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Corporate Finance

Chapter One - Introduction To Corporate Finance

Corporate finance is the study of a business's money-related decisions, whichare essentially all of a business's decisions. Despite its name, corporate finance

applies to all businesses, not just corporations. The primary goal of corporate

finance is to figure out how to maximize a company's value by making good

decisions about investment, financing and dividends. In other words, how

should businesses allocate scarce resources to minimize expenses and

maximize revenues? How should companies acquire these resources - through

stock or bonds, owner capital or bank loans? Finally, what should a company

do with its profits? How much should it reinvest into the company, and howmuch should it pay out to the business's owners? This walkthrough will

explore each of these business decisions in greater depth.

Chapter One - Forms Of Business Organization

A business can be organized in one of several ways, and the form its owners

choose will affect the company's and owners' legal liability and income taxtreatment. Here are the most common options and their major definingcharacteristics.

Sole ProprietorshipThe default option is to be a sole proprietor. With this option there are fewerforms to file than with other business organizations. The business isstructured in such a manner that legal documents are not required todetermine how profit-sharing from business operations will be allocated.

This structure is acceptable if you are the business's sole owner and you donot need to distinguish the business from yourself. Being a sole proprietor doesnot preclude you from using a business name that is different from your ownname, however. In a sole proprietorship all profits, losses, assets and liabilitiesare the direct and sole responsibility of the owner. Also, the sole proprietor willpay self-employment tax on his or her income.

Sole proprietorships are not ideal for high-risk businesses because they putyour personal assets at risk. If you are taking on significant amounts of debt to


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start your business, if you've gotten into trouble with personal debt in the pastor if your business involves an activity for which you might potentially be sued,then you should choose a legal structure that will better protect your personalassets. Nolo, a company whose educational books make legal informationaccessible to the average person, gives several examples of risky businesses,including businesses that involve child care, animal care, manufacturing orselling edible goods, repairing items of value, and providing alcohol. These are

just a few examples. There are many other activities that can make yourbusiness high risk.

If the risks in your line of work are not very high, a good business insurancepolicy can provide protection and peace of mind while allowing you to remain asole proprietor. One of the biggest advantages of a sole proprietorship is theease with which business decisions can be made.

LLC

An LLC is a limited liability company. This business structure protects theowner's personal assets from financial liability and provides some protectionagainst personal liability. There are situations where an LLC owner can still beheld personally responsible, such as if he intentionally does somethingfraudulent, reckless or illegal, or if she fails to adequately separate theactivities of the LLC from her personal affairs.

This structure is established under state law, so the rules governing LLCs varydepending on where your business is located. According to the IRS, most

states do not allow banks, insurance companies or nonprofit organizations tobe LLCs.

Because an LLC is a state structure, there are no special federal tax forms forLLCs. An LLC must elect to be taxed as an individual, partnership orcorporation. You will need to file paperwork with the state if you want to adoptthis business structure, and you will need to pay fees that usually range from$100 to $800. In some states, there is an additional annual fee for being anLLC.

You will also need to name your LLC and file some simple documents, calledarticles of organization, with your state. Depending on your state's laws andyour business's needs, you may also need to create an LLC operatingagreement that spells out each owner's percentage interest in the business,responsibilities and voting power, as well as how profits and losses will beshared and what happens if an owner wants to sell her interest in thebusiness. You may also have to publish a notice in your local newspaperstating that you are forming an LLC.


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CorporationLike the LLC, the corporate structure distinguishes the business entity from itsowner and can reduce liability. However, it is considered more complicated torun a corporation because of tax, accounting, record keeping and paperworkrequirements. Unless you want to have shareholders or your potential clientswill only do business with a corporation, it may not be logical to establish yourbusiness as a corporation from the start - an LLC may be a better choice.

The steps for establishing a corporation are very similar to the steps forestablishing an LLC. You will need to choose a business name, appointdirectors, file articles of incorporation, pay filing fees and follow any otherspecific state/national requirements. (Find out how becoming a corporationcan protect and further your finances. See Should You Incorporate YourBusiness?)

There are two types of corporations: C corporations (C corps) and S

corporations (S corps). C corporations are considered separate tax-payingentities. C corps file their own income tax returns, and income earned remainsin the corporation until it is paid as a salary or wages to the corporation'sofficers and employees. Corporate income is often taxed at lower rates thanpersonal income, so you can save money on taxes by leaving money in thecorporation.

If you're only making enough to get by, however, this won't help you becauseyou'll need to pay almost all of the corporation's earnings to yourself. If the

corporation has shareholders, corporate earnings become subject to doubletaxation in the sense that income earned by the corporation is taxed anddividends distributed to shareholders are also taxed. However, if you are a one-person corporation, you don't have to worry about double taxation.

S corporations are pass-through entities, meaning that their income, losses,deductions and credits pass through the company and become the directresponsibility of the company's shareholders. The shareholders report theseitems on their personal income tax returns, thus S corps avoid the incomedouble taxation that is associated with C corps.

