Understanding Business Structures, Markets, and Financial Ratios
Business Structures
Sole Proprietorship
A firm owned by an individual or family.
The assets and liabilities are the personal assets and liabilities of the proprietor.
- Unlimited liability
- Low administrative costs
Partnership
A firm with 2 owners sharing the equity. A partnership agreement usually stipulates how decisions and profits (losses) are shared.
- General partners: 1 (unlimited liability)
- Limited partners: 0 (don’t manage business)
- Changes in ownership involve dissolving the old partnership and forming a new one.
Corporation
A legal entity, distinct from its ownership.
- May own property, borrow, sue, be sued, and enter into legal contracts.
- Not dissolved when shares are transferred.
- Shareholders elect directors, who appoint management.
- Pays corporate taxes, resulting in double taxation of owner (not sub-chapter S Corp.)
- Limited liability (corporate veil may be lifted)
Financial Markets
Direct Finance
Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets.
Indirect Finance
Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets.
Debt Markets
- Short-Term (maturity < 1 year)
- Long-Term (maturity > 10 year)
- Intermediate term (maturity in-between)
Represented $38.2 trillion at the end of 2012.
Equity Markets
- Pay dividends, in theory forever.
- Represents an ownership claim in the firm.
Total value of all U.S. equity was $18.7 trillion at the end of 2012.
Primary Market
New security issues sold to initial buyers.
Typically involves an investment bank who underwrites the offering.
Secondary Market
Securities previously issued are bought and sold.
Examples include the NYSE and Nasdaq.
Involves both brokers and dealers.
Financial Analysis
Time-Series Analysis
Evaluation of the firm’s financial performance over time using financial ratio analysis.
Cross-Sectional Analysis
Comparison of different firms’ financial ratios at the same point in time; involves comparing the firm’s ratios to those of other firms in its industry or to industry averages.
Arbitrage
Arbitrage
The practice of buying and selling equivalent goods to take advantage of a price difference.
Arbitrage Opportunity
Any situation in which it is possible to make a profit without taking any risk or making any investment.
Key Financial Ratios
- Current ratio = Current assets ÷ Current liabilities
- Average Age of Inventory = 365 ÷ Inventory turnover
- Total asset turnover = Sales ÷ Total assets
- Debt ratio = Total liabilities ÷ Total assets
- Debt to equity = Total liabilities ÷ Common stock equity
- Times interest earned ratio = EBIT ÷ Interest Expense
- Operating profit margin = Operating profits ÷ sales
- Net profit margin = Earnings available for common stockholders ÷ Sales
- Return on total assets (ROA) = Earnings available for common stockholders ÷ Total assets
- Return on Equity (ROE) = Earnings available for common stockholders ÷ Common stock equity
- Price Earnings (P/E) Ratio = Market price per share of common stock ÷ Earnings per share