Engineering Economics Jun24 Notes 1.pdf

What the course is about Engineering economics deals with the methods that enable one to take economic decisions with regards to engineering activities towards minimizing costs and/or maximizing benefits to business organizations. It is rel...

What the course is about Engineering economics deals with the methods that enable one to take economic decisions with regards to engineering activities towards minimizing costs and/or maximizing benefits to business organizations. It is related to revenue, cost, profit, returns, risk and value since engineering activities have a direct financial impact on an organization. Course content 1. Introduction to Engineering Economic Decisions 2. Financial management and analysis 3. Cost of Money 4. Analysis of Assets and Equivalent worth 5. Cost concepts and Cash flows 6. Depreciation and Taxes 7. Project risk and sensitivity analysis 8. Capital Decision Making 3  Course Objectives The student is expected to: Understand the role of engineers in business and the economic decisions they are required to make. Be able to read balance sheet statements and understand the role of accounting in economics and cash in business operation. Appreciate the time value of money. Understand capital decision making as well as how firms screen potential investment opportunities. Perform a proper cost and profit analysis Understand depreciation, taxation and risk handling principles 4  Why is this course important Economics is the overriding consideration in Engineering decision making. In product development, the most fundamental question is: What will be the cost of the finished product? The competent and successful engineer in the twenty-first century must have an improved understanding of the principles of science, engineering, and economics in order to be very efficient in process, systems and technology design. 5  Course references Singh, S. (2014). Economics for Engineering Students. (2nd Ed.). I. K. International Publishing House Pvt. Ltd. New Delhi. White, J. J., Case, K. E., & Pratt, D. B. (2012). Principles of Engineering Economic Analysis. (5th Ed.). Wiley & Sons. Hoboken Sullivan, W. G., Wicks, E. M., & Koelling, C. P. (2014). Engineering Economy. Pearson, NY. Blank, L. & Tarquin, A. (2020). Basics of Engineering Economy. (3rd Ed.). McGraw-Hill. Newnan, D. G., Eschenbach, T. G., and Lavelle, J. P. (2017). Engineering Economic Analysis. (13th Ed.). Oxford University Press. 6  Course organisation Approx. 2 hours regular lectures per week Mid-semester exam (40% of assessment) Final examination (60% of assessment) Academic/Technical discussions: At your convenience through your Rep. 7 Introduction to Engineering Economic Decisions 8 Introduction to Engineering Economic Decisions “Engineering Businesses” Microsoft Corporation is a tech or “computer engineering” company valued at USD 3.05 trillion 9 Introduction to Engineering Economic Decisions “Engineering Businesses” John Deere is an agro-equipment or “agricultural engineering” company valued at USD 112.85 billion. 10 Introduction to Engineering Economic Decisions “Engineering Businesses” Cargill is a leading food processing or “food processing engineering” company valued at USD 61.5 billion. 11 Introduction to Engineering Economic Decisions “Engineering Businesses” Johnson & Johnson is a leading cosmetic or “biomedical engineering” company valued at USD 358.47 billion. 12 Introduction to Engineering Economic Decisions “Engineering Businesses” 3M is a leading polymer or “materials engineering” company valued at USD 53.32 billion. 13 Introduction to Engineering Economic Decisions “Engineering Businesses” Does anyone know these two people? 14 Introduction to Engineering Economic Decisions “Engineering Businesses” Larry Page and Sergey Brin 15 Introduction to Engineering Economic Decisions The Google Story They are the founders of 16  Introduction to Engineering Economic Decisions The Google Story Google started out with the simplest of ideas, with a global audience in mind. In the mid-1990s, Sergey Brin and Larry Page were Stanford students pursuing doctorates in computer science. Brin recalled that at that time there were some five major search engines (lycos, webcrawler, infoseek, Yahoo etc.) but “We believed we could build a better search engine” “We had a simple idea—that not all pages are created equal. Some are more important,” So, they developed a unique approach to solving one of computing’s biggest challenges: retrieving relevant 17 information from a massive set of data  Introduction to Engineering Economic Decisions The Google Story 1995 Developed “BackRub” in the dorm room of Larry Page and Sergey Brin, graduate students at Stanford University 1998 Raised $25 million to set up Google, Inc. Ran 100,000 queries a day out of a garage in Menlo Park 2005 Over 4,000 employees worldwide Over 8 billion pages indexed Google is currently valued at USD 863.2 billion 18  Introduction to Engineering Economic Decisions The Google Story The story of how the Google founders got motivated to invent a search engine and eventually transformed their invention to a multibillion-dollar business is a typical one. Companies such as Dell, Microsoft, and Yahoo all produce computer-related products and have market values of several billion dollars. These companies were all started by highly motivated young college students. 19  Introduction to Engineering Economic Decisions The Google Story One thing that is also common to all these successful businesses is that they have capable and imaginative engineers who constantly generate good ideas for capital investment, execute them well, and obtain good results. 20  Introduction to Engineering Economic Decisions The Google Story Let pause to think about the following: What kind of role did these engineers play in making business decisions? What specific tasks were assigned to these engineers? What tools and techniques were available to them for making such capital investment decisions and to improve their business firm’s profits? 