All shareholders must sign IRS form 2553 to make the business an S corp fortax purposes. The IRS also requires S corps to meet the followingrequirements:

Be a domestic corporationHave only allowable shareholders, including individuals, certain trusts and

estatesNot include partnerships, corporations or non-resident alien shareholders


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Have no more than 100 shareholdersHave one class of stockNot be an ineligible corporation (i.e., certain financial institutions, insurance

companies and domestic international sales corporations)

General Partnerships, Limited Partnerships (LP) and Limited LiabilityPartnerships (LLP)

A partnership is a structure appropriate to use if you are not going to be thesole owner of your new business.

In a general partnership, all partners are personally liable for business debts,any partner can be held totally responsible for the business and any partnercan make decisions that affect the whole business.

In a limited partnership, one partner is responsible for decision-making andcan be held personally liable for business debts. The other partner merely

invests in the business. Although the general structure of limited partnershipscan vary, each individual is liable only to the extent of their invested capital.

LLPs are most commonly used by professionals such as doctors and lawyers.The LLP structure protects each partner's personal assets and each partnerfrom debts or liability incurred by the other partners. Different states havevarying regulations regarding these establishments of which business ownersmust take note.

Partnerships must file information returns with the IRS, but they do not fileseparate tax returns. For tax purposes, the partnership's profits or losses passthrough to its owners, so a partnership's income is taxed at the individuallevel. LPs and LLPs are also state entities and must file paperwork and pay feessimilar to those involved in establishing an LLC.

Regardless of the way a business is structured, its owners will have the sameoverarching goals when it comes to the company's financial management.

Chapter One - Goals Of Financial Management

All businesses aim to maximize their profits, minimize their expenses andmaximize their market share. Here is a look at each of these goals.

Maximize Profits A company's most important goal is to make money and keepit. Profit-margin ratios are one way to measure how much money a companysqueezes from its total revenue or total sales.


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There are three key profit-margin ratios: gross profit margin, operating profitmargin and net profit margin.

1. Gross Profit Margin

The gross profit margin tells us the profit a company makes on its cost of sales

or cost of goods sold. In other words, it indicates how efficiently managementuses labor and supplies in the production process.

Gross Profit Margin = (Sales - Cost of Goods Sold)/SalesSuppose that a company has $1 million in sales and the cost of its labor andmaterials amounts to $600,000. Its gross margin rate would be 40% ($1million - $600,000/$1 million).

The gross profit margin is used to analyze how efficiently a company is using

its raw materials, labor and manufacturing-related fixed assets to generateprofits. A higher margin percentage is a favorable profit indicator.

Gross profit margins can vary drastically from business to business and fromindustry to industry. For instance, the airline industry has a gross margin ofabout 5%, while the software industry has a gross margin of about 90%.

2. Operating Profit MarginBy comparing earnings before interest and taxes (EBIT) to sales, operating

profit margins show how successful a company's management has been atgenerating income from the operation of the business:

Operating Profit Margin = EBIT/Sales

If EBIT amounted to $200,000 and sales equaled $1 million, the operatingprofit margin would be 20%.

This ratio is a rough measure of the operating leverage a company can achievein the conduct of the operational part of its business. It indicates how much

EBIT is generated per dollar of sales. High operating profits can mean thecompany has effective control of costs, or that sales are increasing faster thanoperating costs. Positive and negative trends in this ratio are, for the most part,directly attributable to management decisions.

Because the operating profit margin accounts for not only costs of materialsand labor, but also administration and selling costs, it should be a muchsmaller figure than the gross margin.


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3. Net Profit MarginNet profit margins are those generated from all phases of a business, includingtaxes. In other words, this ratio compares net income with sales. It comes asclose as possible to summing up in a single figure how effectively managersrun the business:

Net Profit Margins = Net Profits after Taxes/Sales

If a company generates after-tax earnings of $100,000 on its $1 million ofsales, then its net margin amounts to 10%.

Often referred to simply as a company's profit margin, the so-called bottom lineis the most often mentioned when discussing a company's profitability.

Again, just like gross and operating profit margins, net margins vary betweenindustries. By comparing a company's gross and net margins, we can get agood sense of its non-production and non-direct costs like administration,

finance and marketing costs.

For example, the international airline industry has a gross margin of just 5%.Its net margin is just a tad lower, at about 4%. On the other hand, discountairline companies have much higher gross and net margin numbers. Thesedifferences provide some insight into these industries' distinct cost structures:compared to its bigger, international cousins, the discount airline industryspends proportionately more on things like finance, administration andmarketing, and proportionately less on items such as fuel and flight crew

salaries.

In the software business, gross margins are very high, while net profit marginsare considerably lower. This shows that marketing and administration costs inthis industry are very high, while cost of sales and operating costs arerelatively low.

When a company has a high profit margin, it usually means that it also hasone or more advantages over its competition. Companies with high net profitmargins have a bigger cushion to protect themselves during the hard times.

Companies with low profit margins can get wiped out in a downturn. Andcompanies with profit margins reflecting a competitive advantage are able toimprove their market share during the hard times, leaving them even betterpositioned when things improve again.

Like all ratios, margin ratios never offer perfect information. They are only asgood as the timeliness and accuracy of the financial data that gets fed intothem, and analyzing them also depends on a consideration of the company's


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industry and its position in the business cycle. Margins tell us a lot about acompany's prospects, but not the whole story.

Minimize CostsCompanies use cost controls to manage and/or reduce their businessexpenses. By identifying and evaluating all of the business's expenses,management can determine whether those costs are reasonable and affordable.

