Critical questions and answers on accounts and finance

Critical questions and answers on accounts and finance

 

1.  You include shipping and taxes in your fixed assets schedule?

If those taxes are not recoverable, you should include everything needed to gain control / ownership of the asset. So yes, shipping and taxes would be included in the fixed assets schedule.

You need add to the equipment or machinery you bought by paying the shipping and taxes – then the total value of that equipment ( FA) is inclusive of these taxes and shipping. In fact you need to take the invoice gross value that is before you deduct any advance payments made by you.

2.  How do you calculate net operating income after taxes if net operating income is negative?

The typical formula is net operating income after taxes = (1-tax rate)(NOI). What do you do if NOI < 0

Roll your negative Net Income into an operating loss carry forward (assuming you’re modeling a C-corp).  This is called an NOL Carry forward (net operating loss carryforward).  There are certain rules and restrictions, but generally you can offset future taxable gains with your NOLs.  (These NOLs become pretty valuable once companies start generating real cash flow.)
Within Excel, this will require a few extra rows or nested If/Then statements. Just hide or group them in your spreadsheet and show Taxes = 0 until your NOLs are exhausted.  Most investors will know what you’re doing without any further explanation required.

If you are asking this question as an investor or to show numbers to investors, be careful about the answers you’re getting about NOLs. It’s rare to see a company acquired for the purpose of NOLs today (at least through a direct acquisition). This is because of 382 limitations on the usability of NOLs in the case of a change in control of a company’s equity rendering your NOLs almost worthless on a present value basis.

NOLs are currently limited to 3.98% of the value of the company during a change of control. This number is determined by the IRS monthly and (along with the value of the company for 382 purposes) will be fixed at the time of the change of control.

Based on your business and applicable tax laws, you may also have to distinguish between cash taxes and accounting taxes. The actual formula for NOI after taxes is simply: NOI – taxes. This is equivalent to (1-taxes) * NOI if your taxes are positive, but should be just NOI since your taxes are zero if your NOI is negative.

 

 

3.  What’s the difference between margin and markup?

Margin and mark-up are both terms used to describe the same ‘thing’, but just from different angles. The ‘thing’ they describe is often called Gross Profit which is the difference between the selling price and the cost price. Both terms are commonly used in the retail/wholesale trade and sometimes wrongly used interchange ability.

As Junjun explains, if you purchased a product for $100 and wanted a 100% mark-up, you would double the price to $200. (i.e. $100 + ($100 x 100%). If you now asked me, “What margin are we making on the $200 sale?”, I would say 50% not 100% (i.e. $100 of the $200 sale is our gross profit $ margin). This can be represented by the formula … $100 gross profit $ / $200 selling price = 50% gross profit % which means that a $200 selling price x 50% gross profit % margin = $100 gross profit $ margin.

So, mark-up is initially used to set a selling price (on-cost) that secures the desired gross profit $ while margin is typically used to calculate and identify the gross profit made on sales (off-sell).

In the specific content of revenues and expenses: Margin means the revenue you retain after accounting for direct costs (ie, variable costs like COGS) to collect the revenue ; whereas markup is a percentage calculated on base costs to theoretically cover overhead (fixed costs)

Purchased at 100, Sold at 200. Markup is 100% while margin in 50%

 

4. What is the difference between gross and net?

Gross and net is like total and the part you are interested in. Like gross weight versus net weight or gross volume versus net volume.

For finance it’s a little more complicated than that:

Gross revenue is the total amount earned from sales

Net revenue = gross revenue – returns and other sources of negative revenue

Net income = gross profit – total operating expenses

Gross profit = gross revenue – cost of goods sold

Net profit = gross profit – overheads – interest payable +/- one off items

Net Income is also known as the “bottom line”

5. How do you read the balance sheet of a company?

A Balance Sheet is one of the financial reports that is provided to the stakeholders of a business to help them quantify the financial strength of a company. Note: The Balance Sheet is a snap-shot of the financial status of a company at a particular point in time. Here is what a typical Balance Sheet looks like:

At its most basic level, the Balance Sheet describes the things of value that the Company owns/controls (Assets) while identifying the people who have claims over those assets. i.e. the external funding entities (Liabilities) and the internal investors (Owners equity). The Balance Sheet gets its name from the fact that the the total value of the Liabilities and the Owners Equity will always equal (be in balance with) the total value of the Assets. i.e. using the example above … Assets 1,275,000 = Liabilities 850,000 + Owners Equity 425,000. This formula is known as the accounting equation. Assets and liabilities are further subdivided as current and non-current to help stakeholders understand their expected time frames. i.e. Debts due within the next 12 months are current liabilities just a assets that can be readily converted into cash are current assets. All else is classified as non-current.

