Business finance

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If you are going to start a business you need to keep track of your finances.[edit | edit source]

MONEY is the life blood of the economy and BUSINESS is the way in which people and capital are organized within the economy to create money and productivity. In essence, business is like the heart of the economy while money is the blood.

Over the years a variety of laws [1] have been introduced to regulate financial aspects of business. Keeping track of finances in business helps to reduce fraud and waste. Keeping track of finances also allows for maximum efficiency to be attained. It is also the law.

This course is intended to help give you an idea of how business finances work. This is a wiki, so you are encouraged to add and edit the course. This course will probably not lead you towards earning a degree in business, finance, accounting, or business finance; however, it will hopefully give you a better idea of how business finance works, and maybe, just maybe, if you wanted to start your own business and use sound financal practices, you could.

The Time Value of Money

Balance sheet structure[edit | edit source]

The following balance sheet structure is just an example. It does not show all possible kinds of assets, equity and liabilities, but it shows the most usual ones. Because it shows Goodwill it could be a consolidated balance sheet. Monetary values are not shown, summary (total) rows are missing as well.

Balance Sheet of XYZ, Ltd. as on 31 December 2005
ASSETS
Current Assets
Cash and cash equivalents
    Marketable Securities
 Accounts receivable
Inventories
  Prepaid Expenses

Investments held for trading

Other current assets
Non-Current Assets (Fixed Assets)
Property, plant and equipment 
Less : Accumulated Depreciation
Goodwill 
Other intangible fixed assets
Investments in associates
Deferred tax assets
LIABILITIES and EQUITY
 Current liabilities
Accounts payable
Current income tax liabilities
Current portion of bank loans payable
Short-term provisions
Other current liabilities

Long term Liabilities (Fixed Liabilities)

Bank loans
Issued debt securities
Deferred tax liability
Provisions
  Minority interest


Capital and reserves

Share capital
Capital reserves
Revaluation reserve
Translation reserve
Retained earnings


Analogy

Knowing is not the same as understanding, so it is helpful to present an analogy.

   * Think of an investment as a water reservoir. The value of the investment is the volume of water in it. The shareholder equity
     (net equity) on the balance sheet measures this value.
   * Streams empty into the reservoir, adding more water. These inflows are measured by Revenues on the Income statement.
   * Streams run out of the reservoir, depleting it. These outflow are measured by Expenses on the Income statement.
         o The difference between these inflows and outflows is the net income, also shown in the Income statement.
   * When a neighbor joins in the investment as a partner, he digs a canal from his own reservoir so it drains into the reservoir.
     This additional water is measured by an increase in the share capital.
   * If you ask a neighbor to add to the reservoir, it is considered as liability, thus reducing net equity but increasing assets.
     These are both shown on the Balance Sheet.

While measuring the volume of water in the reservoir at a point in time (balance sheet) is relatively easy, keeping track of the streams' volumes at every second of the year is difficult. Accountants may choose to ignore some streams: they may not know some streams exist: water may be evaporating, and unmeasurable. As a result the income statement is easily wrong. Regardless, the net sum of inflows less outflows should equal the difference in the reservoir (beginning vs. ending). The statement of changes in shareholder equity attempts this reconciliation.

None of the financial statements measures your own personal share of the reservoir when you have partners. It is up to the individual investor to measure, not the business totals, but his share. The methods to use 'equity per share' is shown at shareholders' equity.

Users of Financial Statements[edit | edit source]

Financial statements are used by a diverse group of parties, both inside and outside a business. Generally, these users are:

1. Internal Users: are owners, managers, employees and other parties who are directly connected with a company.

   * Owners and managers require financial statements to make important business decisions
        that affect its continued operations. Financial analyses are then performed on these 
        statements to provide management with a more detailed understanding of the figures. 
        These statements are also used as part of management's report to its stockholders,
        as it form part of its Annual Report.
   * Employees also need these reports in making collective bargaining agreements (CBA) with
        the management, in the case of labor unions or for individuals in discussing their
        compensation, promotion and rankings. 

2. External Users: are potential investors, banks, government agencies and other parties who are outside the business but need financial information about the business for a diverse number of reasons.

