Liquidity and Strategic Changes in the financial statements for the value creation in the growth stage of a company

 

  1. Introduction:

 

Financial strategy is very important to a company’s business operation. A right financial decision will lead a growth company developed in the right direction. Liquidity is a crucial performance indicator that how well the company operated to cover the debt payment in due. Liquidity management is essential and strategic for company growth development. (Adam, 2008) It is also a part of financial flexibility. If a growth company with high liquidity, it reflects company’s competitive solvency position because they represent quick access to cash and can be used to secure outstanding loans. Financial statements are the direct tool display the liquidity information to the shareholders. The shareholders will set their requirement on the level of liquidity at the growth company. In this context, the financial strategy plays an essential role in the financial statement display. Therefore, this paper will evaluate the importance of liquidity to the growth company, and propose the suggestions about the strategic changes in financial statements influence the value creation in the growth company.

 

  1. Literature Review:

 

Mior (1999) defined that the liquidity of an organization is the ability to make payments as they fall due. Pristas (2007) developed the liquidity concept which is referred to the ability to buy and sell assets quickly, independent of the quantity and with minimal influence on the current market price. Pettit (2007) suggested that liquidity helps offset volatile operating cash flows or interest volatility. Liquidity reduces the risks that stem from markets closing to the issuer: refinancing risk. Shanley (2004) pointed out that liquidity provides an opportunity for the company’s early-stage investors and founders to exit from their investment. Roland (2008) also stated that liquidity is important because it allows companies to raise capital more cheaply, and to design stock-based managerial incentive schemes, spurring company performance, efficiently, and ultimately economic growth. Marks et al (2009) found that financing growth raises the issue of long-term shareholder objective, which many times involve eventual liquidity. As the wave of business transitions driven by baby boomers planning their legacy and succession continues, some shareholders face how to finance the continued growth of their business, creating liquidity for their owners, and lay the foundation for operations independent of the owner or founder.

 

Stern and Chew (2003) pointed out that increasing liquidity and reducing transaction costs are potentially useful ways to increase the value of firms. Adam (2008) found that liquidity provides a leverage effect of external growth compared with capital increase, and funding cost increases with volumes to refinance or market liquidity. Enz (2009) suggested that insufficient liquidity may be a sign that company operating poorly. An organization may have relatively low levels of liquidity as well as low levels of long term debts. By selling long-term debt, the organization could increase the current cash flow and relieve tight liquidity. The growth company often uses this strategy.

 

  1. The importance of liquidity of a firm especially in growth stage of company’s development

 

The manager in the growth type company often needs to consider how to allocate the resource and investment. The liquidity might affect the performance of himself and company. Most investors seek comfort of knowing that they can quit a fund if necessary. Therefore, it is quite important for the manager to identify the appropriate structures for the deployment of his fund’s own surplus liquidity. When the company is expanding its business, it still needs a lot of money to fund its operation. But the company at growth stage may prefer to keep the sufficient cash for the capital investment. It will add the security for the company at security stage. At this stage, external financing needs usually expand dramatically. Commercial banks and other creditors become the key lenders who were asked to increase the financing commitments. Thus, the second around financing usually requires additional equity injections from banks and other creditors who seeking ownership positions. (Leach and Melicher, 2011) Thus, the liquidity is very important to this stage firms, because the investor put great emphasis on the liquidity performance. The low liquidity will become the major barrier for the decreasing availability of venture capital. Therefore, the low liquidity will prevent the new investors from making the investment when the company at the growth stage needs a large amount of money for the capital expansion because the new investors worry about they could not exit easily. However, the high liquidity will also become the other barrier because the high liquidity is always associated with the low profitability. Investors always seek the good investment opportunity that could generate the high return. The relative high liquidity usually means the company always fulfills the short-term debt and neglect the long-term development. For one thing, the high liquidity reflected the company at growth stage could not increase its value efficiently. It has to find the financing source all the time and fulfill its short-term obligation and neglect the operating performance. So it will have a negative impact on the financial performance regarding the profitability. On the other hand, the relative high liquidity reflects the company at growth stage has to pay the additional financing cost such as the interest and agency cost. The financing costs will offset the profitability and influence the financial statements performance, which is the investors most care about. Thus, no matter the low liquidity and high liquidity are not good to the company at the growth stage. A relative appropriate liquidity is very important. It could attract the external financing such as the banks and other creditors, who are seeking the investment opportunities and easily exiting if necessary. Meanwhile, an appropriate liquidity will decrease the financing costs. Then the growth stage company could pay more attention on the business operation and expansion. This in turn will give the confidence to the investors because the company show its high potential at profit earning and easy exit chance if they would like to quit the investment. Moreover, an appropriate liquidity reflects the company at growth stage has the ability to find the investors all the time if one investor would exit his investment. Therefore, the liquidity is crucial for the company at growth stage which needs the external financing to expand its business.