21  Introduction to Engineering Economic Decisions The Sobolo Billionaire Now all throughout our discussion we will make reference to The Sobolo Billionaire. The Sobolo Billionaire is a secret business someone here is planning to set-up and become billionaire with in 10 years. Our goal as a class is to carefully equip that person with enough financial information to be successful. The best part is a Sobolo business is an easy engineering business to start. 22  Introduction to Engineering Economic Decisions Engineering Economic Decisions As an Engineer in a firm/company or institution you may find yourself as The CEO The General Manager or Technical Manager Member of the Product design/R&D team (Perfect role for an Engineer) Member of the Production team (supervisor or engineer or technician) Member of the Quality assurance team Member of the Maintenance team Member of the Sales team (Sales engineer) Researcher or Academic* 23  Introduction to Engineering Economic Decisions Engineering Economic Decisions Engineers typically do four things Develop new products Improve existing products Develop new processes or technologies for making existing products Improve existing processes or technologies for making existing products 24  Introduction to Engineering Economic Decisions Engineering Economic Decisions Engineers are called upon to participate in a variety of decisions, ranging from manufacturing, through marketing, to financing decisions. Lets focus on the various economic decisions related to engineering projects which is referred to as engineering economic decisions. In manufacturing, engineering is involved in every detail of a product’s production, from conceptual design to shipping. Engineering decisions account for the majority (up to 85%) of product costs. 25  Introduction to Engineering Economic Decisions Engineering Economic Decisions Engineers must consider the effective use of capital assets such as buildings and machinery. One of the engineer’s primary tasks is to plan for the acquisition of equipment (capital expenditure) that will enable the firm to design and produce products economically. With the purchase of any fixed asset—such as equipment— we need to estimate the profits (more precisely, cash flows) that the asset will generate during its period of service. Therefore, we have to make capital expenditure decisions based on predictions about the future. 26  Introduction to Engineering Economic Decisions Engineering Economic Decisions For example, You are considering the purchase of a milling machine or a 3-D printer to meet the anticipated demand for certain processes used in the production. The expectation is that the machine should lasts 10 years. This decision therefore involves an implicit 10-year sales forecast for the products. This means that a long waiting period will be required before you will know whether the 27 purchase was justified.  Introduction to Engineering Economic Decisions Engineering Economic Decisions An inaccurate estimate of the need for assets can have serious consequences. If you invest too much in assets, you incur unnecessarily heavy expenses. Spending too little on fixed assets, however, is also harmful, since equipment may be too outdated or too small to produce products competitively. Without an adequate capacity, you may lose a portion of your market share to rival firms. Regaining lost customers involves heavy marketing expenses and may even require price reductions or product 28 improvements, both of which are costly.  Introduction to Engineering Economic Decisions Engineering Economic Decisions Engineering Economic Decisions shares strong similarities with Personal Economic Decisions. An engineer plays a role in the effective utilization of corporate financial assets. Likewise, each of us is responsible for managing our personal financial affairs. 29  Introduction to Engineering Economic Decisions Engineering Economic Decisions Let’s examine it carefully: After we have paid for essential needs, such as rent, food, clothing, and transportation, any remaining money is available for discretionary expenditures on items such as entertainment, travel, and investment. For money we choose to invest, we want to maximize the economic benefit at some acceptable risk. The investment choices are unlimited and include savings accounts, guaranteed investment certificates, stocks, bonds, mutual funds, rental properties, land, business ownership, and more. How do you choose? 30  Introduction to Engineering Economic Decisions Engineering Economic Decisions Side note: let’s briefly distinguish between shares, stocks and bonds Stocks represent part ownership of a company while a Share is a single unit of stock Bonds represents a loan offered to a company or government The fundamental difference between stocks and bonds is that with stocks you own a small portion of a company, whereas with bonds you loan a company or government. The second difference is that in both cases money made; stocks must grow in resale value while bonds are repaid as 31 a fixed interest over time. Introduction to Engineering Economic Decisions Engineering Economic Decisions 32  Introduction to Engineering Economic Decisions Engineering Economic Decisions Let’s examine it carefully: The analysis of one’s personal investment opportunities utilizes the same techniques that are used for engineering economic decisions. Again, the challenge is predicting the performance of an investment into the future. Choosing wisely can be very rewarding, while choosing poorly can be disastrous. A wise investment strategy is a strategy that manages risk by diversifying investments. 