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it turns out that numbers are everywhere
you might say that you want a numbers
person but that statement does not make
numbers go away whether you are in
marketing HR supply chain or strategy
numbers are a key element of all
discussions relating to productivity and
performance people who understand the
numbers and appreciate how they are used
within an organization have a leg up on
those who just dismiss numbers is not
being important or understandable our
objective with this course is to help
you understand the two most common areas
involving numbers within a company
accounting and Finance you will find
that the numbers are just a way to
quantify your intuition numbers help us
to be systematic in our analysis numbers
impose a discipline on us that helps us
to consider and quantify all factors
relevant to a decision the numbers
assist us with our decision making it is
important to always remember that we
don't work for the numbers the numbers
work for us the numbers are just a tool
to help us make better decisions and
that is what we all want to do make
better decisions rather than fear the
numbers or dismiss the numbers or cop
out and say you're not a numbers person
together let us get comfortable
understanding and using the numbers
let's see how we can increase our skill
set by getting comfortable with the
disciplines and terms associated with
these numbers we will begin with a
discussion of Finance
what is finance let's start with a broad
definition finance when we're thinking
about organizations individuals families
companies governments is first about
identifying what things I need second
how do I get the money to buy those
things and third how do I manage those
things efficiently once I have them now
let's drill down inside a company first
how do I decide what things I need well
there are long term decisions that I
need to make do I need to buy some land
do I need to buy a building do I need to
buy machines that decision making
process is part of Finance then there
are short term decision
how much cash do I need how much
inventory should I have on hand making
those decisions as part of Finance other
operating items how about my level of
staffing do I have a research and
development department what about my
marketing budget all of these issues are
issues of Finance and they all require
money so that leads into the second area
of financing how do I get that money do
I borrow it
do I ask shareholders or partners to
pull their personal savings and put it
into the company so that we can use that
to buy the things we need or do I use
internally generated profits and third
once I have all those things that I've
paid for them how do I manage them
that's an issue of timing scheduling
budgets interface with my outside
suppliers my staff and I also need to
decide how to protect the things inside
my company I need to have controls and
procedures in place inside my company to
effectively manage the things that I
have now that's a broad description and
definition of finance but when most
people say finance they have a more
narrow set of issues in mind they are
only focusing on one of the three broad
issues how do I get the money to buy the
things I need how does the company get
the money should they borrow it should
they seek it from investors they have to
get the money from somebody outside of
the company so those Outsiders do they
want to invest in this company or do
they want to invest in that company and
there are third parties involved
financial institutions that put these
parties together a company needs to
borrow money you want to lend money
somebody's got to put the two of you
together so when most people talk about
finance realize they're just focusing on
this one narrow sliver of finance
finance broadly defined involves
deciding what you need to buy how you're
going to get the money to buy those
items and then how to manage those
things once they're inside your company
now let's think about what's going on
outside of companies with regard to
finance let's think about all the
economic activity in the world as a sea
an ocean with three kinds of players
swimming around in that ocean first
there are the entrepreneurs the creators
the doers organizations with ideas
objectives these are the companies
looking for funding they're swimming
around out there
there are also investors swimming around
out there
these are the entities individuals
companies who have saved money in the
past and are now ready to lend it or
invest it in somebody else
finally there are facilitators swimming
around out there specialized
institutions that will match up the
entrepreneurs who have ideas but don't
have money with the investors who've got
the money that's the economic
environment that we're talking about so
we've got the entrepreneurs who are
running companies we've already talked
about what goes on inside companies with
regard to finance entrepreneurs need to
decide what to buy how to get the money
to buy it and how to manage it once they
have it so let's think about what goes
on outside the company in the rest of
the economic sea
what about those investors and savers
what are they thinking about they're
looking at their investment
opportunities under what conditions
under what circumstances should they
provide money to entrepreneurs should
they lend the money should they invest
the money what about their portfolio of
investments they don't want to invest
everything in one company so what
different things should they invest in
then there are the facilitators there
are all kinds of them out there there
are banks there are mutual funds there
are private equity funds there are
insurance companies there are investment
banks who put deals together there are
all kinds of entities swimming around
out there trying to match those who need
money with those who have money finance
allows us to look at each one of these
entities and how they interact one with
another finance is identifying the
necessary resources for an organization
determining how to get the money to buy
those resources and then how to manage
those resources efficiently once you
have them that's the broad definition of
finance when we talk about finance
we're usually talking about just the
middle one determining the best way to
get the money to buy the needed
resources should I borrow the money
should it be invested if I'm an outside
investor under what circumstances under
what conditions should I provide that
capital and then finally what about
those financial institutions that bring
savers and entrepreneurs together how
these three groups work together is a
narrow definition of finance but it's
probably the most common but keep in
mind that within a company finance is
much bigger than just obtaining funding
determining if funding is needed the
amount of funding needed and how to
manage the resources associated with
that funding is also part of Finance
now let's turn our attention to
accounting what is accounting first
accounting is quantitative you knew that
it's numbers second accounting is
financial in nature that means money
numbers about money
third accounting is meant to be useful
it's a very practical field of study
well useful for what that's the fourth
aspect of accounting useful in making
decisions accounting helps you use the
past right now in the present to change
the future
accounting is quantitative numbers about
money to help people you and me make
better decisions
that's accounting now there are four
different types of accounting first the
most fundamental type of accounting is
bookkeeping just the routine gathering
of the information making sure that
everything gets recorded because if it
doesn't get recorded we'll never know
about it
so bookkeeping is the systematic
gathering of financial information
the second flavor of accounting is
called financial accounting this is
reporting to people outside your
organization just summary reports not
the details financial accounting is for
people who want periodic reports as to a
firm's performance so you prepare and
provide them with a report of the
economic resources you have and the
economic obligations you've incurred you
report as to whether you made money last
year did you lose money last year just
summary reports to people outside of
your company who might be thinking of
loaning you money or might be thinking
of investing in your company that's
called financial accounting reporting to
outsiders
now the third field of accounting is
managerial accounting this type of
accounting involves the details within a
company those are the detailed
proprietary data that individuals use
inside their organizations to make
decisions detailed decisions decisions
such as should I raise my prices should
I stop selling shirts and start selling
shoes should I build my factory in
Wyoming or should I build it in Alabama
those detailed decisions that business
people and people running organizations
make every day and this is information
that is known
only to those inside a company they
don't reveal this to outsiders it's
confidential information
that's called managerial accounting and
finally the fourth kind of accounting is
income taxes this is the accounting that
makes sure that you're in compliance
