Forms of Business Organization • The Sole Proprietorship • The Partnership • General Partnership • Limited Partnership • The Corporation
Corporation Partnership Liquidity Shares can be easily exchanged Subject to substantial restrictions Voting Rights Usually each share gets one vote General Partner is in charge; limited partners may have some voting rights Taxation Double Partners pay taxes on distributions Reinvestment and dividend payout Broad latitude All net cash flow is distributed to partners Liability Limited liability General partners may have unlimited liability; limited partners enjoy limited liability Continuity Perpetual life Limited life A Comparison
The Agency Problem • Agency relationship • Principal hires an agent to represent his/her interest • Stockholders (principals) hire managers (agents) to run the company • Agency problem • Conflict of interest between principal and agent
Managerial Goals • Managerial goals may be different from shareholder goals: • Expensive perquisites • Survival • Independence • Increased growth and size are not necessarily equivalent to increased shareholder wealth
Managing Managers • Managerial compensation • Incentives can be used to align management and stockholder interests • The incentives need to be structured carefully to make sure that they achieve their intended goal • Corporate control • The threat of a takeover may result in better management • Other stakeholders
Financial Statement • A financial statement(or financial report) is a formal record of the financial activities of a business, person, or other entity. • For a business enterprise - all the relevant financial information, presented in a structured manner and in a form easy to understand.
An annual report • An annual report is a comprehensive report on a company's activities throughout the preceding year. • Annual reports are intended to give shareholders and other interested people information about the company's activities and financial performance. • Most jurisdictions require companies to prepare and disclose annual reports, and many require the annual report to be filed at the company's registry. • Companies listed on a stock exchange are also required to report at more frequent intervals (depending upon the rules of the stock exchange involved).
Typically annual reports will include: • Chairman's report • CEO's report • Auditor's report on corporate governance • Mission statement • Corporate governance statement of compliance • Statement of directors' responsibilities • Invitation to the company's AGM as well as financial statements including: • Auditor's report on the financial statements • Balance sheet • Statement of retained earnings • Income statement • Cash flow statement • Notes to the financial statements • Accounting policies
Financial Statements • Balance sheet(BS): also referred to as statement of financial position or condition, reports on a company's assets, liabilities, and ownership equity at a given point in time. • Income statement: also referred to as Profit and Loss statement ("P&LA") provides information on the operation of the enterprise, reports on a company's income, expenses, and profits over a period of time.
Financial Statements • Statement of Owner's Equity shows the change in owner's equity during a given time period. It lists the owner equity balance at the beginning of the period, additions and subtractions to the balance, and the ending balance. Additions come from owner investments and income; subtractions from owner withdrawals and losses. • Statement of cash flows: reports on a company's cash flow activities, particularly its operating, investing and financing activities. Indicates whether enough cash is available to carry on routine operations.
Financial Statements • For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements and management discussion and analysis. • The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.
Financial statements Financial statements should be understandable, relevant, reliable and comparable.
Identification of the user • The IASB Framework states: The objective of financial statements is to provide information … that is useful to a wide range of users in making economic decisions. • Owners, prospective investors and managers require financial statements to make important business (investment) decisions (buy/sell/hold) that affect its continued operations. Return on capital employed (ROCE) and related performance and asset management ratios are likely to be of interest to this group of users.
Financial statements - users • Employeesthey need to be able to assess the stability and performance of the entity in order to assess how reliable it is to be employed in it in the longer term. Employees are likely to be interested in disclosures about retirement benefits, remuneration and promotion. • Suppliers - interested in information that helps them to decide whether or not to supply goods or services to an entity. Availability of cash will be of particular interest. Working capital ratios, and the working capital cycle, may be appropriate calculations for this class of user.
Financial statements - users • Lenders and potential lenders - are interested in assessing whether or not the loans that they have made are likely to be repaid, and whether or not the related interest charge will be paid in full and on time. They are particularly interested in ratios such as interest cover and gearing, and will be interested in the nature and longevity of other categories of loan to the entity. • Customers - interested in assessing the risks which threaten their supplier.
Financial statements - users • Government entities require special-purpose reports, especially tax computations, general-purpose reports- statistics. • Media and the general public are also interested in financial statements for a variety of reasons.
