PSY6525 U2 Flash cards

1. The author states there are three basic legal business structures that entities take on in the United States. (A) What three variables are considered when choosing the business structure of an organization? (B) List and briefly describe the three business structures.

1. ANSWER A: Complexity of the business, liability preference, and tax considerations of the owners ANSWER B: 1. Sole proprietorship: business owned by an individual or spouses; owner reaps all profits and had unlimited liability for losses. 2. Partnership: Several owners of the business; each owner claims earnings on their taxes but have unlimited liability (unless a limited partnership, which protects limited partners). 3. Corporation: legal entity separates from the owners; assets and liabilities are both owned by the company, not the individuals, who are protected. Two types: C corp (regular) and S corp (fewer than 35 owners who include earnings on personal taxes to avoid dbl taxation and enjoy the limited liability of the corp status).

10. (A) Provide the fundamental accounting equation. (B) Describe the purpose of this equation. Hint: The answer can be found in the paragraph starting with, "All transactions adhere..." (S: 73,4 - 74,2)

10. ANSWER A: Assets (A) = Liabilities (L) + Owners' Equity (OE). This is What you own (assets) equals the total of what you borrowed (liabilities) and what you have invested (equity) to pay for it. ANSWER B: All transactions adhere to this balancing concept. There is no way to affect one side of the balance sheet without a balancing entry. The accounting records are therefore said to be in "balance" when the assets equal the liabilities and owners' equity (A = L + OE). If the records do not balance, an accountant has made a mistake.

11. Given a blank basic five-box layout (W: 15, Figure 2.4), fill in the balance sheet table completely with the relevant terms and dollar amounts, including all column/row headers. Please do not include acronyms in your table unless you have provided the full term first. Failure to write out the acronyms will result in a point loss. Each column of the balance sheet (assets and liabilities) should have equal values assigned. You do not need to use the exact numbers given in Walsh's example; however, if you produce your own numbers, be sure they balance!

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12. Walsh provides a definition of TA in the form of two equations on pg. 24. (A-B) Provide each of these equations.

12. ANSWER A: Equation focusing on the left column of the balance sheet: Total Assets (TA) = Fixed Assets (FA) + Current Assets (CA) ANSWER B: Equation focusing on the right column of the balance sheet: Total Assets (TA) = Owners' Fund (OF) + Long-Term Loans/Liabilities (LTL) + Current Liabilities (CL)

14. Net worth - (A) Provide the equation for net worth. (B) In addition, use the information in the two paragraphs following the equation to provide a simple explanation of net worth. Be sure you are following the author's prompts back to the five-box balance sheet (Figure 3.3) here. The more you draw all of these terms back to the balance sheet, the easier it is to see how all of them are related to one another. (W: 28,2 - 28,4).

14. ANSWER A: Net Worth = Owners' Fund (OF) à Net Worth = Issued Common Stock + Capital Reserves + Revenue Reserves ANSWER B: Net worth is the value of the company as determined by it's assets minus its liabilities (loans outstanding to third parties) To find this, add all the values on the assets side of the balance sheet and subtract outstanding loans. The balance in the shareholder's money.

15. 1. Working Capital - (A) Provide the equation for working capital. (B) Additionally, provide Walsh's farm example to illustrate the difference between wealth and liquidity. (C) Why is this distinction important? In other words, why is working capital an important financial measure for an organization?

15. ANSWER A: Working Capital (WC) = Current Assets (CA) - Current Liabilities (CL) ANSWER B: Large farm owners have lots of assets but may have difficulty in meeting day-to-day cash demands. They have much wealth, but are not liquid. Working capital is the company's liquidity. Not all high wealth organizations/individuals have high liquidity. ANSWER C: It is not sufficient to have assets. You must ensure that there is also sufficient liquidity to meet ongoing cash needs. At Bob's Market net working capital amounts to $28,000 ($115,000 -$87,000). That's Bob's excess of liquid assets to make good on its current. From a banker's vantage point, a grocer with a large amount of net working capital may be considered a good credit risk because the business can make its debt payments. Conversely, it could also show a corporate raider or operations analyst that the store owner is mismanaging his inventory by holding too many goods on the shelves or too much cash in the registers. An astute operator would reduce inventory levels and the cash on hand to more efficient levels and pocket the difference as a dividend. The proper amount of working capital depends on the industry.

