ACCOUNTING BASICS FOR MBA

 

ACCOUNTING BASICS FOR MBA

THE ACCOUNTING EQUATION

˗     ASSETS

˗     LIABILITIES

˗     OWNERS EQUITY

FINANCIAL STATEMENTS

˗     BALANCE SHEET

˗     INCOME STATEMENT

˗     CASH FLOW STATEMENT

FINANCIAL RATIOS

˗     LIQUIDITY RATIOS

˗     ACTIVITY RATIOS

˗     DEBT OR LEVERAGE RATIOS

˗     PROFITABILITY RATIOS

FINANCIAL FORECAST

˗     SHORT-TERM FINANCIAL FORECASTS

˗     LONG-TERM FINANCIAL FORECASTS

˗     CASH FORECASTS

FINANCIAL CONTROLS

INVESTMENT RISK

ANNUAL REPORT

˗     ANALYZING THE ANNUAL REPORT

FINANCIAL MARKETS

˗     STOCK

˗     STOCK INVESTING

˗     MUTUAL FUNDS

˗     BONDS

 

The entire accounting process from beginning to end is called the accounting cycle. The accounting cycle has three parts:

1)     Transaction: A transaction is something your business does that generates a financial impact. Which is then recorded in the accounting system: a journal for example.

·     If a member of your sales staff sells a three-year subscription of your magazine to an anxious customer and then the check for a hundred and ten dollars arrives and is deposited into your company's bank account. That's a transaction.

·       Similarly when your company makes a payment to joe's house of cheese for supplying food for your company's annual picnic, that creates a transaction.

2)   Journal: as each transaction occurs it gets posted to a journal. A journal is nothing more than a general file to temporarily hold transactions until you can classify them by transaction type.

3)     Ledger: on a regular basis daily weekly monthly or other frequency you classify transactions in the journal by type and move them into individual accounts called ledgers.

Individual ledgers include such accounts as payroll, travel and sales. The collection of all ledgers for a company is called its general ledger. After all transactions have been posted to their ledgers managers, have access to a wide variety of reports that summarize the organization's transactions and their effect on the business which include the income statement, balance sheet and so on.

 

THE ACCOUNTING EQUATION

The accounting equation is the foundation of the science of accounting. A day without the accounting equation is like a day without sunshine (At least it is in our CPA's office). According to the accounting equation, assets equal liabilities plus owner's equity.

The following sections break down each part of the accounting equation and how it affects your organization's finances:

 

ASSETS

An asset generally is anything in a business that has some sort of financial value and can be converted to cash. The products you have stocked in your warehouse are assets, they're converted into cash as you sell them; along with the cash in your register which could also be converted into cash; if you sold it on ebay, the microwave oven in the employee break room.

Remember, assets come in two different flavors. These categories represent how quickly assets can be converted into cash:

1)     Current assets

Current assets are assets that can be converted into cash within one year. Think checks that arrive in the mail today, invoices for a month's worth of consulting services or the computers for sale on your showroom floor.

Assets that you can quickly convert into cash also are known as liquid assets and the speed by which you can convert assets into cash is called liquidity.

2)     Fixed assets  

Fixed assets are assets that take more than a year to be converted into cash. Think that custom-built industrial milling machine that only three companies in the world have any use for, the building that houses your headquarters and that finicky old copier down the hall that may now make a better boat anchor than reproduction machine.

Here's a list of the most common kinds of business assets:

·        Cash

Includes good old-fashioned money and money equivalents, such as checks, money orders, marketable securities, bank deposits.

·        Accounts receivable

Accounts receivable represent the money that your clients and customers owe you for purchasing your products or services. When you allow a customer to buy your goods today and pay later, you are creating a receivable.

If you work strictly on a cash basis hot dog stand, ticket scalper e-commerce site, you don't have any receivables and this item will be zero.

·        Inventory

Inventory comprises the finished products that you purchase or manufacture to sell to customers, as well as raw materials work in progress and supplies used in operations.

If you run a grocery store, your inventory consists of every item on display for sale in your store: the carrots, the tubs of margarine, the boxes of donuts and so on.

·        Prepaid expenses

When you pay for a product or service in advance, you create an asset known as a prepaid expense. Examples include a prepaid maintenance contract on a typewriter, an insurance policy with a one-year term paid in advance and an agreement for security alarm monitoring paid in advance on a quarterly basis.

·        Equipment

Equipment is the wide variety of property that your organization purchases to carry out its operations. Examples include desks, chairs, computers, electronic testing gear, forklifts and lie detectors

·        Real estate

Real estate includes assets such as the land buildings and facilities that your company owns, occupies and utilizes. Some companies have little or no real estate assets and others have sizable ones.

 

LIABILITIES

Liabilities are money owed to others outside your organization. They may include the money you owe to the company that delivers your office supplies, the payments you owe on the construction loan that finance your warehouse expansion or the mortgage on your corporate headquarters building.

As with assets liabilities come in two flavors. Each representing the amount of time it should take to repay the obligations.

1)     Current liabilities

Current liabilities are to be repaid within one year. Think of the money for next week's employee paychecks, the payment your company owes to your office supply business and payment on a short-term loan from the bank.

2)     Long-term liabilities

Long-term liabilities are to be repaid in a period longer than one year. Think the payments on the company delivery van, the mortgage on the company's distribution facility or the money owed to holders of corporate bonds.

Here's a list of the most common business liabilities from both the current and long-term categories:

·        Accounts payable

Accounts payable are the obligations owed to the many individuals and organizations that have provided goods and services to your company. Examples include money owed to your computer network consultant, your local utility company and an out of house advertising agency that your marketing department uses for ad campaigns.

·        Notes payable

Notes payable represents loans made to your company by individuals or organizations, such as banks and savings and loans. The notes could be anything: from an iou promised to an individual; for a small amount of cash to a multi-million dollar loan secured from a large bank.

·        Accrued expenses

Sometimes a company incurs an expense but has no immediate plans to reimburse the individual or organization that's owed the money. Examples include future wages to be paid to employees, interest due on loans and utility bills.

·        Bonds payable

When companies issue bonds to raise money to finance large projects, they incur obligations to pay back the individuals and organizations that purchase them.