33  Introduction to Engineering Economic Decisions Engineering Economic Decisions Let’s examine it carefully: With such an approach, you have a number of different investments ranging from very low to very high risk and are in a number of business sectors. Since you do not have all your money in one place, the risk of losing everything is significantly reduced. 34  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications Many large companies have a specialized project analysis division that actively searches for new ideas, projects, and ventures. Once project ideas are identified, they are typically classified as (1) equipment or process selection, (2) equipment replacement, (3) new product or product expansion, (4) cost reduction (5) improvement in service or quality. 35  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications This classification scheme allows management (i.e. those who run the company on a day-to-day basis) to address key questions: Can the existing plant, for example, be used to attain the new production levels? Does the firm have the knowledge and skill to undertake the new investment? Does the new proposal warrant the recruitment of new technical personnel? The answers to these questions help firms screen out proposals that are not feasible, given a company’s resources. 36  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications Equipment or Process Selection This class of engineering decision problems involves selecting the best course of action out of several that meet a project’s requirements. 37  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications Equipment or Process Selection It answers the question, Which of several proposed items of equipment shall we purchase for a given purpose? The choice often hinges on which item is expected to generate the largest savings (or the largest return on the investment). Many factors will affect the ultimate choice of the material or equipment, and engineers consider all major cost elements, such as the cost of machinery and equipment, tooling, labor, and material. 38  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications Equipment Replacement This category of investment decisions involves considering the expenditure necessary to replace worn-out or obsolete equipment. 39  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications Equipment Replacement For example, a company may purchase 10 large presses, expecting them to produce stamped metal parts for 10 years. After 5 years, however, it may become necessary to produce the parts in plastic, which would require retiring the presses early and purchasing plastic molding machines. Similarly, a company may find that, for competitive reasons, larger and more accurate parts are required, making the purchased machines become obsolete earlier than expected. 40  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications New Product or Product Expansion This involves considering expenditures necessary to produce a new product or to expand into a new geographic area. One common type of expansion decision includes decisions about expenditures aimed at increasing the output of existing production or distribution facilities. 41  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications New Product or Product Expansion It also answers the question, Shall we build or otherwise acquire a new facility? Investments in this category increase company revenues if output is increased. 42  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications Cost Reduction A cost-reduction project is a project that attempts to lower a firm’s operating costs. Typically, we need to consider whether a company should buy equipment to perform an operation currently done manually or spend money now in order to save more money later. The expected future cash inflows on this investment are savings resulting from lower operating costs. 43  Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications Improvement in Service or Quality In some cases, the decision would be to enhance the quality of an existing product. Alternatively it could be to enhance the quality of service delivery with regards to the product such as marketing and distribution. 44 Introduction to Engineering Economic Decisions The Five Engineering Project Decision Classifications For any of these decisions to be made a business must first exist! 45 Introduction to Engineering Economic Decisions Types of Business Organization Summary of a Business Journey (Pitch-to-Market) 1. Idea for a Product 2. Development of the Product Prototype 3. Preparation of Production Plan 4. Business Plan Development 5. Business Registration 6. Capital sourcing 7. Rental/Construction of Work space 8. Equipment and Material Sourcing 9. Commercial Production 10. Marketing 11. Distribution & Sales 12. Business Expansion 13. Sale of Business/Closure 46  Introduction to Engineering Economic Decisions Types of Business Organization Yahoo, Apple and Microsoft produce computer products and have a market value of several billion dollars each. These companies were all started by young college students with technical backgrounds. When they went into the computer business, these students initially organized their companies as proprietorships. As the businesses grew, they became partnerships and were eventually converted to corporations. 47  Introduction to Engineering Economic Decisions Types of Business Organization Proprietorships A proprietorship is a business owned by one individual. This person is responsible for the firm’s policies, owns all its assets, and is personally liable for its debts. 