Before we delve into the subject of finance there are a number of terms we will introduce first so that we speak the same language. In this post we look at definitions for operating cycle, books of accounts, liquidity, financial structure, maturity, Chapter S and forms of business organizations. Attempt the included tests problems to test your grasp of the concepts.
My assumption is that as a student you have some idea of what it takes to run a business and you would like to learn more about how businesses value themselves, raise money, take decisions on projects and investments and allocated financial resources. All of the above require a combination of information about the business itself and the application of some reasonably simple tools. The objective of this course is to make it easy for you to work with the data required as well as the tools used.
So without further delay here is my laundry list of terms that you need to get familiar with:
The operating cycle of a firm consists of four smaller cycles. These are:
- Purchase Cycle. In this phase of the operating cycle the firm receives input from its suppliers. The firm may receive the input on credit. The Purchasing Cycle ends once the firm has received the required input and settles its account with the supplier.
- Manufacturing Cycle takes the input and converts it into finished products that the firm can sell to consumers. This phase of the operating cycle starts when the input hits the production line and ends when finished goods land in warehouse storage.
- Distribution Cycle begins when a product enters inventory storage and ends when it is moves to a distributor, retailer or consumer.
- Collection Cycle commences when distribution ends and is complete when the firm receives payment for good (or services).
All businesses keep a record of their revenues, expenses, profits, losses & investments. We refer to these records as books of account, accounting books, or simply books. They record all business transactions and the firm uses them compile financial statements. Interested parties then use these to assess the financial state and performance of the business.
Book value of an account simply refers to the recorded value in the books of account.
This value may be different from the original cost as well as the current market value. This happens over time since the value of the asset grows or shrinks at different rates in the real world and in the books of accounts.
One way of looking at liquidity is the value of an asset that the firm looses when it converts it to cash. For example, your checking account is 100% liquid. You can take it out anytime you want to without loosing any value. Except when the firm holds its as a security or it has restrictions on withdrawal. On the other hand, an operational plant with a positive book value that can only be sold for scrap is not very liquid. Also, there are assets, which cannot be sold due to legal restrictions, environmental factors and market conditions. As such, liquidity refers to how quickly the firm can convert an asset to cash.
Businesses use a combination of owners’ investment (equity) and long and short-term loans (debt) to meet their financial needs. Financial structure is this combination of equity and debt and it has important ramifications for profitability, growth, returns and risks.
In Accounting and Finance, we use Maturity generally in relation to obligations. You may have heard the statement, “The loan matures in 60 days” or “The bond matures in three years”. This means that the firm needs to repay the loan in 60 days and the bond would repay itself in three years. A safe definition for maturity is the duration after which an obligation, claim or loan has to be repaid.
Test Problems – Operating cycle & Liquidity
1) After packaging, Pepperidge Farm’s chocolate chip cookies are sent to the warehouse for storage. After taking the inventory, the cookies await shipment to the retailers. What stage of the Operating cycle have they just entered?
- Purchase cycle
- Manufacturing cycle
- Distribution cycle
- Collection cycle
2) Dara Singh picks up the phone, and places an order at the nearby Indian grocery store for 10 5kg bags of Basmati rice. What part of the Operating cycle is he in at the moment?
- Purchase cycle
- Manufacturing cycle
- Distribution cycle
- Collection cycle
3) Denise bought a Toyota Camry in January 2000 for $18000. Unfortunately because of shortage of funds, she decides to sell her car in September of the same year. However, she was disappointed to discover that the highest price that anyone was willing to give for it was $15300. What is the liquidity of the Camry?
Forms of ownership
Forms of doing business
There are many forms that a business can take. The form chosen depends on individual preference and knowledge of owners. The decision has strong implications for business continuation as well as taxes paid by owners and the firm.
i. Sole Proprietor
A sole proprietor is the only owner of a business. Three key things to remember about this form are:
- If the firm goes bankrupt and cannot pay off its obligations, the owner of the firm is responsible for paying off these obligations. Creditors can attach the personal property and assets of the owner for the payment of their claims. This is most commonly referred to as unlimited liability.
- On the positive side, all income that the business earns passes on to the owner and his personal tax rate applies for tax purposes. The firm does not pay taxes at the business level. The alternative is double taxation where taxes are paid on the firm income and then are again paid by the owners, when the already “taxed” income is passed on to the owners.
- There is also a continuity issue. On retirement or death of the original owner, transfer of ownership to new owners can have complicated legal and tax issues. An outright sale has to occur and unless this has been planned properly there may be additional costs in terms of taxes, disruption of business, search for a suitable buyer and consultation fees.