·        Mortgages payable

When companies purchase property, they often do so by taking out mortgages, long-term real estate loans just like the one you may have on your home. Secured by the property itself, mortgages payable represents the mortgages that an organization has on all its properties.

 

OWNERS EQUITY

Owner's equity is the money that remains when you take all your company's assets and subtract all your liabilities. Owner's equity represents the owner's direct investment in the firm or the owner's claims on the company's assets. Another way of expressing a company's owner's equity is its net worth. Net worth is simply a snapshot of your company's financial health for a particular period of time.

Here are the two types of owner's equity:

1)     Paid in capital

The money that people invest in a company when companies such as ibm ford motor company or pepsico offer to sell shares of stock to investors in a secondary offering, new stock; or when companies do an initial public offering, go public for the first time; investors provide paid in capital to the companies when they pay money to buy the stock.

2)     Retained earnings

A company's earnings that are held within the company. The money gets reinvested not paid out to shareholders as dividends.

Remember, although owner's equity generally is a positive number, it can go negative when a company takes on large amounts of debt: for example, to acquire another company.

 

FINANCIAL STATEMENTS

Reviewing financial statements is a great way to start analyzing a company's Financial Health and its long-term Outlook. However to get the most mileage out of these reports, you need to undertake a deeper level of analysis. You must apply financial ratios to the numbers contained in the balance sheet and income statement and do Financial forecasting.

When it comes to assessing the overall Financial Health of an organization business, people worldwide use three key financial reports. These reports known more precisely as financial statements are the balance sheet, the income statement, the statement of cash flows.

Managers often receive a variety of Financial and project reports tailored to their exact needs. For instance: a software engineer manager may receive a weekly labor report that shows her exactly who worked on the team's software projects, how many hours each employee worked, the cost of those hours and a variance above or below budget; An accounts receivable manager may get an aging list of receivables that outlines who owes money to the company, how much is owed and for how long; and a production manager may receive regular reports on the cost of returned products customers didn't approve of because of quality problems.

Each of these reports offers a unique perspective for looking at a company's Financial Health and no one financial report can tell you the full story. A Doctor Who's faced with a patient who has an undetermined illness doesn't order only a blood test he also orders a chest x-ray and a complete physical examination. The doctor doesn't know which test will reveal the source of the problem so she orders several different tests. Likewise, you come to understand the complete picture of your organization's status only by reviewing all the financial statements and sometimes by digging even deeper for more information.

Who reads financial statements? If you're a manager or business owner, you're probably very familiar with the three major financial statements: A manager or owner's job description is to keep closed tabs on his organization's performance and make changes in the allocation of company resources to maintain a high level of financial return. If you're part of a self-managing work team or if you work for an open book organization, one that shares financial and other performance data with all employees, you two are probably familiar with the financial statements and the information they provide. If you're in one of these positions and you aren't familiar with financial statements then continue on, people in the following lines of work also pay close attention to financial statements:

·        Banks

Banks need financial statements to make judgments on whether to extend loans or lines of credit.

·        Accountants

Accountants require financial information to assess the health of an organization.

·        Investors and financial analysts

Investors and financial analysts need financial statements to determine the attractiveness of a particular organization when compared with a wide range of other investment opportunities.

What do financial statements tell you? Each different type of financial statement exists for a specific purpose and it provides information that other statements don't. In general, financial statements offer their readers the following important status information:

1)     Liquidity: The company's ability to quickly convert assets into cash to pay expenses such as pay a roll, vendor invoices, creditors and so on

2)     General Financial condition: The long-term balance between debt and Equity the assets left after you deduct liabilities

3)     Owner's equity: The periodic increases and decreases in the company's net worth

4)     Profitability: The ability of the company to earn profits Revenue that exceeds costs consistently during an extended period of time.

5)     Performance: The organization's performance against the financial plans developed by its management team or employees

Remember! As you review financial statements for your organization keep in mind that there's no such thing as a good number or a bad number unless you made an entry error. A high profit number may or may not be good news depending on the situation. Similarly, a low Revenue number may not be bad news again depending on the situation.

If a particular figure isn't what you expect it to be, too high or too low, research why the number is different from what you expect. In other words, take the time to look beyond the errand number itself before you suffer a heart attack or fire your sales staff. For example: if profit declined from one period to the next you may view this as a bad thing in fact your boss may say that it's a very bad thing; however, after researching the subject you may find the decline to be a result of your CFO's decision to draw down profits, reduce profits by expenditures elsewhere in the company to minimize the impact of income taxes on your company definitely a good thing.

 

BALANCE SHEET

The balance sheet gives you a snapshot of your organization's Financial Health at an exact point in time, not over a period of time. You use this snapshot to determine the book value of a company's assets and liabilities including Equity at a particular date.

Before we move forward, I have a question for you: do you know what the accounting equation is? Assets equal liabilities plus owner's equity. The accounting equation is the basis for creating the balance sheet: assets include cash and things that you can convert to cash; liabilities are obligations debt loans mortgages and the like owed to other organizations or people; owner's equity is the net worth of your company after you subtract all the liabilities from the organization's assets. In the balance sheet assets are listed in order from the most liquid readily convertible to cash to the least liquid. Liabilities and owner's equity are listed in the order in which your company plans to pay them

Note:

·        You can convert current assets to cash within a year; current liabilities are scheduled to be paid within a year.

·        Remember! Reviewing may changes in your balance sheets over time. Managers, Bankers, investors and so on can pick up on trends that may affect the long-term viability of the irm and that may positively or negatively impact the value of its stock

 

INCOME STATEMENT

Why does a business exist? To leave a lasting legacy in the world; maybe in some cases to employ thousands of people and pull a city or region out of an economic slump that threatens the fabric of the community. That's happened on more than one occasion to save the world. Perhaps the number one reason that businesses exist is to make money, to make a profit for their owners. Because making money is such an incredibly important part of the day-to-day focus of a business.

