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 are 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 held 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 equal 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
every day 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 by
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
in many cases as a manager you'll want
to know how many units need to be sold
to break even
the breakeven 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
break-even 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 analyst
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 used
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 participative
budgeting
each division manager in a bottom-up
approach prepares a budget request for
his or her segment
these requests are combined and reviewed
as they move their way up the
organizational hierarchy
with adjustments being made to
coordinate the needs and goals 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 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 change
the carrier 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 two
you can wait an entire year to report
and pay tax on this income with the rest
of your year two income
just by pushing it from december to
january
you've pushed your tax liability back an
entire year now
my 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
would have paid as income tax
and you can invest it under an 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 an 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 u.s congress in 1974 to encourage
u.s 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 did 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 contribution
and subsequent earnings when they
retired and started receiving
distributions
that's an ira now a 401k is a similar
concept
the 401 k was created by u.s congress in
1978
as section 401k of the internal revenue
code
this also was to encourage u.s workers
to save for retirement
during a year an employer withholds from
your paycheck
up to 17 500 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 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 r a and a 401 k are
examples of the first
basic tax planning strategy legally
delaying the taxation of income
now for u.s 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 u.s
company they're based in the united
states but are they a u.s company
microsoft reports that it produces and
distributes
products and services through our
foreign regional operations 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 percent
home depot has an average tax rate of 36
percent
microsoft comes in with an average tax
rate of 21
and exxon an average tax rate of 42
percent
why this big variance in average tax
rates
each of these organizations has employed
different tax strategies
to affect their tax rate exxonmobil
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 percent
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 percent
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 u.s company
transfers ownership of valuable
intangible rights to an
irish incorporated company operating in
the cayman islands
where the tax rate is zero percent this
cayman irish company then licenses
its rights at a high price to another
irish company
where the tax rate there is 12.5 percent
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 u.s
company merges with a non-us company
based where tax rates are lower than the
35 percent 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 or sometimes as high as 20 percent
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
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 isos 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 is 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
often the most difficult aspect of
accounting is determining which events
are 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 big mac price the proliferation
of these big mac clones can have a
serious impact on the future 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 ten 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
23 000 worth of repairs and renovations
before it 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 are 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 a 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 dr 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
equaling liabilities and owner's equity
debits 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 a
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 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 and inventory
that is 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 purchase 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 make 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 requires 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 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 cash flow
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 all other things
being equal now if credit sales
increase sales why not offer 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 i owe you 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 accounts
receivable of 7.7 billion dollars
that is customers owed them 7.7 billion
dollars at year end
if they had that 7.7 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 costs
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 are your
practices 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 are costs
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 cash flow 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 are 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 two 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 are 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 outset 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
safeguards 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 underprice
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 cost 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
and 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 in say 30
days you as the business owner need to
pay your rent
pay your insurance pay your employees