Audit and legal implications • Although laws differ from country to country, an audit of the financial statements of a public company is usually required for investment, financing, and tax purposes. These are usually performed by independent accountants or auditing firms. • Results of the audit are summarized in an audit report that either provide an unqualified opinion on the financial statements or qualifications as to its fairness and accuracy. • The audit opinion on the financial statements is usually included in the annual report.
Standards and regulations • Different countries have developed their own accounting principles over time, making international comparisons of companies difficult. • Recently there has been a push towards standardizing accounting rules made by the International Accounting Standards Board ("IASB"). IASB develops International Financial Reporting Standards that have been adopted by e.g.Australia, Canada and the European Union (for publicly quoted companies only) • It ensures uniformity and comparability between financial statements prepared by different companies ( a set of guidelines and rules).
Financial statement analysis …is the application of analytical tools and techniques to general-purpose financial statements and related data to derive estimates and inferences useful in business analysis. …refers to an assessment of the viability, stability and profitability of a business. … decreases the uncertainty of business analysis, and provides a systematic and effective basis for it.
Comparability problems (Accounting risk ) • Lack of uniformity in accounting leads to comparability problems. 2. Discretion and imprecision in accounting can distort financial statement information(errors, omissions). 3. Managers might use their discretion in accounting to manipulate or window-dress financial statements.
The Balance Sheet • An accountant’s snapshot of the firm’s accounting value at a specific point in time. • BS reports the resources of the entity, useful for evaluating the ability of the company to meet its long-term obligations. • BS summarizes the assets, liabilities, and owners’ equity of a company at a specific point in time.
Total Value of Assets: Total Firm Value to Investors: Current Liabilities CurrentAssets Long-Term Debt Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity The Balance Sheet
The Balance Sheet Identity : • Assets ≡ Liabilities + Stockholder’s Equity • Assets - what a company owns • Liabilities - what a company owes • Owners' Equity - claims of owners against the business
Assets - valuable resources providing future benefits to the company • Current assets are assets that quickly and easily can be converted into cash (within 12 months), sometimes at a discount to the purchase price. Current assets include cash, accounts receivable, marketable securities, notes receivable, inventory, and prepaid assets such as prepaid insurance. • Fixed assets (relatively long life) include tangible assets (land, buildings, and equipment, recorded at historical cost, which often is much lower than the market value), and intangible assets such as trademark, patents.
U.S. Composite Corporation Balance Sheet The assets are listed in order by the length of time it would normally take a firm with ongoing operations to convert them into cash. Average values Clearly, cash is much more liquid than property, plant, and equipment. 2007 2006 2007 2006 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation (550) (460) Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock (26) (20) Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
Liabilities (claims to assets) • represent the portion of a firm's assets that are owed to creditors; • present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits • Current liabilities (expected to be liquidated within a year) include accounts payable, notes payable, interest payable, wages payable, and taxes payable. • Long-term liabilities (expected not to be liquidated within a year) include mortgages, notes payable and bonds payable.
Equity (TA – TL) • Equity is referred to as owner's equity in a sole proprietorship or a partnership, and stockholders' equity or shareholders' equity in a corporation. • The equity owners of a business are residual claimants, having a right to what remains only after the creditors have been paid. • In the case of a corporation, equity would be listed as common stock, preferred stock, and retained earnings.
U.S. Composite Corporation Balance Sheet Labilities and Owners’ Equity 2007 2006 Total current liabilities 486 455 Accounts payable 213 197 Notes payable 50 53 Accrued expenses 223 205 Long-term debt 588 562 Total owners’ equity 805 725 Preferred stck 39 39 Common stock ($1) 55 32 Capital surplus 347 327 Retained earnings 390 347 Total liabilities 1879 1742
The Capital Budgeting Decision Current Liabilities Current Assets Long-Term Debt Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity What long-term investments should the firm choose?
The Capital Structure Decision Current Liabilities Current Assets Long-Term Debt How should the firm raise funds for the selected investments? Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity
Balance Sheet Analysis When analyzing a balance sheet, the analyst should be aware of three concerns: • Liquidity • Debt versus equity • Value versus cost
Liquidity • Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value (cost, time) • Current assets are the most liquid. • The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations (financial distress).
