One of the family members of mine contacted me for asking for the advice as he is thinking to start the business for $ 3,000,000. The relative has lack of understanding related to the concepts of finance which include marginal revenue and costs, economic and financial capital, interest rates, opportunity costs, taxes, SWOT analysis a financial plan or financial statements. It is essential to make the relative aware of the financial concepts. This paper will help the relative to take the correct steps for starting the business or leaving the money in the bank account. It is suggested to not to keep the amount in the bank.
Establishing a business entity include four different ways through which a person can form the business. The decision related to business enterprise mainly depends on the circumstances and nature of the proposed business. The below given are the four different forms of the business entity: -
- Sole proprietorship: - A sole proprietorship is a business entity that is mainly owned by the individual owner. This is considered one of the easiest kinds of business because it doesn’t include any legal obligations that are required to be followed by the company (Jones, 2013). Running a business like a sole proprietorship also include few requirements such as simple tax reporting, fewer business expenses and freedom to run the business. In this form, the owner is responsible for the actions that has been taken by them for the company.
- Partnership: - Partnership is a form of business that is formed by the two or more people. The partnership includes the start-up fees which are different from the sole proprietorship. There are different types of partnership that has been performed by the people include limited partnership and limited liability partnership. All the decisions and actions get divided into both the partners with the division of profit (Trotman & Carson, 2018).
- Limited liability Company: - The limited liability company gives the flexibility to the sole proprietorship or partnership along with the protection of a corporation. The setting up of the LLC needs a registration of the company with the state agencies and paying off the fees.
- Incorporation: - Corporation is divided into the C and S Corporation and creating a company needs filling of the paperwork from the state agencies and paying the fees. A corporation can easily attract investors.
Marginal revenue and cost
Marginal revenue is an additional amount of revenue that is created by the increasing the sales of product by every unit. In simple words, it is also known as the unit revenue which was generated from the last item sold. The calculation of the marginal revenue can be done by dividing the changes in the total revenue earned by the change in the number of units sold. Change in total revenue can be calculated by deducting the revenue before the last unit was sold from the total revenue once the unit was sold (Pilbeam, 2018).
The marginal cost is referred to as the cost added by producing an additional unit of the products and services. The calculation of the marginal cost can be done by dividing the change in cost from the change in the quantity (Neave, 2017). This concept is mainly important in the allocation of the resource for the optimum results.
Economic and financial capital
Financial capital: - Financial capital refers to as the money that is mainly used to make the purchase of the needed capital goods. This financial capital can be grouped into the form of equity and debt, in which the debt mainly include the loans taken from a brand or corporate bonds (Hill, 2016).
Economic Capital: - It is referred to as the amount of capital that is mainly used by the organisation in the financial services to cover the unexpected risk that is faced by the company.
Opportunity cost refers to the benefit an individual, investor or business misses out while making the selection of the one alternative over the other. In simple words, it refers to as missing out one opportunity for other and that loss of the other opportunity is the opportunity cost. The analysis of the opportunity cost performs an important role in identifying the capital structure of the business (Accounting tools, 2018).
Opportunity cost= return of the option that is not chosen- the return of the chosen option
Interest rates and taxes
The interest rate is the sum of the interest which is due from a certain period, as a share of the sum lent, borrowed or deposited. The amount of interest rate depends on the sum of principle, the rate of interest, compounding frequency and the time period. This is important to be considered by the person who is looking to start a new business or for the person who is keeping their amount in the bank (Gitman, Juchau & Flanagan, 2015).
For instance; If the relative keeps the amount in the bank for the longer period of time then he will get amount as the interest for keeping their amount in the bank.
Tax is the compulsory economic charge or some type of the levy imposed on the individual person or the corporation by the government or the by the local entity. This will help the government to cover up the public expenditure and to develop the country. The failure of the taxes or resistance might lead to the punishable by the law. These excises can be direct or indirect taxes as it can be paid in the money or as it labour equivalent (Shoup, 2017). The taxes vary according to the government of the countries as they have different policies and regulations.
