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How to read and understand the financial news written by Gerald Warfield

 

How to read and understand the financial news written by Gerald Warfield

Overview:

A clear and accessible guide to learning how to decipher the financial section of the newspaper.

A clear, readable guide to the vocabulary of financial news.

Excerpt:

Is It a Corporation?

Look at the example on the following page. It may seem only to say that Trand's profits are up 22% (and no one needs to be told that that's good news). But wait: The word "corporation" was used and that tells us something important about Trand, particularly if you want to buy some of its stock.

Businesses in the United States usually take three principal forms: individual proprietorships, partnerships, and corpor-ations.1 We will get into the differences among these types a bit later, but for now we can say that of the three, incorporation is the most appropriate for a large business. This is because it offers a legal structure independent of the life or resources of a single individual. A corporation has a board of directors, the members and officers of which can be replaced. It also issues stock, so that when stock is available, ownership is easily transferable.

Assuming our example is from a newspaper, it is likely that Trand is a fairly large corporation and that it has many shareholders. However, it is possible that the company is "privately held," which means that the stock has never been offered publicly. Or the company could be "closely held," which means there may be a legal limit on the number of stockholders, and restrictions on the transferability of the shares.

Privately held and closely held corporations are not required to publish their financial reports, so frequently not much is known about them. A small number of investors may own all the shares, or it may be that members of only one or two families own the stock.

Before going any further, let us now take a look at each of the three structures under whichbusiness can be conducted in the United States. This will give us some important perspectives from which to view corporations.

Individual or Sole Proprietorship

This is a business that is completely owned and controlled by one person. In fact, legally, the owner is the business. Common examples are a small store or a doctor's practice. Among the advantages are that the owner has direct access to the profits and, in comparison to corporations, there are relatively few legal restrictions. There is also the advantage of one level of taxation; that is, only the proprietor is taxed, and not the business. The biggest problems are that it is difficult to obtain substantial long-term credit and that the owner has unlimited personal liability for all debts of the proprietorship.

From a bank's point of view, loans to proprietorships have certain risks. The existence of the business is dependent on one person; if that individual becomes disabled, retires, or dies, that is often (although not always) the end of the business. In addition, liability for the debts of the proprietorship extends to the personal property of the proprietor, and conversely, the business itself is subject to the owner's private debts. This is not very comforting to the proprietor or to the bank. For the proprietor, it means all personal property is at risk should the business fail; as far as the bank is concerned, personal collateral is often insufficient for the amounts of capital required by an ongoing business. There is also the risk that the proprietor's personal debts could adversely affect the business.

Partnership

This is a business owned by two or more persons. Each partner in a regular partnership is essential to the continuous existence of the partnership. Each partner is liable for the business activities of the other within the partnership, and in most states this means unlimited and often unequal personal liability. Thus, if the assets of some partners are insufficient to meet claims on the partnership, other partners can be sued for additional amounts to make up for the shortfall.

The partners usually specify in their partnership agreement how much capital and effort is required from each partner and how profits are to be distributed. The death or departure of a partner will cause the partnership to dissolve and require reforming, unless continuity of the original name is one of the stipulations in the partnership agreement. Partnerships themselves are not taxed, but the income to the partners is taxed as ordinary income. A partnership's losses also pass on (called "flow through") to the partners, which is the reason the partnership format is chosen for tax shelters.

The partnership structure is appropriate for businesses where the individual contribution of each owner is crucial to the business (as is the case for architects), or where a certain amount of sharing of facilities can cut down on each partner's overhead (as is sometimes the case for dentists or accountants). In recent years there has been a tendency for businesses that traditionally form as partnerships to organize as corporations for certain tax advantages.

Limited Partnership

A limited partnership is a special kind of partnership in that it has two kinds of partners: general partners and limited partners. The general partner (often there is only one and it may be a corporate entity or another partnership) runs the business, and bears unlimited liability. The limited partners (there are usually many) have no say in the business, even though they have contributed capital to the partnership. Since they are partners, they still have limited liability, but it is only to the extent of their investment. This feature has frequently been used in the formation of tax shelters.

As in our example, a drilling company may form limited partnerships for drilling new oil wells. The drilling company (or an affiliate created specifically for this purpose) will be the general partner, and investors (who need tax writeoffs as much as they need profits) will become limited partners by adding their capital to that of the general partner. With the pooled money, the general partner initiates the drilling.

Heavy startup costs are typical features of tax shelters, and the partnership will usually show losses the first few years. These losses can be written off by limited partners to the extent of their investment. By the time the wells begin producing, the limited partners have had a couple of years of tax writeoffs and now own part of a valuable business. They can then sell out or begin reaping their profits to the extent permitted by the partnership agreement. There are also strict securities laws that come into effect here too. At any rate, the limited partners will soon be looking for additional tax shelters to compensate for the new profitability of the present partnership. The general partner has profited by the tax writeoff too, but it has also been able to finance new drilling operations without bearing the entire startup cost alone.

Corporation

Most major businesses in the United States are organized as corporations. However, the flexibility of the corporate structure accommodates small businesses as well as the giants of industry. Do not assume that just because the word "corporation" appears in the name, a company is large.

Advantages

Many of the advantages of incorporation have already been mentioned, but perhaps the most significant are limited liability and the ability to raise large sums of capital.

Limited Liability. In the history of business and commerce the importance of limited liability can hardly be overestimated, because of the vast amounts of capital this concept has enabled businesses to raise. Basically, limited liability means that the owners of a business (in the case of corporations, the stockholders) have at risk only the capital that they have put into the enterprise (what they paid for the stock). If the business does well, the value of the percentage of the business owned by each investor increases accordingly; if the business does poorly, the value decreases accordingly.

With limited liability, the owner is protected in case the worst happens and the business fails. In this situation the business is often liquidated (all the assets sold), and if any capital is left over after paying the bills, it is divided among the owners according to their percentage of ownership. If after liquidation there are more debts than there is money to pay them, the owners will receive nothing; but even more important, the creditors do not have recourse to the investors for the obligations the corporation was unable to meet. Thus, while shareholders may lose their entire investment in a business, their losses are limited to the amount they put out for that investment. Shareholders cannot be sued for debts the company never paid. The ultimate losers in this situation are the creditors.

There have been cases where individuals have attempted to evade personal debts through the corporate structure and, more common, where corporate assets were interchangeable with personal assets. When this can be proved in court, the offending shareholder can then be sued for the debts of the corporation. How to Read and Understand the Financial News. Copyright by Gerald Warfield. Reprinted by permission of HarperCollins Publishers, Inc. All rights reserved. Available now wherever books are sold.

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Title: How to read and understand the financial news

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