understanding accounting, bookkeeping, finance key points

as we begin our study of accounting we
should start at the start with the fundamental financial statement the
balance sheet the balance sheet simply lists our stuff the technical term is
asset and how we've been able to pay for that stuff assets our economic resources
owned or controlled by a company that will provide future benefit to the
company examples include cash that certainly provides a future benefit
inventory items help to resell in the future and buildings and equipment the
hope is that these items will provide benefit to the business in the future
now there are two general methods used to finance our assets liabilities and
owner's equity liabilities are obligations that are satisfied either
through payment or by providing services to someone else
we borrow money to buy assets and we have to pay that money back someone pays
us money and we have to provide them a service with liabilities we owe in the
future either money or services those liabilities go away when we pay the
money or we provide the service now owner's equity comes about as owners
invest in the company with no obligation for the company to repay that investment
or the owners leave the profits generated by the company in the company
those retained profits can then be used to purchase additional assets so the
balance sheet can be stated as follows assets equal liabilities plus owner's
equity this equality is termed the accounting equation in fact the name
balance sheet comes from the fact that a proper balance sheet must always balance
total assets must equal the total of liabilities and owner's equity the
accounting equation is not some miraculous coincidence it is true by
definition the two sides of the accounting equation must always be equal
because there are two views of the same company the left-hand side shows the
economic resources controlled by a business and the right-hand side shows
the claims against those resources another way to view this equality is
that the firm's assets must have sources and the right-hand side of the equation
shows the origin of those resources this equal sign is one of the most important
aspects of accounting this mathematical fact
helps us to determine if we've identified all the effects of a
transaction it forces discipline on our analysis we
are required to think through all aspects of a transaction because at the
end of the day the accounting equation has to balance we receive cash assets go
up but why what did that cash come from that equals sign requires us to answer
these questions cash coming in because of loans is different than cash coming
in from profitable operations because the accounting equation must always
balance those preparing the financial statements for our use must carefully
determine why assets changed why liabilities changed and why owner's
equity might have changed the Equality embedded in the accounting equation
forces those preparing financial statements to answer the question that
those of us using financial statements often want answered why so you've been introduced to the
fundamental financial statement the balance sheet but you've probably heard
of others the other two primary financial statements are the income
statement and the statement of cash flows these are the big three financial
statements all publicly traded companies provide these financial statements to
users and most private companies of any size are also preparing these financial
statements as well for use within their company so from where do these financial
statements derive well let's go back to the accounting equation assets equal
liabilities plus owner's equity the left side of the equation the asset side is
made up of a bunch of asset accounts inventory supplies equipment land and
cash the statement of cash flows is simply a detailed analysis of the flows
of cash going in and out of the cash account over a specific time period
those inflows and outflows are categorized as being related to either
operating activities things that happen everyday in a business investing
activities transactions that affect the productive capacity of a business like
buying a building and financing activities borrowing and paying back
money selling and buying your own stock now for a period of time like a quarter
or a year sort the inflows and outflows of cash buy activity and the result the
statement of cash flows now of course that sorting is easier said than done
but that's the gist of it by drilling down on the asset side we separate the
cash account from the other asset accounts and then just do a detailed
analysis of just that account so if we know where to look we can see in the
accounting equation exactly where to find the statement of cash flows now the income statement comes from a
detailed look at an account on the other side of the accounting equation owner's
equity just as assets is comprised of a bunch of individual asset accounts
owner's equity is comprised of individual accounts as well the two most
common are paid in capital and retained earnings now paid in capital is exactly
that it is the amount of money directly invested by the owners of the business
it is the amount of capital that they the owners have paid in hence the name
the other account retained earnings is exactly that it's the earnings that have
been retained in the business since the founding of the business earnings that
have not been retained in the business are called dividends this is cash that
has been returned to the owners so a company's earnings or income are
disclosed or added in owner's equity in the retained earnings account from that
account the earnings that are not retained dividends are subtracted and at
this point we must bring revenues and expenses into the picture obviously they
are part of every ongoing business revenues provide resource inflows they
are increases in resources from the sale of goods or services expenses represent
resource outflows they are costs incurred in generating revenues now note
that revenues are not synonymous with cash or other assets but they are a way
of describing where the assets came from for example cash received from the sale
of a product is recorded as the asset cash but the source of that asset would
be considered revenue in contrast cash received by borrowing from the bank
would not be revenue but would be an increase in a liability by the same
token expenses are a way of describing how an asset has been used thus cash
paid for interest on a loan is an expense but cash paid to buy a building
represents the exchange of one asset for another so how do revenues and expenses
fit into the accounting equation well revenues minus expenses equals net
income and net income is a major source of changes in owner's equity from
one accounting period to the next in this expanded equation we see the
balance sheet the income statement and the statement of cash flows if we know
where to look we can see each of the primary financial statements embedded in
the accounting equation you in many cases as a manager you'll want
to know how many units need to be sold to break-even the break-even point is
defined as the volume of activity at which total revenues equal total costs
or in other words where profit is zero the break-even point may also be thought
of as the volume of activity at which the contribution margin equals the fixed
costs although the goal of business planning is to make a profit not just to
break even knowing the break-even point can be useful in assessing the risk of
selling a new product setting sales goals and commission rates deciding on
marketing and advertising strategies and making other similar operating decisions
because the break-even point is by definition that activity level at which
no profit or loss is earned the basic CVP equation can be modified to
calculate the break-even point as follows all that you need to do to