   * Prospective investors make use of financial statements to assess the viability of
        investing in a business. Financial analysis is often used by investors and is prepared 
        by professionals (Financial Analysts), thus providing them with the basis in making
        investment decisions.
   * Financial institutions (banks and other lending companies) use them to decide whether to
        grant a company with fresh working capital or extend debt securities (such as a long-term
        bank loan or debentures) to finance expansion and other significant expenditures.
   * Government entities (Tax Authorities) need financial statements to ascertain the
        propriety and accuracy of taxes and other duties declared and paid by a company.
   * Media and the general public are also interested in financial statements for a variety 
        of reasons.

Government financial statements[edit | edit source]

The rules for the recording, measurement and presentation of government financial statements may be different from those required for business and even for non-profit organizations. They may use either accrual accounting, or cash accounting, or a combination of the two. A complete set of Chart of Accounts is also used that is substantially different from the Chart of a profit-oriented business.

Audit and Legal Implications[edit | edit source]

Although the legal statutes may differ from country to country, an audit of financial statements is required. 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.

There has been much legal debate over who an auditor is liable to. Since audit reports tend to be addressed to the current shareholders, it is commonly thought that they owe a legal duty of care to them. But this may not be the case as determined by common law precedent. In Canada, auditors are liable only to investors using a prospectus to buy shares in the primary market. In the UK, they have been held liable to potential investors when the auditor was aware of the potential investor and how they would use the information in the financial statements. Nowadays auditors tend to include in their report liability restricting language, discouraging anyone other than the addressees of their report from relying on it. Liability is an important issue: in the UK, for example, auditors have unlimited liability.

In the United States, especially in the post-Enron era there has been substantial concern about the accuracy of financial statements. Corporate officers (the CEO and CFO) are personally liable for attesting that financial statements "do not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by th[e] report". Making or certifiing misleading financial statements exposes the people involved to substantial civil and criminal liability. For example Bernie Ebbers (former CEO of WorldCom) was sentenced to 25 years in federal prison for allowing WorldCom's revenues to be overstated by $11 billion over five years.

Standards and Regulations[edit | edit source]

Different countries have developed their own accounting principles over time, making international comparisons of companies difficult. To ensure uniformity and comparability between financial statements prepared by different companies, a set of guidelines and rules are used. Commonly referred to as Generally Accepted Accounting Principles (GAAP), these set of guidelines provide the basis in the preparation of financial statements.

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 Australia, Canada and the European Union (for publicly quoted companies only), are under consideration in South Africa and other countries. The United States Federal Accounting Standards Board has made a commitment to converge the US GAAP and IFRS over time.

Inclusion in Annual Reports[edit | edit source]

To entice new investors, most public companies assemble their financial statements on fine paper with pleasing graphics and photos in an annual report to shareholders, attempting to capture the excitement and culture of the organization in a "marketing brochure" of sorts. Usually the company's chief executive officer will write a letter to shareholders, describing management's performance and the company's financial highlights.

In the United States, prior to the advent of the internet, the annual report is considered the most effective way for corporations to communicate with individual shareholders. Blue chip companies went to great expense to produce and mail out attractive annual reports to every shareholder. The annual report was often prepared in the style of a coffee table book

In formal bookkeeping and accounting, a balance sheet is a statement of the book value of a business or other organization or person at a particular date, at the end of a period such as a "fiscal year," as distinct from an income statement, also known as a profit and loss account (P&L), which records revenue and expenses over a specified period of time.

A balance sheet is often described as a "snapshot" of the company's financial condition on a given date. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time, instead of a period of time.

A simple business operating entirely in cash could measure its profits by simply withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, real businesses are not paid immediately; they build up inventories of goods to sell and they acquire buildings and equipment. In other words: businesses have assets and so they could not, even if they wanted to, immediately turn these into cash at the end of each period. Real businesses also owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words businesses also have liabilities.

A modern balance sheet usually has three parts: assets, liabilities and shareholders' equity. The main categories of assets are usually listed first and are followed by the liabilities. The difference between the assets and the liabilities is known as the 'net assets' or the 'net worth' of the company.