 

  1. How would the strategic changes in financial statements influence the value creation process?

 

Epstein (2004) pointed out that financial statements provide important information about a company’s ability to achieve its primary strategic objectives, which is to create value for its owners. Sometimes high income does not mean a good thing for the company at growth stage, because they have to pay the high tax. It will make the income statements looks good, but it cause the company to pay more tax, which to some extent will offset the value creation for the company at the growth stage, which needs a large amount of cash for the capital investment or expansion. Therefore, the growth company could choose either to make the income statements look better or to reduce the taxable income for the real value creation. (Vasin et al, 2008) Moreover, Kiesel et al (2010) found that debt financing display the great advantage the interest the company pays to creditors is tax-deductible expense, while dividends, the cost of equity capital, are not. The amount of tax payments which the company can avoid by incurring debt is called tax shield. Caselli (2010) found that the value creation from financing through the debt allows the deduction of interest paid from the company’s incomes. This fiscal benefit allow the company to increase the leverage up to the optimum value of the debt-equity ratio, which permits the tax shield benefit without creating financial distress or reducing the value created. Cooper and Argyris (1998) also stated that interest payment reduce the amount of corporation tax paid and so there is a tax advantage, or ‘shields’, given to debt compared with equity. The value of a company increase as the amount of debt increases. Therefore, strategic changes in the tax liabilities will change the financial statements and create the new value for the firm and investors.

 

On the one hand, the company in the growth stage often has a lot of debts. The bankers or other financial institutions are the lenders. Through the negotiation with the banks, the company could pay the interest in advance and book it as the interest cost. So the company could prepay the interest of the loan and account it in the financial statements so as to decrease the taxable income. Then it will decrease the tax liabilities and increase the real value. Because the investors of the growth stage company did not pay much attention to the current profitability. They regard the long-term development is very important, so they will keep a holding attitude towards their current investment. On the other hand, although the prepaid interest will be booked at the interest costs and current liabilities, the equity of shareholder will decrease through the balance sheet. But the decreasing equity will also lower the shareholder’s income tax. If such income tax is larger than the decreasing equity, then the new value also has been created for the shareholders, because they don’t have to pay much personal income tax.

 

The growth company often may not own the assets in a large volume. Unlike the company at maturity stage with fairly stable and predictable income, which could deduct the income tax through the depreciation of assets, the company at growth stage has few assets is also possible to tax shield. (Cornell, 2003) Leasing assets is another way to deduction from taxable income in the income statements. Since the growth company is not sufficiently profitable to make use of all its depreciation deductions to transfer the deductions to investors in higher tax bracket; it could get financing with a lower effective interest. (Cornell, 2003) When the growth company at the year end, if cash flow permitting, it could prepay the lease payment in advance. The prepaid lease payment will be booked at the operating expenses in the income statements. Therefore, the income taxable liabilities will decrease. This in turn, the tax payment will be reduced. Through a leasing contract and prepaid lease payment is another good way to decrease the income taxable liabilities. Moreover, for the growth company if it acting as a lessor is also possible to enjoy the tax deductions in the income statements. Gurusamy (2009) suggested that leasing is a device offering potential tax benefits to both the lessor and the lessee. Leasing arrangements provide for a significant scope for tax exemption or reduction or deferring of tax liabilities. The income from the leasing contract also can enjoy the tax deductable policy. Therefore, for the lessee, tax shield on lease rental is available as business expenditures and represented a cash inflow; for lessor, depreciation tax shield is available and represents cash inflow. Through this way, it will help the company to save the tax cost and create the new value in the financial statements.