with the tax laws well those are the
four types of accounting bookkeeping
financial accounting manager early
accounting and income taxes both
accounting and finance deal with using
numbers to make better more informed
decisions the numbers certainly do not
drive the decisions but they provide a
significant input into the decision
making process accounting involves
gathering and compiling information for
decision makers both within the company
and outside of the company this
information is often used by those in
the field of finance to determine what
resources are needed and how best to
acquire and utilize those resources
accounting and Finance do not involve
magic they involve understanding our
objective here is to help you gain some
of that understanding not so that you
can become accountants but rather so
that you can understand and appreciate
where those numbers come from and what
those numbers are used for who knows
perhaps you'll find that numbers can
become your friends
we've talked about how accounting and
finance involved compiling and using
quantitative information and making
decisions how's that information
conveyed how do users see and digest
that information well within a company
quantitative information can take on
many shapes and sizes there are no rules
as to how information is used within a
company a company can use information
that it develops within a firm in
whatever way helps that company to make
the best decisions but once you step
outside of a firm there are rules
information used by potential investors
and creditors is governed by rules so
that information can be compared across
time for the same company and across
companies at the same point in time now
we won't get bogged down in how those
rules are created suffice it to say that
there is a formal rulemaking process to
ensure that the information given by
firms to those outside of the firm is
relevant and reliable financial
statements are a method in which the
effects of lots of transactions are
summarized and reported in a manner that
is useful to users of financial
statements who are standing outside the
company the three most common financial
statements are the balance sheet the
income statement and the statement of
cash flows we will look at these three
statements in a bit of detail as they
are quite common if you are evaluating a
competitor's financial position if you
are evaluating a suppliers long-term
viability if you are a member of a labor
union negotiating with a company if
you're assessing a customer's ability to
pay you will use these three financial
statements as part of your assessment
let's take a look at each of these in
turn
we will start with the mother
all financial statements the balance
sheet the balance sheet embodies the
accounting equation one of the greatest
inventions of the human mind invented in
Italy over 500 years ago a listing of
things we own assets is easy anybody can
list assets but the insight from the
accounting equation is to then also list
where did we get the money to buy those
assets the liabilities and the equities
now assets they're valuable resources
they are the items that will provide us
benefit in the future cash for example
is the asset that we can all quickly
identify if you look for example at the
balance sheet of Apple you'll see that
Apple had on September 27 2014 13.8
billion dollars in cash now that's a lot
of money but that's not even close to
being Apple's biggest asset accounts
receivable that's money that's owed by
other people to a company that's another
common asset continuing the Apple
example at the end of September 2014
customers old Apple almost seventeen
point five billion dollars Apple also
had inventory all those iPods iPads IMAX
and iphones at the end of September 2014
Apple had inventory totaling over two
billion dollars another asset land
buildings equipment all of these are
resources that a company uses in
accomplishing and subjective Apple had
twenty point six billion dollars in
property plant equipment but apples
biggest asset as of September 27 2014
was long-term marketable securities
these are the stocks and bonds of other
companies that Apple has purchased that
amount totaled over one hundred and
thirty billion dollars apples total
assets at the end of September 2014
totaled almost two hundred and thirty
two billion dollars Wow again
assets are resources available to a
company that will benefit that company
in the future now how does it company
finance its assets how did Apple finance
that two hundred and thirty two billion
dollars in assets if a company has
assets then that same company also has
to have sources of financing to buy
those assets
what are these sources well one possible
source are liabilities liabilities are
obligations to repay money or to provide
a service in the future
consider for example Walmart where does
Walmart get most of its inventory that's
the things that Walmart has on its shelf
to sell the you and me while suppliers
finance it suppliers say you can pay us
later we call those accounts payable
other liabilities Disney has borrowed
money on a long-term basis sometimes
very long term a hundred years would you
loan money to somebody for a hundred
years well maybe not everybody but you'd
loan money to Disney to pay you back in
a hundred years United Airlines has a
very interesting liability when you and
I fly on United Airlines we pay first
and fly later in the interim United
Airlines owes us a ride on a plane
that's an obligation turns out that's a
liability that's listed on United
Airlines balance sheet at the end of
2014 that obligation to provide airplane
rides to people who had already paid
totaled over 3.7 billion dollars so
let's go back to Apple their biggest
liability was accounts payable companies
that they'd purchased assets from but
hadn't yet paid for the amount of their
accounts payable was thirty point two
billion dollars their second largest
liability was long-term debt totaling
about thirty billion dollars now you
might ask why would a company with
almost 14 billion in cash and 130
billion in marketable securities be
borrowing money but that's a discussion
for another day suffice it to say that
Apple's liabilities as of the end of
September 2014
total to 120 billion dollars now the
second source of financing to buy assets
is owner's equity money provided to the
company by owners owners can do this in
two general ways they can take money out
of their pocket and invest it in the
business we call this paid in capital
that's the first way that owners invest
in their company a second way that
owners invest in the company is by
leaving profits of the company in the
business we call these retained earnings
the profits of a business belong to the
owners the owners can take the
profits out and use them to buy
groceries or to buy a boat or whatever
else they want to do or the owners can
say let's put those profits back into
the business
we call those retained earnings paid in
capital and retained earnings are the
amount of money that are provided to the
company by the owners to then buy assets
in the case of Apple owners have
invested about twenty three point three
billion dollars into the business that's
paid in capital and they have elected to
leave in the business since the business
was started about eighty nine billion
dollars to review remember that Apple
had assets of two hundred thirty two
billion dollars well how did they
finance those assets a hundred and
twenty billion dollars worth were funded
through liabilities and the remainder
were financed by owners to the tune of
about a hundred and twelve million
dollars now the first thing to note is
that they call this financial statement
a balance sheet for a reason it balances
the accounting equation requires assets
to equal liabilities plus owner's equity
it has to balance by definition the
accounting equation always holds always
we can look at a couple of other
companies to show how their balance
sheet balances consider the following
these three companies United Airlines
General Motors in Google vary in size
and they vary in the degree to which
they finance their assets with
liabilities but they all have one thing
in common their assets exactly equal
their liabilities plus their owner's
equity even though these are
sophisticated companies selling products
that are quite innovative and
technologically advanced they still
follow that same accounting equation
that was invented by the Italians over
500 years ago assets equal liabilities
plus equity check it for each one and
you'll see that they add up they always
add up
the second primary financial statement
is the income statement the income
statement tells us revenues minus
expenses and that equals net income we
use the term revenues and expenses all
the time so let's make sure we know what
these words mean in an accounting
context revenue means the amount of
assets generated in doing business and
different companies generate assets in
different ways Walmart for example
generates assets by putting things on
shelves that you and I buy we pay
Walmart more for the inventory than they
themselves paid for it that's how
Walmart creates assets Microsoft creates
assets by creating software and hardware
that you and I then buy and we pay
Microsoft for those things Disney has a