Then, if necessary, they can look for ways to reduce costs through methodssuch as cutting back, moving to a less expensive plan or changing serviceproviders. The cost-control process seeks to manage expenses ranging fromphone, internet and utility bills to employee payroll and outside professionalservices.

To be profitable, companies must not only earn revenues, but also controlcosts. If costs are too high, profit margins will be too low, making it difficult fora company to succeed against its competitors. In the case of a public company,

if costs are too high, the company may find that its share price is depressedand that it is difficult to attract investors.

When examining whether costs are reasonable or unreasonable, it's importantto consider industry standards. Many firms examine their costs during thedrafting of their annual budgets.

Maximize Market ShareMarket share is calculated by taking a company's sales over a given period and

dividing it by the total sales of its industry over the same period. This metricprovides a general idea of a company's size relative to its market and itscompetitors. Companies are always looking to expand their share of themarket, in addition to trying to grow the size of the total market by appealingto larger demographics, lowering prices or through advertising. Market shareincreases can allow a company to achieve greater scale in its operations andimprove profitability.

The size of a market is always in flux, but the rate of change depends onwhether the market is growing or mature. Market share increases and

decreases can be a sign of the relative competitiveness of the company'sproducts or services. As the total market for a product or service grows, acompany that is maintaining its market share is growing revenues at the samerate as the total market. A company that is growing its market share will begrowing its revenues faster than its competitors. Technology companies oftenoperate in a growth market, while consumer goods companies generallyoperate in a mature market.


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New companies that are starting from scratch can experience fast gains inmarket share. Once a company achieves a large market share, however, it willhave a more difficult time growing its sales because there aren't as manypotential customers available.

Next we'll take a look at the potential conflicts of interest that can arise in themanagement of a business's finances.

Chapter One - The Agency Problem

An agency relationship occurs when a principal hires an agent to perform some

duty. A conflict, known as an "agency problem," arises when there is a conflict

of interest between the needs of the principal and the needs of the agent.

In finance, there are two primary agency relationships:

Managers and stockholders

Managers and creditors

1. Stockholders versus Managers

If the manager owns less than 100% of the firm's common stock, a potential

agency problem between mangers and stockholders exists.

Managers may make decisions that conflict with the best interests of the

shareholders. For example, managers may grow their firms to escape a

takeover attempt to increase their own job security. However, a takeover may

be in the shareholders' best interest.

2. Stockholders versus Creditors

Creditors decide to loan money to a corporation based on the riskiness ofthe company, its capital structure and its potential capital structure. All of

these factors will affect the company's potential cash flow, which is a creditors'

main concern.

Stockholders, however, have control of such decisions through the

managers.

Since stockholders will make decisions based on their best interests, a

potential agency problem exists between the stockholders and creditors. For


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example, managers could borrow money to repurchase shares to lower the

corporation's share base and increase shareholder return. Stockholders will

benefit; however, creditors will be concerned given the increase in debt that

would affect future cash flows.

Motivating Managers to Act in Shareholders' Best Interests

There are four primary mechanisms for motivating managers to act in

stockholders' best interests:

Managerial compensation

Direct intervention by stockholders

Threat of firing

Threat of takeovers

1. Managerial Compensation

Managerial compensation should be constructed not only to retain competent

managers, but to align managers' interests with those of stockholders as much

as possible.

This is typically done with an annual salary plus performance bonuses and

company shares.

Company shares are typically distributed to managers either as:Performance shares, where managers will receive a certain number

shares based on the company's performance

Executive stock options, which allow the manager to purchase shares at a

future date and price. With the use of stock options, managers are aligned

closer to the interest of the stockholders as they themselves will be

stockholders.

2. Direct Intervention by StockholdersToday, the majority of a company's stock is owned by large institutional

investors, such as mutual funds and pensions. As such, these large

institutional stockholders can exert influence on mangers and, as a result, the

firm's operations.

3. Threat of Firing


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If stockholders are unhappy with current management, they can encourage the

existing board of directors to change the existing management, or stockholders

may re-elect a new board of directors that will accomplish the task.

4. Threat of Takeovers

If a stock price deteriorates because of management's inability to run thecompany effectively, competitors or stockholders may take a controlling

interest in the company and bring in their own managers.

In the next section, we'll examine the financial institutions and financial

markets that help companies finance their operations.

Chapter One - Types Of Financial Institutions And Their Roles

A financial institution is an establishment that conducts financial transactions

such as investments, loans and deposits. Almost everyone deals with financial

institutions on a regular basis. Everything from depositing money to taking out

loans and exchanging currencies must be done through financial institutions.

Here is an overview of some of the major categories of financial institutions and

their roles in the financial system.

Commercial BanksCommercial banks accept deposits and provide security and convenience to

their customers. Part of the original purpose of banks was to offer customers

safe keeping for their money. By keeping physical cash at home or in a wallet,

there are risks of loss due to theft and accidents, not to mention the loss of

possible income from interest. With banks, consumers no longer need to keep

large amounts of currency on hand; transactions can be handled with checks,

debit cards or credit cards, instead.

Commercial banks also make loans that individuals and businesses use to buy

goods or expand business operations, which in turn leads to more deposited

funds that make their way to banks. If banks can lend money at a higher

interest rate than they have to pay for funds and operating costs, they make

money.


