The Fast Forward MBA in Finance_4 docx

All or part of annual net income may be dis-tributed in cash to its shareowners, which is recorded as adecrease in the business’s owners’ equity.A business needs assets to make profit..

Figure 5.4 displays lines of connection, or tetherlines, from sales revenue and expenses in the incomestatement to their corresponding assets and operating liabili-ties in the balance sheet These lines are not actually shown infinancial reports, of course I include them in Figure 5.4 tostress that the profit-making activities of a business drive agood part of its balance sheet Also, you might note the linefrom net income to owners’ equity; net income increases theowners’ equity All or part of annual net income may be dis-tributed in cash to its shareowners, which is recorded as adecrease in the business’s owners’ equity.

A business needs assets to make profit Therefore a businessmust raise capital for the money to invest in its assets Theseed capital comes from shareowners; they may invest addi-tional money in the business from time to time after the busi-ness gets off the ground Most businesses borrow money onthe basis of interest-bearing debt instruments such as notespayable Profitable businesses retain part or all of their

annual earnings to supplement the money invested in thebusiness by their shareowners

The balance sheet, or statement of financial condition,reports the debt and equity capital sources of a business andthe assets in which the business has invested Several differ-ent types of assets are listed in the balance sheet The balancesheet also reports the operating liabilities of a business thatare generated by its profit-making activities and not from bor-rowing money Operating liabilities are non-interest-bearingpayables of a business, which are quite different from itsinterest-bearing debt obligations

The relationships of sales revenue and expenses reported

in a company’s income statement to the assets and operatingliabilities reported in its balance sheet are not haphazard Farfrom it! Sales revenue and the different expenses in theincome statement match up with particular assets and operat-ing liabilities Business managers, lenders, and investorsshould understand these critical connections between thecomponents of the income statement and the components ofthe balance sheet In particular, the amount of accounts

A S S E T S A N D S O U R C E S O F C A P I T A L

76

receivable should be reasonable in comparison with annual

sales revenue, and the amount of inventories should be

rea-sonable in comparison with annual cost-of-goods-sold

expense

In short, the balance sheet of a business fits tongue and

groove with its income statement These two financial

state-ments are presented separately in financial reports, but

busi-ness managers, lenders, and investors should understand the

interlocking nature of these two primary financial statements

This chapter explores the two basic sources of business

capi-tal: debt and owners’ equity Every business must make a

fun-damental decision regarding how to finance the business,

which refers to the mix or relative proportions of debt and

equity By borrowing money, a business enlarges its equity

capital, so the business has a bigger base of capital to carry

on its profit-making activities More capital generally means a

business can make more sales, and more sales generally

mean more profit

Using debt in addition to equity capital is referred to

as financial leverage If you visualize equity capital

as the fulcrum, then debt may be seen as the lever that serves

to expand the total capital of a business The chapter explains

the gain or loss resulting from financial leverage, which often

is a major factor in bottom-line profit

It’s possible, I suppose, to find a business that is so antidebt

that the only liabilities it has are normal operating liabilities

(i.e., accounts payable and accrued expenses payable)

These short-term liabilities arise spontaneously in making

purchases on credit and from delaying the payment of certain

expenses until sometime after the expenses have been

recorded A business can hardly avoid operating liabilities.But a business doesn’t have to borrow money A businesscould possibly raise all the capital it needs from shareownersand from retaining all or a good part of its annual earnings inthe business In short, a business theoretically could rely

entirely on equity capital and have no debt at all—but thisway of financing a business is very rare indeed

BUSINESS EXAMPLE FOR THIS CHAPTER

Figure 6.1 presents a very condensed balance sheet and anabbreviated income statement for a new business example.The income statement is truncated at earnings before interestand income tax (EBIT) The two financial statements in Figure6.1 are telescoped into a few lines In this chapter we don’tneed all the details that are actually reported in these twofinancial statements (See Figure 4.2 for the full format of abalance sheet and Figure 4.1 for a typical format of an exter-nal income statement.)

To support its $18.5 million annual sales, the business used

$11.5 million total assets Operating liabilities provided $1.5million of its assets In Figure 6.1 the company’s operating lia-bilities are deducted from its total assets to get a very impor-

tant figure—capital invested in assets The business had to

raise $10 million in capital from debt and owners’ equity Thebusiness borrows money on the basis of short-term and long-term notes payable The business built up its owners’ equity

A S S E T S A N D S O U R C E S O F C A P I T A L

80

Balance Sheet Income Statement

FIGURE 6.1 Condensed financial statements.

