Free Cash Flow

The formula for Free Cash Flow is:

Free Cash Flow = Cash Provided by Operations – Capital Expenditures – Cash Dividends

Free Cash Flow is determined from the Statement of Cash Flows. This accounting evaluation is used to determine whether the company has sufficient cash to maintain its operations, invest in new assets and pay dividends to stockholders. Essentially free cash flow is what cash is left over after the company invests in what it needs to produce a product/ service and pays the investors.

What does 2/10 n/30 mean?

2/10 or 1/10 n/30 are discounts that offer an incentive for a customer to pay for purchases in a timely manner. A company offering terms of 2/10 is offering a discount of 2% provided that the invoice is paid within 10 days.
This amounts to a sizable interest rate for paying quickly.

• Paying invoices during the discount period benefits the payer with a savings.
• Speeds up the cash collection for the company offering the incentive, but at a cost.
• Should a company not take advantage of the discount, then the n/30 simply means that the invoice is due within 30 days at the full amount. 

In first semester accounting, this concept is relatively simple, but in later semesters the issue becomes more complex. To account for the discount, debit cash for the actual amount received, debit sales discounts for the deduction taken, and credit accounts payable for the full amount.

Example:
Company A purchases $5000 in inventory from Company B. Terms of the sale are 2/10 n/30.
Within ten days Company A remits the invoice; $5000. less 2% equals $4900.
Company B makes the following journal entries:

Debit Cash 4900
Debit Sales (or Service) discounts  $100
                    Credit Accounts Receivable $5000


Or Within 30 days (but more than 10 days) Company A pays the invoice.

Company B makes the following journal entries:

Debit Cash 5000
      Credit Accounts Receivable $5000

The difference is that Company A did not take advantage of the discount and paid after the 10 days, so they remit the full amount of the invoice.

Natural Balances

In accounting, T-Accounts have a natural balance side. 

This relates to the basic accounting equation:

Assets = Liabilities + Stockholders’ Equity

Assets have a natural balance on the Debit side of the T-Account. When the balance of Assets is increased, the entry is placed into the debit (left) side of the account. Cash coming in is always a debit as is any other asset being acquired: Accounts Receivable, Equipment, Property, Plant, Investments, and Inventory. Reductions in assets are placed on the credit (right) side of the T-Account, such as when cash is paid out.
A credit balance on an asset account would indicate a problem with the T-Account. Why? An asset with a balance on the credit side would indicate a negative asset. What is negative cash? This cannot exist in accounting as a balance on the credit side would be indicative of a liability rather than as an asset. The same is true for equipment as a credit balance would indicate that the equipment's value is less than zero. Can an Account Receivable be negative? This would indicate that someone overpaid their invoice and therefore is entitled to a refund, therefore a credit balance in the Account Receivables could be considered a liability.

Liabilities have a natural balance on the Credit (right) side of the T-Account. When liabilities are increasing such as Accounts Payable, the T-Account is credited with the transaction. When a liability is paid, a debit is entered to reduce the balance of the account. 

Stockholders’ Equity or SE has a natural balance on the Credit side of the T-Account. When stock is purchased by an investor, the cash received by the company is debited as it increases the cash asset; in turn the common stock account is credited. 

Retained Earnings has a natural Credit balance as most companies hope to earn a profit. Should the balance be on the Debit side that would indicate the company is losing money. 

Dividends have a normal balance of on the Debit side. 

Why? Because cash was used to pay the dividend and the dividends paid also reduce Retained Earnings. 

Expenses have a normal balance on the Debit side. 

Why? When cash was paid or liabilities were incurred those transactions were recorded on the Credit Side. To balance the accounting equation, expenses must be entered on the debit side. 

Revenues have a normal balance on the Credit side. 

Why? When cash was received or an Accounts Receivable was earned, those entries are Debits, therefore, to balance the accounting equation, revenues must be entered on the credit side.

Earnings per Share

The formula for Earnings per Share is:

Earnings per Share = (Net Income – Preferred Stock Dividends) / Average Common Shares Outstanding

Earnings per Share represent how much investors earn on their investment of common stocks in a company. This is important to investors as the only reason they are investing is to make money. The formula is rather tricky to use. Note that Preferred Stock Dividends must be subtracted from Net Income. This number is then divided by the Average Common Shares Outstanding. To determine the average: Take the number of stock outstanding at the beginning of the year and add the number of stock outstanding at the end of the year. This figure is then divided by 2 to arrive at the average value.

Solvency Ratios

Solvency ratios are used to measure a company’s ability to stay in business for a long period of time. While liquidity is looking at the current situation, solvency is looking at the long-term situation. 

One common solvency ratio:

Debt to Total Asset Ratio

The formula for Debt to Total Assets Ratio is:

Debt to Total Asset Ratio = Total Liabilities / Total Assets

Debt to Total Asset Ratio is used to examine the company’s long-term ability to meet obligations. Debt-financing is risky for any business as obligations have to be paid on a particular date in time. To utilize the formula take into consideration all liabilities whether short-term or long-term. For assets add up all the assets less depreciation that the company owns. 

Long-term debts are any debts that the company has that will be paid at some time in the future beyond the current year or operating cycle. 

Interpreting results: Higher ratios means the company has less equity. With a high ratio most of the assets are being financed with debt which in turn lowers the cushion that creditors have to collect on those liabilities.

Liquidity Ratios

Liquidity ratios determine the company’s ability to pay its current obligations. 

Before investing in a company, investors would like to know whether the company is profitable enough to pay their bills and dividends on time. This is a short-term measure of the company’s performance in terms of how much cash they have available and how much of their assets are being financed with debt. 

Accounting ratios

Accountants use various ratios to evaluate different aspects of a company. 

Three major types of ratios:

• Profitability Ratios—measures the profitability of a company over a period of time. 
• Liquidity Ratios—Evaluates the short-term ability of a company to meet its obligations.
• Solvency Ratios—Analysis the long-term viability of a company.

Each major group of ratios have different formulas some will have to be memorized, others your teacher may allow for the use of a cheat sheet. 

Ratios can be presented as a;

• Percentage 18% or 0.18
• Rate 0.18 times
• Proportion 0.18: 1