General Business News

When it comes to evaluating a business, especially one that is publicly traded, determining its return on equity (ROE) is one way to see how it’s performing.

What is Return on Equity?

Return on equity is a ratio that gives investors insight into how effectively the company’s management team is taking care of the shareholders’ financial investments in the company. The greater the ROE percentage, the better the business’ management staff is at making income and creating growth from shareholders’ investments.  

How ROE is Determined

In order to calculate ROE, a company’s net income is divided by shareholder equity. To arrive at net income, businesses account for the cost of doing business, which includes the cost of goods sold, sales, operating and general expenses, interest, tax payments, etc. and then subtracts these costs of doing business from all sales. Similarly, the free cash flow figure can be substituted in place of net income.

There are some caveats when it comes to calculating net income. It is determined prior to paying out dividends to common shareholders, but loan interest and preferred shareholder dividend obligations must be met before starting this calculation.

The other part of the equation is the shareholder equity or stockholders’ equity. One definition is to subtract existing liabilities from a business’ assets, and what remains is what owners of a corporation or its shareholders would be able to claim as their equity in the company. Whether it’s done year over year or quarter over quarter, traders and investors can see how well a company performs over different time periods.

Return on equity is also able to be determined if a business’ net income and equity are in the black. The net income is found on the income statement – the ledger of the company’s financial transactions. Shareholders’ equity is found on the balance sheet – which details the business’ assets and financial obligations.

Analyzing a Business’ ROE

Another consideration that industry experts recommend to determine if a company’s ROE is poor or excellent is to see how it compares to the S&P 500 Index’s performance. With the historical rate of return being 10 percent annually over the past decade, and if a ROE is lower than 10 percent, it can give a good indication as to a particular business’ performance. However, a particular company’s ROE also needs to be compared against the industry’s ROE to see if the company is outperforming its sector.

For example, according to Yahoo Finance!, the ROE on Microsoft’s stock is 42.80 percent. This means that the management team running Microsoft is returning just shy of 43 cents for every dollar in shareholders’ equity. Compared to its industry (Software System & Application) ROE of 13.47percent – as cited by New York University’s Stern School of Business – Microsoft has a much higher ROE compared to the industry average. This is just one metric to measure the company’s performance, but it is an important one.

While looking at a company’s return on equity is not the end all or be all, it’s a good start to determine a company’s present and future financial health.

Sources

https://us.spindices.com/indices/equity/sp-500

https://finance.yahoo.com/quote/MSFT/key-statistics?p=MSFT

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html

When it comes to determining depreciation for Furniture, Fixtures and Equipment (FF&E), there are many considerations that exist for accountants and business owners.

Defining Furniture, Fixtures and Equipment

FF&E refers to expenses for business items that are not affixed to the building where that business operates. Real world examples of depreciable assets includes chairs, desks, phones, tables, cabinets, etc., which are used to perform business-related tasks, directly or indirectly. These types of items are associated with long-term use generally more than 12 months, according to the Internal Revenue Service.

Understanding How It Works

When it comes to accounting for the expense of the item, it can be depreciated equally and discreetly over its useful life. According to the IRS’ General Depreciation System (GDS), these office items such as safes, desks and files, are expected to have a seven-year life.

While there are different approaches to calculate depreciation, a common way to do so is through straight-line depreciation. This method is used by many organizations, including The Federal Reserve, and it works by starting with how much the item cost to acquire or its adjusted basis. From there, the item’s cost is reduced by the salvage value, or the asset’s value after its useful life. The resulting figure is divided by the number of months of the asset’s useful life. Once the asset has exhausted this amount of time, it remains on the books as its salvage value until it’s sold or removed from service.

Using the straight-line method, a company might find the monthly depreciation charge for a truck purchase like this. The company purchases a new truck for $40,000; assuming a 60-month useful life allowable by the IRS and a 20 percent salvage value, the formula would be as follows:

1. $40,000 – (20 percent x $40,000) / 60 months
2. $40,000 – ($8,000) / 60 months
3. $32,000 / 60 = $533.33 per month for monthly depreciation

Special Considerations

In addition to tangible property, some intangible property also can be depreciated under the right circumstances. Examples the IRS cites of this primarily intellectual property includes copyrights, patents and software. Conditions for depreciation of this type of intangible property include that it must be owned by the business owner, used within the business or for profit-related activities, have a useful life and can be used by the business for more than a year.

