MBA Accounting & Finance Guide » ACCOUNTING

What Do We Mean By Operating Leverage And What Are The Implications

slang — Tue, 29 Sep 2009 15:32:33 +0000

Below article describes the meaning of operating leverage, some of the ratios to measure operating leverage, its application and users and an illustrated example on how to compute operating leverage.

(a) Meaning of Operating Leverage:

Refers to the existence of fixed costs in a company’s cost structure
Is used to measure operating risk

(b) Following ratios being used to measure operating leverage:

Fixed cost/total cost
% change in operating income/percentage change in sales volume or

Change in profit/profit

———————————-

Change in quantity/quantity

Operating leverage are important to managers and financial analysts to understand the degree of operating leverage of a company. A high operating leverage means greater fixed cost committments that have to be met even when sale volume declines [ note that high degrees of operating leverage plus highly elastic product demand will result in high levels of variability in earnings although such a condition may be inherent in the industry like the airline and auto industries.
Note that the effects of operating leverage diminish as revenue increases above the breakeven point, since the bases to wich increases in earnings are compared become progressively larger. Therefore it is important to examine the relationship between sales and the breakeven point
A company with a high breakeven point is quite vulnerable to economic declines. A high ratio of variable cost to total cost indicates greater stability, because variable cost can be adjusted more easily than fixed cost to meet a declin product demand.

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What Is The Z-Score Model And How Does It Helps To Forecast Business Failures

slang — Sat, 26 Sep 2009 00:00:57 +0000

In interpretating financial statements, whether financial or non-financial managers normally and frequently use the standard traditional business accounting ratio like profitability, liquidity, market based, assets utilization and others.

However, one ratio commonly neglected is the Z-score model which is actually a quantitative model developed in 1968 by an eminent economist, Edward Atlman. So what is this Altman Z-score model and its purpose?

Atlman Z-score model:

Objective:

Is to predict bankruptcy or financial distress of a business using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis(MDA)

Applications of this Z-score model in:

Loan and credit analysis to determine whether bankers should extend a loan. For a vendor, he or she can determine whether his customer-company is good for payment after being supplied with the goods/materials/services. For a customer to review whether an important supplier is in financial distress.
Merger analysis-identify potential problem(s) of a merger candidate
Financial management analysis-to help managers to see wheher the need to curtail capital expansion and dividends pay-out

How to Use the Altman Z-Score Model:

(a) First understand its formula:-

Formula:-Z=1.2*X1 +1.4*X2 + 3.3*X3 + 0.6*X4 +0.999*X5

X1=working capital/total assets

X2=retained earnings/total assets

X3=earnings before interest and taxes (EBIT/total assets)

X5=sales/total assets

(b) Next remember its fundamental guidelines:

Z score Probability of failure

1.8 or less Very high

1.81-2.99 Not sure

3.0 or higher Unlikely

_____________________________________________________________

Simple Illustration Using the Altman Z-score model theory to forecast business failure:

Company XYZ has the following financial details:

Total assets=$2,000

Retained earnings=$750

EBIT=$266

Sales=$3,000

Market value of common and preferred stock=$1,425

Book value of debt=$1,100

Proposed solution:

Computation using the Altman Z-score model formula:

Z=X1=400/2000 *1.2=0.240 + X2=750/2000*1.4=0.525 + X3=266/2,000*3.3=0.439+ X4=1,425/1,100*0.6=0.777 + X5=3,000/2000*0.999 =1.499 =3.480

Conclusion:

Since the score is 3.480 Company XYZ falls into the guidelines/classification of “UNLIKELY” zone which means that there is no change that XYZ will go into bankruptcy within the next two years.

_____________________________________________________________

More salient points on Altman Z-score model:

Many found this model is quite accurate re:#90% accurate in forecasting business failure on year into the future and about #80% accurate in forecasting it two years into the future
With the present global credit crunch, it enable the user to predict with reasonable accuracy whether a company is in increasing financial distress so that protective actions like curtailing capital expansion, reducing dividend pay-out or refinancing short term to long term banking structure or facility,etc
Note that this model can be used for a group of companies.