compute the breakeven point is simply set income equal to zero and then solve
for the unknown such as the number of units to be sold or the total revenues
to be achieved once you understand the basic CVP formula you just set it up and
solve for whatever unknown you're interested in planning another way we
can use CVP analysis in the planning process is to determine what level of
activity is necessary to reach a target level of income instead of setting
profit at zero to do a break-even analysis we can just as easily set
income in the formula at the targeted level and then use the formula to plan
or predict what fixed cost variable cost sales price and sales volume are needed
to achieve the target level of income target income is usually defined as the
amount of income that will enable management to reach its objectives
paying dividends meeting analysts predictions purchasing a new plant and
equipment or paying off existing loans target income can be expressed as either
a percentage of revenue or as a fixed amount the power of the CVP equation
lies in understanding the relationship between sales variable costs and fixed
costs once we quantify those relationships we can do some pretty
simple analysis that yields some pretty powerful results the foundation of management accounting
is cost control to really understand management accounting you need to grasp
the flow of costs in manufacturing service and merchandising organizations
understanding cost flows is a useful way to understand how a business is
structured or organized without accurate cost information it is difficult to set
prices evaluate performance reward employees or make production decisions
it is even difficult to know whether a company should be competing in a
specific market as we discussed previously costs of manufacturing
products can be broken down into three elements direct materials direct labor
and manufacturing overhead to briefly review direct materials include the
costs of raw materials that are used directly in the manufacture of products
and are kept in the raw materials warehouse until use direct labor
includes the wages and other payroll related expenses of factory employees
who work directly on products manufacturing overhead includes all
manufacturing costs that are not classified as direct materials or direct
labor one of the best ways to understand how an organization works is to follow
the money in other words observe how costs flow
through an organization since management accounting systems were originally built
to support the manufacturing process we'll start there a budget is a plan technically it's a
quantitative expression of a plan of action that shows how someone or
something will acquire and use resources over a specific period of time the
budget identifies and allocates resources necessary to effectively and
efficiently carry out the mission of the organization
although budgeting may sound to you like an unappealing activity successful
budgeting is absolutely critical to the success of a business whether we're
talking about an individual a family or a large organization the overall purpose
of a budget is to clearly establish a plan so that performance in relation to
a goal can be carefully monitored thus budgeting has a two-fold purpose the
first purpose is to allow individuals or companies to develop a plan to meet a
specified goal the second purpose is to allow ongoing comparison between actual
results and the plan in order to better control operations or activities
budgeting is such an important activity that the top executives of most
companies coordinate and participate in the process now research and experience
has shown that several behavioral factors determine how successful the
budgeting process will be first the process must have the support of top
management second managers and other employees are more motivated to achieve
budget goals that they understand and help design and third deviations or
variances from the budget must be addressed by managers in a positive and
constructive manner a firm-wide operations budget could be prepared by
top management distributed to the major segments of the firm and then further
spread out to each lower-level segment manager this is the top-down approach
sometimes referred to as authoritative budgeting the alternative is the
bottom-up approach also known as participated budgeting each division
manager in a bottom-up approach prepares a budget request for his or her segments
these requests are combined and reviewed as they move their way up the
organizational hierarchy with adjustments being made to coordinate the
needs and of individual units within the overall
organization because both top-down and bottom-up approaches are legitimate most
organizations use some combination of the two the blending of these are two
approaches will vary among organizations a smaller organization with a few
management levels will rely more on a top-down approach than with a larger
organization top management in smaller organizations tends to be more
knowledgeable about and more involved in the operating details now we're going to talk about basic tax
planning strategies it turns out all complex tax planning strategies are
often a combination of one two or even three of these basic strategies first
shift income from one time period to another usually taxpayers wish to delay
the taxation of income that's the reason for shifting second shift income from
one pocket to another taxpayers may wish to shift income from a high tax state or
country to a low tax state or country and the third common tax strategy
changed the character of the income or the rate of which income is taxed we
just talked about ordinary income versus capital gains income that lowers the tax
rate we're going to talk about each one of these three common tax planning
strategies let's start with the first one shift income from one time period to
another let's take a simple example let's suppose you have a small side
business where you give music lessons to children
you've earned a thousand dollars giving group clarinet lessons do you want to be
paid at the end of December of year one or at the beginning of January of year
two now think about that because the timing of the reporting of income for
income tax purposes is typically based on when you receive the cash if you
receive payment near the end of December you must report that and this year's
income and pay tax on it with the rest of your year one income but if you delay
receiving payment until January of year two yes you may have to wait a little
extra to get your money but – you can wait an entire year to report and pay
tax on this income with the rest of your year to income just by pushing it from
December to January you've pushed your tax liability back an entire ere now why
might you want to legally delay payment of your taxes well you're eventually
going to pay the same amount but during that delay in our example during that
year you can keep the money you will have paid as income tax and you can
invest it and earn interest or you can use it for some other personal purpose
now in the United States there are two common methods of legally delaying the
taxation of income they are first a traditional individual retirement
account at IRA which is created and managed by an individual or the second
type is a 401k that's created and managed by an employer on behalf of an
individual employee we'll look at both of these first let's look at the
traditional individual retirement account the IRA which is created and
managed by an individual the concept of an IRA was approved by the US Congress
in 1974 to encourage US workers to save for retirement during the year they
would make an investment with a financial institution up to $5,500 in
the United States they didn't designate that investment as an IRA and when they
complete their income tax return they would subtract this amount from their