Assets used in making profit $11,500,000

Operating liabilities

(accounts payable and

accrued expenses payable) ($ 1,500,000)

Capital invested in assets $10,000,000

Debt and equity sources of

capital $10,000,000

Sales revenue $18,500,000All operating

expenses ($16,700,000)Earnings before

interest and income tax expenses (EBIT) $ 1,800,000

from money invested by shareowners plus the cumulative

amount of retained earnings over the years (undistributed net

income year after year)

Once Again Quickly: Assets

and Operating Liabilities

Chapter 5 explains that a business that sells products

on credit needs four main assets in making profit:

cash, accounts receivable, inventories, and long-lived

resources such as land, buildings, machinery, and equipment

that are referred to as fixed assets (or, more formally, as

prop-erty, plant, and equipment) The chapter goes into the

charac-teristics of each asset, explaining how sales revenue and

expenses are connected with these assets Chapter 5 also

explains how expenses drive the operating liabilities of a

busi-ness In the process of making profit a business generates

cer-tain short-term, non-interest-bearing operating liabilities that

are inseparable from its profit-making transactions These

payables of a business are called spontaneous liabilities because

operating activities, not borrowing money, causes them

Oper-ating liabilities are deducted from total assets to determine the

amount of capital that has been raised by a business

CAPITAL STRUCTURE OF BUSINESS

The capital a business needs for investing in its assets comes

from two basic sources: debt and equity Managers must

con-vince lenders to loan money to the company and concon-vince

sources of equity capital to invest their money in the company

Both debt and equity sources demand to be compensated for

the use of their capital Interest is paid on debt and reported

in the income statement as an expense, which like all expenses

is deducted from sales revenue to determine bottom-line net

income In contrast, no charge or deduction for using equity

capital is reported in the income statement

Rather, net income is reported as the reward or payoff on

equity capital In other words, profit is defined from the

shareowners point of view, not from the total capital point of

view Interest is treated not as a division of profit to one of the

two sources of capital of the business but as an expense, and

profit is defined to be the residual amount after deductinginterest.

Sometimes the owners’ equity of a business is referred to

as its net worth The fundamental idea of net worth is this:

Net worth = assets − operating liabilities − debtNet income increases the net worth of a business The busi-ness is better off earning net income, because its net worthincreases by the net income amount Suppose another group

of investors stands ready to buy the business for a total priceequal to its net worth This offering price, or market value, ofthe business increases by the amount of net income Cash dis-tributions of net income to shareowners decrease the networth of a business, because cash decreases with no corre-sponding decrease in the operating liabilities or debt of thebusiness

The amounts of cash distributions from net income arereported in the statement of cash flows, which is explained inChapter 2 Dividends are also reported in a separate state-ment of changes in owners’ equity accounts if this particularschedule is included in a financial report (see Figure 4.4 for

an example)

The valuation of a business is not so simple as someonebuying the business for an amount equal to its net worth.Business valuation usually takes into account the net worthreported in its balance sheet, but many other factors play arole in putting a value on a business The amount a buyer iswilling to offer for a business can be considerably higher thanthe company’s net worth based on the figures reported in thecompany’s most recent balance sheet The valuation of a pri-vately owned business is quite a broad topic, which is beyondthe scope of this book Likewise, the valuation of stock shares

of publicly owned business corporations is a far-reachingtopic beyond the confines of this book

At its most recent year-end, the business had $10 millioninvested in assets to carry on its profit-making operations(total assets less its operating liabilities) Suppose that debthas provided $4 million of the total capital invested in assetsand owners’ equity has supplied the other $6 million Collec-tively, the mix of these two capital sources are referred to as

the capitalization or the capital structure of the business Be

A S S E T S A N D S O U R C E S O F C A P I T A L

82

careful about the term capitalization: Similar terms mean

something different The terms market capitalization, market

cap, or cap refer to the total market value of a publicly traded

corporation, which is equal to the current market price per

share of stock times the total number of stock shares

out-standing (in the hands of stockholders)

A perpetual question that’s not easy to answer concerns

whether a business is using the optimal or best capital

struc-ture Perhaps the business in the example should have carried

more debt Maybe the company could have gotten by on a

smaller cash balance, say $500,000 less—which means that

$500,000 less capital would have been needed Perhaps the

business should have kept its accounts receivable and

inven-tory balances lower, which would have reduced the need for

capital Every business has to make tough choices regarding

debt versus equity, asking shareowners for more money

ver-sus retaining earnings, and working with a lean working cash

balance versus a larger and more comfortable cash balance

The answers to these questions are seldom easy and clear cut

Basic Characteristics of Debt

Debt may be very short term, which generally means six

months or less, or it may be long term, which generally means

10 years or longer—or for any period mutually agreed on

between the business and its lender The term debt means

interest-bearing in all cases Interest rates can be fixed over

the life of the debt contract or subject to change, usually at the

lender’s option On short-term debt, interest usually is paid at

the end of the loan period On long-term debt, interest usually

is paid monthly or quarterly (sometimes semiannually)