48  Introduction to Engineering Economic Decisions Types of Business Organization Proprietorships A proprietorship has two major advantages i.e. The owner has full control over all managerial and operational decisions. It can be formed easily and inexpensively with little organizational requirements. The earnings of a proprietorship may be taxed at the owner’s personal tax rate, which may be lower than the rate at which corporate income is taxed. The major disadvantages are personal liability (all debts to the owner) and the inability to raise additional capital for business expansion through stocks and bonds. 49  Introduction to Engineering Economic Decisions Types of Business Organization Partnerships A partnership is similar to a proprietorship, except that it has more than one owner. Most partnerships are established by a written contract between the partners which normally specifies contributions to capital, and the distribution of profits and losses. A partnership has many advantages, these include Lower costs per person and ease of formation. Typically has a larger amount of capital available for business since more than one person makes contributions. 50 Easy to borrow money since the personal assets of all the partners stand behind the business  Introduction to Engineering Economic Decisions Types of Business Organization Partnerships The disadvantage is under partnership law, each partner is liable for a business’s debts meaning that the partners must risk all their personal assets even those not invested in the business. Though each partner is responsible for his or her portion of the debts in the event of bankruptcy, if any partners cannot meet their pro rata claims, the remaining partners must take over the unresolved claims. Finally, a partnership has a limited life, insofar as it must be dissolved and reorganized if one of the partners quits. 51  Introduction to Engineering Economic Decisions Types of Business Organization Corporations A corporation is a legal entity created under law which is separate from its owners and managers. 52  Introduction to Engineering Economic Decisions Types of Business Organization Corporations This separation gives the corporation four major advantages: It can raise capital from a large number of investors by issuing stocks and bonds; It permits easy transfer of ownership interest by trading shares of stock; It allows limited liability—personal liability is limited to the amount of the individual’s investment in the business; It is taxed differently than proprietorships and partnerships, and under certain 53 conditions, the tax laws favour corporations.  Introduction to Engineering Economic Decisions Types of Business Organization Corporations On the negative side, it is expensive to establish a corporation since it is subject to numerous governmental requirements and regulations. 54  Introduction to Engineering Economic Decisions Types of Business Organization Note As a firm grows, it may need to change its legal form because the form of a business affects the extent to which it has control of its own operations and its ability to acquire funds. The legal form of an organization also affects the risk borne by its owners in case of bankruptcy and the manner in which the firm is taxed. 55  Introduction to Engineering Economic Decisions Types of Business Organization Example Apple Computer started out as a two-man garage operation by Steve Jobs and Steve Wozniak (there was third member who left the business early Ronald Wayne). 56  Introduction to Engineering Economic Decisions Types of Business Organization Example As the business grew, the owners felt constricted by this form of organization because: It was difficult to raise capital for business expansion; They felt that the risk of bankruptcy was too high to bear; and as their business income grew, their tax burden grew as well. Eventually, they found it necessary to convert the partnership into a corporation. 57  Introduction to Engineering Economic Decisions Types of Business Organization Business ownership in Ghana In Ghana, the provisions for company or business registration is found in Act 992 (2019). The business registration is now done by the Office of the Registrar of Companies. They categorize registration into five groupings, namely Sole proprietorship External company Private/Public Companies limited by guarantee (respective contribution to assets). Private/Public Companies limited/unlimited by shares. The term Limited Liability Company (LLC) refers to a private company whose owners are legally responsible for its debts only to extent of the amount of capital they invested. (private refers ownership of 1-50 people) 58  Introduction to Engineering Economic Decisions Types of Business Organization Business ownership in Ghana We can have hybrids of the business types with various conditions 59  Introduction to Engineering Economic Decisions Types of Business Organization In terms of total business volume (monetary value of sales), the quantity of business transacted by proprietorships and partnerships is several times less than that of corporations. Therefore in our course we will address economic aspects of corporations and LLCs but note that most of these principles and practices are applicable to all business organizational types. 60 2. Financial management and analysis 61  Financial management and analysis Overview If you want to explore investing in Cargill stock, you will need some information. You would certainly prefer that Cargill have a record of accomplishment of profitable operations, earning a profit (net income) year after year. The company would need a steady stream of cash coming in and a manageable level of debt. Investors commonly use the financial statements often found in the firm’s annual report as the starting point. 62  Financial management and analysis Overview Likewise, as an individual before making any financial decision, it is good to understand an elementary aspect of your financial situation You will first answer the question “How am I doing?” The answer is called your net worth. Net worth is the amount by which a company’s or individual’s assets exceed the company’s or individual’s liabilities. This is routinely required whenever you have to borrow a large sum of money (loan) from a financial institution. 