Chapter 1: Forms Of Business Ownership

1.1 Sole Trader

- A sole trader is a business owned by a single person
- Many farms, retail establishments, and small service businesses are sole trader
- They have unlimited liability
- Funding by the owner -> own capital and some borrowing
- Day to day management by the owner with some delegations of responsibilities

Advantages of Sole Traders:

- Low cost and easy to set up
- Lost cost to operate
- Managerial freedom to make all decisions
- Single layer of taxation -> taxed at the personal income
- Retain all profits
- Less government regulations
- Privacy -> no reporting requirements
- Flexibility and control -> not required approval from a business partner, or boss

Disadvantages of Sole Traders:

- Unlimited liability -> any damages or debts incurred by the business are the owner’s
personal responsibility
- Demands on the owner -> may have long, stressful hours, making all the major
decision, solving all the major problems, hard to take time off
 Access to social media which allows them to reach out for advice, ideas, useful
contacts, or new opportunities for the small businesses
- Limited managerial perspective
 Can turn to a variety of sources for input, including networks, support groups
dedicated for traders to counsel each other’s on key decisions
- Less financial resources and fewer ways to get additional funds from lenders or
investors
 Lack of capital may affect the operation of the business
- No employee benefits
- Finite life span -> the death of the owner may mean the demise of the business

1.2 Partnerships
- A company that is owned by two or more people but is not a corporation
- Appropriate for firms that need more resources and leadership talent than a sole
trader. But don’t need the fundraising capabilities or other advantages of a
corporation
- There are two types of partnerships:
 General partnerships: all partners have joint authority to make decisions for the
firm and joint liability for the firm’s financial obligations
 Limited partnerships: this helps minimise personal liability exposure. The limited
partners who do not participate in the running of the business and who have
limited liability as the maximum they are liable for is the amount they invested in
the business
 - A carefully written partnership agreement can maximise the advantages of the
partnership structure and minimise the potential disadvantages. The agreement
should include:
 Investment percentages  Succession and exit strategies
 Profit sharing percentages  Decision-making strategies
 Management responsibilities  Criteria for admitting new
 Other expectations of each partners
owner  Dispute – resolution
procedures
- A clear and complete agreement is important for every partnership
- Going into a partnership with anyone you have an established relationship with may
get in the way of successful business despite the great personal relationships or the
dynamics of the relationship

Advantages of Partnerships:
- Simplicity -> similar as a sole trader, however you’re in a business together
- Single layer of taxation
- More resources -> increased amount of money, to launch, operate and grow the
business
 A partnership can potentially raise more money because partner’s personal
assets support a larger borrowing capacity
 Partnerships get the opportunity to share costs
 Open to a wide range of skills and experiences within the partnership

Disadvantages of Partnerships:
- Unlimited liability -> all general and limited partners have the same unlimited liability
as sole traders -> bigger partnerships mean greater risks
- Potential for conflicts
- A partnership automatically ends when a partner leaves or dies

1.3 Corporations
- A corporation is a legal entity, distinct from any individual persons, that has the
power to own property and conduct business
- Owned by shareholders, investors who purchase shares of stocks
- The existence of the company is not affected by any change in its owners – the
change of ownerships does not affect the day-to-day operation of the business
- There are two types of corporation:
 Public corporation: a corporation in which shares are sold to anyone that wishes
to purchase them
 Private corporation (Pty Ltd): a corporation In which all the shares are owned by
only a few individuals or companies and is not made available for purchase by
the public
- Corporations can change between the two types of ownerships as their financial
needs or strategic interest changes
Advantages of Corporations:
- Ability to raise capital -> the ability to pool money by selling shares (equity) and
bonds (debts) to outside investors
 Ways a company can raise capital:
o equity capital raising – issuing shares into a market
o debt capital raising – promissory note into the market

- liquidity investors can easily and quickly convert their shares into cash by selling
them on the open market
- longevity: liquidity also helps gives the corporation a long-life span; when
shareholders sell their shares, ownership simply passes to a newer generation, so to
speak
- limited liability: a corporation itself has unlimited liability but the various
shareholders who won the corporation face online limited liability – their maximum
potential costs is only as great as the amount they have invested in the company

