Engineering Finance
Lessons



Economics and Engineers

Economics impacts the world at every level. At the international level countries must manage their international trade and their debt with other countries. At the national level, federal governments must determine how much to tax their constituents, how to spend this money, how to improve the financial well being of their citizens, and how to distribute the national resources. At the state and local level, governments and communities must manage taxes, support many institutions and services and ensure the public's well being. At the organization level, financial officers worry about public versus private financing, revenues and costs, and competitor's finances. Even at the personal level, we need to carefully manage our money, and worry about the balance between our income and expenses.

Goals
Summary Icon
  • Identify economic issues in the world, nation, and state that affect the well being of an engineer.
  • Identify the parts of the balance sheet, income statement and cash flow statement.
  • Given appropriate data be able to construct a balance sheet, income statement and cash flow statement for a simple corporation.
  • Using the financial statements, compute ratios describing the health of the corporation.
Economics and the Engineer

Economics is a big part of an engineer's job. The engineer must translate scientific ideas into products and systems that better humankind. Ideas need to make sense economically and the engineer must be able to convince others that this is so.

Click the Quicktime symbol to view the presentation.

. Presentation Icon
Economics and the Engineer
.

There is no question that economics, trade, finance and money are of great interest in the world of today. The newspapers and other media are full of articles that relate to these subjects. Indeed most newspapers include a special section on Business. Of course the traditional business specialties such as management, finance, and accounting play a big role in these stories, but engineers and scientists are the stars in many cases. Modern technology, invented, developed, manufactured, distributed and maintained by engineers, is the center of the most far-reaching and profitable industries. Many products such as design, consulting and software are intellectually based rather than materially based, and engineers comprise a big part of a country's intellectual capital.

At the same time we realize that, thankfully, money isn't the most important aspect of life and most organizations. The religions and cultures of the world have a lot to say about the relationship between money and humankind, and the message is not usually positive for money. Although we spend most of the time in this course talking about money and the most economic way to accomplish some purpose, it is only one of the measures of a decision. We do live in a world where economics affects our well being, however, and we must be able to operate in this environment.

Corporate Finance

Many engineers work for profit-seeking corporations. Since money is the central issue for corporations, it is important that we learn how it is measured and reported.  We begin with a disclaimer that the discussion in this lesson is your professor's simplified view of financial statements and certainly does not reflect detailed knowledge of accounting principles.

The most common reports are the corporate balance sheet, income statement and cash flow statement. Click the Quicktime symbol to view the presentation.

. Presentation Icon
Financial Reports
.

The link provides a good overview of financial statements.

. WWW Link
Arizona: Basic Financial Statements
.

The example is a little complicated, but it illustrates most of the important features of the financial statements. The problems we deal with for homework and exams are much simpler than the example. It is a good thing for an engineer to be aware that his or her work impacts the financial well being of some organization.

Balance Sheet

Open the documents holding the example of the balance sheet for Consolidated Inc.  The documents show two years of the balance sheet 2002 and 2003. For a particular year the balance sheet shows a snapshot of the corporation at some point of time, December 31 for the example. The Assets part of the balance sheet shows the value of what the corporation owns.

. Window Icon
Balance Sheet: Assets
.

The Liabilities part of the balance sheet shows what the corporation owes and the Equity part shows contribution of the shareholders.

. Window Icon
Balance Sheet: Liabilities and Equity
.

View the presentation to see how the assets are related to the liabilities and equity. The presentation uses the balance sheet for 2003.

. Presentation Icon
The Balance Sheet
.

The assets are the value of the things the corporation owns. The liabilities are the value of what the corporation owes. The equity section shows how much the shareholders have contributed.

The balance sheet shows the financial status of the company at one point in time. The assets must equal the total liabilities and equity.

 

Income Statement

Open the income statement (Profit and Loss) document. It shows the results of operating the company during an interval of time (year, quarter, month). Except for the depreciation item the amounts shown are receipts and expenditures associated with selling and producing the company's product. The example shows the year ending on December 31, 2003. This is the interval between the two years shown for the balance sheet.

. Window Icon
Income Statement
.

The depreciation item deserves special mention because it is a charge for the aging of the assets of the company. It is not a cash expenditure. Depreciation is deducted in the income statement, but added back in the cash flow statement.

View the presentation to see how the income statement is constructed.

. Presentation Icon
The Income Statement
.

The income statement shows the receipts and expenditures associated with operating the company during an interval of time. An important measure is the bottom line or the net profit for the interval.

Cash Flow Statement

The cash flow statement combines the net income found in the income statement with the cash flows from investing activities and the cash flows from financing activities. It is important because its entries describe the change in the balance sheet from one year to the next. Given the balance sheet at the beginning of the year and the cash flow statement, you should be able to construct the balance sheet at the end of the year. Click the icon to see the cash flow statement.

. Window Icon
Cash Flow Statement
.

