Ch2 - Review of Accounting
Income Statement
The statement of income:
Valuation Basics from the Income Statement
Return on Capital
Balance Sheet
Formula
Practice Questions
Did you know?
Income Statement
The statement of income:
Measures the profitability of a firm over a time period (month, year)
Assists financial decision making and analysis, utilizing past patterns for
predicting the timing, uncertainty, and amount of future earnings and cash flows.
Gross profit:
sales (revenues) less cost of goods sold (direct costs related to sales). may
contain some fixed costs but excluded overheads.
⇒ sales minus cost of goods sold
Contribution margin:
sales less variable costs
is the excess of revenues over variable costs
will increase if there is an decrease in variable costs
Operating profit (earnings before interest and taxes):
A measure of how efficient management is in generating revenues and
controlling expenses.
Ch2 - Review of Accounting 1
, Earnings (net income or loss):
Operating profit is adjusted for revenues and expenses not related to operational
matters resulting in net earnings.
Interest reflecting the financing policies of the firm or its financial leverage, and
taxes reflecting government policies are of particular note.
Earnings are not the same as the cash flow because of accrual accounting that
matches revenues earned to expenses incurred, whether or not they are paid.
Earnings represent a longer run view of the firm, while the cash flow statement,
which complements the income statement, focuses on the firm’s cash position
and survival in the short term.
Financial managers must monitor performance (income statement) and liquidity
(cash flow statement)
Earnings (or income) can be paid to shareholders (preferred and common) as
dividends or retained in the firm for reinvestment on behalf of the common
shareholders.
The reinvested funds, identified on the balance sheet, theoretically belong to the
common shareholders but do not represent cash.
These funds will be invested in accounts receivable, inventories, capital, or other
assets, and, it is hoped, provide future earnings and dividends to shareholders
appropriate to the risk assumed.
Valuation Basics from the Income Statement
Shareholders’ claim on earnings is a fundamental measure of value.
Common shareholders are sensitive to the number of shares outstanding with
more shares resulting in lower earnings available to each shareholder.
⇒ To gauge (estimate) shareholder returns, we compute both basic and
diluted Earnings per Share (EPS)
Earning per Share - EPS
→ A measure of the earnings available to common stockholders per share of
stock owned is known as_____
Ch2 - Review of Accounting 2
, Shareholders will also be interested in what percentage of earnings is paid out
immediately as dividends and this is referred to as the Payout Ratio
Shareholders’ reliance on earning per share will influence the price they are
prepared to pay for shares of the firm.
A relationship between earnings per share and current market value is the price -
earnings ratio (P/E ratio)
P/E ratio - price earning ratio
⇒ also referred to as the earnings multiplier
→ Its magnitude is often a reflection of future expected earnings.
→ Will change as the shares’ market price changes and is influenced by:
Earnings after taxes and sales growth
Risk (business performance and debt equity structure)
Dividend payment policy
Quality of management decisions
Many other factors
Dividend yield
→ Dividends per share dividend by market price per share.
→ Dividend yield indicates the percentage return that a shareholder will receive
on dividends alone.
Return on Capital
Characteristics of funds that are reinvested in the business:
They theoretically belong the the common shareholder
It is expected that these reinvested funds will provide future earnings and
dividends.
Ch2 - Review of Accounting 3
Income Statement
The statement of income:
Valuation Basics from the Income Statement
Return on Capital
Balance Sheet
Formula
Practice Questions
Did you know?
Income Statement
The statement of income:
Measures the profitability of a firm over a time period (month, year)
Assists financial decision making and analysis, utilizing past patterns for
predicting the timing, uncertainty, and amount of future earnings and cash flows.
Gross profit:
sales (revenues) less cost of goods sold (direct costs related to sales). may
contain some fixed costs but excluded overheads.
⇒ sales minus cost of goods sold
Contribution margin:
sales less variable costs
is the excess of revenues over variable costs
will increase if there is an decrease in variable costs
Operating profit (earnings before interest and taxes):
A measure of how efficient management is in generating revenues and
controlling expenses.
Ch2 - Review of Accounting 1
, Earnings (net income or loss):
Operating profit is adjusted for revenues and expenses not related to operational
matters resulting in net earnings.
Interest reflecting the financing policies of the firm or its financial leverage, and
taxes reflecting government policies are of particular note.
Earnings are not the same as the cash flow because of accrual accounting that
matches revenues earned to expenses incurred, whether or not they are paid.
Earnings represent a longer run view of the firm, while the cash flow statement,
which complements the income statement, focuses on the firm’s cash position
and survival in the short term.
Financial managers must monitor performance (income statement) and liquidity
(cash flow statement)
Earnings (or income) can be paid to shareholders (preferred and common) as
dividends or retained in the firm for reinvestment on behalf of the common
shareholders.
The reinvested funds, identified on the balance sheet, theoretically belong to the
common shareholders but do not represent cash.
These funds will be invested in accounts receivable, inventories, capital, or other
assets, and, it is hoped, provide future earnings and dividends to shareholders
appropriate to the risk assumed.
Valuation Basics from the Income Statement
Shareholders’ claim on earnings is a fundamental measure of value.
Common shareholders are sensitive to the number of shares outstanding with
more shares resulting in lower earnings available to each shareholder.
⇒ To gauge (estimate) shareholder returns, we compute both basic and
diluted Earnings per Share (EPS)
Earning per Share - EPS
→ A measure of the earnings available to common stockholders per share of
stock owned is known as_____
Ch2 - Review of Accounting 2
, Shareholders will also be interested in what percentage of earnings is paid out
immediately as dividends and this is referred to as the Payout Ratio
Shareholders’ reliance on earning per share will influence the price they are
prepared to pay for shares of the firm.
A relationship between earnings per share and current market value is the price -
earnings ratio (P/E ratio)
P/E ratio - price earning ratio
⇒ also referred to as the earnings multiplier
→ Its magnitude is often a reflection of future expected earnings.
→ Will change as the shares’ market price changes and is influenced by:
Earnings after taxes and sales growth
Risk (business performance and debt equity structure)
Dividend payment policy
Quality of management decisions
Many other factors
Dividend yield
→ Dividends per share dividend by market price per share.
→ Dividend yield indicates the percentage return that a shareholder will receive
on dividends alone.
Return on Capital
Characteristics of funds that are reinvested in the business:
They theoretically belong the the common shareholder
It is expected that these reinvested funds will provide future earnings and
dividends.
Ch2 - Review of Accounting 3
