BUS101 Study Guide
Unit 4: Accounting, Finance, and Banking
4a. Describe the role of accounting and finance in the business process
- Who are the stakeholders in a business?
- Why might the stakeholders be different in managerial or financial accounting?
- What are generally accepted accounting principles (GAAP)?
While businesses focus on more than their profit margin and bottom line, financial management and the business' financial well-being are important to many stakeholders, and different stakeholders are interested in managerial or financial accounting.
The generally accepted accounting principles (GAAP) are a set of accounting principles that are accepted by people in the industry. These may include issuing quarterly statements, ensuring honesty, using the same accounting reporting methods each year, acting in good faith, etc. When everyone in the industry follows the same set of guidelines, it can be assumed that all these principles are aligned.
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4b. Describe and analyze components of the income statement and balance sheet
- What are assets, cash, accounts receivable, inventory, and fixed assets?
- Can you give an example of liabilities, debt, and equity?
- What is the difference between a fiscal and a calendar year?
- What is the difference between an income statement and a balance sheet?
Business managers prepare two financial statements to present information to their stakeholders: the income statement and the balance sheet. Most accounting principles follow a calendar year, which runs from January to December, while a fiscal year may start in any month of the year. For example, a university fiscal year may run from July through June of the following year.
Assets represent economic value and may generate income. Cash flow is the movement of money in and out of a company. A fixed asset is typically for long-term use; examples may be land or buildings. Debt is money owed. An income statement displays a company's expenses, revenue, and profitability, and a balance sheet includes liabilities, assets, and equity at that point in time. Business managers also need to generate a statement of cash flows, which summarizes a company's operating, investing, and financing activities over some time to show how cash is generated and used. Additionally, they must prepare a statement of owner's equity, which shows changes in the owner's interest in the business, including investments, net income, and withdrawals, over a specific period.
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4c. Differentiate between key financial ratios for making business decisions, including profit margin, return on equity, and debt-to-equity ratio
- How would you define profit margin?
- What is the operating margin?
- How would you calculate the profit margin?
- Which financial statement would an analyst review to collect the profit margin?
Financial analysts use ratios to understand how well a business is doing financially. For example, the profit margin tells an analyst how much profit a company makes for every dollar it receives in sales or revenue. This ratio considers the percentage of sales revenue the business receives compared to the amount of money it spends on materials and operating the business. Analysts want to know how much money is left over to invest in the company's future and to pay dividends to shareholders after expenses are paid.
For example, profit margin is the profit a company is left with from revenue after subtracting costs. The return on equity tells an analyst whether management chooses its assets wisely. Financial statements may include a balance sheet, income statement, cash flow statement, or others, and these help demonstrate a company's overall health.
The debt-to-equity ratio indicates the relationship between the amount a company owes and what it owns. This ratio helps potential lenders and investors decide whether a business can afford to borrow any more money.
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4d. Assess the implications of financial ratios for the future performance of a company
- What is a profit margin ratio?
- How would you determine which category of the three ratios (profit margin, return on equity, and debt-to-equity ratio) would apply in certain circumstances?
- What is the most common valuation ratio financial analysts use?
Stakeholders often use financial ratios to predict how a company will do in the future based on its past performance. Analysts put these ratios into specific categories based on the information they provide. These categories include profit margin ratios, management efficiency ratios, management effectiveness ratios, and financial condition ratios.
In the television show "Shark Tank", entrepreneurs try to convince a panel of industry veterans (sharks) to invest in their idea. They talk a lot about valuation or estimates of a company's financial worth. These potential investors determine the financial value of the potential company when they decide whether they would obtain a good return on their investment.
Sharks often think entrepreneurs put too much value on their businesses. This makes sense because entrepreneurs often have a close emotional attachment to the product or service they want to sell and feel consumers would pay a lot of money for it. In terms of the numbers, an entrepreneur who asks an investor to pay $500,000 for a 10 percent share of the company believes their product, company, or idea is worth $5 million (100 percent of the shares). However, the entrepreneur needs to convince the sharks (and other potential investors) that they can generate sufficient revenues: they need to prove the company is really worth that much.
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4e. Describe the roles of the Federal Reserve, banks, interest rates, and credit analysis with respect to decisions of financial lending
- What is the US Federal Reserve, and what are its primary goals?
