Understanding Business Costs, Revenues, and Financing Sources

Average cost (AC)

Refers to the cost per unit of output, calculated as AC = TC ÷ Q, where TC is total cost and Q is quantity.

Average revenue (AR)

Refers to the value of sales received from customers per unit of a good or service sold, calculated as AR = TR ÷ Q = P, where TR is total revenue.

Cost

The sum of money incurred by a business in the production process, including raw materials, wages, insurance, advertising, and rent.

Direct costs

Costs specifically attributed to the production or sale of a particular good or service.

Fixed costs

Costs that do not vary with the level of output and exist even if there is no output.

Indirect costs

Costs that do not directly relate to the production or sale of a specific product.

Price

The amount of money a product is sold for, the sum paid by the customer to purchase a good or service.

Profit

Exists if there is a positive difference between a firm's total revenues and its total costs.

Revenue

The money that a business earns from the sale of goods and services, calculated by multiplying the unit price of each product by the quantity sold.

Revenue stream

The money coming into a business from its various business activities, such as sponsorship deals, merchandise, and royalty payments.

Running costs

The ongoing costs of operating the business.

Set-up costs

The items of expenditure needed to start a business.

Total costs

The sum of all variable costs and all fixed costs of production.

Total revenue

The money coming into a business, usually from the sale of goods and/or services, calculated by multiplying the price of a product with the quantity sold.

Variable costs

Costs of production that change in proportion to the level of output, such as raw materials and hourly wages of production workers.

Business angels

Extremely wealthy individuals who risk their own money by investing in small to medium sized businesses that have high growth potential.

Crowdfunding

The practice of raising finance for a business venture or project by getting small amounts of money from a large number of people, usually through online platforms.

External sources of finance

Funds from outside of the organization, such as through debt (overdrafts and loan capital), share capital, and business angels.

Initial public offering (IPO)

Refers to a business converting its legal status to a publicly traded company by floating (or selling) its shares on a stock exchange for the first time.

Internal sources of finance

Funds generated from within the organization, namely through personal funds, retained profits, and the sale of assets.

Leasing

A form of hiring whereby a lessee pays rental income to hire assets from the lessor, the legal owner of the assets.

Loan capital

Medium- to long-term sources of interest-bearing finance obtained from commercial lenders, including mortgages, business development loans, and debentures.

Long-term sources of finance

Those available for any period of more than 12 months from the accounting period, used for the purchase of fixed assets or to finance the expansion of a business.

Microfinance

A type of financial service aimed at entrepreneurs of small businesses, especially females and those on low incomes.

Overdrafts

Allow a business to spend in excess of the amount in its bank account, up to a pre-determined limit, and are the most flexible form of borrowing for most businesses in the short term.

Personal funds

A source of internal finance, referring to the use of an entrepreneur's own savings, usually used to finance business start-ups for sole traders.

Retained profit

The value of the surplus that a business keeps to use within the business after paying corporate taxes on its profits to the government and dividend payments to its shareholders.

Sale of assets

Selling existing items of value that the business owns, such as dormant assets (unused assets) and obsolete assets (outdated assets).

Share capital

The money raised from selling shares in a limited liability company.

Share issue

An existing publicly held company raises further finance by selling more of its shares.

Short-term sources of finance

Sources available for a period of less than one year, used to pay for the daily or routine operations of the business, such as overdrafts and trade credit.

Sources of finance

The general term used to refer to where or how businesses obtain their funds, such as from personal funds, retained profits, loan capital and share capital.

Stock exchange

A highly regulated marketplace where individuals and businesses can buy and/or sell shares in publicly traded companies.

Trade credit

Allows a business to postpone payments or to 'buy now and pay later'. The credit provider does not receive any cash from the buyer until a later date (usually allow between 30-60 days).

Acid test ratio

A liquidity ratio that measures a firm's ability to meet its short-term debts. It ignores stock because not all inventories can be easily turned into cash in a short time frame.

Capital employed

The value of all long-term sources of finance for a business, namely non-current liabilities plus equity.

Current ratio

A short-term liquidity ratio that calculates the ability of a business to meet its debts within the next twelve months.

Gross profit margin (GPM)

A profitability ratio that shows the value of a firm's gross profit expressed as a percentage of its sales revenue.

Liquid assets

The possessions of a business that can be turned into cash quickly without losing their value, i.e. cash, stocks and debtors.

Liquidity crisis

A situation where a firm is unable to pay its short-term debts, i.e. current liabilities exceed current assets.

Liquidity ratios

Look at the ability of a firm to pay its short-term (current) liabilities, comprised of the current ratio and the acid test (quick) ratio.

Profit margin

A ratio that shows the percentage of sales revenue that turns into profit, i.e. the proportion of sales revenue left over after all direct and indirect costs have been paid.

Profitability ratios

Examine profit in relation to other figures, comprised of the gross profit margin (GPM), profit margin and return on capital employed (ROCE) ratios.

Ratio analysis

A quantitative management tool that compares different financial figures to examine and judge the financial performance of a business.

Return on capital employed (ROCE)

A profitability ratio that measures the financial performance of a firm based on the amount of capital invested.

