Lesson 1: The Business and Its Objectives, University Economics Notes

Basic Notions of Accounting

You have one subject that is accounting, but we need to have a general idea of some accounting concepts and terms to understand some parts of the subject. This concepts are not part of the syllabus, but is useful to know them.

A company uses a Profit and Loss statement ("P&L", also called income statement) to measure the profit in a specific period of time.

The profit is the amount of money a company earns in a period of time. Are the revenues minus the expenses.

A P&L statement has always the same structure:

• Revenues
• COGS (Cost of goods sold)
• Gross margin
• Operating expenses
• EBITDA
• Amortization
• Operating profit
• Interest expenses
• Income before extraordinary items
• Extraordinary items
• Earnings before taxes
• Taxes
• Net income

P&L Explanation in a Restaurant Context

In a restaurant, the explanation of the P&L will be the following: We need to know the period of time of the P&L (a month, a quarter, a semester, a year, etc)

Revenues: +20.000 EUR These are the revenues (or sales) that the restaurant had because they have sold food and drinks.

COGS (Cost of goods sold): - 5.000 EUR This is the cost of the products that they use to generate revenues. The cost of the drinks (beer, water, etc) and the cost of the food that they buy to the suppliers. In manufacturing companies, COGS are high (in relation with the total revenues), in service companies are low (in relation with the total revenues)

Gross margin: 16.000 EUR Is the first measure of margin that we can found. In a restaurant is, for example, the different between the price of a sandwich and the cost of the ingredients of the sandwich (bread, ham, cheese, etc) In a restaurant a common gross margin is between 66% and 75% of the revenues. That means that the price of the product for your costumer is between three times and four times the cost of the ingredients that you use. When we analyse margins is usual to show them as a percentage of the total revenues.

Operating expenses: - 8.000 EUR This are costs necessary for the operations (to produce). For example: electricity, salaries and wages of the employees, rents, etc. In a restaurant the most common operating expenses are the salaries of the employees, the electricity and the rent of the property

EBITDA: 8.000 EUR EBITDA means "earnings before interest, taxes, depreciation and amortization"Is one of the most important figures that you can find in a P&L. Its importance comes from the fact that you can analyse the core business of the company. If the EBITDA of a company is negative, the core business is loosing money. In a restaurant is the money that you have after paying the cost of goods sold (the ingredients), the salaries, the electricity, the rent, and other operating expenses. Basically the EBITDA is going to tell you if the company is generating money or not.

Amortization: - 3.000 EUR Actually is amortization and depreciation but we will focus on the amortization that is a more important concept. Amortization is an accounting concept that doesn't represent a cash out of the company. Imagine that you buy several machines and furniture for your restaurant, you spend 180.000 EUR. After 5 years you know that you have to buy new machines and furniture, so you have an accounting entry that is telling you that every year (or every month in this case) you have to save money because your assets are depreciating. The amortization is the cost of the depreciation of your assets. You have to save every month 3.000 EUR so after 5 years you will have 180.000 EUR to buy the new equipment. But, in fact, you are not giving this money to anyone, this money is in your company. This is something that you will study in detail in accounting, you only need to have a general idea of what amortization is.

Operating profit: 5.000 EUR The operating profit is called EBIT ("earnings before interest and taxes"), specially when there are no extraordinary items. In the restaurant is the money that is earning after "saving" the amortization.

Interest expenses: - 1.000 EUR Interests that you pay for the loans that the company has. The restaurant asked for a loan of 180.000 EUR to buy the machines and furniture, and it has to pay a 6,66% annually in a monthly basis.

Income before extraordinary expenses: 4.000 EUR Many times you won't find this line of the P&L because there are no extraordinary expenses, so you go directly to the earning before taxes.

Extraordinary items: 0 Usually there are no extraordinary items. The concept of an extraordinary item is a profit or a loss that the company has with no relation with the ordinary business. In a restaurant could be any profit or loss that has no relation to the core business as selling assets (you have an old motorcycle for the delivery, you sell it and someone pays to you a lot of money because is a vintage motorcycle model, or you are the owner of the property where you have the restaurant, if you sell the property and you earn a lot of money, this is an extraordinary item) Extraordinary items are not going to happen in the future, is not part of the recurring business of the company.

