ACCOUNTING AND FINANCE

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ACCOUNTING AND FINANCE
PURPOSE

• Accounting
• Record and Report Financial Activities
• Regulatory Compliance and Taxation

• Finance
• Manage Capital Structure Mix of Funding
  Sources (Internal, Debt or Equity)
• Implications of Choices Value and Governance

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ACCOUNTINGS FOCUS

• TAXATION
• Adjustments that convert Profits into Income
• REGULATION
• Non-Compliant or Unacceptable Practices
• CONSISTENCY
• Needed for Comparative Decision-Making

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TWO PERSPECTIVES

• Financial Accounting
• Prepare Financial Reports for External Parties
  (Investors, Creditors and Tax and Regulatory
  Authorities)
• Managerial Accounting
• Prepare Information for Internal Analysis and
  Strategic Decision-making

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FINANCES FOCUS

• Manage Capital Structure - Reconcile Sources/Uses
  of Cash
• Timing and Amounts (Operating and Capital)
• Implications of Capital Structure Choices
• Stockholder Rights (Equity and Internal) versus
  Cash Flow Claims (Debt)

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Essential Accounting Reports

• Balance Sheet
• Income Statement
• Statement Of Cash Flows

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BALANCE SHEET

• Reports Assets, Liabilities and Equity
• Assets Property Owned by Firm
• Liabilities Debts and Financial Obligations
• Equity Stock Investments/Retained Earnings

• Reports Financial Condition as of Specified Date
  (Month/Quarter/Year End)
• Reported Amounts may be Historical Cost or
  Estimates (Which is more Reliable?)

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ESSENTIAL ACCOUNTING CONCEPTS

• THE ACCOUNTING EQUATION
• Assets Liabilities Equity

• Variation for Business Valuation Equity Assets
  Liabilities

Answers Question of Why is it called a
Balance Sheet?
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INCOME STATEMENT

• Reports Firms Financial Performance
• (1) Revenues, (2) Expenses, (3) Profits and (4)
  Net Income

• Information Reported for Prior Period (Month,
  Quarter or Year)
• Profits are Results of Firms Operations
  Revenues Expenses Profit (Loss)
• Net Income includes Allowable Adjustments (Tax
  and Investment Reports)

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ACCOUNTING QUANDRIES

• Which Rule Provides Better Information?
• Should Transactions be Recorded and Reported
• When Cash is Received or Paid (Cash Basis) or...
• When Service Performed or Product Delivered
  (Accrual Basis)
• GAAP says, Report Transactions when Primary
  Purpose accomplished (Payment not relevant)
• Management and Creditors need to know about
  Firms Cash

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STATEMENT OF CASH FLOWS

• Reports Sources and Uses of Cash Categorized by
  Activity
• OPERATING Cash Used in/Generated by Core
  Business
• INVESTING Cash Used in/Generated by
  Buying/Selling Assets
• FINANCING Cash Used to pay Debts or
  Dividends/Generated from Debt or Equity

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ACCOUNTING ISSUES AUDITORS OPINION

• (1) Accountants are Certified, not Information
  and (2) Statements are Fair Presentation
  Accuracy is Managements Responsibility

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ACCOUNTING ISSUES SOX CERTIFICATION

• (1) Personal responsibility for Disclosures, (2)
  Enhanced Internal Controls and (3) More
  Disclosures
• Question SOX enacted in 2002. Did it keep
  current financial crisis from being worse? Or
  did it make things worse?