63  Financial management and analysis Overview Example When you are buying a home, you need to apply for a mortgage (home loan). Customarily, the bank will ask you to submit your net-worth statement as a part of loan processing. Your net-worth statement is a snapshot of where you stand financially at a given point in time. The bank will determine how creditworthy you are by examining your net worth. 64  Financial management and analysis Overview In a similar way, a corporation prepares the same kind of information for its financial planning or to report its financial health to stockholders (or shareholders) or investors. The reporting document is known as the financial statements. 65  Financial management and analysis Accounting - the language of business We need financial information when we are making business decisions. Virtually all businesses and most individuals keep accounting records to aid in making decisions. Accounting can be described as the information system that measures business activities, processes the resulting information into reports, and communicates the results to decision makers. For this reason, we call accounting “the language of business.” 66  Financial management and analysis Accounting - the language of business The better you understand this language, the better you can manage your corporate or individual financial well-being, and the better your financial decisions will be. The uses of accounting information are many and varied and may include Personal financial planning, education expenses, loans, car payments, income taxes, and investments. The accounting information is also used by various categories of people which includes Individuals, Business owners and managers, Investors and Creditors 67  Financial management and analysis Accounting - the language of business Use of Accounting Information by Individuals Individuals use accounting information in their day-to-day affairs to manage bank accounts, to evaluate job prospects, to make investments, and to decide whether to rent an apartment or buy a house. 68  Financial management and analysis Accounting - the language of business Use of Accounting Information by Businesses Business managers and owners use accounting information to set goals for their organizations, evaluate progress toward those goals, take corrective actions if necessary. Decisions based on accounting information may include which building or equipment to purchase, how much merchandise to keep on hand as inventory, and how much cash to borrow. 69  Financial management and analysis Accounting - the language of business Use of Accounting Information by Investors and Creditors Investors and creditors often provide the money a business needs to begin operations. To decide whether to help start a new venture, potential investors evaluate what income they can expect on their investment by analyzing the financial statements of the business. Before giving a loan, banks determine the borrower’s ability to meet scheduled repayments. This kind of evaluation includes a projection of future operations and revenue, based on accounting 70 information. Financial management and analysis Accounting - the language of business** An essential product of an accounting information system is a series of financial statements that allows people to make informed decisions 71  Financial management and analysis Financial Statements – Overview For business use, Financial statements are the documents that report financial information about a business entity to decision makers. They tell us how a business is performing and where it stands financially. Note In this course, our purpose is not to present the bookkeeping details of accounting, but to familiarize you with financial statements. This is to give you the basic information you need to make sound engineering economic decisions. 72  Financial management and analysis Financial Statements – Overview For personal use, The financial statement or net-worth statement is a snapshot of where you stand financially at a given point in time. Net worth refers to the difference between your assets (such as cash, investments, and pension plans) and your liabilities (debts). In simple terms, your net worth is what you would be left with if you sold everything and paid off all you owe. 73  Financial management and analysis Financial Statements – Overview Corporations or Companies issue to their stockholders/shareholders an annual report containing basic financial statements as well as management’s opinion of the past year’s operations and the firm’s future prospects. Managers and investors want to know about the condition of a company at the end of the fiscal year usually by asking four basic questions? What is the company’s financial position at the end of the fiscal period? How well did the company operate during the fiscal period? On what did the company decide to use its profits? How much cash did the company generate and spend during the fiscal period? 