consumer products they have cruises they
have theme parks we pay to use those
things or to buy those products and
that's how Disney generates assets
revenue is the amount of assets
generated in doing business hopefully
the assets generated are less than the
assets consumed expenses are the amount
of assets consumed in doing business for
example Microsoft consumes assets by
paying programmers and by paying for
equipment Walmart consumes assets by
buying the inventory that they then sell
the you and me and then paying rent by
having buildings depreciate by paying
its employees McDonald's consumes
resources by buying food buying paper by
renting facilities in each case the
revenues hopefully are more than the
expenses that are consumed in generating
business all of this is put together in
the income statement net income equals
revenues minus expenses now net income
is a very sophisticated economic measure
it's the net amount of assets generated
by a business through its business
operations this is the income statement
now let's look at the income statement
for some companies of which you've heard
Facebook Google Microsoft and Apple all
of these companies have income
statements that they released to the
public on a regular basis now take a
look at these first of all you see a
difference in scale Apple is so much
larger than Facebook in fact Facebook is
the smallest company on this list and
terms of Revenue yet we talk about
Facebook so much this illustrates an
important point the financial statements
are only one measure of a company's
performance a very important measure but
only one measure now why do we talk
about Facebook so often because for
Facebook its operations now are only a
small fraction of what we think they're
going to be in the future
Facebook is expected to grow
substantially in the future so we talk a
lot about them now the point with the
income statement is this a company
increases its net assets through
profitable operations you can see that
for each of these four companies they've
all been very profitable as a result
their net assets increase year after
year
the third primary financial statement is
the statement of cash flows conceptually
the statement of cash flows is quite
simple cash in cash out the inside of
accountants is to separate those cash
flows into three categories operating
activities investing activities and
financing activities those three
categories of cash flows are what are
reported in the statement of cash flows
now operating activities are what
companies do every single day they
collect cash from customers they pay
cash to buy inventory they pay cash to
employees for rent for advertising for
research and development all of those
things are operating activities think of
operating activities as the things that
their business does every single day and
hopefully a company would generate cash
from its operating activities you would
hope that a business would be collecting
more cash than it spends on a daily
basis
the second category in the statement of
cash flows is investing activities
investing means investing in the
productive capacity of the business
buying machines buying land buying
buildings those are investing activities
in contrast to operating activities
which happen every single day investing
activities happen occasionally
you don't buy land and buildings every
single day you do that on occasion
operating activities are things that a
business does every day
investing activities investing in the
productive capacity of the business
happen occasionally the third category
in the statement of cash flows is
financing activities and that is exactly
what it sounds like financing borrowing
money repaying those loans getting cash
or investors paying dividends to
investors getting the capital or
financing to buy the assets that a
business needs now a way to think of the
statement of cash flows is with
financing activities on getting the
financing that is the capital to buy the
assets the investing activities to then
conduct the operations the operating
activities these are the things that our
business does the statement of cash
flows is built around operating
investing and financing activities let's
look at examples of the statement of
cash flows for three companies about
which you may have heard coca-cola Exxon
mo
and Walmart first thing I want you to
look at is well look at the statement of
cash flows for ExxonMobil particularly
look at their investing activities
billions upon billions of dollars of
investing activities investing in the
productive capacity of these businesses
this business needs larger machines and
buildings and equipment and lots of land
and you see that reflected in the
investing cash outflows of ExxonMobil
these are often called capital
expenditures or capex now I want you to
look at the statement of cash flows for
coca-cola and Walmart we call these cash
cows the reason we call them cash cows
is their operations generate more than
enough cash to pay for all of their
investing activities with cash leftover
they're generating a lot of cash
wouldn't you like to be a personal cash
cow where your daily cash flows were
enough to pay for all your cars and your
houses and your land and everything else
you needed to buy in cash
that's coca-cola that's Walmart and
that's ExxonMobil now let's step back
and remind ourselves why an
understanding of these three financial
statements is important if you are ever
in a position of negotiating with
another company and find yourself
wondering about the company's long-term
viability you will want to know a little
something about their financial position
well their financial position is
summarized quite nicely with using these
three financial statements these three
financial statements may not tell you
everything about a company's future but
they do tell you a lot
in this section we will discuss how
common external financial reports are
used by those who are standing on the
outside of a company and trying to
assess the financial viability on the
inside of a company of course it would
be preferable if we could just get
inside the company to do our analysis
but companies do not like outsiders
poking around on the inside of their
company there's just too much
proprietary information that they do not
want exposed to outsiders things like
cost structures pricing margins and R&D
efforts to name a few we must make do
with the information that is available
another point to keep in mind is that
the analysis techniques that we will
practice on the external financial
statements can be developed and applied
within a firm using proprietary firm
specific information in other words we
will practice the techniques on commonly
available information and you can
develop unique techniques within your
company for analyzing firm specific
information so let's begin first of all
let's ask the question what is financial
ratio analysis we'll begin our
discussions by looking at a company most
of us are familiar with Ford Motor
Company the car company in 2014 they
reported income of 3.2 billion dollars
is that a lot at December 31st 2014 they
reported total assets of 208 point five
billion dollars is that a lot and what
they do with those assets at the end of
December 2014 they had liabilities of a
hundred and eighty three point three
billion dollars is that a lot and what
did they use that money for to answer
these and other questions we'll need to
carefully analyze Ford's financial
statements that brings us to financial
ratio analysis which is simply the
examination of relationships among
financial statement numbers we're going
to do a lot of dividing one number by
another to draw our conclusions when it
comes to ratio analysis we're going to
do two types one we're going to compare
the same company across time to see how
the company is performed over time and
secondly at the same point in time we're
going to compare across companies
for example let's continue with Ford in
2014 they had return on sales of 2.2
percent return on sales is simply net
income divided by sales which is a
measure of how much profit they earned
per dollar in 2014
2.2 percent in 2013 they had a return on
sales of four point nine percent the
obvious question why how did that happen
now comparing forward to General Motors
during 2014 General Motors had a return
on sales of 2.6 percent Ford again 2.2
percent again why what has happened to
Ford's profitability from 2013 to 2014
and during 2014
why is General Motors more profitable
than Ford those are good questions and
we're going to answer them now when it
comes to financial ratio analysis I like
to borrow a quote from Winston Churchill
he said the following the further
backward you look the further forward
you can see we analyzed financial
statements to tell us if a company has
done well or poorly in the past and to
help us see how the company might do in
the future when it comes to financial
ratio analysis there's a four step
process in this course we're going to
introduce you to step one the DuPont
framework to breakdown return on equity
into its component parts so let's do
that next
return equity is a general overall
measure of how well a firm is doing the
DuPont framework brakes return on equity
down into three parts profitability
