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S Corporation vs C Corporation

See Also:
S Corporation
C Corporation
Limited Liability Company (LLC)

S Corporation vs C Corporation

Although these two entities are very similar, there has always been a debate between an S corporation vs C corporation. The S corporation vs C corporation debate has been ongoing for a while. The following are some major differences that exist which may help an entity choose the proper class of corporation.

Double Taxation

In a C corporation, the entity is forced to pay Federal Income Taxes at the entity level and again at the individual level when it distributes dividends to its shareholders. This double taxation is a huge disadvantage to the C corporation. It acts as a flow through entity much like a partnership. Each individual is only taxed on their earnings from the s corp at the individual level on schedule E of the IRS form 1040.

# of Shareholders

An S corporation can only have 100 shareholders total. This is good if it is a smaller company. However, for larger companies, this is simply not possible because of the amount of cash flow needed to finance a larger corporation. Consider all family members within the S corporation as only one shareholder. This means that there is a way in which there could be more than 100 shareholders. It also means that S corporation holders can increase their interest in the business without losing the status of an S corp.

Forms of Stock

C corps can issue several different forms of stock to obtain financing for its operations. In comparison, an S corporation can only have one class of stock. The C corporation’s advantage is that it has the ability to issue preferred shares or other classes depending on its needs.

Type of Company

You can form S corps only after you set a company as a C corp or a Limited Liability Company (LLC). This is a disadvantage for entities that would like the S corporation status (i.e. partnerships because of the similarities between the two).

Note: This is by no means all of the S corporation and C corporation differences. However, our list includes some of the main ones that influence a company to go one way or another.


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Retained Earnings

See Also:
Accounting Income vs Economic Income
Realized and Unrealized Gains and Losses
Operating Income
Overhead Definition

Retained Earnings

Retained earnings (RE) refers to the portion of a company’s net income that is reinvested in the company. It is also the amount of profit left over after the company pays dividends to its stockholders.

Record RE in the owners’ equity section of the balance sheet. The account is cumulative. So, add profits and subtract losses from the account each accounting period. The RE account links the income statement and the balance sheet. If the account is negative, then it is either accumulated deficit, accumulated losses, or retained losses.

Calculating Retained Earnings

To calculate retained earnings, start with the value of the RE account from the previous period. Then add net income for the period and subtract dividends paid. In conclusion, the result is the new value of this account.

New RE = Prior RE + Net IncomeDividends 

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Passive Income

Passive Income Definition 

Tax law distinguishes between active income and passive income. Returns generated from investments or business activities that require the continued effort of the taxpayer are considered active income. Consider returns coming from investments or business activities that require little or no participation from the taxpayer passive income. Another type of income is portfolio income, which includes returns from investments. Some examples include both dividends and capital gains.

The key distinction is that passive losses cannot be deducted from active or portfolio income. Furthermore, passive losses can only be deducted from income that is passive. If passive losses are incurred when the taxpayer has no offsetting passive income, then these losses can be carried forward to a year when the taxpayer does have offsetting the income that is passive.

Examples

Examples include the following:

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Passive Income

See Also:
Economic Income
Remuneration
Pension Plans
Deferred Income Tax
Prepaid Income Tax

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Free Cash Flow Analysis

See Also:
Cash Flow Projections
Discounted Cash Flow Analysis
Cash Cycle
Steps to Track Money In and Out of a Company

Free Cash Flow Analysis Definition

Free cash flow analysis is the amount of cash that a company can put aside after it has paid all of its expenses at the end of an accounting period.

Calculation of Free Cash Flow

Free cash flow = Net cash flow from operating activities – capital expendituresdividends

Or

= Net income + amortization + depreciation + deferred taxes – capital expenditures – dividends


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Applications

Free cash flow is an important measurement of the unconstrained cash flow of the company. It measures a company’s ability to generate internal growth and to return profits to shareholders.

