Capital vs. Equity
January 21st, 2010
Copyright © 2009 Integrated Profitability TM
When I started the “Capital” series back in October 2009, I should have taken that critical first step: set definitions.
In the eagerness to get started on something new, and especially on those projects that are really necessary or important, beginnings sometimes get rushed and that can cause rockiness down the way. For example, the series really isn’t about capital, it’s apart a specific portion of capital: the equity, shareholder/owner portion of capital. The series will be re-named “Equity-Capital.”
So, starting at the beginning as we near the end:
Capital Structure:
The percentage of each type of capital used by the firm—debt, preferred stock, and net worth (net worth consists of capital, paid-in capital, and retained earnings).*1
Equity:
The net worth of a business, consisting of capital stock, capital (or paid-in) surplus, earned surplus (or retained earnings), and, occasionally, certain net worth reserves. Common equity is that part of the total net worth belonging to the common stockholders. Total equity would include preferred stockholders. The terms common stock, net worth, and common equity are frequently used interchangeably.*2
Everything perfectly clear now? While doing research for this blog, I came across a passage in a text book under a sub-title of “Definitions of Capital” which I was quite happy to see:
“When accountants refer to capital they mean stockholders’ equity or owners’ equity.”*3
I couldn’t have said it better myself!
Anyway, remember the earlier series on “Numbers People”?
This definitional issue is a perfect example as to why accountants are so critical to the success of a business. They define the transactions, set the standards, and oversee the infrastructure in which the financial booking takes place.
And they keep those finance people in place. Sooner or later.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 50
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
*1: Eugene F. Brigham, Fundamentals of Financial Management (Illinois: Dryden Press, 1978) p. 568.
*2: Brigham p. 571.
*3: Donald E. Kieso and Jerry J. Weygandt, Intermediate Accounting Second Edition (Santa Barbara: Wiley/Hamilton Publication 1977) p. 602.
Capital Series: Mea Culpa
January 14th, 2010
Copyright © 2010 Integrated Profitability TM
On October 26, 2009 I started this series on “capital” and to date six posts have been made. And every one of them has in intrinsic definitional flaw:
“Capital” includes all sources of funds that may be accessed by a company
I have written each article to focus exclusively on the “owners’” portion of capital. Here’s the issue in a nutshell:
● Capital includes all sources of funds
● Capital includes loans as well as owner investments
● Loans are liabilities
● Capital includes both liabilities (loans) and equity (stock investments)
Unfortunately, in the six posts to date I did not make my focus explicit and, worse, I mis-used the word “capital.” A much better word, given the focus of this series, is “Equity” which is the owners’ investment, or stake, in the company.
I apologize for the mistake. And, make no mistake, it is a mistake. I will go back to every “Capital” post-to-date and make the wording accurate.
If every storm cloud has a silver lining, this episode confirms the importance of several characteristics “Integrated Profitability” strives for:
● Accuracy
● Trust, Honesty, Integrity
● Full Disclosure
● Responsibility
● Accountability
I sincerely apologize for this mistake.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 49
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Equity: Accounting for the Stuff
January 7th, 2010
Copyright © 2010 Integrated Profitability TM
Accountants are indispensable for setting up and maintaining the financial records of your business. They are never more valuable than when accounting for the capital in your business.
Earlier, we covered the two main sources and uses of capital. Here is a high-level overview of how one accounts for the two main sources of capital:
1. Initial Investment
Event:
● Issue 100,000 shares of stock at $1.00 each
● Investors buy the 100,000 shares for an average, net-price of $17.83 per share
● All investors pay for their shares in cash
Balance Sheet
Asset Liabilities
Cash $1,783,000 Liabilities $ 0
Capital
Par Value $ 100,000
Excess over Par $1,683,000
Total: $1,783,000 Total: $1,783,000
2. Retained Earnings
Good news! The first year of business was excellent and your business made money. Being the first year, no dividends were paid and you poured net profit, after tax, back into the business.