SWOT analysis is a study that is conducted by company or firm to determine its internal strengths and weakness with the entire external opportunities along with threats. In simple words, this analysis will help the company in determining the business competition and the project planning related to the financial terms (Chernev, 2018).
The financial statement refers to like the combination of the three major reports that is based on the business. It is the official record of the financial actions and position of a corporate or the added entity. In other words, the financial information is then presented in a set sort of structure manner an in an effective way that is easy to understand. In the perspective of finance, the 4 basic financial statements which are prepared by the company include the Income statement, Balance sheet, statements of cash flows and retained earnings statements (Sedlá?ek, 2016).
Financial principles by ratio analysis
The financial principles are required to be understood with the help of the ratio analysis as this will help them in understanding the benefits of opening the business (Hirschey, 2016). There are different types of the ratios which are essential to be calculated by the company. These include: -
The liquidity ratio helps in measuring the ability of the firm to repay the amount of debt that is taken by them as this will help in meeting the unexpected needs of the cash (Gitman, Juchau & Flanagan, 2015). The liquidity ratio include
Current ratio- This ration helps in measuring the ability to repay the current obligation of the company. The calculation can be done as-
Current ratio = Current assets / Current liabilities
The ratio that is standard is 2:1 which reflects that the company is able to repay the amount because it is able to maintain the current assets.
Acid test ratio- The quick assets or acid test ratio mainly include cash, marketable securities and other elements that can be used by the company to pay the immediate obligation of the company. This can be calculated as
Acid test ratio = Quick Assets / Current liabilities
The traditional rule of thumb for this ratio is equal to the 1:1 (Drexler, Fischer & Schoar 2014). This will help the company in understanding that the company is capable to pay to their obligations or not. If the company is not able to maintain the liquidity then they won’t be able to repay the amount.
The profitability ratio is essential as it measures the enterprise's operating efficiency which shows their capability to produce the income. The flow of the cash amount affects the ability of the company which is essential to obtain the financing of debt and equity (Penman, 2015).
Profit margin- This ratio help the company to measure the abilities of a company to turn the sales of a company into income.
Profit margin = Net income / Net sales
Asset turnover- This helps in analysing the efficiently use of the assets by the company.
Asset Turnover = Net Sales / Average total assets
The ratio reflects the way through which the company are making use of the assets to increase sales.
Return on assets- The ROA reflects the overall measure of profitability and it reflects the net income which is earned by the company. This ratio is the mixture of the asset turnover ratio and profit margin ratio.
Return on assets = Net income / Average total assets
This ratio helps in understanding that the company is earning a profit in the market or not. Therefore they make use of this ratio for evaluating the fact that it is able to survive in the market or not.
Solvency ratios are majorly used to measure the risk related to the long-term and related to the interest of the long-term creditors and investors (Laitinen, 2018).
Debt to total asset ratio- This ratio presents the proportion of the properties that are delivered by the creditors.
Debt to total assets ratio- Total debt / Total assets
Times interest earned ratio- This ratio helps company to indicates the capability of the firm to pay interest that remains due with the company.
Times interest earned= Income before EBIT / Interest expenses
All these ratios reflect the ability of the company to earn the profitability, to maintain the liquidity and to be able to pay off the debts. Further, all these ratios reflect the principles of the finance which is followed by the firm.
In the end, it is suggested to the family member to invest the amount in the business instead of leaving the amount in the bank. The reason behind the same is that they won’t be able to get an effective interest in the banks. The banks will pay the low-interest rate for a certain period of time due to which they won't be able to get the effective returns. The family member should open the business as they will earn more than the interest rates. This will be considered as one-time investment which will offer the benefit in the near future. Moreover, he can alone open the company as a sole proprietor because this form of business enterprise doesn’t involve any kind of legal obligations. Though, they will become eligible for paying the tax on profit that has been earned by them. The company can easily be managed by them if they will follow the essential financial principles which include ratios. The owner can use the ratios for measuring the facts that will guide them while making the decision related to the company. Along with this, they can maintain the financial statement which will help them in attracting the investors towards the company. This reflects that the company should proceed with the business as this is the way through which they can earn a maximum profit and leads to the opportunity for success in the near future.
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