Positive free cash flow means that a company has done a good job of managing its cash. If free cash flow is negative then the company may have to look for other sources of funding such as issuing additional shares or debt financing.

Negative free cash flow is not necessarily an indication of a bad company, however, since many young companies put a lot of their cash into investments, which diminishes their free cash flow. But if a company is spending so much cash, it should have a good reason for doing so and it should be earning a sufficiently high rate of return on its investments.

The CEO's Guide to Improving Cash Flow


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Equity Interest Definition

See Also:
Brand Equity
Return on Common Equity (ROCE)
Return on Equity Analysis
Carried Interests

Equity Interest Definition

Equity interest, defined as the amount of equity a single person holds in a business, is a common concept to the small business world. For example, if an angel investor receives 25% ownership of a company, the investor has a 25% equity interest in that business. Equity interest accounting is simple: equity is worth nothing until it results in cash flows, either through disbursement of dividends or the sale of assets. At this point standard capital gains tax applies.

Equity Interest Explanation

Equity interest is the level of interest an owner has in the success of a company. It is also a basic business concept. The equity interest rate could be seen as the level of motivation a single owner has towards the outcome of the project. For example, a founder with 90% ownership will work harder for a successful outcome than a founder with 1% ownership. Due to the fact that owners have a difficult time leading a business to growth, their ownership in the business is an obvious factor of motivation while working.

To mitigate the risk of business a financial derivative known as an equity interest rate swap has been created. This is an agreement where future success of a business, measured in cash flows, is agreed to be shared between two businesses. If one business sees success, it pays a portion of this success to the other. In the event that the other business sees success, the other business would then pay the first company a portion of their cash flows. An equity interest rate correlation between the cash flows of the two businesses assures that none sees failure outright.

Equity Interest Example

Frank is an angel investor. He has worked hard to build and sell his first company. Since he has already achieved that, he now turns his focus on investing in other budding entrepreneurs. Frank loves to see businesses grow with the owners.

Frank is invested in multiple businesses. One, a green products manufacturer, has received $1,000,000 from Frank. For this he received 40% ownership. Another, a Web 2.0 company, has received $1,500,000 from Frank. In this business, Frank owns 25%. Yet another, a simple e-commerce store, has received only $750,000 from Frank. Frank owns 15% of this business.

The total value of Frank’s equity interest is $3,250,000. Phrased in terms of a percentage, Frank’s equity interest in all of the businesses is a combined 80%. Though Frank does not own a majority percentage of these businesses he has 80% ownership as a total of 3 businesses.

Frank knows that he, in the event of a disagreement, will not be able to argue control of any business that he does not have approximately 30% of ownership for. This is due to the fact that courts tend to rule in the favor of the majority owner. Unless they appear to have been neglecting the business, that is the case. Frank can accept this for 2 reasons. He trusts the majority shareholders and sees this as just a risk of doing business. If Frank could not accept this, he would be wise to only invest in a business with the end result of 30% or more of total shares of stock.

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Earnings per Share (EPS)

See Also:
Price Earnings Growth Ratio Analysis
Price Earnings Ratio Analysis
Gross Profit Margin Ratio Analysis
Net Profit Margin Analysis
Financial Ratios

Earnings per Share (EPS) Definition

The earnings per share or EPS is the amount of profit that accrues to each shareholder based on their percentage ownerships or amount of shares owned within the company.

Earnings per Share (EPS) Explained

The earnings per share ratio is often a good measure of how a company is doing from year to year and is used by many investors in the market. However, companies know that the EPS is often a measure of how they are handling their businesses. This leads several companies to manipulate the EPS ratio. The ratio can be manipulated if the company were to buy or sell its own shares in the market, referred to as Treasury Stock. The net income aspect can also be manipulated through the recognition of revenue as well as other ways.

Earnings per Share (EPS) Formula

The EPS equation is as follows:
(Net Income – Preferred Dividends)/Shares Outstanding

Earnings per Share (EPS) Example

Tim is trying to calculate the EPS for Wawadoo Inc. He was given the following information to solve the problem.