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Banks also serve often under-appreciated roles as payment agents within a

country and between nations. Not only do banks issue debit cards that allow

account holders to pay for goods with the swipe of a card, they can also

arrange wire transfers with other institutions. Banks essentially underwrite

financial transactions by lending their reputation and credibility to the

transaction; a check is basically just a promissory note between two people,

but without a bank's name and information on that note, no merchant wouldaccept it. As payment agents, banks make commercial transactions much

more convenient; it is not necessary to carry around large amounts of physical

currency when merchants will accept the checks, debit cards or credit cards

that banks provide.

Investment Banks

The stock market crash of 1929 and ensuing Great Depression caused the

United States government to increase financial market regulation. The Glass-Steagall Act of 1933 resulted in the separation of investment banking from

commercial banking.

While investment banks may be called "banks," their operations are far

different than deposit-gathering commercial banks. An investment bank is a

financial intermediary that performs a variety of services for businesses and

some governments. These services include underwriting debt and equity

offerings, acting as an intermediary between an issuer of securities and theinvesting public, making markets, facilitating mergers and other corporate

reorganizations, and acting as a broker for institutional clients. They may also

provide research and financial advisory services to companies. As a general

rule, investment banks focus on initial public offerings (IPOs) and large public

and private share offerings. Traditionally, investment banks do not deal with

the general public. However, some of the big names in investment banking,

such as JP Morgan Chase, Bank of America and Citigroup, also operate

commercial banks. Other past and present investment banks you may haveheard of include Morgan Stanley, Goldman Sachs, Lehman Brothers and First

Boston.

Generally speaking, investment banks are subject to less regulation than

commercial banks. While investment banks operate under the supervision of

regulatory bodies, like the Securities and Exchange Commission, FINRA, and


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the U.S. Treasury, there are typically fewer restrictions when it comes to

maintaining capital ratios or introducing new products.

Insurance Companies

Insurance companies pool risk by collecting premiums from a large group of

people who want to protect themselves and/or their loved ones against a

particular loss, such as a fire, car accident, illness, lawsuit, disability or death.Insurance helps individuals and companies manage risk and preserve wealth.

By insuring a large number of people, insurance companies can operate

profitably and at the same time pay for claims that may arise. Insurance

companies use statistical analysis to project what their actual losses will be

within a given class. They know that not all insured individuals will suffer

losses at the same time or at all.

BrokeragesA brokerage acts as an intermediary between buyers and sellers to facilitate

securities transactions. Brokerage companies are compensated via commission

after the transaction has been successfully completed. For example, when a

trade order for a stock is carried out, an individual often pays a transaction fee

for the brokerage company's efforts to execute the trade.

A brokerage can be either full service or discount. A full service brokerage

provides investment advice, portfolio management and trade execution. Inexchange for this high level of service, customers pay significant commissions

on each trade. Discount brokers allow investors to perform their own

investment research and make their own decisions. The brokerage still

executes the investor's trades, but since it doesn't provide the other services of

a full-service brokerage, its trade commissions are much smaller.

Investment Companies

An investment company is a corporation or a trust through which individualsinvest in diversified, professionally managed portfolios of securities by pooling

their funds with those of other investors. Rather than purchasing

combinations of individual stocks and bonds for a portfolio, an investor can

purchase securities indirectly through a package product like a mutual fund.


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There are three fundamental types of investment companies: unit investment

trusts (UITs), face amount certificate companies and managed investment

companies. All three types have the following things in common:

An undivided interest in the fund proportional to the number of shares held

Diversification in a large number of securities

Professional managementSpecific investment objectives

Let's take a closer look at each type of investment company.

Unit Investment Trusts (UITs)

A unit investment trust, or UIT, is a company established under an indenture

or similar agreement. It has the following characteristics:

The management of the trust is supervised by a trustee.

Unit investment trusts sell a fixed number of shares to unit holders, who

receive a proportionate share of net income from the underlying trust.

The UIT security is redeemable and represents an undivided interest in a

specific portfolio of securities.

The portfolio is merely supervised, not managed, as it remains fixed for the

life of the trust. In other words, there is no day-to-day management of the

portfolio.

Face Amount Certificates

A face amount certificate company issues debt certificates at a predetermined

rate of interest. Additional characteristics include:

Certificate holders may redeem their certificates for a fixed amount on a

specified date, or for a specific surrender value, before maturity.

Certificates can be purchased either in periodic installments or all at oncewith a lump-sum payment.

Face amount certificate companies are almost nonexistent today.

Management Investment Companies

The most common type of investment company is the management investment

company, which actively manages a portfolio of securities to achieve its

investment objective. There are two types of management investment company:


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closed-end and open-end. The primary differences between the two come down

to where investors buy and sell their shares - in the primary or secondary

markets - and the type of securities the investment company sells.

Closed-End Investment Companies: A closed-end investment company

issues shares in a one-time public offering. It does not continually offer new

shares, nor does it redeem its shares like an open-end investment company.Once shares are issued, an investor may purchase them on the open market

and sell them in the same way. The market value of the closed-end fund's

shares will be based on supply and demand, much like other securities.

Instead of selling at net asset value, the shares can sell at a premium or at a

discount to the net asset value.