Income Statement
Revenue $1,000,000
Expenses $ 875,000
Pre-tax Net Income $ 125,000
Tax $ 43,750
Net-Profit $ 81,250
Since this is a high-level overview, all the in-&-outs of all the activity of the business are not included: for example, cash from the initial stock offering was used to pay the expenses to generate the revenue; as well as buying a few assets necessary to the running of the business.
So, focusing on the capital accounts:
Balance Sheet
Asset Liabilities
Cash $ 112,000 Liabilities $ 0
Capital
Equip $ 552,000 Par Value $ 100,000
Other $1,200,250 Excess over Par $1,683,000
Retained Earnings $ 81,250
Total: $1, 864,250 Total: $1,864,250
That’s the accounting in a nutshell. The migration of “Net Profit” from the Income Statement to the capital account on the Balance Sheet is one of the most intricate accounting processes.
But it is, for owners, the bottom line.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 48
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
Equity Structures: Market Examples & Other Names for Capital
December 3rd, 2009
Copyright © 2009 Integrated Profitability TM
The Balance Sheet is the financial report that tracks a company’s capital accounts. Picking corporations from different industries, their annual reports show that most of the accounting is standard across industries. Labeling differences are minor:
● Capital in Excess of par value vs. Additional Paid-in capital
● Treasury stock vs. Common Stock in treasury
● Stockholders’ Equity vs. Shareowners’ Equity
The companies selected to illustrate the structure of capital accounts include an automobile manufacturer (Ford), a high-tech computer company (Hewlett-Packard), a grocery chain (Kroger) and a pharmaceutical company (Pfizer).
Capital Accounts for Selected Companies (in millions)
Source: Company Annual Reports
| Ford | HP | Kroger | Pfizer | |
| Preferred Stock | 73 | |||
| Common Stock | 23 | 24 | 955 | 443 |
| Capital in Excess of par value | 9,076 | |||
| Additional Paid-in capital | 14,012 | 3,266 | 70,283 | |
| Accumulated other comprehensive income/(loss) | -(10,085) | -(65) | -(495) | -(4.569) |
| Employee benefit trust | -(425) | |||
| Treasury stock | -(181) | -(57,391) | ||
| Common Stock in treasury | -(6,039) | |||
| Retained earnings (accumulated deficit) | -(16,145) | 24,971 | 7,489 | 49.142 |
| Total Stockholders’ Equity | -(17,311) | 38,942 | 5,176 | 57.556 |
For companies that are structured as corporations, shares of stock, which represent ownership in the company, are issued to the financial markets. As the samples above indicate, stock is issued at par-value (e.g., $1.00) and then sold to investors for prices they are willing to pay. The difference between par-value and what investors actually pay for the stock is “additional paid-in capital.”
After initial capital raising (which might happen in truanches over a period of time), the ongoing operational success of a company’s business drives the amount of capital. The profitability of the company feeds, or starves, the capital accounts. If revenues exceed expenses, then the capital accounts will increase because the amount of “retained earnings” will grow. If revenues do not cover expenses, then the overall capital accounts, the Stockholders’ Equity, will decrease because retained earnings will be lower.
As can be seen from the companies’ capital accounts above, special accounts are set up to handle specific corporate events. The footnotes in the annual reports will provide the nature of such events. Treasury stock are shares, previously issued, that a company buys back when its financial situation and the condition of their stock in the market make it financially worthwhile to remove some of their stock from the investor pool.
Given recent industry history, one can easily see that the capital accounts reflect what is happening in the market place:
● Auto companies are getting hammered
● High tech and pharmaceuticals continue to be in high demand
● Groceries and other staples continue to fulfill ongoing needs
Next in the series: Capital: Its Purpose & Use
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 45
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
Equity-capital: Financial Definitions
November 2nd, 2009
Copyright © 2009 Integrated Profitability TM
The second in a series based on a request to cover “capital”:
“Good! Finally all of this is coming together for me. How about more on capital? What is it? where does it come from, is it actual & stored somewhere physically and separately or virtual like the net or sum of two or more numbers?”