74  Financial management and analysis Financial Statements – Overview The answer to each of these questions is provided by one of the following financial statements: The balance sheet statement, The income statement, The statement of retained earnings, and The cash flow statement. Note: The accounting period or fiscal year (or operating cycle) can be any 12-month period covered by the statement, but is usually January 1 through December 31 of a calendar year. For Example for Dell Inc., the accounting period begins on 75 February 1 and ends on January 31 of the following year. Financial management and analysis Financial Statements – Overview 76  Financial management and analysis Financial Statements – Overview Remember we mentioned earlier that primary responsibilities of engineers in business is to plan for the acquisition of equipment (capital expenditure) that will enable the firm to design and produce products economically. This type of planning will require an estimation of the savings and costs associated with the acquisition of equipment and the degree of risk associated with execution of the project. Such an estimation will affect the business’ bottom line (profitability), which will eventually affect the firm’s stock price (value) in the marketplace. Therefore it is important for engineers to understand the various financial statements in order to communicate with upper management regarding the status of a project’s or decisions profitability. 77  Financial management and analysis Financial Statements – Overview The role of engineers if further illustrated in this diagram 78  Financial management and analysis Financial Statements – For Businesses Example Lets use some data from Dell Corporation to further understand this. Michael Dell also started his IBM computer in his room at the University of Texas in 1984. The company’s revenue in 2005 was $49.205 billion which kept them as world’s number-one supplier of personal computer systems at the time. Dell’s global market share of personal computer sales reached 17.8%. 79  Financial management and analysis Financial Statements – For Businesses Example In the company’s 2005 annual report, management painted an even more optimistic picture for the future, stating that Dell will continue to invest in information systems, research, development, and engineering activities to support its growth and to provide for new competitive products. We will examine what was in their balance sheet that allowed to make such a bold statement. 80  Financial management and analysis Financial Statements – The Balance Sheet Remember: The Balance Sheet answers the question: What is the company’s financial position at the end of the reporting period? A company’s balance sheet is also called statement of financial position. It reports three main categories of items: assets, liabilities, and stockholders’ equity 81  Financial management and analysis The Balance Sheet Example of a Balance Sheet This is the Balance Sheet from Dell Inc. for 2005 which is found in their Annual report for that year. 82  Financial management and analysis The Balance Sheet Assets are arranged in order of liquidity (convert to cash). The most liquid assets appear at the top of the page, the least liquid assets at the bottom of the page. Cash is the most liquid of all assets therefore it is always listed first. Current assets are so critical that they are separately broken out and totaled (They are what will 83 hold the business afloat for the next year)  Financial management and analysis The Balance Sheet Liabilities are arranged in order of payment, the most pressing at the top of the list, the least pressing at the bottom. Like current assets, current liabilities are so critical that they are separately broken out and totaled. They are what will be paid out during the next year. 84  Financial management and analysis The Balance Sheet A company’s financial statements are based on the most fundamental tool of accounting: the accounting equation. The accounting equation shows the relationship among assets, liabilities, and owners’ equity: Every business transaction, no matter how simple or complex, can be expressed in terms of its effect on the accounting equation. Regardless of whether a business grows or shrinks, the equality between the assets and the 85 claims against the assets is always maintained.  Financial management and analysis The Balance Sheet Assets on the Balance Sheet Current assets can be converted to cash or its equivalent in less than one year. They generally include three major accounts: 1. Cash: A firm typically has a cash account at a bank to provide for the funds needed to conduct day-to-day business. Although assets are always stated in terms of dollars, only cash represents actual money. 2. Accounts receivable: This is money that is owed the firm, but has not yet been received. For example, when Dell receives an order from a retail store, the company will send an invoice along with the shipment to the retailer. Then the unpaid bill immediately falls into the accounts receivable category. When the bill is paid, it will be deducted from the accounts receivable account and placed into the cash category. 86 3. Inventories: This shows the dollar amount that a firm has invested in raw materials, work in process, and finished goods available for sale.  Case study Financial management and analysis The Balance Sheet 87  Financial management and analysis The Balance Sheet Assets on the Balance Sheet Fixed assets They reflect the amount of money a firm paid for its plant and equipment when it acquired those assets; these are relatively permanent and take time to convert into cash. The most common fixed asset is the physical investment in the business, such as land, buildings, factory machinery, office equipment, and vehicles. With the exception of land, most fixed assets have a limited useful life. For example, buildings and equipment are used up over a period of years and each year, a portion of the usefulness of these assets expires (de-valued). 88  Financial management and analysis The Balance Sheet Assets on the Balance Sheet Fixed Assets: Therefore a portion of their total cost should be recognized as a depreciation expense; depreciation denotes the accounting process for this gradual conversion of fixed assets into expenses. Property, plant and equipment, net (in the balance sheet) represents the current book value of these assets after deducting depreciation expenses. 