Solution Manual for Principles of Corporate Finance 14th Edition by Richard B...
The Concept of a Balance Sheet
1. The concept of a balance sheetExercise1
What I HAVE What I OWE
2. Exercise1
What I HAVE What I OWE
House
Car
Furniture
Equipment
Savings
“Petty” Cash
Mortgage
Car loan
Equipment loan
Invoices
Overdraft
The concept of a balance sheet
3. Exercise1
What I HAVE What I OWE
House 100
Car 10
Furniture 30
Equipment 20
Savings 10
Petty Cash 5
Adding up 175
Mortgage 65
Car loan 5
Equipment loan 10
Invoices 5
Overdraft 10
Adding up 95
The concept of a balance sheet
4. Exercise1
What I HAVE What I OWE
House 100
Car 10
Furniture 30
Equipment 20
Savings 10
Petty Cash 5
Total 175
Net worth 80
Mortgage 65
Car loan 5
Equipment loan 10
Invoices 5
Overdraft 10
Total 175
The concept of a balance sheet
5. Exercise1 The concept of a balance sheet
Assets =Liabilities +Net Worth
(Equity)
What about income and expenses?
6. Revenues (Income) 1000
- Mortgage loan repayment 300
- Car expenses 50
- Heating, electricity,… 100
- Various expenses 100
- Taxes and Soc. Sec. 400
Revenuesandexpenses
Net income / Savings 50
Where did the money go?
7. The charges to the P & L
Net Result
TheP&LAccount
Other
operational
income
Gross
margin
Added
Value
Gross ops
profit
Profit before
taxes
Goods
& services
Personnel
-expense
Other ops
expenses
Amortisa
tion
EBIT
Financial
expenses
Taxes
Result of
Operations
Financial
Income &
exceptional
Gross
Profit
Other
income
8. P & L N-1 EURO N
Turnover (1)
Purchased goods
- Inventory
= Cost of goods sold (2)
Gross margin (3)=(1)-(2)
+ Other business related income
= Income from operations (4)
- Goods and services (5)
= Added Value (6)=(4)-(5)
- Personnel expense
- Other operational expenses
= Gross operating income
+ Financial revenues
+ Exceptional results
= Gross total revenue (EBITDA)
- Amort., provisions, depreciations
= EBIT
- Financial expenses
- Taxes
= NET PROFIT
ExceptionalExceptional
OperationsOperations
InvestmentsInvestments
FinancingFinancing
Key elements of a P & LTheP&LAccount
10. The balance sheet of a bank
ASSETS LIABILITIES
Differentbalancesheets
What the bank HAS What the bank OWES
11. Example :
The opening balance sheet of a company
Assets Liabilities
Short term asset Net worth
The methodology of double entry accounting
Doubleentry
16. The double entry accountingTOREMEMBER
Asset accounts
D
Increase Decrease
Liability accounts
Decrease Increase
Charges Revenus
P & L Account
17. Barca
P & L account (Income statement)
Revenue 240,000
Cost of materials -80,000
Salaries -48,000
Other operating cost -22,000
EBITDA 90,000
Depreciation -6,250
Op. income EBIT 83,750
Tax -27,638
Net income before div. 56,113
18. Barca
Cash flow
Payments from clients 156,000
Cost of goods sold -77,000
Salaries -48,000
Other op. expenses -22,000
Cash flow from ops 9,000
Cash flow for investments -25,000
Available cash flow
disponible
-16,000
Capital increase 50,000
Dividends -2,000
Cash flow from financing 48,000
Cash flow 32,000
19. Barca
Balance
Fixed assets 18,750
Inventory 15,000
Receivables 84,000
Cash 32,000
Total assets 140,750
Capital 50,000
Ret. Earn. 50,113
Net worth 100,113
Tax due 27,638
Payables 18,000
Div. due 4,000
Liabilities 49,638
N.W. &
Liabilities
towards
third parties
149,750
The following slides are an illustration of what was stated in relation to the EVALUATION OF ASSETS and the impact on the NET WORTH
This is quite a remarkable slide
It shows the P & L statement in a different manner
Look at all this hard work and what is finally left over after taxes
FOR OUR DEALER LESS THAN 1% OF HIS TURNOVER IS LEFT FOR HIM
Now we should really company to what is left over with his initial investment
The return on investment for our car dealer is about 12 to 15 %, in other words it is still worth being a car dealer
Below 7% he better puts his money to fruition somewhere else and enjoy himself rather than working as hard as he is doing
As you can see the Income statement also called the Profit & Loss Account is structured in 4 parts to show income and charges as a result of
