent of the automobile ($280) to her credit card, which she does not pay until February 15.
Finance for Non-Financial Managers I

Cash Accounting
Basic Concept (Cash Accounting and Accrual Accounting) Report Version 1 (Cash Basis) January Report Cash Receipts Sale of 3 spouse houses Cash Disbursements Purchase of 2 spouse houses Office deposit and rent Telephone purchase Telephone service Advertising Total Cash Disbursements Excess of receipts over disbursements $4,500 $1,800 800 150 30 300 $3,080 $1,420

Finance for Non-Financial Managers I

Accrual Accounting
Basic Concept (Cash Accounting and Accrual Accounting) Report Version 2 (Accrual Basis) January Report Revenues Sale of 3 spouse houses Less Cost of Good Sold (3 Spouse Houses @ $900 each) Gross profit Expenses Office rent $400 Telephone service 30 Automobile rent 280 Electricity 100 Advertising 300 Total Cash Disbursements Excess of receipts over disbursements $4,500 (2,700) 1,800

$1,110 $690

Finance for Non-Financial Managers I

Gross Profit (Margin)

Selling price, each Spouse House Subtract cost of each Spouse House Gross profit (margin) Gross profit (margin) percentage ($600/$1,500) Markup percentage ($600/$900) $1,500

(900)
$600 40% 67%

Finance for Non-Financial Managers I

The Importance of Timing

Matching principle: The accrual method matches revenues with associated expenses. Timing: The accrual method records revenue that has been earned but not paid and expenses owed but not paid. Cash flow: The accrual method does not track cash inflows and outflows.
Finance for Non-Financial Managers I

Types of Sales
Cash sales Credit sales Consignment (sale?) Secured sales Floor plan sales Sales of services Long-term contracts
Finance for Non-Financial Managers I

Reduction of Sales
Bad debts Sales returns Sales allowances Warranties Cash discounts

Finance for Non-Financial Managers I

Allowance for Bad Debt

Bad Debt Expenses Incurred $10,000 26,000 60,000 $1,800 80,000 100,000 3,600 140,000 160,000 450,000 Accumulated Allowance for Bad Debt $10,000.00 36,000.00 94,200.00 174,200.00 270,600.00 410,600.00 120,600.00

Year 1 2 3 4 5 6 7

Sales $250,000 650,000 1,500,000 2,000,000 2,500,000 3,500,000 4,000,000

Finance for Non-Financial Managers I

Cost of Sales
Cost of Goods Sold (COGS) Inventory Freight on Purchases Discounts Cost of Services

Finance for Non-Financial Managers I

Inventory Value
FIFO LIFO Average Cost

Finance for Non-Financial Managers I

FIFO vs. LIFO

November--First In, First Out (FIFO) Sales of 10 Spouse Houses @ $1,500 Subtract Cost of Goods Sold: Inventory at beginning of November (4 houses @ $900 each) Purchase 15 houses @ $1,000 each 19 houses available for sale Subtract remaining inventory: 9 houses (purchased in November) @ $1,000 each Cost of Spouse Houses sold Gross profit $ 15,000

$ $

3,600 15,000 18,600

9,000 $ 9,600 5,400

Finance for Non-Financial Managers I

FIFO vs. LIFO

November--Last In, First Out (LIFO) Sales of 10 Spouse Houses @ $1,500 Subtract Cost of Goods Sold: Inventory at beginning of November (4 houses @ $900 each) Purchase 15 houses @ $1,000 each 19 houses available for sale Subtract remaining inventory: 9 houses, 5 @ $1,000 4 @ $900 each Cost of Spouse Houses sold Gross profit $ 15,000

3,600 15,000 $ 18,600 5,000 3,600 $ 10,000 5,000

Finance for Non-Financial Managers I

FIFO vs. LIFO

Inventory available for sale (at cost) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 900 900 900 900 FIFO LIFO $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 900 900 900 900