Operating Income – $350,000
Interest expense – $20,000
Tax rate – 34%
Shares outstanding – 100,000 common (no preferred)

Tim will make the EPS calculation as follows:
$350,000 – (350,000 * .34) – $20,000 = $211,000 = Net Income
$211,000/100,000 = $2.11/share = EPS

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Dividends

See Also:
Dividend Yield
Capital Impairment Rule
Dividend Payout Ratio
Financial Ratios

Dividends Explained

Dividends are corporate profits distributed to shareholders. When a company makes a profit, the board of directors can decide whether to reinvest the profits in the company or to pay out a portion of the profits to shareholders as a dividend on shares. The board of directors determines the amount of the dividend on stocks, as well as the dividend payout dates.

Stockholders typically receive a certain amount of dividends per share for each share of stock they own. Tax rates on dividends, historically, have often differed from tax rates on capital gains from investments. If the dividend tax rate exceeds the capital gains tax rate, it may benefit the shareholders to avoid paying a dividend, and instead to carry out a stock repurchase.

Dividend Yield Definition

We define dividend yield as the dividend amount expressed as a percent of the current stock price. For example, if a stock will pay a $1 dividend at the end of this year, and today the stock price is $10, then that stock’s dividend yield is 10%.

10% = 1/10

Dividend yield equation

Dividend Yield = D1 / P0

D1 = Annual dividend per share amount (the dividend per share at time period one)
P0 = Current stock price (the price at time period zero)

Dividend Date Definitions

The process of distributing dividends to shareholders follows a set schedule. The board of directors announces the dividend on the dividend declaration date. Once the dividend has been declared, the company is legally obligated to pay the stated dividend to shareholders.

The next significant date is the ex dividend date. Investors who purchase the stock on or after the ex-dividend date will not receive the forthcoming dividend. Prior to the ex dividend date, the stock is considered cum dividend, or with dividend. This means that anyone buying the stock during this period will receive the forthcoming dividend.

The ex dividend day precedes the dividend record date, or the dividend date of record, by three days. Shareholders documented as owning the stock on the dividend record date will receive the dividend.

Last is the dividend payable date, or the dividend distribution date. This is the actual date on which the company pays out the dividends to its shareholders. The dividend payable date is typically about a month after the dividend date of record.

Dividend Payout Dates

• Dividend Declaration Date (stock is trading cum dividend)
• Ex-Dividend Date
• Dividend Record Date (three days after the ex-dividend date)
Payable Date for Dividend (one month after the dividend record date)

Dividend Signaling

Dividend signaling hypothesis refers to the idea that changes in a company’s dividend policy reflect management’s perceptions of the company’s future earnings outlook. Basically, it states that a change in a company’s dividend policy can be interpreted as a signal regarding future earnings. The problem is that a company can interpret the signals as contradictory messages.

Dividend Example

For example, if a company announces that it will increase its dividend yield, investors may interpret this as a positive signal. It could mean the company anticipates a profitable future and is allowing shareholders to benefit from these profits.

On the other hand, one can interpret an increase in the dividend payout rate as a negative signal. It could mean that the company has no good investment opportunities, and it has nothing better to do with its cash than to pay it out to shareholders as dividends.

Similarly, if a company announces that it will decrease its dividend payout rate, this can be interpreted as either a positive or negative signal. It could be interpreted as a positive signal because it could mean that the company has so many good investment opportunities that it needs all available cash for positive-NPV investments and projects. This could mean the company is growing and expanding.

On the other hand, if a company cuts its dividend rate, that could mean that the company anticipates lower earnings or even losses. This, of course, could be a bad sign. So as you can see, the logic behind the dividend signaling hypothesis makes sense, but because it can be interpreted in contradictory ways, the reading of the signals is not necessarily very meaningful.

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