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Certified Financial Planner Core Curriculum > Chapter 8: Structure & Taxation of Business Entities > Flashcards

Chapter 8: Structure & Taxation of Business Entities Flashcards

1
Q

Which forms can a partnership take?

A

Partnerships between sole proprietors, between entities such as corporations, limited partnerships, and limited liability partnerships.

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2
Q

How is a joint venture different than a partnership?

A

In a joint venture, venturers are typically setting out to accomplish one goal or project while retaining ownership of all assets associated with the venture.

A joint venture is not a separate tax or legal entity.

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3
Q

Do non-profits have to be incorporated?

A

No, although many are.

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4
Q

How is a charity different than a non-profit?

A

The primary difference is that a charity can issue donation receipts.

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5
Q

What qualifies an entity as a charity?

A

Must fulfill one of four purposes…

  1. Relief of poverty
  2. Advancement of education
  3. Advancement of religion
  4. Other such as promotion of health, environment protection, etc.
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6
Q

What is a co-op?

A

Co-operative, a form of corporation owned by an association of individuals with some shared economic interest.

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7
Q

What are the 4 typical co-op structures?

A
  1. Consumer co-op providing goods & services to its members
  2. Producer co-op giving members easier access to markets (farmers, artists, etc.)
  3. Worker co-op (business owned by its employees)
  4. Multi-stakeholder co-op - variety of interests who can achieve disparate goals by unifying efforts
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8
Q

What is a social enterprise?

A

Entity that overlaps between non-profit/charitable purposes and business purposes. May make money, but is generally not profit-oriented (such as thrift stores).

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9
Q

What must a charity do to maintain its status as a charitable organization?

A

File with the CRA each year. These returns can cost in excess of $5K per year to compile and file due to their complexity.

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10
Q

Are most corporations federally or provincially incorporated?

A

Provincially, only a small number are federally incorporated.

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11
Q

When must a business collect GST/HST/PST?

A

Once an activity generates $30K or more of revenues in a fiscal year. Must continue to do so even if revenues subsequently fall below $30K.

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12
Q

Which accounting standards are used in Canada?

A

International financial reporting standards (IFRS). Previously GAAP (Generally Accepted Accounting Principles).

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13
Q

What are the 4 general financial statements for businesses?

A
  1. Income Statement (Statement of Comprehensive Income)
  2. Statement of Financial Position
  3. Statement of Cash Flows
  4. Statement of Changes in Equity
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14
Q

Why do total assets always equal total equity and liabilities on a statement of financial position?

A

Because of double-entry bookkeeping, no entry on a financial statement should be alone. Every debit must have an offsetting credit and vice versa.

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15
Q

What is a Statement of Changes in Equity used for?

A

Describes allocation of profit towards retained earnings and dividends. Useful for determining whether a company is focused on growth or income for shareholders.

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16
Q

What is a statement of cash flows generally used for?

A

Tracking historical changes in different areas such as A/R and inventories.
Generally used to determine if a company is generating positive cash flow.

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17
Q

Why can a statement of cash flows be used to determine if a company is generating positive cash flow above profitability numbers?

A

Sometimes, because of the nature of certain expenditures, a company can be showing a profit on paper, but not actually making any money. Cash flow statement can be used to help determine the true state of a company’s financial position.

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18
Q

Which statement allows management to explain the details of the four financial statements?

A

The Statement of Management Discussion and Analysis

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19
Q

Why do publicly traded companies prepare financial statements?

A

They must be audited by an independent accounting firm.

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20
Q

Which financial statements do smaller businesses sometimes engage accounting firms to prepare?

A

More basic financial statements based on information provided called “Notice to Reader” statements or a “Compilation” of financial information.

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21
Q

What is a CCPC?

A

Canadian-Controlled Private Corporation.

Private corporation controlled by Canadian residents.

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22
Q

What will CCPCs often do when seeking outside investments?

A

Have an accountant prepare financial statements on a Review Engagement. These are statements that are more exacting than Notice to Reader statements, but not as extensive as audited statements.

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23
Q

Which types of financial statements are most common and why?

A

Notice to Reader (or Compilation) statements (rather than audited ones or Review Engagement ones). This is because most entities prepare financial statements for their own internal decision-making.

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24
Q

What is a Review Engagement?

A

Financial statements prepared by an accountant when an entity has other entities to report to. These are more thorough, the accountant has done some investigation and is confident that the entity’s financial statements are an accurate representation of the entity’s activities. May cost twice as much as a Notice to Reader engagement.