Open-End Investment Companies: Open-end investment companies, also

known as mutual funds, continuously issue new shares. These shares mayonly be purchased from the investment company and sold back to the

investment company. Mutual funds are discussed in more detail in the

Variable Contracts section.

Read more: Series 26 Exam Guide: Investment Companies

Nonbank Financial Institutions

The following institutions are not technically banks but provide some of thesame services as banks.

Savings and Loans

Savings and loan associations, also known as S&Ls or thrifts, resemble banks

in many respects. Most consumers don't know the differences between

commercial banks and S&Ls. By law, savings and loan companies must have

65% or more of their lending in residential mortgages, though other types of

lending is allowed.

S&Ls emerged largely in response to the exclusivity of commercial banks.

There was a time when banks would only accept deposits from people of

relatively high wealth, with references, and would not lend to ordinary workers.

Savings and loans typically offered lower borrowing rates than commercial

banks and higher interest rates on deposits; the narrower profit margin was a

byproduct of the fact that such S&Ls were privately or mutually owned.


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Credit Unions

Credit unions are another alternative to regular commercial banks. Credit

unions are almost always organized as not-for-profit cooperatives. Like banks

and S&Ls, credit unions can be chartered at the federal or state level. Like

S&Ls, credit unions typically offer higher rates on deposits and charge lower

rates on loans in comparison to commercial banks.

In exchange for a little added freedom, there is one particular restriction on

credit unions; membership is not open to the public, but rather restricted to a

particular membership group. In the past, this has meant that employees of

certain companies, members of certain churches, and so on, were the only

ones allowed to join a credit union. In recent years, though, these restrictions

have been eased considerably, very much over the objections of banks.

Shadow Banks

The housing bubble and subsequent credit crisis brought attention to what is

commonly called "the shadow banking system." This is a collection of

investment banks, hedge funds, insurers and other non-bank financial

institutions that replicate some of the activities of regulated banks, but do not

operate in the same regulatory environment.

The shadow banking system funneled a great deal of money into the U.S.residential mortgage market during the bubble. Insurance companies would

buy mortgage bonds from investment banks, which would then use the

proceeds to buy more mortgages, so that they could issue more mortgage

bonds. The banks would use the money obtained from selling mortgages to

write still more mortgages.

Many estimates of the size of the shadow banking system suggest that it had

grown to match the size of the traditional U.S. banking system by 2008.

Apart from the absence of regulation and reporting requirements, the nature of

the operations within the shadow banking system created several problems.

Specifically, many of these institutions "borrowed short" to "lend long." In other

words, they financed long-term commitments with short-term debt. This left

these institutions very vulnerable to increases in short-term rates and when

those rates rose, it forced many institutions to rush to liquidate investments


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and make margin calls. Moreover, as these institutions were not part of the

formal banking system, they did not have access to the same emergency

funding facilities. (Learn more in The Rise And Fall Of The Shadow Banking

System.)

Next, let's learn about the types of financial markets in which these financial

institutions operate.

Chapter One - Types Of Financial Markets And Their Roles

A financial market is a broad term describing any marketplace where buyers

and sellers participate in the trade of assets such as equities, bonds,

currencies and derivatives. Financial markets are typically defined by having

transparent pricing, basic regulations on trading, costs and fees, and market

forces determining the prices of securities that trade.

Financial markets can be found in nearly every nation in the world. Some are

very small, with only a few participants, while others - like the New York Stock

Exchange (NYSE) and the forex markets - trade trillions of dollars daily.

Investors have access to a large number of financial markets and exchangesrepresenting a vast array of financial products. Some of these markets have

always been open to private investors; others remained the exclusive domain of

major international banks and financial professionals until the very end of the

twentieth century.

Capital Markets

A capital market is one in which individuals and institutions trade financial

securities. Organizations and institutions in the public and private sectors also

often sell securities on the capital markets in order to raise funds. Thus, this

type of market is composed of both the primary and secondary markets.


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Any government or corporation requires capital (funds) to finance its

operations and to engage in its own long-term investments. To do this, a

company raises money through the sale of securities - stocks and bonds in the

company's name. These are bought and sold in the capital markets.

Stock Markets

Stock markets allow investors to buy and sell shares in publicly traded

companies. They are one of the most vital areas of a market economy as they

provide companies with access to capital and investors with a slice of

ownership in the company and the potential of gains based on the company's

future performance.

This market can be split into two main sections: the primary market and the

secondary market. The primary market is where new issues are first offered,

with any subsequent trading going on in the secondary market.

Bond Markets

A bond is a debt investment in which an investor loans money to an entity

(corporate or governmental), which borrows the funds for a defined period oftime at a fixed interest rate. Bonds are used by companies, municipalities,

states and U.S. and foreign governments to finance a variety of projects and

activities. Bonds can be bought and sold by investors on credit markets

around the world. This market is alternatively referred to as the debt, credit or

fixed-income market. It is much larger in nominal terms that the world's stock

markets. The main categories of bonds are corporate bonds, municipal bonds,

and U.S. Treasury bonds, notes and bills, which are collectively referred to as

simply "Treasuries." (For more, see the Bond Basics Tutorial.)