The cash flow statement begins with the net income from operations. This entry represents all the items we saw on the income statement. Subsequent entries are added if they increase the cash available to the company and subtracted if they take away cash. The bottom line of this report is line 67 for the example. This line holds the net results of the additions and subtractions. Its value is the change in the cash item on the assets part of the balance sheet.

We see depreciation as a positive contributor to the cash in line 48. It was previously deducted as an expense in the income statement, but that was a charge and not a cash flow. We add it back in the cash flow statement.

We will see in the next section how the cash flow statement changes the balance sheet from one year to the next. You might keep the cash flow statement window open for the discussion.

The cash flow statement shows the additions and subtractions from the cash available to the company.

Changing the Balance Sheet

Every item on the cash flow statement changes some item on the balance sheet. With the balance sheet for one year and the cash flow statement, we can construct the balance sheet for the next year. We illustrate this for our example using the balance sheet for 2002 and show how the balance sheet for 2003 is constructed.

. Window Icon
Change in Assets
.

. Window Icon
Change in Liabilities and Equities
.

We show on the two figures the balance sheet for 2002. For each item on the balance sheet we see the 2002 value, a line number from the cash flow statement that will change that item, the amount of the change (black means add and red means subtract) and the resultant 2003 balance sheet value.

The easiest way to look at this is to start at line 48 of the cash flow statement and see how it affects the assets, liabilities and equity. Each line (not a total) changes some item on the balance sheet. In some cases the change is spread over several items. Continue the process down the cash flow statement. The last line to consider is line 67. It holds the sum of the net income and all the changes. Line 67 is the change in the cash entry in the assets section. Lines 68 and 69 summarize that change.

Item 64, Payments of dividends requires some explanation because its effect is not direct. The net income, or profit, earned by the corporation belongs to the shareholders. Dividends return part of the profit to the shareholders. The difference between net income and dividends increases the retained earnings in the equity part of the balance sheet.

Looking at the changes to the balance sheet we find that the change in the assets must balance the change to the liabilities and equity.

When given a balance sheet for one year and the cash flow statement, one can compute the balance sheet for the next year.

Ratios

Various ratios can be computed from the financial statements. Investors use ratios to help evaluate a company. They are especially relevant when compared with other companies in the same industry. Solvency ratios indicate how well the corporation is positioned to pay off its debt. The values shown are from the financial statements of the example.

. Window Icon
Solvency Ratios
.

Efficiency and profitability ratios indicate how well the corporation does at making profit with the resources available.

. Window Icon
Efficiency/Profitability Ratios
.

Some ratios involve both the balance sheet and the income statement. Since the balance sheet represents one point in time and the income statement describes an interval of time, you might wonder which balance sheet to use for computing the ratio. For example, to compute the return on assets we divide the net income by the total assets. Since the net income for our example is shown for year 2003, it would be reasonable to average the total assets for Dec. 31, 2002 and Dec. 31, 2003. In our example calculations we simplify this by dividing the net income by the total assets for 2003.

Again, one might ask whether the net income used in the ratios is before or after taxes. As the example indicates, we use the after tax value of net income.

The web has a great deal of information regarding investments and corporations. The link to Yahoo Finance is an example. To find financial statements for a particular corporation, enter its symbol in the search field and click on Finance Search. You can also use a search engine like Google to find financial statements. If you wonder about the meaning of the ratios type financial ratios in Google and you will find investor sites that explain them. There are many more ratios than we have described here and the same ratios may have different names.

. WWW Link
Yahoo Finance
.

Division

Summary

 

. Summary Icon
Financial Statements Summary
.
Problems

 

Click the Q icon below to open a quiz on financial statements. It is a PDF document. The quiz is made up of old exam questions. Work the problems to the best of your ability. Then open the Scorecard. This is a Flash movie that you can use to self-grade your quiz. Then click on the Q/A icon to open the key to the quiz. Again, this is a PDF document. The quiz has three questions with a total of 11 parts. Enter 11 on the appropriate scorecard field and follow the instructions to grade yourself on the quiz. If you do well, the scorecard will give you a graphic award.

. Quiz Icon
Financial Statements Quiz
.

The easiest way to do problem 1 is to make an income statement and a cash flow statement for each alternative future. Don't forget to deduct taxes. Compute increase in retained earnings as below. It is hard to construct the new balance sheet without these steps. Considering only the items in problem 1 the statements are computed as below.

Income statement:
Net Income before taxes = Net Sales – Cost of Goods Sold – Depreciation – Admin. Expense + Interest Income – Interest Expense

Tax = (Net Income before taxes)*(tax rate)

Net Income after taxes = Net income before taxes - Tax

Cash Flow statement:
Change in Cash = Net income after taxes + Depreciation + Increase in Capital + New Debt – Repay Debt – Dividends - Inc. in Fixed Assets – Inc. in Other Current Assets

Increase in retained earnings = Net income after taxes - Dividends

. Window Icon
Scorecard
.
. Quiz Icon
Financial Statements Quiz Key
.

 

 

Navigation

Return to Top of Page

Engineering Finance
by Paul A. Jensen
Copyright 2005 - All rights reserved

Front Page Lessons Resources