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links to several thousand public panies’ ‘Report and Accounts’
Accounting 51
online； so you can save yourself the time and trouble of hunting down
pany websites。
RATIO ANALYSIS SPREADSHEETS
biz/ed （bized。uk 》 pany Information 》 Financial Ratio
Analysis） and the Harvard Business School （h。。p：//harvardbusinessonline。
hbsp。harvard。edu/b02/en/academic/edu_tk_acct_fin_ratio。jhtml） have free
tools that calculate financial ratios from your financial data。 They also
provide useful introductions to ratio analysis as well as defining each ratio
and the formula used to calculate it。 You need to register on the Harvard
website to be able to download their spreadsheet。
BREAK…EVEN ANALYSIS
This is a technique that straddles several business disciplines。 It requires
the student to grasp that there are fundamentally two different types of
cost。 Fixed costs are those that don’t vary with the volume of output。 So
the rent on say a retail outlet remains ‘fixed’ irrespective of the amount
of sales actually achieved。 It doesn’t mean； of course； that the cost itself is
fixed as the landlord could change the rent。 Variable costs are those that do
change with sales levels。 So a retailer would need to buy in stock to meet
rising demand and a manufacturer will need more raw materials and more
worker hours。
The break…even equation is：
Break…even point = Fixed costs
Selling price – Unit variable cost
So if； say； the rent was ￡10；000 （fixed costs） and the selling price was ￡5 and
the cost of buying in the only produce we sell was ￡3； then the break…even
point in 5；000 units。 If you goal was to make ￡10；000 profit then by adding
that to the fixed costs you can see that sales need to reach 10；000 units。
There are a number of online spreadsheets and tutorials that will take you
through the process。 biz/ed （bized。uk 》 Virtual Worlds 》 Virtual
Learning Arcade 》 Break…even Analysis） is a simulation that lets you see
the effect of changing variables on a fairly plex breakeven calculation。
Score （score 》 Business Tool 》 Template Gallery 》 Break Even
Analysis） and BizPep （bizpeponline/PricingBreakeven。html） sell
a so。。ware programme that calculated your break…even for prices plus or
minus 50 per cent of your proposed selling price。 You can tweak costs to see
how to optimize your selling price and so hit your profit goal。
Finance
。 Where business gets its money
。 The difference between debt and shareholders’ investment
。 Understanding the role of private equity
。 Floating on a stock market
。 Calculating the cost of capital
。 Budgeting for the future
The dividing line between accounting and finance is blurred。 In basic
terms accounting is considered to be everything concerned with the process
of recording financial events and ensuring that such recordings are
in pliance with the prevailing rules。 Finance is the area concerned
with where the money to run a business actually es from in order
to be accounted for。 In order to be able to understand and interpret the
accounts using such tools as ratios you need a reasonable grasp of both
these areas； though the ratios themselves are generally considered to be in
the accounting domain。 In this book the accounting and finance chapters
have been placed next to each other to eliminate the need for debate on
boundaries。
In many business schools you will find an array of options in addition
to the core elements of this discipline。 At the London Business School；
for example； you will find asset pricing； corporate finance； hedge funds；
corporate governance； investments； mergers and acquisitions； capital
markets and international finance on the menu。 Members of the Finance
Group also run the BNP Paribas Hedge Fund Centre； the Centre for
Corporate Governance； the Private Equity Institute and the London
Share Price Database。 At Cass Business School； City of London； you will
find options on behavioural finance； dealing with financial crime； and
derivatives。 In this chapter there is all that you would find in the core
teaching that you need to understand and sufficient to move on to more
esoteric aspects of finance should the need ever arise。
2
Finance 53
SOURCES OF FUNDS
There are many sources of funds available to businesses； however； not
all of them are equally appropriate to all businesses at all times。 These
different sources of finance carry very different obligations； responsibilities
and opportunities for profitable business。 Having some appreciation of