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What Do We Understand by MBA?

slang — Wed, 02 Sep 2009 13:53:10 +0000

About MBA:

The Master of Business Administration (MBA) is an internationally-recognized degree Currently, this course is the most popular professional degree program in the world. Today there are over 2,500 MBA programs offered worldwide. First introduced at American universities around the turn of the 20th century, MBA programs have evolved in order to keep up with the demands of the times.

Traditionally a MBA program normally takes two-years to complete( USA is quite prevalent). Presently, one-year program, part-time and distance-learning programs are also widely available. Most MBA programs are taught in English, and are therefore attractive to international students wishing to study abroad. Many institutions in non-English speaking countries offer MBA programs in English, as well as in the country’s native language.

When enrolling for a MBA program, the student should take into account factors like location, duration of program, areas of specialization offered by an institution and more important that the business school have been accredited by the proper authorities.

It is interesting to note that there is no one uniform MBA curriculum, but rather a vast range of different kinds of programs to choose from.

Purpose of MBA program:

Designed to prepare students and further develop the skills required for careers in business and management.

Benefits derived from pursuing MBA program:

The value of the MBA, however, is not limited strictly to the ‘business’ world.
Also useful for those pursuing a managerial career in the public sector, government, private industry, and other areas.
MBA programs provide graduates with the preparation and practical skills needed to excel in management and leadership positions.

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The Importance,Function And Benefits Of A Proper Accounting Information System

slang — Tue, 01 Sep 2009 13:20:56 +0000

As accounting has it primary objective of providing information useful to decision makers, the understanding of the role play by Accounting Information Systems is critical to many accountants.

It’s important to understand how the accounting systems work: how to collect data about an organization’s activities and transactions; how to transform that data into information that management can use to run the organization; and how to ensure the availability, reliability and accuracy of that information.

1. What is an Accounting Information Systems?

A system is a set of two more interrelated components that interact to achieve a goal.

For an Accounting Information Systems, it comprises the following components:

People operating and performing the various function of the system;
Procedures in terms of both manual and automated;
Data about the organization’s business processes;
Software used to process the organization’s data and
Lastly the information technology infrastructure which includes computers, peripheral devices and network communication devices.

2. Functions of An Accounting Information Systems (AIS):

Collation and processing data about the organization’s business activities efficiently and effectively;
Converting data into accurate, timely and useful information for management to make decisions and
Establishing adequate controls to ensure that data about business activities are recorded and processed accurately and safeguard both that data and other organizational assets

3. Contributions Or Value Added Roles Of A Well Designed Accounting Information Systems:

Improving efficiency of operations by providing more timely information

Example like a just-in-time manufacturing approach requires constant, accurate,up-to-date information about raw materials, inventories and their locations.

Improve organization profit by improving the efficiency and effectiveness of its supply chain

Example like allowing customers to directly access the company’s inventory and sales order entry systems can reduce the costs of doing business re: cost of sales, marketing activities. By doing so, customer’s cost and time of ordering hence improving sales and customer retention.

Improve decision making by providing accurate information in a timely manner

Example like giants like Wal-Mart and Amazon.com are able to improve sales by using their enormous database on sales transaction to study the customers’ needs.

Facilitates or make easier sharing of knowledge and expertise

Example:

The Accounting Big Four use their information systems to share best practice and to support communication between people located at different offices.

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What Is An Accounting Cycle?

slang — Tue, 01 Sep 2009 12:17:24 +0000

For non financial manager, it is important to know what your accounting personnel meant by an Accounting Cycle.