pay for the inventory
then 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 cash flow issues that you are
facing
they would like to receive their cash
sooner rather than later
step one 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 inventory 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 there
current asset 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 gonna 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 dillards it's also over two
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 two and if you fall
below two
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
two 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 two
in fact you see a list of very safe
financially safe companies here all with
current ratios less than two
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 two
well current ratios are often less than
two 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 of
goods sold
if nordstrom sells you something for a
hundred dollars
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 there
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 ebitda so let's go step
by step here we'll start with
the little brother of ebitda ebit ebit
the acronym stands for earnings
before interest and taxes it's a synonym
for operating income
but ebit sounds much more sophisticated
ebitda
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 ebitda can be viewed as an
approximation of our operating
cash flow and is a very common measure
ebitda if you're hanging around business
people and you say ebitda
you'll feel immediately like one of the
club so a very important
ratio is ebitda divided by sales and
again we see that here for nordstroms
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 ebitda is 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
ebitda multiplied by five now i'm not
giving you appraisal advice here
but ebitda is such a commonly used
number that it's used in appraisals and
other things so make sure that you
remember ebitda
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 and
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 until i collect
the cash
those two together stay sales and
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 day sales and 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
to match a 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
add 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 inventory turnover
cost of goods sold divided by average
inventory
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 detailed budgets then
the long-term strategic plans are
irrelevant
another maybe 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
required 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
laborers 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 an
administrative expense budget then come
together in the construction of
additional budgets
the cash budget and the budgeted or pro
forma 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
drives 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
then 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 now
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 into 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 a 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
she or he can create a very useful set
of budgets for you
but if the sales forecast is inaccurate
even the best account in the world
can't generate good production budgets
labor budgets or cash budgets
after the sales budget is completed the
second 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
a manufacturer want ending inventory
on one side what if we run out of
finished goods we'll have lost sales
perhaps now and forever we'll also have
lost reputation
but on the other hand what if we have
too many finished goods
will have excess resources tied up in
inventory the inventory could get old
and obsolete
eventually having to be sold at a loss
for a company that sells a product the
company's operating cycle
is the amount of time that elapses from
when the company buys the inventory
until when the company collects the cash
from selling that inventory
the length of the operating cycle is the
sum of the length of two very different
processes first
how long from when a company buys the
inventory until it sells or uses that
inventory
second how long from when a company
makes a sale until the company collects
the cash from that sale
let's talk about that first length of
time which is often called the number of
days
sales and inventory let me illustrate
with an example
nike makes athletic shoes and other
sportswear
nike manufactures these items and then
sells them to retail outlets typically
on credit in terms of the length of
nike's operating cycle we must first
consider
how many days elapse from the time that
nike buys raw materials until the time
that nike
sells the finished shoes and sportswear
to retail outlets
using data from nike's financial reports
it can be computed that this is about 80
days
this is called the number of days sales
and inventory
we must then determine how long until
nike collects the cash from these sales
to retail outlets
on average this is about 50 days we call
this the average collection period
if you take these two numbers and add
them together 80 days
from purchase of raw materials to the
sale of the finished goods
and sportswear and then 50 days from the
sale
to the cash collection you get 130 days
that's the length of
nike's operating cycle again the
operating cycle
is the time from the purchase of the raw
materials to the collection of the cash
from the sale of the finished goods for
nike that's 130 days
when nike purchases its raw materials on
credit from its suppliers
nike pays those bills off in about 40
days
so nike buys raw materials on credit and
then pays for those raw materials after
about 40 days
but nike doesn't collect the cash from
selling the finished
shoes and sportswear until a total of
130 days have passed
this is why companies such as nike must
carefully manage purchases
sales and cash collections in order to
balance out this
mismatch between the timing of cash
payments and the timing of cash
collections
if nike wishes to manage its operating
cash flow the company has three