Money Market

The money market is a segment of the financial market in which financial

instruments with high liquidity and very short maturities are traded. The

money market is used by participants as a means for borrowing and lending in


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the short term, from several days to just under a year. Money market

securities consist of negotiable certificates of deposit (CDs), banker's

acceptances, U.S. Treasury bills, commercial paper, municipal notes,

eurodollars, federal funds and repurchase agreements (repos). Money market

investments are also called cash investments because of their short maturities.

The money market is used by a wide array of participants, from a company

raising money by selling commercial paper into the market to an investor

purchasing CDs as a safe place to park money in the short term. The money

market is typically seen as a safe place to put money due the highly liquid

nature of the securities and short maturities. Because they are extremely

conservative, money market securities offer significantly lower returns than

most other securities. However, there are risks in the money market that any

investor needs to be aware of, including the risk of default on securities suchas commercial paper. (To learn more, read our Money Market Tutorial.)

Cash or Spot Market

Investing in the cash or "spot" market is highly sophisticated, with

opportunities for both big losses and big gains. In the cash market, goods are

sold for cash and are delivered immediately. By the same token, contracts

bought and sold on the spot market are immediately effective. Prices are

settled in cash "on the spot" at current market prices. This is notably different

from other markets, in which trades are determined at forward prices.

The cash market is complex and delicate, and generally not suitable for

inexperienced traders. The cash markets tend to be dominated by so-called

institutional market players such as hedge funds, limited partnerships and

corporate investors. The very nature of the products traded requires access to

far-reaching, detailed information and a high level of macroeconomic analysis

and trading skills.

Derivatives Markets


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The derivative is named so for a reason: its value is derived from its underlying

asset or assets. A derivative is a contract, but in this case the contract price is

determined by the market price of the core asset. If that sounds complicated,

it's because it is. The derivatives market adds yet another layer of complexity

and is therefore not ideal for inexperienced traders looking to speculate.

However, it can be used quite effectively as part of a risk management

program. (To get to know derivatives, read The Barnyard Basics Of Derivatives.)

Examples of common derivatives are forwards, futures, options, swaps and

contracts-for-difference (CFDs). Not only are these instruments complex but so

too are the strategies deployed by this market's participants. There are also

many derivatives, structured products and collateralized obligations available,

mainly in the over-the-counter (non-exchange) market, that professional

investors, institutions and hedge fund managers use to varying degrees butthat play an insignificant role in private investing.

Forex and the Interbank Market

The interbank market is the financial system and trading of currencies among

banks and financial institutions, excluding retail investors and smaller trading

parties. While some interbank trading is performed by banks on behalf of large

customers, most interbank trading takes place from the banks' own accounts.

The forex market is where currencies are traded. The forex market is the

largest, most liquid market in the world with an average traded value that

exceeds $1.9 trillion per day and includes all of the currencies in the world.

The forex is the largest market in the world in terms of the total cash value

traded, and any person, firm or country may participate in this market.

There is no central marketplace for currency exchange; trade is conducted over

the counter. The forex market is open 24 hours a day, five days a week and

currencies are traded worldwide among the major financial centers of London,

New York, Tokyo, Zrich, Frankfurt, Hong Kong, Singapore, Paris and Sydney.


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Until recently, forex trading in the currency market had largely been the

domain of large financial institutions, corporations, central banks, hedge funds

and extremely wealthy individuals. The emergence of the internet has changed

all of this, and now it is possible for average investors to buy and sell

currencies easily with the click of a mouse through online brokerage accounts.

(For further reading, see The Foreign Exchange Interbank Market.)

Primary Markets vs. Secondary Markets

A primary market issues new securities on an exchange. Companies,

governments and other groups obtain financing through debt or equity based

securities. Primary markets, also known as "new issue markets," are facilitated

by underwriting groups, which consist of investment banks that will set a

beginning price range for a given security and then oversee its sale directly to

investors.

The primary markets are where investors have their first chance to participate

in a new security issuance. The issuing company or group receives cash

proceeds from the sale, which is then used to fund operations or expand the

business. (For more on the primary market, see our IPO Basics Tutorial.)

The secondary market is where investors purchase securities or assets from

other investors, rather than from issuing companies themselves. The Securities

and Exchange Commission (SEC) registers securities prior to their primary

issuance, then they start trading in the secondary market on the New York

Stock Exchange, Nasdaq or other venue where the securities have been

accepted for listing and trading. (To learn more about the primary and

secondary market, read Markets Demystified.)

The secondary market is where the bulk of exchange trading occurs each day.

Primary markets can see increased volatility over secondary markets because it

is difficult to accurately gauge investor demand for a new security until several

days of trading have occurred. In the primary market, prices are often set


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beforehand, whereas in the secondary market only basic forces like supply and

demand determine the price of the security.

Secondary markets exist for other securities as well, such as when funds,

investment banks or entities such as Fannie Mae purchase mortgages from

issuing lenders. In any secondary market trade, the cash proceeds go to aninvestor rather than to the underlying company/entity directly. (To learn more

about primary and secondary markets, read A Look at Primary and Secondary

Markets.)

The OTC Market

The over-the-counter (OTC) market is a type of secondary market also referredto as a dealer market. The term "over-the-counter" refers to stocks that are not

trading on a stock exchange such as the Nasdaq, NYSE or American Stock

Exchange (AMEX). This generally means that the stock trades either on the

over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these

networks is an exchange; in fact, they describe themselves as providers of

pricing information for securities. OTCBB and pink sheet companies have far

fewer regulations to comply with than those that trade shares on a stock

exchange. Most securities that trade this way are penny stocks or are from

very small companies.