Purchased in November

Left at end of November (9) $9,000

Sold during November (10) $10,000

Sold during November (10) $9,600

Left at end of November (9) $8,600

Purchased in October

Total Inventory

$18,600

$18,600

Finance for Non-Financial Managers I

Average Cost Method

November--Average Cost Method Sales of 10 Spouse Houses @ $1,500 Subtract Cost of Goods Sold: Inventory at beginning of November (4 houses @ $900 each) Purchase 15 houses @ $1,000 each 19 houses available for sale Subtract remaining inventory: 9 houses @ $979 ($18,600/19 = $979) Cost of Spouse Houses sold Gross profit $ 15,000

$ $

3,600 15,000 18,600

8,811 $ 9,789 5,211

Finance for Non-Financial Managers I

Projected Sales
Spouse House Company Projection of Operating Report March 2011 Projected Sales = Sales of Spouse Houses Variable Expenses Cost of goods sold Sales commissions Delivery Bad debt expense Warranty expense Liability insurance Product liability insurance Supplies, warehouse Business license $ 1,500 $ 60.00% 5.00% 3.33% 4.00% 2.00% 0.24% 0.51% 0.31% 0.51% 20 30 40 60,000 36,000 3,000 2,000 2,400 1,200 147 307 187 307 45,547 2,000 1,500 2,000 2,000 430 110 100 1,000 30 130 550 150 10,000 55,547 4,453 1,113 3,340 30,000 $ 45,000 $ 18,000 1,500 1,000 1,200 600 73 153 93 153 22,773 2,000 1,500 2,000 2,000 430 110 100 1,000 30 130 550 150 10,000 32,773 $ $ (2,773) $ 0 (2,773) $ 27,000 2,250 1,500 1,800 900 110 230 140 230 34,160 2,000 1,500 2,000 2,000 430 110 100 1,000 30 130 550 150 10,000 44,160 840 $ 210 630 $

Total variable expenses Fixed Expenses Executive salary Administrative salaries Warehouse and repair salaries Advertising Automobile Worker's compensation insurance Fire and casualty insurance Rent Supplies, office Property taxes Payroll taxes Telephone Total fixed expenses Total expenses Net income (loss) before income tax Income tax Net income (loss)

Finance for Non-Financial Managers I

Break Even
Using the information from the previous slide, compute the variable cost Spouse House Company per house:
Projection of Variable Expenses per Spouse House March 2011

Projected Sales Total variable expenses $ Variable expense per house sold

20

30

40

22,773 $ 34,160 $ 45,547 1,139 1,139 1,139

Each house sells for Subtract variable cost per house Contribution toward fixed expenses

$1,500 1,139 $361

Divide the fixed cost by the contribution margin to determine how many houses must be sold to break even -- $10,000/361 = 27.7 or 28 houses (since you cant sell .7 house).
Finance for Non-Financial Managers I

Maintenance and Depreciation Expense

Depreciation and Maintenance Costs-Straight Line 30

Depreciation and Maintenance-Accelerated 30

25 20 15 10 5 0 1 2 3 4 5 Year of equipment life Maintenance Depreciation

25

Thousands ($)

Thousands ($)

20 15 10 5 0 1 2 3 4 5 Year of equipm ent life Maintenance Depreciation

Finance for Non-Financial Managers I

Payback Method
Spouse Houses clients want three windows put in their houses. Assume it costs $300 per house for the supplier to install the windows. Spouse House could purchase an Automatic Window Machine that would cost $55,000 and would require the following expenses:

Salary for a carpenter for 1 hour Benefit costs for the carpenter Lumber and glass

$12 8 65

Maintenance
Electricity Total cash expenses Depreciation expense Total expenses
Finance for Non-Financial Managers I

10
5 $100 15 $115

Payback Method (cont.)