Companies need a quick and easily understood way to figure out how much money they're making such a tool exists: the income statement. Remember! An income statement also known as a profit and loss statement. A report of earnings or a statement of income and losses gives its readers three key pieces of information:

1)     The businesses sales volume during the period of the report

2)     The businesses expenses during the period of the report

3)     The difference between the businesses sales and its expenses its profit or loss during the period of the report

 

CASH FLOW STATEMENT

Have you ever heard the phrase cash is King? No not queen or Prince; King. For any business cash truly is what matters: it takes cash to pay employees, to purchase supplies, to pay bills and to execute many more business functions. A cash flow statement also known as a statement of cash flows by some, is a specialized report that tracks the sources of cash in a company as well as its inflows money coming into the business and outflows money going out of the business.

The statement is an extremely valuable tool for ensuring that your company has the cash it needs to meet its obligations, when you need it. This can mean the difference between keeping your business afloat and watching it sync.

The business World features a number of different kinds of cash flow statements. Each one suited to a particular business need. Some work best strictly inside a business and some work best outside a business: for investors creditors and other interested parties. Here are a few of the most common types of cash flow statements:

·        Simple cash flow statement or cash budget

Arranges all items into one or two categories. Most often cash inflows and cash outflows.

·        Operating cash flow statement

Limits analysis of cash flows to only items dealing with the operations of a business not its financing.

·        Financing cash flow statement

Includes cash raised by issuing new debt or Equity Capital, as well as expenses incurred for repaying debt or paying dividends on stock

·        Statement of cash flows

Often an external statement that depicts the period to period changes, in balance sheet items and the actual dollar amount for the period in question for income statement items. This statement shows the following categories: operating cash inflows; operating cash outflows; priority outflows such as interest expense and current debt payment; discretionary outflows such as equipment expense; Financial flows, things you borrow or changes in equity.

Remember! Although you can find plenty of different cash flow statements to meet your every mood, whatever you do, don't forget the first and perhaps the most important rule of cash management: happiness is a positive cash flow having a positive cash flow more coming in than going out. Means that you're in a better position to meet your current and future financial obligations

 

FINANCIAL RATIOS

In life and in business, people seek rules or shortcuts that will put complicated processes or data into simple easily understood terms. In that spirit, when looking at a company's financial situation, certainly about as complicated a task as anyone could imagine, business people like to use a variety of financial tools to derive powerful but simple ratios to measure performance. We take a look at these tools in this section.

Remember as you continue through the financial ratios in this section, keep in mind that they can vary. Considerably for companies in different industries manufacturing companies as a group have different ratios than consulting firms or utilities. Be sure that when you compare one company's numbers with the numbers for another, you're comparing apples with apples and oranges with oranges. However, some ratios many of which we explain here are common to all businesses.

 

LIQUIDITY RATIOS

Liquidity ratios are ratios that measure the solvency of a business. Its ability to generate the cash necessary to pay its bills and meet other short-term financial obligations.

·        Current ratio

The current ratio is the ability of a business to pay its current liabilities out of its current assets

·        Quick ratio

The quick ratio also known as the acid test, is a measure of a business's ability to pay its current liabilities out of its current assets. However, the quick ratio subtracts inventory out of the current assets. Providing an even more rigorous test of a firm's ability to pay its current liabilities quickly.

Inventory often is difficult to convert to cash because it may be obsolete or in the case of some fraudulent practices non-existent.

 

ACTIVITY RATIOS

Activity ratios are indications of how efficient your company is at using its resources to generate Revenue. The faster and more efficiently your firm can generate cash, the stronger it is financially and the more attractive it is to investors and lenders and the less likely it is that managers will be laid off.

·        Receivables turnover ratio

The receivables turnover ratio indicates the average amount of time that your company takes to convert its receivables Into Cash. The ratio is a function of how quickly your company's customers and clients pay their bills basically it points out problems that your company may be having in the collections process: average collection period.

You can discover a very interesting piece of information by using your receivables turnover ratio. By divining 365 days by your receivable’s turnover ratio, you find out the average number of days that your company takes to turn over its accounts receivable. This result is known as the average collection period.

·        Inventory turnover ratio

The inventory turnover ratio provides an idea of how quickly your company turns over inventory: sells it off and replaces it with new inventory. During a specific period of time, this number represents the ability of your firm to convert inventory Into Cash. The higher the number the more often you turn over inventory a good thing

 

DEBT OR LEVERAGE RATIOS

For most organizations going into debt is a normal part of doing business that can plug holes when cash flows can't cover all your necessary operating expenses for short periods of time. Debt also allows companies that are growing quickly to finance their expansion. However, you can have too much of a good thing: too much debt for instance, can be a financial drag on any organization. For your measuring pleasure, debt ratios are measures of how much debt a company is carrying and who's financing the debt.

·        Debt to equity ratio

The debt to equity ratio measures the extent to which a company is financed by outside creditors versus shareholders and owners. Here's how it works: debt to equity ratio equals total liabilities divided by owner's equity.

A high ratio anything more than 1.0 is considered bad because it indicates that your company may have difficulty paying back its creditors.

·        Debt to assets ratio

The debt to assets ratio measures how much of a company's assets are financed by outside creditors versus the percentage that the owners cover. In other words, you divide the long-term liabilities you have by your total assets. Debt to assets ratio equals long-term liabilities divided by total assets.

Ratios of up to 0.50 are considered acceptable. Anything more may be a sign  of trouble. Note: however that most manufacturing firms have debt to asset ratios between 0.30 and 0.70

 

PROFITABILITY RATIOS

Except for new startup companies which aren't expected to make money right out of the gate; all companies are expected to generate profit from their operations; and as with sales and revenue, the more profit you generate the merrier your owners and shareholders or investors will be. Profitability ratios indicate the effectiveness of management in controlling expenses and earning a reasonable return for shareholders and owners.

·        Profit ratio

The profit ratio is a measure of how much profit your company generates for each dollar of revenue, after you account for all costs of normal operations. The inverse of this percentage: 100 profit ratio equals the expense ratio or the portion of each sales dollar that's accounted for by expenses from normal operations. The higher the ratio the better.

Remember! The expected ratio can vary considerably from industry to industry. For example: although grocery stores which make money by turning over high volumes of inventory quickly generally are satisfied with profit ratios of just a couple percent; many software developers have profit ratios of 30 to 40 percent or more;

·        Gross margin

The gross margin is an indication of the profitability of a firm to determine gross margin you use your sales revenues and gross profit, which is what's left over after you subtract the cost of goods sold.