Disadvantages of corporations:
- cost and complexity -> selling shares to the public can be extremely expensive for
the firm and time consuming for upper managers
 can cost many hundreds of thousands of dollars for larger firms
- reporting requirements -> to help investors make informed decisions about shares,
government agencies, require publicly traded companies to public extensive and
detailed financial reports, which will take a lot of staff and management time and
they can expose strategic information that might benefit competitors and discourage
investors unwilling to wait for long-term results
- managerial demands -> top executives must make time & energy to meet up with
their shareholder, financial analysts, and the news media
- possible lost of control -> outside investors who acquire enough of a company’s
shares can gain seats on the board of directors and therefore exerting their influence
on company management
- possible lost on control -> outside investors who acquire enough of a company’s
shares can gain seats on the board of directors and therefore exerting their influence
on company management
- double taxation -> corporation must pay corporate tax on its profit, and individual
shareholders must pay income taxes on their share of the company’s profits received
on dividend

- No Liability Company: In Australia, this form on companies is restricted to mining

and resource companies
 Due to high level of risk shareholders face when investing in those companies
 Shareholders issued by a no liability company are commonly on a partly paid
basis
 Shareholders have no liability to pay any future calls on their partly paid shares,
however, by doing so they forfeit shares
 - Corporate governance: can be used in a broad sense to describe all policies,
procedures, relationships and systems in place to oversee the successful and legal
operation of the enterprise
 Shareholders
 Board of directors
 Corporate officers

Chapter 2: Financial Statements and Cash Flows

2.1 Firm Financial Statements

- Income statement – statement of comprehensive income
- Balance sheet – statement of financial position
- Cash flow statement – statement of cash flows
- Statement of change in equity

What are the accounting principles used to prepare financial statements?

- Accrual basis: sales are always reported
 Revenues are recognised when earned, not necessarily when received in cash
 Expenses are recognised when incurred, not necessarily when paid in cash
- Historical cost principles
 Records assets and liabilities at the price paid to acquire them (historical costs),
which is usually not the price the asset could besold for today

2.2 Income Statements

- shows the:
 revenue earned
 expenses incurred and,
 profit generated

Formulas:
- income = gross profit – costs of goods sold
 Y = GP - COGS
- costs of goods sold= opening stock + purchases – closing stock
 COGS = OS + P – CS
- gross profit= sales – costs of goods sold
 GP = S – COGS
- expenses = gross profit – net profit
 E = GP - NP
- net profit = gross profit – expenses
 NP = GP – E
Income Sheet Layout
Sales
less COGS
Gross Profit
less Operating Expenses
Operating Profit
less Interest Expense
Net Profit before Tax
Less Tax
Net Profit
Additional Information
Earnings per share
Dividends per share

- Gross profit margin: the ratio of gross profit (sales less of costs of goods sold)
divided by sales
- Operating profit ratio margin: the ratio of operating profit divided by sales
- Net profit margin: net profit divided by sales

2.3 Balance Sheet

Formula: Assets = Liabilities + Owner’s Equity

- Total liabilities: the total amount of money the firm owes its creditors (including the
firm’s banks and suppliers)
- Owners equity: total assets less than total liabilities represent the new amount
invested by the firm’s owner
- Total assets: the total of current assets and non-current assets recorded in the firm’s
balance sheet
- Market value: the price that a asset would trade for in a competitive market
- Net property plant and equipment: the cumulative historical cost of land, buildings,
plant and equipment owned by the firm (gross property, plant and equipment) less
accumulated depreciation expense that has been charged against those assets over
the useful life

- Assets: The left-hand side of the balance sheet

 Current assets
 Cash
 Account receivable
 Inventories
 Other current assets
 Gross property, plant and equipement
 Less accumulated depreciation
 Net property, plant and equipment
 - Liabilities and owner’s equity: the right-hand side of the balance sheet
 Current liabilities
 Accounts payable
 Accrued expenses
 Short-term notes
 Non-current liabilities
 Owner’s equity

