Finance Step | Basic Accounting

The price/earning (P/E) ratio is another measurement that’s of particular interest to investors in public businesses. The P/E ratio gives you an idea of how much you’re paying in the current price for stock shares for each dollar of earning. Earnings prop up the market value of stock shares, not the book value of the stock shares that’s reported in the balance sheet.

The P/E ratio is a reality check on just how high the current market price is in relation to the underlying profit that the business is earning. Extraordinarily high P/E ratios are justified only when investors think that the company’s earnings per share (EPS) has a lot of upside potential in the future.

The P/E ratio is calculated dividing the current market price of the stock by the most recent trailing 12 months diluted EPS. Stock share prices bounce around day to day and are subject to big changes on short notice. The current P/E ratio should be compared with the average stock market P/E to gauge whether the business selling above or below the market average.

P/E ratios are currently running high, despite a four-year slump in the stock market. P/E ratios vary from industry to industry and from year to year. One dollar of EPS may command only a $10 market value for a mature business in a no-growth industry, while a dollar of EPS in a dynamic business in a growth industry may have a $30 market value per dollar of earnings, or net income.

To sum up, the price/earnings ratio, or P/E ratio is the current market price of a capital stock divided by its trailing 12 months’ diluted earnings per share (EPS) or its basic earnings per share if the business does not report diluted EPS. A low P/E may signal an underbalued stock or a pessimistic forecast by investors. A high P/E may reveal an overvalued stock or might be based on an optimistic forecast by investors.

Anyone who’s worked in an office at some point or another has had to go to accounting. They’re the people who pay and send out the bills that keep the business running. They do a lot more than that, though. Sometimes referred to as “bean counters” they also keep their eye on profits, costs and losses. Unless you’re running your own business and acting as your own accountant, you’d have no way of knowing just how profitable – or not – your business is without some form of accounting.

No matter what business you’re in, even if all you do is balance a checkbook, that’s still accounting. It’s part of even a kid’s life. Saving an allowance, spending it all at once – these are accounting principles.

What are some other businesses where accounting is critical? Well, farmers need to follow careful accounting procedures. Many of them run their farms year to year by taking loans to plant the crops. If it’s a good year, a profitable one, then they can pay off their loan; if not, they might have to carry the loan over, and accrue more interest charges.

Every business and every individual needs to have some kind of accounting system in their lives. Otherwise, the finances can get away from them, they don’t know what they’ve spent, or whether they can expect a profit or a loss from their business. Staying on top of accounting, whether it’s for a multi-billion dollar business or for a personal checking account is a necessary activity on a daily basis if you’re smart. Not doing so can mean anything from a bounced check or posting a loss to a company’s shareholders. Both scenarios can be equally devastating.

Accounting is basically information, and this information is published periodically in business as a profit and loss statement, or an income statement.

Building a financial cushion for your business is never easy. Experts say that businesses should have anywhere from six to nine months worth of income safely stored away in the bank. If you’re a business grossing $250,000 per month, the mere thought of saving over $1.5 million dollars in a savings account will either have you collapsing from fits of laughter or from the paralyzing panic that has just set in. What may be a nice well-advised idea in theory can easily be tossed right out the window when you’re just barely making payroll each month. So how is a small business owner to even begin a prudent savings program for long-term success?

Realizing that your business needs a savings plan is the first step toward better management. The reasons for growing a financial nest egg are strong. Building savings allows you to plan for future growth in your business and have ready the investment capital necessary to launch those plans. Having a source of back-up income can often carry a business through a rough time.
When market fluctuations, such as the dramatic increase in gasoline and oil prices, start to affect your business, you may need to dip into your savings to keep operations running smoothly until the difficulties pass. Savings can also support seasonal businesses with the ability to purchase inventory and cover payroll until the flush of new cash arrives. Try to remember that you didn’t build your business overnight and you cannot build a savings account instantly either.

Review your books monthly and see where you can trim expenses and reroute the savings to a separate account. This will also help to keep you on track with cash flow and other financial issues. While it can be quite alarming to see your cash flowing outward with seemingly no end in sight, it’s better to see it happening and put corrective measures into place, rather than discovering your losses five or six months too late.

Accounting fraud is a deliberate and improper manipulation of the recording of sales revenue and/or expenses in order to make a company’s profit performance appear better than it actually is. Some things that companies do that can constitute fraud are:

–Not listing prepaid expenses or other incidental assets
–Not showing certain classifications of current assets and/or liabilities
–Collapsing short- and long-term debt into one amount.