efficiency and leverage let's use an
example to illustrate we have uncertain
balance sheet and their income statement
what can we conclude by looking at this
for starters we can see that they had
total assets of fourteen thousand five
hundred dollars sales of twenty thousand
dollars and income of seven hundred
dollars is that good is that bad it's
hard to tell so let's compare them with
benchmark company what can we conclude
by looking at benchmark and uncertain
side by side well the first thing we
notice is benchmark is bigger and if we
do a little mental math we can conclude
well it looks like their net incomes
higher relative to their sales but just
a raw comparison of benchmarks financial
statements with uncertain spine an shil
statements that's tough to do there has
got to be a way to compare these two
different companies of different sizes
so we're going to begin with our first
financial ratio my favorite and most
people's favorite return on equity
return on equity is computed by dividing
net income by stockholders equity it's a
measure of the amount of profit earned
per dollar of investment and it's
affectionately known as our OE return on
equity our OE now let's compare
uncertain and benchmarks our OE as you
can see the return on equity for
uncertain was nine point three percent
compare that with benchmark at twenty
point three percent
what does that nine point three percent
mean well it means for every $100 that's
been invested by uncertain Zoners those
owners earned a return of nine dollars
and 30 cents in the most recent year is
that good is that bad well it's
certainly not as good as benchmark but
nine point three percent by itself what
does that tell us well in general with
respect to return on equity or our OE
greater than twenty percent is very good
less than 10 percent nuts are good and
typically companies are between ten and
twenty percent
between 10 and 20 percent is normal so
in the case of uncertain that 9.3% well
that's not good as an example let's take
a look at some companies with which
we're all familiar it's no surprise that
Apple and Microsoft have very good
return on equities no surprises at all
in the case of GAAP a retail clothing
chain their return on equity in 2014 was
a stunning forty two point three percent
above both Apple and Microsoft Walmart
at 19 percent finds itself in the normal
range and you can see for both Ford and
General Motors that they are at twelve
point nine percent and 11.1%
respectively at the lower end of the
normal range when it comes to return on
equity it is a general overall measure
of a company's performance for a given
period of time and it is the foundation
for one of the most amazing creations in
accounting history the DuPont framework
okay as we saw uncertain how to return
on equity of 9.3 percent not good
benchmark had a return on equity of
20.3% very good now anybody can see that
benchmark is higher than uncertain when
it comes to return on equity turns out
we can now either be a problem pointer
or a problem solver anybody can see that
uncertain has a problem what we want to
know is why do they have a problem and
that brings us in all its glory to the
DuPont framework now the DuPont
framework has three components
profitability efficiency and leverage
let's start with leverage because that's
the thing we do first when it comes to
leverage that's an indication of how
much money have we borrowed to purchase
assets and why do we purchase assets we
purchase assets in hopes of generating
sales the leverage measure tells us of
our assets how many were acquired with
the equity that's been put into the
company we've borrowed to buy it gives
us a measure of how much we've borrowed
to buy assets and why do we buy assets
to generate sales that's what the
efficiency ratio is measuring we buy
assets to generate sales the more sales
we can generate per dollar of assets the
better and why do we want sales that
leads us to our profitability measure
the more sales we have the higher our
income is going to be so first of all we
borrow money to buy assets we buy assets
to generate sales we generate sales to
generate income our return on equity
measure tells us how much income would
did we generate given a fixed amount of
stockholders equity that's been invested
by the owners in the firm
now with that framework let's take a
look at uncertain vs. benchmark and use
the DuPont framework to identify not
only how uncertain is done but why they
have performed poorly relative to
benchmark so we can see the two
company's return on equity and the
DuPont framework ratios here uncertain
with 9.3 percent return on equity
benchmark with 20 point three percent
and we can
also see the profitability measures the
efficiency measures and the leverage
measures for uncertain and benchmark to
review we look at leverage efficiency
and profitability for uncertain and
benchmark and the first thing we notice
is that leverage is the same for both
companies
so in explaining the difference in
return on equity between uncertain and
benchmarks it can't be attributed to
leverage so then we look at efficiency
and we find out that uncertain generates
a dollar and 38 cents in sales for every
dollars worth of assets it has compared
to benchmark which generates a dollar
and 70 cents in sales for every dollars
worth of assets they have then we look
at profitability when it comes to
profitability uncertain is generating 3
dollars and 50 cents in profit for every
hundred dollars in sales compared to
benchmark which is generating 6 dollars
and 20 cents in profit for every hundred
dollars worth of sales so why is
benchmarks return on equity so much
higher than uncertain profitability and
efficiency benchmark is much better at
generating sales with its assets and
generating earnings with the sales that
it has so now do we have any other
questions well when it comes to
efficiency which specific assets are
being used inefficiently by uncertain
which expenses are too high which would
account for their lower profitability we
want to know the answer to those
questions and we would do further
analysis to get there
okay we've now completed step one using
the DuPont framework to break down
return on equity into its component
parts now what well it turns out that
the numbers can tell you what has
happened additional analysis can shed
light on why things happen the numbers
as we're going to find sell them provide
the answers to questions the numbers
point you in the direction of the next
question and eventually we're going to
end up talking to an individual so to
review the DuPont framework analysis is
the first step we do that first we take
return on equity and break it down into
a profitability efficiency and leverage
the second step in our analysis would be
to prepare common sized financial
statements common size financial
statements allow us to compare companies
of different sizes both across time or
at the same point in time across
companies step two would be common size
financial statements based on that
analysis we then have additional ratios
we could use we have profitability
ratios we have efficiency ratios and we
have leverage ratios as we saw with Ford
versus General Motors we had differences
relating to efficiency GM was more
efficient at using assets to generate
sales well we can then go and analyze
individual assets to see which assets
are generating more sales and which
assets are not in addition we saw that
with Ford and GM GM was more profitable
there are ratios that allow us to drill
down to find out specifically where we
might be missing on profitability
where's the difference between Ford and
General Motors when it comes to
profitability with a little further
analysis we could answer that question
the first three steps are simply doing
analysis with available information to
lead us to the next clue we drill down a
little more and a little more for
example we didn't need to drill down
with leverage because we saw that Ford
was much more highly leveraged than with
General Motors we don't have additional
questions there but if we did there are
ratios related to leverage that we could
look at all of this analysis eventually
leads us to the right person who can
tell us why we are different from our
competitor or why we were different
from last year we do this analysis to
get us to the right person to ask the
right question that's where we're headed
with all this now as I said before the
objective with this course is not to run
through the entire menu of financial
ratio tools that one can use to analyze
the numbers if you want more of that go
visit our course on understanding
financial ratios
our primary objective here was to show
that a careful analysis of the numbers
can allow us to draw certain conclusions
about the operations of a business we
have used publicly available information
to do that but you can do a similar
analysis within the firm that is
available only to you the point is this
a careful analysis of numbers across
time can allow us to identify issues
that deserve further attention you do
not need to be a numbers person to do
that
everyone numbers person or not knows
that cash is the lifeblood of a business
without cash you will not be in business
for very long you can have a great
marketing plan you can have a great
