1. Explain why investors should use the statement of cash flows.
Cash flow is one of the most important measurements used by investors in valuing a company. You will hear the term used in the context of understanding how much a company is really growing (or not) after accounting conventions are stripped out of the income statement.
Cash flow measures the amount of cash that a company brings in and uses during the course of an accounting period (quarter or year) after all fixed expenses are eliminated.
This number is frequently called earnings before interest, taxes, depreciation and amortization (EBITDA).
The reason investors are interested in cash flow is that it gives them a clearer picture of what the company is truly doing.
Deductions
When you begin deducting interest, taxes, depreciation and amortization, you distort what positive or negative cash flows the company’s operations generated.
The four items (interest, taxes, depreciation and amortization) have nothing to do with the company’s actual operations and are accounting conventions for reducing income for tax purposes. Here’s how each one distorts operating performance: * Interest – Companies can deduct interest expense from their income for tax purposes. This deduction will change from year-to-year as more or less debt is on the books. * Taxes – Taxes are subject to change as laws change and the company’s business and accounting practices may change. This deduction also reduces net income. * Depreciation – The tax code allows companies to deduct a portion of the value of an asset each year over a predetermined schedule. This schedule should coincide with the useful life of the asset. For example, if the company bought a piece of equipment with a 10-year useful life, it could take one-tenth of its value as a deduction each year. This matches the expense of the equipment with the income it generates over its 10-year life. * Amortization – Amortization is the same as depreciation except for intangibles such as goodwill from the acquisition of a company. In this case, if the company paid more than the shareholder equity (a premium) the excess is goodwill and the company would amortize the cost.
Non-Cash Deductions
It is important to note that both depreciation and amortization are non-cash items, that is they are expenses on paper only and do not involve any cash, yet they reduce the company’s net income on the books.
Companies that make heavy investments in capital equipment or buildings and real estate may have so much depreciation that they show very little if any in the way of earnings, yet may be generating strong cash flows.
How to Use
Cash flow is an important measurement and is best understood when you compare a company to its peers and to the market.
Fortunately, a number of Web sites make the calculations for you. One of the best is Reuters.com.
Enter the symbol of the company and go to the quote page. On the left side navigation, click on “ratios.” This will take you to a page of valuation ratios where you will find the cash flow ratio among others.
The company is compared to the industry as a whole, its particular sector and the S&P 500. You can readily see if where the market is pricing the stock.
Conclusion
Cash flow is just one measurement for evaluating a company, but it is important because it focuses on actual operations and eliminates one-time expenses and non-cash charges. 2. Distinguish among operating activities, investing activities, and financing activities?
The statement of cash flows classifies cash receipts and cash payments into operating, investing, and financing activities. Transactions within each activity are as follows: * Operating activities include the cash effects of transactions that create revenues and expenses and thus enter into the determination of net income. There are 2 types of flows inflows and outflows, cash inflows are from sales of goods or services, and from returns on loans (interest) and on equity securities (dividends), whereas cash outflows are to suppliers for inventories, to employees for services, to government for taxes, to lenders for interest, to others for expenses. * Investing activities include (a) purchasing and disposing of investments and productive long-lived assets using cash and (b) lending money and collecting the loans. Cash inflows of investing activities are from sale of property, plant, and equipment, from sale of debt or equity securities of other entities, from collection of principal on loans to other entities. Cash outflows are to purchase property, plant and equipment, to purchase debt or equity securities of other entities, to make loans to other entities. * Financing activities include (a) obtaining cash from issuing debt and repaying the amounts borrowed and (b) obtaining cash from stockholders and paying those dividends. Cash inflows are from sale of equity securities, from issuance of debt (bonds and notes). Cash outflows are to stockholders as dividends, to redeem long term debt or reacuire capital stock.

3. What sources of additional information about a company are available to the investor other than the annual report?
There is much information available to investors other than annual reports, for example: company’s strategy, stock information, presentations and events, shareholder services, request information, investor contacts and also frequently asked questions (FAQ). There are sample of what investor relations, of course they difference from one company to another.

