After looking at a few different concepts from this critical section in our first post, here are a few more!
For businesses, buying equipment, land or most other investments is a way to increase their capacity to make profits over a few years. For example, a company that buys a new delivery truck will be able to use it over a few years to increase its revenues. In this example, the truck would be purchased but used over several years. For that reason, the cost of the truck is “amortized” or divided over several years which will give a more accurate representation of earnings over time. There are many different ways to amortize such investments and you must know them all:
Straight line depreciation expense = (cost – residual value)/ useful life
In our case, if a truck is worth 20,000$, will be used for 10 years, and has a residual value of $2000, the depreciation per year will be (20,000-2000)/10=$1800
Some companies will prefer using accelerated depreciation methods. Why? It will bring most of the costs upfront which will diminish profits and thus diminish taxes payable.
Double Declining Balance depreciation= (2/useful life) (cost-accumulated depreciation)
Inventory methods such as FIFO (First in first out) and LIFO (Last in first out) are critical and must be understood very well. You will be asked many questions relating to these concepts. In order to understand these, let’s assume that prices are increasing (they usually are and it will be easier to understand). Now, let’s imagine that a store buys 5 balls over a year for the following prices:
They also sell 2 balls for 10$ each. In this situation, the store has 3 balls left, so the question is, how much profit was made on the 2 balls that were sold?
If you use LIFO, the two balls sold would be the ones that were bought for 8$ and 9$. That would mean a profit of 3$ (10$+10$-9$-8$) and inventory of 18$ (5$+6$+7$)
If you use FIFO, the two balls sold would be the ones that were bought for 5$ and 6$. That would mean a profit of 9$ (10$+10$-5$-6$) and inventory of 24$ (7$+8$+9$)
If you use the average cost, the profit would be $14 ($10+$10-$7-7$) and inventory would be $21 as the average price paid for the balls was 7$.
You must understand these concepts in order to understand the impact of these ratios on every possible financial information/ratio. Do not try to learn by heart which method will generate more taxes, you should instead understand it in order to be able to find whatever is being asked by yourself.
When evaluating a company’s profit, it is important to distinguish parts of the revenues and earnings that are not expected to occur again as those have less value for the investor. These are the types of non-recurring items:
–Discontinued operations: Management has decided to dispose of a segment but has not necessarily done so yet
–Unusual or infrequent items: Gains or losses from sales of segments, impairments, write-downs, restructuring costs, etc.
–Extraordinary items: Items that are unusual and infrequent (these are the only items that are separated from other earnings in the income statement).