Business expenditure

All businesses have to spend money in order to earn money, referred to as costs.

Examples of fixed costs

Rent on leased premises, interest payments on bank loans, advertising expenditure, market research, management salaries, security.

Examples of variable costs

Raw materials, commission payments to staff, packaging, wages, utilities, repair and maintenance.

Indirect/overhead costs

Costs that cannot be clearly traced to the production or sale of any single product, typically fixed costs.

Personal funds for sole traders

This is the main source of finance for sole traders and for partnerships.

Uses of personal funds

Capital and revenue expenditure.

Advantages of personal funds

Zero cost of finance (unless borrowed from friends and family who expect it to be repaid with interest).

Disadvantages of personal funds

Amount available is limited to the size of savings owned by the sole trader.

Retained profits

This is the value of finance that the business keeps (after paying taxes to the government and dividends to its shareholders) to use within the business.

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Advantages of retained profits

Zero cost of finance (as there are no interest charges).

Disadvantages of retained profits

If the business makes a loss, this source of finance will not be available.

Sales of assets

Businesses can sell their unused assets to raise finance.

Examples of assets sold

Old machinery, computer equipment that has been replaced, land and/or buildings.

Uses of sales of assets

Capital expenditure and revenue expenditure (but only in extreme cases when a business is facing a liquidity crisis).

Advantages of sales of assets

Zero cost of finance (as there are no interest charges).

Disadvantages of sales of assets

If assets are undesirable (e.g. obsolete technology) or there is no demand, fund cannot be raised.

Privately held companies

Cannot sell their shares to the general public.

Publicly held companies

Can raise finance by issuing even more shares, known as share issues.

Uses of share capital

Revenue expenditure.

Advantages of share capital

Can raise a huge amount of finance, especially for publicly held companies.

Disadvantages of share capital

Time-consuming and expensive to prepare and launch.

Characteristics of loan capital

Interest is charged for the loan and the amount borrowed is repaid in instalments over a fixed period of time.

Examples of loan capital

Bank loans, mortgages, debentures.

Uses of loan capital

Capital expenditure.

Advantages of loan capital

Repayment by instalments gives businesses time to earn revenue so they can repay the loan.

Disadvantages of loan capital

Depending on the interest rate, cost of borrowing may be high.

Overdraft

Allows a business to withdraw more than its bank balance up to an agreed limit; a flexible short-term borrowing option.

Uses of overdraft

Revenue expenditure.

Advantages of overdraft

Flexible finance for unexpected large cash outflows.

Disadvantages of overdraft

Cost of borrowing is high due to high interest rates compared to other loan-bearing sources of finance.

Payment period for trade credit

Usually 30 to 60 days.

Advantages of trade credit

Allows time for businesses to process raw materials into goods/services and earn revenue so they can pay for the raw materials.

Disadvantages of trade credit

If payments on invoices are late, businesses can be charged overdue payment penalties.

Advantages of crowdfunding

Potentially high reward in generating funding with low initial risk.

Disadvantages of crowdfunding

Cost of finance in the form of hosting fees to crowdfunding platforms.

Leased Assets

Examples include premises, machinery, and equipment.

Sale and Leaseback

A form of leasing where businesses sell their asset and immediately hire the use of the asset from the new owner.

Capital Expenditure

Funds used by a business to acquire or upgrade physical assets such as property, industrial buildings, or equipment.

Advantages of Leasing

Useful for businesses that do not have the capital to purchase expensive assets outright; repairs and maintenance are the owner's responsibility; leasing is treated as an expense which helps reduce profits tax.

Disadvantages of Leasing

In the long run, the cost of leasing can exceed the cost of purchasing the asset outright.

Microfinance Providers

Financial services aimed at entrepreneurs from disadvantaged sectors to enable access to financial services and help eradicate poverty.

Accessibility to Finance

Microfinance provides access to financial resources for impoverished individuals.

Job Creation

Microfinance can lead to job creation by funding micro-businesses.

Social Well-Being

Increased access to healthcare resulting from microfinance initiatives.

Unethical Lending Practices

Many microfinance lenders operate as for-profit entities, leading to potential exploitation.

Limited Sums of Finance

Due to the high risk of default, microfinance providers may offer limited amounts of funding.

Difference from Venture Capitalists

Business angels invest personally, while venture capitalists operate as a pool of professionally managed funds.

Loss of Control

Businesses may experience some loss of control as business angels tend to take a proactive role.

Types of Costs

Includes fixed, variable, direct, and indirect (overhead) costs.

Indirect Costs (Overheads)

Costs that cannot be traced directly to a specific product, such as rent and utilities.

Revenue Definition

The money received from the sale of goods and/or services, calculated as Sales Revenue = Price × Quantity Sold.

Example of Revenue Calculation

If a company charges $300 per pair of shoes and sells 3,000 pairs, the total sales revenue is $900,000.

Revenue Streams

Sources of revenue beyond sales, including fees, advertising, transaction fees, and sponsorships.

Annual Fees

Recurring charges for services, such as membership or subscription fees.