taxable income when would they pay the tax they would pay the tax on the IRA
IRA contribution and subsequent earnings when they retired and started receiving
distributions that's an IRA now a 401 K is a similar
concept the 401 creek' was created by US Congress in 1978 as section 401 K of the
Internal Revenue Code this also was to encourage US workers to save for
retirement during a year an employer withholds from your paycheck up to
seventeen thousand five hundred dollars in the United States and deposits that
amount in your name in a financial institution often the employer will
match all or part of your on your investment now when you complete your
income tax return again you subtract the amount that you have contributed from
your taxable income thereby lowering your tax liability you take you pay tax
on the 401k contribution and subsequent earnings only when you retire and you
withdraw the money both a traditional IRA and a 401 K are examples of the
first basic tax planning strategy legally delaying the taxation of income
now for US residents let me give you a quick word about the Roth IRA remember a
traditional IRA and a 401 K they're not taxed now but they're fully taxed when
you retire for a Roth IRA they are taxed now but there's no tax ever on
subsequent earnings the Roth IRA is especially attractive to individuals who
pay little or no tax now now keep in mind if our
tax strategist strategy is to shift income from one period to another the
most common way that is done was with a traditional IRA and a 401k these legally
delay the taxation of income until you've retired the second basic tax strategy is to
shift income from one pocket to another to shift income from a high tax state or
country to a low tax state or country as an example let's consider Microsoft are
they a US company they're based in the United States but are they a US company
Microsoft reports that it produces and distributes products and services
through our foreign regional operation centers in Ireland Singapore and Puerto
Rico now why these three locations well I'll
bet if we drill down we'll find out that there are tax advantages to those three
locations here's another exhibit for you to look
at we've got four companies here Exxon Microsoft
Home Depot and Walmart and their income and their taxes that they pay and then
we've calculated their average tax rate you can see that Walmart has an average
tax rate of about 33% Home Depot has an average tax rate of 36% Microsoft comes
in with an average tax rate of 21% and Exxon an average tax rate of 42% why
this big variance in average tax rates each of these organization has applied
different tax strategies to affect their tax rate Exxon Mobil they have to pay
taxes based on where they find the oil and the tax rates in those locations are
high Home Depot primarily based in the United States pays the u.s.

Corporate
tax rate which is right around 36% Walmart which is primarily in the u.s.
but has diversified into other countries you can see that because their tax rates
a little lower than Home Depot Microsoft why are they at 21%
well Ireland Singapore and Puerto Rico they specifically chose those locations
because of their lower tax strategies now this strategy of moving taxes from
one location to another has developed some sort of controversy for example you
may have heard the double Irish this is in the news currently it happens when a
US company transfers ownership of valuable intangible rights to an Irish
incorporated company operating in the Cayman Islands where the tax rate is 0%
this came an Irish company then licenses its rights at a high price to another
Irish company where the tax rate there is 12.5% turns out none of the profits
ever flow back to the United States parent company and as a result they're
taxed at these very very low rates Apple Computer for example has been cited as
doing this in the United States tax rates are at 35 percent by but by
incorporating this double Irish tax rates are down closer to 12 percent
another example of a controversy you may have heard about tax inversion this
happens when a US company merges with a non-us company based where tax rates are
lower than the 35% u.s.

Corporate tax rate the purpose of employing this basic
tax strategy shifting income from a high tax state or country to a lower tax
state or country now the third basic tax strategy is to
change the character of the income or the rate at which the income is taxed
taxpayers wish income would be classified as long-term capital gains
which is usually taxed at a lower rate remember we talked about this previously
ordinary income comes from working for an employee owning and operating your
own business and so forth it's ordinary capital gains income is income earned
from buying an asset low and selling it high an example would include a stock
investment or a real estate investment now with ordinary income in the United
States the tax rates depending on the level of income range from 10 percent to
39.6 percent however again in the United States long term capital gains income
tax rates vary depending on the level of income from 0 to 15 percent or sometimes
as high as 20% the key point depending on how much you make the key point is
that long-term capital gains rates are lower now how do I convert ordinary
income into long-term capital gains well the most common technique is to make
sure that you hold appreciated assets that's stock investments or real estate
investments for more than one year now how about more complex techniques to
convert ordinary income into long-term capital gains well the short answer is
you and I are almost certainly never going to be involved with these complex
strategies now the longer answer is this is where subtle tax shelter arrangements
arise a couple of examples one is called carried interest this is where an
investment fund manager is paid in the form of additional shares in a fund
rather than straight salary that way when those shares appreciate or go up in
value the tax consequences are at capital gains rates not at ordinary
income another example called ISO incentive stock options this is
employees are paid with incentive stock options they hold those shares when they
eventually sell those shares the excess over the option price is termed a
long-term capital gain and is taxed at capital gains rates okay let's review
the three basic tax strategies first shift income from one time period to
another this is where the taxpayer wishes to delay the taxation of income
the second shift income from one pocket to another taxpayers wish to shift
income from a high tax state or country to a low tax state or country now the
third basic tax planning strategy is changing the character of the income or
another way to put that as the rate at which the income is taxed well except
for making sure that we hold investments for more than a year this is probably
not for regular people like you and me you often the most difficult aspect of
accounting is determining which events ought to be reflected in the accounting
records and which are not suppose for example that Burger King introduced a
new Big Mac clone at half the bigmack price the proliferation of these Big Mac
clones could have a serious impact on the future of McDonald's however events
that cannot be reliably measured in monetary terms will not be reflected in
the financial statements since it would be virtually impossible to quantify the
impact of the Big Mac clones on the future profitability of McDonald's that
information will be excluded from the financial statements while there is an
obligation to inform financial statement users about this attack on the Big Mac
the financial statements are not the place to do it the financial statements
are only one part of the information provided to users information relating
to the competitive environment product development and marketing and sales
efforts is included in the company's annual report to stockholders but not as
