Financial Background: A Review of Accounting, Financial Statements, and Taxes
Question 1: Why is EBIT an important line item in the income statement? What does EBIT shows us?
Answer: Earning Before Interests and Taxes (EBIT). EBIT is an important line on the income statement, because it shows the profitability of the firm’s operations before consideration of how it is financed. The line is also called operating profit. To understand the concept of EBIT, let us consider we want to compare the performance of two businesses that are identical except for their financing. Assume one business is entirely equity financed and other has a significant amount of debt. If we try to judge two companies on the basis of net income, we won’t get a true idea of the relative strengths of business operations, because the second firm will have its profit reduced by the interest it pays on borrowed money. The problem arises because the payment to creditors, is shown on the income statement, but dividends, the payment to owners, are not. Therefore a company with debt financing will always look weaker at the net income than an otherwise identical firm that’s equity financed. So basically, EBIT shows the profitability of business operations before results are muddled by the method of financing.
Question 2: How are capital and working capital different ?
Answer: Here is the difference between capital and working capital:
Capital: Capital is how much money has been invested within the company or business. Capital consists of all assets fixed and current. While calculating capital on the basis of assets, following points must be noted.
Any asset which is not in use should be excluded.
Intangible assets like goodwill, patents, trademarks etc should be excluded. If they have some potential sales value, they should be included. Investments which are not concerned with business, should be excluded. Fictitious assets are to be excluded.
Working Capital: Working Capital is what funds you have for the day to day running of the business. Difference between current assets and current liabilities is known as working capital.
Working Capital = Current assets – Current liabilities
Current assets are those assets which will be converted into cash within the current accounting period or within the next year as a result of the ordinary operations of the business. They are cash or near cash resources. These include:
Cash and Bank balances Receivables Inventory : Raw materials, stores and spares ,Work-in-progress , Finished goods Prepaid expenses Short-term advances
Current liabilities are the debts of the firms that have to be paid during the current accounting period or within a year. These include:
Creditors for goods purchased
Outstanding expenses i.e., expenses due but not paid Short-term borrowings Advances received against sales Taxes and dividends payable
Question 3: Discuss the purpose of an accounting system and financial statements in terms of the way the system represents the business.
Answer: Accounting is designed to provide a "picture" of operations in numerical terms. It does that with devices like depreciation which matches the cost of an asset with its service life regardless of the cash flows associated with its acquisition. The portrayal is conceptual in that it attempts to give a broader picture of the condition of a business than the immediate availability of funds.
It is important to understand that financial statements are associated with the point in time at the end of the period, while the income statement and the statement of cash flows are related to the entire period. Statement can, however be…