The formation of a partnership happens when a group of people decides to work together and signs a partnership agreement. The partnership agreement lays out the details of running the day-to-day business of the partnership. It also establishes the basis on which the different partners will share the income, expenses, profits & losses. A Partnership is similar to sole proprietorship in the sense that partners also bear unlimited liability for the obligations of the partnership even though there are multiple owners instead of one. This includes their shares as well as any left over shares from other partners. Similar to a sole proprietorship, no taxes are paid at the business level and all income is passed on to partners and taxed at their personal income tax rates.
The key things to remember are:
- A partnership dissolves when a partner decides to leave or dies. In order for the partnership to continue in such an event, a clause has to be there in the agreement.
- Law limits the number of partners in a partnership
- A Partnership can also be organized in such a way that the liability of individual partners is limited. In such a form there are two categories of partners. The first category is called limited partners. As the name suggests they have limited liability. Their obligation is bounded by their investment in the partnership. Creditors cannot attach the personal assets of such partners. The second category is general partners. General partners in a limited partnership have unlimited liability and also serve as managers of the business. In order to form a limited partnership there must be at least one general partner and a group of limited partners.
Both sole proprietorships and partnerships suffer from a minor (or major) irritant. Their identity and continuation is dependent on the life of the original owners. Although partnerships carry on after the death of original partners, this generally requires the termination of the original partnership agreement and the creation of a new one. Although this may or may not be a significant event, an additional issue is the unlimited liability partners as well as sole proprietors face.
A Corporation solves both of these problems by offering the following characteristics.
- It has a separate identity from the owners and is treated as an entity by itself, which means that it pays taxes and can be held liable (sued) for its actions. However, it also allows the corporation to continue beyond the life of its original owners and founders.
- A Corporation issues shares, which serve as claims on its income and net assets. Shares are certificates of ownership that may trade in public or private exchanges. Shares are the primary mechanism through which a corporation distributes its profits. Corporations declare dividends (payment, income, distribution) on a per share basis when they want to pass on profits to their shareholders.
- Dividends is where its gets interesting. Note that a corporation pays taxes on any income it earns. Shareholders also pay taxes on the dividends they receive from their corporation. This is what is called double taxation since the same income is taxed twice, once in the hands of the corporation, second in the hands of shareholders
A Chapter S Corporation is a special type of a corporation. An S Corporation is not taxed on its corporate income if its meets certain criteria. You may also view an S Corporation as a partnership in corporate clothing. Income is taxed when it is passed to individual shareholders at their personal tax rates. Hence an S corporation avoids double taxation. But there are certain restrictions on the number of owners (less than 99) and their nationality (all partners have to be US residents).
iv. Limited Liability Companies (LLC’s)
Limited Liability companies are corporations that are treated as:
- Partnerships for tax purposes and
- Corporation for all other purposes.
Unlike Chapter S corporations LLC’s do not have any restrictions on number of owners or their nationality. Unlike corporations LLC’s generally do not pay any taxes on their income. All income is taxed at the owner level at their personal income tax rates.
LLC’s are a relatively recent phenomenon in the US. Because of their recency, case law is still under developed compared to other legal forms.
Test Problems – Chapter S, Form of business ownership
1) Señor Castillo has the opportunity to invest on two ventures. Babs, Inc. is a Chapter S corporation, while Buster, LLC is a limited liability company. Being unable to decide which firm to invest in, Señor Castillo is somewhat relieved to learn at the last moment that he did not qualify to invest in Babs, Inc. What do you think is the most likely reason for this?
- Señor Castillo did not meet the minimum investment requirements
- He does not hold an MBA degree
- Señor Castillo is a non-US resident
- He has a bad credit profile
2) Ahmed, Brian, Sandra and Reshma have developed a technology which will enable better control on Internet traffic. They have found venture capitalists to invest in their firm company as partners.All of the partners would like to avoid double taxation on their profits and would like to have limited liability. They would also like to keep on accepting partners as monetary or labor needs may be without restriction on numbers. Note that Ahmed is a Pakistani citizen and resident and Reshma is Indian. What form of ownership would you recommend for their firm?
- Chapter S
- Limited Partnership
- Limited Liability Company
3) Reyasini has the opportunity to invest in 2 ventures. Lotions, Inc., an established firm, promises a return of 10%. Soaps, LLC is a relatively new firm and offers a return of 25%. After due thought, Reyasini decides to invest in Lotions, Inc. What is the most likely reason for this decision?
- Soaps, LLC was a limited liability company
- The risks involved in Soaps, LLC was much higher than that for Lotions, Inc.
- Reyasini is a non-US resident
- Reyasini would have been the 100th partner of Soaps, LLC
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