Finance - XIII

Business Organization and Financial Data

20 Jan 2025

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Starting a business

Business require capital. This capital can come from a variety of sources, such as personal savings, but most businesses raise funds through the financial system. Since investors are only willing to provide capital if they believe that they will receive a return on their investment, the key to raising capital is to convince investors that the business will be profitable.

The mission statement of a business is a document or statement that outlines the overall strategy and goals of the business. For example, the mission statement of a business might include:

• the goods or services that the business will provide;
• justification for why the business should exist;
• opportunities and threats that the business faces.

The mission statement serves as the guiding principle for the business. All top level decisions should be made in line with the mission statement. Mission statements should also be reviewed periodically to ensure that they always reflect the current market conditions and business environment.

Investors look at mission statements to understand the business and its goals, and to determine whether to invest in the business.

Types of business organizations

There are three main types of business organizations: proprietorships, partnerships, and corporations.

A sole proprietorship is a business that is owned and operated by a single individual. The owner receives all the profits from the business, but is also responsible for all the debts and liabilities of the business. Sole proprietorships are the most common type of business organization, though they are also the smallest in terms of assets. Funding for sole proprietorships is usually provided by the owner's personal savings (i.e. equity capital), though they can also raise funds through loans or investments from friends, family, and banks. This may or may not be a problem for the business: the growth of sole proprietorships are often limited by the revenue that the business can generate. Another problem is that the business is tied to the owner: the business ends when the owner dies. Sole proprietorships are also not very liquid. Moreover, they have unlimited liability, which means that the owner is personally responsible for all the debts and liabilities of the business. On the plus side, sole proprietorships are easy to set up and run, as they are less regulated than other types of business organizations. All proceeds from the business also go to the owner.

A partnership is a business that is owned and operated by two or more individuals. This expands the pool of capital that the business can draw from (though still limited to the partners' personal savings), and also allows for the sharing of risks and responsibilities. In a general partnership, the partners are liable for each other's debts and liabilities, which means that creditors can claim the personal assets of any partner to pay off the debts of the business. An alternative arrangement is the limited partnership, where some partners have limited liability (at least one partner is a general partner), and are only liable for the debts of the business up to the amount of their investment. Limited partnerships do not participate in management decisions.

A corporation is a business that is a separate legal entity from its owners. The owners (shareholders) are not personally liable for the debts and liabilities of the business, and the business can continue to exist even if the owners die. The key advantage of a corporation is that it can raise large amounts of capital by issuing shares of stock. They are also more liquid than sole proprietorships and partnerships, as shares can be bought and sold on the stock market. Another advantage is that corporations have limited liability, which means that the owners are not personally responsible for the debts and liabilities of the business (though owners of young corporations may have to provide personal guarantees to secure loans or raise funds). Corporations are harder to set up: charters must be filed with the state, and bylaws established to govern the corporation's operations (e.g. to determine how directors are elected, how profits are distributed, etc.). Another disadvantage is taxation: corporations are taxed on their profits before they can issue dividends, and these dividends are taxed again when they are received by the shareholders. Examples of corporate forms include C-Corporations, S-Corporations, and Limited Liability Companies (LLCs).

Accounting principles

Although closely related, accounting and finance are two distinct disciplines. Accounting activities are focused on the recording and matching of financial transactions (e.g. sales, purchases, etc.), whereas finance activities are focused on identifying cash inflows and outflows. For example, consider a furniture company that sells a furniture set. The furniture set may have been manufactured long before it was sold, and the company may have paid for the materials and labor to produce the set then. At that point, cash has already flowed out of the company. However, no transaction will be recorded in the company accounting books until the furniture set is sold. Only when the furniture set is sold will the company record the revenue from the sale. To further complicate matters, the company may offer credit to the buyer, which means that although a sale has been made, cash has not yet flowed into the company. We can see that there is a time lag between when a transaction occurs and when cash is actually received or paid out. Thus, a firm may appear profitable (i.e. it has a lot of sales), but cash poor (i.e. all sales are made on credit). This has important implications: a firm may be profitable on paper (i.e. based on its accounting books) but still go bankrupt because it doesn't have enough cash to pay its bills.