2.4 Cash Flow Statement

Formula: Opening Cash Balance + Cash Inflows – Cash Outflows = Closing Balance

- the net amounts of cash that the firm collected or spent during the period
- because accountants follow the accrual method of accounting. The change in cash
balance for the period will not necessarily match up with reported net profit

Chapter 3: Entrepreneurship and Small-Business Ownership

Economic Roles of Small Business

- they provide jobs:
 although most small businesses have no employees, those that do, employed
around 4.5 million people in 2012-13, approx. 43 per cent of private sector
employment (Australian Treasury 2014)
- they introduce new products:
 the freedom to innovate that is characteristics of many small firms continues to
yield countless advances. Among all firms that apply for patents or new
inventions, on average, small businesses receive 16 times more patents per
employee than larger firms
- they meet the needs of larger organisations:
 many small businesses act as distributors, servicing agents, and suppliers to
larger corporations and to numerous government agencies (which often reserve
a certain percentage of their purchasing contracts for small businesses)
- they inject a considerable amount of money into the economy:
 small businesses produced $343.4 billion (around 33.1%) in 2013-14 of the
Australian nation’s economic output (Source: ABS, Australian Industry, 2013014,
Cat. No. 81550, Table 5)
- they take risks that larger companies sometimes avoid:
 entrepreneurs play a significant role in the economy as risk takers – people
willing to try new and unproven ideas
- they provide specialised goods and services:
 small businesses frequently spring up to fill niches that aren’t being served by
existing companies

Small Businesses
- majority of small businesses are modest operations with little growth potential,
although some have attractive income potential for the solo business person
 - self-employed consultant or a local florist are sometimes called lifestyle businesses
because they are built around the personal and financial needs of an individual or a
family
- other firms are simply small because they are young, but they have ambitious plans
to grow. These high-growth ventures are usually run by a team rather than by one
individual, and they expand rapidly by obtaining a sizeable supply of investment
capital and by introducing new products or services to a large market

Characteristics of Small Businesses

- regardless of their primary objectives, small companies tend to differ from large ones
in a variety of important ways:
 most small firms have a narrow focus, offering fewer goods and services to fewer
market segments
 small businesses have to get by with limited resources
 small businesses often have more freedom to innovate
 entrepreneurial firms find it easier to make decisions quickly and react to
changes in the marketplace

Factors contributing to the increase in the number of small businesses today

- E-commerce, social media, and other technologies:
 The rapid growth of e-commerce and social media in recent years has
revolutionised the way many businesses operate. Companies such as Facebook
and Twitter couldn’t exist without web technologies, of course, because their
connection to customers happens entirely online.
- Growing diversity in entrepreneurship:
 Small-business growth is being fuelled in part by women, minorities, immigrants,
military veterans who want to apply their leadership skills, older workers who
can’t find employment to fit their interests or skills, and young people who want
alternatives to traditional employment.
- Downsizing and outsourcing:
 Businesses start-ups often soar when the economy sours. During hard times,
many companies downsize or lay off talented employees, who then have little to
lose by pursing self-employment.

The Entrepreneurial Spirit

- The positive, forward-thinking desire to create profitable, sustainable business
enterprises – and the role it can play in every company, not just small or new firms
- Vital to the health of the economy and to everyone’s standard of living, and it can
help even the largest and older companies become profitable and competitive

Why people start their own companies?

- More control over their future
- Tired of working for someone else
- Passion for new product ideas
- Pursue business goals that are important to them on a personal level
- Inability to find attractive employment somewhere else
Business plan and support for business owners
- Business plan:
 A document that summarises a proposed business venture, goals, and plans for
achieving those goals
 Business plans can be written before the company is launched, when the
company is seeking funding, and even after the company is up and running
- Preparing a business plan serves three important functions:
 Guides the company operations and outlines strategies for turning an idea into
reality
 Helps persuade lenders and investors to finance your business if outside money
is required
 Provide a reality check in case an idea just isn’t feasible

