Chapter 3

MANANGING PROFIT
AND FINANCIAL STATEMENTS
TROJAN CO. LTD.

Sales $ 5,000,000
- Cost of Goods Sold - 3,500,000
Gross Profit = $ 1,500,000
- General & Administrative - 250,000
- Selling Expense - 250,000
- Depreciation Expense - 500,000
Pre-Tax Profit = $ 500,000
- Tax - 200,000
Net Income = $ 300,000
2
MANAGING THE INCOME
STATEMENT

3
TROJAN CO. LTD.

• Using the data in Trojan Co. Ltd., let’s see

what can be done to get rid of the Net
Income of $300,000.

4
WAYS TO REPORT SALES

• When you ship, you create a receivable

• Percentage of Completion
– Completed Contract method is no longer OK
• Installment method
– When you receive all the money up front, but
you must provide service over time.
– When you receive only a small portion of the
price and the balance over time.

5
Revenue recognition criteria according to
US GAAP

• US SEC's SAB 101 states that revenue generally

is realized or realizable and earned when all of
the following criteria are met:
– Persuasive evidence of an arrangement exists;
– Delivery has occurred or services have been
rendered;
– The seller's price to the buyer is fixed or
determinable; and
– Collectability is reasonably assured
WAYS TO REPORT SALES

• The SEC reports that with high tech firms

of today, one way they “play games” with
Net Income is through Sales. (Capitalizing
expenses is still probably the most
common way, however.)

7
DETAIL OF COST OF GOODS
SOLD

Direct Labor $ 1,500,000

Cost of Materials + 1,500,000

Factory Overhead + 500,000

Cost of Goods Sold $ 3,500,000

8
COST OF MATERIALS

Beginning Inventory $ 1,500,000

+ Purchases + 1,500,000

- Ending Inventory - 1,500,000

Equals: Cost of Materials $ 1,500,000

9
INVENTORY ADJUSTMENTS

Before After

Beginning Inventory $ 1,500,000 $ 1,500,000

+ Purchases + 1,500,000 + 1,500,000

- Ending Inventory - 1,500,000 - 1,000,000

Equals:
$ 1,500,000 $ 2,000,000
Cost of Materials

10
ADJUSTED COST OF GOODS
SOLD

Direct Labor $ 1,500,000 $ 1,500,000

+ Cost of Materials + 1,500,000 + 2,000,000

+ Factory Overhead + 500,000 + 500,000

Equals:
$ 3,500,000 $ 4,000,000
Cost of Goods Sold

11
ADJUSTED INCOME
STATEMENT
OLD NEW
Sales $ 5,000,000 $ 5,000,000
- Cost of Goods Sold - 3,500,000 - 4,000,000
Equals: Gross Profit $ 1,500,000 $ 1,000,000
- General & Adm.Expense - 300,000 - 300,000
- Selling Expense - 300,000 - 300,000
- Depreciation Expense - 400,000 - 400,000
Equals: Pre-Tax Profit $ 500,000 Nothing
- Tax - 200,000 Sorry
Net Income $ 300,000 Zip!
12
HOW TO SUCCEED IN
BUSINESS!

• HOW DID YOU

DO THAT?

13
INVENTORY VALUATION METHODS

• First in, first out - FIFO

• Last in, first out - LIFO
• Devaluing inventory: Obsolesce
• Next in, first out - NIFO:
This is flat out cheating!

14
FIVE YEAR PROFIT RECORD OF A MAIL
ORDER DISTRIBUTION COMPANY

$140,000 $125,000
$120,000 $112,000

$100,000
$80,000
$80,000
$60,000
$40,000 $25,000
$12,000
$20,000
$0
Year 1 Year 2 Year 3 Year 4 Year 5

Net Profit
15
CHEATING WITH INVENTORY

• Always list inventory at the lower

of cost or market.

What happens when you don’t?

JIM’S RULE ABOUT
INVENTORY

• The HIGHER the ENDING INVENTORY,

the HIGHER the GROSS PROFIT;

• The LOWER the ENDING INVENTORY,

the LOWER the GROSS PROFIT!

17
INVENTORY

• If you suspect that something “funny” is

happening to a company’s “profit” look to
see what is happening to that firm’s
Inventory on the Balance Sheet.
• If the Inventory is suddenly up, then the
reported Profit may be up.

18
DEPRECIATION EXPENSE

• Straight Line
• MACRS
• Other methods
- Decelerated Depreciation
- Unit Method
HOW MANY STATEMENTS?

• Isn’t it immoral to have more than one

financial statement?
• Tax reporting vs. Financial reporting
• OK to have two statements;
just don’t have three!

20
MANAGING THE BALANCE
SHEET

• What’s the first thing you see?

• Cash
• Reporting cash and marketable securities
• Two ways to report marketable securities:
As Current Assets or Other Assets
– If Current Assets, take a loss if securities are
down and take a gain if assets are up in
value.