part of the accounting information now once we've determined that we have a
transaction that needs to be included in the accounting records the event must be
analyzed to determine if an arm's-length transaction has occurred accounting is
concerned primarily with reflecting the effects of transactions between two
independent entities so Delta Airlines signing a contract with Boeing to
purchase airplanes in the future would not be reflected in the financial
statements until the airplanes are manufactured and delivered and Delta has
agreed to pay for them while many transactions between independent parties
are routine some business events are quite complex and require a
comprehensive analysis to determine how the event should be reflected in the
financial statements consider the following example a company buys a
building in addition to paying twenty thousand dollars in cash the company
agrees to pay ten thousand dollars per year for the next 10 years the company
will also pay a two thousand dollar property tax bill associated with the
building from last year as part of the purchase the company gave the former
owners of the building 500 shares of stock finally the building will require
twenty three thousand dollars worth of repairs and renovations before
can even be used now how much should be recorded as the cost of the building
transactions like this can become quite complex but the framework introduced in
this topic will allow you to break complex transactions into manageable
pieces and provide you with a self-checking mechanism to ensure that
you haven't forgotten anything recall that the three primary financial
statements are the balance sheet the income statement and the statement of
cash flows the elements of the balance sheet are assets liabilities and owner's
equity the elements of the income statement are revenues and expenses each
of these elements is comprised of many different accounts an account is a
specific accounting record that provides an efficient way to categorize similar
transactions thus we may designate asset accounts liability accounts and owner's
equity accounts examples of asset accounts are cash inventory and
equipment liability accounts include accounts payable and notes payable for
example the equity accounts for a corporation or capital stock or paid in
capital and retained earnings you can think of an individual account as a
summary of every transaction affecting a certain item like cash the summary may
be recorded on one page of a book or in one column of a spreadsheet as
illustrated here using our previous four transactions we can easily see how the
accounting equation can be expanded to include specific accounts under the
heading of assets liabilities and owner's equity we can also see that
after each transaction the Equality of the accounting equation can be
determined by adding up the balances of all the asset accounts and comparing the
total to the sum of all the liability and owner's equity accounts now when
double entry accounting was formalized over 500 years ago all the adding and
subtracting was done by hand you can imagine the difficulties of tracking
multiple accounts involving hundreds of transactions using the spreadsheet
method above while doing all the computations by hand mixing pluses and
minuses in one column would provide ample opportunity to make mistakes this
problem was solved by separating the pluses and the minuses for each account
into separate columns totaling each column and then computing the difference
between the columns to arrive in an ending balance the simplest most
fundamental format is the configuration of the letter T this is called the T
account note that a t-account is an abbreviated
representation of an actual account which we will illustrate later and is
used as a teaching and learning tool the following segment includes examples of T
accounts representing the transactions described previously the account title
cash for example appears at the top of the T account transaction amounts may be
recorded on both the left and the right side of the t account instead of using
the terms left and right to indicate which side of a t account is affected
terms unique to accounting were developed debit abbreviated er is used
to indicate the left side of a T account and credit abbreviated CR is used to
indicate the right side of a T account debit means left credit means right
nothing more nothing less let me say that again debit means left
and credit means right in addition to representing the left and right sides of
an account the terms debit and credit take on an additional meeting when
coupled with a specific account by convention for asset accounts debits
refer to increases and credits refer to decreases for example to increase the
cash account we debit it to decrease the cash account we credit it since we
expect the total increases in the cash account to be greater than the decreases
the cash account will usually have a debit balance after accounting for all
transactions thus we can make this generalization
asset accounts will usually have debit balances that is their balance will
typically be on the left side of the t account the opposite relationship is
true of liability and owner's equity accounts they are decreased by debits
and increased by credits as a result liability and owner's equity accounts
will typically have credit balances the effect of this system is shown here with
an increase indicated by a plus sign and a decrease indicated by a minus sign now
remember that asset accounts will typically have debit balances whereas
liability and owner's equity accounts will typically have credit balances in
addition to assets equalling liabilities and owner's equity
rabbits should always equal credits if you fully grasp the meaning of these two
equalities you are well on your way to mastering the mechanics of accounting or
learning the language of accounting debits and credits allow us to take a
shortcut to ensure that the accounting equation always balances if for every
transaction debits equal credits then the accounting equation will always
balance to understand why this happens keep in mind three basic facts regarding
double-entry accounting first debits are always entered on the left side of an
account and credits on the right side second for every transaction there must
be at least one debit and one credit third debits must always equal credits
for every transaction if you can grasp these three points you are well on your
way to understanding the mechanics of accounting with our knowledge of the different
types of accounts assets liabilities and owner's equity and the use of the terms
debits and credits debit means left and credit means right we are now ready to
actually record the effective transactions the second step in the
accounting cycle is to record the results of transactions in a journal
journals provide a chronological record of all transactions of a business they
show the dates of the transactions the amounts involved and the particular
accounts affected by the transactions sometimes a detailed description of the
transaction is also included this chronological recording of transactions
in a journal provides a company with a complete record of its activities if
amounts were recorded directly in the accounts it would be difficult if not
impossible for a company to trace a transaction that occurred say six months
previously small companies such as a locally owned pizza restaurant may use
only one journal called the general journal to record all transactions
larger companies having thousands of transactions each year may use special
journals an example of a special journal is a cash receipts journal in addition
to using a general journal a specific format is used in recording transactions
in a journal entry the debit entry is listed first the credit entry is listed
second and is indented to the right normally the date and a brief