location you can have a great product or
service but if you don't turn your cash
into more cash you will not be in
business for very long to begin we'll
talk first about a company's operating
cycle how long it takes from when a
company buys inventory and then turns
that inventory into a receivable and
then returns that receivable into cash
if the operating cycle is too long
things get pretty tough pretty quick for
a company in other words if my cash is
tied up in other assets receivables in
inventory that it's not available for me
to utilize in the business remember when
we are talking about finance we are
talking about identifying those
resources that we need determining the
best way to get the money to buy those
resources and then managing those
resources effectively to do that I need
detailed timely information in this
section we're going to talk about
short-term financial management we are
going to illustrate that using the
operating cycle of a wholesale building
supply company you will notice in this
diagram that we've got various points on
the clock
we begin with cash we take that cash and
we have to purchase inventory so we have
to have relationships with our suppliers
we have got to have suppliers that we
can count on to get us what we need when
we need it
once we've purchased that inventory we
now have to manage our inventory the
last thing we want is not enough
inventory the worst thing that can
happen to a business is to run out of
inventory when a contractor comes in and
needs sheetrock we've got to have it we
don't want to ever run out of inventory
but then we don't want too much
inventory we've got to have what they
need when they need it then we will have
customers come in to make the purchase
they will want to buy stuff from us well
we've got to manage relationships with
our customers we will have large
customers we will have small customers
we will have customers we like and we
will have customers that just are our
favorites we've got to ensure that we
have a system to manage those
relationships you will note that once we
make the sale then we end up with a
receivable we have got to manage our
receivables as well to ensure that we
have prompt collections we may provide
our contractors with terms but if we
don't send them a bill they're just not
going to magically pay us we have got to
manage our receivables to ensure that
this operating cycle this conversion
from inventory to receivables to cash
works and that we eventually get our
cash in a timely fashion we are going to
have to manage this operating cycle
continuously and we will need
information to do that in this chapter
we are going to talk about managing our
cash numbers person or not we need to
watch cash flow the objective of a
business is not to have a lot of
inventory the objective of a business is
not to have a lot of people owe us money
the objective is to manage our inventory
and our receivables so that we convert
our inventory into cash as quickly as is
reasonably possible
so let's begin by talking about cash
management how to manage the cash we
have why should we have any cash at all
as we know cash is a low yielding asset
you don't make a lot of return on cash
so you don't want to have too much but
then you don't want to have too little
either well why have cash at all well it
turns out that bills have to be paid in
cash employees have to be paid in cash
rent has to be paid in cash insurance
has to be paid in cash we've got to
manage our cash to ensure that we have
it when we need it
that requires computers that require
staff that requires sophisticated
projections to ensure that we can
forecast are we going to have enough
cash when we need it a cash shortfall
would be inconvenient and potentially
costly for example if payroll is due on
Friday and it turns out that you don't
have the cash there the consequences are
going to be tragic so we have to make
sure we have sufficient cash why not
have a lot well as I said earlier cash
is a low yielding asset to have cash
sitting in your savings account you're
not to going to get a very large return
on that the opportunity cost of holding
cash can be very high so to ensure we
have not too much and not too little
there are tools that we have to manage
our cash one common tool is a cash
budget we can carefully plan and solve
cashflow problems in advance it turns
out over time we can predict with some
degree of certainty when will our
customers pay us we can predict with
some degree of certainty when are we
going to have to pay our suppliers and
what we want to do is identify well in
advance when are we going to need cash
we don't need to guess we can determine
ahead of time by making a cash budget so
a cash budget allows us to determine
when are we going to have shortfalls of
cash and when are we going to have
excesses in cash and then we can have
strategies to ensure we're ready for
both of these eventualities
okay we just talked about cash
management now let's talk about
receivables management recall that
receivables are the amounts of money
owed to us by customers we want to
manage our receivables to ensure that
they turn into cash but let's ask the
question why would anybody have
receivables in the first place why not
just sell for cash well it turns out
credit sales are a marketing technique
it turns out if we will offer credit we
will get more sales if I'm offering you
a product and you have to pay cash here
and my competitor down the road is
allowing you to pay in 30 days for the
same product you'll go down there
although the things being equal
now if credit sales increase sales why
not have for credit to everyone well it
turns out if you offer credit to anyone
and everyone there will be a lot of
people who won't pay you you'll have bad
debts associated with that and so it's a
trade-off I'll increase my sales but
I'll have people who won't pay me I've
got to measure that trade-off to ensure
that those increased sales are worth it
I've got to be careful who I extend
credit to in addition if you're going to
get into the credit business you got to
keep track of that very rarely will
someone come in and say I know how are
your money but I don't know how much
will you tell me and will you take my
money they will send you money when you
send them a bill so you've got to keep
track of who owes you and how much they
owe and you've got to send them a bill
to ensure that they pay you in addition
by tying up money into receivables that
is an opportunity lost it turns out if
you had had that cash instead you can
invest it
so there's another part of the trade off
for example Boeing in 2014 had
accountable of seven point seven billion
dollars that is customers owed them
seven point seven billion dollars at
year-end if they had that seven point
seven they could have invested it and
earned a return on it but I'm sure
they've done the calculation that
offering credit increased their sales
and more than makes up for any implicit
interest cost that they've lost now when
it comes to determining who do we offer
credit to companies have to manage what
their standards are going to be many
companies are careful who they offer
credit to to ensure that they receive
payment and reduce their bad debts
how long are you going to offer credit
are people going to pay you in 30 days
60 days 90 days if they pay early will
you offer a discount if they pay late
will you charge interest those are
decisions when it comes to managing
receivables that have to be made and if
they don't pay you what do your practice
is going to be to ensure that eventually
you do collect your receivables all of
those things have to be determined when
you're managing receivables now what
starts this off inventory we buy
inventory and we turn it into a
receivable that receivable is eventually
turned into cash when it comes to
inventory how are we going to manage our
inventory to ensure that we have the
right amount of inventory well why have
inventory at all well it turns out if
somebody walks into your store and you
don't have the product they will go
somewhere else and they may not come
back companies carry inventory to ensure
that when a customer needs inventory
they can find it at your store well then
why not just have a lot of inventory why
not make sure we never run out of
inventory well it turns out there are
costs associated with inventory as well
if our money is tied up in inventory
it's not available to be tied up
anywhere else we can't do anything with
that money if we've already got it tied
up in inventory we can't buy equipment
we can't expand our building if our
money's tied up in inventory so we don't
want to have too much when it comes to
inventory we've got to implement the
Goldilocks principle not too much and
not too little when it comes to
inventory we want to make sure it's just
right so again why is this important to
you regardless of your position in an
organization cash is still King
decisions that you make perhaps far away
from the front lines of a business can
push cash further away or draw closer to
collection virtually every decision in a
business has cashflow implications and
remember that cash is the lifeblood of a
business those who can see beyond their
own area of responsibility and recognize
the cash flow implications to the
business of decisions that they make are
more valuable than those who don't
again you don't have to become a numbers
person but it is helpful to the business
and to you if you can appreciate the
effect of your decisions on the numbers
of the business particularly the cash
flow numbers
what can be so hard about pricing a
product don't you just figure out what
your costs are and then add some sort of
markup for profit oh that it were that
easy
if your price is too high regardless of
your cost someone in the market will
underpriced you assuming that the
quality of product or service is similar
in many cases you will be a price taker
and you will have to manage your costs
so that you can earn a profit given a
certain price is determined by the
market now let me say that again in most
instances you don't price your product
to cover your costs instead you
determine if given a certain market
price your cost structure is such that
you can earn a profit
the biggest mistake small business
owners make in product pricing is not
considering and covering all of their
costs when entering a market now it is
true that when you are initially trying
to penetrate a market you may be willing
to lose a little money to gain market
share but that strategy is not
sustainable over time over the long term
you must cover all your cost all your
costs now let's consider a really simple
example to illustrate a very complex
point it's summer time and I'm going
into the snow cone business you know
finely crushed ice that is flavored
perfect for those hot summer days I have
figured that on average the paper cone
costs about 3 cents per snow cone the
ice and the snow cone costs about 2
cents per snow cone that's 5 cents per
cone oh and let's not forget about the
flavoring I estimate that on average
those flavors will cost about 45 cents
per cone so the cost of a snow cone is
about 50 cents each and I figure that on
those hot summer days I can sell a snow
cone for $2 each after all that's the
going rate at other snow cone shacks
that means I will make a dollar fifty
per snow cone that sounds like a money
machine to me but not so fast to this
point I have only considered my variable
cost those costs that vary depending on
the number of cones I produce another
way to think about it is that these
costs stay the same for each cone they
vary
in direct proportion to the number of
cones I sell the more cones sold the
higher the cost of cups the cost of ice
and the cost of flavoring but what about
my fixed cost those costs that are fixed
whether I sell one snow cone or a
thousand costs like the machine to crush
the ice the snow cone shack to house my
equipment the bottle is holding the
flavors and then there are my employees
they get paid whether I have one
customer or a hundred customers these
costs are incurred regardless of the
number of customers in other words these
costs are fixed and these fixed costs
have to be covered so the dollar fifty
that I initially thought of as profit is
actually a term called contribution
margin contribution margin is the
difference between the selling price $2
per snow cone in this example and my
variable costs 50 cents
the contribution margin contributes to
cover my fixed costs once my fixed costs
are covered then each subsequent sale is
contributing a dollar 50 towards profits
but until my fixed costs are covered by
the cumulative contribution margin I'm
not making any profits these fixed costs
are often considered overhead costs and
overhead costs must be covered now why
are they called overhead costs well look
up many of those costs are the costs
over your head the building the lights
the other utilities and they all have to
be covered have you ever taken your car
and to get the oil changed you get 4
quarts of oil and a new oil filter and
someone takes 15 minutes to drain your
oil and replace it and it costs you 50
bucks for quarts of oil at about $3 per
quart and a new oil filter for five
dollars and fifteen minutes of someone's
time and you get charged $50
someone is making some money there but
wait what about the mechanics equipment
the building the computer system to
process payments and track your car's
history the other overhead items all
those costs have to be covered and if
they are not all covered then this
business is not going to be in business
for very long now back to the snow cone
business
if I am not making enough money on the
sno-cones I'm selling then I will just
raise the price remember there are snow
cone shacks all over if your price gets
too high then your customers become
someone else's customers they will vote
with their feet often you cannot just
set your price and assume people will
pay what you are asking it is a
competitive environment out there
whether you are selling snow cones
changing oil and cars or selling
software on the Internet it is very rare
that one can simply ignore market forces
in charge what they want the market is
too competitive for that more often than
not companies are price takers you must
take the price that the market is
offering and then determine if your cost
structure is competitive and when you
are considering your cost structure you
have to consider all of your costs
in the previous video we talked about
the necessity of considering all your
costs when trying to determine if you
can compete in a market okay so now the
big question can we be profitable given
a market price of two dollars per
snowcone that's a tough question to
answer and it's also the wrong question
to ask but if we're determined to remain
a not numbers person our entire life
those are the types of questions we will
be asking the wrong questions the right
question to ask is how many people must
come for us to be profitable clearly if
a million people stop by and buy snow
cones we will be profitable if only ten
people stop by then we will have a
problem and it turns out we can
calculate how many people will need to
stop by for us to what is called
breakeven we can compute our break-even
point that is the point at which we
exactly cover our fixed costs in other
words we haven't made money and we
haven't lost money we've broken even so
how do we do that well we now need to
track our fixed costs recall that we
need machinery to crush the ice we need
containers for our flavors we need a
structure to house our business and
store our ice and we need to pay
employees for simplicity's sake we will
assume that these are all of our fixed
costs let's assume that these fixed
costs totaled $3,000 per month
recall that our contribution margin per
sale was a dollar fifty if we divide our
contribution margin into our fixed costs
we are able to compute our break-even
point we are able to compute the number
of sno-cones we will need to sell to
break-even in this instance we divide
$3,000 by a dollar fifty with the result
being two thousand sno-cones we need to
sell two thousand snow cones to exactly
cover our fixed costs rather than ask
the question can we be profitable
selling snow cones at $2 each a better
question is at $2 per snow cone will we
be able to sell 2,000 each month two
thousand snow cones per month means we
will need to sell on average 67 snow
cones each day assuming 30 days in a
month
that we are open every day assuming we
are open eight hours per day will we be
able to sell on average about 8.4
sno-cones each and every hour we are
open some hours we may sell more and
some hours we may sell less but on
average can we sell 8.4 sno-cones per
hour that is a nice number to know
before you decide to get into the
snowcone business now you can go sit
across the street from your nearest
competitor and watch how many customers
they have each hour if you observe that
they have 20 customers per hour then
this might be a business you want to get
into if they service on average about
five customers per hour you might want
to rethink this business opportunity and
isn't it nice to know this information
before you rent the building and the
machine to crush the ice and before you
buy the flavor containers and hire
employees can this business be
profitable well that depends on how many
customers you can expect and we can
compute the number of customers we will
need through a careful analysis of our
fixed and variable costs but wait no
business is started with the objective
of simply breaking even you don't open
the doors of a new business hoping that
you make nothing you start a new
business hoping to make a profit can we
build a target profit into our
computations we sure can let's assume
we're getting into the business with the
intent of generating a profit of $2,000
per month you simply treat that number
similar to a fixed cost in other words
now our contribution margin needs to
cover our fixed costs of $3,000 per
month and a desired profit of $2,000 per
month for a total of $5,000 per month we
divide this $5,000 by our contribution
margin of a dollar fifty per sno-cone
and the result is 3333 in other words to
generate a target profit of $2,000 we
will need to sell 3333 sno-cones each
and every month or a hundred and eleven
per day or given an eight-hour day about
fourteen sno-cones on average per hour
can we start this business and generate
a profit of $2,000 per month
numbers person would say I hope so I
think so