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THREE ESSENTIAL METRICS

• Current Ratio
• Debt-to-Equity Ratio
• Return-on-Equity Ratio

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THREE ESSENTIAL METRICS
CURRENT RATIO Measures LIQUIDITY by
Comparing Current Assets with Current
Liabilities

• FORMULA Current Assets ? Current Liabilities
• PURPOSE Assesses whether Firm can meet
  Near-term Obligations
• NOTE Analyze Trends - Are changes caused by
  decreasing cash or increasing liabilities?
  Should not consistently be less than 11

(1) Capacity of Business to pay Current
Liabilities (2) Extent of Effect on Assets
Value caused by Sale (conversion to cash)
Current Assets Can or Will be Converted to Cash
within 1 Year Current Liabilities Due within 1
Year
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THREE ESSENTIAL METRICS

• DEBT-TO-EQUITY RATIO
• Assesses Firms Capital Structure (LEVERAGING)
• FORMULA Long-TermDebt ? Equity
• PURPOSE Evaluate Debts Fixed-cost Burden
• Remember Debt requires Periodic Cash Payments
  Equity does not

Mix of Sources of Funds used to Finance Firms
Capital Costs and Operating Expenses
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THREE ESSENTIAL METRICS

• RETURN-ON-EQUITY
• Measures Rate of Return Earned for Shareholders
• FORMULA Net Income ? Shareholders Equity
• Evaluates Managements Efficiency
• NOTE Not Return-on-Investment

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FINANCIAL MANAGEMENT

• RECONCILE SOURCES/ USES OF CASH
• Operating Needs Timing and Amounts
• Capital Needs Growth, Contraction or
  New Enterprises
• Internal and External Contingencies

Strategic Problem Economically balance
Profit-Producing Characteristics of Assets with
Implications of Capital Structure Choices
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CAPITAL STRUCTURE

• FINANCING INTERNAL or EXTERNAL
• Choice depends on Timing, Available Amounts and
  Costs to Obtain and
• Implications for Operations (Debts Claims on
  Cash Flow/Assets) and Governance (Common
  Stockholders Right to Vote)

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CAPITAL STRUCTURE

• INTERNALLY GENERATED FINANCING
• Retained Earnings (No Dividend Payout)
• Vendor Financing (Accounts Payable) or
• Sales Terms (Accounts Receivable)
• Advantages No Application/Approval Process
• Immediately Available
• No Direct Governance Implications

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CAPITAL STRUCTURE

• EXTERNAL FUNDING DEBT
• Obtained from Commercial Banks, Finance Companies
  and Private Parties
• Subject to Creditworthiness/Debt Servicing
  Capacity
• Negative Covenants Restrictions on Other
  Borrowings, Profitability, Current Ratio and more
• Cash Flow Implications Repayment Terms,
  Interest Charges, Fees, Reports and more

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CAPITAL STRUCTURE

• EXTERNAL FUNDING EQUITY
• Public Equity Obtained from Investment Banker
  through Initial Public Offering (IPO)/Stock Issue
  or Private Equity Venture Capitalist
• Sale of Fractional Ownership Cost is tradeoff
  between Capital received and Control Given Up
• Control Rights Employment Agreements, Board
  Memberships, Decision-Making, Voting Interests

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FINANCIAL MANAGEMENT

• CAPITAL STRUCTURE IMPLICATIONS
• Internal Funds (Retained Earnings)
• Shareholder Expectations
• External Debt (Bonds and Loans)
• Covenants may restrict Growth Rate Risk
• External Equity (Sale of Ownership Interest)
• Voting Rights

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The Magic of Leveraging

• What happens to EPS when Capital Structure
  Changes?
• 50 Debt 50 Increase
• 80 Debt EPS Triples!

Shares (10 Par Value) 100 50 20
850 (800) 50 ----- 50 (20)
30 30
850 (800) 50 (50) 0 ------
0 0
850 (800) 50 (80) (30) -----
(30) (1.50)
What happens if (when) Revenues decrease to 850?
Does it help to reduce Interest Rate by 25 to
7½? Answer No. Interest Expense decreases to
60 which only reduces Loss to (50).
Par Value is a Nominal, Minimum Value
assigned to a Companys stock upon its
incorporation
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Howard, Think about your Capital Structure
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Southwests Business Plan
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• June 18, 1971 Began Service (Organized 1967)
• May 2003 Largest Domestic Carrier
• More than 3,400 Daily Flights 64 Market Share
• Flies only Boeing 737 Jets 537 Planes in Fleet.
  Each flies about 12 hours daily (6.25 Trips)
• 83 Unionized (73 at General Motors)