Third and Fourth Markets

You might also hear the terms "third" and "fourth markets." These don't

concern individual investors because they involve significant volumes of shares

to be transacted per trade. These markets deal with transactions between

broker-dealers and large institutions through over-the-counter electronicnetworks. The third market comprises OTC transactions between broker-

dealers and large institutions. The fourth market is made up of transactions

that take place between large institutions. The main reason these third and

fourth market transactions occur is to avoid placing these orders through the

main exchange, which could greatly affect the price of the security. Because

access to the third and fourth markets is limited, their activities have little

effect on the average investor.


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Financial institutions and financial markets help firms raise money. They can

do this by taking out a loan from a bank and repaying it with interest, issuing

bonds to borrow money from investors that will be repaid at a fixed interest

rate, or offering investors partial ownership in the company and a claim on its

residual cash flows in the form of stock.

Financial Statements - Introduction

Financial reporting is the method a firm uses to convey its financial

performance to the market, its investors, and other stakeholders. The objective

of financial reporting is to provide information on the changes in a firms

performance and financial position that can be used to make financial and

operating decisions. In addition to being a management aid, this information isused by analysts to forecast the firms ability to produce future earnings and

as a means to assess the firms intrinsic value. Other stakeholders, such as

creditors, will use financial statements as a way to evaluate the companys

economic and competitive strength.

The timing and the methodology used to record revenues and expenses may

also impact the analysis and comparability of financial statements acrosscompanies. Financial statements are prepared in most cases on the basis of

three basic premises:

1. The company will continue to operate (going-concern assumptions).

2. Revenues are reported as they are earned within the specified accountingperiod (revenues-recognition principle).

3. Expenses should match generated revenues within the specified accounting

period (matching principle).


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Furthermore, financial statements are prepared using one of two basic

accounting methods:

1. Cash-basis accounting - This method consists of recognizing revenue

(income) and expenses when payments are made (when checks are issued) or

when cash is received (and deposited in the bank).

2. Accrual accounting - This method consists of recognizing revenue in the

accounting period in which it is earned, that is, when the company provides a

product or service to a customer, regardless of when the company gets paid.

Expenses are recorded when they are incurred instead of when they are paid

for.

Financial statements dont fit into a single mold. Many articles and books on

financial statement analysis take a one-size-fits-all approach. The less-

experienced investor then gets lost when he or she encounters a presentation

of accounts that falls outside the so-called "typical" company. Remember that

the diverse nature of business activities results in different financial statement

presentations.

The balance sheet is particularly likely to be presented differently from

company to company; the income and cash flow statements are less

susceptible to this phenomenon.

Knowing how to work with the numbers in a company's financial statements is

an essential skill. The meaningful interpretation and analysis of balance

sheets, income statements and cash flow statements to discern a company's

investment qualities is the basis for smart investment choices.

Financial Statements - The Balance Sheet

The balance sheet provides information on what the company owns (its assets),

what it owes (its liabilities) and the value of the business to its stockholders

(the shareholders' equity) as of a specific date. It's called a balance sheet


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because the two sides balance out. This makes sense: a company has to pay

for all the things it has (assets) by either borrowing money (liabilities) or getting

it from shareholders (shareholders' equity).

Assets are economic resources that are expected to produce economic

benefits for their owner

Liabilities are obligations the company has to outside parties. Liabilities

represent others' rights to the company's money or services. Examples include

bank loans, debts to suppliers and debts to employees.

Shareholders' equity is the value of a business to its owners after all of its

obligations have been met. This net worth belongs to the owners. Shareholders'

equity generally reflects the amount of capital the owners have invested, plus

any profits generated that were subsequently reinvested in the company.

The balance sheet must follow the following formula:

Total Assets = Total Liabilities + Shareholders' Equity

Each of the three segments of the balance sheet will have many accounts

within it that document the value of each segment. Accounts such as cash,

inventory and property are on the asset side of the balance sheet, while on the

liability side there are accounts such as accounts payable or long-term debt.

The exact accounts on a balance sheet will differ by company and by industry,as there is no one set template that accurately accommodates the differences

between varying types of businesses.

A balance sheet looks like this:


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Here are the entries youll find on a balance sheet and what each one means.Total Assets

Total assets on the balance sheet are composed of the following:

Current Assets - These are assets that may be converted into cash, sold or

consumed within a year or less. These usually include:

Cash - This is what the company has in cash in the bank. Cash is reported

at its market value at the reporting date in the respective currency in which

the financials are prepared. Different cash denominations are converted at the

market conversion rate.

Marketable securities (short-term investments) - These can be both equity

and/or debt securities for which a ready market exists. Furthermore,


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management expects to sell these investments within one year's time. These

short-term investments are reported at their market value.

Accounts receivable - This represents the money that is owed to the

company for the goods and services it has provided to customers on credit.

Every business has customers that will not pay for the products or services the

company has provided. Management must estimate which customers are

unlikely to pay and create an account called allowance for doubtful accounts.

Variations in this account will impact the reported sales on the income

statement. Accounts receivable reported on the balance sheet are net of their

realizable value (reduced by allowance for doubtful accounts).

