Chapter 7: Accounting and Financial Analysis

Accounting – Terms and Definitions

Anyone who focus on a business entity must learn how to read, understand, and analyze the accounting statements and financial statements even the accounting process itself is performed by accountants.

All the economic events and transactions must be identified, recorded, and results must be reported.

Accounting consists of three basic activities— it identifies, records, and communicates the economic events of an organization to interested users.

Accounting is an information system that provides reports to decision makers about the economic activities and condition of a business.

The purpose of accounting is to provide useful financial information about the business entity to the decision makers that they will be more informed in their decision making process.

Bookkeeping is the act of recording and organizing financial transactions in the accounting system in accordance with the generally accepted accounting principles (GAAP).

Users of Accounting Information

The users of accounting information either directly or indirectly connected to the business entity can be classified as

• Internal users
• External users

Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, finance directors, and company officers.

External users are individuals and organizations outside a company who needs financial information about the company. The two most common types are investors and creditors.

Areas of Accounting

The two most common fields are financial accounting and managerial accounting .

Financial accounting focuses on reporting to external parties such as stockholders, investors, governmental agencies, creditors, banks, and suppliers.

Financial accounting measures and records business transactions and provides financial statements that are based on generally accepted accounting principles (GAAP).

Managerial accounting is concerned with providing information to internal decision makers, such as company managers.

Managerial accounting uses both financial accounting and estimated data to aid management in running day-to-day operations and in planning future operations.

Accountants and Accounting Profession

Accountants can be classified as private and public accountants.

A private accountant works for a business firm in any position not included in public accounting.

A certified management accountant (CMA) is a certified professional who works for a single company.

Public accountants and their staff provide services to the general public on a fee basis.

Certified Public Accountants (CPAs) are licensed professional accountants who serve the general public.

Accountancy profession in Turkey is regulated through the law No. 3568, “The Law of Independent Accountancy, Certified Public Accountancy, and Sworn-in Certified Public Accountancy”.

Recording Business Transactions

An accounting system is the composition of methods and procedures for collecting, classifying, summarizing, and reporting the financial and operating information of a business.

The accounting cycle: The accounting cycle is a set of steps that are repeated in the same order every period to keep track of what happened in the business and to report the financial effect of those transactions.

The accounting cycle is the financial process starting with obtaining data from business transactions and leading up to preparation of financial statements.

Accounting cycle consist of those steps;

1. Identify and analyze business transactions and events
2. Journalize the transactions
3. Post each journal entry to the appropriate ledger accounts.
4. Prepare the trial balance
5. Record the adjustments
6. Prepare the adjusted trial balance
7. Prepare the financial statements
8. Close the books

The Accounting Equation: The accounting equation shows how assets, liabilities, and owners’ equity are related to each other:

assets = liabilities + owners’ equity

Assets are economic resources a business owns.

Liabilities are existing debts and obligations of the company.

Owners’ equity equals what is owned (assets) minus what is owed (liabilities). It is the company’s net worth.

Transaction Analysis : Accounting is based on actual business transactions; not opinions, expectations, or desires. Businesses engage in transactions with customers, suppliers, employees, governmental entities, and others.

A transaction is an event that affects the financial position of the enterprise and requires recording.

Accounting relies on a system of accounts, with a name or a title of each account intended to capture the nature of the items in the account.

An account is a detailed record of increases and decreases in a specific asset, liability, or owner’s equity item.

An account, in its simplest form, has three parts:

• First, each account has a title, which is the name of the item recorded in the account
• Second, each account has a space for recording increases in the amount of the item.
• Third, each account has a space for recording decreases in the amount of the item.

The left side of the account is called the debit side (Dr.) , and the right side is called the credit side (Cr.) .

Debit-Credit Rules and Double Entry Accounting: Entering an amount on the left side of an account is called debiting the account.

Amounts entered on the right side of an account are called credits, and the account is said to be credited .

Accounting uses the double-entry system , which means that we record the dual effects of each transaction.

Whether an account is increased or decreased by a debit or a credit depends on the type of account.

If a debit increases assets, then a credit must be used to increase liabilities or owners’ equity because they are on opposite sides of the equal sign.

Steps in the Recording Process: There are three basic steps in the recording process:

• Analyze each transaction for its effects on the accounts,
• Enter the transaction information in a journal,
• Transfer the journal information to the appropriate accounts in the ledger.

Accountants record transactions first in a journal, which is the chronological record of transactions.

The journal entry presents the full story for each transaction.

Entering transaction data in the journal is known as journalizing .

Companies make separate journal entries for each transaction.

A complete entry consists of:

• the date of the transaction
• the accounts and amounts to be debited and credited
• a brief explanation of the transaction

Transfer the journal information to the appropriate accounts in the ledger is called posting .

Companies use a chart of accounts to list all their accounts along with the account numbers. A list of the accounts in the ledger is called a chart of accounts.

Basic Financial Statements

The financial statements summarize the transaction data into a form that is useful for decision making.

The most important financial statements are the balance sheet, the income statement, and the cash flows statement .