probably but with a little effort and
using a few numbers we can quantify our
costs and ask a better question can we
sell an average of 14 snow cones each
hour if the answer to that is yes then
you are well on your way to running a
profitable business
nobody likes to talk about budgeting
especially individuals who consider
themselves non numbers people budgeting
is for the accounts to do and to worry
about let the people who are good with
the numbers worry about the numbers let
them worry about budgeting well that's
one way to think about it another way to
think about it is this those who
demonstrate that they are good stewards
over a few things will typically be
given the opportunity to grow and
develop to become good stewards over
many things as we said in a previous
module cash is the lifeblood of a
business individuals who are good
stewards over the lifeblood of the
business are valuable and will generally
be given more responsible opportunities
so let's talk about budgeting step one
when it comes to budgeting is to write
your budget down another way to think
about a budget is just to think of it as
a plan a map and the plan needs to be in
writing how will you know if you
achieved your plan if it's not written
down now there are various types of
budgets some budgets involve inflows and
outflows for example a budget for an
entire company will involve cash
collections and cash expenditures a
budget for a department within a company
may only involve expenditures step 2
when it comes to budgeting is to
identify those areas for which you are
responsible and which you control
responsibility accounting generally
holds individuals accountable only for
those inflows and outflows over which
they have control let's use a simple
example to illustrate the effective use
of budgeting let's suppose that I am the
purchasing agent for a company that
manufactures wood tables my job is to
purchase the wood that goes into the
table tops what then would I be
responsible for well it makes sense to
me that I should be responsible for the
price paid for the wood as well as for
the quality of the wood that is
purchased if poor quality wood is
purchased and that wood cannot be used
in the production of the tables that is
my fault and I should be held
accountable in addition it is my job to
negotiate the best possible price on the
quality wood purchases those are the two
items
that ought to be considered as I prepare
my budget the price of the wood
purchased and the amount of waste and
spoilage relating to poor quality wood
step three in the budgeting process is
to quantify expected results that is to
forecast or budget quantities for the
budget period let's say a month in this
case the production forecast for the
upcoming month indicates that the
company will produce 500 tables the
company's standard is that 15 board feet
going to a table and that the price is
$4 per board foot doing the math
indicates that I will need to acquire
7500 board feet of wood at a cost of
$30,000 to keep things simple let's
assume that I have no beginning or
ending inventory of wood I just buy what
I need for that month's production my
budget is as simple as that
you will note that my budget doesn't
just deal with dollars in this case I am
responsible for materials usage as well
this is a quantitative number that tells
me something about the efficiency with
which assets are used in this case wood
the fourth step in budgeting is to
compare actual results to the budget
let's assume that production forecast
was right on and that exactly 500 tables
were produced you can see here that we
actually purchased 7700 board feet to
produce those 500 tables at a cost of 4
dollars and 25 cents per board foot from
this analysis it looks like I overspent
by two thousand seven hundred
twenty-five dollars for the month and I
should be responsible for explaining how
that two thousand seven hundred
twenty-five dollars came about and that
leads us to the fifth step we need to
ask questions to determine why the
deviations from the plan occurred did we
need two hundred more board feet because
I purchased lower quality wood or was it
because those involved in the production
process were inefficient I want to know
the answer to that question was this my
problem or was the overage the result of
someone else's doing also I paid 25
cents more per board foot than I had
planned what happened there was it poor
planning on my part or have prices
increased to the point where the new
normal is now going to be four dollars
and 25 cents per board foot I want to
know the answer to that question
you can see with this simple example
that I can now use the numbers to ask
questions that need to be answered and I
can only ask these questions because I
had a plan I made a budget a budget
allows us to take a look into the future
and make our best guess and when we get
into the future we can then look back
and see how our actual results compared
to what we had planned once we identify
the differences we can then start asking
questions
but without a plan without a budget all
we can do is wonder what happened
let's review the steps associated with a
simple budgeting process step 1
write your budget down I like the quote
a goal unwritten is just a wish if our
budget isn't in writing we might as well
just cross our fingers close our eyes
and hope for the best
step 2 identify those areas for which
you are responsible in which you control
it's not fair and that means generally
that it's not good business to have
someone be accountable and answerable
for something over which they have no
control step 3 is to quantify expected
results this is the budget or the plan
those quantities may be in dollars as
was the case with the price per board
foot in our example or they may be in
units as was the case with the number of
board feet to be purchased a budget is
not necessarily about money it is about
responsibility if you are responsible
for the money then your budget should
reflect the money if you are responsible
for quantities then your budget should
reflect those quantities step 4 is to
compare actual results to the budget you
should be able to identify deviations
from the budget those are the items of
interest we need to know more about
those deviations and that leads us to
the final step in the budgeting process
step 5
ask questions to determine why the
deviations from the plan occurred there
may be legitimate reasons for variances
from the plan and then again those
deviations may be the result of poor
planning or poor execution this final
step in the budgeting process highlights
a point we have made throughout this
course the numbers often don't provide
the answers instead they identify where
we need to go to ask the next question
the numbers assist us in getting to the
bottom of things but the numbers aren't
the bottom of things people are at the
bottom of things it's the people who
make things happen
the numbers just help us get to the
right people
even numbers people can be scared of
income taxes taxes make us nervous
because we're not sure we understand all
the tax implications of our business
decisions it is of critical importance
to engage a professional when in doubt
but with that said an overview of the
purpose of the income tax system can
take some of the edge off so what is an
income tax and income tax is a required
payment to a government based on the
amount of a person's income or a
company's profit now that seems like
such a simple statement but there's so
much controversy and intrigue right
there in that simple statement for
example to what government the
government where I live the government
wire and the money or the government of
which I'm a citizen so that needs to be
decided in income tax accounting income
taxes are based on what based on a
straight percentage of taxable income
based on an increasing percentage that
leads us to the next obvious question
what is taxable income how is income or
profit defined are there allowable
expenses that can be subtracted in the
computation of that income now income
taxes are an important tax but not the
only tax but computing our income taxes
is what makes most of us especially
nervous why because the income tax code
regulations interpretations and
legislative history in the United States
occupy seventy three thousand nine
hundred and fifty four pages as of the
end of 2013 so we will spend a little
time talking about income tax terms and
concepts now we don't all need to be tax
experts but we should all be familiar
with basic income tax issues tax
brackets tax rates and the difference
between tax deductions and tax credits
to name a few again our objective here
is not to make you tax experts but to
provide information to make you a more
informed decision maker
now we're going to talk about a simple
income tax system we're going to use a
lot of terms for example we're going to
go through and define each one of these
a tax rate and a tax bracket what's the
difference between those two we're going
to talk about these terms and illustrate
these terms using a simple tax system
now in this simple tax system we have
the following criteria for income from 0
to $50 you're not going to pay any tax
no income tax at all for all income
above $50 the income tax rate is 50% so
in this simple tax system how much
