AxTenk Blog

To finance ongoing operations, Companies can generate cash flows from a variety of sources, including:

3)  SALE OF INVESTMENTS (such as stock, bonds, or raw land)

Investments are income tax favored throughout the world. In the United States, they usually are capital assets, generating capital gain or loss on sale. Such gains and losses are netted together for the year. If there is a net gain, it is taxed like any other income for corporate taxpayers but at reduced rates (e.g., 15%) for most individual taxpayers. Net losses, however, are nondeductible for corporate taxpayers and must be carried over. Upon carryover, such losses can be used only to offset capital gains. The carryover period is three years back and five years forward. (For individuals, up to $3,000 of losses can offset other income, and the excess is carried forward indefinitely.)

Like net operating losses (NOLs), a regular corporation that generates a net capital loss for a year applies the loss in a stylized way. First, the corporation’s tax return for the year three years before (e.g., year 1 for a loss in year 4) is reviewed. If there were net capital gains for the year, the return would be restated and a tax refund calculated by offsetting these gains with the current year’s loss. If this loss exceeds the capital gains, the excess is carried forward to the second previous year. This is repeated until the fifth year after the net loss. After the fifth subsequent year, any remaining carryover disappears.

Otherwise, the same tax-management principles of timing and negotiation that apply to operating assets also apply to investments. However, the sale of investments can have a very different impact on a U.S. firm’s financial statements than the sale of operating assets. Under U.S. generally accepted accounting principles (GAAP), unrealized gains or losses on operating assets are not recognized, and thus their net book value remains at depreciated historical cost. However, unrealized gains and losses on marketable securities are typically recognized under mark-to-market accounting. Thus, their net book value often is much closer to their current market value, and the gain or loss reported in financial statements in the year of sale year minimal.

To finance ongoing operations, Companies can generate cash flows from a variety of sources, including:

2) SALE OF OPERATING ASSETS (such as plant and equipment)

Gains (losses) on the sale of operating assets generally are taxable (tax deductible).
Some gains may be tax deferred, particularly when the sale was nonvoluntary (e.g., due to condemnation) or old property was being traded in for new.
Some losses are nondeductible: There are limits on capitals losses, passive activity losses, and losses between related parties.

Gain or loss is the difference between an asset’s sales price and its adjusted basis. Adjusted basis is original cost, plus improvements, less accumulated depreciation.

Gains generally are treated as capital gains. capital gains are not taxed in many jurisdictions. In those where they are, capital gains usually are taxed at ordinary income rates unless offset by other capital losses. Losses on the sale of operating assets usually are treated as ordinary losses and are fully deductible.

Note that depreciation previously taken reduces an asset’s basis. This generally results in reducing the loss or increasing the gain if the asset is sold. Thus, the tax benefit of depreciation flows from time value.

Selling operating assets simply to generate cash flow may not make business sense. This is because unless the asset is traded in for a new asset, its absence will decrease value-added. Because there is also a financial accounting gain or loss, there is an effect on earnings that may in turn affect management bonuses. Finally, the timing of any gain on the sale can be negotiated with the buyer. That is, if the buyer is willing to accept payment over time, the tax on the gain can be recognized ratably over time.
On next post, we’ll cover other source of financing.

Companies need a certain amount of working capital to finance ongoing operations, take advantage of unexpected opportunities, and fulfill longer-run strategic plans. For Examples : payments to suppliers and scheduled payments to creditors and bondholders. Another example includes cash for plant expansion and for acquisition of other firms.

Companies manage this by preparing an annual master budget that forecasts operating needs, including any cash needs.

Beyond the cash budget objectives, there are value-adding considerations to cash flows, as well. Capital markets may perceive low levels of cash as a sign of a weak or risky firm. High levels may be seen as healthy. They can also be seen as a sign of poor investment management, or of managers misusing funds (i.e., an agency problem).

To finance ongoing operations, Companies can generate cash flows from a variety of sources, including:
1)    Operating earnings (i.e., net income from sale of products or services)

Operating earnings, after payment of federal, foreign, and state or local taxes, add to retained earnings.
Earnings retained without a legitimate business purpose may be subject to special penalty taxes, such as the U.S. accumulated earnings tax.
Corporations should not be used to hold passive investments merely to take advantage of lower corporate marginal tax rates, and highly successful closely held corporations may have trouble if they accumulate large amounts of liquid assets and do not routinely pay dividends.

On next post, we’ll cover other source of financing.

The financial problems we face in our lives can be categorized by the letters L-I-V-E-S.
L.    LACK OF LIQUIDITY – Liquidity is the possession of sufficient cash and/or income to pay bills, debts, taxes, and other expenses on time. A lack of liquidity is the inability to quickly turn invested capital into spendable cash without incurring unreasonable cost. This problem can result in a forced sale of assets at pennies on the dollar. For instance, if we must sell stocks or mutual fund shares in a “down market,” or if an executor must sell a valuable real estate portfolio to pay federal or state death taxes and administrative expenses, the buyer will offer to pay the lowest possible price for the most precious asset. This forced sale often becomes a “fire sale,” a loss of prime growth or income producing assets at a fraction of their real value.
I.    INADEQUATE RESOURCES – Insufficient capital or income in the event of death, disability, at retirement, or for special needs such as college or preparatory school or to provide needed services for a handicapped child.
I.    INFLATION – Not enough has been done to “inflation proof” our portfolio. We need to understand the crippling impact of inflation on each dollar’s ability to buy goods and services.
I.    IMPROPER DISPOSITION OF ASSETS – We are leaving the wrong asset to the wrong person at the wrong time and in the wrong manner. For example, we are leaving a sports car to a 10-year old child or $100,000 cash outright to a 21 year old college student.
V.    VALUE – Not enough has been done to stabilize and maximize the financial security value of the our business and other assets.
E.    EXCESSIVE TAXES – Excessive taxes add to the cost of an investment and retard progress toward our objectives.
S.    SPECIAL NEEDS – We have desires that go beyond mere quantifiable goals. Psychological assurance and comfort should be part of the financial planning process. For example, we may want to provide additional levels of financial care for a spouse or children who are disabled or emotionally troubled.