these differences will enable managers and directors to make an informed
choice。
Most businesses initially； and o。。en until they go public； floating their
shares on a stock market； confine their financial strategy to bank loans；
either long term or short term； viewing the other financing methods as
either too plex or too risky。 In many respects the reverse is true。 Almost
every finance source other than banks will to a greater or lesser extent share
some of the risks of doing business with the recipient of the funds。
Debt vs equity
Despite the esoteric names – debentures； convertible loan stock； preference
shares – businesses have access to only two fundamentally different sorts
of money。 Equity； or owner’s capital； including retained earnings； is money
that is not a risk to the business。 If no profits are made； then the owner and
other shareholders simply do not get dividends。 They may not be pleased；
but they cannot usually sue； and even where they can sue； the advisers
who remended the share purchase will be first in line。
Debt capital is money borrowed by the business from outside sources； it
puts the business at financial risk and is also risky for the lenders。 In return
for taking that risk they expect an interest payment every year； irrespective
of the performance of the business。 High gearing is the name given when
a business has a high proportion of outside money to inside money。 High
gearing has considerable a。。ractions to a business that wants to make high
returns on shareholders’ capital。
HOW GEARING WORKS
Table 2。1 shows an example of a business that is assumed to need ￡60；000
capital to generate ￡10；000 operating profits。 Four different capital structures
are considered。 They range from all share capital （no gearing） at one end
to nearly all loan capital at the other。 The loan capital has to be ‘serviced’；
that is； interest of 12 per cent has to be paid。 The loan itself can be relatively
indefinite； simply being replaced by another one at market interest rates
when the first loan expires。
Following the tables through； you can see that return on the shareholders’
money （arrived at by dividing the profit by the shareholders’ investment
54 The Thirty…Day MBA
and multiplying by 100 to get a percentage） grows from 16。6 to 30。7 per cent
by virtue of the changed gearing。 If the interest on the loan were lower； the
ROSC； the term used to describe return on shareholders’ capital； would be
even more improved by high gearing； and the higher the interest； the lower
the relative improvement in ROSC。 So in times of low interest； businesses
tend to go for increased borrowings rather than raising more equity； that is；
money from shareholders。
At first sight this looks like a perpetual profit…growth machine。 Naturally；
shareholders and those managing a business whose bonus depends on
shareholders’ returns would rather have someone else ‘lend’ them the
money for the business than ask shareholders for more money； especially if
by doing so they increase the return on investment。 The problem es if
the business does not produce ￡10；000 operating profits。 Very o。。en a drop
in sales of 20 per cent means profits are halved。 If profits were halved in
this example； the business could not meet the interest payments on its loan。
That would make the business insolvent； and so not in a ‘sound financial
position’； in other words； failing to meet one of the two primary business
objectives。
Table 2。1 The effect of gearing on shareholders’ returns
No gearing Average
gearing
High
gearing
Very high
gearing
N/A 1：1 2：1 3：1
Capital structure ￡ ￡ ￡ ￡
Share capital 60；000 30；000 20；000 15；000
Loan capital （at 12％） – 30；000 40；000 45；000
Total capital 60；000 60；000 60；000 60；000
Profits
Operating profit 10；000 10；000 10；000 10；000
Less interest on loan None 3；600 4；800 5；400
Net profit 10；000 6；400 5；200 4；600
Return on share capital = 10；000 6；400 5；200 4；400
60；000 30；000 20；000 15；000
= 16。6％ 21。3％ 26％ 30。7％
Times interest earned = N/A 10；000 10；000 10；000
3；600 4；800 5；400
= N/A 2。8 times 2。1 times 1。8 times
Finance 55
Bankers tend to favour 1 ： 1 gearing as the maximum for a business； although
they have been known to go much higher。 As well as looking at
the gearing； lenders will study the business’s capacity to pay interest。
They do this by using another ratio called ‘times interest earned’。 This is
calculated by dividing the operating profit by the loan interest。 It shows
how many times the loan interest is covered； and gives the lender some
idea of the safety mar