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25
Q

What is the difference between audited and non-audited statements?

A

Means the accountant who prepared the statements has done some investigation and asked questions of the entity in question.

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26
Q

What are the 4 types of ratios normally used in the analysis of financial statements?

A
  • Liquidity ratios
  • Debt ratios
  • Profitability ratios
  • Activity ratios
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27
Q

What are liquidity ratios?

A

Describe a business’ ability to come up with cash.

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28
Q

What can be said about a company with a high liquidity ratio?

A

Has lots of cash on hand, may have too much on hand. This could be a sign of a company not knowing how to use its surplus cash or the management team may be frozen by indecision.

29
Q

What is the Quick Ratio?

A

AKA the Acid Test. Current assets minus inventory divided by current liabilities.

30
Q

Which ratio is often used as the primary measure of company solvency?

A

Quick ratio.

31
Q

According to the Quick Ratio, when may a company be considered insolvent?

A

If it has a ratio of less than 1.0.

32
Q

What does a quick ratio of 2.5 indicate?

A

That a company has about $2.50 of cash or near-cash assets on hand for every dollar that it expects to pay over the next 90 days or so.

33
Q

What is the current ratio?

A

Similar to the Quick Ratio in that it measures a company’s liquidity in the short-term, but does not remove inventory.

34
Q

Why is the current ratio generally considered less reliable than the quick ratio?

A

Inventory cannot always be turned into cash, so it is not always a good representation of a company’s liquidity and solvency.

35
Q

What can be determined if a company has a current ratio of 3.99 and a quick ratio of 3.63?

A

Very little of a company’s liquidity is attributable to inventory.

36
Q

What is another term for the current ratio?

A

Working capital ratio.

37
Q

What is considered the most important debt ratio?

A

Interest Coverage Ratio - describes the amount of interest that a business pays compared to its earnings.

38
Q

What is the Interest Coverage Ratio and what is another name for it?

A

Amount of interest that a business pays compared to its earnings. Sometimes called he Times Interest Earned (TIE) ratio. Can be calculated as EBIT divided by interest expense.

39
Q

What does an interest coverage ratio of 1.5 or less indicate? 1 or less?

A

1.5 or less is a strong indicator that a business is at risk for default. At 1 or less, a business will have to use its cash reserves to meet its obligations.

40
Q

What are the 2 common liquidity ratios?

A

Current ratio and quick ratio.

41
Q

What are the 3 common debt ratios?

A

Interest coverage ratio, debt-to-assets, debt-to-equity ratios.

42
Q

What does the debt-to-assets ratio indicate?

A

How much of the business’ value is associated with leverage.

43
Q

What does the debt-to-equity ratio indicate?

A

How much debt a business owes for every dollar that its shareholders own.

44
Q

What are the 5 profitability ratios we focus on?

A
  1. Gross profit margin
  2. Operating profit margin
  3. Net profit margin (bottom line)
  4. Return on assets (ROA)
  5. ROE
45
Q

How do you calculate gross profit margin? What does it indicate?

A

Revenues - COGS / Revenues

Expresses the cost of being in business. Gross profit margin of 90% indicates that 10% of the revenues it generates go directly to Cost of Sales, which are generally interpreted as items beyond mgmt control.

46
Q

How does operating profit margin differ from gross profit margin? How is it calculated? What does it indicate?

A

Takes into account costs that mgmt incurs to run the business, rather than just cost of sales. Answers the question: “how much is left after mgmt pays the bills?”

Gross profit - all expenses (other than interest and taxes) / revenues.

Operating profit margin of 20% means that after operating the business, shareholders/owners are left with 20% of revenues to pay financing costs, taxes, reinvest back into the business, or pay themselves.

47
Q

What is net profit margin and how is it calculated? What does it indicate?

A

Net profit margin expresses what is left once all other expenses and costs have been paid for (including interest and taxes)

Profit / revenues

Indicates how profitable the business is. With a net profit margin of 10%, investors can know that for every dollar of sales, approximately $0.10 ends up available to that investor.

48
Q

What is return on assets and how is it calculated?

A

Measures the business’ return on the total amount of assets in the company. Shows how efficient management is at managing their assets.

ROA = net income / total average assets

49
Q

What would an ROA of 15% indicate?

A

The return on a business’ assets is 15%. If the business is looking to purchase an asset and its cost of borrowing will be 12%, this may make their decision to borrow easier since their cost of borrowing is lower than the return on the asset itself. This is one item to consider.