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• 101.4 Million Passengers flew on Southwest
  Ticket Sold every 2.7 seconds
• 2009 Received 90,043 Resumes - Hired 831
  Southwest Warriors (1108)
• Consumed 1.4 Billion Gallons of Jet Fuel -
  Average price 1.97/Gallon
• Served 63.2 Million Cans of Soda/Water, 14.3
  Million Adult Beverages
• and 90 Million Bags of Peanuts

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Does Capital Structure Matter?
Long-Term Debt to Stockholders (Book) Equity
Delta 63.90 to 1
Continental 8.97 to 1
Jet Blue 1.90 to 1
Southwest 0.61 to 1
Net Income (Loss) Millions
( 1,237)
( 282)
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99

• Name Two things Southwest has NEVER done?
• Answer (1) Lost Money - Profitable for 37
  Consecutive Years and (2) Laid Anyone Off

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• Lets dive into some of Southwests Numbers

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Revenues 96 from Passenger Ticket
Sales Salaries 34.4 (2009) versus 31.6
(2008) Taxes 39.6 Effective Rate
Fuel Costs 18 Lower Fuel Costs (669M
) Full-Time Employees 780 fewer Employees, but
Salaries and Wages were 3.8 higher
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Comparative Ratio Analysis Comparative Ratio Analysis Comparative Ratio Analysis
2009 2008
Current Ratio 1.251 0.951
Debt-to-Equity 0.611 0.711
Return-on-Equity 1.8 2.6
Valuation Analysis Valuation Analysis
Stock Price (April 14, 2010) 13.40
Market Value (742.8 M Shares) 9,953 M
Book Value (Total Stockholders Equity 5,466 M
Market Value/Book Value 182
Earnings per Share (99/742M) 0.13
Stock Price Multiple (13.40/0.13) 103.1 X
Net Income from Income Statement 99 Million
Shares Outstanding (742.8 M) Number Issued
(807.6 M) less Number held in Treasury (64.8 M)
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• Note Reconciliation of Beginning/End-of-Period
  Cash with Cash on Balance Sheet
• 2009 Operations generated Surplus Cash (985M)
  used to Purchase Aircraft (585M) and Pay
  Revolving Credit Facility (400M)
• Note 2008 Operations did not produce sufficient
  Cash (1.5 B Shortfall).
• 2010 plans call for purchasing 10 aircraft 13
  purchased in 2009 and 28 purchased in 2008

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Why Didnt Anyone See This Coming?
Stock Price Stock Price
January 3, 2000 43.44
August 17 and 23, 2000 90.00
December 29, 2000 83.13
October 29, 2001 13.81
November 30, 2001 26
Significant Events Significant Events
Aug 2001 CEO Jeff Skilling Resigns (October 2006 Sentenced to 24 Years)
Nov 2001 Last 4 Years Earnings Restated Bond Rating lowered to Junk
Dec 2, 2001 Files Chapter 11 (Reorganization) Bankruptcy Petition
Jan 1, 2004 Bankruptcy converted to Chapter 7 (Liquidation)
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Would studying Enrons Statement of Cash Flows
and a Little Common Sense have saved Billions?
Note 9. Supplemental Cash Flow Information Cash Payments for Income Taxes 2000 62 (4.4) Federal Rate 35 Effective Rate 1999 51 (5.1) 1998 73 (8.3)
Note 16. Related Party Transactions In 2000 and 1999, Enron entered into transactions with limited partnerships whose general partners managing member is a senior officer of Enron . Management believes the terms of the transactions were reasonable compared to those which could have been negotiated with unrelated third parties.
Nota Bene Contrast 1998 and 1999 Cash Sources (Operations 1/3 and Financing 2/3) with 2000 Cash Sources