explanation of the transaction are considered essential parts of the
journal entry dollar signs are usually omitted unless otherwise noted this
format but will be used whenever a journal entry is presented now to
illustrate the recording of transactions using a journal entries let's start a
business you're 18 again and you want to work outdoors and set your own schedule
so let's start our own landscaping business this business will involve
mowing lawns pulling weeds trimming and planting shrubs and so forth we will use
this simple business to illustrate the journal entries used to record some
common transactions of a business enterprise everyone numbers person or not knows
that cash is the lifeblood of a business without cash you will not be in business
for very long you can have a great marketing plan you can have a great
location you can have a great product or service but if you don't turn your cash
into more cash you will not be in business for very long to begin we'll
talk first about a company's operating cycle how long it takes from when a
company buys inventory and then turns that inventory into a receivable and
then returns that receivable into cash if the operating cycle is too long
things get pretty tough pretty quick for a company in other words if my cash is
tied up in other assets receivables in inventory that it's not available for me
to utilize in the business remember when we are talking about finance we are
talking about identifying those resources that we need determining the
best way to get the money to buy those resources and then managing those
resources effectively to do that I need detailed timely information in this
section we're going to talk about short-term financial management we are
going to illustrate that using the operating cycle of a wholesale building
supply company you will notice in this diagram that we've got various points on
the clock we begin with cash we take that cash and we have to purchase
inventory so we have to have relationships with our suppliers we have
got to have suppliers that we can count on to get us what we need when we need
it once we've purchased that inventory we
now have to manage our inventory the last thing we want is not enough
inventory the worst thing that can happen to a business is to run out of
inventory when a contractor comes in and needs sheetrock we've got to have it we
don't want to ever run out of inventory but then we don't want too much
inventory we've got to have what they need when they need it then we will have
customers come in to make the purchase they will want to buy stuff from us well
we've got to manage relationships with our customers we will have large
customers we will have small customers we will have customers we like and we
will have customers that just aren't our favorites we've got to ensure that we
have a system to manage those relationships you will note that once we
the sale then we end up with a receivable we have got to manage our
receivables as well to ensure that we have prompt collections we may provide
our contractors with terms but if we don't send them a bill they're just not
going to magically pay us we have got to manage our receivables to ensure that
this operating cycle this conversion from inventory to receivables to cash
works and that we eventually get our cash in a timely fashion we are going to
have to manage this operating cycle continuously and we will need
information to do that in this chapter we are going to talk about managing our
cash numbers person or not we need to watch cash flow the objective of a
business is not to have a lot of inventory the objective of a business is
not to have a lot of people owe us money the objective is to manage our inventory
and our receivables so that we convert our inventory into cash as quickly as is
reasonably possible so let's begin by talking about cash
management how to manage the cash we have why should we have any cash at all
as we know cash is a low yielding asset you don't make a lot of return on cash
so you don't want to have too much but then you don't want to have too little
either well why have cash at all well it turns out that bills have to be paid in
cash employees have to be paid in cash rent has to be paid in cash insurance
has to be paid in cash we've got to manage our cash to ensure that we have
it when we need it that requires computers that require
staff that requires sophisticated projections to ensure that we can
forecast are we going to have enough cash when we need it a cash shortfall
would be inconvenient and potentially costly for example if payroll is due on
Friday and it turns out that you don't have the cash there the consequences are
going to be tragic so we have to make sure we have sufficient cash why not
have a lot well as I said earlier cash is a low yielding asset to have cash
sitting in your savings account you're not to going to get a very large return
on that the opportunity cost of holding cash can be very high so to ensure we
have not too much and not too little there are tools that we have to manage
our cash one common tool is a cash budget we can carefully plan and solve
cashflow problems in advance it turns out over time we can predict with some
degree of certainty when will our customers pay us we can predict with
some degree of certainty when are we going to have to pay our suppliers and
what we want to do is identify well in advance when are we going to need cash
we don't need to guess we can determine ahead of time by making a cash budget so
a cash budget allows us to determine when are we going to have shortfalls of
cash and when are we going to have excesses in cash and then we can have
strategies to ensure we're ready for both of these eventualities okay we just talked about cash
management now let's talk about receivables management recall that
receivables are the amounts of money owed to us by customers we want to
manage our receivables to ensure that they turn into cash but let's ask the
question why would anybody have receivables in the first place why not
just sell for cash well it turns out credit sales are a marketing technique
it turns out if we will offer credit we will get more sales if I'm offering you
a product and you have to pay cash here and my competitor down the road is
allowing you to pay in 30 days for the same product you'll go down there
although the things being equal now if credit sales increase sales why
not have for credit to everyone well it turns out if you offer credit to anyone
and everyone there will be a lot of people who won't pay you you'll have bad
debts associated with that and so it's a trade-off I'll increase my sales but
I'll have people who won't pay me I've got to measure that trade-off to ensure
that those increased sales are worth it I've got to be careful who I extend
credit to in addition if you're going to get into the credit business you got to
keep track of that very rarely will someone come in and say I know how are
your money but I don't know how much will you tell me and will you take my
money they will send you money when you send them a bill so you've got to keep
track of who owes you and how much they owe and you've got to send them a bill
to ensure that they pay you in addition by tying up money into receivables that
is an opportunity lost it turns out if you had had that cash instead you can
invest it so there's another part of the trade off for example Boeing in 2014 had
a countable of seven point seven billion dollars that is customers owed them
seven point seven billion dollars at year-end if they had that seven point
seven they could have invested it and earned a return on it but I'm sure
they've done the calculation that offering credit increased their sales
and more than makes up for any implicit interest cost that they've lost now when
it comes to determining who do we offer credit to companies have to manage what
their standards are going to be many companies are careful who they offer