The computation of cash flow from the Automatic Window Machine from the previous slide is:

If Spouse House used the service of the supplier to install the windows, it would cost (per house) If Spouse House used the Automatic Window Machine, the cash expense would be (per house) The amount saved per house Multiplied by the number of house sold annually Annual cash saved by purchasing the Automatic Window Machine

$300 100 $200 x 100 $20,000

The payback, assuming no interest on a loan and $5,000 salvage value of the equipment would be 2.50 years ($50,000/$20,000).
Finance for Non-Financial Managers I

Time Value of Money

Interest earned on a $55,000 investment that can earn 10% interest Initial investment (present value) Interest, first year Balance, end of first year Interest, second year Balance, end of second year Interest, third year Balance, end of third year Interest, fourth year Balance, end of fourth year Interest, fifth year Balance, end of fifth year or, using a future value table, $ 55,000 x 1.6105 = $ 55,000 5,500 60,500 6,050 66,550 6,655 73,205 7,321 80,526 8,053 88,578 $ 88,578

Finance for Non-Financial Managers I

Time Value of Money (cont.)

End of yr # 1 2 3 4 5 10% 0.90909 0.82645 0.75132 0.68302 0.62093 15% 0.86975 0.75615 0.65752 0.57176 0.49718 20% 0.83333 0.69444 0.57870 0.48225 0.40188 25.365% 0.79767 0.63628 0.50754 0.40485 0.32294

Use the 10% column to determine if purchase of the Automatic Window Machine should be purchased: End of yr # Cash Flow Factor Present Value 1 2 3 $20,000 20,000 20,000 0.90909 0.82645 0.75132 $18,181 16,529 15,026

4
5 Total of present value

20,000
25,000

0.68302
0.62093

13,660
15,523 78,919

Since $78,919 is significantly greater than $55,000 the machine would be justified.
Finance for Non-Financial Managers I

Time Value of Money (cont.)

End of yr # 1 2 10% 0.90909 0.82645 15% 0.86975 0.75615 20% 0.83333 0.69444 25.365% 0.79767 0.63628

3
4 5

0.75132
0.68302 0.62093

0.65752
0.57176 0.49718

0.57870
0.48225 0.40188

0.50754
0.40485 0.32294

Using the above table to calculate the Internal Rate of Return on the $20,000 annual saving on a $55,000 investment with $5,000 salvage value: Year 1 2 Cash Flow $20,000 20,000 Factor 0.79767 0.63628 Present Value $15,953 12,725

3
4 5 Total of Present Values

20,000
20,000 25,000

0.50754
0.40485 0.32294

10,150
8,097 8,073 $54,998

Finance for Non-Financial Managers I

Time Value of Money (cont.)

End of yr # 1 2 3 10% 0.90909 1.73554 2.48685 15% 0.86975 1.62571 2.28323 20% 0.83333 1.52778 2.10648 25.365% 0.79767 1.43395 1.94149

4
5

3.16987
3.79079

2.85498
3.35216

2.58873
2.99061

2.34634
2.66928

Using the above table to calculate the Internal Rate of Return on the $20,000 annual saving on a $55,000 investment with no salvage value:

$20,000 x = $50,000
X = 2.50 x > 25.365%
Finance for Non-Financial Managers I

Cash Flow from Purchase of Equipment

Cash Flow from Purchase of Copy Machine Existing cost (local printer) $ Subtract cash expenses if copy machine is purchased: Paper $ 500 Maintenance 1,500 Supplies 300 Electricity 100 Machine operator 1,000 Total cash expense Cash flow $ Cost of machine $ Payback period (machine cost cash flow) = 1.88 years 5,000

3,400 1,600 3,000

Finance for Non-Financial Managers I

Repair or Replace
Cash Flow Analysis--Repair or Replace New Machine Alternative cost (printer) Subtract cash expenses: Paper Maintenance Supplies Electricity Machine operator Total cash expenses Cash flow Cost of machine Payback, in years Internal rate of return $ 5,000 500 2,000 500 100 500 3,600 $ 1,400 $ 5,000 3.57 12.4% Refurbish Old $ 5,000 500 1,750 500 100 1,000 3,850 $ 1,150 $ 2,800 2.43 30.0%

Finance for Non-Financial Managers I