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Corporate Finance – Financial Statements

4 mins read

Financial Statements and Financial Statements Analysis

In order to determine the health of a business, you need financial statements. Why would you be interested in the health of a business? Can a business be healthy or sick? The answer is a definite ‘yes’. For businesses, cash is the lifeblood that drives everything. Healthy businesses either generate enough cash or have access to sources of cash that allow them to grow and prosper. Sick businesses suffer from the opposite, that is, they have serious liquidity problems. Hence as investors, customers, suppliers and employees, you need to understand how healthy or sick a business is.

  1. As a buyer, you would want to place a value on the business determined by objective and verified information.
  2. As a supplier, you may need to sell merchandise on credit. For example, a customer can walk inside your door and ask you to sell him one thousand laptops with the condition that he will pay you a month later. Do you want to take this business? How will you know you will be paid one month later? This decision is called a credit decision. Right credit decisions can allow your business to grow, wrong credit decisions can push you into bankruptcy.
  3. As a customer, you may need to select contractors who have the financial strength to execute large or long-term contracts.
  4. As an employee, you need to evaluate growth opportunities & financial stability of your prospective employers.

Determining any of the above is a fairly complicated task. Internal and external factors and information need to be assessed. Objective and subjective judgments need to be made. Financial statements go a long way in performing this analysis. For the purpose of this course we only look at the three most common statements.

  1. Balance Sheet
  2. Profit & Loss account (also known as the Income Statement)
  3. Statement of cash flows

The Balance Sheet

The most recent photo of my nine month old shows a lot: it captures him standing by himself, wearing his favorite pullover and jeans, clutching a half eaten pizza crust in his left hand.

A balance sheet is very similar to a snapshot of a business standing still at a point in time. In simple terms it shows what the company owns and what the company owes at that specific point in time. Everything on a balance sheet falls within these two categories – Owns and owes.

However just as the photo of my nine-month-old does not show how much he has grown in the past few months, his very first step or his most recent bout with a cold, a balance sheet is also limited in terms of the information it captures.

A balance sheet is static. It does not capture flow or motion. A balance sheet does not show what happened to the firm the day before or what will happen the day after. It can help you assess the financial health of a firm, but that assessment is limited. Similar to a physician needing a number of tests to confirm his diagnosis, you need the Profit and Loss Statement, the Statement of Cash Flows and the Accounting Notes to reach any firm conclusions about a business.

In order to perform meaningful analysis, it is also important that you have a feel for how the firm has transformed in its recent past. This is why it is important to have a number of years of historical financial statements. History can be used to get a grip over trends and events that have had a major impact on the firm.

The Income Statement

How many times have you heard the term top line and bottom line? If you haven’t you are just about to hear them. Both the terms can be traced to the income statement. Top line refers to total revenues, generally the first line (hence top) in the income statement. Bottom line refers to net income or earnings, usually the last line in this statement (hence bottom).

Also known as the statement of operation and the profit and loss account, the Income Statement summarizes what the firm did over a certain period. By looking at the statement you can understand how much customers paid for the product sold by the company in question; how much was spent in producing these products; what were the other costs of running this business; were there any additional significant expenses; how much taxes were paid? And so on.

Are there any issues with the income statement? Yes. You need to be aware that there is a big difference between the net income declared by a company and the actual cash generated by the business. With the income statement you can understand how profitable a business is, but you cannot determine what percentage of the same profits translates into cash. Why is this important? Remember cash is the lifeblood. You can be very profitable but without cash, profits may not mean much.

The second issue is that earnings can be managed. Firms, within limits, can decide the level of earnings they want to declare. Accounting eccentricities can be used to increase as well as decrease declared income. Once again this high-lights the importance of cash as an absolute measure

Statement of Cash Flows

This is the first statement that I look at when evaluating a business. There is an amazing amount of information that can be compressed in one page and the statement of cash flows demonstrates that. At a glance it can tell you how much income was declared, the actual cash generated by the business, how was that cash used, was any additional financing needed and is the business a source or user of cash.

The statement can generally be broken down into three components.

  1. First, Operating cash flows, which is a summary of the business.
  2. Second, Investing cash flows, which shows how the cash surplus (deficit) generated by the business has been applied (financed).
  3. Third, Financing cash flows, which shows if any additional financing was needed or if a change in the financial structure of the company has occurred.

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Session I – A – Operating Cycle, Books of Accounts and Forms of doing business

7 mins read

Definitions

Before we delve into the subject of finance there are a number of terms that need to be introduced so that we speak the same language.  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:

Operating Cycle

The operating cycle of a firm is made up of four smaller cycles. These are:

  1. Purchase Cycle. In this cycle the firm receives input from its suppliers. The input may be received on credit. The Purchasing Cycle ends once the firm has received the required input and settles its account with the supplier.
  2. Manufacturing Cycle takes the input and converts it into finished products that can be sold to consumers. This cycle starts when the input hits the production line and ends when finished goods land in warehouse storage.
  3. Distribution Cycle begins when a product enters inventory storage and ends when it is moved to a distributor, retailer or consumer.
  4. Collection Cycle takes over when distribution ends and is completed when the firm receives payment for good (or services).

Books

All businesses keep a record of their revenues, expenses, profits, losses & investments. These records are generally referred to as books of account, accounting books, or simply books. They record all business transactions and can be used to compile financial statements that can be used by interested parties 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.

Liquidity

One way of looking at liquidity is the value of an asset that is lost when it is converted 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 it is held as a security or 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 an asset can be converted to cash.

Financial Structure

Businesses use a combination of owners’ investment (equity) and long and short-term loans (debt) to meet their financial needs. This combination of equity and debt is called financial structure and has important ramifications for profitability, growth, returns and risks.

Maturity

In Accounting and Finance, Maturity is generally used 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 loan needs to be repaid 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

1) After being packaged, Pepperidge Farm’s chocolate chip cookies were sent to the warehouse for storage. After the inventory was taken, the cookies awaited their turn to be shipped off to the retailers. What stage of the Operation 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 Operation 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?

  1. 80.3%
  2. 85%
  3. 90%
  4. 75%

2. 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:

  1. 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.
  2. On the positive side, all income earned by the business is passed on to the owner and is then taxed at his personal tax rate. No taxes are paid 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.
  3. 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.

ii. Partnerships

A partnership is formed 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 income, expenses, profits & losses will be shared between different partners. 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:

  1. A partnership has to be dissolved 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.
  2. The number of partners in a partnership is limited by law
  3. 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.

iii. Corporations

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.

  1. 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.
  2. A Corporation issues shares, which serve as claims on its income and net assets. Shares are certificates of ownership that may be traded 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.
  3. 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

Chapter S

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. An S Corporation can also be viewed 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:

  1. Partnerships for tax purposes and
  2. 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 Problem:

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 was 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?

  1. Señor Castillo did not meet the minimum investment requirements
  2. Señor Castillo does not hold an MBA degree
  3. Señor Castillo is a non-US resident
  4. Señor Castillo had 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. It should also be mentioned here that Ahmed is a Pakistani citizen and resident and Reshma is Indian. What form of ownership would you recommend for their firm?

  1. Chapter S
  2. Limited Partnership
  3. Corporation
  4. 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?

  1. Soaps, LLC was a limited liability company
  2. The risks involved in Soaps, LLC was much higher than that for Lotions, Inc.
  3. Reyasini is a non-US resident

Reyasini would have been the 100th partner of Soaps, LLC

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