21
MANAGING THE BALANCE
SHEET

• Short term obligations to a Bank or other

lender can be listed as “long term” if the
intention is to roll over the loan.
– Helps the Current Ratio, but not Debt to
Equity Ratio.
– Accountant checks with lender for intention.
• Debt to Equity Ratio - Most important.
Why?

22
MANAGING THE BALANCE
SHEET

• And speaking of the Current Ratio

– Indicates safety of current debt holders?
– Indicates general health of the business?
• But does it tell you what you think it is
telling you?
• The Current Ratio can be misleading
Here’s why.

23
PROBLEMS WITH THE CURRENT
RATIO

• Confusion stems from terminology

differences. “Short Term Liability” and
“Long term Liability” are accounting terms;
The legal terms are “Secured” and
“General Creditors”.
• Now priorities in bankruptcy will be
discussed.

24
PRIORITIES IN BANKRUPTCY

• Priority claims
– Court costs, certain legal and accounting, taxes,
wages
• Secured Creditors - UCC filing or Trust Deed
• General Creditors
– A long list, including Trade Creditors, wages, taxes
• Subordinated Creditors? To whom?
• Equity stockholders
– Preferred Stock
– Common stock
25
 PROBLEMS WITH THE CURRENT
RATIO
ADAMS’ STORE
Balance Sheet

Assets Liabilities & Capital

Cash $ 100 Accounts payable-trade $ 1,400
Acc’ts receivable 3,050 Due bank 3,500
Inventory 6,000
Total current assets $ 9,150 Total current liabilities $ 4,900

Fixtures & equipment 1,200 Owner's equity 4,460

TOTAL ASSETS $10,360 TOTAL LIAB’S & CAP. $ 10,360

Current Ratio = $9,150 / $4,900 = 1.87 / 1

26
PROBLEMS WITH THE CURRENT
RATIO

• In the prior example, the apparent Current

Ratio is 1.87 / 1. But the bank has a secured
interest in the company’s Receivables and
Inventory (and Cash).
If the disposal of these assets – and assets
shrink in value in bankruptcy – only covers the
bank debt, what’s left for the Accounts Payable
people?
• That’s right: $0 / $1,400
27
 PROBLEMS WITH THE CURRENT
RATIO
GREEN MANUFACTURING CO.
Balance Sheet
Assets Liabilities & Capital
Cash 100,000 Accounts payable $ 2,000,000
Accounts receivable 3,000,000
Inventory 3,000,000 Total current liabilities 2,000,000
Other current assets 200,000
Total current assets $6,300,000 Unsecured long term debt 4,000,000
Long term debt secured by
equipment 2,500,000
Equipment, net of EQUITY
Depreciation reserve 3,700,000 Common stock 2,000,000

of 500,000
_________ Retained earnings 1,500,000

TOTAL ASSETS $10,000,000 TOTAL LIAB’S & CAPITAL $10,000,000

28
PROBLEMS WITH THE CURRENT
RATIO

• Here the Current Ratio is a handsome 3.15 / 1 and we

don’t have any pesky bank loan outstanding, so we have a
good C / R. Right?
• Not exactly… There is $4,000,000 of “Unsecured long term
debt” that has to be paid from the proceeds of the “Assets
available for the General Creditors.” In short, sitting beside
the Accounts Payable people will be a party with a
$4,000,000 claim!
• Instead of a Current Ratio of 3.15 / 1, the effective
Current Ratio is $6,300,000 / $6,000,000; quite a
difference!

29
A PROPOSAL TO CORRECT FOR THE
DEFFICIENCIES OF THE C / R

• In order to correct for the deficiencies of the

Current Ratio, a new ratio is proposed - for
people who like ratios.
• This new ratio is called the “General Creditor
Ratio.” It is defined as follows:

30
GENERAL CREDITOR RATIO

Assets Available for General Creditors

GCR =
General Creditor Claims

31
SUBORDINATED DEBT

• Another important aspect of the bankruptcy

priority list is “Subordinated Debt.” Subordinated
debt, as you can see from the list, comes after
the General Claims.
• (There are cases, however, where you can have
“secured” subordinated debt, but these cases are
unusual. But “subordination” means “coming
after, and that can be any other claim.)

32
SUBORDINATED DEBT

• Two types of subordination:

SPECIFIC and GENERAL:
• List it after the long term debt and before
the equity section.
– Specific, like with a bank
– General - subordinated to all General
Creditors

33
SUBORDINATED DEBT

“Debt
that serves as
Equity!”

A deal person's delight.

TYPES OF STATEMENTS

Verify A/R, Approve Acct. Stmts.Accd’n.

Inv., A/P System to GAAP

Compiled No No No

Reviewed No ? YES

Audited YES YES YES

35
TAKING A FINANCIAL BATH

• What is a financial bath?

• Reasons for a financial bath:
– Management change
– Loss anyway
– Decline in stock price
– “Me too”
– Raging bull market
 Chapter 3

MANANGING PROFIT AND

FINANCIAL STATEMENTS

END

PowerPoint slides prepared by Terry Lichvar, USC FBE Dept.