Over-recording sales revenue is the most common technique of accounting fraud. A business may ship products to customers that they haven’t ordered, knowing that those customers will return the products after the end of the year. Until the returns are made, the business records the shipments as if they were actual sales. Or a business may engage in channel stuffing. It delivers products to dealers or final customers that they really don’t want, but business makes deals on the side that provide incentives and special privileges if the dealers or customers don’t object to taking premature delivery of the products. A business may also delay recording products that have been returned by customers to avoid recognizing these offsets against sales revenue in the current year

The other way a business commits accounting fraud is by under-recording expenses, such as not recording depreciation expense. Or a business may choose not to record all of its cost of goods sold expense fore the sales made during a period. This would make the gross margin higher, but the business’s inventory asset would include products that actually are not in inventory because they’ve been delivered to customers.

A business might also choose not to record asset losses that should be recognized, such as uncollectible accounts receivable, or it might not write down inventory under the lower of cost or market rule. A business might also not record the full amount of the liability for an expense, making that liability understated in the company’s balance sheet. Its profit, therefore, would be overstated.

Inventory is usually the largest current asset of a business that sells products. If the inventory account is greater at the end of the period than at the start of the reporting period, the amount the business actually paid in cash for that inventory is more than what the business recorded as its cost of good sold expense. When that occurs, the accountant deducts the inventory increase from net income for determining cash flow from profit.

the prepaid expenses asset account works in much the same way as the change in inventory and accounts receivable accounts. However, changes in prepaid expenses are usually much smaller than changes in those other two asset accounts.

The beginning balance of prepaid expenses is charged to expense in the current year, but the cash was actually paid out last year. this period, the business pays cash for next period’s prepaid expenses, which affects this period’s cash flow, but doesn’t affect net income until the next period. Simple, right?

As a business grows, it needs to increase its prepaid expenses for such things as fire insurance premiums, which have to be paid in advance of the insurance coverage, and its stocks of office supplies. Increases in accounts receivable, inventory and prepaid expenses are the cash flow price a business has to pay for growth. Rarely do you find a business that can increase its sales revenue without increasing these assets.

The lagging behind effect of cash flow is the price of business growth. Managers and investors need to understand that increasing sales without increasing accounts receivable isn’t a realistic scenario for growth. In the real business world, you generally can’t enjoy growth in revenue without incurring additional expenses.

It’s obvious financial statement have a lot of numbers in them and at first glance it can seem unwieldy to read and understand. One way to interpret a financial report is to compute ratios, which means, divide a particular number in the financial report by another. Financial statement ratios are also useful because they enable the reader to compare a business’s current performance with its past performance or with another business’s performance, regardless of whether sales revenue or net income was bigger or smaller for the other years or the other business. In order words, using ratios can cancel out difference in company sizes.

There aren’t many ratios in financial reports. Publicly owned businesses are required to report just one ratio (earnings per share, or EPS) and privately-owned businesses generally don’t report any ratios. Generally accepted accounting principles (GAAP) don’t require that any ratios be reported, except EPS for publicly owned companies.

Ratios don’t provide definitive answers, however. They’re useful indicators, but aren’t the only factor in gauging the profitability and effectiveness of a company.

One ratio that’s a useful indicator of a company’s profitability is the gross margin ratio. This is the gross margin divided by the sales revenue. Businesses don’t discose margin information in their external financial reports. This information is considered to be proprietary in nature and is kept confidential to shield it from competitors.

The profit ratio is very important in analyzing the bottom-line of a company. It indicates how much net income was earned on each $100 of sales revenue. A profit ratio of 5 to 10 percent is common in most industries, although some highly price-competitive industries, such as retailers or grocery stores will show profit ratios of only 1 to 2 percent.

In an accountant’s reporting systems, depreciation of a business’s fixed assets such as its buildings, equipment, computers, etc. is not recorded as a cash outlay. When an accountant measures profit on the accrual basis of accounting, he or she counts depreciation as an expense. Buildings, machinery, tools, vehicles and furniture all have a limited useful life. All fixed assets, except for actual land, have a limited lifetime of usefulness to a business. Depreciation is the method of accounting that allocates the total cost of fixed assets to each year of their use in helping the business generate revenue.

Part of the total sales revenue of a business includes recover of cost invested in its fixed assets. In a real sense a business sells some of its fixed assets in the sales prices that it charges it customers. For example, when you go to a grocery store, a small portion of the price you pay for eggs or bread goes toward the cost of the buildings, the machinery, bread ovens, etc. Each reporting period, a business recoups part of the cost invested in its fixed assets.

