Corporate finance consists of the financial activities related to running a corporation. Corporate finance is primarily concerned with maximizing shareholder value through long-term and short-term financial planning and the implementation of various strategies.
The American Accounting Association offers this definition: “The process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information.”
The Difference Between Accounting and Bookkeeping
Bookkeeping is the recording of all the economic activity of an organization — sales made, bills paid, capital received — as individual transactions and summarizing them periodically (annually, quarterly, even daily). Accounting professionals design the accounting systems used by bookkeepers. More importantly, they establish the internal controls to protect company resources, the application of accounting standards governing the preparation of financial statements, management reports and tax returns based on that data.
The economic events of a business are recorded as transactions and applied to the various accounts on the organization’s chart of accounts. Double entry means that every transaction will be recorded as debt and credit accounts and for the same amount. The transactions are posted in journals, which were actual books.
The Accounting Processes
Here are the steps in the accounting cycle:
Step 1- Identify the transaction from source documents, like purchase orders, loan agreements, invoices, etc.
Step 2- Record the transaction as a journal entry using the double-entry bookkeeping.
Step 3- Post the entry in the individual accounts in ledgers.
Step 4- At the end of the reporting period (usually the end of the month), create a preliminary trial balance of all the accounts by (a) netting all the debits and credits in each account to calculate their balances and (b) totaling all the left-side (i.e., debit) balances and right-side (i.e., credit) balances. The two columns should be equal.
Step 5- Make additional adjusting entries that are not generated through specific source documents. For example, depreciation expense is periodically recorded for items like equipment to account for the use of the asset and the loss of its value over time.
Step 6- Create an adjusted trial balance of the accounts. Once again, the left-side and right-side entries – i.e. debits and credits – must total to the same amount.
Step 7- Combine the sums in the various accounts and present them in financial statements created for both internal and external use.
Step 8- Close the books for the current month by recording the necessary reversing entries to start fresh in the new period (usually the next month).
Step 9- Nearly all companies create end-of-year financial reports, and a new set of books is begun each year.
A trial balance is a bookkeeping worksheet in which the balances of all ledgers are compiled into debit and credit columns. A company prepares a trial balance periodically, usually at the end of every reporting period. The general purpose of producing a trial balance is to ensure the entries in a company’s bookkeeping system are mathematically correct. Preparing a trial balance for a company serves to detect any mathematical errors that have occurred in the double-entry accounting system. If the total debits equal the total credits, the trial balance is considered to be balanced, and there should be no mathematical errors in the ledgers. At the end of an accounting period, the accounts of asset, expense or loss should each have a debit balance, and the accounts of liability, equity, revenue or gain should each have a credit balance. On a trial balance worksheet, all the debit balances from the left column, and all the credit balances form the right column, with the account titles placed to the far left of the two columns.
It is a view of the company’s financial positions as of the date it is prepared. The balance sheet shows the company’s assets, liabilities and shareholders’ equity. Balance sheet comprises the following accounts:
- Assets are items that provide probable future economic benefits
- Liabilities are obligations of the firm that will be settled by using assets.
- Equity is the residual interest that remains after you subtract liabilities from assets and represents what is left for the shareholders.
The key balance sheet accounting equation is Assets = Liabilities + Owners Equity, or A=L+OE
Assets are broken down into current and non-current (or long-term). Assets are listed from top to bottom in order of decreasing liquidity, i.e., how quickly they can be converted to cash. Current assets are cash and other assets that are expected to be used during the normal operating cycle of the business, usually one year. They typically include cash and cash equivalents, short-term investments, accounts receivables, inventory and prepaid expense. Non-current assets will not be realized in full within one year. They typically include long-term investments: property, plant and equipment; intangible assets and other assets.
Liabilities are listed in order of expected payment. Obligations expected to be satisfied within one year are current liabilities. They include accounts payable, trade notes payable, advances and deposits, current portion of long-term debt and accrued expenses. Non-current liabilities include bonds payable and the portion of long-term debt such as loans maturing in period longer than a year.
The structure of the owners’ equity section depends on whether the entity is an individual, a partnership or a corporation. Assuming it’s a corporation, the section will include capital stock, additional paid-in capital, retained earnings, accumulated other comprehensive income and treasury stock.
Analysts, potential creditors and investors can learn a lot from reviewing a company’s balance sheet. For example:
- How risky is the firm’s capital structure? How does it compare to other companies in the same industry? Too much debt in the capital structure can pose a risk during rough periods in the economy, too little debt might be a sign that too little leverage is being used possibly limiting the company’s ability to grow as quickly as their competitors.