dials it can turn first one is the
number of days sales and inventory
in a manufacturing company such as nike
reducing the number of days
sales and inventory involves
streamlining the production process to
get materials
through the process as quickly as
possible the longer it takes to make the
shoes
after buying the materials then the
longer nike has to wait until collecting
the cash from the sale of the shoes
second dial average collection period if
nike allows
its customers the retail stores to delay
paying for their purchases
that means that nike must borrow cash in
order to pay its own bills
while waiting for the customer cash
there is a fine balance here
balancing the desire to collect the cash
with a desire to please the customer by
not pestering for cash payment too
quickly
the third dial is the number of days
purchases and accounts payable
managing operating cash flow sometimes
means stretching out the time when you
pay
your suppliers again this is a balancing
act
if you can stretch out this time which
averages 40 days for nike then you are
preserving your cash to pay for other
things however you don't want to anger
your suppliers by keeping them waiting
too long
if we put all the numbers together it
takes nike
130 days to convert purchased raw
materials into
operating cash collections 80 days to
make and sell the product and 50 days to
collect the cash
in the meantime nike pays for those raw
materials in about 40 days
so for 90 days the difference between
130 days and 40 days
nike has to use cash from other sources
to keep its operation going
of course in a steady state nike and
other companies can use cash collected
from prior sales
to pay for the materials purchased to
make goods for future sales
but in a growing business where cash
payments to make goods for future sales
are greater than cash collected from
past sales
this operating cycle mismatch can create
large
operating cash flow shortfalls now to
see a different
operating cash flow pattern let's talk
about the cash operating cycle at
mcdonald's
i love the cash flow pattern of
mcdonald's
from the time that mcdonald's buys raw
materials food and packaging
until mcdonald's sells the finished
product the food
wrapped in the packaging about seven
days elapse
cash collection takes about two seconds
because
even when the customer uses a credit or
debit card mcdonald's gets its
electronic cash
almost instantly so the length of
mcdonald's operating
cycle is seven days plus two seconds
seven days from the purchase of the raw
materials until the sale
and then two more seconds to collect the
cash
now if mcdonald's pays its suppliers
under standard credit terms
mcdonald's will pay for the food and
packaging in about 30 days
so for 23 days 30 days minus the seven
days and two seconds
mcdonald's has the cash before needing
to pay its own suppliers
this means that with this pattern of
operating cash flows mcdonald's
or another company with a similar
pattern could grow as
fast as it wanted with the operating
cycle itself providing all the cash to
finance the operating growth
capital expenditures are purchases of
long-term operating assets such as land
buildings and equipment these assets are
required to be used over the course of
several years
in the statement of cash flows we
classify the purchase of these assets as
investing activities the value of
long-term operating assets stems from
the fact that they help companies
generate future cash flows
capital budgeting is the name given to
the process whereby decisions are made
about acquiring long-term operating
assets
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 flows the asset can generate
these computations are very interesting
but are beyond the scope of this course
capital budgeting decisions such as the
purchase of operating assets or the
purchase of another company
are basically cash flow decisions the
company gives up a certain amount of
cash flows today
the purchase price and in the future
operating outlays
in the hope of receiving a greater
amount of cash flows in the future
as the asset generates revenues and or
produces cost savings
to illustrate a simple capital budgeting
decision assume that yosef manufacturing
makes
joysticks and other computer game
accessories
yosef is considering expanding its
operations by buying an additional
production facility
the cost of the new factory is a hundred
million dollars this
is an investing activity yosef expects
to be able to sell the joysticks and
other items made in the factory for 80
million dollars per year
at that level of production the annual
cost of operating the factory
the wages the insurance the materials
the maintenance and so forth is expected
to total
65 million dollars the factory is
expected to remain in operation for
about 20 years
should yousef buy this new factory for
100 million dollars that's an investing
activity decision
to summarize yosef must decide whether
to pay a hundred million dollars for a
factory that will generate a net cash
inflow of 15 million dollars per year
the 80 million inflow and the 65 million
outflow
for 20 years now one simple method that
can be used to analyze this purchase is
called the payback method
or the payback period the payback period
is just the time it takes for the
company to recover its original
investment
calculated by dividing the original
investment cost
by the net annual cash inflows received
from the investment
in the case of the factory purchase
being considered by yosef manufacturing
the payback period is 6.67 years
computed as follows
the payback period is the initial
investment divided by the annual inflow
that's 100 million dollars
divided by 15 million dollars per year
that's 6.67 years that's how long it
takes yosef to get its money back
one way to use this payback period
number
is to invest only in assets that pay
back within a certain period of time
perhaps within five or six years this
required payback period might be set
differently for different types of
assets
in addition qualitative factors such as
strategic positioning for future
expansion and potential positive
motivational effects on employees
would influence the decision the
important concept to remember here
is that long-term operating assets have
value because they are expected to help