The IRS gives an example of an individual buying a patent for $5,100. Using the straight-line method, the IRS permits this type of non-section 197 intangible property to be depreciated under certain conditions. The owner then must reduce any salvage value from the non-section 197 intangible property’s adjusted basis and depreciate it over the patent’s useful life, prorating terms less than a year, if applicable.  

Eligible Intangible Property Example

Assume the individual bought a patent in May to be used starting June 1 of the same year. The patent was bought for $5,100, has a 17-year useful life and won’t have any salvage value.

The first year of depreciation must be prorated for six months, since it will be used from June to December of the first year. Taking these circumstances and rules from the IRS, the first year’s depreciation available is $150. Each subsequent year, the 16 remaining will be $300 each.

While there are many intricacies for depreciation, understanding how it applies to each business’ operations will help give a fair assessment of an equipment’s value.

Sources

https://www.irs.gov/pub/irs-pdf/p946.pdf

As the name implies, First-In, First-Out (FIFO) is a way for companies to value their inventory. The first items put into inventory or produced by the company are accordingly the first taken out of inventory or transferred to customers and therefore expensed. When it comes to accounting for acquisition and/or production costs, initial and earlier costs are the first to be expensed, with more recent costs staying on the balance sheet to be expensed later.

Assume a company already has 200 widgets costing $4/widget. From there, the company increased its inventory at three more times during a selected accounting period. Three hypothetical, additional purchases include:

200 widgets @ $6/widget

200 widgets @ $7/widget

200 widgets @ $8/widget

If the company had 500 widgets purchased, there would be different considerations be it FIFO or LIFO. First, we’ll discuss FIFO.

For the 500 widgets sold to customers, the FIFO’s Cost of Goods Sold (COGS) (assuming there are no additional inputs that would increase the COGS for simplicity sake) would be $2,700.

This calculation will look at how COGS works for FIFO:

200 initial widgets costing $4/widget = $800 in COGS  

200 widgets from the first additional purchase, costing $6/widget = $1,200 in COGS

100 widgets from the second additional purchase, costing $7/widget = $700 in COGS

For a total of $2,700 in COGS

Assuming there were no purchases during the selected accounting period, there would be 300 widgets remaining in inventory, or $3,000 in inventory costs. The inventory would show up on the balance sheet, according to the following calculation:

200 widgets @ $7/widget = $1,400 in inventory

200 widgets @ $8/widget = $1,600 in inventory

Now this is compared to LIFO, or Last-In, First-Out, which accounts for expenses by looking at most recent costs first. With the same company selling the same 500 widgets in the same accounting time-frame, but expensing their most recent 500 widgets first, here is the rundown:

200 widgets @ $8/widget = $1,600 in COGS

200 widgets @ $7/widget = $1,400 in COGS

100 widgets @ $6/widget = $600 in COGS

For a total of $3,600 expensed

The inventory would be left as the following:

100 widgets @ $6/widget = $600

200 widgets @ $4/widget = $800

For a total of $1,400 in remaining inventory.

Considerations Between LIFO and FIFO

One important consideration when choosing between LIFO or FIFO is that more likely than not input costs rise over time. Therefore, valuations can change based on the type of method.

Looking at the LIFO method, taking out inventory that’s been produced most recently does not always reflect market prices of the remaining inventory, especially if remaining stock is a few years old. Along with Costs of Goods Sold lowering net income, if older inventory is obsolete and it can’t be sold, it’ll render the inventory’s value far below market prices.

When it comes to the FIFO method, you get a better indication of the remaining inventory’s value. However, using this method increases a business’ net income since remaining inventory can be older and is valued by the Cost of Goods Sold. Similarly, if net income increases, there’s also a good chance of greater tax obligations for the company.

These scenarios account for rising prices. However, if prices are falling, then these scenarios would be reversed.

With more than 1.4 million accounting jobs in 2018, according to the Bureau of Labor Statistics, there are many different uses for accountants and their skills. With the need for accuracy and transparency in private and public accounting, one important concept to explore is absorption, or full costing.

Absorption or full costing is an accounting method that is used by businesses to determine the complete cost of producing products or services.