Append below is a flowchart from my other blog for a clearer understanding of the Accounting Cycle:

An Accounting Cycle:

Is a series of accounting process which begins with the identification of an economic activity or transaction, recording of the economic activity and ends with the preparation of the financial statements.
The Accounting Cycle is a repeated process where one cycle ends and another cycle (as above) is repeated again

Accounting Cycle is actually a very systematic and repeated process which involve the following STEPS:

Analyse source documents like invoices, receipts, payment vouchers, etc
Record transactions in Journals ( sales journal, purchase journals, etc)
Post to ledger accounts
Prepare Unadjusted Trial Balance
Journalize adjusting entries
Post adjusting entries
Prepare Adjusted Trial Balance
Journalize closing entries
Post closing entries
Prepare post-closing Trial Balance
Prepare financial statements like the Income Statement

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Double Entry System: Debit And Credit Method

slang — Tue, 01 Sep 2009 11:53:12 +0000

For non financial managers who are pursuing MBA accounting who have just read earlier article on the fundamental accounting concepts, below is a worked out example of the dual aspect concept or what usually your accounting colleagues call the double entry system or the debit and credit system

DUAL ASPECT CONCEPT

This dual aspect concept is also called Double Entry Methodology

The key points are All transactions have two(2) dimensions and

this follows from the basic accounting equation which is:

ASSETS= LIABILITIES + OWNERS’ EQUITY

Assets are the resources owned by a businessLiabilities are the rights of the creditors, which represent debts of the business

Owners Equity represents the rights of the owner

UNDERSTANDING THE MECHANISM OF THE DUAL ASPECT CONCEPT

To be able to understand clearly this dual purpose or double entry, let’s go through the below

step-by-step illustration:

Its start with an Individual called Y, who puts in money for shares in a newly formed company called ABC. ABC starts its business activities by the initial purchase of land and inventory. Subsequently, it also receives incomes for services rendered and pay expenses and ultimately leading to the paying of dividend to the shareholder Y

ILLUSTRATIONS:

(1) Y deposits $25,000 in a bank account in the name of Company ABC in return for shares of stock in the company.

ASSETS

OWNERS EQUITY

Bank Account

Paid Up Share Capital re: investment by stockholder

C/f

+ $25,000

+$25,000

Notes:

The Accounting Equation: Assets= Liabilities + Owners Equity balances when Y an individual pays in the bank for shares in the company. Both Bank account and the corresponding entry-Paid Up Capital Account has increased by $25,000

(2) The Company paid $20,000 for purchase of a piece of land.

ASSETS

Bank

ASSETS Land

OWNERS EQUITY

Paid Up Share Capital

B/f

$25,000

C/f

$5,000

$20,000

$25,000

Notes:

In this case, in the Assets Category, bank account has being reduced by $20,000 which is equally represented by the company possessing a land that costs $20,000. What’s important is that the accounting equation balances.

(3) During the month, the company purchased supplies for $1,500 and agreed to pay the supplier in the near future (on account).

ASSET

Bank

ASSETS Land

ASSETS Stocks

LIABILITIES Accounts Payable

OWNERS EQUITY

Paid Up Share Capital

B/f

$5,000

$20,000

$25,000

C/f

$5,000

$20,000

$1,500

$25,000

Notes:

Here, the purchases of supplies has increased the company’s stock by $1,500 with a corresponding increase in accounts Payable

(4) The company provided services to customers, earning fees of $8,000 and received the amount in cash

	ASSET Bank	ASSETS Land	ASSETS Stocks	LIABILITIES Accounts Payable	OWNERS EQUITY Paid Up Share Capital	OWNERS EQUITY Retained Earnings
B/f	$5,000	$20,000	$1,500	$1,500	$25,000
	+$8,000					+$8,000
C/f	$13,000	$20,000	$1,500	$1,500	$25,000	$8,000

Notes: Due to the receipt of money from customer, bank account increased by $8,000 with a corresponding increase in Income (owners’ equity) hence the accounting equation still balances

(5) The Company paid the following expenses: wages, $2,000; rent, $1000; utilities, $500; and miscellaneous, $300.