a company generate cash flows in the
future if events occur
to change this expectation concerning
those future cash flows
then the value of the asset changes for
example if consumer demand for computer
joysticks dries up
the value of a factory built to produce
joysticks can plunge
overnight even though the factory itself
is still as productive as it ever was
in addition to analysis of whether a
certain investing activity cash
investment is a good idea
a manager must also assess the timing of
the investment to fit
current cash management needs some of
the questions that need to be addressed
are as follows
is current cash flow from operating
activities or through financing
activities such as borrowing
sufficient to pay for an attractive
investing activity this year
if not should the acquisition of the
land building
or equipment be delayed until next year
it is often efficient to acquire land
buildings and equipment in amounts a bit
larger than you need immediately
knowing that you will grow into them in
future years this can be better than
expanding your productive capacity a
little bit each year for example
so are current cash flow sufficient to
pay for a large amount of investing
activities
this year you see that managing
investing cash flow requires you to
think about
your current operating and financing
cash flows a company's
cash is a unifying element that links
all
aspects of a business operating
investing and financing
the two sources of cash from financing
activities are borrowing
an owner investment the most desirable
sequence of decision making with respect
to cash from financing activities is as
follows
forecast the level of activity such as
the level of sales
evaluate the amount of cash that will be
generated from or consumed by
operating activities after a careful
capital budgeting process
determine the amount of cash that will
be needed for investing activities
and finally if financing cash inflows
are needed
compare the relative costs of obtaining
cash from borrowing
and cash from owner investment as a
general statement
the interest rate cost of borrowing
money is lower than the cost of giving
up ownership of part of the company
in exchange for new partner investment
or new shareholder investment
the exact decision this year of whether
it's best to obtain financing cash
inflow from borrowing
or from owner investment depends on
market conditions this year
detailed consideration of these
decisions is part of the field of
finance
an important cash outflow from financing
activities is the payment of cash
dividends
a key question in the field of corporate
finance is why do companies pay cash
dividends and if i could answer this
question i'd get a nobel prize in
economics
but what we do observe is the following
most
established companies pay dividends
companies are reluctant to increase
dividends they want to make sure that
they'll be able to permanently sustain
any increased level of dividends cutting
dividends
is viewed as very bad news and finally
dividends seem to be used to give the
illusion of stability
if companies can get investors and
potential investors to focus
on their steady dividends rather than
their volatile net income
then the companies look much less risky
it's the illusion of stability
in terms of managing financing cash
flows it is very important for a company
to manage its relationships with
providers of financing
lenders current investors and potential
future investors reminder
there are two traditional revenue
recognition criteria that both must be
satisfied before revenue can be
recognized
the seller has to do something the work
and the buyer has to do something
pay or provide a valid promise to pay
now in many many cases
revenue recognition is not a big issue
the primary example here is so-called
cash and carry businesses
such as walmart home depot farmers
markets a restaurant
a cash and carry business and one in
which the customer visits the business
receives a service or chooses a good
pays cash
and then leaves from an accounting
standpoint this is a very simple
transaction
now let's think about the biggest cash
and carry business in the world
walmart in terms of the two traditional
revenue recognition criteria
let's examine them first the work
walmart's work
is providing the retail location and the
goods for the customers to choose
once the customer has chosen the
merchandise that they want
put it in their shopping cart and taking
it outside the store
walmart's work is done you can see that
in this cash and carry setting verifying
that the work has been done
is simple and fairly non-controversial
now some of you have just said to
yourselves hey wait what if i return
something to walmart how does that fit
in here no problem
fact if you look in walmart's income
statement you'll see that it doesn't say
sales it says net sales the net means
that walmart has made a subtraction for
the amount of sales that have been
returned
so the net sales reported by walmart is
the amount of final sales
walmart's work is done but still revenue
cannot be recognized unless
both criteria are satisfied the second
one
a cash payment or a valid promise of
payment
the cash payment questions are not a
problem in cash and carry businesses
such as walmart because the customer
can't get out of the building without
paying cash for the goods
now some of you are saying to yourself
what about credit card sales those
aren't cash sales
but from the standpoint of the retailer
such as walmart a
credit card sale is the functional
equivalent of a cash sale
in fact in its financial reports walmart
reports that credit card amounts are
collected so
quickly just a few days at most that the
credit card amounts that are still in
process
are reported as cash so with a cash and
carry business
the revenue recognition issues are quite
simple the work
is completed at the time of the sale
when the goods are provided to the
customer to take home
the cash is collected almost immediately
because
customers are required to pay before
they leave the store
here are the two traditional revenue
recognition criteria that must both be
satisfied before revenue can be
recognized
the seller has to do something the work
and the buyer has to do something
pay or provide a valid promise to pay