The total amount of the Owners Equity (also known as the Net Worth of the company) is the amount of money that would be left over if all the Assets were sold and the external funders (Liabilities) were paid out. This is the first and obvious read of a Balance Sheet in relation to the company’s financial strength. i.e. it quantifies how much the business is worth from an accounting point of view. Note: an accounting point of view does not take into account future profit potential and values assets at the time of purchase not what they might be worth today. Owners Equity is typically made up of the shareholders/owners initial and subsequent investments (Capital), the past profits that have not yet been distributed to the shareholders/owners (Retained Earnings) and the profits from the current trading period (Current Earnings).

6. Reading a Balance Sheet using Financial Ratios
Reading about the financial strength of a business from a balance sheet generally requires a certain amount of analysis and comparison, as well as access to the other financial report, the Income Statement.

This analysis is called the Financial Ratio and Trend analysis. By comparing this period’s calculated ratios with prior periods and industry benchmarks, allows you to identify healthy/unhealthy trends in the financial strength of the company in relation to its past and the industry in general i.e. whether the returns from the business are competitive with other investment options, whether the company is becoming more or less profitable, more or less dependent on external funders, better or less able to meet its financial obligations when they become due or more or less efficient at managing the assets of the company.

7. Financial Ratios

 Leverage Ratios – which calculate the extent to which the company uses external debt in its capital structure rather than equity funders. Over reliance on external debt makes a company’s profitability vulnerable to interest rate raises and is more vulnerable to liquidation actions by creditors during a downturn. The most common leverage ratio is the debt to equity ratio. Using the example above it would be … Total Debt 850,000 / Total Owners Equity 425,000 = 2.0 i.e. for every $1 that the owners have invested, external funders have committed $2. This company would be considered highly geared (leveraged)

Liquidity/Solvency Ratios – which calculate the company’s ability to pay its debts as they become due. Some companies might be profitable but yet unable to pay critical payments like staff, loan repayments or rent because their money is tied up in debtors (money owned to the company by customers) or inventory. The most common Liquidity/Solvency Ratio is the Quick ratio. Using the example above it would be … (Current assets 355,000 – Inventory $250,000) / Current Liabilities 150,000 = 0.70 i.e. for every $1 due for payment in the next month or so, the company has $0.70 in liquid (cash or soon to be cash) assets. Generally a Quick ratio of 1.00 is considered a safe operating ratio.

Operational Ratios – which calculate the efficiency of company’s management in its operations and use of assets. Typical efficiencies deal with stock turn and debtor days which measures respectively, the amount of stock required to achieve sales targets and how many days it takes to get paid by customers. Generally you would not want to over stock and you would want your debtors to pay in the shortest possible time.

Profitability Ratios – which calculate the return on sales and capital employed. These ratios are usually expressed as a % and monitored over time periods to identify healthy/unhealthy trends. Typical % are Gross Profit as a % of sales, Net Profit as a % of sales, Net Profit as a % of Assets, Net Profit as a % of Owners Equity. Using the example above, Net Profit as a % of Assets would be … Current earnings $75,000 / Total Assets 1,275,000 = 5.9% and Net Profit as a % of Owners Equity would be … Current earnings $75,000 / Total Owners Equity 425,000 = 17.6%. i.e. if competing investment opportunities provide a lower return than these, then the investment in this business remains worthwhile.

In summary, by comparing these ratios with prior periods, commonly agreed safe operating levels and industry benchmarks helps you read about the changing financial strength/health of a company from the Balance Sheet report.

8. What is the difference between fiscal and monetary policy?

How does fiscal and monetary policy affect national and global markets and what are the changes that take place on a macro and microeconomic level?

In an effort to respond to the sub-questions posed and understand the “knock-on effects”, it is probably helpful to take a closer look at the levers of fiscal and monetary policy.

Expansionary or “Loose” Fiscal Policy occurs when the government increases spending or decreases taxes.  In isolation, either of these actions should increase disposable income and stimulate consumption and spending in the economy.  However, there are two significant implications:

Crowding Out: When a government pursues a stimulus program (as in the Obama stimulus program or during FDR’s New Deal), it typically finances its spending by issuing government bonds (or borrowing).  This reduces national savings (which is equal to government savings + private savings), and consequently reduces the total amount of money available in the economy for investment.  As a result, the cost of investment, better known as the interest rate, increases.  This phenomenon whereby higher interest rates prevent businesses from investing is called “crowding out.”

  • Impact on Exports: In turn the higher interest rate and promise of a higher return induces foreign investors to buy dollars in order to invest in US securities.  Consequently, classical economic theory predicts that the exchange rate will also appreciate, causing a decline in exports.

Expansionary or “Loose” Monetary Policy occurs when the Central Bank:
Reduces the discount rate (the interest rate at which commercial banks can borrow from the Central Bank)

  • Reduces the reserve requirement (the % of the deposits that the commercial bank is required to hold by the Central Bank so that the commercial bank can meet obligations when depositors decide to withdraw money)
  • Purchases financial securities in open market operations in exchange for cash

The success of the first lever depends on commercial banks passing on lower interest rates to corporate or individual borrowers. The latter two options allow the Federal Reserve to increase the money supply, which in turn should cause the interest rate (aka the cost of borrowing) to fall and stimulate lending and investment

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s