	ASSET Bank	ASSETS Land	ASSETS Stocks	LIABILITIES Accounts Payable	OWNERS EQUITY Paid Up Share Capital	OWNERS EQUITY Retained Earnings
B/f	$13,000	$20,000	$1,500	$1,500	$25,000	$8,000
	-$2,000 -$1,000 -$500 -$300					-$2,000 -$1,000 -$500 -$300
C/f	$9,200	$20,000	$1,500	$1,500	$25,000	$4,200

Notes:

Here, the company is paying off the expenses of $3,800 ($2,000+$1,000+$500+$300)

Which reduces the bank account by $3,800 with a corresponding figure in the Retained Earnings

Assets($30,700) =Liabilities($1,500) + Owners Equity ($29,200)

(6) The Company paid $1,500 to creditors during the month.

	ASSET Bank	ASSETS Land	ASSETS Stocks	LIABILITIES Accounts Payable	OWNERS EQUITY Paid Up Share Capital	OWNERS EQUITY Retained Earnings
B/f	$9,200	$20,000	$1,500	$1,500	$25,000	$4,200
	-$1,500			-$1,500
C/f	$7,700	$20,000	$1,500	$0	$25,000	$4,200

Notes:

The company pays off the amount due to its account payable. This therefore

Reduces the bank account by $1,000 with a corresponding reduction in liabilities

Assets($29,200) =Liabilities($0) + Owners Equity ($29,200)

(7) At the end of the month, the cost of supplies on hand is $500, so $1,000 of supplies were used.

	ASSET Bank	ASSETS Land	ASSETS Stocks	LIABILITIES Accounts Payable	OWNERS EQUITY Paid Up Share Capital	OWNERS EQUITY Retained Earnings
B/f	$7,700	$20,000	$1,500	$0	$25,000	$4,200
			-$1,000			-$1,000
C/f	$7,700	$20,000	$500	$0	$25,000	$3,200

Notes:

From the stock account, $1,000 have been consumed to generate the earlier

Mentioned income of $8,000 so this has to be charged out. Hence, the stock Account is reduced by $1,000 and the corresponding consumption of stocks is charged to owners equity side.

Assets($28,200) =Liabilities($0) + Owners Equity ($28,200)

(8) At the end of the month, the Company pays $2,000 to stockholders

	ASSET Bank	ASSETS Land	ASSETS Stocks	LIABILITIES Accounts Payable	OWNERS EQUITY Paid Up Share Capital	OWNERS EQUITY Retained Earnings
B/f	$7,700	$20,000	$500	$0	$25,000	$3,200
	-$2,000					-$2,000
C/f	$5,700	$20,000	$500	$0	$25,000	$1,200

Notes: Similarly, bank account is used up by $2,000 to be paid to the stockholders which results in a corresponding decrease in Owners’ equity.

However, the accounting equation always balance:

In this case:

Assets ($26,200)= Liabilities ($0) + Owners Equity ($26,200)

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How To Select The Right MBA School.

slang — Thu, 27 Aug 2009 05:40:31 +0000

Similar to pursuing any course say Accountancy, the selection of the “right” MBA School or programme is indeed a very challenging process.

Many prospects would cite factors like cost, reputation, location and type of MBA.However please do not forget one critical factor during the selection of the right MBA which is the ACCREDITATION of the MBA programme.

You may ask why bother to know about accreditation. To answer this we need to understand what’s accreditation is all about.

In simple term, accreditation is like a certificate received by the MBA School whereby it is acknowledged that the MBA School or programme has met certain strict criteria or certain standard required. To achieve accreditation, extensive quality control process is normally carried out by teams of professionals and assisted by senior management from the respective business schools to ultimately determine whether the school or programme has achieved a certain standard. Of course the more accreditation by various international accreditation bodies, the more credibility it has.

A little bit of history of accreditation:

In the early years when the first MBA was established in 1901 there were no real accreditation bodies to determine the quality of such MBA programmes.

Until 1906, the Association of Advance Collegiate Schools of Business(AACSB) in the United States was established with the main objective of raising the standard of management education worldwide.

The following are three well-known accreditation bodies :

(a) Association of Advance Collegiate Schools Of Business (AACSB)

Accreditation assures the stakeholders that

The business schools provide high caliber teaching, curricula and at the same time, cultivate meaningful interaction between students and a qualified faculty
The business school manages its resource to achieve a vibrant mission together with producing graduates who have achieved specified learning

(b) The Association of MBAs

Based in Britain. Established in 1967 with the aim of promoting MBA to institutions, prospective students and employers.