·        Cogs

The direct cost of making a product from revenue. Gross product tells you how much you have left to pay overhead costs and make a net profit.

·        Return on investment ratio

Return on investment better known as roi. Is one of the stars of the world of financial tools. Return on investment measures the ability of a company to create profits for its owners the percentage it spits out: represents the number of dollars of net income earned per dollar of invested capital as such.

Roi is of great interest to investors shareholders and other people with a financial stake in your company these folks want to make as much money as they possibly can on their investment dollars. So the higher the return on investment the better.

·        Return on assets ratio

The return on assets ratio also known as roa takes the ebit earnings before interest and income tax that a company earns from the total capital used to create the profit. Here's the way to calculate return on assets: return on assets ratio equals ebit divided by net operating assets.

In this sense, roa indicates the effectiveness of a company's utilization of capital. Acceptable roa ratios vary depending on the industry. For example: ratios below  five percent are generally indicative of asset heavy businesses such as manufacturing and railroads; while ratios of more than 20 percent are indicative of asset like companies such as software and advertising firms.

 

FINANCIAL FORECAST

Have you ever tried to guess what will happen tomorrow or next week or next year in your business? If you can count on one thing in business, it's that nothing will stay the same for very long. In business today, change is a constant. Therefore, savvy business people try to anticipate forecast and predict change before it occurs. And because financial considerations can mean the difference between life and death to a company, financial forecasts and projections are keystones of proactive business management practice.

·        Ask questions similar to the following if you want to prepare accurate financial forecasts for your business:

·        How many employees will we have on board this year and will we have the money to pay them when we need to?

·        Will we have sufficient funds to invest in new manufacturing equipment that will improve the productivity of our workers while increasing output and lowering rejects?

·        How much money will we need to stock up our inventory in time for the holiday season? Will the money be available when we need it?

·        By what amount can we expect revenues and profit to grow or heaven forbid, shrink over the next year?

·        What is the timing of payments from our major customers and how will they affect our cash flow?

These questions and others like them should constantly be on the minds of financial managers, CFOs, controllers, presidents, vice presidents and others who are responsible for ensuring that a business meets all its financial obligations. For this reason, managers conduct regular financial planning and forecasting sessions. There are two key kinds of financial forecasts and projections: short-term and long-term; in addition, many businesses regularly produce cash forecasts to keep closed tabs on the cash going in and out of the company. In the sections that follow we cover all three

 

SHORT-TERM FINANCIAL FORECASTS

If a financial forecast is for a period of one year or less, it's considered a short-term forecast. Many firms use a variety of short-term financial forecasts and pro forma informal financial statements to manage day-to-day operations.

These types of forecasts and financial statements include: cash, sales or revenue, profit and loss, income statement, balance sheet, receivables. Each of these short-term forecasts and others that an organization may select is important to the people in charge of monitoring a company's near-term financial position

 

LONG-TERM FINANCIAL FORECASTS

If you need to plan for a period that extends more than a year into the future, long-term Financial forecasts are just what the doctor ordered. But given how fast the business environment is changing why would you want to make plans for more than a year into the future? Won't things change at least five or ten times before? Then of course they will, but part of financial planning is planning for change.

Remember! Done Right, long-term plans can provide your business with a definite competitive Advantage. How? By giving your business focus and Direction. Business owners typically have a vision for where they want their companies to be in, say 10 years, so it makes sense to think about the financial Milestones you should cross along the way. In short, long-range plans require long-term Financial forecasts to support them. Although they can never be as accurate as short-term forecasts, they're often better than nothing.

Just as with short-term Financial forecasts, you can forecast all kinds of financial data into the future. Here are some of the most popular kinds of financial data subject to a long-term look: cash, sales or Revenue, profit and loss, income statement, assets liabilities and net worth, balance sheet.

Although long-range forecasting can help you support your long-range plans, the further out you forecast the more likely your figures will be inaccurate. That's why it's important to base your forecasts on sound numbers and an understanding of business trends.

Long-term Financial forecasts are comprised of much the same information as short-term forecasts, just with much longer Horizons. These longer Horizons require careful attention to long-range Trends in markets and technology and they assume the possibility of Greater swings. Here are some tips for putting together accurate long-term Financial forecasts:

·        Look for long-term trends in revenues and expenses  

Are your revenues and expenses gradually trending up or down over a period of five years or longer? Chart these Trends as graphs and make an educated guess as to where the trends will lead in the future.

·        Determine whether there are any business Cycles

A business cycle is a periodic variation in the economic activity, of your business resulting from such things as consumer demand which may rise in anticipation of the holidays and decline immediately thereafter. Many businesses and markets go through regular business Cycles. By looking at the big picture you should be able to pick out the cycles and Factor them into your long-term Financial forecasts.

·        Figure out what kinds of random events are most likely to disturb the long-term trends in revenues and expenses.

What would happen if your company bought out a key competitor? How would that affect revenues and expenses? What if a competitor develops a new process that cuts its cost of production in half? Random events are just that random by Nature they're hard to predict but the more you factor them into your long-term Financial forecasts the more accurate your forecast will be.

 

CASH FORECASTS

By far, the most important forecast for most companies is the cash forecast. As you can see, this type of forecast shows up in both short and long-term predictions. In business cash makes the world go round, especially for young startup companies. Cash or the lack thereof can mean the difference between success and failure.

Remember! Using similar cash forecasts, companies can determine when they'll be taking in more money than they pay out to meet their obligations. They can use this knowledge to guide many decisions such as when and how much to pay vendors; what levels of inventory can they comfortably keep in stock; timing investments in capital equipment.

The second part of the financial management process is the development and execution of budgets. Budgets are similar to financial forecasts, but much more detailed. Remember by comparing the budgeted totals versus the actual results you can quickly grasp exactly where company performance is better or worse than anticipated and redirect your resources accordingly.

 

FINANCIAL CONTROLS

Accounting systems and financial statements and reports are wonderful things. But they aren't worth the software they're built from nor the paper they're printed on if no one analyzes and interprets them. Numbers by themselves mean nothing. Numbers with context and justification mean everything.