4. A friend has come to you for advice on how to organize his business. He is the sole owner of the business, and he wants to know whether he should organize as a sole proprietorship or a corporation. He wants to know the major advantages and disadvantages of each business form. How would you respond?
Advantages of a corporation versus a sole proprietorship

Stockholders in a corporation are not liable for corporate debts
This is the most important attribute of a corporation. In a sole proprietorship, the owners are personally responsible for business debts. If the assets of the sole proprietorship cannot satisfy the debt, creditors can go after each owner's personal bank account, house, etc. to make up the difference. On the other hand, if a corporation runs out of funds, its owners are usually not liable.

Please note that under certain circumstances, an individual stockholder may be liable for corporate debts. This is sometimes referred to as "piercing the corporate veil." Some of these circumstances include: * If a stockholder personally guarantees a debt. * If personal funds are intermingled with corporate funds. * If a corporation fails to have director and shareholder meetings. * If the corporation has minimal capitalization or minimal insurance. * If the corporation fails to pay state taxes or otherwise violates state law (like defrauding customers).
Corporations offer self-employment tax savings
Earnings from a sole proprietorship are subject to self-employment taxes, which are currently a combined 15.3% on the first $106,800 of income. With a corporation, only salaries (and not profits) are subject to such taxes. This can save you thousands of dollars per year.

For example, if a sole proprietorship earns $80,000, a 15.3% tax would have to be paid on the entire $80,000. Assume that a corporation also earns $80,000, but $40,000 of that amount is paid in salary, and $40,000 is deemed as profit. In this case, the self-employment tax would not be paid on the $40,000 profit. This saves you over $5,000 per year. Please note, however, that you should pay yourself a reasonable salary.

Corporations have continuous life
Unlike a sole proprietorship, a corporation does not expire upon the death of its stockholders, directors or officers.
Corporations make raising money easier
A corporation has many avenues to raise capital. It can sell shares of stock and create new types of stock, such as preferred stock, with different voting or profit characteristics. Plus, investors can rest assured knowing they are not personally liable for corporate debts.

Transferring the ownership interests of a corporation is easier
Ownership interests in a corporation may be sold to third parties without disturbing the continued operation of the business. A sole proprietorship or , on the other hand, cannot be sold whole. Instead, each of its assets, licenses and permits must be individually transferred. Plus, new bank accounts and tax identification numbers are required.

Advantages of a sole proprietorship versus a corporation

Sole proprietorships cost less to establish
Corporations cost more to set up and run than a sole proprietorship . For example, there are the initial formation fees, filing fees and annual state fees. However, these costs are partially offset by lower insurance costs.
Sole proprietorships have minimal formalities
A corporation can only be created by filing legal documents with the state. In addition, a corporation must adhere to formalities. These include holding director and shareholder meetings, recording corporate minutes and having the board of directors approve major business transactions. If these formalities are not maintained, the stockholders risk losing their personal liability protection. While keeping corporate formalities is not difficult, it can be time-consuming.
On the other hand, a sole proprietorship can open and operate without any formal organizing or operating procedures - not even a handwritten agreement.

Sole proprietors are not liable for unemployment insurance
A stockholder-employee of a corporation is required to pay unemployment insurance taxes on his or her salary, whereas a sole proprietor or partner is not. 5. A classmate has come to you for help she is wondering why companies whose stock is traded on public stock exchanges must follow Generally Accepted Accounting Principles (GAAP), and why companies, which are not publicly traded would want to follow GAAP. How would you respond?
As a company who is stock traded on public stock exchanges it is its responsibility to be as clear as possible to investors, because investors has the right to know that this specific company is worth investing in, therefore, one of the company’s objectives should be transparency.

And for companies who are not publicly traded, although they don’t have to be clear and transparent to investors, adapting such international principles is very helpful for auditing purposes and documenting, and to present whatever reports they have to responsible authorities. There for adapting Generally Accepted Accounting Principle is important for both companies who are publicly traded and vice versa.