Operations
Exceptional items (for instance head quarters have been sold)
The results (positive or negative) of the investments made by the company
The financial cost and taxes
The purpose to structure a P & L that way is to make comparison possible and show if the money is coming from operations or anything else
As you can see the P & L has its own vocabulary
Turnover – cost of goods sold = GROS MARGIN
GROS MARGIN + OTHER BUSINESS RELATED INCOME = INCOME FROM OPERATIONS
INCOME FROM OPERATIONS – GOODS AND SERVICES = ADDED VALUE
ADDED VALUE – PERSONNEL EXPENSE & OTHER OPERATIONAL EXPENSES = GROS OPERATION INCOME
GROS OPERATING INCOME +/- EXCEPTIONAL ITEMS = EBITDA (Earnings before interest and taxes and before depreciation and amortisation)
EBITDA – AMORTISATION & DEPRECIATIONS & PROVISIONS = EBIT (Earnings before interest and taxes)
EBIT – INTEREST AND TAXES = NET PROFIT
You have to get used to both the terminology and the lay-out
Participants should be in a position to put on paper the basics of a balance sheet of a bank
I WOULD SUGGEST ANOTHER EXERCISE HERE ON DEBITS AND CREDITS
THEY FOLLOW THE SAME CONVENTION AS EARLIER BUT A BANKER THINKS DIFFERENTLY THAN HIS CUSTOMER DUE TO THE FACT THAT WHAT REPRESENTS AN ASSET FOR A CUSTOMER IS A LIABILITY FOR A BANK
When a person puts money in his or her account that person increases his or her assets held at the bank
That same transaction for the bank means that the indebtedness from the bank towards the customer increases
The bank will consider that the money of the customer is a liability
When a liability account increases we talk about a CREDIT
Therefore the banker will say to the customer that the account has been credited
When a bank pays by means of the account a telephone bill, this means that the LIABILITY TOWARDS THE CUSTOMER DERCREASES this means a DEBIT
The bank does not think differently than the customer it is just that what the customer puts on his balance sheet as an asset is put on the banker’s balance sheet as a liability and the other way around
When a customer borrows money from the bank this borrowed money is a liability for the customer and an asset for the bank!
When a bank extends a loan this means an asset account that is increased thus a DEBIT and for instance a CREDIT to the treasury account
The key accounts of the balance sheet of a bank are shown on the next slide
Their source is the CSSF and the figures are aggregated figures for the Luxembourg banking system
Source www.cssf.lu
THIS IS THE WAY IT IS DONE
WHEN A ASSET ITEM INCREASES IT MEANS A DEBIT
Say you get a 500 bill that you have to put into your « petty cash » (cash on hand – it is always an asset item in opposition to treasury which is a broader concept and can be either positive or negative) – this would mean an accounting entry which would start as
DEBIT PETTY CASH 500
CREDIT…..500
What you HAVE is an ASSET and when it INCREASES we talk about a DEBIT
What we OWE is a LIABILITY and when it INCREASES we talk about a CREDIT
Debits and credits are conventions and allow for the double entry concept and for the balance of a balance sheet
Example : My telephone bill of 150 comes in – this means that I have A LIABILITY which INCREASES this means that the accounting entry will be
DEBIT ……150
CREDIT ELECTRICITY SUPPLIER 150
We will see later what we credit and debit and how
As stated there is often a confusion due to the bank terminology whereby the bank considers that your asset is its liability
So when YOUR MONEY IN YOUR BANK ACCOUNT INCREASES IT MEANS AN INCREASE OF THE LIABILITY OF THE BANK TOWARDS YOURSELF AND THEREFORE THE BANK TALKS ABOUT THE FACT THAT YOUR EXTRA MONEY MEANS FOR THEM A CREDIT TO YOUR ACCOUNT HELD WITH THEM
But let us forget about banks for now and think like an entrepreneur or a private citizen
Summary
When an asset account increases the convention is that we DEBIT
Wen a liability account increases the convention is that we CREDIT
IN fact, the only thing you need to remember is the first sentence and the fact it is the opposite for the liability accounts