An annual report contains information about a company's operating and financial performance (past and projected). Although only firms organized as corporations are required to produce annual reports, proprietorships and partnerships may also produce them to facilitate decision making, and to attract investors. Annual reports contain three key documents: the income statement, the balance sheet, and the statement of cash flows.

Income statement

The income statement shows the revenues and expenses of a firm over a period of time (e.g. quarterly, annually). The income statement contains the following information:

• gross revenue: total revenue generated;
• net revenue: gross revenue minus various expenses (such as discounts, returns, and allowances);
• cost of goods sold (COGS): costs associated with producing or manufacturing goods or services, including materials, labor, and overhead;
• selling, general, and administrative expenses (SG&A): costs associated with running the business, such as salaries, commissions, and advertising;
• depreciation: allocation of the cost of a fixed asset over its useful life;
• operating income: profit generated by the firm's core business operations, i.e. revenue minus COGS and SG&A (and other costs associated with running the business);
• interest expense: cost of debt financing, i.e. interest paid to creditors;
• earnings: net income, i.e. profit after taxes, often expressed on a per share basis as earnings per share (EPS).

Balance sheet

The balance sheet shows the financial position of a firm at a specific point in time. The contents of the balance sheet can be broadly categorized into:

• assets: resources owned by the firm, such as cash, accounts receivable, inventory, and fixed assets (e.g. buildings, machinery);
• liabilities: obligations owed by the firm, such as accounts payable, loans, and bonds;
• equity: the difference between assets and liabilities, i.e. the net worth of the firm, or the amount of funds that "belong" the owners of the firm.

Assets:

• cash and cash equivalents: cash, and other assets that can be quickly converted into cash (e.g. marketable securities); also called working capital used to carry out business operations;
• accounts receivable: money owed to the firm by customers, e.g. credit sales;
• inventory: finished goods held for sale, e.g. unsold furniture sets, and raw materials;
• long-term assets: assets that are not expected to be converted into cash within a year, e.g. buildings to hold inventory, machinery to produce goods; land is also a type of fixed asset;
• goodwill and intangible assets: assets that do not have a physical form, e.g. brand names, patents; firms receive excess funds from loyal customers, or from acquirer firms who value the firm's reputation or intellectual property;

Liabilities:

• accounts payable: money owed by the firm to suppliers, e.g. loans taken from suppliers/firms directly (in contrast to direct short-term loans from banks);
• note payable: short-term loans taken from banks to purchase inventory or to finance operations;
• accrued liabilities: expenses that have been incurred but not yet paid (at the time of the balance sheet), e.g. wages owed to employees, taxes owed to the government;
• short-term debt: debt that is due within a year, e.g. loans taken from banks;
• long-term debt: debt that is due after a year, e.g. bonds issued by the firm (collateralized by the firm's assets such as buildings);

Equity:

• preferred equity: equity that has a higher claim on the firm's assets and earnings than common equity;
• common equity: equity that has the lowest claim on the firm's assets and earnings;
• retained earnings: earnings that are reinvested in the firm (i.e. not paid out as dividends to shareholders).

Statement of cash flows

A statement of cash flows shows the cash inflows (i.e. sources) and outflows (i.e. uses) of a firm over a period of time.

Cash inflows:

• amount of net income (plus depreciation): cash generated from the firm's core business operations;
• decrease in an asset account: cash generated from selling an asset, e.g. selling a building;
• increase in a liability account: cash generated from taking on debt, e.g. taking out a loan;
• increase in an equity account: cash generated from issuing stock, e.g. issuing new shares.

Cash outflows:

• increase in an asset account: cash used to purchase an asset, e.g. buying a building;
• decrease in a liability account: cash used to pay off debt, e.g. paying off a loan;
• decrease in an equity account: cash used to buy back stock, e.g. repurchasing shares.
• dividends: cash paid out to shareholders.