- What is an interest rate, and how might that change depending on credit scores?
- How do banks expand the money supply?
- What is a credit analysis?
We have many options for investing our money, whether in a savings account, a checking account, a money market account, or under our mattress. Businesses have the same options, but perhaps on a larger scale. There are six types of financial institutions: commercial banks, savings banks, credit unions, finance companies, insurance companies, and brokerage firms.
There are five Cs of credit analysis: capacity, capital, collateral, conditions, and character. These assist a banker in deciding on the worthiness of a potential borrower.
American financial institutions turn to the US Federal Reserve (the Fed) for guidance on making their financial investments. The Federal Reserve sets the discount rate and prime rate (the current interest rates that banks charge customers).
Collateral is anything that may be used to help secure a loan. For example, if a business owns land or a building without a current mortgage, that may be used as collateral for another purchase. If the business defaults on the loan, the bank may take the land or building to pay the loan. Compound interest is the interest earned that is added to the principal balance, which then grows at a faster rate.
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4f. Describe different options for financing
- What is equity financing?
- How does the US Stock Market work?
- What types of assets can a business use for collateral for a loan?
- Can you think of the types of businesses that would require a seasonal loan?
Businesses often need an influx of capital (money) to help expand their business or cover a temporary deficit in their cash flow. They have two options for getting some extra money into their coffers: equity financing and debt financing. Businesses do not need to repay the money they obtain through equity financing. The business owner may provide the money themselves (from their savings account), or the business could sell shares of ownership in the business to an investor.
Businesses must repay the money they borrow through debt financing. The repayment usually involves a fee (usually in the form of interest). The interest rate is the rate that a bank charges on a loan, and it typically reaches around the prime rate set by the Federal Reserve. The US stock market is a collection of publicly traded American companies, and investors purchase shares in that stock or company.
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4g. List and explain the tools available to the Federal Reserve during financial crises
- What tools might the US Federal Reserve use during a financial crisis?
- How does the US Federal Reserve use open market operations to control the money supply in the United States?
- How did the 2008 mortgage crisis affect home buyers?
The US Federal Reserve uses several tools during financial crises to control cash flow, including interest rates, the open market, the prime rate, the discount rate, etc. The US Federal Reserve buys and sells government securities to control the money supply in the United States.
During the recession from 2007 to 2009, the mortgage crisis occurred for several reasons, including a housing bubble and inappropriate lending from banks. Banks approved home buyers for higher loans than they could reasonably afford, and eventually, numerous homeowners were forced to walk away from their homes and high mortgages.
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4h. Analyze the causes and implications of the 2008 financial meltdown
- What role did banks have in the 2008 financial crisis?
- What role did the housing industry have in the 2008 financial crisis?
- What role did the US Federal Reserve have in the 2008 financial crisis?
During the 2008 financial crisis, banks provided loans to people who could not afford the payments. Not only did consumers lose during the 2008 financial crisis, but banks also lost a considerable amount of money, and some had to be bailed out by the federal government.
After the 2008 mortgage crisis, there was a decline in interest rates, new home construction, and employment. In those few years after the 2008 mortgage crisis, new home construction was limited, and over time, this created a shortage of new homes being built. The housing market eventually increased, but it took almost a decade in some areas. The US Federal Reserve responded to the 2008 financial crisis by assisting banks and providing liquidity.
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4i. Calculate the time value of money
- How would you explain compound interest?
- What formula is used to calculate the future value of money?
- How much money would you earn if you invested $1,000 in an account that earned five percent for 10 years?
Business owners must determine the opportunity cost of investing the profits they make. In other words, they need to calculate what they will earn from an investment and whether investing in something else would be more profitable. The time value of money says the dollar you receive today is worth more than a dollar you could receive in the future. By investing that dollar and with compounded interest, it will be worth more in the future.
Compounded interest means that interest earned is added to the principal balance, and then interest is paid on both. Over time, the compounded interest grows substantially.
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Unit 4 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- asset
- balance sheet
- cash flow
- collateral
- compound interest
- credit analysis
- debt
- debt-to-equity ratio
- financial statement
- fiscal year
- fixed asset
- generally accepted accounting principles (GAAP)
- income statement
- interest rate
- prime rate
- profit margin
- return on equity
- statement of cash flows
- statement of owner's equity
- time value of money
- US stock market