Balance sheet: A balance sheet or statement of financial position is a financial statement that reports a business’s assets, liabilities, and equity on a specific date.

A balance sheet has two sides:

• assets are listed and totaled on the left side
• liabilities and equity are listed and totaled on the right side

Assets will be classified as current assets and non- current assets .

Current assets are the assets that a company expects to convert to cash or use up within one year or within its operating cycle, whichever is longer.

Non-current assets include long-term investments, property, plant and equipment (fixed assets), and intangible assets.

Liabilities will be classified as current liabilities and non-current liabilities.

Current liabilities are all those debts of the company that are expected to be paid within the next 12 months, the same period in which the current assets are expected to become cash.

Non-current (long-term) liabilities are obligations that a company expects to pay after one year.

Owners’ (stockholders’ or shareholders’) equity. The owners’ claims to the assets of the business is called owners’ equity.

Owners’ equity consists of

• contributed capital
• retained earnings and
• other reserves

Contributed capital is the amount that the owners have invested in the company.

Retained earnings are the profits that the owners do not take out of the business but instead save for use by the business.

Income Statement: The income statement shows the amount of sales, all the costs incurred in making those sales and all the overhead costs incurred in running the operations of the company so it would be able to deliver on its promises to customers.

Net income, in its simplest form, is measured as the difference between revenues and expenses when revenues exceed expenses:

Net Income = Revenues - Expenses

Revenues are increases in owners’ equity resulting from selling goods, rendering services, or performing other business activities.

Expenses are decreases in owners’ equity resulting from the cost of selling goods or rendering services and the cost of the activities necessary to carry on a business, such as attracting and serving customers.

Analyzing Financial Statements

Accounting is designed to provide information that business owners, managers, and lenders use for decision making. The basic financial statements provide much of the information users need to make economic decisions about businesses.

Financial ratios provide a quick and relatively simple means of assessing the financial health of a business. Ratio analysis expresses the relationship among selected items of financial statement data.

Measures and Evaluation of Liquidity: Liquidity is a firm’s ability to meet short-term obligations. The greater the level of current assets available relative to current liabilities, the greater the firm’s liquidity.

Since short-term assets are commonly used to pay short- term obligations (which are current liabilities), most liquidity measures compare current assets with current liabilities.

The current ratio is used to assess a company’s ability to pay current liabilities as they become due.

The quick ratio (acid test ratio) is a liquidity ratio that measures the ability of a company to pay its current liabilities with most liquid assets. The quick ratio is similar to the current ratio, but it’s a tougher measure of liquidity than the current ratio, because it excludes inventories.

Measures of Efficiency: Efficiency ratios (Activity ratios) measure how efficiently a firm manages its assets.

The accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year.

The average collection period measures the average number of days it takes for a company to collect revenue from its credit sales.

The total assets turnover ratio measures a firm’s ability to generate sales from a particular level of investment in assets, or alternatively, to control the amount of assets it uses to generate a particular level of sales.

Inventory turnover is a ratio showing how many times a company's inventory is sold and replaced over a period of time.

Days of inventory outstanding measures the number of days it will take a company to sell all of its inventory.

Measures and Evaluation of Long-term Solvency: Long- term solvency is about a company’s ability to survive for many years in financial terms. Solvency analysis evaluates the ability of a company to pay its long term debt and the interest on that debt.

Firms that borrow a large proportion of their funds, have a high degree of financial leverage. Financial leverage represents the degree to which a firm uses borrowed funds to finance its assets.

Solvency ratios , also called leverage ratios , measure a company's ability to sustain operations indefinitely by comparing debt levels with equity, assets, and earnings.

The debt-to-total–assets ratio measures the percentage of total financing provided by creditors. It measures a company's total liabilities as a percentage of its total assets.

A measure of the amount of long-term financing provided by debt relative to equity is called the debt-to-equity ratio. This ratio measures the percentage of debt tied up in the owner’s equity.

Times interest earned , sometimes called the interest coverage ratio , measures a firm’s ability to cover its interest payments. This ratio shows how many times the interest expenses are covered by the net operating income, income before interest and tax, of the company.

Measures and Evaluation of Profitability: Profitability ratios measure the income or operating success of an enterprise for a given period of time. A company’s income, or the lack of it, affects its ability to obtain debt and equity financing, its liquidity position, and its ability to grow

Gross profit margin indicates the percentage of revenue available to cover operating and other expenditures.

The operating profit margin (OPM) is a measure of overall operating efficiency and incorporates all of the expenses associated with ordinary business activities.

Net profit margin shows how much of each sales amount shows up as net income after all expenses are paid. Net profit margin is calculated by net income dividing by sales revenue.

The return on assets (ROA) ratio measures the overall profitability of assets in terms of the income earned on each dollar invested in assets. It is computed by dividing net income by average total assets

Return on equity (ROE) is about the profitability of the owners’ equity. Of course, owners are interested in how much they have earned on their investment in the business. This ratio shows how much net income the company earned for each dollar or Turkish lira invested by the owners. It measures how much profit each dollar or lira of owners' equity generates.