Ensures the accredited MBA programmes produce professional managers.
Accredition is valid for up to five years after which the school must submit for re-accreditation.

Founded 30 years ago, EQUIS is recognized as one of the leading international accreditation bodies for business schools.

It ensures accredited institutions attain high standards in the national market and is also credible in the international arena.

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Economic Value Added(EVA)As the Performance Metric To Measure Increase or Decrease In Shareholder Value

slang — Thu, 24 Apr 2008 12:14:00 +0000

Introduction:

Economic value-added (EVA) has increasingly gain acceptance amongst many top-notched organization. This performance metric for creating shareholders wealth is closely tied with the Value Based Management as they share the same principle of realigning business practices towards increasing shareholder value.

Formula:

In simple term, EVA is:

after-tax operating profit remaining after deducting a charge for the capital employed in the business:

EVA=Net operating profit after tax(NOPAT)-(Capital employed x Cost of capital)

[ NOPAT is a measure of the operating profit of an organization whilst capital employed is a measure of its business investment and cost of capital is the financing cost similar but not identical to borrowing costs.]
As this represents real profit, positive EVA enhances shareholder value whilst negative EVA reduces shareholder value.

Advantages Of EVA Versus Other Performance Metrics:

Many are still using earnings per share and return on assets to reflect increase or decrease in shareholder value. However, there are limitations in using such ratios:

Earnings per share tell us nothing about the cost of generating those profits. If the cost of capital (loans, bonds, equity) is, say, 17 percent, then a 16 percent earning is actually a reduction, not a gain, in economic value. These profits also increase taxes, thereby reducing cash flow, which drain economic value of the company.

Return on assets is a more realistic measure of economic performance as it attempts to relate how much profit a business generates relative to its asset levels, but again this metric ignores the cost of capital. A company might have a high profitable year with high return on assets but it might not be a surprise if its cost of capital can be higher than its ROA %.

Advantages/Benefits of Using EVA:

As for EVA we can see some of the following distinctive advantages:

In my earlier article, we have compared EVA with earnings per share and return on investment/assets and found that both the traditional ratios do not reflect the true cost of capital- there is no hinge whether shareholders value have been created or destroyed,

EVA is extremely easy to compute- just extract the data from both the income statement and the balance sheet and put in some adjustments to derive the EVA,

EVA is easy to understand like the net present value (NPV) concept wherein EVA( particularly future EVA) if positive, increases shareholders’ wealth and a negative EVA is vice versa,

EVA is easy for layman besides accountants to understand its concept as it is logical and comply with the economic terms of “economic profit” ,

EVA is part of Return on Investment re deploys assets turnovers and utilization which ordinary managers can easily relate to,

EVA is also really the discounted free cash flows of a business,

EVA is an all round performance metric which measures the operating profit, business investment and the cost of capital as a financing cost .

As EVA is a performance metric principally for gauging the creation or not of the shareholder value, it therefore should complements very greatly the Value-based management (VBM) methodology.

Limitations/Pitfall/Cons Of EVA:

However, like any other financial performance metric, EVA still suffers the following pitfall(s) or cons:-

As EVA is still based on an accounting based concept, it therefore suffers:

like other accounting rate of returns for example like the ROI. Using the normal accounting convention of the historical costs concept, asset values are quoted on historical costs unaffected by inflation, the true rate of return is not able to be properly ascertained,

EVA is distorted by the fact of the upfront normal depreciation being small at the beginning of a project and big at the end of the project. Therefore companies with a lot of new investments have lower EVA than their true profitability would imply and companies with a lot of old investments have bigger EVA than their true profitability would imply. The extent of this challenge depends on the asset structure (the relative proportions of current assets, depreciable assets, un-depreciable assets) and on the length of the investment period. This pattern is similar to the ROI where when we examine a single project the ROI is a poor estimator or the true rate of return, since at the beginning of the project when the capital base is big, the ROI is small and then at the end when the capital base is small then the ROI is big.