16. Provide Walsh's definition of the Profit/Loss (P/L) account. In your definition, be sure to include that the P/L account relates to some specific time period (date range), rather than a specific date like a balance sheet. The reason I am asking you to study Walsh's definition instead of Silbiger's is because Walsh does a better job of describing the P/L account in the context of two balance sheets which is crucial to understanding the utility of the P/L account. (W: 34,0)

16. ANSWER: Profit/Loss (P/L) account: A link or bridge between the opening and closing balance sheets of an accounting period The P/L Account is a link or bridge between the opening and closing balance sheets of an accounting period. Its function is to identify the total revenue earned and the total costs incurred over that period. The difference between these two values is the operating profit.

17. Given a blank version of the Walsh's Figure 4.1 on pg. 35, fill in each item, including the relevant dates related to the balance sheets. Understanding this figure is extremely important to understanding how the balance sheets and P/L accounts are related to one another.

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18. 1. Define (A) gross margin, (B) operating profit, and (C) net income. You can either provide a written definition or an equation. Both answers will be accepted on the exam. (S: 80,1 - 82, 2)

18. ANSWER A: Gross Margin = (Net) Sales - The "Direct" Cost of the Goods or Services Sold (COGS) ANSWER B: Operating Profit = Total Revenue - Total Operating Cost ANSWER C: Net Income = Revenue - Cost of Goods Sold - Expenses

19. 1. Describe how the P/L account is linked to the balance sheet. (S: 84,3 - 85,0)

19. ANSWER: The income statement is the result of many activities during the year. Assets and liabilities are affected upward and downward during the year through many individual transactions. At year's end, the net assets of the firm, as totaled by the balance sheet, had changed because of operating activities. The net income, as calculated by the income statement, tells the story of the year's operations by showing how that change in net assets occurred.

2.. (A) Briefly describe the two tools used to make business investment decisions (S: 208,2 - 212,0). (B) Additionally, briefly describe the five ways of financing a company's needs (S: 212,2 - 214,4).

2. ANSWER A: Payback period: make decision based on how long it will take to pay back the investment. Net Present Value: The further in the future a dollar is received, the greater the uncertainty that it will be received (risk) and the greater the loss of opportunity to use those funds (opportunity costs). Accordingly, cash flows received in the future will be discounted more steeply depending on the riskiness of the project. ANSWER B: a. Receive Credit from Suppliers: Companies buy goods and services and have anywhere from seven days to a year to pay their bills. When companies need more credit from suppliers, financial managers negotiate longer credit terms or larger credit lines. b. Obtain Lease Financing: Companies leasing equipment instead of buying them. Short term= operating lease and is turned in to the finance company at the end of use. Capital leases are long term lease and usually end with worn equipment that can be "bought" through a bargain purchase. c. Obtain Bank Loans: Banks can loan money for long-term or short periods of time. If a company has a credit line or revolver with a bank, it draws down and pays back up to set limits of credit as cash is needed and generated by the business. The credit is often secured by the assets of the firm. If a business runs into trouble, it may not be able to pay the bank and may go into bankruptcy. d. Issue Bonds: Banks can loan money for long-term or short periods of time. If a company has a credit line or revolver with a bank, it draws down and pays back up to set limits of credit as cash is needed and generated by the business. The credit is often secured by the assets of the firm. If a business runs into trouble, it may not be able to pay the bank and may go into bankruptcy e. Issue Stock: Banks can loan money for long-term or short periods of time. If a company has a credit line or revolver with a bank, it draws down and pays back up to set limits of credit as cash is needed and generated by the business. The credit is often secured by the assets of the firm. If a business runs into trouble, it may not be able to pay the bank and may go into bankruptcy.

20. Reflecting back to the financial KPIs you learned in Marr, Part 1 (refer to SO 4), use the information in the two P/L accounts below (note the dates on each statement) and (A) calculate Bob's operating profit margin and revenue growth rate for each statement. (B) Describe the differences in those two KPIs across statements and what they say about the financial standing of Bob's Market. (M: 1 - 7

