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Best if printed in landscape. Accounting Profit, Depreciation, Financial Analysis and Opportunity CostAnalyzing financial statements often involves the application of several financial and economic concepts. This page reviews a few of these concepts: accounting profit, depreciation, opportunity cost, return on assets (ROA) and return on equity (ROE). Accounting Profit or Net Income By preparing an income statement, an accountant calculates the profit earned by the business for the period covered by the income statement. However after the income statement is prepared, it is the responsibility of the manager to assess the information. For example, the manager would want to determine whether the profit was adequate to justify continuing to operate the business.
The accountant can prepare the financial statements, such as the income statement, but it is the manager who must decide whether the financial progress, as reported by these financial statements, is adequate. In making that assessment, the manager will want to consider several concepts, such as depreciation and opportunity cost. Depreciation is a cost, but what is depreciation?
Reference page: Depreciation Opportunity Cost -- The amount of income that could be earned if the economic resource was put to an alternative use. Or everything has a cost! Why do we make this statement? How does the answer to that question relate to management?
Can we begin to answer these questions? The basic premise: Business owners almost always operate the business with some combination of owned resources and resources acquired from others, such as input suppliers, landowners, employees, and lenders.
The following table may help illustrate this idea.
Compensating others for providing resources for use in your business are recognized as costs on an income statement. The return available to compensate the business owners for their resources is the "net income" or "accounting profit" on an income statement. That is, the business owners are not likely to pay themselves for the use of their resources; they simply keep whatever is left from the revenue after the costs are paid. Net income reflects the shaded cells.
A key question is whether this residual is enough to justify that the business owners continue to operate the business. For example if a landowner is not paid rent, the landowner will shift the land to another use that pays a rent. Likewise, the business owners need to decide if the business is generating enough return to justify keeping the land in the current business. If no, the business owners would be expect to shift the land to an alternative use. Only the business owners can make this assessment; that is "is the accounting profit enough to justify the business owners continuing to use their resources in their own business?" How much should the business owner expect as a minimum return? Managers begin to answer this question by determining what the owners are investing in the business and how much return the owners want to justify staying in the business. This thought process could start with "how much would I receive if I discontinued the business and shifted the resources to another use?" That statement sounds like opportunity cost; that is, "how much income would I receive if my resource was put to an alternative use?". Example: if the net income for the business is $10,000; that is the amount the business owners are receiving for their investment in the business. Their investment in the business could include their land, capital, time, and the risk they were exposed to. But is $10,000 an adequate return? To answer this question, the business owners might consider, for example,
If we now subtract these amounts ($8,100) from our net income ($10,000), the remaining $1,900 is our return for our information and risk exposure. In this example, the business owner assumed that the $8,100 is an adequate return for their land, capital and labor. They must now decide whether $1,900 is an adequate return for their information and risk exposure. Example: The business owners feel that the land should generate $3,500 in rent, their capital should generate $3,500 in interest, and the labor should generate $3,500 in wages. In this case, the $10,000 net income is not enough to compensate the owners for their resources. Even without placing any value on their information and risk exposure, the business is already $500 short (10,000 -10,500). In this second example, the business owners might quickly recognize that the business is not generating enough net return to justify continuing to operate the business. Managers could perform this analysis in numerous ways. For example, the manager may decide to place a "cost" on their labor, information and land, and then assess whether the remainder of the net profit was adequate to compensate for their capital investment and risk exposure. Regardless of how the managers address this question, they need to assess whether the net profit is adequate to justify their continued investment in and operation of the business. There will be times when the business owner will accept less than the opportunity cost, such as, "even though I could earn more doing something else, I receive utility (pleasure, pride) by owning and operating a business. Therefore, I am willing to accept a slightly lower return on my resources than I could receive from an alternative use so I can continue to operate my own business."
Only the business owner can make that assessment!!! Reference page: Opportunity Cost Financial analysis As an introduction to this subtopic (financial analysis), consider "why do we organize this information about our business into these documents or statements?" What is the purpose of preparing these financial documents? What is the purpose of analyzing this financial information (as we will discuss in this section)? How do the answers to these questions relate to topics previously discussed in this course?
Review -- what does the balance sheet reveal about the business? What does the income statement reveal about the business? What does the cash flow statement reveal about the business?
What does a series of balance sheets reveal about the business? What does an income statement for the past reveal and what does an income statement for the future (a projected income statement) reveal? What does a projected cash flow statement reveal? What do these statements collectively reveal? (see the next topic) Rate of return on assets (ROA) -- profit plus interest expense for the time period (as calculated on the income statement) minus opportunity cost for unpaid labor and management divided by the total value of assets (as reported on the balance sheet).
ROA is based on the shaded cells
If there is a major change in value of assets during the period being analyzed (as revealed by the balance sheet from the start of the period and the balance sheet from the end of the period), a manager may want to average the value of the assets from the two balance sheets to determine the value of assets to use in computing return on assets.
Rate of return on equity (ROE) -- profit for the time period (as calculated on the income statement) minus opportunity cost for unpaid labor and management divided by the equity as calculated on the balance sheet.
ROE is based on the shaded cells
A business' ROE should be greater than its ROA. This indicates that the business is increasing its profit by borrowing. If ROA exceeds ROE, the business may want to consider whether it wants to use some of its assets to reduce its debt.
Resource: Financial Characteristics of North Dakota Farms 2001-2003; give special attention to the definitions and explanations on pp. 7-10 of the pdf file. Financial Goals
Last Updated October 7, 2010 |
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Email: David.Saxowsky@ndsu.edu This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions. |
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