Are Accounting and Finance just about the same thing? What do those people working in Accounting do all day? The Finance people seem to be sharper dressers and all drive BMWs, but what are they supposed to be doing?
Our week in the worlds of Accounting and Finance will try to answer (some of) those questions. During your visit, you'll be introduced to lots of new terminology, even more than usual. Because this material is new and very different from anything you've seen before, students have (occasionally) become frustrated. Hint: Flash cards work well for keeping all these new terms straight.
To help out, we'll shorten up the list of ratios to study. There are just three to focus on: (1) Current Ratio, (2) Debt/Equity Ratio and (3) Return-on-Equity Ratio. We'll also add another financial report to know (the Statement of Cash Flows), but you'll see that studying it will be almost as exciting as reading a New York Times best-seller.
The continuation page has some more helpful hints, but to get started, here are my lecture notes and PowerPoint slides:
Here's a list of some of the key points you'll want to know:
- Understand what information is being reported by the Balance Sheet (Assets, Liabilities and Equity) and the Income Statement (Revenues, Expenses, Profits (Losses) and Income (Loss)).
- Know that the Income Statement is reporting the financial results of the firm's operations for a specified period while the Balance Sheet is reporting the firm's financial condition as of a specified date.
- Know the Accounting Equation and how it describes the balance between a firm's Assets and the claims made against those assets (Liabilities = Direct Claims; Equity = Residual Claims).
- Understand the audit function and what a firm's external auditors do and, more important, don't do.
- Review the Post about the "Big Three" Ratios ("Getting Right with your Ratios"). Make sure you know what it means for a firm to be "liquid" (and not liquid) and "leveraged" (and not leveraged). Don't forget the ROE ratio and how it measures whether a firm's assets are being efficiently managed. And don't get ROE confused with "Return on Investment": they're completely opposite approaches.
- Review the Post about the Statement of Cash Flows ("Keep an Eye on those Cash Flows").
- Know the essential characteristics of debt versus equity financing. Debt always has to be repaid, includes interest and may include collateral as a source of repayment if the Debtor can't (or doesn't) make the scheduled payments. The most common source for loans (which are a type of debt) is a Commercial Bank. Equity represents a fractional ownership interest, doesn't have to be repaid and includes a right to vote (common stock only) at the Company's annual meeting for who will be its Directors. Dividends aren't required to be paid; the Board of Directors decides if any will be paid and how much they might be. Equity financing is usually obtained through an investment banker who essentially acts as a broker finding potential stockholders for the company seeking financing.
- Know that Loans, Bonds and Commercial Paper are all forms of Debt. Loans are usually obtained from financial institutions such as a commercial bank or finance company. Individuals can also, of course, be lenders. Loans are also usually obtained for a specific purpose (working capital, build a warehouse, etc.). Bonds are usually issued by Federal, State or Local Governments or very-large public corporations and are purchased by institutional investors such as pension funds. The purpose behind a bond financing is secondary and the collateral isn't the primary source of repayment; bonds are sold on the basis of the financial strength and reliability of the issuer. Commercial Paper is essentially a short-term bond; bonds will have repayment terms of up to 20 years (and occasionally longer) whereas commercial paper will be a few days or months.
- Understand the implications of altering a firm's capital structure. Additional debt (higher leveraging) will decrease a firm's cash flows and reduce its break-even point, thereby increasing a firm's overall riskiness. Equity financing has the virtue of not being repayable, but investors obtain a measure of control over the company because of common stock's voting right.
- Know that Preferred Stock is a hybrid financing mechanism. It has a preferred rate of return (like interest on debt) and no voting right, but upon a company's liquidation, will have claims that are superior to those made by the common stockholders.
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