Earnings before taxes: 4.000 EUR

Taxes: - 1.000 EUR In Spain is a 25% of the earning before taxes.

Net income: 3.000 EUR The money that you earn is not the same as the money that you generate. The money that you generate is the cash flow, the money that you earn is the net income. You can see the difference with the amortization. The restaurant is earning 3.000 EUR, but in the bank they have 6.000 EUR (net income + amortization). Don't worry because you have a subject to study and understand this concepts. The concepts that are more important and you need to understand are the revenues, the EBITDA and the net income.

Balance Sheet Overview

The balance sheet is a picture of the rights and duties that a company has in a specific time, the assets that a company has and how did they get this assets. In a balance sheet we have two parts, one are the assets and the other are the liabilities and the equity.

Assets: Rights and resources owned by the company. Is what the company has. Liabilities and equity: Are the explanation of how the company got the assets. Liabilities are debts and duties that the company has. Equity is the money that the owners have invested and re-invested.

Example: Imagine that all the properties that you have are one car that cost you 15.000 EUR and 2.000 EUR in a bank account. The car and the bank account are your assets. You obtained the car with a loan of 12.000 EUR and the rest with your savings.

15.000 Car 2.000 Bank account Bank loan 12.000 Equity (personal savings) 5.000

The Cash Flow statement measure the evolution of the cash flow of a company in a period of time. The cash flow is the money generated by a company in a period of time.

Business as a Production Economic Unit

Classical Definition of Business

When we talk of classical definition we are talking of the fathers of the economy that founded the modern economic theories in the 18th and 19th century in Great Britain:

• Adam Smith (1723-1790). Founder of the classical free market economic theory. His most famous book is The Wealth of Nations (1776).
• David Ricardo (1772-1823). His most famous book is Principles of Political Economy and Taxation (1817)
• John Stuart Mill (1806-1873)

In the classical school a business is an institution that t ransforms the main factors (labour, capital and natural resources or land) into goods and services. The objective of a company is to transform inputs into outputs. This theory is based on three assumptions that are:

• Perfect markets (but markets are not perfect as we see when arbitrage opportunities arise or when financial bubbles appear)
• Transparency of pricing (but there is usually no transparency of pricing)
• Rational agents (but there is no "homo economicus", actually there is one branch of the economy called behavioral economics that explains the irrationality of the agents)

Market Theorem

The company is going to be studied only as part of the markets. The analysis should be focus on the supply and demand of the markets, not on the participants of the market.

Transaction Cost Theorem

It is a theorem developed by Ronald H. Coase (1910-2013) in 1937, Ronald H. Coase received the Novel price of Economic Sciences in 1991. Why companies appear instead of markets? In the classical economic school, markets are always efficient, so why would companies appear? Companies substitute markets when they are more efficient allocating resources. To know who is more efficient allocating resources we must compare market transaction costs to internal organization costs of the company. If market transaction costs are lower than internal organization costs of companies, markets will appear.

Market transaction costs can be divided into:

• Information costs. Is easy to identify the agents involved in a transaction? If we want to buy an illegal drug, it is difficult to find a supplier, if we want to buy fruit is easy to identify them. With Internet, information is more available, and is easier that markets appear because is easier to find the suppliers.
• Bargaining costs. Is the contract standardize? Do we need to create specific clauses and conditions for our contract? If the contract is standardize, the bargaining costs are low (when we want to buy fruit the clauses are really simple, you pay and you receive a piece of fruit), but sometimes contracts are complex and we need to negotiate a lot of clauses (imagine you want to built a skyscraper, you need to negotiate the materials, cost, schedule, etc), in this case bargaining costs are high and is more difficult that markets appear.
• Policing and enforcement costs. Do we need a continuous supervision of the product in the future? If we need to supervise and monitor the performance of the product, or if we need that the supplier guarantees the performance of the product, policing and enforcement costs are high. If I am going to built a skyscraper, I need that the constructor could