Part 4. Accounting and Finance

 

Exercise 15. Match the words and the definitions:

1. Accounting A document reporting the results of company operations over a particular period of time.

2. Income statement A financial statement that reports the financial position of a firm at a specific time.

3. Balance sheet Acquiring funds for the firm and managing funds within a firm.

4. Financing Recording data from transactions and preparing financial statements.

Accounting

Accounting process consists of two major functions:

1. Recording data from transactions;

2. Preparing financial statements.

Transactions include buying and selling goods and services, acquiring insurance, using supplies, and paying taxes. After the transactions have been recorded, they are usually classified into groups that have common characteristics. For example, all purchases are grouped together, as are all sales transactions. Other kinds of accounting documents are: purchasing documents, payroll records, bank documents, travel and entertainment records. The business is thus able to obtain needed information about purchases, sales and other transactions that occur over a given period of time. The methods used to record and summarize accounting data into reports is called an accounting system. One purpose of accounting is to help managers evaluate the financial condition and the operating performance of the firm so that they may take better decisions. Another is to report financial information to people outside the firm such as owners, creditors, suppliers, and the government (for tax purposes).

When recording the original transaction documents in a journal the accountant places them in certain accounts.

Accountants use five major accounts to prepare financial statements:

1. Assets. Assets are what a business owns, property that have money value. Assets include the following:

· Cash (cash on hand and deposits in banks)

· Accounts receivable (money owed to a business from customers who bought goods on credit)

· Inventory

· Investments

· Land

· Equipment

· Buildings

· Motor vehicles

· Patents

· Copyrights

Assets are divided into three categories:

1) Current assets (items that can be converted to cash within one year),

2) Fixed assets (items such as land, buildings and fixtures that are relatively permanent),

3) Other (intangible) assets (patents and copyright).

2. Liabilities. Liabilities are what the business owes to others. They include:

· Accounts payable (money owed to others for merchandise and services purchased on credit, but not paid for yet),

· Accrued expenses payable (expenses the firm owes that haven’t been paid),

· Bonds payable (these represent money loaned to the firm that it must pay back).

Liabilities are divided into two categories:

Current liabilities or obligations that must be paid within one year, such as accounts payable.

Long term liabilities or obligations that will not be paid within one year, such as bonds.

3. Owners’ equity. It is assets minus liabilities. For sole proprietors, owners’ equity means the value of everything owned by the business minus any liabilities of the owners (for example, outstanding loans). For corporation, the owners’ equity account records the owners’ claims to funds they have invested in the firm (capital stock) plus earnings kept in the business and not paid out in dividends (retained earnings).

4. Revenues. Revenues is the value of what is received for goods sold, services rendered, and from other sources. That includes sales revenues, rental revenues, commissions, royalties.

5. Expenses. They are costs incurred in operating the business, such as rent, utilities, salaries and wages, insurance, advertising etc.

Financial documents

The two most important financial statements are: the income statement and the balance sheet.

1. The income statement is also called profit and loss statement. It summarizes all the resources that came into the firm from operating activities (called revenue), money resources that were used up (called cost of goods sold and expenses), and what resources were left after all costs and expenses were incurred (net income or net loss). It reports the results of operating over a particular period of time.

2. The balance sheet is the financial statement that reports the financial position of a firm at a specific time. The words "balance sheet" imply, that the report shows a balance, an equality between two figures. That is the balance sheet shows a balance between assets and liabilities plus owner’s equity.

The formula Assets = Liabilities + Owners’ equity is the basis for the balance sheet.

On the balance sheet, you list assets in a separate column from liabilities and owner’s equity. The assets are equal to or are balanced with the liabilities and owners’ equity.

Exercise 16. True or false?

1. Accountants use two major accounts to prepare financial statements.

2. The main financial statements are purchasing documents and payroll records.

3. Liabilities are what a business owns.

4. Long term liabilities must be paid within a year.

5. The basis of a balance sheet is a formula Assets = Liabilities + Owners’ Equity.

Finance

Finance is the function in a business that is responsible for acquiring funds for the firm and managing funds within the firm (planning, using and controlling money effectively).

A financial plan for a business specifies the amount of money needed for various time periods and the most appropriate sources and uses of funds.

Long-term financing is money, obtained from the owners of the firm and lenders who do not expect repayment within 2 or more years. Long-term capital is used to buy long-term assets such as a plant and equipment and to finance any expansions of the organization. Initial long-term financing comes from three sources:

1. Equity capital comes from the owners of the firm in a form of personal savings, friends’ loans, and mainly sale of stock.

Advantages of selling stock are:

· Because stockholders are owners of the business, their investment never has to be repaid.

· There is no legal obligation to pay dividends (a share of the profits) to stockholders; therefore, income can be used for additional growth.

· Selling stock improves the condition of the balance sheet. Because no debt is incurred, the corporation is stronger financially and able to borrow funds more easily.

