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Chapter 17

ADMS 3531 Chapter Notes - Chapter 17: Net Income, Shamrock, Standard Accounting Practice


Department
Administrative Studies
Course Code
ADMS 3531
Professor
Dale Domian
Chapter
17

Page:
of 4
Chapter 17: Projected Cash Flow and Earnings
17.1 Sources of Financial Information
- in the daily stock price reports of the newspaper, you will see a shamrock symbol (clover) next to entries for many
individual stocks and it symbolizes that the company will send annual reports to readers who request them through The
Globe and Mail – requests can be made through telephone or fax
- online websites where companies whose stock trades on the exchange sometimes provide recent quarterly or annual
financial reports
- in addition to company reports, a wealth of primary financial information is available to investors through Ontario
Securities (OSC), it requires publicly traded companies to submit financial statements on a regular basis
- investors can get financial statements of Canadian companies from SEDAR files – SEDAR lists company reports,
announcements, and other info about public companies and mutual funds since 1997
- investors can use EDGAR files from Securities and Exchange Commission (SEC) website to find financial statements of
US stock exchange listed companies
- majority of big Canadian companies are listed on the US stock markets as well as on the Canadian exchanges
- Ontario Securities Exchange Commission’s disclosure regulations require that when a company discloses material
non-public information to security analysts and stockholders who may well trade on the basis of the information, it must
also make a simultaneous disclosure of that information to the general public
- disclosure regulations: requires companies making a public disclosure of material non-public information to do so fairly
without preferential recipients
- material non-public information: any information that could reasonably be expected to affected the price of a security
17.2 Financial Statements
- financial statements reveal hard facts about a company’s operating and financial performance
- OSC requires timely dissemination of financial statements to the public
- firm’s balance sheet, income statement, and cash flow statement are essential reading for security analysts
- balance sheet: provides a snapshot view of a company’s assets and liabilities on a particular date
- income statement: measures operating performance over an accounting period, usually a quarter or a year, and
summarizes company revenues and expenses
- cash flow statement: reports how cash was generated and where it was used over the accounting period
The Balance Sheet
Fixed Assets Accounting Style Numeric Style
Plant Facilities $35,000 $35,000
Production Equipment 20,000 +20,000
Administrative Facilities 15,000 +15,000
Patents 10,000 +10,000
Accumulated Depreciation (20,000) -20,000
Total Fixed Assets $60,000 $60,000
- common to both numerical columns, an underline indicates that the numbers listed above should be summed
- however, accounting notation omits the “+” sign and “-“ sign, and it is indicated by parentheses “( )” instead
- asset categories include: current assets, fixed assets, goodwill, and other assets
- current assets: cash or items that will be converted to cash or be used within a year (for example, inventory will be sold,
accounts receivable will be collected, and materials and supplies will be used within a year
- fixed assets: have an expected life longer than one year and are used in normal business operations (they may be
tangible or intangible), tangible fixed assets include property, plant, and equipment, intangible assets include rights,
patents, and licenses
- except for land, all fixed assets normally depreciate in value over time
- goodwill: measures the premium paid over market value to acquire an asset
- other assets: miscellaneous items not really fitting into any of the other asset categories
- liability categories include current liabilities, long-term debt, and other liabilities
- current liabilities: require payment or other action within a one-year period
- long-term debt: notes, bonds, or other loans with a maturity longer than one year
- other liabilities: miscellaneous items not belonging to any other liability category
- shareholders equity: the difference between the total assets and total liabilities (it includes paid-in capital, which is the
amount received by the company from issuing common stock, and retained earnings, which represent accumulated
income not paid out as dividends but instead used to finance company growth)
- ASSETS = LIABILITIES + EQUITY
Income Statement
- income statements begin with net sales from which cost of goods sold (COGS) is subtracted to yield gross profit