It’s not enough for the accountant to add back depreciation for the year to bottom-line profit. The changes in other assets, as well as the changes in liabilities, also affect cash flow from profit. The competent accountant will factor in all the changes that determine cash flow from profit. Depreciation is only one of many adjustments to the net income of a business to determine cash flow from operating activities. Amortization of intangible assets is another expense that is recorded against a business’s assets for year. It’s different in that it doesn’t require cash outlay in the year being charged with the expense. That occurred when the business invested in those tangible assets.

Financial managers can do certain things to increase or decrease net income that’s recorded in the year. This is called profit smoothing, income smoothing or just plain old window dressing. This isn’t the same as fraud, or cooking the books.

Most profit smoothing involves pushing some amount of revenue and/or expenses into other years than they would normally be recorded. A common technique for profit smoothing is to delay normal maintenance and repairs. This is referred to as deferred maintenance. Many routine and recurring maintenance costs required for autos, trucks, machines, equipment and buildings can be delayed, or deferred until later.

A business that spends a significant amount of money for employee training and development may delay these programs until the next year so the expense in the current year is lower.

A company can cut back on its current year’s outlays for market research and product development.

A business can ease up on its rules regarding when slow-paying customers are written off to expense as bad debts or uncollectible accounts receivable. The business can put off recording some of its bad debts expense until the next reporting year.

A fixed asset that is not being actively used may have very little current or future value to a business. Instead of writing off the un-depreciated cost of the impaired asset as a loss in the current year, the business might delay the write-off until the next year.

You can see how manipulating the timing of certain expenses can make an impact on net income. This isn’t illegal although companies can go too far in massaging the numbers so that its financial statements are misleading. For the most part though, profit smoothing isn’t much more than robbing Peter to pay Paul. Accountants refer to these as compensatory effects. The effects next year offset and cancel out the effects in the current year. Less expense this year is balanced by more expense the next year.

A public corporation is a business whose securities are traded on the public stock exchanges, such as the New York Stock Exchange and Nasdaq. A private company is held solely by its owners and is not traded publicly. When the shareholders of a private business receive the periodical financial reports, they are entitled to assume that the company’s financial statements and footnotes are prepared in accordance with GAAP. Otherwise the president of chief officer of the business should clearly warn the shareholders that GAAP have not been followed in one or more respects. The content of a private business’s annual financial report is often minimal. It includes the three primary financial statements – the balance sheet, income statement and statement of cash flows. There’s generally no letter from the chief executive, no photographs, no charts.

In contrast, the annual report of a publicly traded company has more bells and whistles to it. There are also more requirements for reporting. These include the management discussion and analysis (MD&A) section that presents the top managers’ interpretation and analysis of the business’s profit performance and other important financial developments over the year.

Another section required for public companies is the earnings per share (EPS). This is the only ratio that a public business is required to report, although most public companies report a few others as well. A three-year comparative income statement is also required.

Many publicly owned businesses make their required filings with the SEC, but they present very different annual financial reports to their stockholders. A large number of public companies include only condensed financial information rather than comprehensive financial statements. They will generally refer the reader to a more detailed SEC financial report for more specifics.

Most businesses start out as a small company, owned by one person or by a partnership. The most common type of business when there are multiple owners is a corporation. The law sees a corporation as real, live person. Like an adult, a corporation is treated as a distinct and independent individual who has rights and responsibilities. A corporation’s “birth certificate” is the legal form that is filed with the Secretary of State of the state in which the corporation is created, or incorporated. It must have a legal name, just like a person.

A corporation is separate from its owners. It’s responsible for its own debts. The bank can’t come after the stockholders if a corporation goes bankrupt.

A corporation issues ownership share to persons who invest money in the business. These ownership shares are documented by stock certificates, which state the name of the owner and how many shares are owned. the corporation has to keep a register, or list, of how many shares everyone owns. Owners of a corporation are called stockholders because they own shares of stock issued by the corporation. One share of stock is one unit of ownership; how much one share is worth depends on the total number of shares that the business issues. the more shares a business issues, the smaller the percentage of total owners’ equity each share represents.

Stock shares come in different classes of stock. Preferred stockholders are promised a certain amount of cash dividends each year. Common stockholders have the most risk. If a corporation ends up in financial trouble, it’s required to pay off its liabilities first. If any money is left over, then that money goes first to the preferred stockholders. If anything is left over after that, then that money is distributed to the common stockholders.