The net assets shown by the balance sheet equals the third part of the balance sheet, which is known as the shareholders' equity. This balance is not a coincidence. Records of the values of each account in the balance sheet are maintained using a system of accounting known as double-entry bookkeeping.

Some Future Value Definitions[edit | edit source]

Future Value (FV): The amount an investment is worth after one or more periods.

Simple Interest: Interest earned only on the original principal amount invested.

Compound Interest: Interest earned on both the initial principal and the interest reinvested from prior periods.

Compounding: The process of accumulating interest on an investment over time to earn more interest.

Financial Statements[edit | edit source]

Financial statements (or financial reports) are formal records of a business' financial activities. These statements provide an overview of a business' profitability and financial condition in both short and long term. There are four basic financial statements:

1. Balance Sheet: also referred to as statement of financial condition, reports on a company's assets, liabilities and net equity as of a given point in time.

2. Income Statement: also referred to as Profit or loss statement, reports on a company's results of operations over a period of time.

3. Cash Flow Statement: reports on a company's cash flow activities, particularly its operating, investing and financing activities.

4. Statement of changes in shareholder equity: reconciles the difference between net equity at two different points in time.

Because these statements are often complex, an extensive set of Notes to the Financial Statements and management discussion and analysis is usually included. The notes will typically describe each item on the Balance sheet, Income statement and Cash flow statement in further details. Notes to Financial Statements are considered as an integral part of the Financial Statements.

Constructing a Balance Sheet[edit | edit source]

Case Study

1.1
A new business starts up as a limited company called Sunrise Ltd by raising $10,000 from the owners i.e. share holders. The money is put in to a new bank account. What would the assets, liabilities and equity be?

Assets:
Bank Balance		10,000
Equity & Liabilities:
Share Capital		10,000

1.2
They then use 6,000 of its bank account to buy a delivery van. Assets and liabilities after this transaction:

Assets:
Bank Balance		 4,000
Delivery Van		 6,000
Equity & Liabilities:
Share Capital		10,000

1.3
Sunrise Ltd then buys some inventory at 3,000 on credit. Assets and liabilities after this transaction:

Assets:
Bank Balance		 4,000
Delivery Van		 6,000
Inventory		 3,000
Liabilities:
Accounts Payable	 3,000	(to be paid to creditors)
Equity:
Share Capital		10,000

Total assets must always equal total liabilities (and equity). It is inevitable as the liabilities (and equity) are providing the funds that we are spending on these assets.

1.4
Shortly afterwards, after selling 1,000 of inventory for 2,500, payment of 2,600 of the accounts payable and the purchase of 2,200 of machinery financed by a 2,200 bank loan, the assets and liabilities change to the following:

Sunrise Ltd.
Balance Sheet
As of December 31, 2005
-----------------------------------
Fixed Assets
Delivery Van		 6,000
Machinery		 2,200
-----------------------------------
Total fixed assets			 8,200
Current Assets
Bank Balance		 1,400
Inventory		 2,000
Accounts Receivable	 2,500
-----------------------------------
Total 			 5,900
Accounts Payable	        400
-----------------------------------
Net current assets 			 5,500
Total assets                        13,700
Long-Term Liabilities
Loans Repayable		 2,200
-----------------------------------
Total Long Term Liabilities		 2,200
-----------------------------------
NET ASSETS				11,500
-----------------------------------
Shareholders' Equity
Share Capital		10,000
Retained profits	 1,500
-----------------------------------
TOTAL SHAREHOLDERS' EQUITY		11,500
-----------------------------------

Points to note:

  • Must be headed with the name of the reporting entity (e.g. Sunrise Ltd) and the date.
  • The van has not been depreciated and there are no other trading expenses
  • The terms 'Current Liability' and 'Long-Term Liability' are the traditional names possibly used by sole traders or partnerships. Limited companies may use the phrases 'Liabilities: Amounts falling due within 1 year' and 'Liabilities: Amounts falling due after 1 year'.
  • The Total Equity may also be called the 'Net Worth'.
  • The Net Worth is in principle what the company is worth, it shows the monetary amount that would effectively be left, if all assets were sold and all liabilities paid off.


See also[edit | edit source]

Financial Governance