20. ANSWER A: Operating profit margin= (operating profit/ revenue) * 100. For account A: Operating profit margin = ($44,000 /$5,200,000) * 100. Therefore, operating profit margin A = ~.85%. For Account B: Operating Profit Margin = (107,000/ 7,500,000) * 100. Therefore, operating profit margin B = 1.43%. Revenue Growth rate = [current-past (month, quarter, year)/ past (month, quarter, year)] * 100. (($7,500,000 - $5,200,000)/$5,200,000)*100 = 44% Revenue Growth Rate. ANSWER B: In 2000 (Statement A ) Bob's market made less in sales and had lower expenses in than a 2001 (statement B) [5,200,000 vs 7.500,000]. In 2001 they saw an increase in sale by 44% (Revenue Growth Rate). Despite this increase, the ratio of sales/cost (operating profit margin) is only 1.43% which is slightly higher than 2000: .85%. In order to increase their operating profit margin, they might consider decreasing their operating expenses and Cost of the Goods or Services Sold (COGS).

21. 1. (A) What is the overall importance of monitoring and documenting cash flow in an organization (S: 85, 1 - 86, 2)? (B) What five questions do cash flow statements answer (S: 87, 3 - 88, 0)?

21. ANSWER A: Without cash a business cannot function. Because the cash is critical for operations, and most important in order to stay out of bankruptcy, the FASB (Financial Accounting Standards Board) wrote rule No. 95 mandating that all financial statements include the Statement of Cash Flows or Cash Flow Statement. The inability to manage a company's cash needs is often the primary cause of the demise of many "profitable" enterprises. ANSWER B: 1. What is the relationship between cash flow and earnings? 2. How are dividends financed? 3. How are debts paid off? 4. How is the cash generated by operations used? 5. Are management's stated financial policies reflected in the cash flow?

22. 1. (A) Once prepared, what does the cash flow statement mean? (B) What questions can be answered by the cash flow statement that cannot be answered by the balance sheet or income statement? (S: 92, 2 - 92,3)

22. ANSWER A: The cash flow statement shows the net change in cash for the year. It appears at the bottom of the statement. ANSWER B: Was the company a seemingly profitable company, but must borrow heavily just to stay alive? Did the company's operations throw off cash, even though it may be just marginally profitable according to the income statement?

23. 1. The author provides a general question that is answered by each section of the cashflow statement: (A) operating activities, (B) investment activities, and (C) financing activities. Provide those questions AND which section of the cashflow statement each question corresponds to. (S: 92,4 - 93,2)

23. ANSWER A: Operating Activities: Is the company generating cash? When a company is healthy, operating activities will generate cash. That message is delivered by the net income adjusted for changes in working capital (Operating Activities). ANSWER B: Investing Activities: Does the company require a great investment in fixed assets such as new equipment or technology? Is the company selling off its assets to fill an insatiable cash drain from operations?

24. According to the author, "absolute numbers in a financial statement in and of themselves often are of limited significance." Explain why ratios are where the "real information" comes from using the grocery and jewelry store examples. (S: 93,6 - 94,0)

24. ANSWER: Absolute numbers in a financial statement in and of themselves often are of limited significance. Ratios are where the "real information" comes from - the relationship of one number to another or of one company to another in the same industry. In the grocery game, profits are usually low in relation to sales, so grocers must sell in large volume to make any real profit. A jewelry store survives on slower-paced sales but higher profits per item. That is why ratios are used to compare performances among companies within an industry and against a company's own historical performance.

3. (A) What are the four financial reasons for mergers and acquisitions? (B) Provide a definition for both a merger and an acquisition. (C) What are the two types of acquisitions? (S: 223,6 - 224,7)

3. ANSWER A: - Diversify the company - Improve sales and earnings - Purchase and undervalued Company - Lower operating costs ANSWER B: If two companies decide to join forces to become one company, this is called a merger. If one company buys another company it is called an acquisition. ANSWER C: If both parties agree to the purchase, it is called a friendly acquisition. If not, it is called a hostile takeover.

4. For each of the following terms, describe what each KPI tells you AND how frequently it is measured: (A) Net profit, (B) net profit margin, (C) gross profit margin, (D) operating profit margin, (E) EBITDA, (F) revenue growth rate, (G) return on investment, (H) return on capital employed, (I) cash conversion cycle, and (J) operating expense ratio. (M: 1,0 - 63)