It is therefore essential to know if an account is a asset or liability account
We have general agreed standards for that like in Belgium we habe a Belgian Accounting Plan or a GAAP general accepted accounting practice and each account has a specific number
For instance the 1… accounts are for equity and reserves,; the 6 ….. Accounts are for charges and the 7….. For revenues and so on
The balance sheet of the EIB is based on the IFRS schedule or the International Financial Reporting Standards
Those standards gain universal acceptance and even the USA is leaning towards the use of these standards
It is not an academic issue as the companies quoted on various stock exchanges have to publish their balance sheet according to different schedules which represent quite an expense
The need for a universal lay out and structure is quite obvious
The first accounting entry for a new company would be (not taking into account expenses, notary cost)
DEBIT PETTY CASH or BANK ACCOUNT100
CREDIT EQUITY or DUE TO SHAREHOLDERS100
It balances and we have a debit and a credit
You will notice that you always need the two (a debit AND a credit) and that it is ESSENTIAL to ask yourself if you deal with an ASSET ACCOUNT or a LIABILITY ACCOUNT which is increasing or decreasing
Let us look at a few examples and after that we will have an exercise or two to get it into the fingers
This slide explains BEFORE the example and the exercise that it is a CONVENTION FOR THE REVENUE ACCOUNT OR ALSO CALLED THE PROFIT AND LOSS ACCOUNT TO DEBIT FOR A CHARGE
CREDIT FOR A REVENUE
Example – the payment of a telephone bill would be considered as a charge and would mean a DEBIT to the P&L Account
Example – the payment by a customer you invoiced would be considered as an income and would mean a CREDIT to the P&L Account
Say we put 100 on the table to start a NEW COMPANY without taking into account notary expenses and other expenses we would have 100 as an asset of the newly founded company and 100 as a liability towards the shareholders
The asset total would be 100 and the liability total would be 100
In other words the asset of the company is 100% financed by the shareholders
A share is a portion of the capital
Say we would be 10 shareholders of the new company with an incorporated capital of 100 it would mean that each shareholder would hold 1/10 or 10
As soon as the company starts his life the assets and the liabilities will vary and the net worth (the difference between the assets and the liabilities) will move upwards or downwards
Say we put 100 on the table to start a NEW COMPANY without taking into account notary expenses and other expenses we would have 100 as an asset of the newly founded company and 100 as a liability towards the shareholders
The asset total would be 100 and the liability total would be 100
In other words the asset of the company is 100% financed by the shareholders
A share is a portion of the capital
Say we would be 10 shareholders of the new company with an incorporated capital of 100 it would mean that each shareholder would hold 1/10 or 10
As soon as the company starts his life the assets and the liabilities will vary and the net worth (the difference between the assets and the liabilities) will move upwards or downwards
Say we put 100 on the table to start a NEW COMPANY without taking into account notary expenses and other expenses we would have 100 as an asset of the newly founded company and 100 as a liability towards the shareholders
The asset total would be 100 and the liability total would be 100
In other words the asset of the company is 100% financed by the shareholders
A share is a portion of the capital
Say we would be 10 shareholders of the new company with an incorporated capital of 100 it would mean that each shareholder would hold 1/10 or 10
As soon as the company starts his life the assets and the liabilities will vary and the net worth (the difference between the assets and the liabilities) will move upwards or downwards