- cost of goods sold (COGS): represents direct costs of production and sales (costs that vary directly with level of
production and sales)
- next, operating expenses are subtracted from gross profit to yield operating income
- operating expenses: indirect costs of administration and marketing (costs that do not vary directly with production and
sales)
- subtracting interest expense on debt from operating income yields pretax income
- then finally, subtracting income taxes from pretax income yields net income
- net income: is the “bottom line” because it is normally the last line of the income statement
- NET INCOME = DIVIDENDS + RETAINED EARNINGS
Example of an Income Statement
Borg Corporation
Net Sales
Cost of Goods Sold
Gross Profit
Depreciation
Other Operating Expenses
Operating Income
Interest Expense
Pretax Income
Income Taxes
Net Income
Dividends
Retained Earnings
Year 2536
$110,000
(89,000)
$ 21,000
(3,000)
(10,000)
$ 8,000
(2,000)
$ 6,000
(2,400)
$ 3,600
(1,080)
$ 2,520
The Cash Flow Statement
- reports where a company generated cash and where cash was used over a specific accounting period
- cash flow statement assigns cash flows in one of three categories: operating cash flows, investment cash flows, or
financing cash flow
- cash flow statement begins with net income which is principal accounting measure of earnings for a corporation
Example of a Condensed Cash Flow Statement
Condensed Cash Flow Statement – Borg Corporation
Year 2536
Net income $ 3,600
Depreciation 3,000
Operating cash flow $ 6,600
Investment cash flow * (15,000)
Financing cash flow ** 8,920
Net cash increase $ 520
*December 31, 2536, purchase of distribution facilities from Klingon Enterprises for $15,000 (including $5,000 goodwill)
**Issue of $10,000 par value 5 percent coupon bonds, less a $1,080 dividend payout
- net income and cash flow are not the same and often deviate greatly from each other
- income differs from cash flow because income contains noncash items
- for instance, an example of a noncash item includes depreciation
- adjusting net income for noncash items yields operating cash flow
- under this system, businesses recognize income and expenses as they are incurred, rather than when the cash flow is
actually paid or received
- investment cash flow: includes any purchases or sales of fixed assets and investments (i.e., the purchase of Klingon
Enterprise’s distribution facilities reported in footnote “*” is an investment cash flow)
- financing cash flow: includes any funds raised by issuing securities or expended by a repurchase of outstanding
securities (i.e., in the above example, the $10,000 debt issue and $1,080 dividend payout reported in footnote “**” are
examples of financing cash flows)
- standard accounting practice specifies that dividend payments to stockholders are financing cash flows, whereas interest
payments to bondholders are operating cash flows
- dividend payments are discretionary whereas interest payments are mandatory
- interest payments are tax-deductible expenses, but dividend payouts are not tax deductible
- sum of operating cash flow, investment cash flow, and financing cash flow yields the NET CHANGE in the firm’s cash
- the change is the “bottom line” of the cash flow statement and reveals how much cash flowed into or out of the
company’s cash account during an accounting period
- a positive number reveals cash flowing into the company, a negative number reveals cash flowing out of the company
Performance Ratios and Price Ratios
1. Gross Margin = Gross Profit / Net Sales
2. Operating Margin = Operating Income / Net Sales
3. Return on Assets = Net Income / Total Assets
4. Return on Equity = Net Income / Shareholder Equity
- for return on assets and return on equity, they are calculated using current year-end values for total assets and
stockholder equity
- the use of current year-end values is more common
- one of the most popular valuation ratios calculated and reported by companies is called Tobin’s q ratio  dividing market
price of assets into replacement cost of assets
- if ratio value exceeds one then this indicates the company is managing well
- annual reports may also report per-share calculations of book value, earnings, and operating cash flow, respectively
- per-share calculations require number of common stock shares outstanding
1. Book Value Per Share (BVPS) = Shareholder Equity / Shares Outstanding
2. Earnings Per Share (EPS) = Net Income / Shares Outstanding
3. Cash Flow Per Share (CFPS) = Operating Cash Flow / Shares Outstanding
- notice: CFPS is calculated using operating cash flow—not the bottom line on the cash flow statement
- most of the time, when you hear “cash flow” it refers to operating cash flow
- using the per share values calculated above, we get the following price ratios: