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Basic Financial Terms

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Business Studies

The word 'terminology' refers to the language used in a specific field. For example, health, science, and finance all have their own terminology. Knowing the specific terminology of a subject is crucial to understanding industry reports and discussing relevant issues with your peers. Read on for an introduction to basic financial terms in business.

Basic financial terms in business

Revenue, costs, profit and loss, the average rate of return, and break-even are basic financial terms you can find in most companies' documents and financial reports.

Let’s take a closer look at each of them:

Revenue and costs

Revenue includes the total sales of a business’s products and services, calculated by multiplying the price per unit by the number of units sold.

Here's the formula for calculating revenue:

Check out our explanation on Revenue to explore this topic in more detail!

Total costs are all the costs spent on producing a company’s output.

Total costs consist of variable costs and fixed costs:

  • Variable costs are costs that change as the number of goods or services a business produces changes. For example, wages (the amount employees are paid per hour), packaging, utilities, and raw materials are variable costs.

  • Fixed costs are costs that a company must pay each month regardless of how much it produces. Rent, salaries, insurance, interests, depreciation, and property taxes are common examples of fixed costs.

To learn more about the differences between fixed and variable costs, take a look at our explanation on Costs!

Here's the formula for calculating total costs:

Salary vs wage per hour: Salaries are considered fixed costs, as salaried employees get paid the same no matter how the business is doing. On the other hand, variable labour costs can come from workers who work per hour and receive wages depending on the business' needs.

A doughnut shop sells its doughnuts at £2 apiece. The variable cost per doughnut is 30p. The shop spends £1,000 on fixed costs per week.

Calculate:

a. The total revenue of the doughnut shop per month.

b. The total costs if the shop sells 800 doughnuts per week.

Answer:

a. Total revenue = Price x Number of units sold

Revenue for the doughnut shop per week is £2 X 800 = £1,600

b. Total costs = (variable costs per unit x quantity) + fixed costs

Total costs for the doughnut shop per week is (£0.30 X 800) + 1,000 = £1,240

Profit and loss

Profit (or loss) is the difference between the business’s revenue and total costs.

Profit occurs when a business’s revenue is greater than the total cost. By contrast, a loss happens when the total costs exceed total revenues.

A surplus of revenue is vital to business growth, as the extra funds can be used to purchase new machinery, more raw materials or hire more employees. Repeated losses can bring about a shortage of capital and result in business failure.

Here's the formula for calculating profit:

Continuing with the example above, the doughnut shop makes £1,320 in revenue per week. Suppose the total cost for running the business is £1,120. How much profit does the company make?

Answer:

Profit = Total revenue - Total costs

The doughnut shop has made a profit: £1,320 - £1,120 = £200 per week.

The average rate of return

Investment in machinery, workforce, inventory, etc. is vital to a business’s growth. How can a business decide when to make an investment?

A good investment is one that brings the company more financial gain than if it had put the money elsewhere. For example, if a business knows it can get 1% interest from its bank account, any investment that generates more than 1% in profit is considered a good investment.

The average rate of return (ARR) is a calculation that helps a business compare different investment options. It compares the average annual profit of an investment with its initial costs.

Here are two steps to calculate the average rate of return:

Step 1: Calculate the annual profit of a company:

Step 2: Calculate the average rate of return of the investment:

A company has to choose between two investment projects A and B. The initial cost of investment is £100,000. The following table breaks down the estimated annual profit for each project in 5 years. Can you tell which one the company will choose to invest in?

Year

Project A

Project B

Estimated annual profit (£)

Estimated annual profit (£)

1

20,000

0

2

20,000

0

3

40,000

70,000

4

40,000

80,000

5

50,000

80,000

Total profit

170,000

230,000

Average annual profit

170,000/5 = 34,000

230,000/5 = 46,000

Average rate of return

34,000/100,000 = 34%

46,000/100,000 = 46%

Project B is more profitable since 46% > 34%.

Basic Financial Terms: Break-even

Break-even is the point where revenue equals total costs. The business makes neither a profit nor a loss.

The output at which the company needs to sell to reach the break-even point (BEP) is called the break-even level of output.

To determine the point of break-even, we often use a break-even analysis. The break-even analysis calculates how many sales the company has to make to cover the fixed and variable costs of production.

To learn more, take a look at our explanation Break-even analysis!

Here's the formula for calculating the break-even point:

A company with lower fixed costs will have a lower break-even point, assuming the variable costs do not exceed revenue.

An item is sold for £50. The total fixed cost is £1,000 and variable costs are £10 per unit.

Calculate:

a. The contribution margin per unit.

b. The break-even point of sales.

Answer:

a. The contribution margin per unit = selling price per unit - variable cost per unit = £50 - £10 = £40

b. The break-even point = fixed costs/contribution margin per unit = 1,000/40 = 25 (units)

At the fixed cost of £1000, the company needs to make 25 units to reach the break-even point.

Break-even graph

The break-even graph represents the break-even point visually.

Basic Financial Terms break-even graph StudySmarterFigure 1. Break-even graph, StudySmarter

Looking at Figure 1:

  • The break-even point is the intersection of the total cost and revenue.

  • Loss is depicted below the break-even point (the space between revenue and the total cost line).

  • Profit is depicted above the break-even point (the space between revenue and total cost line).

Check out our Break-even analysis charts explanation for more information!

Margin of safety

The margin of safety is the number of sales that a business makes before the break-even point.

Here's the formula for calculating the margin of safety:

Supposing a business has a break-even point of 75 products and it has sold 100, the margin of safety is 100 - 75 = 25 (products)

Interpretation: The company can make a profit on its remaining 25 units sold - sales could fall by 25 units before the break-even point is reached.

Financial statements

Financial statements are documents that give a picture of how well the company is doing financially. It includes three main documents: balance sheet, income statement, and cash flow statement.

Balance sheet

A balance sheet gives information on what a company owns (assets) and owes (liabilities) at the end of a certain period.

A balance sheet might include the following components:

Balance Sheet
ASSETSLIABILITIES
Current AssetsEquity
Fixed AssetsLong-term Liabilities
Current Liabilities

Assets are what a company owns. There are fixed assets and current assets:

  • Fixed assets are assets that will not be sold in the near future such as machinery, buildings, land, and equipment.

  • Current assets are assets used in production or covering business immediate expenses. Some examples include cash, inventory, and accounts receivable.

Liabilities are what a company owes to others. They can be divided into short-term and long-term liabilities:

  • Short-term (current) liabilities are debts that have to be paid back within a year. For example, accounts payable, overdrafts, dividends, etc.

  • Long-term liabilities are debts that will be paid back over many years. For example, mortgages, bank loans, etc.

Equity represents ownership of a company. It is the deduction of liabilities from assets.

Suppose your company is worth £35,000 but you have £10,000 in debt, the equity is £25,000.

Here's an example of what a balance sheet might look like:

balance sheet example, StudySmarterFigure 2. Balance sheet example, StudySmarter

Accounts receivable vs accounts payable in finance

Accounts receivable is the money that the customer owes to the company. It appears on the balance sheet under the current assets.

Accounts payable, on the other hand, is the money that the company owes to the supplier. It appears on the balance sheet under the current liabilities.

Both accounts receivable and accounts payable are money not yet paid.

An apple juice company buys fresh apples from a farm with a promise to pay back another day, this transaction will appear as accounts payable on the company's balance sheet. Suppose a client makes an order of apple juice from this company, the transaction will be recorded as accounts receivable.

Income statement

An income statement gives the financial picture of a company over a period of time. It reveals the business's loss or profit by comparing the total revenue with the total expenses.

An example of an income statement:

Company A Income Statement in quarter 1 of 2022
Sales revenue750,000
Cost of sales400,000
Gross profit350,000
Overhead costs90,000
Operating profit260,000
Tax and interests80,000
Net profit180,000

Company A earned a total of £750,000 in the first quarter of 2022. Its gross profit is calculated as sales revenues minus the cost of sales, which was around £350,000. After deducting the overhead costs, taxes and interests, the company was left with a net profit of £180,000. This is the money it could reinvest into the business or distribute to the shareholders.

Cash flow statement

A cash flow statement specifies the sources of a company's cash flows.

Unlike the balance sheet and income statement, the cash flow statement does not include non-cash transactions such as accounts receivable or depreciation.

Here's a simple version of a company's cash flow statement:

Statement of cash flow
Cash flow from operating+ £5,000
Cash flow from investing- £2,000
Cash flow from financing- £1,000
Net cash flow£2,000

By keeping track of the cash flow, the company can assess its ability to pay off debts or convert non-cash assets into cash.

Now, let's have a look at the two ways companies can raise capital: equity financing and debt financing.

Equity financing

The type of financing with no repayment obligation is equity financing.

Equity financing involves a company's equity to raise capital for business needs.

Equity financing does not require the company to repay the money it acquires. However, the owners need to give up part of their company's ownership to the investors.

A company needs to raise capital to expand its facility. The owner is willing to give up 15% ownership in exchange for an investor's funding. The investor now owns 15% of the company and receives an invoice of business decisions making use of his invested money.

Debt financing

A more common type of financing is debt financing.

Debt financing is the borrowing of money to cover business needs.

When financed by debt, the owner does not need to give up part of the company's ownership. Also, once the debt is paid off, the relationship between the owner and the lender ends. The lender doesn't get to control the business.

The main drawback of this approach is that the company is liable to pay its debt along with interests.

Basic Financial Terms - Key takeaways

  • The basic financial terms include revenue, costs, profits and loss, the average rate of return, and break-even.

  • Revenue is the total sales of a business’s products or services, calculated by multiplying the price per unit by the number of units sold.

  • Total costs are all the costs spent on producing a company’s output, consisting of

    • Variable costs change as the number of goods or services a business produces changes.

    • Fixed costs remain the same regardless of how many units are sold.

  • The average rate of return (ARR) is a financial tool that helps a business compare different investment options, calculated by dividing the average annual profit by the cost of the initial investment.

  • Break-even is the point at which revenue equals total costs.

  • The overall financial performance of a business can be analysed via the financial statements which include the balance sheet, the income statement, and the cash flow statement.

    • The balance sheet gives information on what a company owns and owes to others at a specific point in time.
    • The income statement provides data on a company's revenues, expenses, losses or profits.
    • The cash flow statement specifies where a company's sources of cash inflows are from.
  • There are two ways for a company to raise capital: debt financing and equity financing.

Basic Financial Terms

Debt financing is a type of financing where the company issues a loan to cover its business expenses. The main benefit of debt financing is that the owner doesn't have to give up part of the company's ownership to the lender, as opposed to equity financing. 

Some examples of financial assets are cash and cash equivalents, stocks, bonds, mutual funds, and bank deposits. Financial assets don’t have a physical form, unlike tangible assets such as land, buildings, or machinery. 

Fixed assets are assets that will not be sold in the short term such as machinery, buildings, or land. Current assets are assets that can be used to cover immediate expenses or turned into final products, e.g., inventory, cash, or accounts receivable. 

Equity financing is a type of financing where the business gives up part of its ownership (equity) in exchange for money to cover business needs. Unlike debt financing, equity financing comes with no repayment obligations. 

A company's expenses can be categorised into fixed costs and variable costs. Fixed costs are costs that remain the same regardless of the number of units sold, e.g. fixed salary, rent, interest payments, etc. Variable costs, on the other hand, are costs that change as the number of products produced changes, e.g. material costs, salary by the hour, etc. 

Final Basic Financial Terms Quiz

Question

What is revenue?

Show answer

Answer

Revenue is the total sales a business makes by selling its products or/and services.

Show question

Question

What do total costs include?

Show answer

Answer

variable and fixed costs

Show question

Question

What is not a fixed cost?

1- Raw materials

2- Rental lease

3- Insurance

4- Interest payments


Show answer

Answer

1

Show question

Question

What is not a variable cost?

1- Wages (staff paid by the hour)

2- Rents

3. Raw materials

4. Utilities


Show answer

Answer

1


Show question

Question

What is the difference between variable and fixed costs?


Show answer

Answer

Fixed costs remain the same regardless of how many units of product a company produces. Variable costs change as the number of units produced change.

Show question

Question

What is the formula to calculate the profit of a company?

Show answer

Answer

Profit/Loss = revenue - total costs

Show question

Question

When does a company make a loss?


Show answer

Answer

When the cost of production exceeds the revenue it makes

Show question

Question

What financial tool helps the company choose between different investment options?


Show answer

Answer

Average annual return rate

Show question

Question

How is the average annual return rate (ARR) calculated?


Show answer

Answer

Average rate of rate (%) = Average annual profit/cost of investment * 100

Show question

Question

What is the break-even point?


Show answer

Answer

Break-even point is the point at which the company’s sales revenue equals its total costs.

Show question

Question

Why is break-even analysis important?


Show answer

Answer

The break-even analysis helps the company determine how many products it needs to sell to break even.

Show question

Question

What is not shown on the break-even graph?

1- selling price

2- units sold

3- fixed costs

4- average annual rate of return

Show answer

Answer

1

Show question

Question

What is the margin of safety?


Show answer

Answer

The number of sales a business can fall before reaching its break-even point

Show question

Question

A business has a break-even point of 100 units and has sold 50 units. Calculate the margin of safety and interpret what this means.


Show answer

Answer

Margin of safety = 100 - 50 = 50 (units) → the business is making profits with 50 units; it can fall by 50 units before the break-even point is reached. 

Show question

Question

What is the formula for calculating the total costs?


Show answer

Answer

Total costs = (Variable costs per unit X quantity) + fixed costs

Show question

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