When it comes to calculating the full cost, there are three main categories taken in account:

1. Direct Costs – How much material, labor, machinery, etc. it costs to produce each product.
2. Total Amount of Fixed Costs – Examples include monthly rent payments, tax payments, base salaries, etc. These are the types of expenses a company would incur regardless of the level of production.
3. Total Amount of Variable Costs – If there’s increased demand for a particular product, companies would incur variable costs to meet that demand. Examples would include additional wage payments, increased electricity bills for extended or additional shifts, etc. Unlike a pre-negotiated rate for a lease, paying overtime or for more staff would vary based on changes in production needs.

It’s important to note that with absorption or full costing, regardless of the accounting period, both variable and fixed selling and administrative costs are not included when calculating cost per item. These costs are accounted for in the accounting time, whenever the expenses actually occurred or on an accrual basis.

Along with being GAAP-compliant (following Generally Accepting Accounting Principles) when it comes to absorption or full costing, the direct material costs, labor costs and variable and fixed overhead expenses are factored into the per-product cost to the point of sale. Once sold, the expenses will then be reflected on the Income Statement within the COGS fields (Costs of Good Sold).

Further Considerations and Differences with Variable Costing

The primary difference between full costing and variable costing can be seen when it comes to fixed overhead manufacturing costs.

For the absorption or full costing approach, fixed manufacturing overhead costs are recognized when the product is sold. With the variable costing method, the fixed manufacturing overhead costs are accounted for when the business incurs the expenses for that product (i.e., during production time).

Whether or not produced items are sold or still part of the business’ inventory, the absorption costing approach assigns all expenses to the inventory. This helps companies calculate their net profit more precisely. The approach to determining net profit is especially helpful if a company’s inventory is unsold after the accounting timeframe when production occurred.

When fixed costs such as insurance, salary, advertising and related expenses add up quickly and to great amounts, this is something to keep in mind when determining private performance and public perception for publicly traded companies.

Sources

https://www.bls.gov/ooh/business-and-financial/accountants-and-auditors.htm

When it comes to tracking incoming sales and outgoing expenses, there are many ways businesses can keep up with their invoices and implement strategies to reduce the time they spend on unpaid sales.

Accounts Receivable Turnover Ratio

Simply defined, the accounts receivable turnover ratio is a way of showing what percent of a company’s receivables or invoices are paid by clients. 

The U.S. Small Business Administration explains this ratio is determined by “dividing average accounts receivable by sales.” Determining average accounts receivable is done by adding the beginning and ending figures — be it a month, quarter or year, then dividing by 2. Determining the sales figure is calculated by taking the total sales still on credit and deducting any allowances or returns from the gross sales figure.    

If the beginning and ending accounts receivables for a 12-month period were $20,000 and $30,000, the average accounts receivable would be $50,000/2 or $25,000. If the gross sales were $200,000 for the 12-month period and there were $20,000 in returns, it would leave $180,000/$25,000 or an accounts receivable turnover ratio of 7.2

Accounts Payable Turnover Ratio

The payable turnover ratio is determined by taking all purchases from suppliers and dividing the supplier purchase figure by the mean accounts payable figure. The average accounts payable figure is calculated by adding the starting accounts payable figure and the ending accounts payable figure, normally at the beginning and ending of a period, such as 12 months. From there, the summed up accounts payable figure is divided by 2 to get an average.  

A business made yearly purchases on credit for about $250,000 from suppliers and had returns to those suppliers for about $20,000. If at the beginning of the 12-month period accounts payable were $11,000, then at the end of the period the accounts payable balance was $26,000, the total figures would equal $37,000.

From that point, there would be $230,000 in net yearly purchases on credit for the business and an average of $18,500 for the period’s accounts payable. Dividing the $230,000 by $18,500 equals 12.43. Therefore, the business’ accounts payable turned over about 12.5 times during the period. As the SBA explains, the higher the ratio, the more dependent companies are on accounts payable to acquire inventory.   

Accounts Payable Aging Report

When it comes to defining an accounts payable aging report, businesses can use this tool to determine and organize outstanding accounts payable to vendors or suppliers and how much each is owed. While it can be broken into discreet time frames, such as net-14 or net-60 or net-90, depending on how the supplier and business decided on payment terms, commonly accepted time frames established are: up to 30 days; 31 to 60 days; and so on.