- How liquid is the company? This can be assessed by looking at the firm’s current assets relative to their current liabilities.
- The balance sheet in combination with other financial statements is a key tool in reviewing a company’s financial picture and its financial viability.
The income statement (also known as the profit and loss statement or P&L) tells you both the earnings and profitability of a business. The P&L is always for a specific period of time, such as a month, a quarter or a year. The periodic nature of the income statement is essential as this allows users to compare results for the company over similar periods of time, and to the results of other firms for the same period.
The format of the income statement (continuous operation) is:
(Cost of good sold)
= Gross Profit or loss
= Earning before interest and tax
= Earning Before Tax
Yearly tax expense
= Net Profit (earning) or loss
The income statement is broken into several parts:
- Income from continuing operations
- Results from discontinued operations (if any)
- Extraordinary items (if any)
- Cumulative effect of a change in accounting principle (if any)
- Net income
- Other comprehensive income
- Earnings per share information
Results from continuing operations are of primary interest because they are ongoing and can be predictive of future earnings; investors put less weight on discontinued operations (which are about the past) and extraordinary items (unusual and infrequent, thus unlikely to recur).
Cash Flow Statement
The cash-flow document provides aggregate data regarding all cash inflows a company receives from its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given quarter.
The cash flow statement is split between three different business activities: operations, investing and financing.
- Cash Flows From Operations
The first set of cash flow transactions is from operational business activities. Cash flows from operations starts with net income and then reconciles all non-cash items to cash items within business operations. Cash flow operation begins from the net profit (or loss) adding all non-cash expenses (depreciation & provisions) plus decrease on current assets plus increase in current liabilities. The cash flow operation is important to value the business and make investment decisions.
- Cash Flows From Investing
Cash flows from investing activities includes cash spent on property, plant and equipment. This is where analysts look to find changes in capital expenditures (CAPEX). While positive cash flows from investing activities is a good thing, investors prefer companies that generate cash flows primarily from business operations, not investing and financing activities.
- Cash Flows From Financing
Cash flows from financing is the last business activity detailed on the cash flow statement. The section provides an overview of cash used in business financing. Analysts use the cash flows from financing section to find the amount paid out in dividends or share buybacks. Cash obtained or paid back from capital fundraising efforts, such as equity or debt, is also listed.
The important cash flow analysis is that for the Free cash flow (FCF). It is a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value.
Change in statement of Stockholders’ Equity’
Stockholders’ equity is the portion of the balance sheet that represents the capital received from investors in exchange for stock (paid-in capital), donated capital and retained earnings. Stockholders’ equity represents the equity stake currently held on the books by a firm’s equity investors. It is calculated either as a firm’s total assets minus its total liabilities or as share capital plus retained earnings minus treasury shares.
Financial Analysis- Ratio Analysis
When investors and analysts talk about fundamental or quantitative analysis, they are usually referring to ratio analysis. Ratio analysis involves evaluating the performance and financial health of a company by using data from the current and historical financial statements. The data retrieved from the statements is used to – compare a company’s performance over time to assess whether the company is improving or deteriorating; compare a company’s financial standing with the industry average; or compare a company to one or more other companies operating in its sector to see how the company stacks up. The bellow is the ratio analysis sections:
- Liquidity Ratios: liquidity ratios measure a company’s ability to pay off its short-term debts as they come due using the company’s current or quick assets. Liquidity ratios include current ratio, quick ratio, and working capital ratio.
- Solvency Ratios: also called financial leverage ratios, solvency ratios compare a company’s debt levels with its assets, equity, and earnings to evaluate whether a company can stay afloat in the long-term by paying its long-term debt and interest on the debt. Examples of solvency ratios include debt-equity ratio, debt-assets ratio, and interest coverage ratio.
- Profitability Ratios: these ratios show how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratio are examples of profitability ratios.
- Efficiency Ratios: also called activity ratios, efficiency ratios evaluate how well a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios are the asset turnover ratio, inventory turnover, and days’ sales in inventory.
- Coverage Ratios: these ratios measure a company’s ability to make the interest payments and other obligations associated with its debts. Times interest earned ratio and debt-service coverage ratio are two examples of coverage ratios.
- Market Prospect Ratios: e.g. dividend yield, P/E ratio, earnings per share, and dividend payout ratio. These are the most commonly used ratios in fundamental analysis. Investors use these ratios to determine what they may receive in earnings from their investments and to predict what the trend of a stock will be in the future. For example, if the average P/E ratio of all companies in the S&P 500 index is 20, with the majority of companies having a P/E between 15 and 25, a stock with a P/E ratio of 7 would be considered undervalued, while one with a P/E of 50 would be considered overvalued. The former may trend upwards in the future, while the latter will trend downwards until it matches with its intrinsic value.