89  Case study Financial management and analysis The Balance Sheet 90  Financial management and analysis The Balance Sheet Assets on the Balance Sheet Other Noncurrent Assets They include investments made in other companies and intangible assets such as goodwill, copyrights, franchises, and so forth. Goodwill indicates any additional amount paid for a business above the fair market value of the business. (Here, the fair market value is defined as the price that a buyer is willing to pay when the business is offered for sale.). 91  Case study Financial management and analysis The Balance Sheet 92  Financial management and analysis The Balance Sheet Liabilities and Stockholders’ Equity The claims against assets are of two types: liabilities and stockholders’ equity. The liabilities of a company indicate where the company obtained the funds to acquire its assets and to operate the business i.e. liability is money the company owes. Stockholders’ equity is that portion of the assets of a company which is provided by the investors (owners) i.e. stockholders’ equity is the liability of a company to its owners. 93  Case study Financial management and analysis The Balance Sheet 94  Financial management and analysis The Balance Sheet Liabilities and Stockholders’ Equity Current liabilities are those debts which must be paid in the near future (normally, within one year). The major current liabilities include accounts and notes payable within a year. Also included are accrued expenses (wages, salaries, interest, rent, taxes, etc., owed, but not yet due for payment), and advance payments and deposits from customers. Other liabilities include long-term liabilities, such as bonds, mortgages, and long-term notes, that are due and payable more than one year in the future. 95  Case study Financial management and analysis The Balance Sheet 96  Financial management and analysis The Balance Sheet Liabilities and Stockholders’ Equity Stockholders’ equity represents the amount that is available to the owners after all other debts have been paid. Generally, stockholders’ equity consists of preferred and common stock, treasury stock, capital surplus, and retained earnings. Preferred stock is a hybrid between common stock and debt i.e. in case the company goes bankrupt, it must pay its preferred stockholders after its debtors, but before its common stockholders. Preferred dividend is fixed, so preferred stockholders do not benefit if the company’s earnings grow (In fact, many firms do not use preferred stock). 97  Financial management and analysis The Balance Sheet Liabilities and Stockholders’ Equity Stockholders’ equity Common stock is the aggregate par value (face or true value) of the company’s stock issued. Note that companies rarely issue stocks at a discount (i.e., at an amount below the stated par). Normally, corporations set the par value low enough so that, in practice, stock is usually sold at a premium (price is significantly higher than normal). 98  Financial management and analysis The Balance Sheet Liabilities and Stockholders’ Equity Stockholders’ equity Paid-in capital (capital surplus) is the amount of money received from the sale of stock that is over and above the par value of the stock. Outstanding stock is the number of shares issued that actually are held by the public. If the corporation buys back part of its own issued stock, that stock is listed as treasury stock on the balance sheet. 99  Financial management and analysis The Balance Sheet Liabilities and Stockholders’ Equity Stockholders’ equity Retained earnings represent the cumulative net income of the firm since its inception, less the total dividends that have been paid to stockholders. In other words, retained earnings indicate the amount of assets that have been financed by plowing profits back into the business. Therefore, retained earnings belong to the stockholders. 100  Case study Financial management and analysis The Balance Sheet 101  Financial management and analysis The Income Statement The second financial report is the income statement, which indicates whether the company is making or losing money during a stated period, usually a year. Most businesses prepare quarterly (every 3 months) and monthly income statements as well. The Basic Income Statement Equation: 102  Financial management and analysis The Income Statement Typical components in the income statement Note: Revenue refers to the income from goods sold and services rendered during a given accounting period. Net revenue represents gross sales (sales without any deduction), less any sales return and allowances. Cost of revenue: The largest expense for a typical manufacturing firm is the expense it incurs in making a product (such as labor, materials, and overhead), called the cost of revenue (or cost of goods sold). 103 Case study 104  Financial management and analysis The Income Statement Typical components in the income statement Operating expenses: These are expenses associated with paying interest (on any loan), leasing machinery or equipment, selling, staff wages and administration. Note that the income taxes is only from the taxable income. Net income is also commonly known as accounting income. 105 Case study 106  Financial management and analysis The Income Statement Typical components in the income statement Earnings per Share (EPS) This is another important piece of financial information provided in the income statement. In simple situations, we compute the EPS as Stockholders and potential investors want to know what their share of profits is, not just the total dollar amount. The presentation of profits on a per share basis allows the stockholders to relate earnings to what they paid for a share of stock. 