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Finance 101

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Agenda

An Introduction to Accounting

Types of Financing

Corporate Structure

Markets

Valuation

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Accounting in 20 minutes

Accounting is the language of business

Its a way to track and report financial status and transacti

For example, accountants generate financial statements th

where money is in the business, how much money they m

much money they spent, etc.

The financial statements accountants generate and reevery year (and fourth of a year) are investors best s

information

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Accounting in 20 minutes

Accounting revolves around one key idea

The accounting equation:

Assets = Liabilities + Owners Equit

Resources of the business (assets) are either from mon

we got from loans (liabilities) or from our personal

investment or others (Owners Equity)

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The Accounting Equation

You decide to open a lemonade stand and calculate tha

need $100 to cover a table, cups, lemons, and water.

You crack open the piggy bank and find $50 and decide

contribute it to your new business venture. This is equi

You talk to your parents and they offer to cover the last

tell you that you have to pay them back. This is called d

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The Accounting Equation

Assets = Liabilities + Owners Equit$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 th

resources you receive from funding sources (yourse

bank, your parents loan)

This always happens. The accounting equation is alw

in balance

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The Accounting Equation

Assets = Liabilities + Owners Equit$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 arent required

to pay equity holders

anything for their

investment, but by investing

in equity, these shareholdersget a controlling interest in a

business and a share of

profits.

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Accounting Statements

Investors use 3 main financial statements to assess a

The Balance Sheet- a snapshot of the assets, liabilities, an

the business on a specific day

The Income Statement- shows how much money a compa

in from sales and the expenses it paid to make that revenu

past year The Statement of Cash Flows- shows how much cash a com

brought in and how much cash it paid out over the past ye

Can be found by searching company name 10-k

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The Balance Sheet

Broken into Assets, Liabilities, and Equity

Assets section has dollar value of the cash in bank, equipm

buildings, inventory the company plans to sell, and more

Liabilities section has dollar value of loans the company to

Equity section has dollar value of money contributed by in

owners, as well as the amount of recycled profits in the bu

How do investors use this information?

We look at if a company has enough cash to cover payme

liabilities and how much interest a company has to pay on

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The Balance Sheet

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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).

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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 re

becomes profit after costs are taken out), we can compare

company to a similar company and see which company is

efficient By comparing with previous years, we can assess trends li

company continually making more revenue each year? Are

(efficiency) improving year-over-year?

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The Income Statement

Revenue $100,000Less: 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 gros

% of sale

after takis 40%

30% ope

margin

25% profit

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The Statement of Cash Flows

Broken into 3 sections:

Net Cash Flows from Operations- Cash flows generated fro

business activities

Net Cash Flows from Financing- Cash flows generated from

loans, or paying them off

Net Cash Flows from Investing- Cash generated from sellinlong-term assets (buildings, land, equipment)

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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

and end up making it go bankrupt or out of business

We look at operating cash flows to tell us if a company is m

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 exa

business earns and pays out.

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Summary of Accounting

Accounting serves as our means of understanding a c

financial situation through the usage of financial stat

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 +/- Financin

Investing CF = Net CF

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Financing

You realize that you are actually a lemonade-making

and want to expand your business to the entire state

Maryland.

Youve exhausted your own personal contribution ($5

your parents refuse to loan you several million dollar

Where do you go, what do you do?

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Financing

Businesses have a number of sources to tap into for f

Can receive capitalfrom:

Venture Capital Funds- investment funds set up to contrib

to start-up companies in return for a large share of owner

Banks- can give you a loan (a contract to pay back principa

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

you sell part of full ownership of your company in the form

to raise money or organize a bond (publicly traded debt) o

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Capital Financing

Financing is broken into two categories

Debt (found under liabilities section of balance sheet)

Equity (found under equity section of balance sheet)

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Capital Financing: Debt

Your lemonade stand can raise debtto fund its growt

Terminology:

Par value: Initial amount paid by investor; returned at ma

Interest/Coupon: Amount paid periodically to investors

Types of Debt:

Bonds (source - public markets)

Loans (source - privately traded ornot traded)

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So what does debt look like?

BOND

$100,000 Face Value

5 Year Life

Interest paid every year end @10% of

Principal

As a financial institution or lender, you give

$100,000, and receive 5 payments of $10,00

course of the bonds life.

At the end of the 5th year, you receive the la

interest payment and your $100,000.

As an borrower, the transaction is flipped. Y

the $100,000 to finance your activities, but

return the money (and pay interest periodic

So when you borrow money, you need a pla

back, otherwise the lender has legal rights t

your companys assets.

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Capital Financing: Equity

You can also raise equityto fund its growth

Terminology:

Stock: a share of ownership in a company

Initial Public Offering: initial issuance of stock by a comp

Secondary Markets: investors exchanging securities

Types of Equity:

Common Stock: no guaranteed dividend, voting power

Preferred Stock: guaranteed a dividend, no vote

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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 co

divided up into million

and sold off to investo

stocks.

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Debt vs Equity

Debt

Advantages:

Doesnt 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

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Issuing Equity

When looking to expand your business, you decide th

need to raise $100 million and decide to pursue it threquity financing.

To raise your $100M, you can sell 1M shares at $100

2M shares at $50 apiece or 10M shares at $10 apiece

is important because it shows that share price has nodo with value. You could issue 100 shares at $1M eac

doesnt make your company more valuable.

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Issuing Equity

An investment bank decides how much your compan

then decides what percentage of the company is wor$100M. It then takes the shares to be issued to raise

money and finds investors who are willing to buy the

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

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

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Corporate Structure

Shareholders

Board of Directors & Chairman

Managers, CEO, CFO, COO, CIO

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Problems in the Corporate Structu

The goal of the corporation is to maximize money for

shareholders. If the corporation is making a profit andmanagement gets rewarded for profits, shouldnt their

be aligned?NO! Many times management is more concerned with short-term prof

maximize how good they look, where as shareholders want to maximiz

period, not at the expense of later periods.

Theres also a problem of shareholders having high demands on a quar

(when financial statements are released) that stress managements pla

future.

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Why is this important?

When evaluating a company to invest in, managemen

company is incredibly important. We look at a number of factors to assess the quality of ma

Historical performance at the company and at other companies

Big spender vs. too frugal

Plans outlined

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Markets

So what exactly is a market?

Its a medium for buyers and sellers to exchange goods.

Its 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

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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

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Markets

A stocks priceline is actually just millions of trades lik

plotted and traced, meaning that if you see the priceAAPL at $450.13, that means that the last transaction

the agreed upon price of $450.13.

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Markets

Do fluctuations in a stocks price affect the company

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 companys hands), some companies

compensate their employees with stock options (more onthese next time) that increase in value if the stock performs

well.

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Valuation

At this point weve discussed:

accounting methodologies that provide us with informatiocan use to make informed investment decisions

A general idea of where stocks come from (equity financinIPOs)

How a corporation is structured

What a market is

So how do we determine where the stocks price will years?

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An Introduction to Valuation Metho

Intrinsic Valuation

Discounted Cash Flow Model- We forecast out a companies amake cash in the future, then add it all up and divide by how m

it has to find what the share price should be.

Relative Valuation

Company Comparables Model- we look at how much similar c

are trading at with respect to a measurement of company prof

Precedent Transaction Model- we look at how much similar co

were acquired by other companies for, and use these numbers

determine valuation

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Next Time

Either relative valuation or options/derivatives marke

depending on cheering.