credit to to ensure that they receive payment and reduce their bad debts
how long are you going to offer credit are people going to pay you in 30 days
60 days 90 days if they pay early will you offer a discount if they pay late
will you charge interest those are decisions when it comes to managing
receivables that have to be made and if they don't pay you what do your practice
is going to be to ensure that eventually you do collect your receivables all of
those things have to be determined when you're managing receivables now what
starts this off inventory we buy inventory and we turn
it into a receivable that receivable is eventually turned into cash when it
comes to inventory how are we going to manage our inventory to ensure that we
have the right amount of inventory well why have inventory at all well it turns
out if somebody walks into your store and you don't have the product they will
go somewhere else and they may not come back companies carry inventory to ensure
that when a customer needs inventory they can find it at your store well then
why not just have a lot of inventory why not make sure we never run out of
inventory well it turns out there a cost associated with inventory as well if our
money is tied up in inventory it's not available to be tied up anywhere else we
can't do anything with that money if we've already got it tied up in
inventory we can't buy equipment we can't expand our building if our money's
tied up in inventory so we don't want to have too much when it comes to inventory
we've got to implement the Goldilocks principle not too much and not too
little when it comes to inventory we want to make sure it's just right so
again why is this important to you regardless of your position in an
organization cash is still king decisions that you make perhaps far away
from the front lines of a business can push cash further away or draw closer to
collection virtually every decision in a business has cashflow implications and
remember that cash is the lifeblood of a business those who can see beyond their
own area of responsibility and recognize the cash flow implications to the
business of decisions that they make are more valuable than those who don't
again you don't have to become a numbers person but it is helpful to the business
and to you if you can appreciate the effect of your decisions on the numbers
of the business particularly the cash flow numbers now about controls what are they
controls our procedures that should be in place to ensure that one the
information that is being collected in your accounting system is accurate and
reliable thereby helping you to run your business better and to to safeguard your
assets and your records now what sort of control should I have on information
that I will collect you will need to answer questions like how will you
document that your cash outflows our legitimate business expenses
you better have proper documentation if I'm in a business that has inventory for
resale how will I know how much I have on hand how do I know how many hours my
employees have worked you better have a system for tracking
this information and of course you will need a system that collects information
about your cash inflows and your cash outflows and you also need to know who
you owe and who owes you we've talked about that what else well you'll have
information that's confidential about employees pay rates Social Security
numbers etc that all has to be safeguarded what about customer lists
what about pricing information as you can imagine there's a lot of top-secret
information relating to the inner workings of your business that you don't
want getting out you need to ensure that you have systems that protect your
information and ensures that the system producing your information is accurate
and reliable one last thing to mention that is often taken for granted you will
need to safeguard your cash you will need procedures in place to make sure
that cash and checks are quickly and correctly deposited in the bank and that
only authorized expenditures are made this is no fun to talk about but we tend
to assume that those with whom we work are looking out for the best interest of
the company now that is often the case but is also often not the case many
individuals are looking out for them you need to make sure that those individuals
are never given the opportunity to be exposed to a situation where they might
compromise their integrity that is done by developing a set of controls within
your business to ensure that information is collected quickly and correctly and
that procedures are in place to ensure that assets especially cash are handled
properly now remember we said at the outs
that this topic is the no fun part of business no one likes to talk about
paperwork if you don't talk about and establish a system that collects
accurate information in a timely fashion and safeguard your assets you will have
plenty time to talk about that topic later when your business folds up a good
system of record-keeping and controls is what the scientists would call a
necessary but not sufficient condition a good information system will not ensure
the success of your business but a bad information system will
certainly contribute to your lack of success so what can be so hard about pricing a
product don't you just figure out what your costs are and then add some sort of
markup for profit oh that it were that easy if your price is too high
regardless of your cost someone in the market will enter price you assuming
that the quality of product or service is similar in many cases you will be a
price taker and you will have to manage your costs so that you can earn a profit
given a certain price is determined by the market now let me say that again in
most instances you don't price your product to cover your cost instead you
determine if given a certain market price your cost structure is such that
you can earn a profit the biggest mistake new business owners make in
product pricing is not considering and covering all of their costs when
entering a market now it is true that when you are initially trying to
penetrate a market you may be willing to lose a little money to gain market share
but that strategy is not sustainable over time over the long term you must
cover all of your costs all of your costs now to our last topic uncontrolled
growth growth is awesome increased market share is good sales trending
upward is the dream an unmanaged growth has killed a lot of companies growth
must be carefully done or it could be fatal to your business
the reason being is that growth often requires cash and cash is often the one
thing that new businesses do not have a lot of in fact a lot of new business
owners when faced with the cash flow issues associated with starting a new
business they mistakenly think that the solution to their cash flow problems is
to grow faster not realizing that the fast growth is causing the cash flow
problem in the first place in other words they hit the gas when
they should hit the brake so how does growth cause cash flow problems well
think about it in a typical business that is selling a product to a customer
on credit that is the customer will pay and say 30 days you as the business
owner need to pay your rent pay your insurance pay your employees pay for the
inventory that sell that inventory and wait for 30 days to collect the cash to
grow faster means you need to buy and pay for more inventory and then sell
that inventory and wait for 30 days to collect the cash the more inventory you
have to buy the more inventory you have to pay for and then still wait 30 days
to collect the cash well let's just have our suppliers wait longer to collect
from us until we collect from our customers remember this your suppliers
are having the same cashflow issues that you are facing they would like to
receive their cash sooner rather than later step1 in a financial analysis is