so is it okay to recognize revenue
before
the cash is collected well yes if the
buyer has provided a
valid promise to pay this is just an
ordinary credit sale
the customer buys now and pays later so
let's talk about credit sales for just a
moment
selling on credit is a marketing
technique providing a service to
customers to entice more customers to
buy
companies sell on credit to the extent
that the increase in sales
justifies the increased bookkeeping bad
debt
and carrying costs associated with
credit sales here's an example
almost all of boeing sales are credit
sales
almost all of mcdonald's sales are cash
sales now why does boeing sell on credit
and why doesn't mcdonald's sell on
credit now remember for the seller a
credit card sale is the functional
equivalent of a cash sale because the
credit card company
sends the cash to the seller within a
couple of days at most
let's analyze the three costs of selling
on credit in order to determine why
mcdonald's does not sell on credit
but boeing does the first cost of
selling on credit
bad debts once a big mac is eaten
mcdonald's leverage in the collection
process
is substantially diminished they can't
get the inventory
the big mac back and the cost to collect
going around the people's homes to
collect
would exceed the cost of the meal in
contrast for boeing
the thought that an airline may fail to
pay its bill is tempered by the
knowledge that boeing can recover the
airplane
and sell it to someone else the second
cost of selling on credit
bookkeeping costs we all know that
mcdonald's has served billions and
billions of people
imagine the number of monthly statements
that would have to be mailed if
mcdonald's were to sell on credit
the posted cost alone would be huge in
addition
mcdonald's would have to maintain a
large computer database to track each of
the millions of credit customers
also if mcdonald's were to sell on
credit a credit check would need to be
run on each
potential credit customer in order to
keep the amounts of bad debts at a
reasonable level
because the transaction amounts are so
small this process would be
prohibitively expensive
finally each mcdonald's location would
have to hire several new staff people
who would do nothing
but manage the bookkeeping associated
with credit sales it is entirely
possible
that the bookkeeping costs associated
with a single credit sale
would exceed the cost of the meal in
contrast for a company like boeing where
each credit transaction
totals tens of millions of dollars the
associated bookkeeping cost is really
not large enough to worry about
and the third cost of selling on credit
carrying cost
with cash tied up in receivables
mcdonald's would have to pay
its operating expenses and finance its
expansion through increased borrowing
increasing its annual interest expense
presumably the managers of boeing have
done an analysis and have concluded that
the benefit of selling on credit
in terms of attracting more customers
exceeds this increased borrowing cost
now in summary credit sales make the
most sense for companies like boeing
where the number of individual accounts
is small the value of each transaction
is large
and the recoverability of the inventory
reduces the expected cost of bad debts
for all of these same reasons a business
like mcdonald's with
lots of customer transactions with small
dollar values and where the inventory is
not recoverable
is not a good candidate for credit sales
walmart is the biggest purchaser
on credit in the world the following
companies
sell substantial amounts of goods to
walmart all on
credit terms with walmart agreeing to
pay in 30 to 60 days
pepsico with 8 billion dollars of annual
credit sales to walmart
craft foods with 4.7 billion dollars of
annual credit sales to walmart
kellogg 3.1 billion smuckers 2.4 billion
campbell soup 1.6 billion and clorox 1.5
billion now in terms of the two
traditional revenue recognition criteria
the necessary work of these companies is
to deliver goods to walmart
in order to recognize revenue they must
then receive a valid promise of payment
from walmart
and given the financial strength long
history
and valuable reputation of walmart these
companies are almost
certain to eventually collect their cash
from walmart
so walmart's promise to pay later is
indeed a
valid promise of payment and these
companies who sell on credit
to walmart recognize revenue from credit
sales a month or two before they ever
receive the cash from walmart
rent a center on the other hand does not
deal with customers who are as
creditworthy as is walmart
as mentioned earlier rent-a-center
states that less than 25 percent of its
customers
complete the full term of their
agreement meaning that 75 percent don't
with such a high likelihood of customers
stopping payments on their rental
agreements
rent-a-center cannot recognize revenue
when it delivers furniture
or a tv to a customer because
rent-a-center has not received a
valid promise of payment with a credit
sale
the selling company should recognize
revenue at the time of the sale
if the seller has determined that it is
probable that the buyer will eventually
pay
for the good or the service
both of the two traditional revenue
recognition criteria must be satisfied
before revenue can be recognized the
seller has to do something
the work and the buyer has to do
something pay
or provide a valid promise to pay so is
it
okay to recognize revenue after the cash
has been collected
but before the work has been done no
no no you have to have the work done
let's consider two examples
airline tickets and gift cards first
airline tickets
everyone who flies on an airplane pays
in advance
thus between the time that you pay
united airlines for your flight
and the time that you actually fly
united cannot recognize the revenue they
haven't done the work yet they have your
cash
but they have not yet done the work so
united must record an
obligation to give you a ride on a plane
for which you have already paid
united calls this liability this
obligation advanced ticket sales
as of the end of 2014 united reported
this obligation to be 3.7 billion
dollars
this represents the amount of cash
united had collected from you
and from me in 2014 for tickets that we
would not be using until sometime in
2015.