Here are what a FINANCIAL PLANNING REPORT should cover:

1.    Analysis – WHERE YOU ARE NOW
Where You Are Now
1.     balance sheet
2.     cash flow analysis
a)     normal situation—current
b)     normal situation—projected
c)     death of “breadwinner”
d)     disability of “breadwinner”
e)     retirement
3.     asset liquidity analysis
4.     employee benefits
5.     risk assessment
6.     risk tolerance

2.    Objectives – WHERE YOU WANT TO BE
Where You Want to Be
Quantification of goals
1.     increasing investable income
2.     improving liquidity
3.     reducing risk
4.     increasing income or meeting capital needs at death, disability, retirement, or for special situations
5.     increasing financial security for heirs and satisfying charitable objectives

3.    Strategy – HOW TO GET TO WHERE YOU WANT TO BE

How to Get to Where You Want to Be
1.     tax strategy
•     income     •     estate and gift
2.     investment strategy
•     selection     •     portfolio balancing and asset allocation
•     diversification
3.     risk management strategy
•     life     •     health & long-term care
•     disability     •     asset preservation & protection
•     property & liability
4.     wealth transfer strategy
•     estate planning     •     trusts
•     retirement plan beneficiary elections     •     business succession
•     titling     •     charity

The length of the report must be determined by the task set by the client (does the client want you to do a full analysis or just solve one or two problems?), by time and cost considerations, by your style as a professional, and by your feelings as to how much the client needs to know to have confidence in and take action on your suggestions.

Preparing and maintain your Personal Budget  using the following guides:

STEP 1 – Estimate the family’s annual income. Identify fixed amounts of income expected from the following:
a.    salary
b.    bonus
c.    self-employment (business)
d.    real estate
e.    dividends – close corporations
f.    dividends – publicly traded corporations
g.    interest – savings accounts
h.    interest – taxable bonds
i.    interest – tax free bonds
j.    trust income
k.    other fixed payment income
l.    variable sources of income

STEP 2 – Develop expenditure estimates broken down between fixed and discretionary expenses. Canceled checks and charge account receipts serve as a good basis for developing the following expenditure estimates:

FIXED
a.    housing (mortgage or rental payments)
b.    utilities
c.    food, groceries, etc.
d.    clothing and cleaning
e.    income taxes
f.    social security
g.    property taxes
h.    transportation
i.    medical and dental
j.    debt repayment
k.    household supplies and maintenance
l.    life and disability insurance
m.    property and liability insurance,
n.    current school expenses

DISCRETIONARY
a.    vacations, travel, etc.
b.    recreation and entertainment
c.    gifts and contributions
d.    household furnishings
e.    education fund
f.    savings
g.    investments
h.    other

STEP 3 – Determine the excess or shortfall of income within the budget period.
STEP 4 – Consider available methods of increasing income or decreasing expenses.
STEP 5 – Calculate both income and expenses as a percentage of the total and determine if there is a better or preferable allocation of resources.

Here are some guidelines you can use when establishing a budget:
1.    Make the budget flexible enough so that it will work even if there are emergencies, unexpected opportunities, or other unforeseen circumstances.
2.    Keep the budget period short enough so that the estimates you make will involve the minimum amount of guesswork.
3.    Establish a budget period long enough to utilize an investment strategy and a workable series of investment procedures. A typical family budget will cover twelve months and coincide with a calendar year.
4.    Make the budget simple, short, and understandable.
5.    Follow the form and content of the budget consistently.
6.    Eliminate any extraneous information.
7.    Do not attempt to obtain absolute accuracy, especially with insignificant items.
8.    Tailor the budget to specific goals and objectives.
9.    Remember that a budget is also a guideline against which actual results are to be measured. Unexpected results, highlighted by comparison with the budget, should be analyzed. It may be that the unexpected variance is in fact the norm, and should therefore be incorporated in a revised budget.
10.    Determine, in advance, all the variables that may influence the amounts of specific items of income and expenditures. Income items include expected annual raises and increases or decreases in interest or dividend rates. Expenditures include increased costs, changing tastes or preferences, or changes in family circumstances.

ADVANTAGES OF BUDGETING
1.    Budgeting helps coordinate activity of the investor and financial counselor/advisor in developing objectives.
2.    Budgeting reveals inefficient, ineffective, or unusual utilization of resources.
3.    Budgeting makes family members aware of the need to conserve resources and helps to allocate roles in achieving overall financial objectives to various individuals.
4.    Budgeting provides a means of financial self-evaluation and a guideline to measure actual performance.
5.    Budgeting allows the recognition and forces the anticipation of problems before they occur and, thus, permits corrective action or preparation to be taken.
6.    Budgeting highlights the possibility of, and the need for, alternative courses of action.
7.    Budgeting provides a motivation for performance.

DISADVANTAGES OF BUDGETING
1.    To the extent the data utilized are inaccurate, the conclusions drawn from the budget may be misleading.
2.    Many individuals have a psychological aversion to the record keeping required and may not maintain sufficient information for the budget to be of use.
3.    A rote dependence on budgeted numbers inhibits creativity, tends to stifle “risk taking,” and encourages mechanical thinking. Such an investor may forfeit opportunities or fail to minimize losses.