computing return on equity and then the DuPont framework analysis to look at the
profitability efficiency and leverage components we're now going to hone in on
the leverage component of return on equity with some specific ratios first
we'll look at current ratio which is one of the top five ratios of all time then
the debt ratio debt to equity ratio and then the times interest earned ratio
let's start with current ratio current ratio is a measure of liquidity
liquidity reflects the ability of a company to pay its obligations in the
short term short term we typically define as less than one year current
ratio is computed as current assets divided by current liabilities and let
me remind you what a current asset is and what a current liability is a
current asset is an asset expected to be used or turned into cash within one year
so for example accounts receivable that's a current asset because we expect
those accounts to be collected in cash within one year inventory is a current
asset because we expect that image going to be sold and then the cash collected
all within one year land is not a current asset typically because if we
come back a year from now we expect that land to still be their current asset a
cash is also a great current asset because already is cash so our current
assets are the liquid assets the ones that we expect to become cash soon in
less than one year similarly current liabilities are the liabilities that we
expect to have to pay within one year accounts payable is a good example of a
current liability we're going to pay our suppliers what we owe them within one
year so the current ratio reflects the balance between the assets that we have
that are going to become cash within one year and the liabilities that we have
that we're going to have to pay within one year and we like to see a bit of a
cushion there so the current ratio for nordstrom is 2.1 in 2013 for Dillard's
is also over 2 the general rule of thumb for current
ratios is that they're typically greater than two banks like to see current
ratios typically greater than two in fact it's very common
in bank loan contracts that a bank will say to a borrower your current ratio has
to stay above a certain level above 1.5 or above – and if you fall below 2 we
start to get nervous maybe you're not going to be able to pay us when you are
supposed to pay us and so your loan is in default so the rule of thumb is
current ratios should be greater than 2 but that's an old rule of thumb in the
new world that we have now the technology world companies are able to
manage their current assets much more efficiently companies don't need as much
inventory as they used to need because their information systems can track
their inventory very carefully and so companies don't need to have as much
extra inventory lying around cash can be managed more tightly accounts receivable
can be tracked more precisely so in recent years current ratios have slipped
below – in fact you see a list of very safe financially safe companies here all
with current ratios less than 2 that's normal these days so the old rule of
thumb the rule that your mom and dad learned when they went to school was
current ratio should be about – all current ratios are often less than 2 now
but in general remember that the current ratio reflects liquidity the ability of
a company to pay its debts in the short term and we like to see that steady if
that starts to slip in any given company we get nervous about that company's
ability to pay its debts in the short term now let's look at some specific
profitability ratios and we'll start right at the top of the income statement
with gross profit percentage gross profit is sales minus cost a good salt
if Nordstrom's sells you something for $100 and they pay $65 to buy that thing
from their supplier then Nordstrom's gross profit is $35 and their gross
profit percentage is 35% the fraction of the selling price that Nordstrom gets to
keep right off the top and in a retail organization or in a manufacturing
organization or an organization that sells a service you would hope that this
gross profit percentage stays stable now the gross profit percentage is very
important because if you start to have problems they're the only way to make up
for that further down in the income statement is by belt-tightening pay our
employees less pay less for electricity pay less for rent it's tough if the
gross profit percentage starts to suffer it's hard to maintain profits by
tightening up on your overhead expenses let's go down the income statement one
more step and look at operating profit percentage operating profit is the
profit made by a company by doing what it normally does from its operations
it's gross profit minus those overhead expenses the selling general and
administrative expenses and in a business we want to see operating profit
percentage be stable now there's a ratio that is related to operating profit and
it's called EBIT da so let's go step by step here we'll start with the little
brother of EEMA da e 'but EBIT the acronym stands for earnings before
interest and taxes it's a synonym for operating income but even sounds much
more sophisticated EBIT DA the DA part stands for depreciation and amortization
these are legitimate business expenses the wearing out of our machines and our
buildings and other assets but they don't involve cash this year so EBIT da
can be viewed as an approximation of our operating cash flow and is a very common
measure EBIT da if you're hanging around business people and you say 'hey but
you'll feel immediately like one of the club so a very important ratio is e but
na divided by sales and again we see that
for Nordstrom's and remember what this reflects is an approximation of
operating profitability from a cash standpoint and we would expect our
operating profitability always to remain stable now Amit does a very well-known
number and I'll just give you when appraisers are appraising small
businesses a simple rule of thumb is this a small business is worth that
business's EBIT da multiplied by five now I'm not giving you appraisal advice
here but EBIT dies such a commonly used number that it's used in appraisals and
other things so make sure that you remember eBay da earnings before
interest taxes depreciation and amortization okay we just finished looking at the
profitability ratios now let's look at the efficiency ratios we have three
specific efficiency ratios we're going to drill down on first one is number of
days sales in inventory the second is average collection period and the third
is the fixed asset turnover what are those well the number of days sales and
inventory tells me how long on average does my inventory stay with me until
it's sold the average collection period tells me on average how long from when I
sell something on credit till I collect the cash those two together stays sales
in inventory and average collection period indicate what we call the
company's operating cycle then the third efficiency ratio we're going to look at
is our fixed asset turnover that is how many dollars worth of sales do our fixed
assets generate so let's look first at the inventory turnover we buy inventory
and the question is how long until we sell that inventory can we calculate on
average how long our inventory sits in our store for example well we have a
measure for that it's called days sales in inventory and the first step in
calculating day sales and inventory is we take a measure called our inventory
turnover that is how often do we turn our inventory over every year think of
it this way I have inventory how long until I sell it all buy more sell it all
buy more sell it all how many times do I do that in a year there's an easy way to
calculate that and that is to take our cost of goods sold and divide that by
our average inventory for the year now why use average inventory for the year
well cost of goods sold occurs throughout the year and our inventory