Net Working Capital • A measure of both a company's efficiency and its short-term financial health. • Net Working Capital ≡ Current Assets – Current Liabilities • NWC usually grows with the firm
Short-Term Asset Management Current Liabilities Current Assets Net Working Capital Long-Term Debt How should short-term assets be managed and financed? Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity
Net Working Capital • Positive working capital means that the company is able to pay off its short-term liabilities. • Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory). • A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis.
$252m = $707- $455 $23 million $275m = $761m- $486m U.S.C.C. Balance Sheet 2007 2006 2007 2006 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Here we see NWC grow to $275 million in 2006 from $252 million in 2005. Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation (550) (460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 par value) 55 32 This increase of $23 million is an investment of the firm. Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock (26) (20) Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
Debt versus Equity • Creditors generally receive the first claim on the firm’s cash flow. • Shareholder’s equity is the residual difference between assets and liabilities. • Shareholders’ equity = Assets – Liabilities
25% Debt 70% Debt 30% Equity 75% Equity Capital Structure The value of the firm can be thought of as a pie. 50% Debt The goal of the manager is to increase the size of the pie. 50% Equity The Capital Structure decision can be viewed as how best to slice the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters.
Value versus Cost • Under Generally Accepted Accounting Principles (GAAP), audited financial statements of firms in the U.S. carry assets at cost. • Market value is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a completely different concept from historical cost.
The Income Statement (a video) • measures financial performance (the results of the entity's operations) over a specific period of time. • summarizes the revenues and expenses of a company for a period of time. • The accounting definition of income is: Revenue – Expenses ≡ Income
Income Statement Revenuerefers to inflows from the delivery or manufacture of a product or from the rendering of a service. Expenses are outflows incurred to produce revenue (cost of doing business). It is an outflow of cash or other valuable assets from a person or company to another person or company.
U.S.C.C. Income Statement Total operating revenues $2,262 The operations section of the income statement reports the firm’s revenues and expenses from principal operations. Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 $190 Operating income 29 Other income Earnings before interest and taxes $219 Interest expense 49 Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86 Addition to retained earnings $43 Dividends: $43
U.S.C.C. Income Statement Total operating revenues $2,262 The non-operating section of the income statement includes all financing costs, such as interest expense. Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 29 Other income Earnings before interest and taxes $219 Interest expense 49 $170 Pretax income Taxes 84 Current: $71 Deferred: $13 Net income $86 Addition to retained earnings: $43 Dividends: $43
U.S.C.C. Income Statement Total operating revenues $2,262 Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 Other income 29 Earnings before interest and taxes $219 Interest expense 49 Net income is the “bottom line.” Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86 Retained earnings: $43 Dividends: $43
Cash Flow Statement • The nature of accrual accounting is such that a company may be profitable but nonetheless experience a shortfall in cash. • The statement of cash flows is useful in evaluating a company's ability to pay its bills. For a given period, the cash flow statement provides the following information: • Sources of cash • Uses of cash • Change in cash balance
Cash Flow Statement • The financial statement that summarizes an entity’s cash receipts and cash payments during the period. It breaks the sources and uses of cash into the following categories: • operating activities – concerned with the acquisition and sale of products and services • investing activities – concerned with the acquisition and disposal of long-term assets • Financing activities - concerned with the raising and repayment of funds in the form of debt and equity.
Financial Cash Flow • The information used to construct the cash flow statement comes from the beginning and ending balance sheets for the period and from the income statement for the period. • the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders. CF(A)≡CF(C) + CF(S)
CASH FLOW EQUATIONS – Cash flow from assets Cash flow from assets = operating cash flow – net capital spending - Change in net working capital OCF = EBIT + depreciation – taxes NCS = ending net fixed assets – beginning net fixed assets + depreciation change inNWC = ending NWC – begining NWC
CASH FLOW EQUATIONS- cash flow to creditors Cash flow to creditors = interest expense- net new borrowing from creditors Net new borrowing = ending long-term liabilities – begining long-term liabilities
CASH FLOW EQUATIONS- cash flow to owners Cash flow to owners = dividends – net new borrowing from owners Net new borrowing from owners = change in equity Change in equity = ending common stock and paid-in-surplus –beginning common stock and paid-in-surplus