Finance 101. Agenda An Introduction to Accounting Types of Financing Corporate Structure Markets Valuation.

Finance 101

AgendaAn Introduction to Accounting

Types of Financing

Corporate Structure

Markets

Valuation

Accounting in 20 minutes

• Accounting is the “language of business”– It’s a way to track and report financial status and transactions– For example, accountants generate financial statements that cover

where money is in the business, how much money they made, how much money they spent, etc.

• The financial statements accountants generate and release every year (and fourth of a year) are investors’ best source of information

Accounting in 20 minutes

• Accounting revolves around one key idea– The accounting equation:

Assets = Liabilities + Owner’s Equity

Resources of the business (assets) are either from money we got from loans (liabilities) or from our personal

investment or others’ (Owner’s Equity)

The Accounting Equation

You decide to open a lemonade stand and calculate that you need $100 to cover a table, cups, lemons, and water.

You crack open the piggy bank and find $50 and decide to contribute it to your new business venture. This is equity.

You talk to your parents and they offer to cover the last $50, but tell you that you have to pay them back. This is called debt.

The Accounting Equation

Assets = Liabilities + Owner’s Equity$50 spent on a table

$20 spent on lemons

$10 spent on cups

$10 spent on water

$10 left in cash to make change

$50 from parents $50 from your personal bank

Notice how the resources in the business equal the resources you receive from funding sources (yourself, a

bank, your parents’ loan)

This always happens. The accounting equation is always in balance

The Accounting Equation

Assets = Liabilities + Owner’s Equity$50 spent on a table

$20 spent on lemons

$10 spent on cups

$10 spent on water

$10 left in cash to make change

$50 from parents $50 from your personal bank

Liabilities are legal obligations to pay creditors

Companies aren’t required to pay equity holders

anything for their investment, but by investing in equity, these shareholders get a controlling interest in a

business and a share of profits.

Accounting Statements

• Investors use 3 main financial statements to assess a company– The Balance Sheet- a snapshot of the assets, liabilities, and equity in

the business on a specific day– The Income Statement- shows how much money a company brought

in from sales and the expenses it paid to make that revenue in the past year

– The Statement of Cash Flows- shows how much cash a company brought in and how much cash it paid out over the past year

• Can be found by searching “company name 10-k”

The Balance Sheet

• Broken into Assets, Liabilities, and Equity– Assets section has dollar value of the cash in bank, equipment and

buildings, inventory the company plans to sell, and more– Liabilities section has dollar value of loans the company took out– Equity section has dollar value of money contributed by investors and

owners, as well as the amount of recycled profits in the business• How do investors use this information?– We look at if a company has enough cash to cover payments of

liabilities and how much interest a company has to pay on its debt

The Balance Sheet

The Income Statement

Revenue$100,000

Less: Cost of Goods Sold($60,000)

Gross Profit$40,000

Less: Operating Expenses($10,000)

Operating Income$30,000

Less: Tax Expense($5,000)

Net Income$25,000

Shows the revenues (money a company has earned) and associated expenses (costs a company paid to earn that

revenue).

The Income Statement

• How do investors use this information? – Investors want companies that are making a profit– By looking at margins (the percentage of each dollar of revenue that

becomes profit after costs are taken out), we can compare one company to a similar company and see which company is more efficient

– By comparing with previous years, we can assess trends like: is this company continually making more revenue each year? Are margins (efficiency) improving year-over-year?

The Income Statement

Revenue$100,000

Less: Cost of Goods Sold($60,000)

Gross Profit$40,000

Less: Operating Expenses($10,000)

Operating Income$30,000

Less: Tax Expense($5,000)

Net Income$25,000

The gross margin, or % of sales that is left after taking out costs is 40%

30% operating margin

25% profit margin

The Statement of Cash Flows

• Broken into 3 sections:– Net Cash Flows from Operations- Cash flows generated from normal

business activities– Net Cash Flows from Financing- Cash flows generated from receiving

loans, or paying them off– Net Cash Flows from Investing- Cash generated from selling or buying

long-term assets (buildings, land, equipment)

The Statement of Cash Flows

• How do investors use this statement?– Largely considered the most important to investors– It is possible to earn a profit but not have enough cash to pay its bills

and end up making it go bankrupt or out of business– We look at operating cash flows to tell us if a company is making

enough cash to pay the bills– There are many accounting gimmicks to inflate the income

statement. By converting to a cash basis, we can know exactly what a business earns and pays out.

Summary of Accounting

• Accounting serves as our means of understanding a company’s financial situation through the usage of financial statements

• The three financial statements we use are – The Balance Sheet- Assets = Liabilities + Equity– The Income Statement- Revenues – Expenses = Profit– The Statement of Cash Flows- Operating CF +/- Financing CF +/-

Investing CF = Net CF

Financing

• You realize that you are actually a lemonade-making genius and want to expand your business to the entire state of Maryland.

• You’ve exhausted your own personal contribution ($50) and your parents refuse to loan you several million dollars.

• Where do you go, what do you do?