comes and goes throughout the year as well so tamasha cost of goods sold
throughout the year measure we approximate how much inventory do we
have on average throughout the year we'll take our beginning inventory
balance at our ending inventory balance divided by two to get an approximation
of how much inventory did we have on average throughout the year so to
calculate turnover cost of goods sold divided by
average inventory you the master budget is the most detailed
and most heavily used budget in an organization this budget is an
integrated group of detailed budgets that together constitute the overall
operating investing and financing plans for a specific time period the flow of
the preparation of the individual budgets within this master budget
Network works like this first the budgeting process should be based on the
long-term strategic goals and plans of the company in fact if there is no
connection between the company's long-term strategic plans and the
company's detail budgets then the long-term strategic plans are irrelevant
another may be more positive way to say that same thing is that the detailed
budgets within the master budget give relevance to the company's long-term
strategic goals now in a manufacturing firm the master budget begins with a
forecast of sales the sales forecast in connection with the long-term strategic
plan leads to the capital budget or the plan for the purchase of long-term
assets the label capital expenditures is given to purchases of long-term
operating assets such as land buildings and equipment these assets are acquired
to be used over the course of several years
there are several financial models used to make capital budgeting decisions a
simple one is called payback period and involves computing how many years it
will take to recover the initial investment cost net present value or NPV
analysis involves comparing the cost of the asset with the value of the expected
cash inflows after adjusting for the time value of money the value of a
long-term operating asset can disappear instantly if events lower expectations
about the future cash inflows that the asset can generate these computations
are very interesting but unfortunately are beyond the scope of this course now
the sales forecast also leads to the short term operational plans established
by top management once the sales forecast or sales budget is created the
budgeting team in a manufacturing company splits into two sub teams one of
the sub teams will use the sales forecast to determine the detailed plan
for production the production budget this team will consider the amount and
timing of purchases of raw materials the hiring needs for the production Labor's
and the budget for the infrastructure or overhead costs this collection of
production budgets provide a numerical plan for what will happen inside the
factory or the production facility at the same time using that same sales
budget the other sub team uses that sales budget to then construct a budget
for the activities that occur outside the production facility so this selling
and administrative expense budget involves the numerical plan for the
advertising payments to the sales team cost of company headquarters and so
forth the capital budget production budgets and selling and administrative
expense budget then come together in the construction of additional budgets the
cash budget and the budgeted or pro form of financial statements preparation of
the cash budget is discussed later in this course the construction of the pro
forma financial statements is unfortunately outside the scope of this
course a formalized budgeting activity forces management to make many important
decisions that guide a company towards its goals decisions involving scheduling
pricing borrowing investing and cost control so we'll begin our master budget
with perhaps its most important budget component the sales budget the sales
budget always begins the budgeting process and dries many of the related
budgets for example how much inventory we make is a function of how much we're
going to sell how much inventory we determined to make ven drives how much
material we need to purchase how many workers we need to hire and so on
remember the term master budget is not just one budget it is a series of
budgets that taken together comprise what is termed the master budget the
master budget starts with a long term strategic plan made operational this
year with the sales budget for this year the first step in developing a master
budget is to prepare a sales budget all the other budgets are developed from
this sales budget projecting accurate sales is very difficult however because
sales are a function of both uncontrollable external variables such
as customer tastes and economic conditions and controllable internal
variables such as price sales effort and advertising expenditures those
uncontrollable external factors driving sales include the following first
there's the business environment which includes current government policies and
law the status of the economy demographics which are characteristics
of the population such as age wealth family status and so forth and the state
of Technology another external factor customer needs and taste with respect to
the product or service being analyzed and other substitute products another
factor intensity of the competition and possible barriers to market entry
barriers that can include technology copyrights government contracts
reputation or large sales volumes that provide economies of scale another
external factor seasonal cycles creating abrupt changes in sales demand due to
holidays or weather patterns and finally external factors such as unexpected
events droughts hurricanes earthquakes no analysis of these external variables
is accomplished through research and sales forecasting techniques these
techniques may be as simple as having the sales staff ask major customers
about their buying plans for the next year or as sophisticated as statistical
market research techniques some firms use quantitative forecasting models
these range from simple growth rate trends derived from the past year sales
to complex forecasting models that attempt to measure the influence of many
economic and industry variables data used to drive these analyses are
obtained from a variety of sources now for most organizations they divide their
yearly sales budget in the monthly weekly or even daily budgets in order to
plan production schedules and cash flows more precisely now regardless of whether
the budget is on a quarterly or yearly basis the concepts are the same
remember the sales budget is the most difficult but the most important budget
in this entire budgeting process if you give an accountant an accurate sales
forecast or he can create a very useful set of
budgets for you but if the sales forecast is inaccurate even the best
accountant in the world can't generate good production budgets labor budgets or
cash budgets after the sales budget is completed ii
detailed budget covers the number of units to be produced during the period
three factors need to be considered in preparing this production budget first
the projected sales volume for the period second the desired amount of
ending inventory and third the amount of inventory already on hand in the
beginning inventory ending inventory is an important figure because management
wants enough units on hand to meet customer demands but not so many that
unnecessary costs will be incurred because of excessive inventory so let's
consider the question why does the manufacturer want ending inventory on
one side what if we run out of finished goods will have lost sales perhaps now
and forever will also have lost reputation but on the other hand what if
we have too many finished goods we'll have excess resources tied up in
inventory the inventory could get old and obsolete eventually having to be
sold at a loss you

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