50
Q

What is ROE, how is it calculated, and when is it used?

A

Describes how good mgmt is at creating profits for a business’ investors. Not always a useful figure and can be easily manipulated.

Profit / Shareholder’s Total Equity

10% ROE indicates that for every $100 that shareholders have invested, they are generating an annual return of $10.

51
Q

What are the problems with ROE?

A

Can be inconsistent from year to year.

Relatively easy to manipulate. (Consider a company that doesn’t reinvest back into its infrastructure, it may have a high ROE but poor future prospects.)

Can be deceptive as to the nature of further investment. As a company grows, it may get harder to generate the returns a smaller company currently is earning.

52
Q

What are activity ratios? What is the most common example of an activity ratio?

A

Often industry-specific ratios that describe how busy the business is and how much it’s using its assets. Inventory turnover ratio is a common example.

53
Q

What are some of the factors involved in pricing a business?

A
  • Earnings (or Net Income/profit)
  • Assets
  • Control (per cent of shares owned)
  • Tax liabilities
  • Intangibles
  • Depreciation
  • Timelines for sale of business
  • Marketability
  • Nature of assets
54
Q

In the event that a business is being sold, who would prefer to sell/purchase the assets and who would prefer to sell/purchase the shares?

A

The seller would generally prefer to sell the shares as the lifetime capital gains exemption can be utilized which is far more efficient for the seller.

The purchaser would generally prefer to purchase the assets. If not, a later sale of those assets would likely trigger capital gains and recapture of depreciation.

55
Q

What are the 4 most common business valuation methods?

A
  1. Liquidation valuation
  2. Going Concern valuation
  3. Discounted Future Earnings
  4. Market Value
56
Q

How does the liquidation valuation work?

A

Subtract liabilities from assets, effectively sell a company for its net worth. This is also known as book value.

57
Q

When would a business be sold at liquidation value?

A

Usually indicates that the sale is not taking place under optimal circumstances.

58
Q

What is the going concern valuation and which figures is this valuation generally based on?

A 
Also known as total value, this is the preferred valuation for selling a business. It's based on the ability to generate profit for investors. 
Generally based on...
- Revenues
- EBITDA
- Net income or earnings or profit
- Seller's discretionary earnings
59
Q

How does the discounted future earnings (DFE) valuation method work?

A

More of an analyst’s tool than a valuation tool. Uses a similar method to TVM to build a price based on the PV of future expected earnings. Discount rate is usually based on the WACC (weighed average cost of capital). The WACC is generally the cost of either borrowing money or raising equity in a business.

60
Q

Describe the market value valuation method.

A

Rarely available for small businesses, but is the ideal method for valuation. This is how publicly traded companies are valued, share price is set by market forces. May be used if there was a recent share sale that can shed some light on the total value of the business.

61
Q

What is the accounting value of goodwill?

A

Difference between the liquidation value and the price at which a business sells. If a company acquires a business for $2M, it had assets of $2.5M and liabilities of $1M, the purchaser would likely record the acquisition of net assets of $1.5M and $500K of goodwill.

62
Q

How does a business end up with a balance of goodwill on its balance sheet?

A

Only through acquisition from another business, cannot be generated organically.

63
Q

What are 5 common types of business lending?

A
  1. Operating line of credit
  2. Commercial mortgage
  3. Business loan
  4. Letter of credit
  5. Leasing
64
Q

How does a business loan differ from an operating line of credit?

A

Normally used for a single purpose.

65
Q

What is a letter of credit?

A

Bank or other financial institution uses its good credit to support a customer in demonstrating financial position. Business can apply for a Letter of Credit to demonstrate to another business or institution that they will be in a sufficient position to fund future projects (like a pre-approval for a business). The letter of credit is then used to pay its costs of entering into a contract with a company and would be redeemed once revenues start to show up. Allows a business to demonstrate financial stability.

66
Q

Why is there more risk involved with business lending than personal lending?

A

Business owners will typically allow their businesses to fail before they let their family’s financial position fail.

67
Q

What is a personal guarantee?

A

A common form of personal collateral used to obtain a business loan. Rather than pledging a specific asset, the personal guarantee allows a lender to seize any personal assets owned by the business owner (other than assets specifically protected by creditor claims).

68
Q

How can a capital gains reserve be used to improve tax efficiency?

A

Allows a seller of capital property (including shares of a business) to report capital gains over several years following a sale, given that they receive payments over several years.

Certified Financial Planner Core Curriculum (16 decks)

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