Remember! The whole point of preparing financial forecasts and budgets is to attempt to predict future performance while creating baselines by which you can compare actual results. If results you experience are as predicted, terrific! You're right on track toward your goals. If the actual results are significantly less or significantly more than predicted however it's time to look for the sources of these variances.

Here are some ways that you can analyze your company's performance against expectations:

·        Variance analysis

By comparing your organization's actual results versus its budgeted results. For example: your actual revenues versus budgeted revenues you get a quick picture of whether your company is on or off track and by how much.

·        Ratio analysis

By comparing certain financial results within your company's financial statements particularly the income statement and balance sheet you can determine whether your company is operating within the normal limits for your industry. For example: dividing your company's current assets by its current liabilities results in a ratio.

·        The quick ratio

That tells you whether your company is solvent and can meet its financial obligations to your lenders.

·        Cost volume profit analysis

By determining what products or services are the most and the least profitable for your company, you can make decisions about where to invest your company's time and resources. There are a couple key approaches to cost volume profit analysis.

·        Break even analysis

A break-even analysis be allows you to determine at what sales volume you can earn a profit after paying all the expenses of producing your product or service. Be is the point at which the cost of the product or service equals the sales volume. Everything above that point is gross profit.

Using electronic spreadsheets you can run all sorts of what-if scenarios with a variety of different cost and price assumptions.

·        Contribution margin analysis

Contribution margin analysis compares the profitability of each of your company's products or services, as well as the products or services relative contribution to your company's bottom line. This analysis quickly points out underperforming products and services that your company should either restructure or terminate.

If your company is underperforming, you can redirect resources to boost performance or you can change plans to bring your expectations in line with reality. If your company is over performing you can identify the reasons why and do more of the same. At the same time, you can modify your budgets upward to accommodate the improved performance.

 

INVESTMENT RISK

As every manager and business owner knows, a company has limited resources to fund Capital Investments. Long-term investments in assets such as manufacturing equipment, office equipment, buildings and so on. Therefore, a company must analyze Capital Investments by using a set of simple mathematical equations. Equations that are part of the basic toolbox given to MBA students around the world. Managers and Executives regularly use these equations to help guide their investment decisions.

·        Net Present Value

Net Present Value (NPV) is the anticipated profitability of a particular investment. Considering projected cash flows discounted by a risk factor that takes into account inflation level of risk and returns required. In simpler terms, you compare a dollar invested today to projected dollars generated from the investment at some point in the future (the time value of the money). By calculating npv you can determine whether your company should pursue a particular investment in Capital Equipment or other assets.

Following is the official formula for calculating Net Present Value. However we suggest that you bypass much of the heavy lifting here by using tables readily available on the net or in financial reference books to obtain your discount rates, then you can simply multiply the discount rates from the tables times your annual cash flows to calculate npv.

¾    T is the time of the cash flow

¾    N is the total time of the project

¾    R is the discount rate

¾    C sub T is the net cash flow (the amount of cash at time t)

¾    C Sub Zero is the capital outlay at the beginning of the investment time  T equals zero

¾    Npv minus n over Sigma over T equals one

¾    Times C sub T over open parentheses 1 plus r close parentheses to the power of T minus C Sub Zero

Remember! When working with npv, you need to keep the following points in mind:

¾    When NPV is greater than zero the investment is adding value to your firm. If it offers more value than competing Investments, you should pursue it.

¾    When NPV is less than zero the investment is taking value away from your business and you should reject it.

¾    When NPV equals zero there's usually no advantage to pursue the investment unless you're investing for other factors such as positioning in your industry or securing important customers.

 

·        Internal rate of return

Internal rate of return (IRR) is another approach to determining whether the return of a particular investment makes it worthwhile to pursue. RR is simply the rate of return that the investment produces or the reward for making the investment.

IRR is related to the NPV. In that, it represents the discount rate in which the NPV of a cash flow stream inflows and outflows equals zero. In fact IRR and NBV are two sides of the same coin. With NPV you discount a future stream of cash flows by your minimum desired rate of return; with IRR you actually compute your break even rate of return. Therefore you use a discount rate above which you'd have a negative NPV and a poor investment and Below which you'd have a positive NPV and a great investment, all things being equal.

IRR often is used to compare a potential investment against current rates of return in the Securities Market.  When calculating IRR you make the present value of an investment's cash flow equal to the cost of the project.

·        Payback period

The payback period equation gives you a way to calculate how long it will take to earn back the money from a particular investment. You calculate payback period by using the following formula: a back period equals investment divided by annual cash inflow.

·        Profitability index

Profitability index also known as the benefit cost ratio gives you a way to evaluate different investment proposals that have determined Net Present values. You calculate profitability index by using the following formula: profitability index equals present value of future cash flows npv divided by initial investment. The higher the profitability index moves above 1.0 the better the investment is for your firm.

 

ANNUAL REPORT

The point of the annual report is to provide a summary of exactly how a company has performed in the preceding year, as well as to provide a glimpse of the future. The report is the best source of information for most people to determine the financial health of a company and to learn of any potential problems or opportunities.

Building a compelling annual report is a real art and science affair. And more than a few consulting firms are doing very well by hiring themselves out to create reports for all kinds of companies.

Reading an annual report can be a daunting prospect if you don't know exactly what you're looking for and where to find it. The good news however is that most reports are now standardized around a common model of nine key parts. This organization makes it easy to review any company's annual report after you get the hang of it. Here are the nine parts generally presented in the following order:

·        Letter from the chairman

The letter from the chairman of the board is the traditional place for a company's top management team to explain what a great job it did during the preceding year and to lay out the company's goals and strategies for the future. The letter also is a great place to find apologies for problems that occurred during the year which may or may not have been solved.

·        Sales and marketing

This section contains complete information about a company's products and services as well as descriptions of its major divisions and groups and what they do 10-year summary of financial results. If the company is at least 10 years old its annual report contains a presentation of financial results during that period of time.

This section is a terrific place to look for trends in growth or non-growth of revenues and profit and other leading indicators of a company's financial success

·        Management decision and analysis

This section is the place where a company's management team has the opportunity to present a candid discussion of significant financial trends within the company during the past couple years.

