Firms and Financial Statements

The Firm

Shareholders vs. Debtholders

Shareholders（股东）

A firm’s owners are called shareholders (also called stockholders or equity holders).

they:

  • own stocks of the firm;
  • may receive dividends;
  • can sell their stocks;
  • are the residual claimants of the firm.

也叫 stockholders / equity holders，意思都是“公司的所有者”。他们持有公司的股票，可以获得 dividend（股息），也可以把股票卖掉。

例如你买了某公司 100 股股票，你就是这个公司的 shareholder。公司赚了钱以后，可能会给你分红；但注意，是“可能”，不是一定。

Debtholders（债权人）

公司不只可以靠股东的钱，还可以借钱。把钱借给公司的个人或机构，就是 debtholder。

例如：

  • 银行给公司贷款 → 银行是 debtholder
  • 投资者购买公司发行的 bond（债券） → 投资者是 debtholder

公司需要向债权人偿还 principal + interest，也就是：

\text{本金 principal}+\text{利息 interest}

Shareholders are residual claimants, meaning that the firm must satisfy the claims of debtholders before distributing the remaining value to shareholders.

Interest payments are contractual, while dividends are not guaranteed.

公司对债权人的 interest（利息）是必须支付的债务义务；但给股东的 dividend（股息）并不保证一定支付。

Objective of a Firm

The objective of a firm is to maximize shareholders’ wealth, measured by the market value of the firm’s stock.

\text{Market Value of Stock} = \text{Market Price per Share} \times \text{Number of Shares}

The market price reflects:

  • present earnings;
  • prospective earnings;
  • timing and duration of earnings;
  • risk;
  • other relevant factors.

Maximizing shareholders’ wealth is not the same as maximizing current profits, because stock value reflects not only earnings, but also their timing, duration, and risk.

Three Decisions of a Firm

Investment Decision

The investment decision, also called capital budgeting, concerns the allocation of capital among competing investment projects.

Capital budgeting is difficult because future outcomes are uncertain.

Typical activities include:

  • developing new investment opportunities;
  • estimating future cash flows;
  • organizing capital expenditure programs;
  • reviewing investment programs.

Financing Decision

The financing decision determines the sources of funds used to finance investments.

There are two main types:

  • Equity financing

    • issue new stocks;
    • retained earnings.

  • Debt financing

    • issue bonds;
    • loans from financial institutions.

A firm may use a combination of equity and debt financing.

Dividend Policy

Dividend policy determines how much and how often dividends are paid to shareholders and whether they are paid in cash or stock.

\text{Payout Ratio} = \frac{\text{Dividends}}{\text{Earnings}}

Common dividend policies:

  • Regular dividend: fixed dividend amount;
  • Stable dividend: relatively stable payout ratio;
  • Residual dividend: dividends are paid from earnings remaining after investment needs are funded;
  • Irregular dividend: no fixed schedule or amount.

Firms with high-growth opportunities often retain more earnings and pay lower dividends, while mature firms may favor stable or regular dividends.

Relationship among the Three Decisions

The firm's investment, financing, and dividend decisions are not independent.

  • Investment depends on the firm's access to funding.
  • Current investment decisions may affect future access to financing.
  • A higher dividend payout reduces retained earnings and therefore reduces internal funds available for reinvestment.

All three decisions should be made with the objective of maximizing shareholders' wealth in mind.

Financial Statements

Accounting Information

Accounting information is useful in capital budgeting because an investment project should be evaluated not only by its own profitability, but also by its effect on the firm's financial condition and financial position.

Accounting information has two major uses:

  • Forecasting: past financial data can help predict future financial conditions.
  • Post-evaluation: actual project performance can be compared with predicted performance.

The three major financial statements are:

  • Balance Sheet
  • Income Statement
  • Cash Flow Statement

Basic Principles of Accounting

Monetary Measurement

Accounting records facts that can be expressed in monetary terms.

Cost Principle

Assets are generally recorded at their acquisition cost, rather than their current market value.

Accrual Concept

Revenues and expenses are recognized when they are earned or incurred, regardless of when cash is received or paid.

Balance Sheet

A balance sheet shows the financial condition of a firm at a specific point in time.

The fundamental accounting identity is:

Assets=Liabilities+Equity
  • Assets represent the use of money.
  • Liabilities and equity represent the sources of money.

Assets

Current Assets

Assets that can be converted into cash or cash equivalents in less than one year.

Main items:

  • Cash
  • Marketable securities - Short-term liquid financial instruments that can be converted into cash quickly.
  • Accounts receivable - Money owed to the firm by customers for goods or services already delivered.
  • Inventories - Goods owned by the firm but not yet sold. Inventories are recorded at their cost, rather than their selling price.
  • Prepaid expenses - Payments made in advance for goods or services to be received later. The unused portion remains an asset.
  • Deferred charges - Similar to prepaid expenses, but generally associated with a longer period.

Fixed Assets

Relatively permanent assets used in normal business operations and not normally converted into cash during the operating cycle.

Examples of categories include:

  • land
  • buildings
  • machinery
  • equipment
  • vehicles

Other Assets

Other assets may include investments in other companies and intangible assets.

Important intangible assets include:

  • Goodwill - Goodwill arises when a company acquires another business and pays more than the net asset value of that business.
  • Copyright - A copyright is a legal right associated with intellectual property. It gives the owner the exclusive right to reproduce a work.
  • Franchise - A franchise is a type of license that allows a franchisee to use the franchisor’s: business knowledge, processes, trademarks, business name.

Liabilities

Current Liabilities

Current liabilities are debts payable within one year.

Examples include:

  • accounts payable;
  • accrued expenses;
  • short-term bonds or loans.

Other / Long-term Liabilities

These are obligations due more than one year in the future.

Examples include:

  • bonds;
  • mortgages;
  • long-term notes.

Equity

Equity represents the shareholders’ interest in the firm.

Main components include:

  • Common stock
  • Preferred stock
  • Paid-in capital
  • Retained earnings

Preferred stockholders have priority over common stockholders in dividends and liquidation claims, but rank after bondholders.

\text{Bondholders} > \text{Preferred Stockholders} > \text{Common Stockholders}

Paid-in capital is the amount raised from stock issuance:

\text{Paid-in Capital} = \text{Par Value} + \text{Capital Surplus}

Retained earnings are accumulated earnings kept in the firm rather than distributed as dividends.

Working Capital

Working capital represents the excess of short-term assets over short-term obligations.

\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}

Working capital 主要反映公司的短期财务余量。Current assets 超过 current liabilities 越多，通常说明公司短期资金状况越宽松。

Income Statement

EPS and ROE

Cash Flow Statement

Accounting Scandals