107 Case study 108  Financial management and analysis The Income Statement Typical components in the income statement Earnings per Share (EPS) Naturally, companies want to report a higher EPS to their investors as a means of summarizing how well they managed their businesses for the benefits of the owners. Example: Dell earned $1.21 per share in 2005, up from $1.03 in 2004, but it paid no dividends. EPS is generally considered to be the single most important variable in determining a share’s price (value of a share). Diluted EPS accounts for any dilutive stock related actions such as employee stock options 109  Financial management and analysis The Income Statement Typical components in the income statement Retained earnings As a supplement to the income statement, many corporations also report their retained earnings during the accounting period. When a corporation makes some profits, it has to decide what to do with those profits. The corporation may decide to pay out some of the profits as dividends to its stockholders and retain the remaining profits in the business in order to finance expansion or support other business activities. Therefore Retained earnings refers to earnings not paid out as dividends but instead are reinvested in the core business or used to pay off debt. (Note: Retained earnings are always presented in the Balance sheet) 110  Financial management and analysis The Income Statement Typical components in the income statement Retained earnings When the corporation declares dividends, preferred stock has priority over common stock since preferred stock pays a stated dividend, much like the interest payment on bonds. The dividend is not a legal liability until the board of directors has declared it. However, many corporations view the dividend payments to preferred stockholders as a liability. Therefore, “available for common stockholders” reflects the net earnings of the corporation, less the preferred stock dividends. 111  Financial management and analysis The Income Statement Typical components in the income statement Retained earnings When preferred and common stock dividends are subtracted from net income, the remainder is retained earnings (profits) for the year. As mentioned previously, these retained earnings are reinvested into the business. 112  Financial management and analysis The Cash Flow Statement Note that the income statement only indicates whether the company was making or losing money during the reporting period. Therefore, the emphasis was on determining the net income (profits) of the firm for supporting its operating activities. However, the income statement ignores two other important business activities for the period: financing and investing activities. Therefore, we need another financial statement - the cash flow statement, which details how the company generated the cash it received how the company used that cash during the reporting period 113  Financial management and analysis The Cash Flow Statement The difference between the sources (inflows) and uses (outflows) of cash represents the net cash flow during the reporting period. This is a very important piece of information, because investors determine the value of an asset (or, indeed, of a whole firm) by the cash flows it generates. A firm’s net income is important, but cash flows are even more important because the company needs cash to pay dividends and to purchase the assets required to continue its operations. 114  Financial management and analysis The Cash Flow Statement Note: the goal of the firm should be to maximize the price of its stock. Therefore, investment decisions are made on the basis of cash flows rather than profits. For such investment decisions, it is necessary to convert profits (as determined in the income statement) to cash flows. 115  Financial management and analysis The Cash Flow Statement Typical components in the Cash Flow statement Many companies prepare their cash flow statements by identifying the sources and uses of cash based on the types of business activities. The cash flow statements will have three cash flow major components: Cash flows from Operating activities Cash flows from Investing activities Cash flows from Financing activities 116  Financial management and analysis The Cash Flow Statement Typical components in the Cash Flow statement Operating activities It begins with the net change in operating cash flows from the income statement. Operating cash flows represent those cash flows related to production and the sales of goods or services. All non-cash expenses are simply added back to net income (or after-tax profits). For example, an expense such as depreciation is only an accounting expense (a bookkeeping entry). Although we may charge depreciation against current income as an expense, it does not involve an actual cash outflow. The actual cash flow may have occurred when the asset was purchased. 117 Case study 118  Financial management and analysis The Cash Flow Statement Typical components in the Cash Flow statement Investing activities Once we determine the operating cash flows, we consider any cash flow transactions related to investment activities, which include purchasing new fixed assets (cash outflow), reselling old equipment (cash inflow), and buying and selling financial assets. 119 Case study 120  Financial management and analysis The Cash Flow Statement Typical components in the Cash Flow statement Financing activities Finally, we detail cash transactions related to financing any capital used in business. For example, the company could sell more stock, resulting in cash inflows. Paying off existing debt is also accounted since it will result in cash outflows. Case study 121  Financial management and analysis The Cash Flow Statement Typical components in the Cash Flow statement A summary of cash inflows and outflows from three activities for a given accounting period is also provided in order to obtain the net change in the cash flow position of the company. Case study 122 Case study: A summary of Dell’s Financial statements for 2005 (all data is in “USD million”) 123 124