·        Letter of CPA opinion

To be considered reliable, a company's financial statements have to be reviewed and audited for accuracy by a certified public accountant (CPA). In this letter, a CPA firm states any qualifications that it has with the company's financial statements. These statements can have great bearing on the reliability of the data or of management's assessment of it.

·        Financial statements

Financial statements are the bread and butter of the annual report. This section. Is where a company presents its financial performance data. At a minimum, expect to see an income statement a balance sheet and a cash flow statement.

·        Tip

Be sure to watch for footnotes to the financial statements and read them carefully you often find valuable information about an organization structure and financial status that hasn't been publicized elsewhere in the report. For example: you may notice information on a management reorganization or details on a bad debt that was written off by the company.

·        Subsidiaries brands and addresses

Here you find listings of company locations: domestic and foreign, as well as contact information, brand names and product lines.

·        List of directors and officers

Corporations typically have boards of directors senior business people from both inside and outside the organizations to help guide them and provide a broader view of markets and business environments than what's seen by internal managers officers include the president chief executive officer ceo, vice presidents, chief financial officer cfo and so forth.

·        Stock price history

This section gives a brief history of the company's stock prices and dividends. Showing upward and downward trends over time included is information on a company stock symbol and the listing stock exchange. For example: the new york stock exchange, nyse or nasdaq.

If you want to read a company's annual report but can't find it you can go online. With the help of online search engines, finding a company's annual report is easier than ever. Many companies also have investor relations pages on their website where you can find copies of annual reports and quarterly filings with the securities and exchange commission.

 

ANALYZING THE ANNUAL REPORT

An annual report is the best tool that the public has to review the performance of a company. Most annual reports contain plenty of useful information. But now that you have all this terrific info, what should you do with it? You can analyze the information in a report to get a sense of the near and long-term health of a firm. Here are some definite musts when it comes to reading and analyzing an annual report:

·        Review the company's financial statements and look for trends in profitability growth stability and dividends.

·        Read the report thoroughly to pick out hints that the company is poised for explosive growth or on the brink of disaster. Places to look for such hints include: the letter from the chairman, the sales and marketing section and the management discussion and analysis, of course it also pays to keep an eye on the company through the business press and analyst reports.

·        Carefully read the letter of cpa opinion be sure that the firm agrees that the company's financial statements are an accurate portrayal of its financial reality.

·        Carefully read any footnotes to the financial statements. These footnotes often contain information about company assumptions that can be critical to a full understanding of the financial statements.

 

FINANCIAL MARKETS

The financial Market in which Securities are traded such as stocks and bonds is divided into two segments: a secondary Market which consists of existing securities; a primary Market which consists of new Securities created when companies seek investment capital in exchange for equity in their companies.

Within the secondary Market, you find the major stock exchanges that you often hear about in the news: the New York Stock Exchange NYSE, the American Stock Exchange Amex the NASDAQ stock market, the Tokyo Stock Exchange TSE and the Australian Securities Exchange ASX. You also find dealer or over-the-counter Market OTC where Securities are not listed on an exchange but are traded through a network of middlemen and numerous Futures exchanges for trading Commodities such as crude oils, soybeans and gold.

Most people think of the New York Stock Exchange NYSE when they think of the stock market. The NYSC is the largest Exchange in the world and only companies that meet specific and minimum requirements on earning power. Total value of outstanding stock and number of shareholders can join.

What exactly do we mean by a stock exchange? A stock exchange is simply a voluntary organization that's formed to provide a way to trade Securities and facilitate the payments of dividends and income. The members of the stock exchange owned seats on the exchange and they're the only people who can trade on the floor of the exchange. The memberships in the exchange are traded and their prices vary with the stock market ups and downs. Orders to buy and sell always go through members of The Exchange.

In exchanges that have trading floors such as the NYSE, you see a form of Controlled Chaos. The floor of a stock exchange is an actual place and it's a hotbed of activity. If you visit the floor of the NYSE, you'll see that it contains an enormous amount of communications equipment and computers because the members must have access to information from the outside as well as the capability to handle stock transactions from investors. You'll also see a variety of people on the floor from actual investors to wire Services people, exchange employees and brokers who take orders from the public at times, it looks as though they're all shouting at each other, but bona fide trading is actually going on.

Another type of secondary Market is the over-the-counter Market OTC in this market no trading floor exists and securities don't need to be registered with the SEC.  Traders are scattered around the country and their buyers deal directly with them. The Traders are much like retail. Stores that keep an inventory of stocks bonds. Commodities or derivatives for sale. A derivative is basically a security such as an option right to buy or Futures Contract contract to buy or sell at a specific date, whose value depends on how its underlying asset performs. Derivatives can be contracted for stocks, bonds, currencies and commodities, among other things.

The NASDAQ Market, a third type of secondary Market is the NASDAQ or National Association of Securities dealers automated quotation Market you may know it as the home of most high technology companies such as Electronic Arts and of course most of the big internet companies such as Yahoo and Google. NASDAQ is a derivative of the OTC market. But unlike the OTC, NASDAQ Securities must be registered with the Securities and Exchange Commission SEC. The

NASDAQ is the largest U.S electronic stock market and trading takes place via computer and mostly without telephone assistance. Many people trade on the NASDAQ via their computers, through discount brokers or at locations set up by companies with access to the exchange.

The PC and the internet have opened up a whole new category of stock investor: the day trader, an individual who buys and sells multiple times in a single day to make quick profits. However day Traders typically work on borrowed money which can be very risky if their bets don't pay off. Day trading is like gambling: If you have the stomach for it and the enormous amount of time it takes to monitor the market day, trading might be for you. Just make sure that you're trading with money you can afford to lose or you may be in trouble very quickly.

 

STOCK

A stock is essentially an ownership interest in a company that may be private or public and listed on one of the stock exchanges. Owning stock is a way to participate in the economic growth of the nation as well as the global economy. Purchasing stock traditionally is a great way to hedge inflation and achieve good returns on investments over the long term. Remember! The general rule is that you'll make money in stocks if you hold them at least five years.

Types of stock: two basic types of stock exist: preferred and common. Each is quite different from the other, so it's important that you understand these differences before you purchase.