However, there are some disadvantages:

· Because stockholders are owners of the firm, they can vote through the board of directors, on who will manage the firm and what the policies will be. Having other owners takes away some freedom and control from those who started the firm and invested much time and effort in getting it started.

· Equity financing is relatively expensive form of fund rising. It is more costly to pay dividends than interest because dividend income is taxed twice – it is taxed at the corporate level and taxed again as income to the stockholders.

2. Retained earnings is income that the firm earns from its operating. As dividends a taxed twice, both the corporation and the stockholders may prefer that the company keep (retain) those profits and reinvest them. This benefits stockholders because the company can prosper and grow using those profits. It also benefits the firm in that it has more money to use. The profits that the company keeps are called retained earnings, therefore, because they are retained rather than paid out in dividends.

3. Debt financing. A financial alternative to selling stock is to sell bonds. A bond is the certificate that shows that a person has loaned money to a firm. With debt financing the company has a legal obligation to pay interest payment to bond holders. The amount of interest a company is willing to pay to borrow funds is written on the bond. How high that interest rate must be depends on how risky the company is and what the prevailing interest rate is.

The advantages of selling bonds are the following:

· Unlike stockholders, bondholders have no vote on corporate affairs, thus management retains control over the firm. Bondholders are creditors, not owners.

· Bonds are more flexible than stock. Whereas stockholders have ownership forever, bondholders represent more temporary sources of funds that can be tapped when needed.

Bonds also have their drawbacks:

· Bonds are an increase in debt (liabilities) and may make it more difficult to obtain other financing.

· Interest on bonds is a legal obligation. A corporation cannot delay or halt such payment as they may do with dividends.

· Interest payments on bonds affect the firm’s cash flow negatively in that they come out of the cash account.

Short-term financing. Small business rarely use stocks and bonds as sources of capital. Day-to-day operations of the firm call for careful management of short-term financial needs. Cash may be needed for additional inventory or bills may come due unexpectedly, so a business sometimes needs to obtain short-term funds when other funds run out. Short term funds are those that are scheduled for repayment in less than a year. Short-term financing includes trade credit, family and friends, commercial banks, factoring, commercial paper, and internal sources.

Trade credit. Is the most widely used source of short-term funding. This means that a business is able to buy goods today and pay for them sometimes in the future. When a firm buys merchandise it receive an invoice (bill) much like the one you receive when you buy sometimes on credit. A business invoice often contains terms such as "2/10, net 30". This means that the buyer can take a 2% discount for paying within 10 days. The total bill is due in 30 days if the discount is not taken.

A second source of short-term funds for most smaller firms is money lent to them by family and friends. Such loans can be dangerous if the firm does not understand cash flow. Several bills can come due at the same time when there are no other sources of funds. It is better, therefore, if you do borrow from family or friends, to be very professional about the deal and

1) agree on terms at the beginning,

2) write an agreement,

3) pay them back the same way you would a bank loan.

Commercial banks usually offer quite low rates in comparison with finance companies, so a small to medium-sized business should have the person in charge of keeping in very close touch with a local bank in case a business suddenly finds itself in a position where many bills come due at once: utilities, insurance, payroll, new equipment and more. Most times commercial banks can help. The most difficult kind of loan to get from a bank or other financial institution is an unsecured loan. This is a loan that is not backed by any collateral.

A secured loan is one backed by something valuable, such as property. If the borrower fails to pay the loan the lender may take possession of the collateral. That takes some of the risk out of lending money. Different property can be used as collateral, including buildings, machinery, stocks or bonds etc.

Factoring is a relatively expensive source of funds for a firm. The way it works is this: a firm sells many of its products on credit to consumers and other business. Some of these buyers are slow in paying their bills. The company may thus have a large amount of money due in accounts receivable. A factor buys the accounts receivable from the firm for cash (paying 50% to 70% of the value of the accounts receivable) and then collects the money due the firm. Factoring, then, is the process of selling accounts receivable for cash. How much this costs the firm depends on the rate the factor charges for this service. The discount rate for factoring depends on the age of the accounts receivable, the nature of the business, and the conditions of the economy.

Commercial paper is a way to get short-term funds for less than bank rates. It consists of promissory notes, in amount ranging from 25,000 up, that mature in 270 day or less. Commercial paper is insecured, so only the more financially stable firms can sell it.

Internal sources of funds is a wise way to generate more cash. For example, inventory and costs may be reduced, expenses can be cut, accounts receivable can be collected more quickly. A good finance team is able to save a business much money by finding such internal sources of funds and freeing them.

Exercise 17. True or false?

1. Friends’ loans is an example of debt financing.

2. Bondholders are only creditors, they don't own the company.

3. Interest on bonds is an obligation for a company.

4. Factoring is cheaper for a company then using commercial banks' services.

5. Reducing inventory and cutting expenses are examples of internal sources of funds.