Business valuation is the process of determining the economic value of a business or company. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership, and divorce proceedings. The topic of business valuation is frequently discussed in corporate finance. Business valuation is typically evaluated when a company is looking to sell all or a portion of its operations or looking to merge with or acquire another company. The valuation of a business is the process of determining the current worth of a business, using objective measures, and evaluating all aspects of the business. A business valuation might include an analysis of the company’s management, its capital structure, its future earnings prospects, or the market value of its assets. The field of business valuation encompasses a wide array of fields and methods. The tools and methods used for valuation can vary among evaluators, businesses, and industries. Common approaches to business valuation include review of financial statements, discounting cash flow models, and similar company comparisons.
There are a number of ways a company can be valued. Some of these methods include:
- Market Capitalization: This is the simplest method of business valuation. It is calculated by multiplying the company’s share price by its total number of shares outstanding.
- Times Revenue Method: Under this business valuation method, a stream of revenues generated over a certain period of time is applied to a multiplier which depends on the industry and economic environment. For example, a tech company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue.
- Earnings Multiplier: In place of the times revenue method, the earnings multiplier may be used to get a more accurate picture of the real value of accompany, since a company’s profits are a more reliable indicator of its financial success than sales revenue. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. In other words, It adjusts the current P/E ratio to account for current interest rates.
- Discounted Cash Flow (DCF) Method: This method of business valuation is similar to the earnings multiplier. This method is based on projections of future cash flows which are adjusted to get the current market value of the company. The main difference between discounted cash flow method and the profit multiplier method is that it takes inflation into consideration to calculate the present value.
- Book Value: This is the value of shareholders’ equity of a business as shown on the balance sheet statement. The book value is derived by subtracting total liabilities of a company from its total assets.
- Liquidation Value: This is the net cash that a business will receive if its assets were liquidated and liabilities were paid off today.
- Asset-based Value: This is a type of business valuation that focuses on a company’s net asset value (NAV), or the fair-market value of its total assets minus its total liabilities, to determine what it would cost to recreate the business.
Online Accounting Systems For Small Businesses
- Wave Accounting: it is a favorite online accounting software for online entrepreneurs and service-based businesses. The basic tools are free for single-member businesses without an employee payroll. Accounting features include automatic transaction downloads and categorization from bank and credit card accounts, custom reports, full business accounting capabilities and accountant access.Business with employees can use Wave Accounting’s full-featured payroll service for a fee. The service offers full integration into the accounting suite. Additionally, for a competitive fee, you can also use Wave for payment collections.
- Quickbooks Online: It is the best known brand in small business accounting, and the online version offers the same features and functionality through a cloud-based platform. The platform can handle all business bookkeeping, reporting, invoicing, payroll, reporting, tax preparation, payments and accountant collaboration. Quickbooks Online is the most robust Internet-based accounting option: it can handle virtually any accounting requirement for most small to mid-sized businesses.
- GoDaddy Online Bookkeeping: Formerly known as Outright Accounting, GoDaddy Bookkeeping brings your bookkeeping and website management under one roof. GoDaddy Bookkeeping features standard accounting tools such as bookkeeping, invoicing, tax preparation and profit and loss reporting. The service focuses on keeping the tools simple through a minimalist approach.
- Freshbooks: Freelancers and other service-type businesses that heavily depend on invoicing for cash flow are best suited for Freshbooks. The service tracks financial accounts and helps with tax preparation, but its most distinguishing feature is its invoicing capabilities. Freelancers and business owners can use Freshbooks to track billable hours or manually input invoices for your clients.
- Xero: Based on available features, Xero is Quickbooks Online’s biggest competitor. Xero has robust features such as bookkeeping, invoicing, bank reconciliation, expense management, purchase orders, payroll, and the ability to add additional user accounts. The service’s most powerful differentiator is its library of over 350 apps that can be connected to a Xero account. These third-party add-ons including payroll services, inventory management, payment processing, customer relation management, e-commerce, retail store POS integration, customer credit management, and management of business loans.
- The Bottom Line: Running a business can be a complicated undertaking. Small and medium-sized business owners have to keep track of many moving parts including their finances, taxes, government obligations and their customers. Online accounting tools have taken the ease and simplicity of computerized accounting to the next level. Instead of downloading software and updating it, you can now keep your books online to access from anywhere.
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Written by: Munther Al Dawood
Enterprise Development Services