Why new businesses fail

- Leadership issues
 Managerial incompetence
 Lack of strategic planning
 Lack of relevant experience
 Inability to make the transition from corporate employee to entrepreneur
- Marketing and sale issues
 Ineffective marketing
 Uncontrolled growth
 Overreliance on a single customer
- Financial issues
 Inadequate financing
 Poor cash management
 Too much overhead
- Systems and facilities issues
 Poor location
 Poor inventory control

Advice and support for business owners

- Keeping a business going is no simple task. Fortunately, entrepreneurs can get advice
and support from a wide variety of sources:
 Government agencies and not-for-profit organisations: numerous city, state,
and federal government agencies offer business owners advice, assistance and
even financing in some cases. E.g. Grants and Assistance Finder provides advice
and help finding finance for your business
 Business partners: banks, credit card companies, software companies
 Mentors and advisory boards:
 Advisory board is a team of people with subject-area expertise or vital
contacts who help a business owner review plans and decisions
 Mentoring can happen through both formal programs such as WorkCover
Mentor Program in NSW and informal relationships developed in person or
online
 Print and Online Media: local library and internet can offer information
  Network and support groups: social networking technology gives entrepreneurs
an endless array of opportunities to connect online
 Business incubators: facilities that house small businesses and provide support
services during the company’s early growth phase including various
combinations of advice, financial support, access to industry insiders and
connections

Financing Options for small businesses

- Private financing
 Seed money: first infusion of capital used to get a capital business started,
through family loans.
 Bank and microlenders: most important sources of financing for small
businesses. In most cases, banks would not lend money to a start-up that hasn’t
established a successful track record.
 Microlenders: organisations, often not-for-profit, that lend smaller amounts of
money to business owners who might not quality for conventional bank loans
 Venture capitals: long-term finance (usually equity finance) provided by certain
institutions to small and medium-sized businesses in order to exploit relatively
high-risk opportunities. Ventures capitals providers may be interested in a variety
of businesses for various purposes:
 Business start ups
 Early stage capital
 Expansion capital
 Buy-out or buy-in capital
 Business angels: wealthy, successful business owners who are willing to invest,
through a shareholding, in a start-up or developing stage of a business’s life and
in smaller amounts than Venture Capitals are willing to invest or banks are willing
to lend
Question 7-5: Liquidity Analysis
The King Carpet Company has $3,000,000 in cash and a total of $12,000,000 in current
assets. The firm’s current liabilities equal $6,000,000 such that the firm’s current ratio
equals 2. The company’s managers want to reduce the firm’s cash holds to $1,000,000 by
paying $500,000 in cash to expand the firm’s truck fleet and using $1,500,000 in cash to
retire a short-term note. If they carry this plan through, what will happen to the firm’s
current ratio?

- Current ratio: a measure of the firm’s liquidity position, equal to the ratio of current
assets to current liabilities. Generally, the higher the current ratio, the more liquid a
firm is.

- If the plan is carried through, cash (a current asset) will decrease by $2m, while
short-term notes (a current liability) will decreased by $1.5m

- The firm has $2.2 in current assets for every $1 that it owes in current liabilities

Question 7-6: Capital Structure Analysis

The liabilities and shareholders’ equity for Campbell Industries are as follows:

a) What fraction of the firm’s assets does the firm finance using debt (liabilities)?
b) If Campbell were to purchase a new warehouse for $1 million and finance it using
long-term debt, what would happen to the firm’s debt ratio?

a) Debt ratio: measures the extent to which the firm has used non-owner financing to
finance its assets. The higher the ratio, the greater the reliance on borrowed
financing or financial leverage.
 b)

Question 7-12
In the year just ended, Callaway Lighting had sales of $5,000,000 and incurred a cost of
goods sold equal to $4,500,000. The firm’s operating expenses were $130,000 and its
increase in retained earnings was $40,000 for the year. There are currently 100,000 ordinary
shares outstanding in…

a) Assuming the firm’s earning are taxed at 30%, construct the firm’s income statement

b) Calculate the firm’s operating profit margin and net profit margin
- Operating profit margin: informs managers how much profit they generated from
each dollar of sales after accounting of both COGS and operating expenses.
Measures how well the firm is managing its income statement, considering an
objective of managing operations is to keep costs and expenses to a minimum
relative to sales