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The CashFlow Statement(Part2of2)

slang — Wed, 23 Apr 2008 13:33:42 +0000

In earlier Part1, we understand the importance of Cash Flow Statement. This Part 2 explains what’s in a Cash flow Statement:-

Basically The Cash Flow Statement comprises the following:

Closing Cash Balance (a)

Opening Cash Balance (b)

Net Change of Cash Balance ( c ) = (a-b)

( Cash balance also includes cash equivalent(refer to my earlier article on this)

This Net Change of Cash Balance is represented by:

Net Cash flows from Operations ( normal day-to-day business activities)

Net Cash flows from Investing Activities

Net Cash flows from Financing Activities

Cash Flows From Operating Activities/ Operations

Operating Activities is the normal day-to-day business activities ( making and selling product) of a business.

Examples of Cash Coming In & Going Out from Its Operating Activities:

Receipts from customers

-Cash payments to suppliers and employees

+Cash from interest earned

-Cash paid for interest

-Income tax paid

Cash Flows From Investing Activities

By Investing activities is what the business has invested in property, plant and equipment so as to have the capacity to manufacture its products for sale. Money can be spent for plant, equipment, machinery, premises. However, money also can come in when the enterprise dispose of its unwanted/surplus machinery, equipment and others.

Besides this, the enterprise might have spent money to invest in equity in other companies, invest in shares in public listed companies hence receiving dividend and others. This can be vice versa, when the enterprise sold off its subsidiaries or its other investments.

Examples:Proceeds from sale of assets ( includes property, plant and marketable securities)

- Payment for purchase of property, plant and machinery

+ Dividend income

+ Finance income

Investment in an associated company

Cash Flows From Financing Activities

From the financing activities, it reflects what sources of funds the company have received during the period scrutinized- financing from bankers in various forms, or rights issue and share warrants are issued. Also dividend paid to shareholders are also reflected in this category.

Examples:Proceeds from share issue, warrants

Net Proceeds from bankers acceptance

+ Increase in bills payable

-Repayment of hire purchase liabilities

- Finance cost

-Dividends paid

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The Cash Flow Statement(Part1of2)

slang — Wed, 23 Apr 2008 13:04:53 +0000

To understand the true creation of shareholder value, we should not solely rely on accounting earnings/profits as it can be manipulated by overzealous aggressive top management. We need to be vigilant about accounting earnings vs cash.

The basic essential is that we need to appreciate Cash Flow Statement.

This article is of 2 parts- this Part 1 to understand the importance of cashflow statement and Part 2 to understand what’s in the Cash Flow Statement.

Basics:

Cash Flow Statements form an integral part of the financial statements. However, many readers tend to under-emphasize this statement, believing that the Income Statement and the Balance Sheet holds the key to their answers. There is a serious need to combine the use of Income Statement, Balance Sheet WITH the Cash Flow Statement to have a clear and better understanding of the business.

By understanding the cash flow statements, the readers can:

Clearly see how the Board of Directors uses the cash of the company.
Has the cash for that period in discussion increase or decrease?
What cause the increase – too much investments in another entity or too much purchases of fixed assets for the long term success? [Don’t forget that Income Statement only shows the profitability of a business, a Balance sheet reflects only the assets and liabilities of the business at a point of time! Both Income Statement and Balance Sheet do not reflect the actual cash used by the business.]
Management can manipulate accounting profits using creative accounting but cash flow statements reflect straightforward company’s transaction on cash basis.
The cash flow statements tracks the MOVEMENT OF CASH through the business over a period of time ( say a 12 month period) [ In the Cash Flow Statement, it traces the cash balance at the beginning of the period, add or minus whatever involves the movement of cash to derive the ending cash balance.]
Its shows how the business how much cash has been spent whether on its operations, investing and or financing activities
Just imagine that a Cash Flow Statement is your own cash book where all the ins & outs were shown for a certain period of time.

Next article is on the basic understanding of what’s in a Cash Flow Statement.

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