4. ANSWER A: Net Profit (AKA Net Income): To what extent are we generating bottom-line results? Usually measured each month as part of income statement preparation. Net profit ($) = Sales revenue ($) − Total costs ($) ANSWER B: Net Profit Margin (AKA Return on Sales or Net Income Margin): How much profit are we generating for each dollar in sales? Usually measured each month as part of income statement preparation. Net Profit Margin = (Net Profit)/Revenues x 100 ANSWER C: Gross Profit Margin: How much profit are we generating for each dollar in sales? Calculated monthly as part of the normal management reporting cycle. Gross Profit Margin = (Revenue − Cost of Goods Sold)/Revenues x 100 ANSWER D: Operating Profit Margin (AKA Operating Margin). To what extent are we operating our business efficiently? Usually calculated monthly or quarterly as part of the normal management reporting cycle. Operating Profit Margin = (Operating Profit)/Revenue x 100 [Where Operating Profit = EBIT (Earnings Before Interest and Taxes)] ANSWER E: EBITDA. To what extent are we operating our business efficiently to generate profits? As with any earnings or cash-flow metric, EBITDA is usually calculated on a quarterly or monthly basis. But organizations will typically project EBITDA over a 12-month period and report over the previous 12-month period. EBITDA = Revenue − Expenses (excluding interest, tax, depreciation and amortization). ANSWER F: Revenue Growth Rate: How well are we growing the business? Revenues are calculated monthly and reported in the monthly management accounts. Growth rates might be reported on a quarterly basis with multi-quarter and/or year-on-year comparisons. Revenue Growth Rate = (Current −Past (month, quarter, year))/(Past (month, quarter, year)) x 100 ANSWER G: Return on Investment (ROI): How well are we generating sustainable profits? ROI can then be measured at the end of a program (such as a marketing effort, where it is straightforward to calculate the ROI based on known and complete costs and benefits).However, ROI is also measured as a percentage of return over a period of a year (most useful for longer-term projects), thus giving a calculation of how long it will take the organization to cover its investment and then make a profit from that investment. ROI for program period = ((Gain from Investment − Cost of Investment))/(Cost of Investment OR ROI annualized = ((Profit/(Cost )) x 100) x ((Year Days)/(Period )) ANSWER H: Return on Capital Employed (ROCE): How well are we generating earnings from our capital investments? Usually measured on an annual basis. ROCE = EBIT/(Total Capital Employed) ANSWER I: Cash Conversion Cycle (CCC): How well are we doing at maintaining a healthy cash position? Typically measured on an annual basis, but might report it quarterly on a rolling annual basis. CCC = DIO + DSO − DPO, where DIO = days inventory outstanding, DSO = days sales outstanding, DPO = days payable outstanding ANSWER J: Operating Expense Ratio (OER). How well are we managing our operating expenses? Typically collected on a monthly or quarterly basis. OER = ((OPEX in Period t)/(Sales Revenue in Period t)) x 100

5. (A) Provide an organization and any given root question with a short description. (B) Provide the 3 most relevant KPIs for the situation and include a rationale for why each is a relevant KPI for the situation. (C) Provide the 3 KPIs that are not particularly relevant for the situation and include a rationale for why each is an irrelevant or less relevant KPI for the situation. (M: 1,0 - 63)

5. ANSWER A: ORS hair company. This is an organization that specializes in ethnic haircare. It was once very popular due to the prevalence of the use of chemical hair straighteners. This company is currently under scrutiny for selling carcinogenic chemical hair altering products (relaxers) and not as profitable due to less people using relaxers, though they do have other products. Root Question: Would investing in marketing our product with "natural hair" influencers makes a positive difference in the company's reputation and/or profits. ANSWER B: ROI: we are looking to see a return in investment in marketing efforts in increased sales. Gross Profit Margin: A small increase in product price may be implemented to increase revenue if this KPI is not where it needs to be or more funding is needed for marketing. Revenue growth rate: this is needed to track past and present growth rates which provides an opportunity to set quarterly goals. ANSWER C: OER. operating costs are not being used for this root question we expect this to be relatively the same as we are not changing the products being sold. ROCE; We are not concerned with capitol investments in the situation. CCC Cash Conversion Cycle: It does not seem too relevant for this situation but could possibly be used if products are not being sold, thus an inflated enventory may change this number.