The last article, Capital: An Introduction, painted a high-level picture of the arena in which one finds capital. To put some meat on those bare-bones, here are definitions for the main concepts—in a kind of reverse order:
● Revenue: money that comes into a business. This represents the value of what customers are paying for products and services provided by your business; a.k.a.: income.
● Expense: money that goes out of a business, particularly funds spent to make, deliver and support products and services purchased by customers; a.k.a.: cost.
● Net-Profit: what is leftover from revenue after all expenses are paid. “Net-profit” is merely a mathematical equation and depending on the two inputs, it can be positive (a good thing) or negative (not such a good thing).
● Income Statement: the summary statement that contains revenue and expense, and ends with the difference between the two (revenue minus expense). Net-Profit is either positive or negative. There may not be consensus on what the former is called, but the latter is universally known as “a loss.” Which is why the Income Statement is also known as The Profit and Loss Statement.
● Assets: what you own.
● Liabilities: what you owe.
● Capital: the difference between what you own and what you owe. Like with Net-Profit, this is a mathematical calculation. If Assets are greater than Liabilities, the company has positive capital. If, however, a company’s effort and investment haven’t worked out, Assets may be lower than Liabilities which leaves the company with negative capital.
● Balance Sheet: a summary statement that contains all of a company’s assets, liabilities and capital. In the wonderful world of T-accounts, double-entry bookkeeping, journals and ledgers, Assets are shown on the left half of a page (Note: as you are looking at it; not from the page’s perspective) while the Liabilities and Capital are on the right half of the page. The convention is that Liabilities are always on top—possibly in homage to the fact that if a company goes into a death spiral and splats into bankruptcy, the people holding Liabilities get paid before those holding Capital.
With perfect timing, The Contra Costa Times this morning (November 2, 2009), had an article covering the bankruptcy filing for the CIT Group (Morning Report; “Key Lender files for Chapter 11”; page AA1). Two pertinent points related to capital:
“…, CIT’s bankruptcy filing shows $71 billion in finance and leasing assets against total debt of $64.9 billion.”
“Treasury Department spokesman Andrew Williams said the government will be closely monitoring the bankruptcy proceedings, but acknowledged that “recovery to preferred and common equity holders will be minimal.””
Apparently, good and bad news are twins.
Please let me know if there are other terms for which definitions would be beneficial, or helpful, or add clarity.
Next in the series: The Market & Other Names for Capital
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 44
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
Got Numbers People?
August 27th, 2009
Copyright © 2009 Integrated Profitability TM
If your business is squarely on the road to riches and you “don’t need no stinkin’ Numbers People,” then STOP READING! Go straight to your favorite entertainment place and reward yourself with whatever you enjoy the most.
On the other hand, if your numbers are not everything you would like them to be, then feel free to read on. If your numbers don’t exist, are unknowably mysterious or are plummeting out of control, then definitely continue reading.
You’re in good shape when you have:
● a business model that is clear, easy to understand and comprehensive
● accounting books that are accurate and timely
● financial reporting that is timely, insightful and which acts as an actionable bridge between the accounting numbers and your business processes
● planning that links the financial numbers to the future of the business and incorporates the experience and knowledge of key stakeholders
You’re not in good shape if none of the above exists.
You’re in poor shape if:
● your business model isn’t written down. Or your written business model doesn’t show, precisely, how you make money and where you might lose money.
● your “accounting” is a shoebox full of paper that you (or somebody else) go through once a year…to keep the Tax People happy and off your back
● financial numbers are only pulled together when taxes are due, a government filing is needed, or a potential lender/investor needs background information
● planning is done over coffee and a donut each morning…if ever
You’re in really bad shape if all the conditions of “in poor shape” exist AND you’re losing money hand-over-fist.
Numbers People in Action: Finance Analysis
August 18th, 2009
Copyright © 2009 Integrated Profitability TM
A further continuation of the suggestion that came in to “…include a simple but meaningful scenario which you’d have the three Numbers People work through to posting, reporting and interpretation and planning…” The first article set up the simple scenario, the second dealt with Accountants & Bookkeepers, the third with basic Finance reporting. This article focuses on the analysis that Finance does.