·        Preferred stock

In general, preferred stock doesn't carry voting rights in a company but it does have a guaranteed dividend or payout usually quarterly that's a percentage of its par value. That guaranteed dividend is what you receive for giving up voting rights par value is simply the face value of the stock at purchase or at the date at which dividends are declared.

·        Common stock

Common stock is the basic form of ownership in a corporation. No corporation can exist without it. Common stock has what's known as a residual claim on the assets of a company. Residual claim means that common stockholders get paid after all other claimants are paid. Consequently common stock is more risky than preferred stock. But the shareholders liability is limited to the amount of the shareholders investment in the company. Common stockholders enjoy cash dividend rights and voting rights and they may also benefit from stock dividends and stock splits.

With a stock dividend, the company issues stock rather than cash. Usually as a percentage of the shareholders existing shares. For example, a company may issue 0.08 shares for each share an investor owns. In a stock split, the percentage increase in the number of shares you hold, goes up by more than 25 percent. Suppose that you hold 100 shares of stock in xyz corporation trading at sixty dollars a share, making the total value of your holdings six thousand dollars. Now suppose that the company declares a two-for-one stock split: this means that you now hold 200 shares but they're valued at thirty dollars each at the time of the split.

Remember! One reason companies choose to do stock splits is to keep their per share values at a level most investors can tolerate. It's conceivable that if a company didn't split its stock: the price could go beyond the affordability of most investors.

·        Stock quotes

A stock quote is simply a listing of prices for a stock at a specific point during the trading day. It provides the basic information you need to check on the status of any stock in your portfolio.

·        The peony ratio price per earnings

Which is the market value per share divided by the earnings per share. Typically reflects the company's last four quarters of earnings. A high peony ratio normally forecasts higher earnings growth in the future: making it a good way to compare one company with another within the same industry, sometimes called a multiple the ratio, tells you how much investors will pay per dollar of earnings.

Remember when investing don't ever make a decision to invest based solely on peony ratio, because the figure is only as good as the basis on which the earnings were determined. You need to go back to the financial statements to check how earnings were calculated the peony ratio is just one metric to consider before making a decision.

 

STOCK INVESTING

Everyone has an opinion on the best way to pick a winning stock. This section explains in detail three popular strategies for picking stocks value investing going for dividend growth and picking businesses you like.

·        Value investing

If you're the kind of person who never buys a new car so you can avoid the immediate depreciation and value as you drive it off the lot, or if you're the kind of person who spends hours looking for the best bargain; value investing may be for you.

Value investors in the stock market look for cheap stocks that don't make the news because either everyone has left them for dead or they're just not sexy enough. Well, some cheap stocks may make the news if they're particularly bad, but for the most part you'll find these stocks by looking for ugly boring securities with low price per earnings ratios: less than 10 times earnings during the past year. You also can discover them by looking for stocks that the analysts aren't crowding around.

Remember! Deciding when to buy is more art than science, but if you determine that a stock is a great, buy at 10. You can deduce, that it's an even better, buy hand eight. With a great stock you should buy more as it's going down and sell off when it goes up past your lowest average cost. Unfortunately, most investors do just the opposite they sell off a good stock as it's going down in price and buy as it's going up.

·        Investors seeking dividend growth

Investors seeking dividend growth aren't interested in the current yield on a stock. They're more interested in finding companies whose dividends increase on a regular basis during a long period of time. Rising dividends often are the signs of a successful company, because you need excess cash to distribute dividends. A regularly rising dividend, may indicate a friendly and somewhat stable business environment a very positive indicator.

Remember! Of course you don't want to focus on growing dividends in a vacuum, you also want to look at a company's peony price per earnings ratio to make sure that it's in line with other companies in the industry. The peony ratio is the ratio of the price of one share of stock to the earnings per share of the company. It's a multiple such as 5 or 10.

If a company you're considering for investment purposes has a multiple of five times earnings per share while similar companies in the industry have multiples of 10 times earnings per share, you may want to do some further investigation to find out why such a discrepancy exists.

·        Investing in companies you like

The strategy of investing in companies you like, is one followed by some very successful investors such as warren buffett, charlie munger and peter lynch. The strategy is to invest in companies that have products and services you use and believe in. The interesting thing about such companies is that they often also meet the criteria we discuss in the value investing section. So combining value investing with this strategy makes sense.

Here's how to make this strategy work for you: think about a product or service you currently use, investigate the company that makes it and determine whether the manufacturer is a public company; determine whether other people have also discovered this company. To find out, compare its price per earnings pe ratio, with its current growth rate or projected growth rate, typically you want to stock with a peony ratio lower than its earnings growth rate; call the company to ask about projected profits and anything else that may help you make a sound investment decision. Most public companies have designated shareholder liaisons who will answer your questions and see to it that you receive any materials you want to study.

 

MUTUAL FUNDS

A mutual fund is a portfolio of stocks that's managed by a professional company. Investing in a mutual fund is a way to avoid the risk of picking individual stocks. Fund manager strategy for selecting stocks depends on the goal of the mutual fund: growth, annuity and so forth. But in general, the manager wants to spread the risk over a fairly large number of stocks so that a loss on anyone's stock does not significantly damage the return on the entire fund.

Mutual funds are also probably the safest and least costly way to invest in lucrative foreign stocks which have different fee structures and reporting requirements. Mutual funds are very popular investment vehicles for several other reasons:

·        Finding the best mutual fund is now easier because many publications in print or on the internet are evaluating various funds and giving advice to consumers.

·        You can rely on the expertise of a professional money manager hired by the mutual fund.

·        You can achieve a diversified portfolio: one with a variety of different types of stocks and bonds. In other words, with relatively little money. Although you may not beat the averages in the short term you'll do well over the long term.

Warning! One substantial disadvantage of mutual funds has to do with the associated tax implications. When you invest in mutual funds, you receive an annual statement of investment gains in the form of income and capital gains distributions, as well as a report on any dividend distributions. Which are taxed as ordinary income. Whether or not you reinvest these gains, you have to pay taxes on them and it's difficult to know in advance how much you'll be liable for. If you invest in individual stocks on the other hand, you can decide when to take profits and when to pay taxes on them.