the numbers suggest that passengers pay
united approximately 40 days before
flying
on average remember revenue and cash
flow are not the same thing
the 3.7 billion dollars represents a
cash inflow from operations for united
and would be reported in the company
statement of cash flows but this is
not revenue in the income statement
because united has not yet done the work
now let's think about gift cards many
companies
retailers restaurants and so forth sell
gift cards
the business collects the cash now but
will not provide
any good or service until the future
when the gift card recipient redeems the
gift card
so when is the revenue recognized well
let's analyze this question in terms of
the two
traditional revenue recognition criteria
let's think about the second criterion
first
has the buyer of the gift card provided
a valid promise of payment well yes
indeed the buyer has paid cash
so that condition is satisfied now to
the first criterion
has the seller done the work no the gift
card seller has done
nothing except take the buyer's cash no
revenue can be recognized until the
buyer or the person to whom the buyer
has given the gift card
actually uses the card walmart reports
the following with respect to its
revenue recognition practice for the
shopping carts that the company sells
customer purchases of shopping carts are
not recognized as revenue
until the card is redeemed and the
customer purchases merchandise using the
shopping cart
now there is one more interesting little
twist here
as many of us know from personal
experience we sometimes forget about
these gift cards or shopping carts after
we buy them
we might lose the shopping cart so the
card is never redeemed
walmart has our cash but we will never
redeem the card
so walmart can never do the work what
happens then
walmart and all other companies that
sell gift cards do the following
this is as described in the notes to
walmart's financial statements
shopping carts in the u.s do not carry
an expiration date therefore
customers and members can redeem their
shopping cards for merchandise
indefinitely
shopping cards in certain foreign
countries where the company does
business may have expiration dates
a certain number of shopping cards both
with and without
expiration dates will not be fully
redeemed
management estimates unredeemed shopping
cards and recognizes revenue for these
amounts
over shopping cart historical usage
periods
based on historical redemption rates so
assume that walmart sells a thousand
dollars worth of shopping cards
also assume that based on historical
experience walmart estimates that 10
percent
or a hundred dollars worth of the
shopping carts will never be used
also let's assume that historically the
cards that are used have been redeemed
evenly over
say a two year period on average what
walmart would then do
is recognize fifty dollars of unredeemed
card revenue in the first year
and fifty dollars of unredeemed card
revenue in the second year
hey the next time you go to walmart and
see shopping carts for sale
or the next time you fly on an airplane
smile to yourself in the knowledge that
you are among the few
who understand how the revenue for these
transactions is reported
the two traditional revenue recognition
criteria are
first the seller has to do something the
work
second the buyer has to do something pay
or provide a valid promise to pay
both of these criteria must be satisfied
before revenue can be recognized
these criteria make sure that a company
cannot recognize revenue casually
something real must happen first work
must be done
and a valid verifiable promise of
payment must have been received
you