income tax would you pay if you made $50
or 51 dollars or $100 now for all income
over $50 you've got to pay a rate of 50%
so this is going to make our calculation
very simple again this has all the
elements of the tax systems of the
United States and the European Union and
Hong Kong and China and everywhere else
we'll use this to represent the tax
systems around the world we'll answer
these questions under this tax system
how much would you pay if you made $50
what if you made $51 what if you made
$100 let's do the computation in each
one of these three cases first of all if
you make $50 you don't pay any income
tax under this system the first $50 is
tax free so that's a pretty easy
computation to do all right but what if
you make $51 okay again for the first
$50 you still pay no taxes that 50 first
dollar you're going to pay at a tax rate
of 50% so your total tax that you're
going to pay is 50 cents this
illustrates the important notion of the
tax bracket you'll sometimes hear people
complain I got a raise so now I'm in the
next tax bracket well that's kind of a
naive comment and I'll show you why the
first tax bracket in this case is from 0
to $50 and the rate on this first $50 is
always zero no matter how much you make
ever so when you make the 51st dollar
you go up into that next tax bracket
where your income is taxed at a rate of
50% that
rate is not applied retroactively li you
don't have to go back and pay 50 percent
on the first $50 the first fifty dollars
is never taxed and the rate is always
zero that's the first tax bracket the
second tax bracket in this simple
example is everything over $50 and at
the second tax bracket yes the tax rate
is 50 percent but let's think should we
be sad that we got a raise in this case
we went from making $50 to $51 has that
cost us any money well no it does not
cost us because when I make $50 I have
the $50 and I don't pay any tax if I
make $51 yes it's true that I now have
to pay half of that 51st dollar in tax
so I have to pay 50 cents in tax but I
get to keep half of the 51st dollar so
that I now have 50 dollars and 50 cents
going to the next tax bracket doesn't
cost you any money it just means that
you have to pay a different tax rate on
the extra income that you're going to
make so don't be afraid of making more
money and going into the next tax
bracket that is a cause for celebration
okay we've talked about tax brackets now
let's talk about tax rates under this
simple tax system how much tax do you
pay if you make $100 well again the
first $50 is never taxed at all so the
tax that you pay on that is 0 the second
$50 is taxed at the rate of 50% so
you're going to pay a total of $25 in
tax if your taxable income is a hundred
this allows us to discuss two important
concepts the average tax rate and the
marginal tax rate the average tax rate
is simply the tax that you owe 25
dollars in this case divided by how much
you've made $100 in this case 25 dollars
divided by a hundred dollars that's 25
percent that's the average tax rate and
it's a very intuitive notion what's the
average tax rate for all taxpayers in
the United States it's somewhere between
17 percent and 20 percent that's the
average tax rate
the tax that they have to pay / the
amount that they make in this case it's
25% that's the average tax rate if you
make $100 economists say that the more
important rate than the average tax rate
is the marginal tax rate the marginal
tax rate is the rate I'm going to pay on
the next dollar that I make in this case
if you make $100 your average tax rate
is 25% your marginal tax rate is 50%
that is if I work a little harder and
make another dollar fifty percent of
that is going to pay for income taxes
tax brackets tax rates these and other
factors influence individuals and
businesses when making financial
decisions we should always consider the
tax implications of those decisions
so let me ask you a question which would
you prefer a tax deduction or a tax
credit well by the end of this chapter
hopefully you'll be able to answer that
question now recall in our previous
example we took our taxable income and
multiplied it by our tax rate to
determine how much in tax we owed well
what's the impact of a tax deduction in
our simple tax system let's again assume
we made $100 remember the first $50 is
never taxed the second $50 would be
taxed at the 50% rate so you're going to
pay 25 dollars in tax total now let's
say of that hundred dollars you decide
to spend ten dollars in a way that the
government favors perhaps you spend that
ten dollars as a charitable contribution
or you spend that ten dollars paying
mortgage interest on your home so the
government says yep we want to encourage
that behavior that's a good way to spend
10 dollars then you're going to get a
tax deduction for that ten dollars so
how does that tax deduction enter into
your payment of taxes well now you have
to compute your taxable income you've
made $100 but ten dollars of that was
spent in a special way which is tax
deductible so your taxable income is
only $90 the first 50 dollars is still
tax-free now the second $40 is taxed at
the 50 percent rate so you're only going
to pay twenty dollars in tax so you see
here that the tax deduction of ten
dollars reduces your income tax from $25
to $20 after you subtract the tax
deduction the effect is that tax
deductions reduce your taxable income
again what are tax deductions their
expenditures by individuals that the
government favors and wants to encourage
now if I have a business and I make $100
but I then use ten dollars of that to
pay wages to my employees or pay
electricity on my building or pay
property taxes these are tax deductions
any legitimate business expense is going
to qualify as a tax deduction and reduce
my taxable income and as a result reduce
my taxes now let's contrast
deduction with a tax credit in the case
of a tax deduction remember that that
reduced our taxable income what's the
difference between a tax deduction and a
tax credit well a tax credit directly
reduces your taxes let's go back to our
same example you make $100 in our system
the first $50 you pay no tax
the second $50 you pay the rate of 50%
so you're going to end up again paying
$25 in taxes that's great now let's say
that you pay 10 of those dollars in a
very favored way according to the
government maybe you spend the $10
increasing the energy efficiency of your
home you put solar panels on the roof
you did something that the government
really wants to encourage in this case
they're not going to give you a tax
deduction they're going to give you a
tax credit so how does the tax credit
differ from a tax deduction when you
compute your tax remember we pay no tax
on the first $50 on the second $50 our
tax rate is 50% so you're going to owe
50% of that $50 or $25 but if the
government says we're going to give you
a tax credit on that $10 expenditure
what they're going to allow you to do is
to reduce your $25 in taxes down to $15
a tax credit directly reduces the amount
of taxes you owe so which is better the
tax deduction or the tax credit well we
see that the $10 tax credit reduced my
income taxes from $25 down to $15 if it
was a tax deduction it reduced my taxes
from $25 down to $20 the tax deduction
reduces my taxes by $5 so if somebody
gave you your choice if you want a $10
tax deduction or a $10 tax credit you
show them how wise you are you take the
tax credit when it comes to income taxes
they can make even the status of Hearts
a little nervous so if you're not a
numbers person you're not alone when it
comes to income taxes but truth be told
the basic concepts behind income taxes
are easy to understand
different tax rates different tax
that's the difference between a tax
deduction and a tax credit we can
understand those ideas when it comes to
the details of completing a tax return
that can get tough but our objective
here has been to help us become
comfortable with terms and concepts
hopefully we were able to do exactly
that
you
well we made it we've been introduced to
some of the basics of accounting and
Finance and we've lived to tell about it
so what should you do next first
appreciate that numbers are tools they
are not to be feared they're to be used
numbers can assist you in becoming a
better manager in whatever area of the
business you function you can use
numbers to your advantage and
supply-chain Human Resources strategy or
wherever you find yourself in a business
second have the courage to use numbers
in your job there are ways to apply the
concepts we've talked about you just
need to think about the appropriate
application third don't think too big
moderation in all things identify a
couple of areas where numbers might help
you in monitoring progress evaluating
performance or assessing productivity
and start using numbers to assist you
fourth you might want to know more maybe
you feel like you're operating your
business blind your profitability seems
low but you can't figure out why then
you need some exposure to some simple
techniques of financial analysis at the
end of the day please remember that it's
always about people numbers can help us
but numbers aren't the answer people are
the answer
never forget regardless of what we do
for a living we are in the people
business
you