The third step for Finance is to provide analysis and interpretation of the numbers. To the extent possible from the general ledger accounts, Finance will dig into changes in the numbers and provide explanations as to what is causing those changes, as well as identifying interconnected events. They use the information they have reported: what the number are and how they have turned out. The analytical stage focuses on explaining the numbers, and their movement, in terms of what is happening with the business creating the numbers.
For example,
● if the expense figure for the snacks has increased, it would be good if sales revenue has also increased. Even better if it has increased at a faster pace.
● if the amount in inventory is increasing, a fall off in sales would help explain what is going on
● if net profit is increasing, a decrease in expense or an increase in revenue would help explain the beneficial outcome
But what if things aren’t moving in expected, or at least hoped for, ways?
Numbers People in Action: Basic Finance
August 13th, 2009
Copyright © 2009 Integrated Profitability TM
Another continuation of the suggestion that came in to “…include a simple but meaningful scenario which you’d have the three Numbers People work through to posting, reporting and interpretation and planning…” The first article set up the simple scenario, the second dealt with Accountants & Bookkeepers. Now, it’s time for Finance.
Once the close is completed, the Finance Folks grab the numbers-baton and start running. The first step for Finance is to review the numbers from the general ledger close. The purpose of the review is to do a high level check as to whether the numbers “make sense,” whether they past the tummy-test. If something looks out of the ordinary, or outside expectations, Finance will immediately go back to the Accountants and ask for confirmation that the abnormality is accurate: that is, the numbers are an exact reflection of a business transaction.
For example, let’s say sales have been running at $XXX a month for the last six months but this month, they are only 50% of that number (or, better, 150%!). Before involving the Accountants, Finance will first check comparable periods in prior years. If there IS an annual dip (or bump) in sales in this particular month, then there is no question. It is a normal part of the business. If not, the details need to be obtained from the Accountants (who certified the close).
Numbers People in Action: Accountants & Bookkeepers
August 10th, 2009
Copyright © 2009 Integrated Profitability TM
A continuation of the suggestion that came in to “…include a simple but meaningful scenario which you’d have the three Numbers People work through to posting, reporting and interpretation and planning…” The first article set up the simple scenario.
With the business model articulated, Accountants step in. Their job is to determine what all the different transactions mentioned or extrapolated from the Business Plan are–from a financial, general ledger perspective. This determination automatically dictates, in the accounting world, how these transactions need to be booked. The accountant will lay out treatment for both the Income Statement (revenue and expense) and the Balance Sheet (assets, liabilities and capital).
For example,
● buying the snacks is an expense
● selling the snacks to harried hungry people is revenue
● if you pay for the snacks with cash, the warehouse trip will decrease cash (an asset) and increase inventory (also an asset)
● if you pay with a credit card, the warehouse trip will increase your credit card debt (a liability) and increase inventory (an asset)
Isn’t double-entry accounting awe-inspiring?
Number Games
July 2nd, 2009
Copyright © 2009 Integrated Profitability TM
Any blog on finance and profitability must deal with numbers. Which can be tedious and boring. One of the main points behind the “Small Business Finance & Profitability” is that owners and other stakeholders in the business need to actively understand those numbers: which are reporting the direction and health of your business. You can hire others to do the tedious chores, as long as you hire trustworthy and conscientious people. But what can never be sub-contracted, at least not without major risk, is the knowledge of what the numbers are telling you.
An earlier blog, “Numbers People,” provided an introduction to types of jobs and careers that are involved with company numbers. At the end, it was stated that some functions should be separated to some extent as a matter of prudent “checks & balances.”
Here’s an example from a large company. Let’s say the company is experiencing a squeeze on profitability because of a very tough market. Sort of like the one we are in right now. Further, a mandate comes down from management that the whole company has to cut expenses.
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