Firm goals

The primary goal of a firm is to maximize shareholder wealth. Shareholder wealth is measured by the market value of the firm's stock. Although other goals (e.g. social responsibility, employee welfare) are also important, they are secondary to the goal of maximizing shareholder wealth.

Managers of a firm should pay attention to the movement of the stock price, as it reflects the market's perception of the firm's performance. For instance, a declining stock price may indicate that the firm is not performing well, and that changes need to be made to improve performance (e.g. corrective actions, restructuring, new proposals etc.).

One criticism of the shareholder wealth maximization goal is that it may lead to unethical behavior. For example, managers may be tempted to manipulate financial statements to boost the stock price, or to cut corners to increase profits. Unethical behavior can damage the reputation of the firm, and may lead to legal consequences (e.g. fines, lawsuits, etc.). One way to mitigate this risk is to align the interests of managers with those of shareholders. For example, managers can be compensated with stock options, which give them the right to buy shares of the firm's stock at a predetermined price.

Corporate governance

Often in large corporations, there is a separation between ownership and control. Shareholders own the firm, but managers control it, and the interests of both may not always align. For examples, managers may increase their own compensation at the expense of shareholders, or may manipulate financial statements to boost the stock price.

The technical term for this problem of misalignment of interests is the principal-agent problem. Ideally, the agents should run the firm in the best interests of the principals. However, conflicts of interest may arise due to ethical lapses, self-interest, information asymmetry, lack of trust, etc. The costs associated with tackling the principal-agent problem are called agency costs. One example of an agency cost is the cost of monitoring managers to ensure that they are acting in the best interests of shareholders. Another is independent audits to ensure that financial statements are accurate and reliable. Some firms may even pay inflated salaries to managers to retain their services, or to compensate them for the risks they take in running the firm.

One scenario which illuminates the principal-agent problem is during a hostile takeover. In a hostile takeover, the acquiring firm buys a controlling stake in the target firm without the approval of the target firm's management. Managers of the target firm may resist the takeover because they fear losing their jobs, or because they believe that the acquiring firm will not run the firm in the best interests of shareholders. Thus, they may take actions to prevent the takeover, employing delaying tactics, such as a poison pill (e.g. issuing new shares to existing shareholders at a discount, which dilutes the acquirer's stake), or a golden parachute (e.g. a large severance package for managers if they are fired after the takeover).

The most crucial consequence of the principal-agent problem is that it can lead to a reduction in shareholder wealth or firm value. Since some expenses are incurred to address the problem, which is unnecessary if managers act in the best interests of shareholders, these expenses become deadweight losses to the firm.

One way to reduce agency problems is to offer stock options (i.e. an option to buy shares at a predetermined price) to managers. But stock options may also lead to unintended consequences, such as managers taking excessive risks to boost the stock price, or engaging in short-term thinking to maximize their own compensation. Managers who are seeking to cash out their stock options may also engage in stock price manipulation to inflate the stock price. Some firms offer restricted stock instead of stock options, which are shares of stock that cannot be sold until a certain period of time (i.e. a vesting period) has passed. Another way to reduce agency problems is to implement more stringent oversight mechanisms to make managers more accountable to shareholders. For example, firms can appoint independent directors to the board, or hire external auditors to review the firm's financial statements.

Finance in the organization chart

The top manager responsible for financial matters in a firm is the Chief Financial Officer (CFO). Other common titles include treasurer and controller. CFO compensations can be quite high, as they are responsible for managing the firm's financial health, which is crucial to the firm's success. The CFO works with other top officers to develop the firm's financial strategy, which is reflected in the firm's financial statements. Most balance sheet shows the firm's answers to several basic questions:

• (Capital budgeting) What fixed/long-term assets should the firm invest in to produce its goods and services?
• (Capital structure) How should the firm finance these purchases?
• (Operations) How should the firm manage its inventory and other day-do-day operations, such as collecting payments, paying suppliers, and managing cash flow?