 

Moreover, increasing the benefits of the employee is also a good way to reduce income tax liabilities and create value. For one thing, company could issue the medical expense reimbursement for the employee or buy the gifts. This amount of payment will be booked as the operating costs, and then decrease operating income. This in turn will reduce the tax payment. For another thing, employee will be happy if such expenses can be reimbursed. Through this strategy, it will motivate the employees working hard because the employees receive the benefits from the company. The gift buying is also a good way to motivate the employee and book as the operating cost in the income statements. Company at the growth stage needs the employees’ support through their hardworking and professional knowledge. If the employee could be motivated through the related benefits, and the income tax liabilities could be reduced. Moreover, this strategy will also lower the operating risk because the good benefits will retain the talents for the company especially during the growth stage. Meanwhile, it will also relieve the burden of additional benefits providing. Such strategy reflected in the financial statements was the income taxable liabilities in the income statements decreased, the potential tax saving increased. The new value created through increasing the employee benefits. The medical expenses or gift expenses will be booked as the current liabilities at the balance sheet, which will lead to the low equity of investors. The investors may not have to pay the high personal income tax, and the new value has been created.

 

  1. Conclusion:

 

For the value creation in the growth company, liquidity is important because the company has to make sure it has the ability to pay back the debts and has the sufficient cash flow to meet the capital requirements such as leasing or buying assets, and paying interest payment. An appropriate liquidity level will not only ensure the growth company fund debt from the bank and other financial institution, but also enable the company to pay back the short-term debts such as the interest cost or leasing payments. If the growth company has the appropriate liquidity level, how to retain the profit becomes the key mission for the growth company. Tax shields become a key strategy using in the financial statements for the value creation. Income taxable liabilities are potential to some extent decreasing the profitability and investor’s income. Tax shields could be realized through different ways: the interest of debt may be prepaid before the annual report making, which will decrease the income taxable liabilities to a large extent. It will help the company to save the tax cost, and the new value will be created. Moreover, by leasing, the company in the growth stage now matter is a lessor or lessee, it will benefit the tax deduction in the income statements through the depreciation or the prepaid leasing payment. The income from the leasing also could enjoy the lower tax rate. Increasing the employee benefits is another way to create value in the income statements. Medical expense or gift expenses will reduce the income taxable liabilities as the operation expenses. It will help the company to save the tax cost and motivate its employee work better due to the better benefits. The tax saving is the direct value creation. The employee getting motivation and working hard is the indirect value creation for the growth company.

 

Reference:

 

Adam, A. (2008). Handbook of Asset and Liability Management: From Models to Optimal Return Strategies. New Jersey: John Wiley & Sons. pp.204

 

Caselli, S. (2010). Private Equity and Venture Capital in Europe: Markets Techniques, and Deals. Oxford: Elsevier. pp.121

 

Cooper, C.L & Argyris, C. (1998). The concise Blackwell encyclopedia of management. Massachusetts: Blackwell Publisher. pp.68

 

Gurusamy, S. (2009). Financial Services and System. 2nd ed. New Delhi: McGraw-Hill. pp. 145

 

Enz, C.A. (2009). Hospitality Strategic Management: Concepts and Cases. 2nd ed. New Jersey: John Wiley & Sons. pp.128

 

Epstein, M.J. (2004). Performance Measurement and Management Control: Super Organizational Performance. Oxford: Elsevier. pp.124

 

Leach, J.C & Melicher, R.W. (2011). Entrepreneurial Finance. 4th ed. Mason: South-Western Cengage Learning. pp. 153

 

Kiesel, R. et al. (2010). Alternative Investments and Strategies. Singapore: World Scientific Publishing. pp.28

 

Marks, K.H. et al. (2009). The Handbook of Financing Growth: Strategies, Capital Structure, and M&A Transactions. New Jersey: John Wiley & Sons. pp. 41

 

Mior, L. (1999). Managing Corporate Liquidity. Chicago: GPCo. pp.1

 

Pettit, J. (2007). Strategic Corporate Finance: Applications in Valuation and Capital Structure. New Jersey: John Wiley & Sons. pp.163

 

Pristas, G. (2006). Limit Order Book Dynamics and Asset Liquidity. Nonnensieg: Cuvilier Verlag. pp. 18

 

Roland, G. (2008). Privatization: successes and failures. New York: Columbia University Press. pp. 46

 

Shanley, R. P. (2004). Financing Technologys Frontier: Decision-making Models for Investors and Advisors. 2nd ed. New Jersey: John Wiley & Sons. pp.54

 

Stern, J.M. & Chew, D. H. (2003) The Revolution in Corporate Finance. 4th ed. Oxford: Blackwell Publishing. pp.270

 

Vasin, D. (2008). Tax Minimization Strategies. Sydney: Maurice Vasin & Associates.

原文链接:Financial Strategy 案例分析