Business 101: Breaking Business Down to Brass Tacks - PowerPoint Presentation

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Business 101: Breaking Business Down to Brass Tacks

Q: What's the difference between an accountant and a lawyer?

A: Accountants know they're boring.

Bill H. dropped out of law school to start a farm. He owns ten cows, land, a barn, and has $100.

Bill sells milk for $5 and cheese for $10. It costs him $3 to make milk, and $6 to make cheese.

Costs $3, sells for $5 Costs $6, sells for $10

Each year, Bill has income (a.k.a. sales, revenue) and expenses (costs & bills).

Income:

He sells 120 each of milk and cheese

(120 x $5 = $600 milk) + (120 x $10 = $1200 cheese) = $1,800 per year (“revenue”)

Sometimes he gets paid in cash, sometimes he adds it to his customer’s tab (“accounts receivable”)

Expenses:

He pays $1,080 for supplies (cow food? cheesecloth?)(120 x $3 = $360 milk) + ($120 x $6 = $720 cheese) = $1,080Sometimes he pays cash, sometimes suppliers add it to his tab (“accounts payable”)

Represents Bill’s Costs of his Goods (milk & cheese) Sold (“COGS”)He pays $360 for electricity & utilities in cashRepresents operating expenses (“Opex

”)

Income Statement (a.k.a. Profit & Loss Statement, a.k.a. “P&L”)

Income Statement

Fiscal Year Ending 20X1

Revenues

Sales

$1,800

Expenses

Cost

of Goods Sold ($1,080)

Operating Expenses ($360)

Operating Income

$360

Other Income & Expenses

Interest

Expense

($9

)

Net

Income

$351

Financing

Bill wants to buy another cow.

Each cow costs $300.

Bill has two options to get some more cash: Borrow from a bank: get cash in exchange for Bill promising to pay them back in the future, with interest

Taking on debt (a “liability”)Or, find some investors: get cash in exchange for partial ownership of the farmBill will still run the farm This should sound familiar! There are arguments for and against both of these options.

Debt

LOANS

The bank offers Bill a $100 loan, due in five years, with a 5% annual interest rate.

So, Bill gets $100 in cash now, and in five years, he will pay the bank $100 back. In the meantime, he will pay the bank $5 each year in interest.

BONDS

Bill sells his friend Camille 10 bonds at $5 each ($50 total), due in 10 years, with 8% annual interest.

So, Bill gets $50 in cash now, and in ten years, he will pay Camille $50 back. In the meantime, he will pay her $4 each year in interest.

In olden times, bonds were paper and had coupons that the owners would bring in to get interest payments in cash. So, sometimes the interest rate for a bond is called the “coupon rate.”

Income Statement (a.k.a. Profit & Loss Statement, a.k.a. “P&L”)

Income Statement

Fiscal Year Ending 20X1

Revenues

Sales

$1,800

Expenses

Cost

of Goods Sold ($1,080)

Operating Expenses ($360)

Operating Income

$360

Other Income & Expenses

Interest

Expense

($9)

Net

Income

$351

Equity: Stock

Bill’s friend Joanna invests $150, and in exchange Bill gives Joanna a 5% ownership stake in the farm.

This means the farm is worth $3,000 total

Which sounds right, because the cows are worth $3,000, and he makes $360/year

Because Joanna is a shareholder in Bill’s farm, Bill’s decisions about the farm are on her behalf, too, even though he’s running everything

Bill owes Joanna a duty to act in the farm’s best interest, which is also Joanna’s best interest.

Balance Sheet:Assets = Liabilities & Equity

Assets

Liabilities & Equity

Cash $251

Liabilities

Accounts

Receivable $50

Accounts Payable $150

Inventory $300Debt $100

Property, Plant, & Equipment (PP&E) $6,000Stock $50

Land $2,000

EquityFarm $1,000

Common Stock Issued $150Cows $3,000

Owners Interest $11,800

Retained Earnings $351

Total Assets: $12,601

Total Liabilities & Equity: $12,601

Statement

of Cash Flows

Fiscal Year Ending 20X1

Cash

Flows from Operations

Net Income

$351

Changes in Accounts Receivable

($50)

Changes in Inventory

($300)

Changes in Accounts Payable

$150

Net Cash Flows from Operations

$151

Cash

Flows from Investing

Purchase of PP&E (Cows)

($300)

Net Cash Flows from Investing

($300)

Cash

Flows from Financing

Issuance

of Stock

$150

Issuance of Bonds

$50

Bank

Loan

$100

Net Cash Flows from Operations

$300

Beginning Cash

$100

Change in Cash

$151

Ending Cash

$251

Statement

of Cash Flows

(“SOCF”)

*Sort of Crying Feeling

Reporting

Bill could offer to sell small pieces of ownership of the farm to investors on a public exchange

Ex: NASDAQ, New York Stock Exchange (“NYSE”)

The first time Bill does this is called an Initial Public Offering, an “IPO”

To do that, Bill needs audited financial statements

Bill needs to work with attorneys to make sure he dots his i’s and crosses his t’s (“due diligence”)

The Sarbanes-Oxley

Act (SOX) requires

public companies to file annual audited financial statements (a 10-K) and quarterly financial statements (10-Qs) with the Securities and Exchange Commission (“SEC”)

Usher!

Special Projects

Mergers

A deal to unite two

companies into one company.

AcquisitionA company buys an asset or some or all of another company Joint Ventures (“JV”)Commercial enterprise undertaken by two or more parties that otherwise retain their distinct identities

*Full disclosure: “Hathaway” was a mill and didn’t make stomach bitters but they had no cool pictures

A Glossary of Random Terms

Liquidity = how easily you can convert an asset cash

Very liquid = cash, 3 month CDs

Not at all liquid = paintings worth $50 million

In the middle = stocks & bonds

Capital, capitalized, etc. Something becomes an assetGAAP/IFRS

Generally Accepted Accounting Principles International Financial Reporting StandardsInvoice

A bill for goods or servicesInternal ControlsWays to ensure your company complies with laws, regulations, internal & external policies

GoodwillOverpaying for a company because you think it’s just got something extra specialWrite-offs/Bad Debt

An expense in the year you realize you won’t get paid back money you're owedAccrual

Accounting for the lag in time between when you’re legally entitled to an asset or liability versus when you actually get paid or pay the vendor Fixed expenses vs. variable expenses Rent = fixed expense = same each month

Electric = higher bill when you use more = varies each monthResearch & Development (“R&D”)

A Glossary of Random Terms (continued)

Budget-to-Actual

How much your estimates were off

The “delta” is the change -> a big delta is a bad delta

Dodd-Frank Act = post-Recession regulation of investments

Securitize/ securitized assets Groups of future payments, sold as a bundle and made “liquid”

See “The Big Short”Off-balance sheetEnronBig 4 Accounting

HedgesOffsetting investment risksDiversify

Shorting Ratios/MetricsNet income

Gross profitEBIT = Earnings Before Interest & TaxesEBITDA = Earnings Before Interest, Taxes, Depreciation, & Amortization

ROA = Return on AssetsDebt/Equity a.k.a. “Leverage”

Securities = tradeable financial asset Short-term (within 1 year) vs. long-term (over 1 year)Ex: Short term debt