A key feature of debt is whether the principal of the

loan (the amount borrowed) is amortized over the

life of the loan instead of being paid at the end of the loan

period In addition to paying interest, the business (who is the

borrower, or debtor) may be required to make payments

peri-odically that reduce the principal balance of the debt instead

of waiting until the final maturity date to pay off the entire

principal amount at one time For example, a loan may call

for equal quarterly amounts over five years Each quarterly

payment is calculated to pay interest and to reduce a part ofthe principal balance so that at the end of the five years theloan principal will be paid off Alternatively, the business may

negotiate a term loan Nothing is paid to reduce the principal

balance during the life of a term loan; the entire amount rowed (the principal) is paid at the maturity date of the loan.The lender may demand that certain assets of the business

bor-be pledged as collateral The lender would bor-be granted the

right to take control of the property in the event the businessdefaults on the loan Real estate (land and buildings) is themost common type of collateral, and these types of loans are

called mortgages Inventory and other assets also serve as

col-lateral on some business loans Debt instruments such as

bonds may have very restrictive covenants (conditions) or,

conversely, may be quite liberal and nonbinding on the ness Some debt is convertible into equity stock shares,though generally this feature is limited to publicly held corpo-rations whose stock shares are actively traded The debt of abusiness may be a private loan, or debt securities may beissued to the public at large and be actively traded on a bondmarket

busi-Lenders look over the shoulders of the managers of thebusiness Lenders do not simply say, “Here’s the money andcall us if you need more.” A business does not exactly have tobare its soul when applying for a loan, but the lender usuallydemands a lot of information from the business If a businessdefaults on a loan (not making an interest payment on time ornot being able to pay off the loan at maturity), the terms of theloan give the lender legally enforceable options that in theextreme could force the business into bankruptcy If a busi-ness does not comply fully with the terms and provisions of itsloans, it is more or less at the mercy of its lenders, whichcould cause serious disruptions or even force the business toterminate its operations

Basic Characteristics of Equity

One person may operate a business as the sole proprietor and

provide all the equity capital of the business A sole

propri-etorship business is not a separate legal entity; it’s an

exten-sion of the individual Many businesses are legally organized

as a partnership of two or more persons A partnership is a

separate entity or person in the eyes of the law The general

partners of the business can be held responsible for the

liabili-ties of the partnership Creditors can reach beyond the assets

of the partnership to the personal assets of the individual

partners to satisfy their claims against the business The

gen-eral partners have unlimited liability for the liabilities of the

partnership Some partnerships have two classes of partners—

general and limited Limited partners escape the unlimited

liability of general partners but they have no voice in the

man-agement of the business

Most businesses, even relatively small ones, favor the

corpo-rate form of organization A corporation is a legal entity

sepa-rate from its individual owners A corporation is a legal entity

that shields the personal assets of the owners (the

stockhold-ers, or shareowners) from the creditors of the business A

business may deliberately defraud its creditors and attempt to

abuse the limited liability of corporate shareowners In this

case the law will “pierce the corporate veil” and hold the

guilty individuals responsible for the debts of the business

The corporate form is a practical way to collect a pool of

equity capital from a large number of investors There are

lit-erally millions of corporations in the American economy In

1997 the Internal Revenue Service received over 4.7 million

tax returns from business corporations Most were small

busi-nesses However, more than 860,000 businesses corporations

had annual sales revenue over $1 million

Other countries around the globe have the equivalent of

cor-porations, although the names of these organizations as well

as their legal and political features differ from country to

country A recent development in the United States is the

cre-ation of a new type of business legal entity called a limited

lia-bility company (LLC) This innovative business entity is a

hybrid between a partnership and a corporation; it has

char-acteristics of both Most states have passed laws enabling the

creation of LLCs

Corporations issue capital stock shares; these are the units

of equity ownership in the business A corporation may issue

only one class of stock shares, called common stock or capital

stock Or a corporation may issue both preferred stock and

common stock shares Preferred stock shares are promised an

annual cash dividend per share (The actual payment of thedividend is contingent on the corporation earning enough netincome and having enough cash on hand to pay the dividend.)

A corporation may issue both voting and nonvoting classes ofstock shares Some corporations issue two classes of votingshares that have different voting power per share (e.g., oneclass may have ten votes per share and the other only onevote per share)

Debt bears an explicit and legally contracted rate of est Equity capital does not Nevertheless, equity capital has

inter-an imputed or implicit cost Minter-anagement must earn a factory rate of earnings on the equity capital of the business

satis-to justify the use of this capital Failure satis-to do so reduces thevalue of the equity and makes it more difficult to attract addi-tional equity capital (if and when needed) In extreme circum-stances, the majority of stockholders could vote to dissolve thecorporation and force the business to liquidate its assets, payoff its liabilities, and distribute the remainder to the stock-holders

The equity shareholders in a business (the stockholders of

a corporation) take the risk of business failure and poorperformance On the optimistic side, the shareowners have

no limit on their participation in the success of the business.Continued growth can lead to continued growth in cash divi-dends And the market value of the equity shares has no theo-retical upper limit The lower limit of market value is zero (theshares become worthless)—although corporate stock shares

could be assessable, which means the corporation has the

right to assess shareholders and make them contribute tional capital to the organization Almost all corporate stockshares are issued as nonassessable shares, although equityinvestors in a business can’t be too careful about this

addi-RETURN ON INVESTMENT

I was a stockholder in a privately owned business a few yearsago I owned 1,000 shares of common stock in the businessand served on its board of directors One thing really hit home

I came to appreciate firsthand that we (the stockholders) had alot of money invested, and we expected the business to do wellwith our money We could have invested our money elsewhereand received interest income or earned some other type of

DANGER!

A S S E T S A N D S O U R C E S O F C A P I T A L

86