Notes receivable - This account is similar in nature to accounts receivable

but it is supported by more formal agreements such as a "promissory notes"

(usually a short-term loan that carries interest). Furthermore, the maturity of

notes receivable is generally longer than accounts receivable but less than ayear. Notes receivable is reported at its net realizable value (the amount that

will be collected).

Inventory - This represents raw materials and items that are available for

sale or are in the process of being made ready for sale. These items can be

valued individually by several different means, including at cost or current

market value, and collectively by FIFO (first in, first out), LIFO (last in, first

out) or average-cost method. Inventory is valued at the lower of the cost or

market price to preclude overstating earnings and assets.

Prepaid expenses - These are payments that have been made for services

that the company expects to receive in the near future. Typical prepaid

expenses include rent, insurance premiums and taxes. These expenses are

valued at their original (or historical) cost.

Long-Term assets - These are assets that may not be converted into cash, soldor consumed within a year or less. The heading "Long-Term Assets" is usually

not displayed on a company's consolidated balance sheet. However, all items

that are not included in current assets are considered long-term assets. These

are:


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Investments - These are investments that management does not expect to

sell within the year. These investments can include bonds, common stock,

long-term notes, investments in tangible fixed assets not currently used in

operations (such as land held for speculation) and investments set aside in

special funds, such as sinking funds, pension funds and plan-expansion

funds. These long-term investments are reported at their historical cost or

market value on the balance sheet.

Fixed assets - These are durable physical properties used in operations that

have a useful life longer than one year. This includes:

Machinery and equipment - This category represents the total machinery,

equipment and furniture used in the company's operations. These assets are

reported at their historical cost less accumulated depreciation.

Buildings or Plants - These are buildings that the company uses for its

operations. These assets are depreciated and are reported at historical cost

less accumulated depreciation.

Land - The land owned by the company on which the company's

buildings or plants are sitting on. Land is valued at historical cost and is not

depreciable under U.S. GAAP.

Other assets - This is a special classification for unusual items that cannot

be included in one of the other asset categories. Examples include deferred

charges (long-term prepaid expenses), non-current receivables and advances to

subsidiaries.

Intangible assets - These are assets that lack physical substance but provide

economic rights and advantages: patents, franchises, copyrights, goodwill,

trademarks and organization costs. These assets have a high degree of

uncertainty in regard to whether future benefits will be realized. They are

reported at historical cost net of accumulated depreciation.

Total Liabilities

Liabilities have the same classifications as assets: current and long term.


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Current liabilities - These are debts that are due to be paid within one year or

the operating cycle, whichever is longer. Such obligations will typically involve

the use of current assets, the creation of another current liability or the

providing of some service.

Usually included in this section are:

Bank indebtedness - This amount is owed to the bank in the short term,

such as a bank line of credit.

Accounts payable - This amount is owed to suppliers for products and

services that are delivered but not paid for.

Wages payable (salaries), rent, tax and utilities - This amount is payable to

employees, landlords, government and others.

Accrued liabilities (accrued expenses) - These liabilities arise because an

expense occurs in a period prior to the related cash payment. This accounting

term is usually used as an all-encompassing term that includes customer

prepayments, dividends payables and wages payables, among others.

Notes payable (short-term loans) - This is an amount that the company owes

to a creditor, and it usually carries an interest expense.

Unearned revenues (customer prepayments) - These are payments received

by customers for products and services the company has not delivered or for

which the company has not yet started to incur any cost for delivery.

Dividends payable - This occurs as a company declares a dividend but has

not yet paid it out to its owners.Current portion of long-term debt - The currently maturing portion of the

long-term debt is classified as a current liability. Theoretically, any related

premium or discount should also be reclassified as a current liability.

Current portion of capital-lease obligation - This is the portion of a long-

term capital lease that is due within the next year.


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4. Long-term Liabilities - These are obligations that are reasonably expected to

be liquidated at some date beyond one year or one operating cycle. Long-term

obligations are reported as the present value of all future cash payments.

Usually included are:

Notes payables - This is an amount the company owes to a creditor, whichusually carries an interest expense.

Long-term debt (bonds payable) - This is long-term debt net of current

portion.

Deferred income tax liability - GAAP allows management to use different

accounting principles and/or methods for reporting purposes than it uses for

corporate tax fillings to the IRS. Deferred tax liabilities are taxes due in the

future (future cash outflow for taxes payable) on income that has already beenrecognized for the books. In effect, although the company has already

recognized the income on its books, the IRS lets it pay the taxes later due to

the timing difference. If a company's tax expense is greater than its tax

payable, then the company has created a future tax liability (the inverse would

be accounted for as a deferred tax asset).

Pension fund liability - This is a company's obligation to pay its past and

current employees' post-retirement benefits; they are expected to materialize

when the employees take their retirement for structures like a defined-benefit

plan. This amount is valued by actuaries and represents the estimated present

value of future pension expense, compared to the current value of the pension

fund. The pension fund liability represents the additional amount the company

will have to contribute to the current pension fund to meet future obligations.

Long-term capital-lease obligation - This is a written agreement under which

a property owner allows a tenant to use and rent the property for a specified

period of time. Long-term capital-lease obligations are net of current portion.


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