Practice English Speaking&Listening with: accounting online classes, understanding accounting, bookkeeping, and finance

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 our 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 help 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 equals 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

everyday 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 buy 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

you

in many cases as a manager you'll want to know how many units need to be sold

to break-even the break-even 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 breakeven 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 analysts

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 use 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

participated budgeting each division manager in a bottom-up approach prepares

a budget request for his or her segments these requests are combined and reviewed

as they move their way up the organizational hierarchy with

adjustments being made to coordinate the needs and

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 are 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 changed the character 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 - you can

wait an entire year to report and pay tax on this income with the rest of your

year to income just by pushing it from December to January you've pushed your

tax liability back an entire ere now 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 will

have paid as income tax and you can invest it and earn 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 at 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 US Congress in 1974 to encourage US 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 didn't 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 IRA contribution and subsequent earnings

when they retired and started receiving distributions

that's an IRA now a 401 K is a similar concept the 401 creek' was created by US

Congress in 1978 as section 401 K of the Internal Revenue Code this also was to

encourage US workers to save for retirement during a year an employer

withholds from your paycheck up to seventeen thousand five hundred dollars

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 on 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

IRA and a 401 K are examples of the first basic tax planning strategy

legally delaying the taxation of income now for US 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 US company they're based in the

United States but are they a US company Microsoft reports that it produces and

distributes products and services through our foreign regional operation

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% Home Depot has an

average tax rate of 36% Microsoft comes in with an average tax rate of 21% and

Exxon an average tax rate of 42% why this big variance in average tax rates

each of these organization has applied different tax strategies to affect their

tax rate Exxon Mobil 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%

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% 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 US company transfers ownership of

valuable intangible rights to an Irish incorporated company operating in the

Cayman Islands where the tax rate is 0% this came an Irish company then licenses

its rights at a high price to another Irish company where the tax rate there

is 12.5% 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 US company merges with a

non-us company based where tax rates are lower than the 35% 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 percent or sometimes as high as 20% 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 a 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 ISO

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 as 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

you

often the most difficult aspect of accounting is determining which events

ought 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 bigmack

price the proliferation of these Big Mac clones could have a serious impact on

the future of 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 10 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 twenty three thousand dollars worth of

repairs and renovations before 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 or 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 the 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 er 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 equalling liabilities and owner's

equity rabbits 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 the 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 but 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 in

inventory that it's 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've purchased 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 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 require 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 to 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 cashflow 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 although the things being equal

now if credit sales increase sales why not have for 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 how are your 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 a countable of seven point seven billion

dollars that is customers owed them seven point seven billion dollars at

year-end if they had that seven point seven 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 cost 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 do your practice is 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 a cost

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 cashflow 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 our 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 to 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 our

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

outs 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 safeguard 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 enter price 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 costs 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 an 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 and say 30 days

you as the business owner need to pay your rent pay your insurance pay your

employees pay for the inventory that 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 cashflow issues that you are facing they

would like to receive their cash sooner rather than later

step1 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 image going

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 their current asset a 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 going to 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 Dillard's is also over 2

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 - and if you fall below 2 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 2

but 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 - in fact you see a list of very

safe financially safe companies here all with current ratios less than 2 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 - all

current ratios are often less than 2 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 a good salt if Nordstrom's sells you something for

$100 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 they're 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 EBIT da so let's go step by

step here we'll start with the little brother of EEMA da e 'but EBIT the

acronym stands for earnings before interest and taxes it's a synonym for

operating income but even sounds much more sophisticated EBIT DA 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 EBIT da can be viewed as an approximation of our

operating cash flow and is a very common measure EBIT da if you're hanging around

business people and you say 'hey but you'll feel immediately like one of the

club so a very important ratio is e but na divided by sales and again we see

that for Nordstrom's 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 Amit does 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 EBIT da multiplied by five

now I'm not giving you appraisal advice here but EBIT dies such a commonly used

number that it's used in appraisals and other things so make sure that you

remember eBay da 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 in 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 till I collect

the cash those two together stays sales in 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 days sales

in 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 tamasha 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 at 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

turnover cost of goods sold divided by average inventory

you

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 detail budgets then the

long-term strategic plans are irrelevant another may be 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 acquired 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 Labor's 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 and administrative expense budget then come together in the

construction of additional budgets the cash budget and the budgeted or pro form

of 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 dries 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 ven 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

no 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 in the 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 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

or he can create a very useful set of budgets for you but if the sales

forecast is inaccurate even the best accountant in the world can't generate

good production budgets labor budgets or cash budgets

after the sales budget is completed ii 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 the

manufacturer want ending inventory on one side what if we run out of finished

goods will have lost sales perhaps now and forever will also have lost

reputation but on the other hand what if we have too many finished goods

we'll have excess resources tied up in inventory the inventory could get old

and obsolete eventually having to be sold at a loss

you 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 in 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 Nikes 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 Nikes 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 a hundred and thirty days that's the length of Nikes

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 a hundred and thirty 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 in 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 in 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 average is 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 a hundred and thirty days to convert

purchased raw materials into operating cash collections 80 days to make and

sell the product and fifty 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 elapsed 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 in 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 our 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 Yosef buy this new factory for

100 million dollars that's an investing activity decision to summarize Yosef

must decide whether to pay one 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

purchased being considered by yosef manufacturing the payback period is six

point six seven years computed as follows the payback period is the

initial investment divided by the annual inflow that's a hundred million dollars

divided by fifteen million dollars per year that's six point six seven years

that's how long it takes yourself 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 or 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

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 our current cash flow is 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 and 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

determined the amount of cash that will be needed for investing activities and

finally if financing cash inflows are needed compare the relative cost 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 to 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

in fact if you look in Walmart's income statement you will 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 well 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 of 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 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 MacDonald's sales are cash sales now why does Boeing sell on credit

and why doesnt McDonald 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 click 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 costs of selling on credit

book keeping 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

bookie being associated with credit sales it is entirely possible that the

bookkeeping cost 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 or 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

of 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 Mexico with 8

billion dollars of annual credit sales to Walmart Kraft Foods with four point

seven 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 to traditional revenue recognition criteria the necessary work

of these companies is to deliver goods to Walmart in order recognized 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 to eventually collect their cash from

Walmart so Walmart's promised 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 Renta

Center on the other hand does not deal with customers who are as credit worthy

as is Walmart as mentioned earlier Renta Center states that less than 25 percent

of its customers complete the full term of their agreement meaning that 75%

don't well such a high likelihood of customers stopping payments on the

rental agreements Renta Center cannot recognize revenue when it delivers

furniture or a TV to a customer because Renta 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 Reb 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

ok 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 four 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 three point seven

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 to 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 nothing except take the buyers 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 cards that the

company sells customer purchases of shopping cards are not recognized as

revenue until the card is redeemed and the customer purchases merchandise using

the shopping card 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 cards after we buy them we might lose the shopping card 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 cards 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 card

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 $100 worth

of the shopping cards 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 $50 of unredeemed card revenue

in the first year and 50 dollars of unredeemed card revenue in the second

year hey the next time you go to Walmart and see shopping cards 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

as 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 makes 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