- Net profit margin: percentage of revenue remaining after all operating expenses,
interest, taxes and preferred stock dividends have been deducted from a company’s
total revenue, we can see what percentage of revenue made it all the way to the
bottom line, which is good for investors.
 c) Compute the interest coverage ratio. What does this ratio tell you about Callaway’s
ability to pat its interest expense?
Interest coverage ratio: measures the firm’s ability to pay its interest expenses from the
firm’s operation profit. A higher ratio indicates that the firms is able to pay its interest in a
timely manner

Question 7-18
Question 8 -1
What are the financial markets? What functions do they perform? How would an economy
be worse off without them?
- Financial markets are institutions and procedures that facilitate transactions for all
types of financial claims
- Financial markets perform the function of allocating savings in the economy to the
ultimate demanders of those savings
- Without financial markets the total wealth of the economy would be lessened

Question 8 -2
Who are the three major groups of players that interact in the financial markets? Briefly
describe them
- Borrowers – those who need money to finance their purchase including businesses
and individuals
- Lender or investors (saver) – those who have money to invest; principally individuals
who save money for a variety of reasons, and firms with excess cash
-

Question 8-4
What are the main activities of an investment bank? How do investment banks differ from
commercial banks?
- Investment banks are specialised financial intermediaries that help companies and
government raise money and provide advisory service to client firms
- Their main source of revenue is fees for financial services rendered, whereas the
main activity of commercial banks is taking deposits and lending money from those
pooled deposits, earning revenue from the margin between the interest rates that
they pay and receive

Question 8-7
Distinguish between the money market and the capital market
- The money markets consists of all institutions and procedures that accomplish
transactions in short-term (usually less than 12 months) debt instruments issued by
borrowers with (typically) high credit ratings
 Examples of securities traded in the money market include treasury notes, bank
bills and promissory notes
 - The capital market provides for transaction in long-term financial claims (those
claims with maturity periods extending or likely to extend beyond one year)
 Examples of securities traded in the capital market include bonds, debentures
and equities

Question 8 – 11
In the last decade there has been a shift towards the direct transfer of funds from investors
to the corporate sector, Examine some of the reasons for this trend.
- The shift from indirect financing to direct financing has been explained by both
demand and supply factors
 On the demand side, advancement in information technology makes it easier for
individuals to directly buy and sell shares online. Individuals are also better
equipped with information about the financial markets and how they function
 On the supply side, corporations are improving their credit ratings and are better
known to the public. As a result, on many occasions they choose to raise funds
from the public as opposed to resorting to financial institutions for financing

Question 8 – 12
What are the two major market-traded forms of financial derivatives? Outline the main
features of these contracts.
- The two major market-traded derivatives are futures and options
 Futures are a contract between two parties to buy/sell a certain asset at a price
fixed today at a predetermined date in the future. There are a couple of main
features associating with futures including:
o Contracts are standardised,
o Marking to market and;
o Margin requirements
 An option is a right but not an obligation to buy/sell an asset at the strike price
on or before a certain date known as the expiry date. The main feature of
options of distinguishing it from futures contracts is it represent the right but not
the obligation to participate in the transaction

Question 8-13
Outline the major funds flows in the Australian financial economy. In your answer, clearly
identity the sectors that are net savers
- The household sectors: the main net saver with financial claims over the
government, the financial sector and the non-financial sector
- The non-financial sectors: the main user of funds owing money to all other sectors
of the economy including the rest of the world
- the government sector: has financial claims over non-financial corporations but
borrows money from the household sector and the rest of the world
- the financial sector: borrows from the household sectors and the government to
finance their investments in the non-financial corporations and in foreign securities
- the foreign sector: funds activities of non-financial corporations and the government
but is a net user of funds from the household sector and the financial corporations
Question 8 – 15
- maturity transformation: the banks borrow from a large number of people and firms
who can withdraw their money at short notice. They can lend on a long-term basis in
the knowledge that net withdrawals at any one time will be small. This process is
maturity transformation
- risk transformation: a similar process operates to facilitate risk transformation.
Financial intermediaries lend to large numbers of borrowers and thus the risk of
default can be spread