This report is used to organize which supplier invoices are due and when. One important consideration to note is if the report assumes that all invoices are due within 30 days. If there’s special arrangements or terms from important suppliers, it could need adjusting as determined by individual supplier payment terms.  

By using an accounts payable aging report, businesses will see when they need to pay their bills on time and what percentage are being paid on time (or not). It will help businesses see if they’re paying late fees by organizing invoices. Businesses can also identify if there’s a need to negotiate with suppliers for reduced payments for early payments or for extended time to pay invoices if cash flow is an issue. 

Accounts Receivable Aging Report

Similar to an accounts payable aging report, an accounts receivable aging report helps businesses track outstanding invoices owed by clients. It also contains the client name, the time when payment is due and how late, if at all, client invoices are for issued invoices.

These reports help businesses determine the likelihood of debt becoming bad, and if unpaid invoices need to be sent to collections or written off. It can also measure in short and long terms how clients have made timely payments on their invoices. This can help businesses determine if they should reduce existing credit terms to their clients or to make an offer to discount what’s owed in order to get an otherwise uncollectible invoice paid.

Whether a company owes money or expects to be paid for a product or service, with the proper accounting tools, there’s a way to keep track of all inflows and outflows.

Sources

https://www.sba.gov/offices/district/nd/fargo/resources/capacity-and-credit

According to data from a U.S. Small Business Administration Office of Advocacy report from August 2018, businesses have varied longevity.

Nearly 80 percent (79.8 percent) of business startups in 2016 lasted until 2017. Between 2005 and 2017, the SBA mentions that 78.6 of new businesses lasted 12 months. Similarly, nearly 50 percent lasted at least five years.  

While there are many reasons why a company goes out of business – one is profitability. Knowing when the business is breaking even and will start making a profit can be accomplished with a break-even analysis.

Defining a Break-Even Analysis

As the SBA explains, a Break-Even Analysis is a useful way to measure the level of sales necessary to determine how many products or the amount of services that must be sold in order to pay for fixed and variable costs, otherwise known as “breaking even.” It refers to the time at which cost and revenue reach an equilibrium.

In order to get the Break-Even Quantity (BEQ), as the SBA uses, businesses must take their fixed costs per month and divide this figure by what’s left over after subtracting the variable cost per unit from the price per unit – or the product’s selling price.

Fixed Costs

These types of costs can include things such as rent or lease payments, property taxes, insurance, interest payments or monthly machine rental costs.

Variable Costs

In contrast to fixed costs, such as taxes or interest payments for the next month or year, business owners also must deal with variable costs. Utilities and raw material expenses are two examples of variable costs.

Looking at electricity costs, the amount and price of kilowatts used per month will vary based on the amount and length of usage of lights, climate control equipment, production runs and the rate of kilowatts from the supplier.

Looking at raw materials, such as oil or precious metals, these costs can decrease or increase frequently due to tariff or commodity fluctuations.

Sales Price Per Unit and Further Considerations

When it comes to how much an item is ultimately sold for, there are different considerations for different product sales. If a company is selling a product for $100 on the retail level, and the business’ fixed costs are $4,000 and there’s $50 in variable costs, the Break-Even Quantity can be calculated like this:

$4,000 / ($100 – $50) = $4,000 / ($50) = 80 products (to break even)

If those products are surfboards priced at $100 each, then sales of the 81st surfboard and onward would represent profits for the company. It’s also important to see how changing either fixed costs or variable costs can make a difference in the break-even point.

Reducing Fixed Costs

If a business owner refinances a loan to a lower, fixed interest rate, or reduces a salary for the next 12 months, the overall fixed costs will go down. Here’s an example with a lower fixed cost for the same scenario:

$3,500 / $50 = 70 products (to break even)

Reducing Variable Costs

If a business owner searches for another supplier, such as one that’s not subject to import tariff costs that get passed on to consumers, variable costs can be reduced for the same scenario. In this example, the variable cost is reduced to $45.

($100 – $45) = 55

$4,000 / $55 = 73 products (to break even)

While each business has its unique costs and industry conditions, a break-even analysis can help business owners determine future moves.

Sources

https://www.sba.gov/sites/default/files/advocacy/Frequently-Asked-Questions-Small-Business-2018.pdf

https://www.sba.gov/sites/default/files/Worksheet_Pricing_Models_for_Successful_Business.pdf