Financing

• Businesses have a number of sources to tap into for financing.• Can receive capital from:– Venture Capital Funds- investment funds set up to contribute money

to start-up companies in return for a large share of ownership– Banks- can give you a loan (a contract to pay back principal and

interest periodically)– Investment Banks- can set up an initial public offering (IPO) where

you sell part of full ownership of your company in the form of stock to raise money or organize a bond (publicly traded debt) offering

Capital Financing

• Financing is broken into two categories– Debt (found under liabilities section of balance sheet)– Equity (found under equity section of balance sheet)

Capital Financing: Debt

• Your lemonade stand can raise debt to fund its growth• Terminology:– Par value: Initial amount paid by investor; returned at maturity– Interest/Coupon: Amount paid periodically to investors

• Types of Debt:– Bonds (source - public markets)– Loans (source - privately traded or not traded)

So what does debt look like?

BOND

$100,000 Face Value5 Year Life

Interest paid every year end @10% of Principal

As a financial institution or lender, you give away the $100,000, and receive 5 payments of $10,000 over the course of the bond’s life.

At the end of the 5th year, you receive the last $10,000 interest payment and your $100,000.

As an borrower, the transaction is flipped. You receive the $100,000 to finance your activities, but have to return the money (and pay interest periodically).

So when you borrow money, you need a plan to pay it back, otherwise the lender has legal rights to repossess your company’s assets.

Capital Financing: Equity

• You can also raise equity to fund its growth• Terminology:– Stock: a share of ownership in a company– Initial Public Offering: initial issuance of stock by a company– Secondary Markets: investors exchanging securities

• Types of Equity:– Common Stock: no guaranteed dividend, voting power– Preferred Stock: guaranteed a dividend, no vote

What does equity look like?

Originally, equity in a company is just the amount of money that owners contribute to the business.

When the company grows, it soon needs more money to finance its expansion. These companies raise money by undergoing an initial public offering (IPO), where they agree to relinquish a portion of the company in return for money.

This portion of the company is then divided up into millions of portions and sold off to investors in the form of stocks.

Debt vs Equity

Debt

• Advantages:– Doesn’t seize ownership– Not as influence by market

swings– Easy to raise

• Disadvantages:– Legal obligation to pay– Claim on assets during

bankruptcy

Equity

• Advantages:– No legal obligation to pay– No claims on assets

• Disadvantages:– Giving over ownership

• Shareholder activism• Outside investors (hostile)

– Voting rights

Issuing Equity

• When looking to expand your business, you decide that you need to raise $100 million and decide to pursue it through equity financing.

• To raise your $100M, you can sell 1M shares at $100 apiece or 2M shares at $50 apiece or 10M shares at $10 apiece, etc. This is important because it shows that share price has nothing to do with value. You could issue 100 shares at $1M each, it doesn’t make your company more valuable.

Issuing Equity

• An investment bank decides how much your company is worth, then decides what percentage of the company is worth $100M. It then takes the shares to be issued to raise the money and finds investors who are willing to buy the shares.

Money to be raised / Estimated Value of the company = Percentage of the company to sell

$100M / $400M = shares issued will control 25% of the company

Corporate Structure

Shareholders

Board of Directors & Chairman

Managers, CEO, CFO, COO, CIO

Problems in the Corporate Structure

The goal of the corporation is to maximize money for shareholders. If the corporation is making a profit and management gets rewarded for profits, shouldn’t their interests be aligned?

NO! Many times management is more concerned with short-term profits that maximize how good they look, where as shareholders want to maximize profits period, not at the expense of later periods.

There’s also a problem of shareholders having high demands on a quarterly basis (when financial statements are released) that stress managements’ plans for the future.

Why is this important?

• When evaluating a company to invest in, management of the company is incredibly important.– We look at a number of factors to assess the quality of management:• Historical performance at the company and at other companies• Big spender vs. too frugal• Plans outlined

Markets

• So what exactly is a market?It’s a medium for buyers and sellers to exchange goods.

It’s a medium for buyers and sellers to exchange financial goods.

So what is a financial market?

So what are the financial goods?Anything from shares of a company (stocks) to bonds (publicly traded debt), derivatives (more on this next time), etc

Markets

Trading: when a buyer finds a seller

Buyer

Looking to buy 100 shares AAPL @

450ea

Seller

Looking to sell 200 shares AAPL @

450ea

Transaction:100 shares @450

Markets

• A stock’s priceline is actually just millions of trades like this plotted and traced, meaning that if you see the price quote of AAPL at $450.13, that means that the last transaction was at the agreed upon price of $450.13.

Markets

• Do fluctuations in a stock’s price affect the company that issued the shares?

Yes and no. While a stock price shooting up has no direct effect on the actual assets the company has (because the shares were traded for a fixed amount of money and are now out of the company’s hands), some companies compensate their employees with stock options (more on these next time) that increase in value if the stock performs well.

Valuation

• At this point we’ve discussed: – accounting methodologies that provide us with information that we

can use to make informed investment decisions– A general idea of where stocks come from (equity financing through

IPOs)– How a corporation is structured– What a market is

• So how do we determine where the stock’s price will be in 3 years?

An Introduction to Valuation Methods

• Intrinsic Valuation– Discounted Cash Flow Model- We forecast out a companies ability to

make cash in the future, then add it all up and divide by how many shares it has to find what the share price should be.

• Relative Valuation– Company Comparables Model- we look at how much similar companies

are trading at with respect to a measurement of company profits– Precedent Transaction Model- we look at how much similar companies

were acquired by other companies for, and use these numbers to determine valuation

Next Time

• Either relative valuation or options/derivatives markets depending on cheering.