Chapter 1: The key principles of finance Flashcards
What are the 4 main business structures?
- sole trader
- partnership
- private limited company
- public limited company
What is a sole trader?
- A business owned by one person, that is not a limited company
- Typically this business is small, perhaps with just a few employees
- It is quick and easy to set up (no documentation needed) however, they do need to fill out tax returns
- Unlimited liability: the sole trader is liable for any losses made by the business (all personal wealth is at risk
The owner’s personal wealth is at risk, if the business fails, their assets might be seized
What is a partnership?
Ordinary vs LL
- Set up by more than one person, not as a limited company
- The owners are partners, they may own equal or unequal proportions of the business.
- Profits can be taken out of the partnership and shared amongst the business.
- An ordinary partnership, each partner has unlimited liability.
- A limited liability partnership, enables partners to have limited liability (typically to the amount invested) and is a separate legal entity. There is a defualt agreement if a bespoke one isn’t made
There is usually a partnership agreement in place which governs how the partnership operates. But it is not a legal requirement
What might be included in a partnership agreement?
- The rules for making decisions
- The roles and responsibilities of partners
- The percentage share of profits to which each partner is entitled
- What happens if a partner decides to leave the business
What is a company?
A company has its own distinct legal identity. this means for example:
* it can enter into contracts, such as loan arrangements in its own right
* it can own property, for example a factory
In addition it can sue other parties or be sued and subject to fines.
Owners liability is limited to the fully paid value of their shares
What is a shareholder?
- Almost all limited companies are set up by the issue of shares. Investors who own shares in the company are called shareholders.
- The size of the shareholding can vary.
- They have limited liability, meaning they can only lose the money they invested in the company if the company becomes bankrupt.
- They often have no direct involvement in the day-to-day running of the business.
- However, they normally get the right to vote on certain matters at company meetings and hence at a high level they exert some control on the direction of the company.
- They can also appoint directors who are responsible for the control of the company on their behalf
- They may recieve a return on their investment through dividend payments.
What are dividend payments?
How often are they paid?
A share of a company profits.
They are normally paid half-yearly
What are the two types of company structure?
- Public limited companies where they offer their shares publicly. Most times they are listed on the stock exchange so it is easy for investors to buy/sell. In the UK they have PLC at the end of their name. Most say so in their documentationa and have issued share capital >=£50,000. Name ends in plc (or public limited company)
- Private limited companies, where shares must be bought/sold privately. Generally they are smaller than public ones. Name ends in limited
What is the main aim of shareholders and management? How is this achieved?
- Shareholders - maximise their own wealth
- Management - maximise shareholder wealth
This is achieved by undertaking profitable projects and raising the money to invest in those projects in the most efficient way.
max shareholder wealth is also a goal of other workers who are responsible for making financial decisions
Who runs a company?
Normally shareholders elect a Board of Directors to govern a company on their behalf. Sometimes the directors run the company, sometimes they hire managers, who are experts in their fields to run the company on a day-to-day basis.
The CEO (Chief Executive Officer) normally manages the company and is responsible for the strategic direction of the business and for hiring the rest of the management team.
The CFO (Chief Financial Officer) is responsible for deciding on the resources the company needs and the projects the company should invest in.
The company Treasurer is responsible for raising the money to pay for these resources and projects.
What are the pros and cons of the separation of ownership and management?
Pros:
* Gives management the freedom for the owners to change (i.e. if shares are sold) without day-to-day activites of the company being affected
* Gives managers the freedom to hire/fire personnel to run the business
Cons:
* Different shareholders might have different needs
* Shareholders and managers may have different views on how the company should be run.
How might needs and objectives vary by shareholder?
- Different attitudes towards risk - individuals may be much more risk averse than a large pension scheme.
- Different preferences for receiving the return on shares - some may prefer a regular income stream, others may prefer their shares increasing in value (and making more when they sell it) [This is called a capital gain]
This may be influenced by tax treatment. I.e. shareholders that are taxed more heavily on income will prefer capital gains - Time horizon of their investment - Some want a quick profit, others care more for the long-term fortunes of the company
How does a CFO meet the needs of shareholders?
It is difficult for a CFO to even know the needs of shareholders so they focus on maximising wealth given the following assumptions
* shareholders can pick from a wide range of appropriately priced shares in the market (the market for shares is accesible and competitive)
* they desire to be as rich as possible
* they will choose whichever shares meet their own risk appetite and cashflow needs.
In order to do this, they need to make decisions on what assets to buy, what projects to invest in and how to raise the finance to pay for that.
What are real assets?
Real assets are items owned by a company needed to run its day to day business.
Tangible assets are ones that physically exist (i.e. a factory or machines), intangible assets do not (i.e. brand name or a good relationship with the workforce).
What is an investment budgeting decision?
AKA capital budgeting decision. The choice of real assets or projects to invest in.
It is very important and the choices made will impact the future of the company.
It is normally the concern of the CFO, but managers are often consulted