6. (A-G) List and briefly describe the seven fundamental concepts of accounting. You can think of these concepts similarly to how we look at the concepts of behavior. They provide a foundation for everything that we do and act as a basis for practice and decision-making. NOTE: You will not need to provide examples of each for the exam; however, it is important that you read and understand the examples provided by the author in this section. (65,3 - 71,3)

6. ANSWER A: The Entity: Accounting reports communicate the activities of a specific entity. A reporting entity can be a single grocery store, a production plant, an entire business, or a conglomerate ANSWER B: Cash and Accrual Accounting: Using cash basis accounting, transactions are recorded only when cash changes hands. Cash accounting tells you when and how much cash changed hands, but it doesn't try to match the costs of conducting business with their related sales ANSWER C: Objectivity: Accounting records only contain transactions that have been "completed" and that have a "quantifiable" monetary value. Accountants also have an objectivity rule to guide them when in doubt. ANSWER D: Conservatism: When companies incur losses that are probable and that can reasonably be estimated, accountants record them, even if the losses have not actually been realized. When gains are expected, accountants postpone recording them until they actually are realized. ANSWER E: Going Concern: Financial statements describe businesses as operating entities. The values assigned to items in the accounting records assume that the business is a going concern. Refers to a company that has the resources needed to continue operating indefinitely until it provides evidence to the contrary. If a business is not a going concern, it means it's gone bankrupt, and its assets were liquidated ANSWER F: Consistency: The consistency concept is crucial to readers of financial statements. Accounting rules demand that an entity use the same accounting rules year after year. That enables an analyst to compare past with current results. The consistency rule insists that companies value their inventory the same way from year to year. ANSWER G: Materiality: An important caveat of financial statements is that they are not exact to the penny, even though you would expect that tenacious accountants would produce such reports. In fact, they are only materially correct so that a reader can get a fairly stated view of where an entity stands. Financial statements give a materially accurate picture so that a reasonable person can make informed decisions based on the report.

7. (A) What three major financial statements are important to be able to read and understand? (B) What function inside of the organization is responsible for producing those reports? (71,4 - 72,0)

7. ANSWER A: The Balance Sheet, The Income Statement, The Statement of Cash Flows ANSWER B: Final product of the accounting function

8. Describe the purpose of the balance sheet (i.e., what you will learn by reading and interpreting a balance sheet). In your answer, be sure to include that a balance sheet is a "snapshot" of the business's finances at a specific point in time. Thus, you compare the balance sheets across two points in time in order to gain information about the business's finances. Walsh and Silbiger both provide descriptions of the balance sheet. Silbiger's writing is, in general, more technical so it is probably best that you read Walsh's definition and description first and then go back and read Silbiger's definition and description. You should use both readings in your answer. (W: 12,4 - 14,2; S: 72,1 - 73)

8. ANSWER: The balance sheet presents the assets owned by a company, the liabilities owed to others, and the accumulated investment of its owners (owners' equity). A balance sheet is a "snapshot" of the business's finances at a specific point in time. Thus, you compare the balance sheets across two points in time in order to gain information about the business's finances.

9. Define and provide an example of the following terms: (A) assets, (B) liabilities, and (C) owner's equity, (S: 73,0 - 73,3)

9. ANSWER A: Assets are the resources that the company possesses (items of value owned by the company) for the future benefit of the business. Cash, Inventory, Customers receivables—accounts receivable, Equipment, Buildings ANSWER B: Liabilities are dollar-specific obligations to repay borrowing, debts, and other obligations to provide goods or services to others: Bank debt, Amounts owed to suppliers—accounts payable, Prepaid accounts or advances from customers to deliver goods and services, Taxes owed, Wages owed to employees ANSWER C: Owners' equity is the accumulated dollar measure of the owners' investment in the company. Their investment can be either in the form of cash, other assets, or the reinvestment of earnings of the company. Ex: Common stock—investment by owners, Additional paid-in capital—investment by owners, Retained earnings—reinvestment of earnings by owners

25. (A-D) What are the four main categories of ratios AND what questions are answered by each? (S: 94,1) I won't ask you to learn the eight specific ratios that Silbiger provides, but the descriptions actually are pretty helpful for understanding the ratio categories. I'd encourage you to read through them as many times as it takes to generally understand them. (S: 94,2 - 98,1)

ANSWER A: Liquidity measures: How much is on hand that can be converted to cash to pay the bills? ANSWER B: Capitalization measures: Is a company heavily burdened with debt? Are its investors financing the company? How is the company funding itself? ANSWER C: Activity measures: How actively are the firm's assets being deployed? (MBAs deploy assets, rather than just use them.) ANSWER D: Profitability measures: How profitable is a company in relation to the assets and the sales that made its profits possible?