So many mutual funds, how can you possibly choose? Here's a simple guide to follow:

·        Decide which types of funds you want to own. Among the many choices are a single broad-based fund, that buys a variety of different types of stocks and bonds: specialized funds for example, high growth funds, foreign stock funds, an emerging market fund that focuses on new markets and newer companies. The choice of fund will depend on your financial goals, how old you are and how much you have to invest.

·        Identify the costs associated with the fund. Recognize that foreign stock funds generally have higher costs for instance. Don't choose funds that have costs higher than industry averages. Look at what other funds of the same type are charging.

·        We also suggest you look seriously at no load funds. These funds charge no sales fees and don't use brokers to deal with the public. All your money is invested in the fund.

·        Consider the risks associated with the fund. With a more diversified stock fund, you can better manage your risk, you can even choose funds that invest exclusively in more conservative stocks.

·        Look at the funds track record. Be sure to compare apples to apples or in stock funds with foreign stock funds for instance. Also make sure that the overall performance figure of the fund isn't based on one or two years. A good fund has consistently performed well over a protracted period of time.

·        Find out who's managing the fund. Every fund has one person who's a key stock picker make. Sure that this person has a successful track record and plans to be around for a while.

Remember! Mutual funds aren't perfect financial vehicles for investment. They often underperform the market while demonstrating fairly erratic performance behavior in general. Nevertheless if held over a long period of time, say 20 years or more, with regular investment, they'll typically outperform most professional investors. The key is holding them for a long time.

 

BONDS

Bonds are debt Securities, where the issuer of the bond promises to repay the holder of the bond: you, the principal, what was borrowed and interest at some future date. Unlike stock, the bondholder doesn't have Equity or an ownership stake in the company or governmental agency that issues the bond.

Basically three types of entities issue bonds: the U.S government, corporations and municipalities.

·        U.S government bonds

The U.S government is the largest debtor in the world: about nine trillion dollars as of press time. And you thought you had a lot of debt? The government borrows more money than anyone, through two types of debt instruments: treasury debt and federal agency debt.

¾    Treasury debt

We assume many of you have purchased treasury bills: t-bills notes and savings bonds. They're all debt instruments but they differ in their maturity date.

If you look at the Returns on bills and bonds over a long period of time, you find that treasury bill investors have never lost any money. Because the government typically pays these on time. On the other hand, those who have invested in treasury bonds have experienced the loss in a given year. Even though the government actually paid the bonds when due. What this means is that: in a year with a loss, the decrease in the bond price was greater than the interest income the investor received.

You can find out what the various treasure instruments are paying by looking in the financial section of a major newspaper such as the Wall Street Journal or the Los Angeles Times or by going online. Treasuries are sold through more than 150 competitive auctions throughout the Year.

¾    Federal agency debt

Many federal agencies called government-sponsored Enterprises or gses issued debt. Some include the government National Mortgage Association gnma pronounced Ginny May, Federal home loan Banks, Federal Farm Credit system Banks and the U.S Postal Service. Experts estimate that there's 2.3 trillion dollars in current outstanding agency debt, which is equivalent to the economies of several countries.

·        Corporate bonds

Corporate bonds are the smallest sector of the bond markets. This type of debt is issued by large corporations that promise to make payments to the bondholder over a period of time. In this type of investment, it's important that you check on the corporation's ability to repay. You can do this by looking at the standard and Poor's or Moody's Bond rating. The rating should give you an idea of how much risk you're facing.

·        Municipal bonds

Municipal bonds are issued by governments and governmental or quasi-governmental agencies that aren't at the federal level. The important thing to know about municipal bonds is that: they're exempt from federal income taxation which makes them very different from other types of bonds. Because they aren't taxed. Municipal bonds are most valuable to investors who want to enjoy that extra benefit from a bond investment.

To give you an example of the benefit: it's possible to achieve the same after tax return from a low-yield municipal bond that you do from a high yield taxable Bond. When you compare bonds that have the same interest rate and maturity, you should choose the one that has the highest after tax return.

How bonds are valued:

Bonds generally come in two flavors, pure discount bonds also known as zero coupon bonds and coupon bonds. The difference is simple zero coupon bonds make no payments to the holders between the dates they're issued and the maturity dates. In other words, you get nothing until the end coupon bonds make a series of equal payments throughout the life of the bonds. So if you are looking for an annuity, this is the way to go.

Remember! As soon as a bond is trading in the bond market, its future payouts are decided and the only thing that changes is the asking price. Your yield to maturity will go up if you can buy the bond at a lower price because bond prices and yields move in opposite directions.  

The amount that a bond pays at maturity is called its par value or Face Value, the discount amounts to the difference between the selling price of the bond and its par value. Whenever you're dealing with financial assets such as bonds, you need to understand that the price of a bond is equal to the present value of any future cash flows generated by the bond.

How bonds are rated:

Bonds are rated from AAA to D, depending on the rating agency. In general, a bond That's rated A is the most secure given, whatever fluctuations may occur in the economy. If your bond is rated in any of the B categories, there's a chance that your issuer May default on the interest payments. Bonds rated below Triple B are called Junk bonds and are pretty precarious Investments for the average person.

The two major rating agencies are Moody's and standard and Poor's. Many investors like bonds because they provide more immediate income than stocks; in terms of performance, they tend to be less volatile than stocks and they often climb while stock prices are falling; in addition, tax-free municipal bonds are one of a Dying Breed of tax shelters.

Every investment has a downside and bonds are no exception. Here are the four major negatives related to bonds:

1)     Companies and governments sometimes default on their interest payments. What that means to you, is that you get hit twice. You lose your income stream and the price of your bond may drop as well. To avoid this problem, be sure to select highly rated bonds. Bonds that are rated AAA are about as safe as those issued by the U.S treasury.

2)     Interest rates rise. Bond prices are inversely correlated with interest rates. That is when interest rates rise, bond prices fall and the earlier that happens the greater the loss to you.

3)     Investment costs are high. Not only do you have to invest in larger dollar amounts with bonds, but there are also fees associated with Bond purchases.

4)     Bonds are sometimes called or paid off before they mature. Sometimes Bond issuers choose to pay off the debt before the maturity date of the bond. For the bondholder or investor, this situation can cause a problem. Particularly if interest rates have dropped. When you go to replace the bond with another, you may not be able to find an equivalent interest rate